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Editorial Disclosure: The author of this article has a business relationship with James Phare, CEO and founder of Neural Alpha.
What does sustainability actually mean for organizations? Can it be measured, and if yes, how so? Often, these are obvious questions with less-than-obvious answers, even for sustainability and environmental, social and governance (ESG) professionals like James Phare.
Phare is the CEO and founder of Neural Alpha, a sustainable fintech company based in London. He spent most of his career working in financial services, advising businesses on how to manage data as an asset, design data governance policies, proactively manage quality and deliver better analytics.
After having worked with the likes of the Man Group, Commerce Bank and HSBC, helping implement data warehouse and business intelligence solutions for compliance, know your customer (KYC) and anti-money laundering initiatives, Phare got re-acquainted with sustainability in 2016 and decided to make it his day job. Refocusing attention on sustainability and its relationship with the ESG space, Phare shared some of his insights about its current state and trajectory and how data and analytics can help.
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Sustainability and ESG
Phare’s background is in economics. As he shared, a big part of that was applied economics and economic history, including modules on international development and environmental economics.
“We looked at things like negative externalities and Pigovian taxation. I found it really exciting how policymakers could use tools to try and make society a more sustainable place. Then I entered the world of work and thought, ‘well, that’s been really interesting, but I’m not sure I’ll ever get the opportunity to actually work in that space,’” Phare said. “But we’re very fortunate, really, that ESG has become this huge megatrend within finance. There’s a lot of demand now for new tools and new datasets in that space.”
As Phare explained, finance is where ESG originated and a key driver of its growth. Historically, he said, the Stockholm Environment Summit in 1972 was considered a milestone in advancing sustainability as a defined concept in terms of where ESG fits into this. Environmental, social and governance criteria are a set of standards for a company’s behavior used by socially conscious investors to screen potential investments.
In a 2020 survey by Investopedia and Treehugger, 58% of respondents indicated increased interest in ESG investments. Additionally, 19% reported using ESG considerations in selecting investments. The problem is that what constitutes ESG is more than a bit fuzzy.
Phare said that ESG was developed as a term to try to shape a framework for managing sustainability-focused metrics (particularly non-financial metrics), which have an impact on a company’s performance and reputation. But what are some examples of such metrics?
A common metric used in the environmental (E) pillar of ESG is carbon emissions. Scope one, scope two, scope three emissions are the most predominantly used metrics in that space, although there are other considerations, like biodiversity and nature loss, Phare said.
The social (S) part of ESG tends to focus more on things like sustainable development goals, gender equality and labor rights. Governance (G) metrics are more focused on corporate governance, which as Phare pointed out was a big focus long before ESG existed.
That could range from how companies are legally structured to the composition of their boards, and down to things like how they structure different share classes for bringing in external investors. This cacophony is one of the biggest issues plaguing ESG — and it’s not limited to governance alone.
ESG: Fragmented and controversial
Currently, Phare said, ESG is a fragmented landscape and there are many standardizing bodies out there working on different things. However, he added, there is a big groundswell going on, with groups coming together and starting to form coalitions to try to pursue a universal set of ESG standards.
These efforts are focused on producing universal ESG scores that are comparable across different industrial sectors. A recent incident that Phare noted was comparing Tesla’s ESG score to those of Big Oil companies like Exxon Mobil. Recently, Elon Musk’s Tesla was booted off the S&P 500 ESG Index, while Exxon made the top of the list. As a consequence, Musk called ESG “a scam.”
Phare noted that this result was mostly due to strong governance sub-scores for Exxon. That highlights whether lumping all of those areas together really makes sense. Others point out what is a fundamental characteristic of ESG reporting at this point: It’s all voluntary and not governed by regulations. Hence, the veracity of ESG data is questionable, and ESG scores are not easily comparable.
“You’ve got initiatives like GRI, Carbon Disclosure Project (CDP) and also accounting standards bodies, people like the Sustainable Accounting Standards Board (SASB), also other standards bodies, people like the Chartered Financial Analyst Institute also working with some of these other bodies to try and produce common standards,” Phare said. “In some ways, there is a parallel to the VHS vs. Betamax battle in the 1980s. It’s a bit unclear who will win out in those battles, but certainly, we’re in a period of convergence at the moment.”
