A key to future-proofing your business is to understand the challenges ahead. As climate risk emerges and socially responsible decisions are becoming more desirable, risk managers in finance must ask: How do we make those decisions in a way that makes sense for the business and the clients? In this article, Julie Sherratt, Head of Investment Risk at TD Asset Management, explores the ways ESG data can be used and what its current limitations are.
Developing Environmental, Social and Governance (ESG) relevant investment processes has brought both clarity and questions, revealing useful risk dynamics but also uncovering data complexities. These points, taken together, reinforce the importance of pushing forward with ESG integration so that the greater utility of the information is not lost to the initial limitations. Only by doing so can ESG analyses become more refined, reliable, and robust. The central underlying goal is to meet our fiduciary duty to ensure that the risks taken are in line with a fund's investment objectives, minimising any unintended downside risk in both the short- and long-term.
Moreover, this is the momentum demonstrated by key ESG reporting frameworks, particularly in regards to managing climate-based risks within investment portfolios. The Task Force on Climate-related Financial Disclosures’ (TCFD) recommendations are becoming firmly rooted and seen as best practice, with major institutional and government buy-in requiring asset managers to become well-versed in climate change and resource scarcity. The United Nations-supported Principles for Responsible Investment (UN PRI) and the European Commission's Non-Financial Reporting Directive (NFRD) are examples of this, both modelling elements of their reporting frameworks around TCFD. When laying out their recommendations on climate disclosures, TCFD speaks to the evolving nature of both climate data and the tools by which firms can assess climate risks. This goes for other aspects of ESG as well, with analyses evolving as all industries better equip themselves to meet the demands for more accurate, financially material, and decision-useful information.
This has required additional resources, spending time analysing data and collaborating on the creation of new analytical tools. TD Asset Management (TDAM) has expanded its ESG capabilities, making use of third-party ESG ratings as well as the underlying indicators that inform those ratings. This has allowed us to build more comprehensive dashboards of ESG considerations, which help us to focus in on the holdings most exposed to material ESG risks. At the same time, we continually engage ESG data providers, discussing potential data limitations and improvements to ensure data quality.
TDAM also recently partnered with the United Nations Environmental Programme's Finance Initiative (UNEP FI) and several other firms as part of the UNEP FI TCFD Investor Pilot. Within this pilot, investors and asset managers came together to inform, test, and learn from the development of a scenario analysis tool created by Carbon Delta, a provider of climate data. The conversations around climate risks, both in regards to Carbon Delta's scenario analysis tool as well as other environmental risk assessments, served as an avenue to test our own ideas and understanding. From this, we have become more aware of the information and methodologies available to assess the risks associated with a transition to a low carbon economy and the physical risks stemming from acute and chronic climate change.
There is still a need to push further, improving corporate disclosures so that ESG data and ratings fully demonstrate the ESG performance of all companies. Data limitations are not foreign to other aspects of risk assessment, and we intend to move forward and refine our approaches, share perspectives, and make the best assessment of ESG risks possible given available information. However, we remain mindful of the caveats. At present, ESG ratings can be biased towards companies with more ESG disclosure, with the level of disclosure varying across company size and geographic regions. We have found that larger market cap companies and companies based in regions that have higher ESG disclosure requirements are those that have better ratings. The industry could also benefit from more consistency in how companies report metrics, so that comparisons can be made more readily and reduce the need to sift through variations of scale or convention, which tend to interfere with company rankings in terms of carbon emissions, for example. For now, we only have a short history of ESG data to work with, but the data is becoming more robust, and with every year there is likely to be less comparative caveats and limitations.
With greater exposure and familiarity with ESG analytical tools, firms can be more effective in scrutinising and pushing to improve data provided by companies as well as the methodologies established by data providers. As entities such as the UN PRI begin to make reporting on various ESG aspects mandatory, transparency of ESG assessments and comparability between them will become even more critical. Working towards standards could provide a common base of analysis, from which comparisons can be made or to which adjustments can be applied to reflect varied investment risk perspectives. We continue to operationalise our learnings, engaging various investment teams and external data providers in order to refine our own ESG risk assessments.