As the climate heats up, so too are requirements around carbon reporting. Unfortunately for investors who want to incorporate this form of ESG data into their investment portfolios, it’s difficult to make like-for-like comparisons between companies, and materiality is—like efforts to reduce carbon emissions globally—a moving target, reports Rebecca Natale.

Six years ago, Matt Moscardi was in Europe, trying to win some new business for MSCI from an institutional asset manager. He was showing off the company’s environmental, social and governance (ESG) information-ratings system, and to help with the presentation, he brought a carefully thought-out spiel and a tall stack of papers.

With a wry smile, Moscardi, executive director of ESG research at MSCI, admits that the stack was to show off “how incredibly smart” the company was. Unfortunately, the meeting wasn’t exactly a rousing success—at least not at first. “They were kind of nonplussed; they just didn’t care,” he recalls.

He shook hands and thanked them for their time. Before leaving, he slid the pile of documents across the table. At the top of the stack was the firm’s own portfolio, which Moscardi had already run through MSCI’s analytics. He turned, walked out the door, headed halfway down the hallway, but before he could get to the elevator, a man from the meeting stopped him.

“He said, ‘This paper says 2% of our portfolio is exposed to conflict in Sudan—what the hell is that? What does that even mean? Where do you even get that?’” Moscardi recalls.

What followed was a one-hour conversation in the hallway as to just what ESG risk exposure and materiality can mean in a market that’s heating up—in more ways than one.

Despite being the talk of the town when it comes to ESG, carbon remains somewhat elusive to track and articulate. There’s no shortage of carbon, or data on it, but how to put that data in context, how it ranks within wildly differing scores, and how to measure where it begins and ends with a particular company are murky at best.

Some investors say there’s too much data. Others—or sometimes the same investors—want more data, and want it to be cleaner and more in-depth. The common thread between ESG issues and data is clear, but investors’ aims might be better served by unbundling the large dataset, making them independent of each other, and examining risk, not through a wide lens, but a high-powered microscope.

WatersTechnology spoke with asset managers, vendors, and researchers about carbon data—what it consists of, how it’s collected and contextualized, and whether or not investors can rely on it. The consensus is that firms need to look at these metrics with a skeptical eye. But if these kinks can get ironed out, as regulators and governments take a closer look at carbon, the data surrounding this space will only become increasingly valuable.

Materiality

ESG performance is governed by what’s known as materiality, or relevance, of issues that are specific to returns, stakeholders, and company operations. For each of the many metrics that fall under the large ESG umbrella—say, for board diversity or child labor policies—firms make decisions as to how important these numbers are when it comes to a company outperforming revenue expectations. For many of these subsets, there’s plenty of measurable, consistent data available. Carbon is trickier. For issues under the “E” silo of ESG, it’s easier to measure physical climate risks like land and water usage, or whether a facility will succumb to sea-level rise. Like smoke, carbon leaves damage behind long after the fire’s out, and has a far-reaching effect, making defining materiality around carbon difficult.

Moscardi, whose company receives requests for even esoteric data points such as the sizes of drift nets used by commercial fishing boats, has learned that materiality isn’t one size fits all. “The definition of materiality is actually a negative,” he says. “If you look up the regulatory definition of what is material, it varies by jurisdiction, but it largely relies on a variation of this: If information you didn’t know would have changed your decision, it’s effectively material. And in that case, it could be anything.”

For carbon to be a dataset upon which investors can make well-informed investment decisions, find alpha and mitigate risk, it has to become more digestible, transparent and consistent, and that starts with what companies report.

The overlap in skillsets between finance and sustainability is low. It’s a bunch of different people with a bunch of different priorities, and it’s kind of a fruitcake that gets baked together and is hard for people to parse out.

Kellen Parker

Arabesque Asset Management, born out of Barclays in Europe in 2011, assesses the performance and sustainability of more than 7,000 companies in the investment universe in real-time. It is developing a new scoring tool that is aimed at sifting through the carbon mess. It will rate how companies are reporting their carbon emissions and their contributions to global warming, says Rebecca Thomas, an ESG research associate at the asset manager who is working on the project. The tool is part of Arabesque’s effort to line companies up behind a single, widely followed regulation—the Greenhouse Gas Protocol—to help users put carbon into context.

“It might not be the perfect regulation, but at least following one that’s generally accepted could really help with understanding comparability between companies and between actions, as well,” Thomas says.

The big question in determining what’s material to a company, she says, will be answered by digging into what’s known as carbon scope three.

A Bad Kind of Wash

When a company reports its carbon footprint, much of that data relies on carbon scopes one and two. These two measurements include onsite emissions from facilities owned or controlled by the company, as well as emissions from purchased energy. A third measurement, carbon scope three, encompasses the entire value chain of a company’s resources and products down the line until they decompose and become atmospheric gas. Roughly, scope three is equal to about three times the impact of the former two, according to Kellen Parker, vice president of analytics at Flat World Partners, an investment advisory firm focused on impact investments. It’s also the least reported.

It’s hard to measure, and both the tools and data needed to paint the full picture don’t exist yet. However, Parker says, companies know this and use the data gap to their advantage.

