Can ESG Data Improve Investment and Lending Decisions? Digital Disclosures as a Vehicle for Insight
After a fantastic presentation at XBRL Europe’s Digital Reporting in Europe event, we were lucky enough to catch up with Dr Jane Thostrup Jagd, Director of Net Zero Finance, We Mean Business Coalition, for this interview.
What does the future look like for how we use ESG data, and how does that differ from today?
What I want to see is ESG data being combined with financial data to provide predictive value information in terms of understanding companies’ future performance. The real opportunity is not ESG analysis in isolation, but integrated analysis based on both financial and ESG data that provides a more comprehensive view of future performance, risks and opportunities – ultimately giving capital providers a better understanding of individual companies and enhancing their decision making.
When banks and investors use ESG data today, it’s as an overlay: an extra layer that goes on top of the financial data. It’s typically a rating or ranking that somebody else has already done, and it’s used to screen investment prospects in a fairly unsophisticated way – so, for example, every company above a certain threshold gets a green light, and/or anything below it is off the table – also known as positive or negative screening. We have yet to see convincing evidence that many current ESG investment approaches consistently generate additional value for investors.
One of the problems with these methods is that the data forming the basis for all these ratings and rankings is incredibly old. It takes something like a year and a half after companies have reported for ratings to be available. Everything in there is already known to the market, which means no new insights and no alpha for investors. You simply cannot identify tomorrow’s winners with yesterday’s data.
The other issue with using composite ratings is that you can’t focus on the specific factors that are important to you. That might be metrics around climate risk, but if you’re a bank looking at funding expansion for a company in a service industry, you might be more interested in employee turnover. If that metric is unusually high the likelihood is that it’s a horrible place to work, and the best staff are running out of the door and will leave the company as soon as they can – and that creates risks for any expansion plans.
I am very confident that some – perhaps not all – ESG data will have real predictive value. What we need to do now is (1) identify the KPIs that are most useful, and (2) develop new analysis methods to help capital providers identify the winners they are looking for and avoid unnecessary risks.
Turnover is a great example. What other ESG variables do you think we might we be leveraging? What should people start thinking about first?
One key metric is probably going to be greenhouse gases, and carbon-adjusted profitability. If you find that a company has higher emissions relative to profits when compared with industry peers, that can potentially indicate a number of significant risks for capital providers. In many jurisdictions, higher emissions will give rise to higher tax obligations. Higher emissions can indicate aging assets and, in some cases, a risk of future stranded assets – for example, in transport companies with diesel vehicles that are being phased out of European city centres. If that’s where your customers are based, you have a problem.
We’re not necessarily just talking about numbers: narrative disclosures can also provide important information. If your business makes cakes, your reliance on natural vanilla might be just as important as your reliance on natural gas. Global vanilla production is concentrated in Madagascar, and it is vulnerable to major fires and extreme weather events. Capital providers need to know that you have identified the key sustainability-related risks to your business, and that you have contingency plans in place to ensure resilience.
What are the puzzle pieces that need to be in place for integrated ESG analysis?
First, the data needs to be discoverable, and second it needs to be digital. Right now, data in PDF reports is incredibly difficult both to find and to compare. Digitally tagged reports can be consumed instantly and accurately by analytics software (or AI models), without manual capture and transformation, which means higher quality, easier comparison and more timely insights.
Third, disclosures need to be mandatory. An incomplete set of data is like a single sock: of very limited use.
Fourth, disclosures need to be assured by an auditor, including the digital content; in other words, auditors need to check the digital tags, not just the human-readable bits.
Those are the cornerstones of high-value data. Then as I mentioned we will need to figure out the most informative KPIs – and at WMBC we’re planning a hackathon later this year to make a serious attempt at that in collaboration with investors and analysts – and through that develop integrated analysis methods. To do both, we need data. To an extent we are in a Catch-22 situation, but we also have the opportunity to feed a virtuous cycle: the more digital ESG data becomes available, the better we’ll be able to understand and demonstrate how to extract maximum value from it. One good place to start right now is India’s BRSR data, which offers the first solid digital ESG dataset.
