27 April 2023

ESG data and verification in private equity - part one

This is a redacted version of a conversation in London convened and moderated by Environmental Finance and sponsored by SGS.

The participants were:

Amara Goeree - Sustainability Director Private Equity, Schroders Capital
Carol Tarr - IMM Lead, Phenix Capital Group
James Magor - Director, Sustainability, ACTIS
Simon Colton - Business Development Director, Sustainable Solutions, SGS
Stanley Kwong
- Principal, Sustainable Investing, KKR
Peter Cripps - Editor, Environmental Finance

Peter Cripps: How do you go about verifying the ESG claims and impact of your investments?

Stanley Kwong: I think collecting the data in a systematic way across the different regions is the stage we're at. So, we haven't necessarily gone out to verify all this data. We've put in a lot of effort to actually just make sure we capture the right data.

And then we do a quality assurance with the support of an ESG consultant. So, it's about verification as well as adding a layer of validity checking on whether the data coming in is correct.

Peter Cripps: Which ESG consultant do you use?

Stanley Kwong: We use various. It depends on the different requirements. But it just provides a sense-check to the team looking at the data.

And then what we're trying to implement a bit more is having benchmark data to support that verification and validation as well. So, if a utility water company is reporting this level of water, is that the right comparison in the market? Is it way off or is it not?

For aspects which are ESG-linked, either as a loan or to compensation, we probably add an additional layer of what we call verification and validation, because it needs to be very specific. It needs to be very exact what is reported back to us.

Peter Cripps: And who would that be verified by?

Stanley Kwong: It could be second-party opinion. It depends on the mechanism.

If it's a sustainability-linked loan, then normally there's some kind of external verification. If it's an ESG-linked compensation, again depending on the mechanism, there should be some verification somewhere, so it's not just reported and we say: 'Okay'.

James Magor: I think ESG data verification is still quite nascent. Impact probably moved before ESG.

We were one of the founding signatories of the Operating Principles for Impact Management in 2019, which includes verification requirements.

We've had assurance of our impact system quite regularly over the last four years to give ourselves, but more importantly to give our investors, confidence that when we talk about our impact measurement approach, what we're saying we're doing.

Also, we recently completed a verification audit with Blue Mark, and they were great because they gave us a lot of really valuable ideas about how to continuously improve and strengthen our system. So, it wasn't just about the assurance; it was also about learning and continuously improving.

Amara GoereeAmara Goeree: We've just finished some diagnostic work with Blue Mark as well. Their hands-on take on verification of the impact investment process has been very meaningful to us.

They focused on the overall robustness of our process, including ESG integration. We have spent much of the past 24 months refining and developing multiple aspects of the process. Their comprehensive feedback gave us confirmation that we are on the right track both with regard to what we already have in place and the roadmap to continuously further refine the process.

Switching to our sourcing and due diligence procedures, when investing in impact fund strategies, we are seeking a high level of professionalisation. We really have to be comfortable that the funds that we invest in also have a process in place that is at least as robust as ours and is set up to create competitive value.

This is where verification, from our perspective, could come in. When we speak to an impact manager that has had credible external verification of their process (and data), we consider it a big plus.

Nonetheless, we encourage our GPs to focus on external verification that adds most value to their investment practice. If you compare verification for the Operating Principles for Impact Management, to SBTi or even B Corp, we would see the first as most valuable. It is industry specific and process oriented.

Simon Colton: I think some of the good feedback that we've been getting from our sustainable report assurance clients is the fact that we give recommendations as well. It's not just a pass/fail type assurance report. It's: you are doing all right here but you could improve this. And so that sort of diagnostic feedback I think is quite useful.

Carol Tarr: The E in ESG is mature, right? We've established points and verification, collection of that data. But I'm still seeing a lag in the social processes of data collection, the data points, what the expectations are, how you can verify that. So, for me, that's a particular pain point.

And I would like to get more capital moving towards more of these projects working on, say, education. So, what kind of inputs or outputs would be meaningful there?

So, I see this as being a real area of opportunity. And the fact that the social taxonomies aren't coming out any time soon from the EU – is that because of shifting priorities, or because it's too complicated? I don't know what's going on – but for me, I would love to see that area take off and have social KPIs that we can all agree on, that we can measure.

Simon Colton: If you look at the Corporate Sustainability Due Diligence Directive (CSDDD), that supply chain part has an element of human rights in it. So, will that push things forward? Mainly just focusing on anti-slavery, anti-bribery, not looking at the KPIs ...

Carol Tarr: Right, looking for these particular areas of risk mitigation. For me, we're missing the benchmarks for this, missing the leadership on it.

I've seen it said that there is not the potential for financial return for the social investments on the level of environmental investments. And if you don't have a benchmark in place, and you don't have anything really quantitative in place for this, it's never going to assure investors that this is a good place to move capital.

Stanley Kwong: The businesses which we work with may find it increasingly challenging to do various ESG assessments, such as the EU taxonomy. As such, if we bring in a consultant to verify or validate such assessments, they must be well equipped and knowledgeable on the regulatory context.

Peter Cripps: What I've never understood is the 'big four' firms, which are already doing all the accounts and assurance, particularly as reports are becoming more integrated, they're ideally placed to sign all this stuff off and solve these problems. Why is that not happening more?

