Is your ESG data unlocking long-term value?

While ESG was already an important factor for many, the COVID-19 pandemic has led to a rapid evolution. The 2021 research shows it is seen as central to how investors make their decisions:

• Ninety percent of investors surveyed said that, since the COVID-19 pandemic, they attach greater importance to corporates’ ESG performance when it comes to their investment strategy and decision-making.
• Eighty-six percent of investors surveyed said that a corporate having a strong ESG program and performance would have a significant and direct impact on analyst recommendations today.

But at the same time, the research also found that slightly fewer than half (49%) of investors had updated their ESG investment approaches.

The research also found that ESG risks had become a more important part of investment decision-making and portfolio construction, with close to three-quarters (74%) of investors surveyed stating that the COVID-19 pandemic had made them more likely to divest based on poor ESG performance. However, fewer than half (44%) of investors surveyed said the events of the past 18 months had resulted in them updating their investment risk management strategies and processes.

The COVID-19 pandemic has also brought social considerations to the fore, with consumers mobilized on social issues and investors placing a greater focus on the “S” element of ESG.

Investors are focused on consumers when it comes to social risks

What are the two issues that are most important when you are evaluating a company’s performance or risk against social issues?

Note: Respondents were only able to select two issues – the most important. Each percentage shows how many respondents selected an area as among their top two issues. The table features the top five risk issues only.

Moving forward, the challenge for the investment industry will likely be how to access and analyze the data required to link social impacts to financial performance. The lack of data could make it difficult to achieve a comprehensive inclusion of social factors in portfolio decision-making.

Investors are putting significant and increasing emphasis on their portfolios’ exposure to climate change – both the physical climate risks and the risks from the inevitable transition toward a net zero global economy:

• Seventy-seven percent of investors surveyed said that, over the next two years, they will devote considerable time and attention to evaluating physical risk implications when they make asset allocation and selection decisions – an increase from 73% of investors surveyed in 2020.
• Seventy-nine percent of investors surveyed said that, over the next two years, they will devote considerable time and attention to evaluating transition risk implications when they make asset allocation and selection decisions – an increase from 71% of investors surveyed in 2020.

However, the research found that fewer than half of investors surveyed (44%) have a highly mature approach when it comes to assessing performance from a climate risk perspective.

Assessing climate risk can be challenging: it is highly uncertain, sometimes difficult to quantify, and difficult to hedge against, because of the systemic and pervasive nature of climate risk. The issue is complicated because there is still more to be done on the corporate side regarding climate risk. The 2021 EY Climate Risk Disclosure Barometer, which examines more than 1,100 companies across sectors, found that not all are undertaking a climate scenario analysis, and those that do are inconsistent in their approach. The research shows that only 41% of the organizations assessed have disclosed whether they conduct scenario analysis to examine the likely scale and timings of particular risks and prepare for the worst-case outcomes.

Furthermore, the research shows that corporate decarbonization is central to investors’ investment decision-making, with 86% of respondents saying that investing in companies that have aggressive carbon reduction strategies is an important part of their strategy. Making progress toward net zero and decarbonization will likely require companies to produce a robust approach to scenario planning, and investors to engage closely with organizations on their strategies:

• Companies should undertake robust scenario planning to help understand the potential implications of a range of climate outcomes and stress-test the current risk management and strategy processes within their business.
• Investors should engage with companies on the need to recast their organizational strategies to incorporate decarbonization and ESG factors. They should also determine a forward-looking view of decarbonization strategies.

While the transition toward a net zero carbon economy presents significant material challenges, efforts by national governments to encourage the transition could also be an opportunity for investors. Ninety-two percent of investors surveyed said they had made an investment during the previous 12 months because they saw that target benefiting from the green recovery.

However, this opportunity could become a victim of its own success. With a potentially limited supply of suitable green investments achieving high sustainability scores from ratings providers, there is a risk of a market bubble: 76% of investors surveyed said the “shortage of supply in suitable green investments will lead to some investors overpaying for green assets, creating the risk of a market bubble.” As we explore in an article on the role of investors in financing the green recovery, there are also other factors that could dampen some of the concerns over a market bubble: the sheer volume of finance likely required to achieve renewables goals and the significant amount of equity capital that will likely need to flow to those organizations in emissions-intensive sectors.

While investors are putting ESG performance at the heart of their decision-making, there are two priorities that could help to realize its full potential.

First, investors should receive better-quality ESG disclosures and data from companies. Progress also should be made by standard-setters and policy-makers around a clearer regulatory landscape governing these disclosures. Despite the importance of ESG performance reporting to the industry, there are some concerns about the transparency and quality of ESG disclosures they receive, particularly around their materiality.

In fact, this concern is growing: 50% of investors surveyed said they are concerned about a lack of focus on material issues – an increase from 37% in 2020. Investors are also clear that globally consistent standards are likely to be important to improving the quality and transparency of corporates’ ESG reporting: 89% of investors surveyed said they would like to see reporting of ESG performance measures against a set of globally consistent standards become a mandatory requirement. As examined in a previous EY article, this perhaps reflects the importance of more uniform global standards to transparent measurement and high-quality disclosures around ESG performance, which in turn can underpin good business management, and help to build and preserve stakeholder trust.

Second, building data analytics capabilities could be key to helping corporates produce trusted ESG performance reporting and investors incorporate that insight into their investment decision-making process.

To build a data edge and improve quality, investors will likely require a data management approach where they can process and channel relevant and high-quality data with flexibility, cost efficiency and effectiveness – with security and resilience – into the investment process. However, the research shows that fewer than half (46%) of investors surveyed have a fully deployed and sophisticated approach to data management, with a central ESG data repository where data can be accessed simultaneously and in real time by many different applications.

Technology and data innovation can be important to both the companies issuing ESG performance data and the investors consuming that insight:

• As demand for deeper and more credible ESG performance data and insight grows, corporates should improve the way they collect, aggregate and take management responsibility for their own data.
• For investors, innovation in areas ranging from cloud computing to AI can help integrate ESG data into investment analysis. For example, AI can allow investors to uncover material data that may exist outside a company’s formal ESG disclosures.

To help ESG factors play an important role in post-COVID-19 pandemic economic health and renewal, there are a number of important actions for both the corporates issuing ESG reporting and the investors that then utilize that information:

• Corporates should better understand the climate risk disclosure element of ESG reporting; make strategic use of the sustainability function to help inject rigor into the process to determine the materiality of their ESG context; engage with, and embed, the finance function to consider and align financial and value implications; and deepen engagement with investors, including understanding the new ESG disclosure requirements that can differentiate a company from its competitors.
• Investors should update their investment policies and frameworks for ESG investments while building an ESG-driven culture; update approaches to climate risk so they can interpret and understand scenario analysis of the potential consequences of climate risks to target companies and sectors over the short, medium and long term; and put in place a bold and forward-looking data analytics strategy.

Summary

The COVID-19 pandemic has helped to catalyze the importance of ESG-driven approaches in both the investor and corporate communities. But the research shows both sides have more to do to help ESG-driven approaches provide greater impact. Forward-looking companies may be more likely to unlock the value of ESG data – helping them to play an important role in building a more sustainable and prosperous post-COVID-19 future.