Incorporating ENVIRONMENTAL, SOCIAL and GOVERNANCE (ESG) Factors into FIXED INCOME INVESTMENT Georg Inderst and Fiona Stewart © 2018 The World Bank Group 1818 H Street NW Washington, DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org All rights reserved. This volume is a product of the staff of the World Bank Group. The World Bank Group refers to the member institutions of the World Bank Group: The World Bank (International Bank for Reconstruction and Development); International Finance Corporation (IFC); and Multilateral Investment Guarantee Agency (MIGA), which are separate and distinct legal entities each organized under its respective Articles of Agreement. We encourage use for educational and non- commercial purposes. The findings, interpretations, and conclusions expressed in this volume do not necessarily reflect the views of the Directors or Executive Directors of the respective institutions of the World Bank Group or the governments they represent. The World Bank Group does not guarantee the accuracy of the data included in this work. Rights and Permissions The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. All queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2422; e-mail: pubrights@worldbank.org. Citation: Inderst, G. and Stewart, F., Incorporating Environmental, Social and Governance (ESG) Factors into Fixed Income Investment. World Bank Group publication, April 2018. Photo Credits: IFC and World Bank Photo Libraries and Shutterstock TABLE of CONTENTS ACRONYMS AND ABBREVIATIONS III ACKNOWLEDGMENTS V EXECUTIVE SUMMARY VII 1. INTRODUCTION AND BACKGROUND 1 Definition of ESG Investing 2 Investor Motivations 3 ESG and Impact Investment Approaches 6 2. WHAT IS ESG ANALYSIS IN FIXED INCOME INVESTING? 9 Corporate Issuers 11 Sovereign Issuers 12 Other Debt and Securities 14 3. ESG AND FINANCIAL PERFORMANCE – MAIN RESEARCH FINDINGS 17 Corporate Bonds 17 Sovereign Bonds 19 Fixed Income Funds 19 4. ESG INVESTMENT TOOLS FOR FIXED INCOME 23 Credit Ratings and ESG 23 ESG Scores/Rankings 24 Country Scores 26 ESG Fixed Income Indices 27 5. HOW IS ESG BEING IMPLEMENTED BY FIXED INCOME INVESTORS? 31 Green, Social, Sustainable and Other Thematic Bonds 32 Passive Investing 35 Active Investing 36 ESG ‘Holistic’ 36 INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT |I 6. MAIN TRENDS AND CHALLENGES 39 State of the Art 39 Issues with ESG Investing 40 7. CONCLUSIONS: FROM PROCESS TO IMPACT 45 Key Lessons for Investors 45 Ways Forward 46 APPENDICES 49 REFERENCES 55 Appendix 1: Institutions Interviewed for This Report 49 Appendix 2: ESG Criteria 50 Appendix 3: Characteristics of Fixed Income and Implications for ESG 51 Appendix 4: Structure of RobecoSAM’s Country Sustainability Framework 52 Appendix 5: Bloomberg Barclays MSCI ESG Fixed Income Family 53 ENDNOTES 61 BOXES Box 1: ESG Investor Associations, Standards and Codes 4 Box 2: ESG and Regulation 5 Box 3: Climate Investing 6 Box 4: EAPF’s Sustainable Investment and Carbon Targets 38 FIGURES Figure 1: Impact Investment Drivers 8 Figure 2: Suitability of ESG Investment Strategies for Equity and Fixed Income Investing 10 Figure 3: Level of ESG Incorporation in Fixed Income 15 Figure 4: Main Research Findings 20 Figure 5: RobecosSAM ESG Weightings 27 Figure 6: Level of ESG Integration 32 Figure 7: Labelled Green Bond Market Volume by Type of Issuer 33 Figure 8: Labelled Green Bond Market Volume by Country 34 Figure 9: PGGM ESG Approach 37 TABLES Table 1: Engagement for Equity and Bond Investors 11 Table 2: Screening Criteria for Different Types of Issuers 13 Table 3: MSCI ESG Key Issues for Companies 25 Table 4: Categories Available for Bespoke Screening 28 Table 5: ESG Strategies in Fixed Income (by Volume of Assets) 31 II | TABLE OF CONTENTS Acronyms and Abbreviations ABS Asset-backed Securities AI Artificial Intelligence AIGCC Asia Investor Group on Climate Change AIM Affirmative Investment Management ALM Asset and Liability Management ICGN International AODP Asset Owners Disclosure Project Corporate CAT Catastrophe Bonds Governance Network CCM Convention on Cluster Munitions ICMA International Capital Market CDP Carbon Disclosure Project Association CDS Credit Default Swap IFC International Finance Corporation CFP Corporate Financial Performance IG Investment-grade CRA Credit Rating Agency IGCC Investor Group on Climate Change CSR Corporate Social Responsibility IIGCC Institutional Investors Group on EAPF Environment Agency Pension Fund Climate Change EIB European Investment Bank ILS Insurance- linked Securities ETF Exchange Traded Funds IRIS Impact Reporting and Investment ESG Environmental, Social and Governance Standards GBP Green Bond Principles JFSA Japan’s Financial Service Authority GIC Global Investor Coalition on Climate LDI Liability-driven Investment Change MBS Mortgage-Backed Security GIIN Global Impact Investing Network OECD Organization for Economic GP General Partner Co-operation and Development GPIF Government Pension Investment Fund PE Private Equity GRI Global Reporting Initiative PRI UN Principles of Responsible Investing GSIA Global Sustainable Investment Alliance RI Responsible Investing GSSB Global Sustainability Standards Board INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | III III SASB Sustainability Accounting Standards SPV Special Purpose Vehicle Board SRI Socially Responsible Investment SBP Social Bond Principles TCFD Task Force on Climate-related SDGs Sustainable Development Goals Financial Disclosures SDSN Sustainable Development Solutions TIPP The Investment Integration Project Network UNEP United Nations Environment SI Sustainable Investing Programme SIB Social Impact Bonds UNGC UN Global Compact IV | ACRONYMS AND ABBREVIATIONS Acknowledgments T his research report is the result of a partnership between the World Bank Group (WBG) and Government Pension Investment Fund (GPIF) of Japan, initiated by the World Bank Group’s President, Jim Yong Kim, and GPIF’s Chief Investment Officer, Hiro Mizuno. The aim is for the World Bank and IFC – member of the World Bank Group focused on the private sector – and GPIF to collaborate on initiatives that promote strategies for including environmental, social and governance (ESG) criteria in investment decisions across asset classes. Ultimately, the goal is to direct more capital towards sustainable investments and leverage the private sector to achieve the scale of investment needed to meet the Sustainable Development Goals. The partnership reflects GPIF’s strategic associations, private sector service providers commitment to advancing the integration of ESG and individual experts for sharing their expertise considerations into all asset classes of its portfolio. and experiences. In addition, Joaquim Levy, The research report is focused on integration of Managing Director and World Bank Group CFO, ESG considerations for fixed income. From the Arunma Oteh, World Bank Treasurer and Vice World Bank Group side, the research contributes President, Jingdong Hua, IFC Vice President and to the commitment to maximizing finance for Treasurer, Monish Mahurkah, IFC Vice President, development and catalyzing the development for spearheading this work within the World Bank towards more sustainable capital markets. Group. Heike Reichelt and Atiyah Curmally for leading the partnership with GPIF, and the following The authors of the paper are Georg Inderst and for their support and input to the study: Alfonso Fiona Stewart. Georg Inderst is an independent Garcia Mora, John Gandolfo, George Richardson, Expert Consultant, specializing in green finance and Andrew Cross and Samuel Munzele Maimbo. and infrastructure investment (Inderst Advisory, The authors are particularly grateful to Colleen London). Fiona Stewart is a Lead Finance Sector Keenan, Marcelo Jordan, Martijn Regelink, Specialist in the Finance, Competitiveness and Harun Dogo, Svetlana Klimenko, Berit Lindholdt- Innovation Global Practice of the World Bank. Lauridsen and Alex Berg for their expert input. The authors would, in the first place, thank all the Yoshiyuki Arima, Kenichiro Shiozawa and Misa asset owners, investment managers, international Yanagi from the Tokyo office for all their assistance INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT |V – including arranging for the report to be translated Oy, and Judith Moore. Finally, it has been a pleasure into Japanese. Aichin Lim Jones for graphic design working with the GPIF team. We would like to and layout, Luidmila Uvarova and Nina Vucenik thank Norihiro Takahashi and Hiro Mizuno and for knowledge management and communications for their support and leadership, and Tetsuya Oishi, support, and Inna Remizova and Leah Kusensela Genzo Kimura, Daiki Nishida, and Keiji Watanabe for being excellent research assistants. The report for their helpful input and collaboration. We look benefited from comments from peer reviewers forward to continuing the dialogue and working including Akinchan Jain, Greg Rosenberg, Eivind with them in future. VI | ACKNOWLEDGMENTS Executive Summary A growing body of research shows that Environmental, Social and Governance (ESG) factors are material credit risk for fixed income investors. The evidence suggests that incorporating ESG into fixed income investing should be part of the overall credit risk analysis and should contribute to more stable financial returns. It also dispels the myth that incorporating ESG means having to sacrifice financial returns. ESG investing is increasingly becoming part of the mainstream investment process for fixed income investors, as opposed to a specialist, segregated activity, often confined to green bonds. Though fixed income has its own challenges with external service providers and /or by customizing integrating ESG issues, it is catching up fast with the such products with the institutional investor’s own equity space (particularly corporate and supranational philosophy and goals. bonds but less - so far - sovereign issuers, asset- backed or private debt). Leading investors are going Yet, many investors find implementing ESG in further and viewing ESG not just as an aspect of risk practice a challenge, which can be exacerbated and return, but merging ESG and ‘impact’ investing. when it comes to their fixed income portfolios. This includes measuring the impact of their portfolios There are still no standard definitions of ESG on targeted environmental and social outcomes, and – with diverse views particularly in the ‘social’ beyond, such as mapping impact using the Sustainable area. Data – though improving and coming from Development Goals (SDGs). increasingly varied sources – is still wanting particularly in emerging markets. In fixed income, Different methods for applying ESG are being there are additional issues such as how to pursue adopted by fixed income investors: from purchasing engagement with issuers (particularly sovereigns), ‘labelled’ (green, social, and/or sustainable) bonds the role ESG plays in credit ratings, the lack of and setting up or investing in ESG/SRI (Socially choice of indices compared to the equity space, as Responsible Investment) funds; to following well as a dearth of specific ESG-focused products. ESG indices; to hiring ESG active managers; to There are also challenges in the green bond markets incorporating and embedding ESG across the with demand outstripping supply. Conceptual work whole investment process. This can be done by on ESG and fixed income also needs to go beyond either following the methodology of different credit risk (such as the relationship of ESG