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Understanding ESG

Preqin

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In this article

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Challenges in ESG Investing

One of the biggest challenges to ESG is the metrics for measuring ESG accountability. A lack of available information, and standardized frameworks for analysis, present a major problem for investors conducting due diligence on investment opportunities. ‘Greenwashing’ is an increasing problem within the industry, as firms promote their ESG commitments without presenting reliable evidence or data to prove their validity.

Furthermore, it is not uncommon for a fund manager to receive a higher grade from one ratings provider than from another, due to differences in thresholds and reporting requirements. This is particularly true where some data is self-reported, while other data is audited by third parties. These discrepancies cause a lot of confusion for investors looking for points of comparison.

ESG Public Markets vs. ESG Private Markets

As a result of stricter reporting and compliance, there is much more data available for public markets than for private markets. The alternative sector is opaque in nature and is especially lacking transparency when it comes to ESG disclosures. Firms might have policies and initiatives in place, but either don’t see the need to communicate that information publicly, or actively prefer not to because of competition or compliance reasons.

However, this is not to say private markets are avoiding ESG. Alternative assets may have fewer regulatory reporting requirements, but they face greater accountability to investors. In fact, many capital allocators and asset managers are increasingly seeking out ESG data across private market asset classes.

Since efforts to collect data are often undertaken through direct engagement, rather than via standardized reporting frameworks, the process and outputs vary significantly between industry participants and their use cases.

For instance, some GPs focus solely on risk management to prevent costly incidents, while others seek to create impact by investing in underrepresented regions, social groups and causes.

Stewardship in Alternative Assets

Stewardship in alternative assets looks quite different when compared to public markets, as there are stricter reporting requirements for public companies. There are some nation-level initiatives such as ‘The Stewardship Code,’ which is a part of UK Company Law and underlines the principles that institutional investors are expected to follow. Managed by the Financial Reporting Council (FRC), its goal is to get institutional investors to be proactive and engage with stakeholders.

Global ESG Organizations and Frameworks

As discussed in Lesson Two: History of ESG, a large number of global organizations have been launched in recent years with a particular sustainability purpose in mind. Some of the more established names include United Nations Principles of Responsible Investing (UNPRI), Sustainability Accounting Standards Board (SASB), Global ESG Benchmark for Real Assets (GRESB), and the Task Force on Climate Related Financial Disclosures (TCFD).

The Principles for Responsible Investment (UNPRI or PRI) is one of the most popular affiliations. The collective AUM represented by PRI signatories increased by 20% from 2019 to 2020, from $86.3tn to $103.4tn as of 31 March 2020, across 3,038 signatories (2,701 investors and 337 service providers).This is the most popular affiliation among the GPs covered by Preqin’s ESG module – of currently covered firms, 74% are signatories. See UNPRI's Annual Report here.

Global Approaches to ESG

It’s not uncommon to come across a fund manager that doesn’t disclose their executive members publicly, or a GP that swears by its ESG investment policy that’s also not to be found publicly. This is less common in the European Union and the United States, which stand out for their high level of disclosures, as seen in the chart below. However, when it comes to the world of alternative investments, ESG transparency isn't as consistent as in the public markets. 

The chart below shows the AUM under ESG commitment from around the world. This provides insight into which regions are most transparent about their ESG-committed capital.








Within the United States and the European Union, there is more pressure from investors for transparency, and a greater regulatory push from lawmakers. While the Sustainable Finance Disclosure Regulation (SDFR) in the European Union came into force in March 2021, the US Securities and Exchange Commission (SEC) is catching up quickly, and new disclosures rules are in the making.

Regulation in the EU has started cracking down on Sustainability Reporting standards for private capital. This is exemplified by a set of EU rules from the Sustainable Finance Disclosure Regulation, which classifies funds into Article 6 (no ESG incorporation), Article 8 (ESG Fund), or Article 9 (Impact Fund). This is designed to improve transparency across ESG-related investments. The SFDR is also part of the European Green Deal, which targets a carbon neutral EU by 2050.

Meanwhile, the SEC in the US has announced the creation of an Enforcement Task Force focused on Climate and ESG issues in March 2021 as a response to increasing push from investors on more ESG transparency. See the SEC's announcement here

Government support for ESG in Asia-Pacific has started to ramp up over the past year. In 2020, China, Japan, and South Korea all pledged to achieve complete carbon neutrality by 2050-2060. In March 2021, the Chinese Government put a priority on climate change in its 14th five-year plan, outlining a 18% reduction target for “CO2 intensity.” The national pension and sovereign funds in China, Hong Kong, Malaysia, and Thailand have also incorporated ESG into their investment strategies.

