What's Your Prior?

Data Hunters Part 2: is ESG a goldmine or a distraction?

May 26, 2021 Damian Handzy Season 1 Episode 9
What's Your Prior?
Data Hunters Part 2: is ESG a goldmine or a distraction?
Chapters
What's Your Prior?
Data Hunters Part 2: is ESG a goldmine or a distraction?
May 26, 2021 Season 1 Episode 9
Damian Handzy

ESG is all about the data. My guests explore what people are doing with ESG data, how the data is sourced, and how investors can beat the market with ESG. My guests for this episode are:


Show Notes Transcript

ESG is all about the data. My guests explore what people are doing with ESG data, how the data is sourced, and how investors can beat the market with ESG. My guests for this episode are:


Damian:

How do you decide the best method to measure something? Even when it comes to an everyday concept temperature? We have three different methods that people use. Urban legend has it that Daniel Fahrenheit said that the temperature of zero, that number should represent the coldest day he's ever felt. And 100 should be the hottest, but in reality, he used the equilibrium temperature of a mixture of ammonium chloride, water, and water ice for the zero point, and he used approximate human body temperature to determine 100. His scale has the convenient feature that the range of water's freezing point to boiling point is about 180 degrees. And that's a number that you can evenly divide by a lot of different, smaller numbers. So it's convenient and his scale is still used at least in the U S and its territories, but far more people around the world use a scale named after the Swedish astronomer Anders Celsius. And of course, there's also the Kelvin scale created by William Thompson, who was also known as Lord Kelvin. Using the same sized temperature differences of Celsius, his scale sets the zero point as the absolute zero of energy, meaning none . Now Lord Kelvin is maybe he's the first person to express the concept of you can't manage what you don't measure. His exact quote was that if you don't use numbers to describe a particular topic, then quote, your knowledge is of a meager and unsatisfactory kind. Now between these three different methods of measuring temperature, there are simple formulas to translate between the three different scales, but even more importantly, at least they -- well, now -- they all agree on direction. Bigger numbers mean more heat. As we'll see in today's episode agreement on what scores high and what scores low, isn't all that easy in financial data.

Intro Music:

Hello and welcome to what's your prior the podcast, pretty adaptable investor with your host Damian Handzy,

Damian:

Welcome to data hunters , part two in which we'll continue the conversation from the last episode with the same guests and turning the focus onto ESG data. Now, my three guests are Lisa Conner, Jeremy Backsht, and Bill Haney. Each of whom has decades of experience in all aspects of providing, sourcing, analyzing, using, buying, and selling financial and ESG data. Now , information about a company's ESG profile is sold to professional investors a lot like a credit rating might be. There are a few outside agencies that specialize in evaluating companies' environmental, social, and governance practices, and then scoring them on that basis. The ESG data market has simply exploded with the popularity of ESG investing. So let's start with Jeremy. How would you describe the state of the art in ESG data today?

Jeremy:

I think ESG is one of the most interesting and influential topics of our time. And obviously there's this total stakeholder approach and other reasons why this has really come here to forward and probably accelerated by COVID. But I think it's important to start by dis-aggregating the pieces. It's interesting that we've concatenated environmental, societal, and governance kind of into one framework. So I think the environmental component might be one of the easiest, maybe not to index, maybe not to benchmark, but at least to sort of measure. If you look at pollutants and carbon emissions and other very hyper-specific components, you can at least measure those. The metrics can become common, but I think from an environmental perspective, at least you can look at that into its various components of filtration, emissions, and other components. So that's a little bit more scientific. I think the art of the societal overlay is probably the most difficult, you know, how do you score diversity and inclusion initiatives? How do you think about hiring practices? How do you think about the treatment of the retiring workforce? Those are very, very challenging from a governance perspective, at least, you know , having some sense for in the room of the typical board structure, that's maybe a little easier to quantify as well. So as I kind of tossed through this, I think about, is there a global standard that an MSCI and other big players will come up with that will eventually meet some sort of reference adoption? Cause that's really the goal. You want your ESG benchmarks to be the reference that everybody needs to buy, at least as a data vendor. And then as an asset manager, if everybody can agree where you're supposed to be coming out on your benchmarks, that's very helpful particularly to keeping your LPs happy. So I think the top-down approach is really useful.