What does your vision mean for investors and lenders, and for how companies approach sustainability disclosures?
As decision-grade ESG data and analytics become available, capital providers will leverage whatever value they provide. Companies need to approach ESG in that light. As a company, the more you invest in ESG disclosure and take it seriously, the more it becomes an asset in terms of your visibility, access to capital, and even long-term viability.
Many companies, particularly large listed companies, are already doing fantastic work, but there are others who still treat ESG as a marketing exercise, and that is a mistake. A lot of non-listed companies and SMEs feel like they are off the hook in terms of providing information to investors – but they are forgetting that ESG data is also in demand by banks.
For instance, the European Banking Authority have said that they want all EU banks to assess their loan portfolios in terms of climate risk. That means banks will be asking their clients – and they will be asking their suppliers – about climate vulnerabilities: what happens to your business in case of wildfires, drought, or flooding? How dependent are you on fossil fuels? How are you monitoring and mitigating risk? Have you done the right scenario testing? Do you have a contingency plan?
We will increasingly see capital being funnelled towards those companies that both have invested in risk mitigation and resilience and – crucially – are demonstrating that resilience through high-quality, discoverable ESG disclosures. Around 60 countries are already committed to CSRD or ISSB reporting, and that’s going to have an even wider trickle-down impact through supply chains and capital providers.
One of the biggest things that will help companies, particularly small suppliers, is ensuring that all this disclosure happens in XBRL rather than endless back-and-forth emails with surveys. With XBRL, SMEs can provide a single digital report rather than filling in 400 different engagement forms and surveys for their different customers – which is currently a huge burden for SMEs.
That brings us to the next question – what should regulators and policy makers be doing to maximise the utility of ESG data?
Firstly, and crucially, they need to make sure that all the reports they collect will go to one central repository, making the data discoverable and accessible. In Europe, that’s what the European Single Access Point (ESAP) aims to achieve.
Secondly, the full sustainability report needs to be digitally tagged using XBRL. Both right now, so we can experiment with full sets of disclosures from hundreds or thousands of companies to identify KPIs and refine analytics, and in the long term to facilitate decision-grade integrated analysis.
AI is going to expand the possibilities of what we can do with ESG data – but what we can’t do is just report in PDF and give the files to an AI to analyse. The fact is, AI makes serious blunders when it comes to consuming and understanding ESG reports. The last big analysis I saw on this concluded that today’s AI interprets about 80% of the facts correctly – and there are some blatant errors in the other 20%. I don’t know any investor who is willing to part with their money based on data that’s 80% accurate.
By asking companies to digitally tag their reports we ensure that every AI model can access structured facts consistently and with far greater accuracy, which means trustable, decision-grade analysis.
On the other hand, I do hear from companies who find tagging burdensome – and what we can do with an AI that gets it 80% right is make tagging easier. What I would really recommend is that companies embrace AI tools to semi-automate the tagging process so that most of the tagging gets done by AI and staff focus on reviewing, correcting and making expert decisions about the trickiest 20%, giving them a high-quality XBRL report for considerably less effort.
So, what’s the next step? If someone’s reading this and they like the vision of getting real value from ESG data, where should they start?
We need to make our voices heard. We need to convince reporting companies and auditors about the value of ESG disclosures. We need to push decision-makers to support central repositories of accessible digital data. If they step back on this, then we are back to square one with ESG reporting – back to PDFs that are scattered all over the place and nobody able to find anything. We’re stuck in a scenario where only large institutional investors can afford to buy ESG datasets compiled by data providers, which themselves have quality and timeliness issues, and no-one else can access real predictive value.
The next steps depend on who you are. They might be about advocating for digital mandates, investing in reporting processes, or experimenting with analysis. But the core message is that we need to think differently about ESG reports. ESG is not a marketing exercise. It is valuable information that can tell capital providers about a company’s future. In a world that’s increasingly shaped by ESG-related risks and opportunities, that information will play a vital role in directing lending and investment towards the right companies.
