In the bond market, investment grade is code for quality and robustness. But what exactly is an investment grade asset—and could the term be applied to ESG (environmental, social and governance) data to help investors and real estate owners get a true picture of a portfolio’s performance in these areas?
Investment grade securities refer to those that have been diligently scrutinized, assessed, and weighted to ensure they are of the highest quality against a benchmark of peers. Of course, a high level of due diligence doesn’t guarantee the asset will perform well. But, at the very least, the label provides investors with the assurance that the asset they’ve chosen is the genuine article—that it is what it claims to be.
So how could this apply to ESG?
A company’s ESG efforts have become a popular criterion for both retail and institutional investors. The idea is that if a company follows robust ESG guidelines, it is a better long-term bet as an investment because it has taken the sustainability of the business into account. A strong ESG performance means a good investment—or so the theory goes.
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But some investors and investment professionals are skeptical that strong ESG performance actually correlates with better financial performance—especially in the real estate sector. And absent hard data, such an assertion can be difficult to prove—even if some of the biggest names in the investment world believe it and quite a bit of research suggests it may be true.
Both ESG advocates and skeptics would agree that better ESG data is essential to evaluate an asset’s performance. After all, reliable and accurate quarterly financial reports are vital indicators of performance and mandatory for regulated companies and stocks.
“Companies do not go in front of auditors or investors and say ‘Here’s our estimated financial performance for the past year,’ so why treat ESG performance any differently?” says Matt Ellis, CEO of Measurabl.
“This is the difference between investment grade ESG and greenwashing: Investment grade means actual, auditable data. Greenwashing means guesses.”
Transparency is key
Fixed income investments—better known as bonds, bills and notes—are rated by credit agencies—notably S&P, Moody’s, and Fitch—to provide a useful measure for comparing securities. These agencies rate companies based on their financial strengths, prospects, and past histories. Simply stated, companies with manageable levels of debt, good debt-paying records and good earnings potential have good credit ratings, while companies deficient in those criteria do not.
Corporate bonds that the ratings agencies have deemed not investment grade—known as “junk bonds”—are usually issued by companies that are not financially sound. They tend to have higher returns than other types of bonds, but they come with a considerable amount of risk.
So what does investment grade ESG look like, and how could firms achieve the necessary data quality? Would it look like bond ratings or something else?
“This is the difference between investment grade ESG and greenwashing: Investment grade means actual, auditable data. Greenwashing means guesses.”
Matt Ellis, CEO of Measurabl
Shanka Jayasinha, CEO of EDGE AI Technologies, believes the idea of investment grade ESG combines two different concepts. First, an investment grade opportunity will meet specific requirements in terms of its balance sheet and other financial measures and will be healthy overall with robust cash flows. But the ESG component needs to ensure the company’s interests align with the well-being of the company by measuring its progress.
“Overall, investment grade ESG would look at how a company positions itself for the future,” says Jayasinha of ESG vehicles generally, and real estate assets in particular. “You need maybe five years to a decade to develop an impactful ESG strategy that will make sense financially.”
Jayasinha says an ESG rating for real estate and general assets alike represents little more than good publicity unless it’s adequately measured.
“But ESG metrics are tough to qualify because of the variety of factors and indicators you could use to measure environmental or social impact,” he says.
MSCI, a leading provider of research-based indexes and analytics, currently provides ratings based on ESG, and Jayasinha notes that many growth companies in the tech field such as Alphabet, Texas Instruments, Microsoft, Salesforce all have strong ESG ratings.
“MSCI researchers have done a great job quantifying their own factors, but they could explain their methodology in a more transparent way,” he says. Jayasinha adds that he wouldn’t rate MSCI’s scores as differentiating “investment grade” ESG companies from the rest of the crop.
For real estate assets to be seen as investment grade ESG opportunities, the same principles would be applied. But the challenge is one of scale.
“For single-family units, social and governance criteria wouldn’t necessarily apply. But if you look at real estate investment trusts, you would need an assessment on every asset of the portfolio to say if the REIT is ESG approved,” says Jayasinha, adding that such an assessment becomes difficult when there is little in the way of standardized ESG criteria on offer to real estate asset holders. “I know some REITs proclaim themselves as sustainable, but it is tough to see which ones truly have an impact on an investor’s performance.”
