Much has been written about the challenges of ESG (environmental, social, and governance) data. While well-reasoned in their construction, the ratings produced by the large ESG data vendors are not as comparable as one might hope, leading to scepticism and a debate over which companies are actually ‘good’ from an ESG perspective.
Skipping these headline ratings in favour of the data that underlies them is a natural reaction (and is the practice of most sophisticated investors). However, focusing on the raw data does not solve the three key problems of paucity, believability and ubiquity.
Given the challenges of traditional ESG data, investment practitioners have a strong incentive to look to alternative data sets for help. These step away from what is reported by companies and captured in the traditional, structured ESG data sets produced by MSCI and the like, and instead focus on big data and/or unstructured data.
This is the data we find on websites, social media, physical sensor data, satellite data, images and videos, for example. By most estimates, 80–90% of data produced on companies fall into the unstructured category. Therefore, we have an enormous incentive to dig for information here.
Importantly, though, the usefulness of these data sets depends on our ability to extract actionable information from them — for this, we turn to a host of quantitative methods, from machine learning to natural language processing (NLP) and even blockchain.
Breaking down the wall
We have found that this new, alternative data allows us to start chipping away at the three problems mentioned above. Specifically, we can use these new sources of information for augmentation of traditional datasets, addressing the paucity problem.
Within E, S, and G, there are lots of omissions in company-reported, structured data, such as one would find in corporate social responsibility (CSR) reporting or even in some regulatory reports. Because most ESG reporting is voluntary, most companies reveal only a subset of items and may do so in non-standardised ways.
Data on workplace safety and protection, diversity, and other aspects of the relationship between labour and management are examples of ‘S’, or social data, that is often underreported (and therefore missing) for many companies. We can capture this social information through web scraping or from sites like Glassdoor or even Twitter [TWTR] to help us paint a more complete picture of what’s actually going on inside companies and fill in some of the known ‘holes’ in traditional data.
Validation of ESG information is critical to our practice. The believability of company claims is often in question, especially in the absence of multiple data sources. For example, companies have adopted myriad policies to combat destructive environmental practices (e.g. threats to biodiversity), ensure data privacy or prohibit questionable labour practices.
As an outside observer of the company, it is difficult to gauge the effectiveness of these policies (or even to what extent management takes them seriously). We can look to alternative data to help us gain confidence in the typically structured, company-reported information that forms the backbone of much of our work.
For example, company supply chains are notoriously opaque. Companies claiming to have supply chain practices that are free from child or slave labour, or even free from commodities sourced in precarious ecosystems, are difficult to validate — both for investors and often the companies themselves.
We are excited about the various efforts underway to use blockchain to validate supply chain claims. With the origins and movements of goods recorded immutably in a distributed ledger, we could have far greater confidence in programmes aimed at mitigating supply chain risk. Initiatives like these are already at work in the precious metals and gemstones, minerals mining, automotive, food and apparel sectors.
Everywhere and nowhere
The ubiquitous nature of company-reported, structured data is problematic. By virtue of the fact that it forms the basis for most of the large ESG data vendors’ ratings, it means that all investors are, de facto, using the same data.
As active managers, we seek novelty when it comes to information. ESG is no different. Our goal is to produce the most robust view of the threats and opportunities faced by companies — new or proprietary data sources can give us an edge when it comes to better identifying ESG-related downside risks or upside potential.
Furthermore, novel data — especially that which is not under the control of companies — is a powerful source of diversification within our data pool.
ESG news flow analysis naturally falls into this category, not only by virtue of being a new data source, but more importantly being a new concept when compared to traditional ESG data. By using NLP paired with deep subject matter knowledge, we can produce what is essentially ESG sentiment information that is based on a wide number of text-based data sources. Again, the beauty of this information is that it represents a genuinely new concept and is largely independent of what companies say about themselves.
But alternative data itself is not without its challenges.
First and foremost, the bulk of this data has not been road-tested in an investment context. We must approach the data by asking what fundamental economic question it answers, and be circumspect about what it will bring to our process.
Next, it is important to acknowledge that this data can be very expensive. Data vendors are pouring into this space because 1) the technical barriers to entry are much lower than they were even five years ago, and 2) they know that managers will pay big bucks for data sets that might give them an advantage (even a reputational one).
Finally, we see many examples of investors being blinded by technique. For example, while there is truly astonishing work going on in the field of artificial intelligence, it doesn’t mean that the work will necessarily result in information that will add to our understanding of companies’ ESG attributes.
In sum, we are excited and cautiously optimistic about what alternative data can add to our understanding of companies’ ESG practices. We would never suggest using alternative ESG data in isolation. However, when combined with traditional, structured data sets, we believe it could result in a much more robust understanding of the true threats and opportunities that companies face.
This article was written for Opto by Kathryn McDonald, co-founder of RadiantESG Global Investors.
Co-founded by Heidi Ridley and Kathryn McDonald, RadiantESG is an asset management firm founded on the belief that ESG considerations have the power to drive innovation and change in societies around the world, as well as improve investment outcomes.
With 30 years’ experience in asset management each, Heidi and Kathryn are excellently placed to provide unique insights into the increasingly popular world of sustainable investing. To read more insights from Radiant ESG, visit their site here.
Disclaimer Past performance is not a reliable indicator of future results.
CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.
The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.
CMC Markets does not endorse or offer opinion on the trading strategies used by the author. Their trading strategies do not guarantee any return and CMC Markets shall not be held responsible for any loss that you may incur, either directly or indirectly, arising from any investment based on any information contained herein.
*Tax treatment depends on individual circumstances and can change or may differ in a jurisdiction other than the UK.