On September 29, we hosted a webinar entitled, ESG Due Diligence: How Databases and Subscribers are Using Data to Manage a $53 Trillion Opportunity.
Rather than approaching the ESG question from a philosophical point of view, what we wanted to provide was a look at the ESG issue from three practical, et distinct perspectives: the global databases, the investment consultants, and the ratings agencies. Despite some technical issues throughout, we feel the discussion was a smashing success.
Our panel consisted of:
- Manesha Sampath, Vice President at The RockCreek Group, an investment consultant specializing in ESG and DEI placements.
- Jim Monroe is a Senior Consultant at Investment Metrics, with extensive experience in style factor research, which he and a colleague leveraged for a comprehensive research report on ESG performance.
- Ben Webster is the CEO of OWL Analytics, an ESG data firm that has developed a quantitative model for measuring ESG across 12 broad categories.
We cannot thank them enough for their participation and insights, and here is a very small sampling of the most salient insights our panel offered:
ESG Outperformance. Based on Jim’s research for IM’s report, What’s ESG Got to Do With It?, IM found that high ESG stock portfolios overperformed the market by 12 percentage points per annum, adjusted for factor & sector biases. What was even more interesting was that on an absolute basis over the same time period, IM failed to find a similar alpha anywhere in the US market.
They did note that since Nov 2020, there has been a rally in ESG stocks, which might be explained by momentum and the growing relevance of ESG to the industry, but it is equally plausible that firms with a strong focus on environmental, social, and governance-based accountability in their businesses are merely positioning themselves competitively for the future, and are thus seeing higher valuations as a result.
It occurred to me that, for example, as the climate continues to warm, and fossil fuels come under stronger and stronger regulatory strictures and social vilification, it doesn’t take much imagination to envision that an oil exploration firm’s future profitability and growth will be viewed in a darker light than a company researching and producing the next-generation of lithium batteries.
The Value of Transparency. One of the many, many important takeaways from Manesha’s presentation on behalf of RockCreek is that managers seeking to use ESG and DEI (diversity, equity, inclusion) as a marketing asset must be completely transparent with regard to their own internal policies and practices.
Because RockCreek is both a signatory to the ILPA Diversity in Action initiative (which brings together Limited Partners and General Partners to advance diversity, equity and inclusion in the private equity industry), as well as a member of ILPA’s Diversity Committee working towards establishing best practices for firms looking to advance DEI over time, their experience and expertise here is unimpeachable.
When working on behalf of an asset owner with a DEI- or ESG-specific placement, RockCreek’s consultants leverage a comprehensive, highly detailed “common app” that managers seeking inclusion in their database, RockImpact, must complete.
This portal application helps their consultants to clearly and cleanly differentiate a manager’s approach and business model, providing RockCreek’s consultants with a number of analytical advantages that help them to differentiate between those managers committed to these important issues, and those merely looking to take advantage of a trending investment framework (i.e.: greenwashing). Important areas of concern include:
- What is the process for incorporating ESG into the security selection process?
- What does their topline business framework look like?
- How does a firm reflect these values across their entire organization on a day-to-day basis?
Those with transparent answers to these sorts of questions will rise to the top in the Rock Creek rankings.
Importantly, even those managers with less-developed ESG & DEI strategies can earn consideration with a clearly-written and defined commitment to working towards ESG and DEI-centric outcomes for their business. And RockCreek helps such managers to do so.
Iffy Correlations Between Ratings Agencies. Ben from OWL Analytics noted that while the correlations between ratings produced by the bond rating agencies are upwards of 95%, those for ESG are at a middling 40% - 50%. While these are better than the 30% correlations from years ago, strongly divergent opinions that fall well-within the margins of ESG and DEI remain.
OWL believes that the reason for this lack of correlation is that ESG scoring is highly subjective.
Ben acknowledged that large ratings firms have a tough task - even in Europe, where ESG is more mature, ratings have still been largely unregulated & unstructured, making it difficult to rate a firm on something as nebulous as “ESG” or “DEI.” After all, what “diversity” means in the US departs dramatically from how it is perceived in Japan, for example.
Compounding the problem is that different firms rate each constituent part of ESG/DEI differently, and there is a lack of ready access to relevant data. After all, there are hundreds of different ESG issues, and depending on the rating agency, one might be more passionate about a particular issue compared with others. And another firm may come to different a different conclusion, based on the clients with whom they work, their culture, region, asset class etc.
Because of all this subjectivity, capturing this diversity in a way that even remotely resembles standardization is incredibly difficult, which is what OWL is trying to rectify with its quantitative-based ESG scoring system. They do so by:
- Aggregating source data with the goal of collecting as much ESG information as possible about each company under coverage; then
- dentify the key ESG issues each source deems relevant for each industry. For each source & industry combination, OWL tracks the data powering their ratings for each key ESG issue.
- Then, they isolate the ESG key issue overlap, i.e. the consensus, between the industry level models of sources.
- Finally, within each industry-level consensus model, OWL weights more strongly the key ESG components that MORE sources agree are relevant for that industry, with lower weightings for those ESG that FEWER sources agree are relevant for that industry.
In the end...
The entire hour-long program is well worth your time, as our piece here only scratches the surface of what was discussed. As we noted earlier, regardless of one’s view of ESG and DEI, the industry thinks it is an extremely important long-term issue, so managers, consultants, and asset owners must take it seriously.