Meeting the ESG data needs of institutional investors

Panelists in the May Think ESG webcast weigh in on the latest reporting developments in the ESG ecosystem.

In brief

• At a minimum, deploy an investor-focused materiality approach to focus on the most significant ESG issues (though increasingly a broader lens of materiality is expected).
• Develop an appropriate communication cadence to keep the markets informed on ESG topics; be consistent across the disclosure footprint.

Ernst & Young LLP hosted the Think ESG: meeting the ESG data needs of institutional investors webcast that provided key takeaways for investors and preparers on emerging issues identified around environmental, social and governance (ESG) data. The webcast addressed institutional investors’ perceptions of the level of depth and context in ESG reported data, the interaction between corporate strategies and ESG data, the reporting ecosystem, and priorities for ESG disclosure.

1. Lack of depth and context in ESG reporting

Analysis of ESG data, narratives and trends can provide a broad range of insights into a company’s operational performance and financial prospects, supplementing insights derived from financial data. Unfortunately, many of the investors we speak to indicate that that ESG disclosures often miss the context that makes the information useful.

Absent information that grounds a metric within the business model, scale or geography of the firm’s operations, such data can be hard to use in investment management. For example, you could have the exact same reported metric from one company that means great performance, and the same metric for another company in the same industry can mean poor performance; the difference between the two could be scale, location or degree of vertical integration, among other factors. Investors on our webinar also noted that to readily incorporate ESG data into investment management practice, companies should also focus on the accessibility and machine-readability of the ESG data they disclose.

Effective use of disclosed ESG data by investment managers requires knowledge and judgment — the type that is based on deep industry experience. Single data points and scores are unlikely alone to tell a useful story about ESG and its connection to financial performance.

Investors on our webinar highlighted that it is important for companies to provide relevant ESG data in a spreadsheet file — make it machine-readable and thus more accessible for the investment management community.

2. How do strategies and ESG data interact?

Another takeaway from the investor panel is that a missing element in ESG disclosure is often the forward story. Given the connection of ESG to long-term value, an understanding of a company’s present and future strategy for ESG may be important for evaluation of performance and prospects, particularly in the context of the transition to a low-carbon economy.

A company’s strategy toward ESG will depend on many factors, from negative business model impacts, the extent of consumer pressure and investor engagement to exposure to regulatory initiatives in key markets. Companies do have a menu of choices: to be a leader, a fast follower or an intentional laggard in the sustainability transition. Some companies want to get ahead early, demonstrate stakeholder awareness and use ESG as a strategic opportunity. Others want to see how practice develops before diving in — in the context of regulation, to focus on compliance rather than transformation.

Many investors, such as those on our panel, are trying to identify and assess the key financial drivers of a company’s success, by sector, and then looking at how ESG issues either directly or indirectly intersect with those financial drivers. In the tech sector (as in so many others), for example, human capital is a key financial driver. An investor analyzing a company in that sector may need to form a view of the people who work there and the human capital management practices and corporate culture that surround them. Are workers engaged? Is turnover high? Can the firm tap necessary talent pools? Answers to these questions can have direct financial impact on costs of labor. Is there plenty of appropriate workplace training? Is the workplace diverse? These appear to be key questions for both a management team and an investor. Asset managers point out that answers can rarely be derived from the lengthy narratives in published reports or in a company’s ESG ratings. Several investors noted that some of this informational gap could potentially be bridged by the SEC’s anticipated rulemaking on human capital disclosure, extending the 2020 changes on human capital disclosure in Regulation S-K.

The interaction of strategy and ESG data is dependent upon understanding the key financial drivers of a company’s success, by sector, and the interaction of those financial drivers with ESG issues.

The investors were clear that ESG is not a monolith (and the term “ESG” is a shorthand that likely is overused). The type of ESG information investors seek is not uniform. For example, fixed-income investors don’t invest the same way that equity investors do; credit investors may be more focused on downside risk within the tenor and call structure of the debt. That may narrow the set of both financial and nonfinancial indicators relevant to that investor. When a fixed-income investor is engaging with the company, they’re more likely to engage with finance rather than investor relations and ask about shorter-term risks and risks that have the potential to be acute.

3. ESG data ecosystem

Integration of ESG issues into investment management is becoming increasingly sophisticated. Investors are using judgment, industry expertise and sustainability-issue awareness to drive analysis, products and strategies. For data to be useful, it should be relevant and related to the primary activities of the company. The investors indicated that a materiality lens can provide this focus, lessening the tendency for companies to lose their ESG narrative in peripheral or largely irrelevant topics.

The significance of ESG issues also varies significantly by sector, with sector analysts adding ESG benchmarking, on material issues, to existing peer comparison approaches. Consequently, sophisticated investors are looking beyond a headline ESG rating, drilling into the most critical data points by sector and comparing across peer groups. Depending on sectors, those data points could be carbon intensities, waste intensities, employee turnover, diversity rates and injury rates. How do these look over time? Is there momentum? How do they compare? Has a company set targets? What was the basis of those targets? Is it decarbonizing faster or slower than its peers?

Companies should develop a very clear narrative for the capital markets, embedding ESG consistently across its disclosure footprint. Ongoing, year-round engagement with institutional investors can help with rigor and focus.

ESG data should be relevant and related to the primary activities of the company. A materiality lens can provide focus and prioritization.

A common mistake in the ESG data ecosystem is to equate ESG ratings with credit ratings; often they use the same type of rating output, but the underlying work is very different. A credit rating looks at a narrow set of financial data to understand the likelihood of financial default. By comparison, an ESG rating is based on a much broader range of themes whose significance is contested. For example, the same ESG data is often treated very differently within rating taxonomies. That causes the ratings of the same companies to diverge in a way that credit ratings do not. In fact, the more companies disclose, the more divergent the ESG ratings appear to become. As such, it’s important to treat an ESG rating as a potentially useful opinion — just another data point in a sea of data points that requires knowledge and experience to interpret.

Engage with your 10 biggest investors to understand the ESG themes they follow and the data they need.

4. Priorities for disclosure

In summary, our panelists wanted to see prioritization and focus in approaches to ESG and attention not just on disclosure but on strategy and the forward story. The following are a few simple elements to that approach:

• At a minimum, deploy an investor-focused materiality approach to focus on the most significant ESG issues (though increasingly a broader lens of materiality is expected).
• Integrate ESG into strategy.
• Develop an appropriate communication cadence to keep the markets informed on ESG topics; be consistent across the disclosure footprint.
• Provide a forward story across a time horizon appropriate to your industry.
• Prepare for regulation.
• Engage with investors year-round.

The views reflected in this article are the views of the author and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization.