The Challenges and Opportunities of ESG Investing In A Complex Regulatory Landscape

Investments in Environmental, Social, and Governance (ESG) have grown astoundingly in the last few years. A growing consciousness of environmental and social issues, such as corporate governance, inequality, and climate change, is responsible for this upsurge.  

Investors want to support businesses that exhibit responsible practices because they are becoming more aware of the wider impact of their investments. The environment is now the focal point of this changing landscape because addressing climate change is more urgent than ever.  

Countries all over the world have enacted a range of climate action plans or international accords such as the Paris Agreement, which set targets for cutting greenhouse gas emissions. 

Governments are now imposing stricter regulations on the extraction and production of fossil fuels, such as limiting the number of new coal-fired power plants and eliminating fossil fuel subsidies.  

Tailpipe emission standards are being tightened, and most European countries have set a deadline for the end of ICE (Internal Combustion Engine) vehicle sales.  

The United Nations Principles for Responsible Investment (UNPRI) reports that over 800 ESG policies have been developed, with 96 per cent of them post-2000. In 2021 alone, 225 new or revised policy instruments were introduced, doubling the changes seen in 2020.  

This proliferation of ESG regulations across different countries and regions has created a complex and fragmented landscape. Corporations operating in multiple jurisdictions face challenges of complying with varying regulations.  

Investors on the other hand encounter difficulties in comparing and accurately assessing performance due to the lack of standardization, different reporting standards, and requirements. 

Central banks around the world are pressuring banks in their own nations to calculate the carbon footprint of their portfolios for both institutional and retail customers. As part of this mandate, they have to create plans, create goals, and run scenario studies to take into consideration different policy and climate-related contingencies. 

Regulations are changing quickly, but access to high-quality ESG data remains extremely difficult, with issues with availability, consistency, and accuracy, especially for smaller listed and private companies.  

Despite the fact that rating providers are available in the market, things have become more difficult due to their inconsistent ratings. To get around these challenges, institutional investors are increasingly looking to do their own in-house ESG research rather than relying solely on independent ESG reports from rating agencies. 

The BFSI industry's provider of ESG solutions, ESG Data Solutions Pvt Ltd. (ESGDS), makes it possible to measure a company's ESG performance using custom models and curate high-quality data. 

According to ESGDS, which boasts a team of over 240 domain experts, institutional investors grapple with several major challenges: 

Poor Data Quality: Inadequate research or controls often result in low-quality ESG data, making it difficult to make informed investment decisions. 

Lack of Data Granularity and Provenance: Investors face challenges due to the absence of detailed data and clear data sources, hindering their ability to assess ESG risk and performance accurately. 

Transparency Issues with Rating Providers: Current rating providers often fall short in providing the transparency required to evaluate ESG risk and performance effectively. 

Addressing these challenges necessitates the development of platform solutions to automate ESG research and overcome data-related obstacles. 

Measuring ESG is inherently complex due to the evolving landscape and inconsistent reporting. Key challenges include: 

Technical Expertise: Effective ESG data collection and analysis require both domain expertise and technological capability. Public companies report their data periodically, but with evolving standards and frameworks, there is no consistency in reporting. Private companies, not mandated by regulators to report, further complicate matters. A mechanism for collecting and expertly guiding data collection is essential. 

Measurement Discrepancies: A 2021 MIT study revealed that the correlation among six prominent ESG rating agencies averaged at 0.61, considerably lower than the near-perfect correlation of mainstream credit ratings at 0.99. This divergence creates mixed signals for companies and makes it challenging for investors to measure performance accurately. Variations stem from differences in risk issues, sector classifications, materiality, weightings, and scales used by different assessment providers. 

In conclusion, ESG investing is poised for continued growth, driven by increasing awareness of environmental and social challenges. However, navigating the complex regulatory landscape, addressing data quality issues, and achieving measurement consistency remain critical hurdles. As the ESG landscape evolves, stakeholders must collaborate to develop standardized reporting frameworks, invest in data quality, and foster transparency to enable informed ESG investing decisions. 

Authored by Ramnath Iyer, Co-Founder and CEO, ESGDS