Comment: Solving the ESG credentials dilemma

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While there is no doubt that the current pandemic has catalysed rising demand for ESG investing, what remains to be seen is the impact this is going to have on the existing structures within the wealth management industry. The priority, though, lies with fine-tuning the ESG scoring system, writes Andrew Watson.

It is important to remember that this sector is still very much in its infancy, with a looming lack of clarity around how ESG criteria is and should be calculated. What needs to accompany this growth in the sector is greater uniformity to how we quantify and classify ESG.

There are those that have argued the covid-19 economic downturn will reduce the quality of ESG data as firms look to cut back on costs. Despite this argument not being without basis - in the past financial downturns have often led to reductions in data quality - this will not be the case here.

It remains to be seen what approach will be taken to bridge the information gap that currently exists across the industry."

Why? With the sheer amount of money that is now invested in firms and funds with higher ESG credentials, any company that fails to provide this information will find it very difficult to attract capital. Recent headlines have strengthened this point further, with many investors ranking ESG factors as a more important consideration before making an investment than the interest rate outlook.

Certainly, in the short-term scandal avoidance equals more profit and in turn avoiding large fines or the consumer tide turning against you. In the long-term, with the UK government target of achieving net carbon neutrality by 2050,  we could start to see sanctions for companies with high carbon emissions.

Another area which is likely to change is ESG scoring, driven on the one hand by a renewed regulatory focus and shifting investor expectations on the other. The main area that scoring is helpful for is monitoring changes of ESG factors within a portfolio to show areas that need to be investigated further, however ESG scores in themselves are not.

When it comes to reporting the value of ESG investments to clients, scoring is very problematic, as it oversimplifies that change, giving neither context nor justification. What investment managers should be providing their clients with is a narrative and rationale for that investment alongside metrics that have real meaning.

For example, imagine a client goes to their wealth manager and says ‘I want a portfolio with tangible ESG considerations, and I'm particularly interested in carbon emissions. The wealth manager responds with ‘this  has an ESG rating of 8/10, invest here.'

What does that really tell me? What the wealth manager needs to do here is to show they understand which aspects of ESG the client cares about most, and break this down into meaningful insights that clients can understand, such as: "You should invest here because this company has recently lowered their carbon emissions by X% and is changing their sustainability policies, which has positively impacted the share price by X% over the last month."

Investment managers will have greeted the rising popularity of ESG investments with joy, but they must not rest on their laurels. With increased interest is going to come increased expectation. Getting ahead of the curve now with the right technology to gather these insights and communicate them back to the end-investor will not only enable investment managers to provide a better client service, but also prepare them for likely regulatory change in the future.  

It remains to be seen what approach will be taken to bridge the information gap that currently exists across the industry. With there still being an absence of definition from regulatory bodies, changes are likely to come on a company by company basis.

The challenge that must be acknowledged is that ESG is just one of many considerations that must be balanced with elements such as performance and risk. Within this context,  regardless of the ESG methodology wealth managers adopt, ultimately it needs to be able to explain the complexities of ESG factors in a way that clients can understand, and be rooted in data driven insights to be able to withstand these challenges.

Andrew Watson is chief product officer at JHC.