The role of impact in the SFDR and ESG data overload

Investors and asset managers are about to get their hands on a lot more data. As EU regulations like the Sustainable Finance Disclosure Regulation (SFDR), the EU Taxonomy and the Corporate Sustainability Reporting Directive (CSRD) come into effect, companies will be pushed to disclose far more information about their operations and impacts. Asset managers with ESG-focused products will be filling in detailed templates to report that data back to investors. If you’re an asset manager, you are undoubtedly grappling with these templates and the sheer volume of data that’s required. Disclosures include everything from hazardous waste ratios to board diversity to the percentages of revenues, capital expenditure and operating expenses aligned with environmentally sustainable activities.

These additional disclosures are a step forward because they bring transparency. In recent decades, many investors have had to rely on ESG ratings, where providers use complex methodologies to arrive at mystical scores for each company. It can be difficult to understand why companies get certain ratings and the results can be counterintuitive. Now, with easier access to the underlying data, investors will have more control. They can select particular indicators that they care about – perhaps greenhouse gas emissions or number of patients treated – and monitor those indicators within their portfolios. However, these large sets of individual data points leave one important question unanswered: what is the overall impact of my portfolio?

Taking large sets of ESG data and coming to an overall conclusion about a company is exactly what ESG providers do when they calculate scores and ratings. However, in general, ESG scores and ratings are not good measures of impact. There are two reasons for this.

Firstly, most ESG scores are trying to answer a different question. They are less concerned with the impact of a company on people and planet and more concerned with the impact of people and planet on a company. They focus on working out which ESG factors are “material” for a company’s financial performance, and then assess how it is managing the risks and opportunities that those factors represent. There are good historical reasons for this. A decade ago, the way to convince investors to consider ESG was to show that it mattered to financial performance. However, the world has moved on. Most investors not only accept the importance of ESG to financial returns but are equally concerned with the environmental and social impacts of the companies they invest in (“double materiality”).

The second challenge for ESG ratings providers is that impact isn’t easily measured by finite data sets and rigid methodologies. You never know where or how impacts will arise, or what the knock-on effects could be. The actions of one company could cause a ripple of impacts on other companies or communities – positive or negative – that no pre-defined set of metrics could capture. However, any formal methodology for calculating an overall impact score or rating will need to make some decisions in advance: firstly, which data points it will use to measure impacts, and secondly how it will weight those different data points. For example, is water pollution relevant to an e-commerce company? Is job creation more or less important than greenhouse gas emissions or child labour? The need to make this kind of decision would limit the scope of impact ratings and prevent them from capturing the full breadth and depth of impacts – particularly anything unusual or unpredicted. This approach is also unavoidably subjective. Although ratings providers follow a rules-based methodology, there were many subjective decisions involved in developing that methodology. This helps to explain why ESG ratings for a single company can vary so much across the different ratings providers.