issues with liquidity and other market risks). INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | VII ESG investing is developing from a purely process- principles and metrics for applying ESG and driven to a more outcome-driven activity. Going impact investing can be refined to allow investors forward, first, initiatives to improve the breadth and to customize their approach from a robust basis. depth of ESG data should continue to be supported. Finally, more innovative, scalable products to Second, more rigorous research on the relationship accommodate the growing demand for fixed income between ESG factors and financial risks and returns sustainable investments could be developed. in fixed income is also required. Third, standards, VIII | EXECUTIVE SUMMARY 1. Introduction and background C apital markets play a vital role in channeling investment into the economy to help drive growth and prosperity. Asset owners and financial intermediaries are asked to contribute to financing sustainable development that meets the need of the present, without compromising the ability of future generations to meet their own needs. Sustainable investment, including socially as the Bank of England Governor Mark responsible, ethical, and ESG (environmental, Carney.2 social and governance) investing, is increasingly gaining a foothold in mainstream financial markets. Traditionally, the main focus of ESG investing Globally, sustainable investments grew by a quarter has been on equity markets. In recent years, to $23 trillion over the last two years, according to however, ESG has spread out increasingly to other the Global Sustainable Investment Alliance (GSIA asset classes, in particular fixed income, given 2017). This equates to around one-quarter of that bonds constitute a substantial percentage ‘professionally managed’ assets globally.1 of institutional investors’ assets.3 Considerable academic and industry research has been conducted ESG investing has been gathering attention since the on the relationship between ESG investing and 1990s. From its origins in the equity markets with performance in equity markets, but far less is religious, values-based or thematic (environmental) available on its effect on the fixed income markets. investors, the movement spread with the launch of the UN Principles of Responsible Investment (UN As a further development, many asset owners PRI) in 2006 and was catalyzed for fixed income are looking to increase investments that make a with the issuance of labelled bonds by multilateral positive social and environmental impact on top of organizations from 2007. The issue has received their financial objectives. Some have also started renewed high-profile support in recent years through to re-assess their investment policies in the light of the European Commission’s High-Level Expert climate change risks and policies post Paris COP21, Group on Sustainable Finance and the Financial as well as the 2015 UN Sustainable Investment Stability Board’s (FSB) Task Force on Climate- Goals (SDG). All assets, including fixed income, related Financial Disclosure (TCFD) initiative, as will increasingly be measured also by social and well as public interventions by stakeholders such environmental outcomes and externalities. INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT |1 This research report provides an overview on Definition of ESG Investing sustainable investing in fixed income that is developing fast these days. It discusses the core areas of: ESG investing incorporates environmental, social, and governance issues into the analysis, selection • the specific nature and issues of ESG investing in and management of investments. Key issues for this asset class; consideration typically include: • the rationale for ESG analysis in fixed income – E: climate change, carbon emissions, pollution, including research findings; resource efficiency, biodiversity; • ESG investment tools and ways of implementing S: human rights, labor standards, health & ESG strategies in fixed income; safety, diversity policies, community relations, • on-going challenges to greater integration of ESG development of human capital (health & education); into mainstream investing; and G: corporate governance, corruption, rule of law, • suggestions for how to catalyze the further institutional strength, transparency. adoption of ESG approaches. Historically, governance-related investment The study builds on both research and practical codes were probably first relevant for investment experiences to date on ESG approaches for fixed strategies, with green and social issues, and more income portfolios. An extensive literature review generally a view to sustainable investing, growing was conducted to inform the findings. It was not in relevance over the last two decades. There are possible to undertake new primary research for this many different, and more specific, definitions in the paper, but suggestions for further analysis are made. market place. Appendix 2 shows a list of standard The paper also includes findings which draw on the ESG criteria applied by the CFA (2015), and for practical experience of a number of stakeholders sovereign and corporate bonds by the UN Principles (asset owners, asset managers, data providers etc.) of Responsible Investing (PRI) (2014), and those who are integrating ESG factors into fixed income used in the IFC Performance Standards (2012) and investments and were interviewed and participated Corporate Governance Methodology. in a workshop and roundtable discussions as part of this research project. Their insights are reflected A definitive list of ESG issues does not exist – and it across the paper, and their input is most appreciated.4 looks impossible to agree on. Markets, technologies, policies, values and social preferences change all The focus of the report is primarily on the main fixed the time, and vary from region to region, country to income investment instruments, such as sovereign, country and even within countries. Therefore, an supranational, and corporate bonds. Research open and dynamic approach to defining “green” or and application of ESG for other fixed income “sustainable” investments is preferable – and is used investments (sub-sovereigns, covered bonds and in this paper – embedded in a clear and transparent other asset backed securities, private debt etc.) are governance framework (Inderst, Kaminker and still very limited. However, thematic investments Stewart 2012).5 such as green, social and sustainable bonds are growing and are facilitating the integration of ESG For fixed income, a survey by PRI (2017a) found for fixed income. Therefore, the discussion is not slightly more investors follow governance than limited only to the labelled bond market, but is also social and environmental factors. Russell (2017) on incorporating ESG factors into fixed income also found that governance is widely being portfolios more broadly. considered the most important factor. Other common terms in this context include sustainable investing (SI), responsible investing 2 | 1. INTRODUCTION AND BACKGROUND (RI) and socially responsible investing (SRI). They members, clients and other stakeholders; increasing are often being used synonymously in the market awareness of climate change risks and policies by place. So does this report, for simplicity, being investor boards; social and political concerns; legal aware that some industry practice and academia and regulatory changes; voluntary codes; fiduciary differentiate these terms. duty; technology change and disruption; and reputational risks; public and peer pressure. There are other related investment strategies with a somewhat different focus (such as long-term investing, universal ownership6), or strategies that Financial and non-financial objectives concentrate on a particular aspect of ESG (e.g. green, Institutional investors must be able to reconcile their climate change, social, ethical, religious investing).7 actions in terms of ESG issues with their obligations to members, beneficiaries, policyholders and clients, Finally, there is an increasing focus on non-financial and look to use their investments for a positive social outcomes and externalities of investments. Impact purpose. For most investors, the main objectives are investing aims to generate a measurable, beneficial financial results (e.g. risk-adjusted returns, liability- social or environmental result alongside a financial matching cash flows). Some investors also have non- return.8 Blended finance is the strategic use of financial objectives (e.g. ethical, religious, political, development finance and philanthropic funds to cultural values and preferences) beside financial mobilize private capital flows to emerging and objectives. ‘Reputational/ brand’ motivations can frontier markets (e.g. OECD 2018). The newly also play a part. The potential trade-off between developing SDG investing takes considerations of financial return and ESG is still being debated by issues beyond traditional ESG, using the United investors. This is not so clear, even in theory, and Nations’ Sustainable Development Goals (SDGs) therefore the debate is mostly driven by ‘beliefs’. On as a framework. the one hand, considering ESG as risk factors should contribute to more stable returns over time. However, by narrowing the potential universe of investments, Investor Motivations ESG could lower returns. Further theoretical and Each investor has specific investment objectives empirical work on this issue – particularly for the and strategy, its own legal mandate, and particular fixed income universe – is required. expectations placed on it by its beneficiaries and the society within which it operates. Therefore, Short-termism and long-term investing responsible investment has no singular motivation, and there is no single strategy or set of approaches The priority, or even exclusiveness, of financial that is followed universally (Dimson et al. 2013).9 objectives does not preclude the consideration of non-financial factors in the analysis and There are many investor questionnaires undertaken management of investments. This may lead to an on ESG, and they vary widely in many respects, improved understanding of long-term trends. Asset which may reflect different universes, concepts owners are trying to move towards longer-term and languages, among other reasons. Most surveys investment frameworks than in the past. confirm that ESG is most prevalent in listed equities. According to CFA (2017), 45% of fixed ESG as risk factors vs ESG as an income investors integrate ESG analysis compared investment opportunity to 76% for listed equities (and much fewer for other asset classes). However, many investors plan to Investor motivations are often driven by risk enhance ESG in the future in fixed income, private management, i.e. the relevance of environmental, assets and alternative asset classes. There are social or governance risks. The risk aspect is several drivers for this development: preferences of naturally a main concern of insurance companies and INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT |3 other low-risk investors. However, some investors • Increasingly investors seek to combine certain also look at ESG as an investment opportunity, non-financial objectives (e.g. ethical, religious, seeking “alpha”. For example, ESG analysis may political, cultural, societal values and preferences) improve the understanding of longer-term trends. without hampering financial objectives. Some investors even