Damian:

Alright -- Lisa what's your take?

Lisa:

ESG is pretty exciting. I had a conversation with some guys from MSCI a couple of years ago, and I said, you know, listen , we've been talking about ESG data for quite some time. When is this really going to really hit the ground? And he said, listen, when these old portfolio managers get out of the way -- they use the expression fall off the perch -- that ESG will really explode. And I think, you know, that was a couple of years ago and I really think ESG given the regulatory environment in Europe, and the change in the administration in the US, the Paris climate accord, I think you're seeing a lot more companies really take a look at and trying to engage the millennials, right? You're seeing more companies take a look at how do we customize holdings. We have so many requests at RIMES right now to do custom holdings for ESG aligned indices because the millennials are really pushing at their portfolio managers and saying, listen, we're going to give you money. We're not going to give you a lot of it. We're going to give you something, but we want our money to be invested in companies that have the strategy and initiatives that we care about. So I really think that there's a couple of factors that are moving the market more towards the use of ESG. And I think that millennials are one of the big driving forces. So I think ESG is a hot, hot topic. And I think you're going to just see more and more of that customization of data using ESG. The issue is Jeremy, to your point, the standardization, no one understands what MSCI, how MSCI is , were ratings compared to Sustainalytics or any of the other ESG providers that are out there. How do they relate? I think they're having a really hard time getting their arms around these rating values that there's no transparency behind

Bill:

Don't you think it will get worse before it gets better. Right? And I say that because the regulators for many years have yet to step in, even for simple things that Jeremy rightly mentioned around emissions and carbon, number one. Number two, I actually think investors and issuers are getting further apart, not closer. I'll give you a recent example, which is one of the world's most respected and media savvy public officials on the planet, M ark Carney, who's now with Brookfield, he really made a terrible mistake when he said Brookfield was, u h, y ou k now, net zero emissions. You know, that's a pretty simple thing to claim and yet the outcry was immediate and large. And so if Mark Carney can't get it right. How's the rest of us g oing t o do?

Lisa:

I agree. I agree, Bill. I think it gets worse before it gets better. I think there's too much differentiation and lack of understanding to be able to understand, to really fully understand what these ratings represent. You really have to look under the covers and understand how these, the derivation of all these values. And so until you get to that level of understanding, you're going to make some bad decisions, I think. So I think it does get worse before it gets better. There needs to be more transparency.

Jeremy:

And I absolutely hate to make this an echo chamber, but I think Lisa, you said it from, from the get-go , if you look at millennials, they basically have an asset base that is typically 60% lower than their parents just based on inflation valuations, where things are in their life cycles. They're just not buying homes. They're not buying assets. They're , they're dabbling in equities. You hear the big, the big equity stories, but they don't nearly have as much exposure as their parents. And in part that's because yields for their parents were super high and equity valuations in relative terms were super low. Now we have this runaway equity valuation with free money that sort of crowds them out of meaningful positions in the market. Now don't get me wrong. We do have a very collapsed tech stack and a beautiful devaluation of what tech can do. Just given tech is practically free. At this point for them, there will be winners. They will obviously grow their money. Gen Z will have opportunities for breakout moments. But I think on the aggregate, the investing pool is very small for this new generation. So I think you said it right, this perch may be extended for another decade or two. And then until millennials and gen Z have significant asset tipping power, I agree. It's, it's a topic and it's an important topic, but it's one that isn't sort of pulled through until

Damian:

Unfortunately Jeremy's connection drops in and out for the last part of his thoughts. He essentially mentioned that he sees it taking another 10 to 20 years before the millennials grow their assets to the point of being able to pull punches and demand ESG investing. I told them that I see things a bit differently because the demographics tell me that baby boomers are there now between the ages of 57 and 75. So about half of them are already of retirement age and the oldest ones are approaching average us lifespan. So that means we're already beginning to experience the generational transfer of wealth from the boomer parents to their millennial children. And that trend will increase for the next decade or so. Millennials, obviously we all know have a very different priority set than their parents. And I think the relevance of ESG investing in the US will increase very quickly just because of these demographic shifts. Adding societal pressure and governmental policies. on top of that just gives me more reason to believe that the change is going to be fast. And with that, I turn the topic to how ESG data is being used today for investments. And specifically, I brought up the topic of ESG momentum. So the idea is that you may not necessarily make more money by investing in companies with high ESG scores, but the claim is, and there's some statistical evidence behind this, that companies with rising ESG scores do outperform the market. So ESG momentum, increasing ESG score seems to be a profit generating investment strategy.