How to Incorporate ESG into an Alternatives Portfolio

Preqin’s ESG Transparency Framework compiles multiple metrics that help measure both GPs’ and LPs’ commitment to ESG. Subscribers can “cherry-pick” which factors are of interest to them, and filter firms with criteria disclosed either publicly or privately to Preqin. While it’s very common to think that a comprehensive ESG Policy would be the single most important factor, this approach is limiting because it doesn’t describe the depth of the commitment. This is best measured using a combination of data points at different levels. Click through the drop-down below to explore examples of data points.
Firm-level
Firm-level: A modern slavery or human rights policy, Insider Trading policy, disclosure of a Public Sustainability Report, or any mention of ESG consideration in operations.
Portfolio-level
Portfolio-level: Total AUM in Impact or SDG-related companies, fund offerings sold as "Impact" or "SDG" funds, total AUM disclosed as subject to ESG criteria or policies, dedicated ESG investment staff, or an investment policy that includes ESG issues.
Asset-level
Asset-level: Reporting or monitoring portfolio companies using ESG KPIs, tracking of GHG emissions at portfolio companies, an engagement process focused on ESG issues with portfolio companies, or a code of conduct policy for portfolio companies.
Views of ESG transparency are also available across the variety of filters on the Preqin Pro platform.

For example, certain clients are specifically targeting indicators developed by the Sustainability Accounting Standards Board, as part of their due diligence in ESG. By filtering the ESG Core Data for data points applicable to the SASB Materiality frameworks, Pro users can create their own view of ESG transparency, based on publicly disclosed SASB data points captured by Preqin.

The below chart shows you the percentage of ESG transparency different firms have. As you can see, the disclosure of ESG commitments by firms are greatly varied, with some having a 10% ESG transparency metric, and others having over 90%.

ESG Risk Exposure

Risk Exposure is the second part of Preqin’s ESG product. It was created in partnership with SASB by combining SASB’s industry risk-mapping with Preqin’s rich proprietary deals information.

To find out more about SASB, click here.

Preqin's ESG Risk Exposure module shows the count of active investments (portfolio companies) within a fund that fall under each of 26 issues (which are further divided into Environmental, Social, and Governance pillars). The brighter the yellow color of a given issue, for example Energy Management, the more portfolio companies operate in the industry/field that presents this inherent risk. It doesn’t mean these risks will become material, but it’s helpful to use this heat map when assessing exposure of a given fund, and for starting the conversation with a GP regarding mitigation of specific risks.

The risk-mapping module covers both the firm and fund level. With the ability to look at all active PE/VC/PD portfolio companies, Preqin can analyze risk against SASB’s 26 factors, to show where there is volume in exposure to materiality.

The below graphic shows a sample of what Preqin’s interface can display. In practice, the module allows you to click between a firm or fund chart and see a table with all a firm’s funds, or all of a fund’s individual assets. To see SASB's materiality map of 26 factors, click here.





GPs are now required to demonstrate their capabilities assessing the ESG risk exposure of their investments when managing portfolios. At the same time, an LP frequently conducts due diligence for a particular GP's investments, to make sure they are adhering to the LP's chosen ESG policies. Preqin's data platform, Preqin Pro, now has a 'Risk Magnitude Score'. This ESG Solutions tool features risk scores for over 124,000 private companies, based on both industry and geographical risk. This provides a top-level score of GP’s investment at the asset and fund-level, through digestible and comparable metrics. In practice, GPs and LPs use these risk evaluation metrics to benchmark themselves against their peers, to understand the level of ESG risk associated with their investments, and as a tool for reporting to comply with regulatory requirements.

When industry participants are evaluating portfolios, they often consider the potential for positive impact resulting from the investments. With ESG changing the expectations of alternative asset investors all the time, understanding the short and long-term impacts of an investment is key. With Preqin's Impact Assessments, LPs have the ability to assess GP portfolios based on its potential to make a positive impact, using the Sustainable Development Goals as a reference. Using these robust metrics, LPs can gather the transparency they need to understand the likelihood of positive impact. With transparent data and ESG metrics, industry participants are equipped with the knowledge to help them invest responsibly.


In this lesson, we covered the challenges involved in ESG investing, how global approaches and frameworks differ, and how industry participants can measure their ESG risk exposure.