With the Sustainable Finance Disclosure Regulation (SFDR), the EU taxonomy, the election of Joe Biden, the European Green Recovery and a furious investor appetite for ESG products, the green transition is well and truly underway. However, the corresponding rush for ESG data, especially the data necessary for compliance with EU green regulations, has led asset managers to prioritise ESG concerns over SME investment, according to sources.
One unfortunate and unintended consequence of a data-driven green transition is that a number of SMEs have been locked out of green investment.
“Buyside firms are more concerned about differentiated and future-proof ESG data sets and research provision than they are about SME research,” said Mike Carrodus, CEO of Substantive Research, a firm that works with buyside firms in research discovery and comparison.
“The green transition is still very young but moving fast,” he added. “There are investors on the early part of the curve, trying to figure out how to get their data sets. Then you have investors further down the curve who have greater tenure.”
Those latter investors still need to monitor the data they have acquired, because the companies they looked at “six months ago might have released new data since then”.
Thus, the green rush for ESG data follows a two-step path: initial mapping followed by continual monitoring.
See also: Sustainable finance reforms for asset managers, threat or opportunity
Meanwhile, those SMEs that fail to provide the requisite data may lose out from green investors over time.
“Institutional investors looking to divest from firms without the requisite ESG data will become a more and more of a systematic problem for small caps,” said Maxime Mathon, head of external relations and communications at Paris-based AlphaValue. “As small caps can’t release as much data as the big caps, the portfolio managers will not be able to invest, because those companies can’t offer alignment with SFDR and the Paris Agreement. Scope 2 and scope 3 of SFDR, for example, are especially costly to produce and maintain for small caps.”
Mathon added that the assumption that small caps would have an easier time gathering the necessary data, since they are smaller, is false. “Often it is too costly and complicated for them to produce,” he said.
Mathon suggested that regulators help on-board SMEs so they can actively benefit from the taxonomy, NFRD and SFDR, as opposed to the current situation where they risk being locked out and left behind. “NFRD and the taxonomy are clearly good objectives, for the moment they do not help small companies produce the necessary data,” he said. “Regulators need to find a way to help small caps produce that data. That will be on the menu of discussions on NFRD, which start in Brussels on April 21.”
Meanwhile, Dominik Hatiar, regulatory policy adviser at European Fund and Asset Manager Association (EFAMA), stressed the lack of publicly available information as the main reason why asset managers are heavily reliant on information from third-party providers of ESG data, research and ratings, which “comes with high costs and many questions in terms of comparability, reliability and transparency”.
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According to Hatiar, asset managers are the biggest buyers of ESG data at 59%, followed by sell-side institutions at 19% and asset owners at 12%. “Asset managers use ESG data across the investment decision-making process, including portfolio selection, index construction, risk management and stewardship of investee companies,” he added.
The rush for green data is both demand-driven and regulatory driven. According to EFAMA’s ESG market insights, ESG funds saw their assets increase by 37.1 percent in 2020 to reach €1.2 trillion at the end of December. Net sales of ESG funds grew from €9.5 billion in 2016 to €235 billion in 2020.
“To use the Taxonomy and develop ESG investing products, asset managers need to be able to assess companies against specific ESG metrics set out in the Taxonomy technical screening criteria and SFDR Principle Adverse Impact indicators,“ Hatiar said.
Arthur Carabia, director, market practice and regulatory policy secretary to the International Capital Market Association’s (ICMA) Asset Management and Investors Council (AMIC) also stressed the massive ESG data challenge formalised by the recent wave of European regulation.
“When combined, the EU Taxonomy and SFDR feature extensive and detailed reporting requirements for the buyside,” he said. One of the biggest challenge is the lack of data on novel concepts introduced by the EU Taxonomy (e.g. "do no significant harm", "minimum social safeguards" in the EU taxonomy) and on certain KPIs introduced by SFDR which are not adapted to all asset classes and issuers.”
This data shortfall, he said, poses “very concrete challenges” in the short term, especially as labels are expected to be based to the EU Taxonomy (EU Ecolabel for funds and the EU Green Bond Standard for bonds). It also goes some way to explain the current “green rush” for ESG data among asset managers.
In the US, where there are not yet any stringent regulations, high demand means a similar dynamic is at play, as buyside firms look to divest from SMEs if they can’t provide the data they need, according to sources.
“ESG in financial services is a hugely growing focus area, not just from asset managers, but also from core investment banks and wider financial participants,” said Tej Patel, partner at Capco. “The demand for ESG consideration in financial services, initially driven by government and supra-national bodies, came first and the transparency obligations followed. Now firms are trying to understand how to collect and utilise the necessary and relevant data on which to judge ESG decision making.”
See also: Primer on the EU’s sustainable finance disclosure regulation
According to Patel, trying to reach a high level of accuracy in the classification of data is one of the biggest challenges. “It’s not good enough to say you’ve captured the data, you also have to stand by the data,” he said. “Fund managers that say the fund is ESG focused need to prove their ESG credentials and approach. That’s where the regulations come in to formalise the data driven aspect of what constitutes an ESG fund.”
“The obligations are difficult and the solutions costly to implement. Moreover, some of the data that funds need to capture is hard to standardise,” he added.
It is also fitting to remember that the green rush for ESG data is not the only factor behind the poor coverage of SMEs. Sources consistently stress that the decline in SME research is a long-term trend that predates even Mifid II.
Part of the problem is that the current structure of financial markets automatically puts SMEs at a disadvantage.
“For many asset management firms, small and mid-cap stocks are inherently unattractive,” said Steve Kelly, who is a special advisor to the European Association of Independent Research Providers (Euro IRP). “There are a number of stumbling blocks. Firstly, because SME stocks are relatively illiquid and not large in scale, an asset manager will struggle to acquire a comfortable amount of that stock without it being very visible in the market.”
“Then, even if they do succeed, and the stock performs well, since it is a small stock, it won’t have much of an impact on the overall performance of that asset management firm,” he said.
This means that asset managers investing in large caps is easier and potentially more profitable. However, it also means, that the more intrepid asset manager may find unseen value in small stocks, and of course there are a limited number of funds set up with this specific objective in mind.
“The virtuous circle concept – the idea that more interest and more coverage generates more liquidity and more investment – is true, at least in theory,” he said. “The hard part is getting the virtuous circle set up in practice - and circumventing the aforementioned structural forces that push the circle the other way: less coverage, less liquidity, less investment.”
See also: Taxonomy accelerates green market activity
According to Kelly, there needs to be at least three research providers to write about an SME stock to generate a sufficiently attractive level of interest and liquidity. The hard part is finding those three research providers.