find new investment targets in • Certain investors are willing and able to sacrifice the green and social space. some or all financial return to achieve other social or environmental benefits (impact/community In practice, ESG investors can broadly be classified investing; charity investing). into three groups: There is plenty of general ESG guidance already • For a large group of investors, the sole purpose available for all types of investors, offered by remains financial performance, but with a belief various organizations (Box 1). that ESG factors have a material effect on investment risks and returns. Box 1: ESG Investor Associations, Standards and Codes Asset owners and investment managers have Green and climate change investment formed or joined a range voluntary associations Associations and networks in the field of ESG, corporate • Institutional Investors Group on Climate governance, climate change, and related issues. Change (IIGCC) There are also other voluntary codes many • Investor Group on Climate Change (IGCC) investors comply with. Many of them are at the • Asia Investor Group on Climate Change national level (e.g. by pension fund organizations). (AIGCC) Here are some important international examples: • GIC global platform • Ceres Responsible and sustainable investment • UN Global Compact (UNGC) Initiatives • UN Principles for Responsible Investment (PRI) • Carbon Disclosure Project (CDP) • EuroSIF, UKSIF, USSIF, SIF Japan, ASrIA, • Asset Owners Disclosure Project (AODP) RIA Canada, RIA Australasia, etc. • Montreal Carbon Pledge • Global Sustainable Investment Alliance (GSIA) • Portfolio Decarbonization Coalition • Equator Principles • Action 100+ • International Capital Market Association (ICMA) Green Bond Principles (GBP) and Impact investing Social Bond Principles (SBP) • Global Impact Investing Network (GIIN) Corporate governance, accounting and Industry guides disclosure Practical investor guidance on ESG investing can • International Corporate Governance Network be found in many publications by the industry and (ICGN) organizations such as the CFA, PRI, SSF (2017), • Global Reporting Initiative (GRI); Global BNP Paribas (2016). More specifically on fixed Sustainability Standards Board (GSSB) income, see, e.g., PRI (2014), Klein (2015). For • Sustainability Accounting Standards Board guidance on climate change investing, including (SASB) the implications for fixed income, see, e.g., IIGCC • The FSB Task Force on Climate-related (2015), Mercer (2015), Forum Ethibel (2017). Financial Disclosures (TCFD) 4 | 1. INTRODUCTION AND BACKGROUND ESG and regulation been developing over time. From initial rulings requiring fiduciaries to only consider financial Regulation can be both a driver and a barrier for ESG returns when acting in the interest of beneficiaries, investing. For example, a relatively prescriptive interpretation developed so that consideration approach is being proposed in Europe, whilst of other factors was not seen a fiduciary breach. interpretations of regulation in Asia have been more Guidance is now going a step further and in voluntary but supportive. In North America, a lack of some cases requiring fiduciaries to incorporate interpretation around existing laws is still felt to be a ESG factors into their investment decisions. barrier to further ESG integration by some investors. For example, the United Nations Environment Some main trends are summarized in Box 2. Programme (UNEP publication (UNEP 2015) concluded that: “failing to consider all long-term The debate over whether ESG investing is investment value drivers, including ESG issues, is compatible with investors fiduciary duty10 has also a failure of fiduciary duty”. Box 2: ESG and Regulation It is important to distinguish between ESG- • The EU High-Level Expert Group on Sustainable specific regulation (e.g. for companies), investor Finance published several investor-related regulation, and other rules and laws that may affect proposals (EU 2018). In 2018, The European ESG investing positively or negatively. Investor Commissions announced plans for establishing regulation may include funding and accounting an EU taxonomy/classification system for regulation, or even outright investment constraints sustainable activities, creating EU labels for green on certain asset classes and instruments. financial products, clarifying fiduciary duties Regulation also applies at different levels: of asset managers and institutional investors, company, investment manager/fund, asset owner enhance corporate reporting, among others. (e.g. PRI 2016a, Northern Trust 2015). OECD • In 2015, Article 173 of France’s law on ‘Energy (2017) summarizes the main developments: Transition for Green Growth’ introduced • Regulatory frameworks for investment mandatory climate change reporting for financial governance rarely make explicit reference institutions. This has been hailed as ground to ESG issues, although this is changing in a breaking with potentially far reaching implications. number of jurisdictions such as France, the • Furthermore, many countries have stewardship Netherlands, Chile. codes, corporate disclosure codes or stock • Several countries have some form of ESG exchange rules that cover governance and other reporting and disclosure requirements for investors ESG issues. The Stewardship Code issued by (e.g. Australia, France, Germany, Sweden, UK). Japan’s Financial Services Authority (JFSA), • Regulatory frameworks for the most part do not released in 2014 (revised 2017) is said to have prevent ESG integration, and other legislation been particularly influential, and indeed was or voluntary codes may encourage institutional one of the drivers for the GPIF to adopt ESG investors to take ESG factors into account (e.g. principles within their investment approach. In USA, UK, South Africa, Ontario). addition, there are various principles and best- practice guides available for governments and • However, institutional investors may lack investors by international organizations such as clarity as to how ESG integration fits with their the UN and the OECD. country’s legal, regulatory and other obligations. Many asset owners considered fiduciary duty as At the end of 2017, central banks and regulators an obstacle to ESG integration but there seems initiated a new Network on Greening the Financial to be a shift from a “narrow” to “broader” System, aimed at sharing supervisory practices interpretations (OECD 2017). on climate change and other environmental risks. INCORPORATING ENVIRONMENT, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT |5 ESG and Impact Investment sector and factor biases in the portfolios. Such Approaches issues need to be well managed. Investors use a range of methods for bringing ESG Active ownership/voting/engagement/ considerations into their decision-making. They stewardship: were traditionally applied to equity investments, but are also being used for fixed income and other asset This refers to the practice of entering into a classes. These methods are not mutually exclusive dialogue with companies or countries on ESG and are often used in combination. Furthermore, the issues and exercising both ownership rights various ESG approaches can be implemented with (including. voting) and “voice” (especially relevant active or passive investment styles. ESG integration, in cases where investors do not have voting rights, engagement and screening capture about 99% of such as bondholders) to effect change. This is an assets, with themed and impact investments making alternative to “exit”, i.e. selling off the investments up the remaining 1%.11 with questionable practices, or divesting based on specific issues (e.g. removing exposure to fossil Negative/exclusionary screening: fuels as ‘stranded assets’). Some investors also like to lobby for ESG themes more widely in politics. This involves excluding securities of specific activities or industries (e.g. controversial weapons, ESG integration: tobacco, fossil fuels) deemed unacceptable. Reasons may be ethical, legal or other norms and standards This is the systematic inclusion of ESG risks and (e.g. human rights, labor conditions, corruption). opportunities in investment analysis, portfolio construction and risk management. It is being Positive screening/best-in-class implemented in different ways across investment selection: organizations.12 This is a positive selection or overweighting of Thematic investing: companies or countries with better or improving ESG performance relative to sector peers. It can be A number of investment themes are based on ESG implemented on either the level of ESG measures issues, including clean technology, renewable or their potential for change (ESG momentum). energy, energy efficiency, sustainable forestry and agriculture, water, education, health and diversity. An immediate concern with exclusions or best-in- Climate investing more broadly is receiving class is the potential reduction of the investment increasing attention (see Box 3). universe. Also, screening may lead to unintended Box 3: Climate Investing Since Paris COP21, more investors have developed • gradual decarburization targets for portfolios; practical climate change policies. They are often • exclusions/underweight of particular industries/ simple green thematic investing or included in companies (e.g. coal, fossil fuels); traditional ESG policies. For some investors, they • energy efficiency targets (e.g. in real estate); go well beyond. They include, among others: • green infrastructure investments (e.g. clean • climate change scenario analysis in asset allocation; energy, climate change adaptation); • measurement of carbon emission/carbon • green and climate bonds; footprint; • divesting, and the concept of “stranded assets”.13 6 | 1. INTRODUCTION AND BACKGROUND Impact investing: Measuring “impact” is not an easy task. Many investors are still not clear what appropriate metrics In general terms, this is investing with the intention should be for the measuring impact on E, S and G to generate and measure social and environmental individually, and collectively or indeed whether benefits alongside a financial return.14 Impact there should be a ‘one size fits all’ approach. The investors typically set outcome goals or targets ex most advanced metrics in this respect appears to ante, make and monitor the investment and then be carbon emissions/footprint. GIIN developed measure ex post results. They try to strike a balance impact reporting and investment standards (IRIS), between an economic and social return – with a i.e. a catalogue of performance metrics for various varying emphasis, depending on the specific impact sectors. New research is being undertaken in this project/fund. field.15 There are different approaches to impact investing. The early developments were more in the way of SDG investing “community investing”, i.e. investments by small The second major driver for impact investing has funds to help fund smaller social or environmental been the publishing of the SDGs. In 2015, the projects in municipalities/regions. As a new United Nations approved the 17 SDGs and 169 development, impact investing has spread also to individual targets. The SDGs were not primarily non-specialist investors. Mainstream investors made for investors but achievement of the Goals now feel urged to measure the ‘impact’ of their recognizes the necessary contribution of all, portfolios, but are generally not mandated to give including the private sector and investors. It is less up