The following is a summary of the chapter entitled ‘Index and Analytics Provider’ in the ‘Sustainable Capital Markets’ book, edited by Stephan Leithner from Deutsche Börse Group.
By Holger Wohlenberg, Chief Strategy Officer at Qontigo
With the so-called passive revolution unabated, indices and analytics are playing an increasingly important role in capital and investment markets. Today, the investment process more and more involves the use of data and intelligent tools, be it in defining the overall strategy, or in portfolio construction, risk monitoring and performance reporting.
The growth of index-based investing has been a feature of the asset-management industry in recent years. Up to 40% of the US investment market is now allocated to passive vehicles.
Sustainable index-based investment products represent only a fraction of that, even if since the early 2000s sustainability criteria and policies have steadily permeated the mandates of big investors. In the first quarter of 2021, there were just over 200 billion euros invested globally in sustainable ETFs1, or 2% of all passive investments. While sustainable ETF assets are growing at five times the pace of their traditional counterparts, they could and should be growing at an even faster speed. A large share of asset owners and managers already include sustainability data and principles in their investment decisions, and investors willing to reallocate their capital into sustainable ETFs have no shortage of options.
In parallel, the development of sustainable investment analytics solutions is an important complementary factor for the full integration of sustainability in the investment process.
Sustainability-related analytics go far beyond mere scores, to deliver metrics for investment decisions. But they require sophisticated modeling tools to explore new multidimensional interactions between risk, return and societal impact. Modeling and optimization are, therefore, the most important tools to achieve the best sustainability performance in compliance with financial objectives.
Accelerators and decelerators — lessons from the recent practice
The regulatory environment plays a big role in the speed of capital market migration. In the analytics and indexing environment, we can identify at least four key drivers that impact the speed of money inflows into sustainable products: product efficiency, standards and labels, issuer transparency and method design.
> Product efficiency
Current inflows into sustainable investment vehicles are primarily funded by released liquidity. The sale of ‘brown’ assets as a source of funding, however, has not yet taken place in significant quantities. Fund sponsors have only selectively slowed down the distribution of non-sustainable offerings, mindful of the competitive landscape in the market. Asset owners, meanwhile, face transaction costs and capital gains taxes from the reallocation of assets. For those without the pressure of a sustainability mandate, it takes a very efficient product proposition or improved portfolio performance to entice them to switch.
> Standards and labels
While Europe has developed the world’s most comprehensive sustainable investing agenda, uncoordinated action at the national level has impacted market transparency, costs and liquidity for index and fund providers. This is particularly true around sustainability fund labels, which are supposed to act as an important guarantor of quality. Across Europe, these labels differ in scope, rating and weighting. It is thus impossible to develop a sustainable investment product that meets all labels and complies with the regulation across the entire European market.
The lack of a common pan-European understanding of what constitutes a sustainable investment product results in major disadvantages. Among them are:
> Issuer transparency
- Financial market participants have to bear higher costs as the fragmentation of investments prevents economies of scale on the provider side
- Products have to be updated regularly according to ad-hoc requirements and as expectations are revised, leading to significant costs and a deterioration in transparency
- Substantial assets continue to flow into investments that make no meaningful contribution to urgent objectives, such as working towards the UN Sustainable Development Goals (SDGs) or achieving net-zero emissions
In the absence of complete and thorough sustainability indicators from companies, vendors of investment products and data often need to rely on models and assumptions that are not necessarily realistic.
That said, data reporting is likely to continue to improve as several recent initiatives (International Financial Reporting Standards, Task Force on Climate-Related Financial Disclosures, Corporate Sustainability Reporting Directive) may force companies to better disclose non-financial metrics. Such disclosures are an essential prerequisite for high-quality sustainable investment products and for higher and faster acceptance from investors.