Amara Goeree: I am not sure to what extent it's a question of they 'can't' or 'won't'. Companies should have revenue information at a product/service level available internally, that should allow them to report EU taxonomy-alignment. But today, very few companies are reporting that level of detail.

When they provide detail, they usually pick regional – or maybe country or product group revenues – but not product by product. I think that's the complexity around the roll out of the EU green taxonomy.

Carol Tarr: Why are they avoiding the transparency?

Amara Goeree: I can't speak to why are they avoiding the transparency, but I do believe that private equity investments are for the most part better positioned because there are usually fewer business lines, and generally smaller firms. Yet, we also still see little adoption of the taxonomy at our fund managers.

By way of contrast, even when I was on the ESG rating side 5-10 years ago, getting product-level revenue information was something we always tried to get. Listed companies just didn't provide it in public reporting. At best, they might do country or product group, like Philips I believe does. Or they used to at least...

James Magor: An area that we are exploring increasingly is, how do we provide buyers of our companies with objective evidence that the company is truly a sustainability leader?

One of our ambitions is that all of our companies should be sustainability leaders in their sector and market. Now, how do we validate that point?

We recently completed an exit of an African wind power company called Lekela. And when we started the exit process, as a shareholder and management team, we believed we'd created a truly remarkable company. But how could we show that to the buyers?

You can't rely on buyers finding the great stories during their due diligence because inevitably, they may be short on time, they're focused on material risk, and not so much on finding the positive aspects of ESG performance.

The company, Lekela, won a number of awards, which create external proof points, including from Environmental Finance. But to further demonstrate sustainability leadership, we obtained a private rating with Sustainalytics and, at the time that Lekela was rated in 2021, they were rated as the number one power utility in the world from a sustainability perspective. This is an African power company!

You know, a lot of buyers would look at that acquisition opportunity and would be concerned about "Africa risk" and emerging markets risk more generally, but the rating enabled us to demonstrate objectively that, relative to their peers all over the world, in Europe and the US, in much more developed markets from an ESG risk management perspective, Lekela were ahead of their peers and they were number one. That external point was, we believe, very valuable during the exit process.

Peter Cripps: And have you done that for many of your holdings?

James Magor: Lekela was the first but it's something we are looking to do more and more to validate our companies' sustainability leadership.

Stanley, is that something you've looked at?

Stanley Kwong: I'd say no, not yet. But I think, I guess my personal view of ESG ratings is that it's aggregate so – that you form a view on the ESG rating of the company. Whereas what we're seeking to do is assess the performance of underlying variables like, emissions of a particular company, human rights, etc.

So, rather than provide an overall score, we're trying to be a bit more granular.

Amara Goeree: Combining methodologies is likely to provide the best of both worlds. Viewing an asset's firm-level ESG score or benchmark performance with sharper focus on individual metrics, and how they are developing in isolation and against competitor firms, could create an optimal ESG outcome.

There is still a gap for both in the private equity space. I think that's what the ESG Data Convergence Initiative (EDCI) is doing well, at least on data points: starting to offer a benchmark to the private equity space.

This market gap is probably why a number of ESG ratings like Sustainalytics and S&P are trying to reshape their assessments so it fits private equity. And they do have some LPs who are working with them. There are also players popping up that have created ESG ratings for private equity. But data sharing remains a sensitive topic. So, it's really hard to get to a significant benchmark.

For now we will have to rely on our own expertise, our own benchmarks, and hopefully, with the scaling of initiatives like EDCI, have some benchmarks on data soon.

Carol TarrCarol Tarr: This is an area with a conflict of interest that I see a lot: where you have the verification done by the same company that provides the advice. So, are they representing the LPs? Are they representing GPs? They're representing both?

We're really trying to push that as an industry standard that you don't verify your own work. Because that's very common and accepted right now.

But we really think that there should be some kind of clear bifurcation in the process, and we'd love to get other people to sign on the idea.

You could say that you don't have lunch together, that you sit on different sides of the office. But until you really make sure of that, you can't do both in the same company.

You would think that as the industry matures, that these kind of questions would come into play more. And we have all these regulatory standards, and we talk about everything, but we have not talked about the basic conflict of interest here, where you can verify your own work and ...

Peter Cripps: Mark your homework?

Carol Tarr: Yeah. And I think that this is a conversation that really needs to be picked up and something has to be done about it.

Peter Cripps: Is this something that's on LPs' radars, that they're saying: 'Okay, who's really verifying all these claims?'

Amara Goeree: We recently marketed a couple of SFDR Article 9 strategies, where the promise of external verification on the Operating Principles for Impact Management definitely added value in the sales proposition.

The general increase of ESG and impact investment strategies since 2015, the EU SFDR regulation and other regulators challenging greenwashing has increased the demand for external opinion on the credibility of an investment approach.

Data and reporting also play a big role in that. The market will doubt the credibility of a product if there is no quantitative ESG or impact reporting as an output of the investment process.

But there seems to be little pressure to have that data itself verified to date, especially if the process has been through verification.

One thing I do feel strongly about is that, as the private investment market's external verification expectations mature, we should use the lessons learnt from sustainability reporting assurance. Having gone through that process, and analysed the approaches of multiple providers, I remember that players like SGS have strong and credible approaches. Let's look at the standards we already have and start applying them to our own ESG and impact processes.

I hope current regulatory developments, under for example CSRD, will also contribute to standardisation on the investment side.

In the second part of this discussion, the participants address the topic of the quality of data provided by private holdings.