financial return. clear what these contributions look like for such a broad range of targets. Sometimes it is easier There are various motivations behind this move, to address an SDG through investment decisions; but two in particular standout (Figure 1). First is sometimes it is easier to incorporate the SDG in the increasing influence of millennial investors. active ownership (PRI 2017b). According to a survey conducted in the United States by Morgan Stanley (The Economist 2017), SDG-related investment is still in its infancy. The 75% of millennials agreed that their investments analysis currently focuses on mapping investors could influence climate change, compared with 58% corporate holdings to a selection of the SDG. of the overall population. They are also twice as Several investors such as the Dutch APG and likely as investors in general to invest in companies PGGM, or the Swedish AP2 are trying to work that espouse social or environmental objectives. out investment possibilities associated with SDGs. As ‘The Economist’ article quotes: “boomers see One of the commonly stated obstacles is the doing good as separate from investing; whereas challenge surrounding impact measurement. Some millennials don’t see how you could possibly organizations are working on investor-relevant separate the two.” SDG impact indicators and metrics (e.g. DNB 2017, Trucost 2017). The Investment Integration Impact investing covers all asset classes, including Project (TIIP) is a further initiative looking to help bonds (e.g. social impact bonds), private equity investors map the link between the investments in and private debt (GIIN 2017). Returns can show their portfolio and the SDGs (TIPP 2018).16 low correlations with mainstream asset classes as income is typically not related to financial markets (SSF 2017). INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT |7 Figure 1: Impact Investment Drivers Investing for Millennials Millennials Want to have an Impact Percentage of Respondents Who Agree My investment decisions It is possible to achieve market are a way to express my rate returns investing in social, political, or companies based on their environmental values. social or environmental impact. Impact Millennials 67% 73% Investing Gen X 44% 61% Baby Boomers 36% 58% 69+ Years 34% 47% Sustainable Investing SDG Impact Indicators 86% 61% 75% 84% A Guide for Investors and Companies are “very have made at think their think their interested” least one investments investments or “interested” sustainable can influence can help fight in sustainable investment climate poverty investing action in the change last year Source: U.S. Trust Insights on Wealth and Worth, 2014, Harvard Business Review (October 3 2014), Morgan Stanley (on-line presentation August 9 2017), Visual Capitalist (on-line presentation August 11 2017), and DNB (2017) 8 | 1. INTRODUCTION AND BACKGROUND 2. What is ESG Analysis in Fixed Income Investing? S ince most ESG research has been undertaken on equities, it is less clear to what extent, how and when ESG considerations can be applied to fixed income investments. Applying ESG to other asset classes requires adaptation (e.g. Johnson 2017). Fixed income management consists of several building blocks, including the analysis of interest rates, inflation, credit quality and liquidity risks. Fixed income investment is very much a quantitative process. Managers find it difficult to include ESG criteria in their financial models, and may therefore be more ‘resistant’ to ESG-related change.17 There are a number of key differences between • The importance of sovereign, sub-sovereign, equities and fixed income, especially the focus on supranational and agency issuers; downside capital risk and cash flow stability vs. • Different analytical approaches (e.g. duration, upside, capital appreciation: yield curve, spread management); • Creditworthiness and the ability to pay back debt • The specifics of asset-backed securities, project are key - therefore, there is a focus on credit and bonds and other instruments; default risk • The high share of institutional participation in • Asymmetrical downside risk vs. upside potential corporate bond issuance; of fixed income investments; • The use of bonds in long-term liability management • Duration (fixed income investments have a finite by insurance companies and pension funds; period vs. equity holdings which can be perpetual); • Issues around market capitalization-weighted • Position in capital structure, and with different indices (with heavy weights to debt-ridden issuers); layers (e.g. senior, subordinated debt, hybrid); • The rising importance of private debt in investor • Trading of fixed income products largely OTC/ portfolios. off-market; There are implications of these differences for • The difference between bondholder rights and ESG investing in fixed income compared to equity shareholder rights; analysis (see Appendix 3 for an overview by the PRI 2014): INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT |9 • Engagement policies will look different for equity • Debt-related benchmarks may be even more and bond holders; problematic from an ESG perspective (e.g. the • Sovereign (along with sub-sovereign and relationship between a high debt load and poor supranational) issuers are fundamentally different governance/institutions); from corporate issuers; • Fixed income indices are more difficult to compile • Event risks can dominate issuers’ creditworthiness (as fixed income indices include multiple bonds and downgrades; per issuer, multiple issuers per corporate family, • In fixed income, liquidity can suddenly dry up private companies where data is hard to gather, even for large issues; and non-corporate entities, covered bonds and • Risk analysis needs to apply to various corporate other asset-backed securities etc.). levels (holding company, subsidiaries, special purpose vehicles (SPVs), originators); The relevance of the various ESG approaches varies across asset classes and across types of fixed • Bonds can be complex contracts (e.g. attached income securities, although views seem to differ on covenants, embedded options), also in relation to this. Ngo (2016), e.g., finds significant scope for ESG risks; integration but limited scope for other strategies • Concentration risk rises for issuers with multiple with sovereign issuers (Figure 2). SSF (2017) also securities; distinguishes between active and passive corporates, but comes to rather different conclusions. Figure 2: Suitability of ESG Investment Strategies for Equity and Fixed Income Investing Equity Versus FIxed Income Investing ESG Ethical Norms- ESG ESG ESG best in ESG investment (negative/ based integration engagement/ class (positive/ strategies/asset exclusions) screening activism thematic) class screening investing Equities Significant Significant Significant Significant Significant/ Significant/ scope scope scope scope some scope some scope Fixed income: Some scope Some scope Significant Some/limited Limited Significant/ corporates scope scope scope some scope Fixed income: Limited Some scope Significant Limited Limited Limited sovereigns scope scope scope scope scope Source: Ngo (2016) 10 | 2. WHAT IS ESG ANALYSIS IN FIXED INCOME INVESTING? We now look at the various types of securities in Bondholder rights more detail. As lenders of capital and not owners of shares, bondholders generally have fewer obvious Corporate Issuers opportunities to engage with companies, such as exercising voting rights and speaking at AGMs. Corporate governance factors (e.g., a company’s However, bondholders can, in specific situations, accountability, risk management and director demand transparency. They can consider engagement independence) have strong links to credit strength. during investor roadshows, at debt reissuance and in Good corporate governance should lead to a higher collaboration with other bondholders (Table 1). Bond credit rating and lower cost of debt, and vice issuers repeatedly come to the market; therefore, a versa. Well-managed companies tend to be more new debt issuance can be a good time around ESG aligned with bondholder interests, and corporate issues. On those occasions, it is possible to demand transparency keeps bondholders better informed of borrower disclosure of information on ESGrisk. exposure and management of risk. It can be argued that bondholders, in some aspects, Poor environmental or social management may may actually be more powerful than equity holders. lead to lower credit ratings and higher cost of debt. In market conditions such as currently where The materiality of E and S factors vary considerably companies are buying back rather than issuing new across sectors and industries. For example, shares, equity investors ultimately have the power environmental issues are often relevant in energy, of divesting their holdings is an engagement is utilities, resources and other heavy industries. unsuccessful. Bond holdings, by way of contrast, Water stress is likely to be material for certain frequently have to be refinanced at maturity. At that sectors, such as extractives, food and beverage, point, the bondholder potentially has a lot of leverage and agricultural companies. For airline companies, over the company if they choose not to reinvest or fuel efficiency may be a key environmental and only to provide capital at much higher rates. financial metric. In practice, investors have shown different ESG investing for corporate bonds is closely approaches to bondholder engagement that range related to established ESG process for listed from – the predominant – passivity to aggressive equities. For example, exclusion lists and ESG activism used by some hedge funds (Celik et al. screens tend to be very similar. However, there are 2015). It should not be overlooked, though, that some significant differences. bondholders’ interests may be conflicting with shareholder interests, especially in the short term. Table 1: Engagement for Equity and Bond Investors Product Feature Equity Bond Dialogue ü ü Request for increased transparency ü ü Media ü ü Buy and sell holdings ü ü Voting ü X Source: Aberdeen (2017) INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 11 Duration management Private placements Different ESG factors will present greater risks They tend to have low transparency, large over different time periods. In the short term, ticket sizes, long maturities, and are difficult to investors face a greater threat from the fallout of divest. However, large creditors may be able to low-frequency, high-impact events such as extreme negotiate more favorable covenants and reporting weather or industrial disasters. Longer term, ESG requirements to address ESG concerns. trends such as demographic changes and climate change, are likely to have a significant impact on bond yields, but the extent of this is more uncertain. Sovereign Issuers Analysis of company and sovereign creditworthiness Liquidity is markedly different in all aspects of ESG. The political and institutional system, macroeconomic Liquidity tends to dry up when needed most, i.e. at development, and government policies play a key times of crisis, leading to expensive restructurings role in assessing a country’s ability and willingness of portfolios. Liability-driven investment (LDI) to repay its debt on time. The relationship of risk strategies have typically long-time horizons. A buy- and return in sovereign instruments is complex, and and-hold strategy for investing in relatively illiquid not linear (Schroders 