Variations in sustainability indicators can seem unclear and difficult to interpret without the right methodology and analytical tools. However, for financial institutions, it is essential to understand precisely the factors influencing these changes. This is key to adjusting investment strategy and making the right decisions.
But how can we explain why the same indicator, such as the carbon intensity of a portfolio, can vary significantly from one quarter to the next? What factors can we actually attribute these changes to? The answer to these questions lies first and foremost in a clear understanding of the factors that can cause an indicator to vary.
The first factor, and undoubtedly the most intuitive, is the exposure effect. This results directly from active decisions taken by the portfolio manager: the purchase of new positions, the strengthening of existing positions or the divestment (total or partial) of certain assets.
The exposure effect is particularly important to isolate because it reflects the manager's deliberate strategy. It is this factor over which the manager has the most direct control and can act to align their portfolio with their sustainability objectives.
Less obvious but equally influential, the market effect stems from fluctuations in the prices of financial instruments, which alter their weighting within the portfolio. This factor is independent of the manager's active decisions and can sometimes mask or amplify the impact of their investment choices.
For example, if the shares of carbon-intensive companies outperform the market over a given period, their relative weight in the portfolio will automatically increase, potentially degrading environmental indicators, even without any change in the composition of the portfolio.
Isolating this effect is necessary to distinguish between market movements and what actually results from the investment strategy.Â
Without this distinction, a manager could be unfairly penalised for a deterioration in an indicator that does not reflect their allocation decisions.
The third factor relates to the impact of the availability and quality of ESG data itself, whether it comes from public or private sources.
Paradoxically, improved coverage may appear to cause certain indicators to deteriorate, simply because more companies are now included in the calculation. Conversely, reduced coverage may artificially improve an indicator by excluding certain underperforming companies from the calculation.
Understanding the impact of these variations in coverage is essential for correctly interpreting changes in ESG indicators and avoiding hasty or erroneous conclusions about a portfolio's sustainable performance. However, this is no easy task, as there are numerous sources (on average, a financial institution uses around ten) and the data is often heterogeneous and needs to be processed before it can be used.
Finally, ESG indicators may vary due to intrinsic changes in the companies in the portfolio. A company may improve its environmental performance, strengthen its social policy or change its governance, thereby impacting the portfolio's indicators without changing its weighting.
These changes may result from genuine efforts by companies to improve their practices, but sometimes also from changes in their reporting or calculation methodologies. Distinguishing between these two aspects is important for assessing the portfolio's actual ESG performance.
The effect of invested positions is particularly important to monitor, as it can reveal the effectiveness of shareholder engagement policies. If an investor has actively engaged with a company to encourage it to improve its practices, an improvement in that company's ESG data is an indicator of the success of this approach.
In a world where sustainable finance is becoming the norm, financial institutions that are able to quickly identify these different factors will have a significant competitive advantage and will be able to use technology to enhance their sustainable performance. They will be able to set ambitious targets, monitor their progress in real time and communicate it more easily to all their stakeholders.
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