Coralie De Maesschalck
Head of CSR & ESG, Kartesia
ESG data – its availability, relevance and comparability - is at the center of a wide industry debate which is even more lively for private markets. We discuss three ways to deal with this issue, and reemphasize the central role of due diligence in the ESG analysis process.
Small is beautiful. Small is dynamic and responsive - but also often less researched. The availability and quality of company data is a key challenge to ESG research in general, and even more so in private markets where regulations related to sustainability disclosures are less stringent than for larger listed companies.
Data sourcing: Small = challenging
The first and very practical challenge for ESG analysts when looking at smaller companies lies in the lack of resources: many companies are simply not able to allocate time or staff to the production of ESG reports.
The availability and quality of data is also uneven and very much linked to company activity or sector. For example, a small industrial company like a glassware manufacturer or a producer of aluminium components may be able to report on primary energy sources or machine energy efficiency, given that these issues are particularly important for the sector - and companies may even be required to report on them. However, this may not be the case for other sectors and other types of businesses. On some factors, such as gender equality or full-time vs temporary staff breakdowns, most companies do not routinely disclose data.
Due diligence: Small = proximity
The ESG data challenge highlights the crucial step in the ESG analytical process: the due diligence phase. To compensate the fact that we are lenders (debt investors) and not company owners (equity investors), we take advantage of this due diligence phase to get some proximity with management. For instance, we always negotiate to have the ESG report integrated in the list of required legal documents, and to have a seat at the board, or, at least, a quarterly meeting with top management. It is very important to have a continuous and regular dialogue with the board. Where required, we use our ESG expertise, as well as our independence, to challenge companies’ management and achieve progress in sustainability areas.
The due diligence phase entails a comprehensive analysis of companies’ strengths and weaknesses in terms of sustainability, which may help them raise their ESG profile substantially. During this step, we have noted that the management of smaller companies tend to show more sensitivity to sustainability issues than larger firms. They also tend to have a clearer and more concrete idea of the environmental or social impact of their activities.
We are thus able to set relevant indicators and KPIs in a collaborative mode, favouring those that are most material for stakeholders, including on intangible assets. This KPI definition step has utmost importance as favourable lending conditions may be conditional to objectives being met.
Moreover, including industry best practices in the conversation can be both insightful and mutually beneficial for companies and ESG analysts alike.
We cannot insist enough on the importance of comprehensive carbon audits, including for small businesses. We use our influence to push companies in this direction.
ESG analysis also needs to include an assessment of the companies’ dependency to fossil fuels and a comprehensive analysis of energy costs, as these are key externalities and key risks. This should be based on a mapping of the various steps of the production process - data related to the use of basic materials are key inputs to the analysis of supply chains, as many sectors are facing shortages of semiconductors or fertilizers.
Data relevance: Small = specific
When it comes to smaller companies, one cannot use a standard data set. The relevance of data has to be assessed on a case-to-case basis, depending on the sector, regulatory environment, and societal transformations. In this respect, staff retention has become a challenge for many sectors since the COVID-19 pandemic. For example, when we consider a provider of mobility services to disabled people, meaningful indicators will include its scope 3 emissions[1], as well as the number of vulnerable people who were transported. In contrast, for a provider of personal care services, we will consider employee turnover and/or staff training numbers. Industrial companies’ KPIs ten to focus on carbon footprint and energy efficiency.
SFDR still needs to go one step forward
With its willingness to bring more transparency to the market, the Sustainable Finance Disclosure Regulation (SFDR) is certainly a step in the right direction, but the relevance of the chosen data remains questionable. First, the Regulatory Technical Standards due to come into effect on 1 January 2023, which aim to bring a concrete definition of activities with an environmental/ social contribution, still lack clarity regarding both indicators and templates. Second, a strict interpretation of regulations related to product categories (article 9 funds in particular, which ‘target sustainable investments’) is leading the industry to focus on high stake sectors and specific themes that maximise positive externalities (energy efficiency, circular economy), possibly leading to assets concentration on specific stocks or sectors.
Assessing the debt of a private small company requires specific expertise that differs from evaluating the credit profile of a blue chip. Just like in the case of a flute and piccolo, which look very similar but produce quite different types of sounds. Good ESG analysis and a continuous exchange with management will allow you to get the best out of your preferred instrument, regardless of its characteristics.
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[1] Scope 1 covers direct emissions from owned or controlled sources. Scope 2 covers indirect emissions from the generation of purchased electricity, steam, heating and cooling consumed by the reporting company. Scope 3 includes all other indirect emissions that occur in a company’s value chain.