2017a). bonds requires consideration of all pertinent risk factors - ESG and others - over the relevant period. In terms of G, among the crucial factors are the rule of law, the strength of the country’s institutions, Low liquidity of bonds can also be a potential political stability, regulatory consistency and threat against a poor company. The sale of bonds corruption. Energy/water/other resource reserves by one investor can lead to price volatility, and and management, as well as green/climate subsequently, to higher costs of capital for such a change policies are of varying importance for company. creditworthiness across countries and periods. High yield bonds Social factors tend to be given greater weight by analysts than environmental factors because of Specific segments are potentially more exposed links between political stability, governance and a to ESG risks. For example, high-yield issuers country’s ability to raise taxes or make reforms. Key tend to be smaller; many are private companies social factors include human rights, labor standards, and, therefore, do not have to report the same education system, health care, and demographics. information or operate to the same standards. They are more likely to have unconventional governance There are pronounced differences in the application structures that may be misaligned with creditor of ESG investment approaches to sovereign bonds, interests. The amount of leverage used by high and they can be politically sensitive. For example, yield issuers makes bondholders a critical source it implies the possible exclusion of whole country of capital alongside equity owners and can provide issuances based on being outside of certain treaties meaningful opportunities for engagement with or conventions (Table 2). A widespread practice is company management teams (Aristotle 2016). to overweight “good” countries and underweight “bad” countries based on an ESG scoring system. 12 | 2. WHAT IS ESG ANALYSIS IN FIXED INCOME INVESTING? Table 2: Screening Criteria for Different Types of Issuers Screening Approach Corporate Criteria Government Criteria Financial Sector Criteria Ethical/reputation Revenue derived from: • Adherence to • Financing or ownership screens • Tobacco international standards of business activities • Controversial weapons on human rights and listed under corporate • Nuclear energy environmental issues criteria (on left) • Pornography (see below) • Origination of ABS • Arms • Use of capital financing business • Gambling punishment activities listed under • Alcohol corporate criteria (on left) • Animal testing • Predatory lending • Aggressive tax avoidance schemes or consultancy Norms, standards and • Illegal activites • Trade embargoes • Export controls international laws • Export controls • US, EU, UN sactions • Whistle-blower policy • International Labour • ILO conventions • Regulatory compliance Organisation • Human rights • Community conventions conventions Reinvestment Act (US) • UN Global Compact • Montreal Treaty • IFC Performance Standards • Kyoto Protocol Standards • World Governance • Equator Principles Indicators • International sanctions • Ottawa Treaty (anti- personnel mines) • Convention on Cluster Munitions (CCM) Source: PRI (2014) Naturally, engagement with sovereigns is quite Emerging market debt different from engaging with companies, and undertaken less in practice. Investors may seek Many investors find that ESG factors tend to be a dialogue with regulators, policy-makers and particularly useful in the assessment of emerging standard-setters (including officials from treasury and frontier market bonds. Political and social departments, government agencies and debt developments are often difficult to grasp, and they management offices). The “size gap” between may not be fully reflected in credit ratings or in investor and issuer may even be more of an issue current market prices. Regulatory frameworks here than with large corporations. Collaborations and transparency can be poor. Issuers may be between investors may be particularly useful in following the IFC’s Performance Standards or the bond holder engagements. Equator Principles. ESG information on governments is available Sub-sovereign issuers from UN bodies, the OECD, CIA World Factbook, Transparency International, the World Bank States, regions, cities and other entities can issue and similar organizations. Certain segments of bonds at a sub-sovereign level. Municipal bonds sovereign bonds require particular attention. are a very sizeable market (of about US$4tn) in the INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 13 USA, and used in other countries. Local government Covered bonds bonds can be divided into two categories: general obligation bonds backed by tax inflows, and revenue Covered bonds ae a particular type of ABS, bonds backed by revenues from a specific project predominantly financing residential mortgages and such as toll roads. Such instruments are often used public-sector loans. As with ABS, investors should for economic infrastructure (e.g. transport, energy, consider ESG risks relating to the issuer and the water, waste) or social infrastructure (e.g. schools sustainability of the assets themselves. If a bank and hospitals). Local and project-specific ESG seizes a defaulted issuers’ assets, it also takes on its factors come into play. liabilities, which may include fines, ongoing legal costs and environmental clean-ups. Supranational issuers Insurance-linked securities Supranational organizations, such as the World Bank (IBRD), IFC, Asian Development Bank, European Insurance-linked securities (ILS) are financial Investment Bank, European Bank for Reconstruction instruments tied to certain risk events, e.g. weather. and Development, regularly issue bonds to finance Catastrophe bonds (CAT bonds) are risk-linked development–related projects and businesses. These securities that transfer a specified set of risks from organizations are typically considered low risk, (re)insurance companies to investors. There is a with good ESG practices and issue investment- natural connotation to climate change risks here, grade (AAA) bonds. As a result, ESG analysis on and, as proceeds are used to rebuild communities supranationals tends to be more focused on their use after disasters, a link is sometimes also made to of proceeds rather than on the creditworthiness of social investing. the issuer itself. Supranational have issued labelled bonds such as green, social and/or sustainable bonds Structured products to raise awareness for certain types of development programs and priorities, responding to investor There are many other structured fixed income interest in investing for purpose. products that are being used in investor portfolios. They typically carry augmented risks of complexity and transparency. The mapping of ESG factors will Other Debt and Securities be particularly tricky. There is a range of other fixed income securities in investor portfolios, often issued by banks or Private debt financial sector companies. Private equity appeared much later on the ESG radar screen than listed equity. Private debt plays Asset-backed securities (ABS) an increasing role in the portfolios of insurance companies and pension funds, e.g. corporate, ESG analysis of ABS needs to capture risks relating real estate and infrastructure loans. This has been to the originator of the securities, the servicer and spurred by a lengthy period of low interest rates and the ‘cover pool’ of assets, respectively. Investors by the partial withdrawal of traditional banks from should also consider how ESG factors might longer-term lending following tighter regulation affect the financial sustainability of ‘asset pools’ or (e.g. Basel III). As for all private assets, there are standalone projects covering the security, such as augmented issues of liquidity and transparency. auto loans and mortgages. In some cases, investors There is still little experience on the side of investors focus on the use of proceeds for a particular ABS on the connection to ESG issues. issued (monitoring the composition and changes in the pool of assets). 14 | 2. WHAT IS ESG ANALYSIS IN FIXED INCOME INVESTING? To summarize, ESG investing in the fixed income debt as well as equity holdings. A survey by PRI space is gradually catching up with equities - (2017a) finds corporate bonds are better covered although it is facing its own challenges. It is more than sovereign bonds by ESG analysis, while advanced for corporate bonds where, for example, securitized assets are far behind in this respect – but engagement teams are working across asset classes more research and developments can be expected in and interacting with companies where they have these other classes (Figure 3). Figure 3: Level of ESG Incorporation in Fixed Income Source: Authors INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 15 16 | 2. WHAT IS ESG ANALYSIS IN FIXED INCOME INVESTING? 3. ESG and Financial Performance – Main Research Findings M any studies have been published with the purpose to establish an empirical link between ESG and financial indicators. Much of the research focus in the past was on equities but more studies relevant for fixed income have been undertaken in recent years. 18 A comprehensive survey article summarizes • default risk; credit default swap the results of 2,200 primary and review studies (CDS) spreads; (Friede et al. 2015). Roughly 90% of studies find • bond price performance; yields; a nonnegative relation between ESG and corporate • market risk; financial performance (CFP). However, the findings • company value; are more neutral/mixed for ‘portfolio studies’, i.e. • country economic growth and other macro using portfolio data19 (including ESG funds and variables; indices) rather than single firm data. There are only • other proxy variables for performance. a comparatively small number of studies for non- equity asset classes. “The share of positive votes for Fixed income investors are particularly interested the 36 analyzed bond studies stands at 63.9% – with in the relationship between ESG and credit risk, i.e. 13 neutral or mixed findings (36.1%).” (p. 222) how environmental, social and governance factors may affect creditworthiness. There are two further How do ESG factors influence the financial strands of research as studies typically concentrate performance of fixed income investments? on either companies/corporate issuers or countries/ sovereign issuers. The former appears to be more The various researchers take different approaches, advanced while the latter had been surprisingly and use very different methodologies, data sets and overlooked for a long time. time frames. They try to give a better understanding on a number of key questions of the relationship between ESG factors and: Corporate Bonds Several studies have looked at the relationship • cost of capital (debt and equity); between corporate bond performance and ESG. • credit risks; credit spreads; Here are some examples of industry and academic • credit ratings; research. INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 17 Barclays (2015, 2016) studied the impact of ratings are associated with reduced financial risk ESG on the performance of US investment-grade while negative ESG performance scores lead to corporate bonds (between 2007 and 2015) and increased financial distress. Investors respond more found that a high ESG rating results in a small to positive ESG ratings.20 but steady performance advantage. The effect was strongest for a