“When a company says they’re cleaner, a lot of the time it’s because they’ve outsourced some of their activities to suppliers and contractors,” he says. “They typically only control—or only buy off—for scopes one and two, and not for their entire chain. They can justify it by saying they’ve pressured their suppliers to adopt similar targets, but rarely is it a make-or-break thing.”

Parker estimates about half of the companies listed in the S&P 500 report on scopes one and two, and that number drops to about 40% when it comes to scope three. The intention might not be to deceive, but the missing data does create another ironic risk for investors hoping to reap long-term returns by investing in companies that seem low-carbon, and therefore, low-risk.

It’s a hard question, Parker says, to answer how one comes up with better indicators and how to add context in terms of risk versus impact.  

“We’ve been cautious with how much weight we want to give [the supply-chain side of the equation] given the uncertainties there,” he says. “We started with showing the issues inherent in the industry. If you’re invested in a commodity, and if we have some location data, we’ll map that to show where we think factories are located to show relevant risk.”

A Heavy Hand

One of the pervasive problems with ESG is the lack of standardization around the data, made more complicated by varying degrees of regulation from country to country. When it comes to reporting, Nordic firms have relatively stringent requirements. Well over a decade ago, the mostly self-regulated Norwegian Government Pension Fund initiated a now-standard approach of negative screening, or blacklisting companies based on ethical guidelines. Earlier this year, the Swedish Investment Fund Association enacted a sustainability information standard, applying to all securities funds that operate within the country.

In Japan, like the Nordics, regulation is mostly derived from investor expectations instead of governmental action. As a result, the Government Pension Investment Fund (GPIF), the largest pension fund in the world, picked the S&P Dow Jones Carbon Efficient Index as its ESG benchmark this past September. Per the Paris Agreement, the nation pledged a 26% reduction in emissions by 2030, compared to 2013, its peak year for emissions following the Fukushima nuclear disaster.

When we know more about what aspects are material, we can drive the regulation toward making that more standardized so that when we’re comparing emissions for a particular activity, we’re comparing the same things across different companies

Rebecca Thomas

In March, the EU, which has pledged at least a 40% reduction in 1990-level emissions by 2030, adopted a disclosure regulation into the European Commission’s sustainable finance plan, aimed at limiting “greenwashing,” or misleading on environmental friendliness. The mandate adhered to sustainable development goals (SDGs) and the Paris Agreement, and served as the first regulator-backed sustainable investment framework in the region.

The US, however, stands in contrast, as it pulled out of the Paris Agreement in 2017, and the Department of Labor earlier this year issued a warning to financial managers that ESG investments aren’t always “prudent.” With the US pumping the brakes on federally mandated carbon-focused requirements, it could make it even more difficult to compare companies.

Global approaches to ESG—and, specifically, to addressing climate change—are fragmented. Still, ESG investing is still relatively young—it wasn’t until the late 1960s and early 1970s that it started to gain any real traction—so it lacks the longevity other investment strategies do. Arabesque’s Thomas says clarity can come from combined efforts from regulators, local governments, investors and businesses, combined with better artificial intelligence integration. Regulators might consider ensuring companies adhere to a single standard, while machine learning can help investors understand which components of carbon emissions are material across industries. [See BOX below for how AI is being used to find value in carbon data.]

“When we know more about what aspects are material, we can drive the regulation toward making that more standardized so that when we’re comparing emissions for a particular activity, we’re comparing the same things across different companies,” Thomas says.

Forward Thinking

A catch-all solution, in pursuit of the level of granularity and context that investors want, might lie in a total overhaul of the way carbon is presented. This would entail making three independent datasets—with E, S, and G unbundled, with different sets of standards and methods around each one. The paradox here is that while there’s already so much data, it’s also not enough, and some vendors have already begun to unbundle the silos.

 “I find it a fallacy that such diverse topics all the way from data privacy issues to child labor issues get bundled up in those three letters, so we’ve unbundled all of ESG,” says TruValue’s Bartel, adding that apart from building hundreds of risk signals, the company’s base materiality framework is malleable. Though it rests on the SDGs or the US-based Sustainability Accounting Standards Board (SASB), it can be reconstituted to fit managers’ own viewpoints of materiality or their own ESG theories.

Similarly, on the management side, some have started to diverge from relying on mainstream ESG rankings and are separating the themes. For example, Flat World’s Parker cites Facebook as a hard pill to swallow. “Facebook has been massively profitable; they have very good governance on that side, but they’re very bad as a global citizen,” Parker says. “It’s hard. The overlap in skillsets between finance and sustainability is low. It’s a bunch of different people with a bunch of different priorities, and it’s kind of a fruitcake that gets baked together and is hard for people to parse out.”

Carbon’s reach, like “Lion King” Simba’s kingdom, extends to everything the light touches. Every company and industry consumes energy, and as governments at every level rally around the idea of a 2°C Scenario—the goal for a maximum temperature increase of 2 degrees Celsius before pre-industrial levels—investors have to, as the saying goes, know what they own before it’s too late.