The role of impact in the SFDR and ESG data overload

As we’re increasingly swamped with environmental, social and governance (ESG) data, how can we use it to answer meaningful questions about the impacts of our investments?

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.

More data means more transparency

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?

But what’s my impact?

As regulators ask companies and asset managers to disclose ever more information, it’s worth taking a moment to review the end goal of all these disclosures. For a growing number of investors, investing in companies with positive impact is now just as important as achieving financial goals. In particular, we want to understand the impact of our investments on the UN’s Sustainable Development Goals (SDGs). Are we investing in companies that make positive or negative contributions, both overall and to individual SDGs? As more data becomes available, how do we use that data to come to a general conclusion about a company or a portfolio’s impact?

Why ESG scores aren’t enough

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.

Harnessing the wisdom of crowds

In finance, we usually try to eliminate subjectivity. However, the solution to the challenge of impact assessment is to embrace it. Impacts are impacts on people and the environment that people live in, so what people think and feel about impact is impact. Regulations like SFDR and CSRD will put a lot more ESG data at our disposal. What if a broad community of experts – tens of thousands of people rather than a single ESG rating provider – could review that data and decide which data points are relevant to which companies and what they tell us about a company’s impact? What if they could also supplement that data with local or industry-specific data that the regulatory data sets don’t capture? If this community is sufficiently large and diverse, their collective view on the impacts of a company is surely valid. It is more neutral and objective than the views of individual ratings providers, and closer to a market valuation of impact. This is the future of impact assessment and – thanks to global connectivity and the power of the internet – it’s already a reality.

Article written by Bertrand Gacon, CEO and Co-founder of Impaakt: Impact Data, beyond ESG.

Get in touch with Impaakt via clients@impaakt.com to find out more about their collaborative, community-driven impact ratings.