Sovereign Investors and ESG: Appeal and Reality

Corinne Neale, Global Head of Business Applications, BNY Mellon Data and Analytics Solutions

Environmental, Social and Governance (ESG) considerations are increasingly front-of-mind for sovereign investors – including sovereign funds, central banks and public pension funds. In fact, most we have come across already consider underlying ESG issues as part of their investment decision-making processes – at least informally.

A recent discussion at BNY Mellon’s recent Sovereign Academy, however, highlighted that widespread ESG integration continues to be hindered by the ongoing confusion that stems from the lack of common industry standards and lack of consistency in ESG data. With hundreds of vendors flooding the market offering their own take at sustainability scoring, integration has become a more confusing prospect, creating a paradox of choice.

Anecdotally, most sovereign investors are in fact keen to understand and adopt ESG analysis in their investment strategies. Given their varied mandates and often longer investment horizons, ESG and impact investing can offer a compelling opportunity to put capital to work into sustainable investment strategies and markets. Singapore’s Temasek, for instance, is among those that have already established an impact fund to invest in companies supporting everything from financial inclusion and health, to smart cities and companies tackling climate change.

Still, while sovereign institutions will have a critical role in scaling up ESG investments globally, the discussions with sovereign stakeholders in recent months have surfaced no shortage of frustrations around issues that are currently hindering adoption.

Consider, for instance, the lack of consistency in ESG scores across suppliers. There are currently more than 150 vendors providing data or sustainability rankings, which lends to discrepancies and trust issues in the underlying factor data. Some vendors may reward companies for disclosure alone, whereas others focus more closely on specific metrics reflecting a corporation’s environmental and social impact. Unlike credit rating agencies, which are largely aligned in how they assess and report credit risk, the lack of a common standard to arrive at ESG scores makes it difficult for investors to contextualize the materiality of the rankings.

Another issue relates to the scale of available opportunities. While ESG as a topic continues to surge in popularity, identifying compelling opportunities remains a challenge. The latest GIIN survey, published in June, saw nearly three quarters of respondents (74%) cite the lack of high-quality investment opportunities as either a significant or moderate challenge for those seeking ESG or impact investments. This shortage of opportunities is even more pronounced for sovereign investors with assets under management that can extend to 12 figures.

Moving from the ‘Why?’ to the ‘How?’
Contrary to public perception though, the slow momentum among some sovereign investors when it comes to ESG investing is not intentional. In fact, there was a clear demand among those at the BNY Mellon Sovereign Academy event for clearer data and industry support to use ESG more actively in portfolio construction.

The good news is that technology should help sovereign investors to better monitor and establish their own set of ESG guidelines quickly once they get their arms around their approach to ESG and their specific objectives. Many sovereigns were initially reluctant to embrace the cloud, for instance. However, as institutional investors gravitate to data science applications, there is growing recognition that cloud adoption cannot be put off any longer. The upshot, as it relates to ESG, is that the cloud will help to facilitate the dissemination of information and allow for further experimentation to refine and improve current analysis. Moreover, the development of cloud-enabled solutions lends itself to creating greater transparency in a market that remains quite opaque. As a consensus forms, it will serve to eliminate some of the confusion around the preferred metrics and ESG factors that influence value creation.

Another related challenge that can be addressed with the right technology has been the ability to attribute ESG factors to outperformance. There are studies that help make the case for ESG in certain circumstances. For instance, one study outlined that board diversity could be correlated to stocks with lower volatility, higher outperformance and companies that invest more in R&D. And anecdotal evidence – from the BP oil spill to PG&E’s recent bankruptcy to WeWork’s failed IPO more recently – highlights the risk of overlooking environmental, social and governance factors in stock selection. Within individual portfolios, artificial intelligence, machine learning and data science are critical to identifying the extent to which ESG factors contribute to value creation, risk management and ultimately gauging whether specific investment and sustainability objectives are being met.

Several challenges remain before ESG truly gains critical mass across the global investment landscape. That said, the pace at which the investment community understands ESG and recognizes its potential is rapidly accelerating. In a way, too, some of the issues that confound sovereign investors and other asset owners today – such as the influx of vendors and available metrics – speak to role of the platform model in data management and analysis. Because just as an open ecosystem encourages innovation today, it will ultimately facilitate adoption once a consensus forms around the metrics and strategies that are most material in driving value creation.

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