ESG measurement – hot data for a cooler world

Trustees are expected to demonstrate good governance too. Crucially, this no longer simply involves knowing how much return was generated, and how much risk was needed to achieve it. Good governance – as supported by the Pension Regulator’s (‘TPR’) guidance – requires trustees to understand what caused the returns. It implores trustees to try to positively influence and improve the sustainability of their investee companies through engagement with their investment managers.

To introduce greater rigour into this process, TPR now requires trustees to disclose their policies on Enviromental, Social and Governance (ESG) and climate risk and how they incentivise asset managers across their investment portfolio in their Statement of Investment Principles for responsible investment which has to be published online from 1 October (and earlier for some schemes). Trustees are required to publish how they are following those policies in their annual report and accounts via an Implementation Statement, which comes into force later this year.

This additional reporting, and therefore the measurement necessary for it, has taken on increasing importance. But what does it mean?  In this blog we focus on helping you to understand what climate data you may see, from what sources, and what you should do with it. 

Recent draft guidance from the Pensions Climate Risk Industry Group recommends schemes “should request data from their asset managers on carbon footprinting, engagement and exposure to carbon-related assets. They should analyse that data, and use it to inform decision-making, as well as aggregating the data to an asset class-, fund- or portfolio-level and report it.” 

The guidance also states that “trustees’ choice of metrics should also include both outcome metrics – those measuring the climate change risks and impacts of their investments (GHG emissions, weighted average carbon intensity, exposure to carbon-related assets, proportion of fund in low carbon opportunities) – and process metrics – those reflecting governance processes for managing exposure to climate change.”

Trustees need quality, decision-useful data in order to properly analyse and compare investments, so their decision making is rigorous, informed and beneficial. 

There are three key sources of data that are important for a scheme: investee company, asset manager and investment consultant. There should be one key objective from all three – enable the trustees to be better informed, and help them make decisions that lead to better returns with your sustainable investing.
 

Most pension schemes employ asset managers to select ESG investments and engage with the underlying companies. Through their stewardship, trustees want their asset managers to drive changes that will enhance returns and/or reduce risk. 

Sir Dave Brailford, the cycling coach, famously aligned winning with the aggregate impact of marginal gains. Do asset managers place enough emphasis on marginal gains? Is there pressure on companies to disclose data that will be useful and meaningful sufficient in achieving these gains? How do we know if they are marginal or likely to have a more profound impact?

Company disclosure is key to asset managers (and therefore pension schemes) ability to consider climate risk in their investments strategies. We have seen company disclosure improve over the past few years, primarily due to: 

• Standardised reporting frameworks such as the Taskforce for Climate-related Financial Disclosures (TCFD) framework, which has become the primary reporting framework for climate-related data.
• Legislation and government policy that is increasingly requiring companies to disclose key carbon metrics and climate risk action plans. Indeed, Canada made climate disclosure a requirement for companies who were to receive government bailout money after the recent Covid-19 epidemic. 

The direction of travel will see companies disclose additional ESG data that asset managers may take into account either in their investment decision making or their stewardship efforts. For example, the UK Government has required companies with over 250 employees to report their gender pay gap. Similar disclosure on racial grounds has been speculated on. Other forms of data investors may be interested in include water usage, power usage, pay ratios and political lobbying. 
 

Past performance is no guide to the future. It is trotted out as the ubiquitous caveat. However, the future is a guide to performance. If only we could read it. 

In the absence of a working crystal ball, we need to rely on experienced investors making informed decisions. To be in a position to do so, asset managers have had to increase the level and transparency of what they report on due to client demand, market expectation and regulatory changes such as the 2020 UK Stewardship Code.  

We are seeing a reporting shift from a “tell me what you’re doing” (reporting on their policies) to “show me what you’re doing” (report on how these policies have been actioned). Managers will be required to provide additional analysis on not only how they voted and engaged but why, and how it fits into their long-term plans or views. We are also seeing an increase in the depth of reporting across all asset classes as opposed to just equities. This may reflect the increase in data coming out of companies as well as the increase in the diversity of asset classes investors now hold. 

There are some newer areas of reporting that we feel will become more common in the long term. These are: 

• Climate scenario analysis:  will become increasingly common in reporting as the capability increases within managers, including metrics included in the TCFD recommendations such as carbon foot printing and weighted average carbon intensity. 
• SDG mapping: Managers being able to ‘map’ their investments to the Sustainable Development Goals (SDGs). While this mapping can be more tenuous and requires a bit more scepticism on the part of the investor, institutional investors are increasingly interested in how their investments are impacting societies and how they are helping to achieve global goals. 

These currently tend to rely on less detailed, less standardised disclosures from companies. In the shorter-term, we do not envisage this being of significant consequence to clients. The quality of disclosures and analysis of relevance will dictate and improve these measures going forward. Additionally from a client perspective climate scenario analysis looks over long time frames where there will always be elements of model risk and input bias. The exact figures should not be dictating client decision making, rather the trends they are showing should be a guide for the types of actions trustees need to take. 

Over time, we expect the quality and contents of manager reports to standardise, as best practices emerge and an industry agreed template or set of guidance appears. In fact, the Pensions and Lifetime Savings Association (PLSA) is putting together guidance/requirements for managers and platform providers to improve consistency and ensure that their reporting is fit for purpose. 

A word of warning:  The old adage about lies damned lies and statistics is evident when thinking about ESG.  Some third party data providers also advise companies on how to improve their ESG scores.  Improving your score is not the same as ‘living’ the score. There is the potential for investor backlash as companies manipulating these scores are found out, and asset managers lacking rigour take a dogmatic approach to the use of external screening.
 

One of the key aims of our investment reporting is to help clients understand how returns have been produced.  We see providing clients with ESG and climate data as integral to this. 

There is currently no standard for what ESG data should be reported by consultants, or in what format. We hope that with greater levels of disclosure a standard will emerge. We consider decision-useful data for schemes to include:

•  ESG Ratings: these are particularly useful when undertaking a manager selection process.
• Information on how climate and ESG issues are both measured and integrated into the investment process. This data is important regardless of asset class.  
• Climate risk metrics: This may take the form of carbon intensity metrics or carbon exposure relative to a benchmark, but over time we expect to see this morph into how a particular fund or scheme is aligned to a 2 degree temperature target. We also think over time this risk may be split out into physical risk and transition risk.
• Information on how asset managers engage with us as consultants on their stewardship, climate and ESG credentials.
• Information on how an asset manager casts votes, as opposed to whether or not an asset manager votes. 

To be decision-useful for trustees we expect this information to be reported in a manner that is standard and comparable between investment managers and asset classes.
 

• Accept that it is not perfect: The volume and quality of data available to investors today would have been unimaginable to investors ten years ago. However, that does not mean today's data is not without limitations. Trustees should appreciate where the limitations lie and how to consider those limitations in their decision making. 
• Get familiar with it: There are a number of trustee duties that ESG data and reporting will feed into. Climate data will be useful as it is likely to become mandatory for large UK asset owners to report in line with TCFD from 2022. 
• Challenge your consultants and asset managers: ESG data from asset managers and consultants will help trustees produce Implementation Reports and feed into the monitoring that in turn will help trustees act in accordance with the ESG policies in their Statement of Investment Principles. Trustees need to challenge their consultants and managers to be providing the right information to them at the right time. 
• Use it: Trustees should not be scared of using the data just because it may not be ‘perfect’. By waiting for flawless data you will be holding onto climate risk for much longer than schemes who use imperfect data in a considered way.