If the available data is too superficial, financial service providers are limited in what they can do and will struggle to adhere to sustainable investment standards. Only “double materiality”2 — i.e., the documentation of the effects of corporate activities on the environment and society — can guarantee a holistic approach to sustainability performance and take into account negative social externalities that have not been priced in.
Finally, a global alignment of disclosure standards will prevent benchmarks from being set around the lowest common denominator of national requirements.
> Method design
To reduce complexity and prevent greenwashing, governments and regulators have in very recent years introduced methodological standards and guidelines for sustainability indices. These include the legislation behind the Paris Aligned Benchmarks (PABs) and Climate Transition Benchmarks (CTBs), as well as the EU Taxonomy.
It is crucial to develop such methods with an understanding of market psychology, including the interest of market participants, awareness of the mechanics of financial products, and the availability and feasibility of datasets. In particular, the data required for the calculation of the indices must be available at a reasonable cost.
Regulatory ways to improve sustainability indices and analytics
All four mentioned drivers of indexing and analytics are exposed to a considerable influence from regulators. It is in their hand, therefore, to enable Europe to stay at the forefront of sustainable capital markets through the proper use of indices and analytics. Some recommendations in this sense include:
> Create incentives for the switch to sustainability
Stronger regulatory incentives are needed to catalyze the switch to sustainable investments. These could include:
- A greater tolerance of tracking error in investment portfolios targeting sustainable performance
- Incentives, such as tax breaks on necessary trading transactions, for switching to sustainable benchmarks
- Offering investors broader opportunities in stocks, real estate, infrastructure and private assets to encourage the switch to sustainability
In addition, incentives must remain for providers of sustainability indices and analytics to introduce attractive products. Financial market participants will continue to develop innovative solutions and invest in sustainability-related R&D if they can keep control of transaction costs.
> Harmonize European standards and labels
The European regulatory agenda for sustainable investment is unprecedented.
It can influence similar regulations in other parts of the world and lead to a consistent, comprehensive and competitive environment. To achieve this, European policies must be consolidated, or at least harmonized, across the various working groups and initiatives (Sustainable Finance Disclosure Regulation, CSRD, Markets in Financial Instruments Directive, EU Taxonomy). In addition, regulators must play a pioneering role in the convergence of the numerous sustainability standards that are issued at the local or national level, which, as they are, lead to a patchwork of interpretations.
A building block approach to sustainability portfolios
Download our new research paper to learn how portfolios can be built that provide more attractive sustainability characteristics – without taking on too much risk.
Download >> Include standards for disclosure of double materiality
In order for investors to make effective decisions with their analytics and risk models, companies must disclose significantly more about themselves. Although the EU has made the disclosure of data part of their sustainability agenda, the scope and depth of current reporting is still not sufficient. Ideally, issuers should be required to produce the mandatory information as early and as comprehensively as possible, and to make historical time series available. This data set should not be limited to climate factors.
European regulators could set precedence by defining the concept of double materiality in a broad context and with a long-term perspective. The European Single Access Point (ESAP) for financial and non-financial information can play an important role in this. It should include a wide spectrum of data and should be open to non-EU companies.
> Include European index providers in standardization bodies
To have a leading role in the global conversation about sustainability, Europe must speak in a single voice. This means that major European players along the entire value chain of investments must come together.
Index and analytics providers are an important link between investors, data providers and regulators. However, today European index providers are not directly connected with the EU’s Platform on Sustainable Finance, a situation that limits their contribution to developments and the enhancement of index methodologies. They should become part of the official regulatory and standards development bodies to ensure a market impact.
1 Source: trackinsight.
2 The European Commission’s 2017 Non-Binding Guidelines on Non-Financial Reporting introduced a new ‘double materiality’ element to be taken into account when assessing the materiality of non-financial information. A first reference is that climate-related information should be reported if it is necessary for an understanding of the development, performance and position of the company. The second reference is on environmental and social materiality: climate-related information should be reported if it is necessary for an understanding of the external impacts of the company. See Official Journal of the European Union, (2019/C 209/01).