positive tilt towards the G factor, In contrast, Amiraslani et al. (2017) detected no while favoring issuers with a strong E and S rating relationship between corporate social responsibility was not detrimental to bond returns. Also, issuers and bond spreads over the period 2005-2013. with high G scores experienced lower incidence of However, during the 2008-2009 financial crisis, downgrades by credit rating agencies. high-CSR firms benefited from lower bond spreads. Hoepner and Nilsson (2017a) argue that bonds issued In a different approach to pricing ESG risk, Hermes by companies with “no strengths, no concerns, and (2017) relates its proprietary measure of ESG risk no controversies” significantly outperform the – the QESG Score – for companies to credit default market. These findings are particularly strong in swap (CDS) indices. Companies with the lowest times of market turmoil. QESG Scores tend to have the widest CDS spreads and broadest distributions of average annual CDS Infrastructure bonds are a growing segment spreads. Moreover, credit ratings do not accurately in investor portfolios. Kiose and Keen (2017) reflect ESG risks and thereby do not serve as a tested the financial risk implications of social and sufficient proxy for ESG risk. environmental risk factors. Carbon emissions and independent directors on the board are significant Insight Investment (2016) looks at one particular in this respect. approach, i.e., exclusions, in a corporate bond portfolio. Broad ethical screens are likely to have A review of research for investment grade (IG) a minimal effect on long-term returns but more corporates by Allianz (2017a) summarizes: focused screens could have a larger impact. The direction of impact – i.e. whether the exclusions • Within investment grade bonds, issuers with lead to performance being better or worse than the material ESG risks and persistently low ESG relevant index – cannot be predicted. scores are to be avoided (also for tail risks); • Expected ESG momentum (positive or negative) For corporate bond issuers, good/bad ESG may not be fully priced into the markets; management corporate social responsibility (CSR) behavior is rewarded/penalized by lower/higher • An exclusion filter seems to lead to no significant bond yield spreads, according to research by performance impairment. Oikonomou et al. (2014). Similar results apply to bond ratings. In their research, Bauer and Hann There are contrasting views. Cantino et al. (2017) (2010) conclude that environmental concerns are conclude, from their review of ESG and financial associated with a higher cost of debt financing capital structure, that there is some consensus on and lower credit ratings, and that proactive the positive effect of ESG on the cost of equity. environmental practices are associated with a lower However, “results concerning the relationship cost of debt. between ESG sustainability and debt financing are ambiguous and no clear-cut defined” (p. 124). In his Hsu and Cheng (2015) found that socially theses, Bektić (2018) argues that the conclusions responsible firms usually perform better in terms on ESG factors in corporate level returns are still of their credit ratings and have lower credit risk mixed and therefore premature. (in terms of loan spreads, defaults). Positive ESG 18 | 3. ESG AND FINANCIAL PERFORMANCE – MAIN RESEARCH FINDINGS Sovereign Bonds Research by international institutions provides some evidence. For example, using a data set In sovereign debt analysis, in addition to assessing of 90 countries, Qian (2012), shows that strong an issuer’s ability to repay its debt, investors institutions are associated with fewer sovereign are using ESG information to assess an issuer’s default crises. In addition, when institutions are willingness to repay. To date, most of the attention weak, a more polarized government tends to default has been on governance factors, such as institutional more often. strength and political risks. Several individual governance factors such One of the few academic research papers to study as corruption or transparency have also been the relationship between ESG and sovereign bond scrutinized in this context. For example, Union performance is Capelle-Blancard et al. (2017). In Investment (2014) considers corruption a key a comprehensive analysis of OECD sovereigns, indicator of sovereign credit strength in fundamental it concludes that countries with good ESG evaluations because of the relationship between performance tend to have less default risk and fraud, tax avoidance, financial management and an thus lower bond spreads. Moreover, the economic issuer’s ability to repay its debt obligations. There impact is stronger in the long-run, suggesting that are strong correlations between corruption and the ESG performance is a long-lasting phenomenon. number of sovereign defaults. Choi and Hashimoto The environmental dimension appears to have no (2017) show that data transparency policy financial impact whereas governance weighs more reforms, reflected in subscriptions to the IMF’s than social factors. Data Standards Initiatives, reduce the spreads of emerging market sovereign bonds. New industry research had been undertaken on sovereign bonds, much of it focused on ESG and credit ratings. Allianz (2017b) finds evidence that Fixed Income Funds ESG risk factors are not fully reflected in sovereign Some researchers looked at the performance of credit ratings. Bad governance is a key risk, ESG/SRI fixed income funds and fund managers. followed by social risks. Tail risk may be better For example, Henke (2016) detected that during the mitigated through ESG factor integration into period 2001–2014, socially responsible bond funds sovereign issuer credit analysis. outperformed by half a percent annually. This is mainly due to the exclusion of corporate bond issuers Sustainalytics (2017a) reveals a positive correlation with poor corporate social responsibility activities. between countries’ ESG and credit rating agency Outperformance is especially likely to occur during (CRA) ratings, and their ESG momentum and GDP recessions or bear market periods. Leite and Cortez per capita growth. Blending CRA ratings with ESG (2016) detect cyclical patterns: European SRI funds scores and momentum may help identify countries provide some protection in market downturns, but that are undervalued or overvalued. otherwise the verdict is mixed. Other industry research focuses on ESG and credit Hoepner and Nilsson (2017b) investigated the ESG spreads. Lazard (2017) estimates the portion of the engagement activities of fixed income managers. yield spread attributable to ESG considerations. Funds from fund management companies not A strong relationship between a country’s ESG involved in ESG engagement activities perform standards and its creditworthiness/cost of borrowing significantly worse indicating the materiality of is particularly discernible in emerging markets. ESG expertise and ESG engagement in fixed income investments. High institutional quality is widely seen as an important factor for sovereign creditworthiness. INCORPORATING ENVIRONMENT, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 19 Figure 4: Main Research Findings Incorporating ESG factors ESG factors are material does not mean having to sacrifice return credit risk Source: Authors In summary, there has been a growing research • Academic research exploring the link between effort to analyze the relevance of ESG factors in ESG factors and sovereign creditworthiness is less fixed income. Whilst the methodology for individual well supported. Nevertheless, there is evidence studies varies greatly and may be questioned, on the impact of ESG factors on macroeconomic overall, the growing body of research supports a variables and potential growth. more widely held view that: 1) ESG factors can constitute material credit risk, and 2) incorporating It is important to qualify the importance of research ESG factors does not mean having to sacrificing findings to date, and their application in the return (Figure 4). There are some interesting early investment practice: results in this process but much more will need to be done. PRI (2017a) produced some ‘takeaways’ • Most of the ESG research use past data. Past at this juncture: results may not hold in future. Investment policy cannot solely rely on a “majority vote” of past • Both academic and market research supports the research results. notion that there is a link between ESG factors • Difficulty in back testing some of the results and the credit risk of a borrower; given limited historical data. • Most academic research is based on credit ratings • Research typically finds correlation, and not to measure credit risk and very few papers use necessarily causality (DB 2012); alternative measures (such as credit default swaps); • There is still little understanding and consistency about how ESG “factors” relate to the established • Anecdotal observation of defaults, particularly factors in asset pricing models, such as value/ of investment-grade corporates, highlight growth, size, liquidity; that governance has a clearer link to corporate failures, while environmental and social issues • The structure of economies and markets changes are more difficult to capture; over time, and so do policies. Investors need to make decisions looking forward; 20 | 3. ESG AND FINANCIAL PERFORMANCE – MAIN RESEARCH FINDINGS • There may be (selection, data, size and other) Finally, some observers feel that – while certainly biases at work. As ESG research matures, it will relevant – financial performance has received face stronger scrutiny; too much attention in recent times compared to conceptual research and empirical evidence on • Research on ESG in fixed income is still very extra-financial performances (e.g. Capelle-Blancard limited; and Monjon 2012). Overall, it is still early days for research on financial performance, and even more • Most of it is focused on credit risks. There is still so for non-financial performance, of ESG in fixed little analysis of the relationship of ESG factors income. on market risks, inflation, liquidity, maturity, term structures and yield curves, income stability, More robust research is needed on the link between total returns, and other risks/opportunities such as ESG and financial performance of fixed income default risk or recovery rates; investments. Further academic, as opposed to industry studies are needed, looking at the link • Implementation costs (e.g. for transactions, between fixed income and ESG factors using management, reporting) need to be considered; transparent methodologies, over longer time periods, across a broader range of fixed income • Investors are advised to apply their own additional assets and countries. Considering factors other than research and insights; credit risk is required to provide a solid base of evidence as ESG fixed income investing becomes • Different reporting standards results in a lack of more mainstream. comparability between findings. INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 21 22 | 3. ESG AND FINANCIAL PERFORMANCE – MAIN RESEARCH FINDINGS 4. ESG Investment Tools for Fixed Income A number of tools have been created over time to assist investors in the analysis of ESG risks and opportunities. Here, too, fixed income is lagging equities.21 Nonetheless, a number of ESG frameworks have been developed in recent times for bonds, in particular ESG scores22 and rankings for companies, countries and other issues as well as ESG