Bill:

I have found it to be mostly about at this point, other than very sophisticated , uh, Quant shops with lots of resources. I have found it to be mostly about inclusion or exclusion of a name. Damian, you and I were talking about this on another day, but you know, let's take BP for example, which is peer basis, one of the best investors in green energy, but still dominates most of their revenue, and most of their profits don't come from fossil. And so do you include in trying to change their stripes or do you exclude it because of who they are?

Lisa:

Yeah, I think it is inclusion or exclusion, right? It's I want to exclude gun manufacturers, but I'm going to include solar energy panel manufacturers or something. I feel like it's really customed to what the drivers are. You know, people's personal preferences towards what things they consider to be valuable. Right. I have a friend that works for a small foundation that's a bunch of elderly nuns. And so they partner with UBS and they talk about what's the moral compass on my holdings. And so that's the way that they determine what's in their portfolio. I think it is personal preference at this point. I haven't seen it be momentum, but it's an interesting thing to go out and talk to some clients about Damian. And I'll tell you, I will absolutely be asking some clients that we have who are using ESG data and saying, you know, listen, are you using this as a construct? Or are you using this as a signal? Right. Cause I think that's, there's two different concepts there.

Jeremy:

I think the only thing that I would add to that is really kind of the, is there a hiding in plain sight aspect of somebody like a BP versus Cargill? Like I'm trying to think through Cargill or private companies, you know, there's a lot of politically charged statements around what people think of say the Koch brothers or what people think about Cargill, but is there a sort of an ability if you're a family office or a little bit more internally driven to sort of accelerate this, if you want to? I mean, I think the positive externality of this signaling is if you want to get ahead of it and you can control the narrative, you can do it. And I think some of the private equity firms that I know that have brought up in ESG team will actually use it as an accelerant, sort of are required to do it. They've already done it early. So I think, you know , having a via negativa on, do you exclude it or not exclude a BP because of the fossil component, that's absolutely one way to look at it. And then the other is, well, if your constituents are allowing you or you're a private company and you're allowing yourself the time to do it right, do you sort of force that austerity on yourself, just knowing you're getting ahead of it. So, you know, if Elon Musk commits to being the most perfect ESG company in the world, does that double his valuation again? You know, it could, it could very well if he's sort of saying, you know, we have perfect governance and wait , we don't use any sort of negative , uh , negative energy inputs into Space-X. Like, does that make his stock triple? I think it could. So I'd be interested to see, and I'm not saying he's committed to this yet. I just mean to be illustrative, can this whole social media angle of trying to go bottoms up and attract every retail investor, is there some signaling that somebody that's super Uber famous, like an Elon Musk could do if they wanted to do I remain fascinated by this topic? It is one of the most seminal and evolving that we can have.

Lisa:

I think Damian, one of the things that you mentioned is really interesting because I think it really ties back and it speaks to who's using the data, but it ties back to something that everyone knows, right? Which is fundamental data analysis -- looking at, you know, where's the revenue coming from to Bill's point and to your point, right, BP may be out leading the way in terms of green energy and green energy solutions. But a majority of their revenue is still derived from natural gas and oil exploration. Right? So I just wonder if there's not something that says we're going to dip our toe into the ESG water, and we're going to say, we're going to add it as another variable to something that we already know and know very well and do very well, which is fundamental data analysis. We have all of these analysts who are scouring all of the sec filings for instance, right. And saying, we need all of this data let's layer on the ESG values. And to your point, maybe we're creating our own ESG score that says, well, this doesn't seem to be representative of the ratings that I see out in the market, but I believed them to be true. And maybe that's the way that we'll really start to embrace the use that inclusion of ESG data in portfolio management overall.

Intro Music:

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