Written by: Antony Bream, Executive Contributor
Executive Contributors at Brainz Magazine are handpicked and invited to contribute because of their knowledge and valuable insight within their area of expertise.
2022 broke all records across the world as the climate heats up amidst desperate efforts at UN climate change conferences to find ways to reduce carbon emissions.
Corporations face a huge responsibility to play a part in achieving the target of limiting a 1.5 degC temperature rise by reducing global emissions 45% by 2030. The Net-Zero Asset Owners Alliance, the gold standard for credible commitments and transparent targets, is managing $10 trillion in assets and catalysing change across industries but more needs to be done. Another such initiative aimed at corporations to make them achieve this target is driven by ESG, a framework to help stakeholders understand how an organisation is managing risks and opportunities related to environmental, social, and governance criteria (sometimes called ESG factors). ESG takes the holistic view that sustainability extends beyond just environmental issues. While the term ESG is often used in the context of investing, stakeholders include not just the investment community but also customers, suppliers, and employees, all of whom are increasingly interested in how sustainable an organisation’s operations are. The Capital Markets can be a powerful tool to create change. By restricting access to capital (or making the terms under which it’s available less favourable), bad actors may be incentivised to improve performance across E, S, or G measures. Conversely, rewarding companies and their management teams that are performing well against ESG factors encourage continued progress and improvements. Many ESG investment vehicles have emerged, including green bonds, mutual funds, ETFs, and index funds (among others). These publicly traded instruments make it easier for investors to align their investment decisions more closely with their own beliefs and values around E, S, or G factors. But Can ESG data be used to generate alpha? Finally, the data and evidence to answer this question follows:
Asset Managers are facing a predicament. We’re not talking about dealing with all the confusing ESG rules and regulations (although that’s high on the list). We’re talking about whether ESG data can be used to generate alpha. We know the importance of ESG in making the world a better and fairer place, but there’s also a great deal of empathy for Asset Managers who need to generate a healthy financial return during our economic uncertainty ‒ one that’s presented itself so shortly after the pandemic. The good news is the correlation between ESG factors and alpha may be stronger than you think.
Let’s clarify, what do we mean by alpha when it comes to ESG? Alpha is the excess return of an investment relative to the return of a benchmark, such as the S&P 500 index. In the context of ESG, many investors are now attempting to carry out ESG performance attribution and assess the importance of ESG factors on performance. This involves breaking down any alpha generated from a fund so that investors can determine the impact of ESG integration on their fund’s returns...
Why has the relationship between ESG and alpha been hard to prove historically? A large part of it comes down to the quality of data.
Asset Managers have largely had to go by on inconsistent data, varying standards, data gaps and inauthentic data disclosures. With the data being unreliable and/or not indicative of the full picture, it skews any workaround attributing performance to ESG factors. This is still a challenge today with the S in ESG being particularly challenging as a lot of social data points are inherently more subjective than Environmental or Governance data points. On that note, things have got, and are getting, a lot better. Bringing us on to the next question. How is ESG data improving? Leading ESG measurement frameworks are starting to converge, creating the possibility of a more standardised landscape for tracking and measuring ESG performance. There’s increasing pressure now on corporations to disclose more and there’s initiatives to make it easier to do so, such as the CDP and TCFD. This means Asset Managers will get more disclosed data from businesses. Now that’s great but Asset Managers then need to make sense of the data, and this only becomes faster, easier and more reliable with the use of advanced technology. Fortunately, this is now more readily available for Asset Managers to use within a few clicks (watch out for platforms claiming to be advanced but only deliver a basic view).
One of the features of advanced ESG analytics should be that it collects a lot of data from a variety of different sources (such as NGOs) so that you’re not just relying on company disclosures alone ‒ particularly at a time where greenwashing is so prevalent. What does some of the most advanced data show when it comes to a correlation between ESG performance and returns? One company providing the data and analytics to address these challenges is GaiaLens with an advanced ESG analytics platform who did a little data digging.
They carried out research investigating the relationship between their S & G scores and company valuations for companies by country. For the US, when they ran the top-scoring companies and the bottom-scoring companies through the valuation model, they found that on an EV/IC basis, the top-scoring companies trade on 1.4x vs. 0.9x for the bottom-scoring companies representing a significant difference. It’s not too dissimilar for the UK. On an EV/IC basis, the top-scoring companies trade on 1.3x vs. 0.8x for the bottom-scoring companies. The data highlights a strong positive correlation between their S & G scores and company valuation, and this was the case for many other countries as well. A trading idea off the back of this would be to look at those companies that score highly but are trading at a discount relative to peers.
How can you do the analysis yourself and tell if your ESG funds will generate alpha? As mentioned, you need access to comprehensive, reliable and transparent data that also scores individual companies. Crucially, when it comes to ESG scores, you need daily scores with a history of at least 2 years and if you want to carry out analysis over a longer time period, you need historical ESG scores going back at least 10 years. This allows you to identify companies that are well-managed, have strong governance practices, and are committed to sustainability, so that you can see if they are outperforming companies with lower ESG scores. Don’t underestimate how important the right technology is here. You need a platform that can collect, store, and analyse large amounts of ESG data from various sources, allowing investors to quickly and easily access the information they need. GaiaLens’ platform used for the analysis above, combines both structured data (e.g., carbon emissions) and unstructured data (e.g., processing the news for 17,500 companies that we cover and highlighting the latest ESG scandals in real-time) to provide Asset Managers with the full picture. What should Asset Managers do going forward? Going into a recession, Asset Managers are struggling to get the balance between focussing on ESG as well as focussing on their returns target. Knowing that there’s a relationship between the two is reassuring, but you can easily do this analysis (and a lot more) if you have access to the right ESG data and scores. You’ll be able to see how individual companies are performing on the ESG front and you’ll also mitigate risk by avoiding companies with poor ESG practices, which can lead to negative impacts on financial performance. So, step 1 is to get yourself access to the data. Step 2 is to ensure you’re not letting the looming recession, budget cuts, and a skills shortage deter you from your ESG efforts. When taking ESG factors into account, it can lead to outperformance compared to the broader market. To find out more about how our ESG analytics platform can support you through the whole ESG investment lifecycle and save you a significant amount of time and money, visit www.gaia-lens.com and book a demo.
Gordon Tveito-Duncan, Co-Founder of GaiaLens
Gordon is Co-Founder of GaiaLens, a comprehensive ESG analytics platform for asset managers and investors. He’s also an experienced financial analyst having worked as an Equity Research Analyst at an investment bank covering the Technology sector. Connect with him on LinkedIn.
Antony Bream, Executive Contributor Brainz Magazine
Antony Bream, is a business advisor and executive coach working closely alongside founders, boards and their teams to help them and their businesses take the leap to their next level. With a passion for understanding the processes and psychology behind how companies sell their products and customers buy them, he formed Ribbit Consulting to bring that experience and knowledge to his customers to empower them to reach their full potential.