fixed income indices. First, an immediate question arising is, how ESG relates to the traditional credit ratings that are a core element in traditional fixed income management. Credit Ratings and ESG factors, but only where they are relevant to the assessment of credit risk.” (FitchRatings 2017, p.1) A discussion is ongoing on the extent to which ESG “Our objective is not to capture all considerations factors are relevant for credit risks, and in particular that may be labelled green, sustainable or ethical, credit ratings. Some investors have asked for a but rather those that have a material impact on clarification of the role of ESG factors in credit credit quality.” (Moody’s 2017, p.3) ratings, or demand an explicit integration of ESG by credit rating agencies (CRA) (PRI 2017a).23 Time horizon ESG incorporation The focus is not on an exact time frame but on “the most forward-looking view that visibility All major rating agencies say they already incorporate permits” (Moody’s 2017, p.3). S&Ps forecasts ESG considerations in their traditional analysis (S&P generally cover a time horizon of up to two years Global Ratings 2017, Moody’s 2017, Fitch Ratings for speculative-grade corporate entities (that is, 2017). At the same time, they are deepening and those rated ‘BB+’ and below), and no more than widening the research of ESG topics, in particular five years for investment-grade entities, but they on climate change risks. They also want to improve can go longer. For example, for E factors that affect communication on these matters. sovereign ratings, the time horizon is 5-10 years. Materiality Sectors “Fitch Ratings’ criteria and analysis incorporate ESG themes vary widely across sectors. According environmental, social and governance (ESG) risk to Moody’s, for example, 14 sectors have elevated INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 23 credit exposure to carbon regulations. S&P Each ESG category has numerous underlying counted 106 cases in the period 2015-2017 when factors that are analyzed and ranked, and then environmental and climate risks were a key reason combined in an aggregate ESG score for a sector, for a rating action, most notably in the energy, region and an overall portfolio score. The scoring resources and vehicle industries. methods and weightings for the E, the S and the G, and the underlying factors may vary across sectors and countries. Sovereign issuers For all CRAs, different sets of ESG factors are The most common ESG scores are at the micro relevant for corporate, sovereign and other issuers. level and provide some measure of a company’s For sovereigns, S&P considers ESG factors in the ESG performance. There are also country-level context of the assessment of institutional quality and ESG scores that complement traditional methods governance effectiveness, but also social cohesion, of assessing a country’s long-term economic climate change and other key factors. Moody’s prospects, creditworthiness as well as potential names 5 key ESG trends for sovereigns: country reputational risks. competitiveness, government effectiveness, control of corruption, rule of law or physical climate There are external, commercial providers of ESG change. For Fitch, governance indicators have the scores. Although the methodologies are quantitative, greatest weighting for sovereign ratings. the assessments are inherently qualitative. Some investors therefore also set up in-house, proprietary Overall, credit ratings can only partially account ESG scoring systems, overlaying external for long-term sustainability risks, mainly because information with their own analysis. According to of the focus on materiality for credit risk and the Russell (2017), 52% of the respondent fixed income relatively short time horizon. Other methodologies managers utilize third-party vendors exclusively to have been developed to compensate for that obtain ESG scores. 35% utilize external vendors limitation, but fall outside the credit rating space. with an in-house ESG analysis overlay. 15% only Some investors would like the CRA to extend their use internal analysis. The two market leaders in fixed ESG output, including: income are currently Sustainalytics and MSCI, with investors and product providers overwhelmingly • longer time horizons for ratings; relying on these sources. • separate E, S and G factors; • more extensive ESG disclosures; Sustainalytics • an ESG rating alongside the traditional credit rating. Sustainalytics’ ESG scores give individual points CRAs have started to develop separate assessments for companies’ E, S and G elements (0-100). The specifically for environmental and ESG risks. overall ESG score provides an absolute measure On example of a specialist “E” product for a of a company’s ESG performance as well as its popular financial instrument is Moody’s Green relative position within an industry. The set of Bonds Assessment.24 In 2016, S&P published two issues and specific weights vary by industry; at proposals for a potential new ESG evaluation tool least 70 indicators in each industry are covered as well as for a green bond scoring framework, both (Sustainalytics 2017b). separate from traditional credit ratings. For sovereign bond investors, there is also a country ESG score that is based on 36 third-party indicators ESG Scores/Rankings that should complement traditional macro analyses. Generally speaking, an ESG score is measure of It results in country scores for E, S and G separately, environmental, social, and governance factors. and an overall ESG score (0-100). Finally, there is 24 | 4. ESG INVESTMENT TOOLS FOR FIXED INCOME a country ESG rating ranging from A to E that is a 7-point ‘AAA’ to ‘CCC’ scale according to their allocated on set standard deviations from the average. exposure to industry-specific ESG risks and their ability to manage those risks relative to peers. A detailed description is given in MSCI (2017a). MSCI MSCI ESG Ratings identify 10 ESG themes with The MSCI ESG Government Ratings assesses 37 key ESG issues where companies can face large government and certain government-related environmental or social externalities. Corporate issuers. Countries are rated on a 7-point ‘AAA’ to governance is assessed for all companies, whereas ‘CCC’ scale and reflect how countries’ exposure to, the rating model determines the most financially and management of, ESG risk factors may affect significant environmental and social issues for the long-term sustainability of their economies. The each sub-industry (Table 3). It ranks companies on ESG factors for government bonds include political Table 3: MSCI ESG Key Issues for Companies27 3 Pillars 10 Themes 37 Key Issues Environment Climate Change • Carbon Emissions • Financing Environmental • Product Carbon Footprint Impact • Climate Change Vulnerability Natural Capital • Water Stress • Raw Material Sourcing • Biodiversity & Land Use Pollution & Waste • Toxic Emissions & Waste • Electronic Waste • Packaging Material & Waste Environmental • Opp’s in Clean Tech • Opp’s in Renewable Energy Opportunities • Opp’s in Green Building Social Human Capital • Labor Management • Human Capital • Health & Safety Development • Supply Chain Labor Standards Product Liability • Product Safety & Quality • Privacy & Data Security • Chemical Safety • Responsible Investment • Financial Product Safety • Health & Demographic Risk Stakeholder Opposition • Controversial Sourcing Social Opportunities • Access to Communications • Access to Health Care • Access to Finance • Opp’s in Nutrition & Health Governance Corporate Governance* • Board* • Ownership* • Pay* • Accounting* Corporate Behavior • Business Ethics • Corruption & Instability • Anti-Competitive Practices • Financial System Instability • Tax Transparency Source: MSCI (2017a) * Corporate Governance carries weight in the ESG Rating model for all companies. Other Key Issues are assessed on an industry- specific basis. INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 25 risks, human rights and environmental issues. As Country Scores a practical example, Swiss Re (2017) applies a concept of minimum ESG rating standards in their In addition, several fund managers and asset asset liability management (ALM) approach. owners have developed their own ESG scoring systems, or variations using raw data from MSCI or Sustainalytics in a different way, especially at Other providers company level. Here are some examples for ESG There are several more specialist services on the country scores. Developed countries typically fare market of company ESG scores of some sort, better than emerging, frontier markets - especially including RepRisk, ISS-Ethix, Bloomberg, Thomson when looking at ‘levels’ rather than ‘changes’. This Reuters/Eikon.25 Verisk Maplecroft, VigeoEiris and raises serious questions on ESG analysis in the Oekom Research also offer a sustainability rating sovereign space. also for countries. Beyond Ratings and several French banks have announced plans for a first credit RobecoSAM ratings agency to systematically integrate ESG factors into financial ratings and provide investors RobecoSAM’s is one of the more transparent with an “augmented assessment of creditworthiness” country sustainability frameworks. It evaluates 65 in 2018. In practice, investors often use more than countries (22 developed and 43 emerging markets). one external provider of ESG scores. Standardized scores and indicator weights result in a country sustainability score ranging from 1 to 10 (RobecoSAM, 2015). The framework is based on Sustainability rating for funds 17 environmental, social and governance indicators ESG ratings for funds have been introduced (each of which is based on various data series, by a number of companies, including MSCI, or sub-indicators). They are grouped in the three Barron’s and Corporate Knights. One example, E, S, & G dimensions, which receive a weight of the Morningstar Sustainability Rating is a measure 15%, 25% and 60% of the total score, respectively of how well the companies held by a fund are (Figure 5 and Appendix 4). The selection and managing their ESG risks and opportunities weightings of the indicators was primarily based when compared with similar funds. It is based on their financial relevance for the assessment of on company-level ESG data from Sustainalytics. sovereign bond markets. The list is currently being Scores are aggregated to a portfolio ESG score led by four Nordic states, Switzerland, Canada and using an asset-weighted average of all covered Australia. securities (equity and fixed-income). Funds are sorted into five normally distributed groups (1-5 DZ Bank stars). DZ Bank developed a sustainability rating for However, criticism has been levied that the analysis countries that combines an ESG methodology (with behind the ratings does not fully reflect the true raw data from Sustainalytics) with an economic ESG level of integration or impact of the funds. For sustainability dimension, i.e. a four-dimensional example, no recognition is given to investors efforts EESG analysis model. The weighting of E factors on shareholder engagement and public advocacy. is 20%, S 30%, G 30% and economic factors Furthermore, there is no consideration of the real 30%. Countries are grouped into “sustainable”, impact and managers with specific impact-focused “transformation states” and “unsustainable”. The mandates – including those operating in emerging current list is being led by Nordic and middle markets or developing countries – can be penalized European states (DZ Bank 2015). (e.g., Krosinsky 2018).26 26 | 4. ESG INVESTMENT TOOLS FOR FIXED INCOME Figure 5: RobecosSAM ESG Weightings27 ESG Weights in the CSR, from Environmental Factors to Social Unrest and Aging Populations Environmental Status 10% E Energy 2.5% 15% Environmental Risk 2.5% Social Indicators 10% S Human Development 10% 25% Social Unrest 5% Liberty & Inequality 10% Competitiveness 10% G Political Risk 10% 60% Aging 10% Institutions 5% Six Other Factors 15% Source: RobecosSAM Candriam SDG scores Candriam’s ESG country analysis is based on four The Bertelsmann Stiftung and the Sustainable ‘capital ‘domains to cover all the United Nations Development Solutions Network (SDSN) developed SDGs: Human Capital, Natural Capital, Social an SDG Index. Its scores signify a country’s Capital and Economic Capital. These four equally position between the worst (0) and best (100) weighted factors have a number of sub-factors. The outcomes. The 2017 index is led by 10 European overall ESG score includes components for both countries, followed by Japan (Bertelsmann 2017). the level and trend. No application of SDG scores to fixed income is known to date. The Candriam ESG Country report (2017) analyzed 123 countries (35 advanced and 88 emerging economies). 