Digital analysis’s potential to transform sustainable investing

Using artificial intelligence and big data, several digital agencies have set up to analyse environmental, social and governance (ESG) data. They deploy algorithms to screen tens of thousands of data points, collecting the results to award ESG ratings to individual companies.

It’s too early to conclude that all the agencies offering digital ratings will generate investment signals that will reliably outperform. But their ratings are already being used by significant numbers of major institutional investors as a valuable addition to conventional ESG analysis. Whether they become a mainstream part of ESG investing will depend on conclusive evidence that they can predict future outperformance.

“Investors are pragmatic,” notes Isabelle Millat, Head of Sustainable Investment Solutions, Global Markets, Societe Generale. “They like to do good by doing well but ultimately they are looking for outperformance. And so, I think it will be very important to see whether this digital data delivers similar outperformance or superior outperformance versus the data of traditional ESG agencies.”

Complementing traditional ESG ratings

Until now, traditional research agencies such as Sustainalytics and RobecoSAM have granted ESG ratings to companies. They have done so by reviewing annual reports’ ESG sections, monitoring the media and scrutinising non-governmental organisation (NGO) reports. The resulting ratings are widely used by investors, especially as more and more have seen that ESG behaviours, or so-called non-financial indicators, are beneficial for judging a company’s management quality and positively correlated to financial performance.

Speaking at the Societe Generale Sustainable & Positive Impact Conference in Paris in November 2018, Andrea van Dijk, Director of Client Relations, Sustainalytics viewed the work of digital agencies as complementary to her firm’s approach. They would free up analysts’ time, she said, so that they could focus more closely on what was most relevant.

There are areas such as carbon footprinting where digital analysis has limitations. However, there are also gaps in the traditional agencies’ ratings that their up-and-coming digital peers should be well-equipped to fill. In emerging markets, for example, reporting transparency is poor and traditional agencies have in the past struggled to find enough data to construct robust ratings. As digital agencies search a wider range of sources, they can collect sufficient information to widen the coverage of ratings. The one source they generally avoid is social media – excepting a few respected opinion formers – because its content is often unreliable and subject to ‘fake news’.

Additionally, digital agencies are now developing specialist ratings for topics such as gender equality or human rights, which are gaining traction with investors, according to Andreas Feiner of Arabesque that spoke at the Paris conference, and which is offering « S-Ray » - a quantitative ESG analysis tool. They also cater to a growing demand for ratings based on the sustainable impact of a company’s products and services in addition to ESG behaviour, which is what ratings are normally based on. For example, an aircraft manufacturer might have an exemplary ESG rating for how it treats its employees and its governance but if it makes half the world’s commercial aircraft then it has responsibility for major greenhouse gas emissions. In particular, investors are increasingly interested in tracking how a company’s products and services contribute to the achievement of the 17 UN Sustainable Development Goals.

Predicting outperformance?

Returning to the key issue at the heart of the quest to do good by doing well, some digital ESG rating agencies are beginning to publish papers considering whether their ratings are genuine signals of outperformance.

In Millat’s view, the jury is out for now on whether they do so. Nonetheless, she is convinced of the potential for investors to use non-financial indicators to identify significant future stock price outperformance. For evidence, she points to the SGI European ESG Champions Index, which tracks the top ten percent of the Eurostoxx 600 companies as identified by Societe Generale’s in-house ESG research team. Their selection has outperformed the Eurostoxx by 27.7% between February 2013 and September 2018.

“For now, digital ESG analysis is just one more input for making an informed investment decision. In the future if digital provides outperformance, some investors will take it even more seriously,” concludes Isabelle Millat.