A related set of developments comes from the regulatory front, with regulations emerging around the world, Phare noted.
One of the areas he emphasized is the use of taxonomies by regulators to try to signpost green products and divert money towards those. The EU is leading the way there with the green taxonomy, Phare noted. The green taxonomy aims to classify different industrial sectors and companies operating in those sectors as to whether they are considered green or not.
Allied to that, Phare added, there’s another important regulation coming down the pipe: the Sustainable Finance Disclosure Regulation (SFDR), which is much more aimed at addressing things like greenwashing and looking at how financial products, particularly investment products, are labeled to consumers.
So-called greenwashing is another byproduct of the state of flux in which ESG is presently. Greenwashing includes advertising practices labeling financial and other products as “green” or “sustainable” when in fact they are not. A high-profile case of greenwashing transpired recently when the German police raided the headquarters of Deutsche Bank and its asset-management subsidiary DWS over allegations that investors were misled about sustainable investments.
Though ESG has seen growth, greenwashing is “the other side of the sword,” Phare said, as the financial industry has been rushing to keep up.
“There’s been this huge war of talent and we know it takes a long time to develop really credible, detailed data infrastructure to actually manage the ESG aspects of your portfolios,” Phare said.
He also attributed DWS’s woes at least partially to the use of legacy technology, making it difficult to incorporate ESG data into its practices.
Connected data: From graphs to trees
If “legacy technology” does not cut it, then what does? The answer? Connected data, which is what Neural Alpha uses to build bespoke software and data products for financial institutions as well as NGOs and civil society. Connected data is a set of technologies that include taxonomies, ontologies, knowledge graphs, graph databases, graph analytics and graph AI.
Neural Alpha’s sweet spot is applying those technologies to ESG issues that are typically obscured or hard to analyze because of global supply chains and complex ownership structures, Phare said. One of the company’s flagship, award-winning projects is Trase finance, which is focused on looking at how the financial industry is exposed to deforestation.
The project investigates deforestation associated with soy and beef, palm oil and other soft commodities, as well as non-food based commodities such as wood pulp. The challenge with deforestation is that it’s very difficult to link on-the-ground deforestation happening in places like Indonesia and the Amazon to investors in New York or London because there are many actors involved in different parts of the supply chain, Phare said.
Phare called this “a unique partnership with a number of NGOs,” including Global Canopy and the Stockholm Environment Institute (SEI). The SEI team includes several world-renowned sustainability-focused researchers whose work is at the heart of the project. They build probabilistic models that take tons of export products and can disaggregate and assign them to different in-country commodity infrastructure.
“In the case of soy, you have things like soy crashing facilities and silos for storage in countries and also at the ports. Trase models assign volumes to that infrastructure. Then, they look at the region that supplies that infrastructure and the deforestation that’s occurring in that region, to calculate a deforestation exposure in hectares,” Phare explained. “That is then linked to particular commodity traders and sourcing practices.
“Then it comes to looking at how those sustainability risks translate into equity, credit and other risks for the financial industry through different ownership structures, different lending structures. It’s a big challenge and it’s great to play a part in solving some of those problems.”
Except for its heavy reliance on connected data, Neural Alpha is typical in its technology stack. Where the technology does make a difference is when it comes to data integration and multi-hop queries. Both of those are pain points that utilizing different tools from the connected data stack helps address. It would not be too far-fetched to say that Neural Alpha helps turn graphs to trees.
As to what the future holds for ESG, Phare noted that historically, there has been a huge dependence on ESG scores and trying to manage the inundation of data that people have by simplifying things. Now, many people can really see the limitations of oversimplification.
“In many cases, ESG scores are just not fit for purpose,” Phare said.
As a result, he added, more people are turning their attention to using more efficient techniques and tools to be able to more readily simulate and integrate more of the raw data and really understand the context. Ultimately, Phare noted, ESG is an incredibly subjective space and very context-specific.
“What I’m really excited about in the direction that we’re heading in Neural Alpha is how we can bring more context-rich tools to the market that enable people to embrace this complexity and not run away from it. In terms of what that means on the ground, I think [it means] a much wider application of graphs and connected data technologies to other ESG topics,” Phare concluded.