Investors want benchmarks
Cynthia Dalagelis is a fintech specialist who has worked for many years in what’s known as family office—private wealth management for ultra-high-net-worth individuals or families. She believes that investment grade ESG is not only possible but “critical.”
But like Jayasinha, Dalagelis says some of the current data offerings benchmarking ESG performance compared to traditional or non-ESG investments “are still not concrete.” But she is encouraged that they’ll get there.
“Some investments have fared better than their non-ESG counterparts simply because the level of scrutiny and fine-tooth analysis that goes into an ESG investment is much more in-depth than traditional investments,” she says.
Still, benchmarks might not currently reflect this internal scrutiny. Others like Dalagelis are looking forward to seeing more scalable solutions to measure and accurately rate ESG vehicles.
Dalagelis says that within the ultra-high net worth space, real estate is an asset prized for both its wealth creation and preservation qualities. Yet for those wanting to invest in ESG real estate, there is a “large hurdle within projects considered sustainable or green accredited and a lack of consistency in standards from project to project.”
Dalagelis says numerous firms are striving to streamline data that will make its acceptance more universal among real estate and infrastructure investors.
“What is needed to create wider adoption is a sophisticated approach to data modelling, and quantitative assessment while reviewing the performance of companies and investment portfolios against financially-material metrics to uncover long-term value that is ESG aligned,” Dalagelis says. “What truly moves the needle long term is considerations and tangible incentives on both sides of the market, that are backed by industry-accepted data that assures long term upside.”
How investment grade ESG data in the real estate sector will be achieved is still in the process of being decided, Dalagelis says. But she believes it is on its way.
“Some investments have fared better than their non-ESG counterparts simply because the level of scrutiny and fine-tooth analysis that goes into an ESG investment is much more in-depth than traditional investments”
Cynthia Dalagelis, Fintech Expert
Mitigating risk
Megan Morrice, head of operations for advisor-client matchmaking tool ValuesAdvisor, offers an even more blunt analysis: “Investment grade ESG is currently not a thing,” she says. “But it should be.”
Ratings agencies today largely focus on the price and growth of an ESG investment. And while there is evidence that ESG compliance correlates with better financial performance, Morrice believes there’s a stronger case that ESG data assesses risk.
“Just like an investment grade bond, a company with higher ESG scores is at a lower risk of default,” says Morrice. “For environmental impact, think of the BP Deep Horizon rig spill in 2010 or Pacific Gas and Electric’s role in California’s wildfires. For the impact of governance, the recent scandal with German fintech firm Wirecard is a great example of how ESG can home in on areas that traditional credit raters can miss—their ‘Business Ethics’ score plummeted years before the arrest of the CEO.”
Morrice suggests investment grade ESG could be scored similarly to investment grade bonds. Just as the SEC designated ratings agencies as Nationally Recognized Statistical Rating Organizations (NRSROs), certain data firms could be designated Nationally Recognized ESG Rating Organizations (NREROs).
“The biggest improvement to current ESG providers could be made by giving them more access to quality data by making more disclosures required,” says Morrice. “No business wants onerous reporting requirements, but there is already data that companies are required to collect and not share. For example, companies with more than 100 employees are already required to collect gender and racial diversity data to file to the Federal government.”
One thing seems clear: For the idea of investment grade ESG to truly take off, uniform, robust data will be the key. Without an accurate and consistent way to track and report environment, social, and governance data—three components that are very different in their own right—it is challenging to compare ESG investments and rate their performance against a benchmark.
More headway has been made on environmental issues, which may be easier to quantify with hard data like carbon emissions, energy and water usage, waste output and carbon offsetting efforts. But social and governance measures are still somewhat elusive—tracking efforts in these areas will require some level of ingenuity until standardized methods are developed.
Yet with the big ratings agencies all coming out with their own ESG indices and trying to quantify the sustainability progress of companies, it seems the concept of an investment grade ESG is on the verge of becoming reality—a welcome development by ESG advocates and skeptics alike.