FINANCE & SUSTAINABILITY
Data Limitations
Linking sustainability to financial outcomes has inherent environmental, social and governance (ESG) data limitations, especially given how new sustainability practices are in financial fields. These limitations are a key barrier to widespread sustainable investing. ESG data is made available to investors through corporate sustainability reports, traditional financial reports like 10-K/10-Q, and a wide range of ESG ratings/indices.
However, the sources of data are not yet advanced enough to provide flawless information that allows investors to make decisions effectively while using it–or ensure that the actual social and/or environmental impact outcomes are being realized.
Lack of Comparability
For the incorporation of ESG information into basic investment models to be effective, the ESG data needs to be of high quality. Unfortunately, this data tends to be unreliable and inconsistent, which means using it in investment models is difficult. One of the most prominent issues with the data is its lack of standardization between companies. Most ESG data is company-generated without any structure. While reporting framework organizations are attempting to change that, ESG incorporation into models will be limited until they succeed.
Limitations of Sustainability Reports
According to World Resource Institute’s (WRI), “What Investors Want from Sustainability Data“, the current problems with sustainability reporting are varied but all due to the fact that it is voluntary and lacks a standardized structure. This is a problem when relaying sustainability information to investors. WRI points out that reports are often incomplete and are inconsistent in their methods and metrics.
Another limitation is weak identification of Sustainability Performance Indicators (SPIs), which are ESG versions of Key Performance Indicators (KPIs). Finally, experts struggle to determine the correlation of sustainability data with financial materiality, so it is difficult to know if reports show true material performance.
ESG Ratings/Indices Limitations
When ESG data comes from ESG ratings agencies and indices, there are inaccuracies as well. According to economics think tank Bruegel’s “Sustainable investing: How to do it” ESG ratings can become skewed when companies report high scores on immaterial items. Moreover, there are biases because ratings favor large companies with a lot of sustainability information to report, so a small to mid-sized companies may look worse–for lack of data not lack of performance.
ESG ratings also are industry-focused and are based on operations which could make companies in an unsustainable industry look better than emerging sustainability-focused players. Users of ratings should carefully examine the criteria and methods used to determine a specific ESG rating.
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