74 countries were categorized as ESG Fixed Income Indices investible and 49 as non- investible. Of the 35 Investment managers usually organize their advanced economies analyzed, only Greece was investments around established investment indices. considered non-investable. Of the 88 emerging They are typically used as performance benchmarks economies (which have a lower inclusion in active investing and for replication in passive threshold), 40 were classified as investable and 48 investing. Many fixed income indices are offered non-investable. by global or local index providers, and they all differ in several respects. Some investors like to use Similar approaches have been developed by indices that incorporate ESG risk and exposures in other investment houses, including BY Mellon/ some form. Standish (2016), among others. Global Evolution, Neuberger Berman (2013) and Lazard (2017) are However, unlike equities, not many ESG indices examples of ESG scoring models that concentrate are currently available for fixed income. This can on emerging markets. partly be explained by the fact that ESG integration is newer in the fixed income field than in equities INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 27 (which was initially driven by shareholder voting index. This allocation rule is meant to reward and stewardship). In addition, more data is issuers that exhibit stronger ESG fundamentals, available on public companies than other debt as well as those that are demonstrating improving issuers, particularly non-corporate entities. As fundamentals. noted, the index compilers are also the providers of These indexes are available for corporate and ESG data, which clients then use to build their own aggregate (corporate plus sovereign) but – methodologies. Finally, there may also be ‘cultural’ interestingly - not for sovereign only benchmark reasons, especially the fixation on traditional indexes. There are sub-indexes for different regions, quantitative analysis in fixed income. maturities, currency-hedged, etc. Barclays MSCI S&P Dow Jones In 2013, Barclays and MSCI (now Bloomberg • The S&P ESG Sovereign Bond Index family, Barclays MSCI) co-produced a new family of started in 2015, is based on standard cap-weighted rules-based fixed income benchmark indices. They sovereign bond indices but tilts the country reflect three different ESG incorporation strategies weights towards more sustainable countries, (MSCI 2017b) (Appendix 45 for more detail): based on RobecoSAM’s Country Sustainability Ranking (S&P Dow Jones Indexes 2017). • Socially Responsible Investment (SRI) indices negatively screen out issuers from existing • Incorporating long-term sustainability as a Barclays indices that may be involved in dimension of credit analysis aims to serve as business lines or activities that are in conflict with an additional, risk-reducing tool, especially investment policies, values, or social norms (e.g. given that cap-weighted bond indices are highly controversial weapons). They can be customized exposed to highly indebted and therefore risky further for exclusion of specific issues (e.g. countries. Currently, there is only one such index Catholic values) (Table 4) available: The S&P ESG Pan-Europe Developed Sovereign Bond Index. • Sustainability indices use sector-specific positive ESG screens to adjust weights in the direction of Other providers “best-in-class” peers. Issuers must have MSCI ESG ratings of BBB or higher. • Several other index providers are currently working on ESG fixed income indices (e.g. FTSE • ESG-weighted indices use MSCI ESG ratings levels and momentum to adjust or tilt index weights within an existing Barclays fixed income Table 4: Categories Available for Bespoke Screening Abortion & contraceptives Defense & weapons Nuclear power Adult Entertainment Gambling Pork Alcohol Genetic engineering Predatory lending Animal welfare Global norms Religious values Board diversity Global sactions Stem cell Child labor Human rights Tobacco Source: MSCI (2017b) 28 | 4. ESG INVESTMENT TOOLS FOR FIXED INCOME expected to launch in 2018/19, UBS are working • Solactive Green Bond Index; on setting up sustainable indices for multilateral • ChinaBond China Green Bond Index. development bank bonds). Low carbon indices Green bond indices • Low carbon or carbon-efficient indices have • Since 2014, various providers created indices to been on the market for equities for some time exclusively cover green bonds. Eligibility criteria for but are less common for bonds. In 2016, a new inclusion, methodologies and coverage differ. Some Solactive SPG Euro IG Low Carbon Bond Index examples: was launched. The index covers investment • Bank of America Merrill Lynch Green Bond Index; grade corporate bonds of companies that are • Barclays MSCI Green Bond Index; less dependent on fossil fuels relative to higher carbon-emitting peers. • S&P Green Bond Index and Green Project Bond Index; INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 29 30 | 4. ESG INVESTMENT TOOLS FOR FIXED INCOME How is ESG 5. being Implemented by Fixed Income Investors? E SG investing is being implemented in very different ways by investment managers and asset owners. Different types of investors will naturally have different approaches, according to their size (smaller institutions will be able to do less in-house), regulatory framework (which can impose greater restrictions according to financial sector, geographic location etc.), nature of business (some institutions are driven more by ALM considerations than alpha returns) etc. As a stylized description, it can take place at any Table 5: ESG Strategies in Fixed of these levels of investment operation, or any Income (by Volume of Assets) combination: policy, investment process, products, underlying assets (e.g. companies), marketing/ Combined FI Approaches in US$TRN public relations and reporting. Screening alone $2.3 ESG investing in fixed income is developing fast Thematic alone $0.1 these days. As a snapshot, a survey of 109 fixed income managers by Russell (2017) found that 68% Integration alone $9.6 of managers have integrated ESG somehow into the Screening + integration strategies $5.8 investment process. However, this means different things to different people, and there are question Thematic + integration strategies $0.1 marks over the real implementation so far. Screening + thematic strategies $0.4 Which ESG strategies are most commonly applied All three strategies combined $1.4 by investors? For fixed income, a survey by PRI No incorporation strategies applied $2.3 (2017a) finds integration ahead of screening and thematic investing. Only 6% of managers (by assets) Grand total (actively managed) $21.9 use all three approaches (Table 5). Furthermore, Source: PRI (2017a) corporate bonds are better covered than sovereign bonds by ESG analysis, while securitized assets are far behind in this respect. INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 31 For some investors, ESG investing is limited to the or projects. In the ESG context, by far the most use of ESG products (such as green bonds or an popular are “green bonds” and “climate bonds”, SRI fund). Other investors have decided to follow but thematic “social bonds” and “SDG bonds” passively an ESG index for some asset classes. have also been developing in recent years. Fund Many asset owners are going down the route of managers also offer thematic green or social selecting active ESG managers or developing bond fund vehicles (e.g. the IFC/Amundi Planet active ESG in-house strategies for certain asset Emerging Green One green bond fund for emerging classes. Finally, there is a ‘holistic’ approach with markets, Threadneedle’s UK Social Bond Fund, full integration across all asset classes and risk AIM/ Lombard Odier Global Climate Bond Fund). management (Figure 6). Here, the focus is on specific applications for fixed income. Although growing in importance and recognized as a catalyst for the integration of ESG into fixed income How these different approaches to ESG investing portfolios, the labelled bond market is still tiny – less are being applied by different categories of asset than 0.1% of the total global bond market. owners and other investors is a topic which deserves further research. Likewise, the success of the different approaches and tools is a topic which Green bonds this overview paper has not been able to delve into, Green Bonds are defined as fixed-income but also would be worthy of further study. securities that raise capital to support projects or activities with specific climate or environmental sustainability purposes. Multilateral institutions Green, Social, Sustainable and Other like the European Investment Bank (EIB) and Thematic Bonds World Bank led the issuance in the green bond Thematic bonds or labelled bonds are bonds with market. Green municipal, state and corporate green proceeds earmarked to specific themes, sectors bonds followed, and high yield green bonds are starting to develop. Figure 6: Level of ESG Integration ESG ‘Active’ ESG ‘Holistic’ ESG Labeled (mandate (in-house ‘Passive’ Bonds with integration (via index) specialist across all asset manager) classes) Source: Authors 32 | 5. HOW IS ESG BEING IMPLEMENTED BY FIXED INCOME INVESTORS? There are four types of green bonds: standard The “Climate Bonds Standard and Certification recourse-to-the-issuer debt obligation, non- Scheme” provides sector-specific eligibility criteria recourse-to-the-issuer debt obligation, green project for assets and projects that can be used for climate bond and green securitized bond (covered, ABS, bonds and green bonds (CBI 2016). Green bond MBS etc.). Proceeds are most commonly allocated assessments are undertaken by companies such as to renewable energy projects, such as wind farms, Sustainalytics, VigeoEiris and Oekom Research, or cleaner forms of public transport. Moodys, Cicero and Trucost (now part of S&P Dow Jones Indexes). The labelled green bond market has taken off in recent years (Figure 7). In 2017, over $160 billion As the popularity and interest in the green bond was issued, with over U$200 billion in green market rises, issuers are increasingly stretching bonds already issued between 2007 and 2016 the boundary of what qualifies as a green or social (World Bank). A further $700bn outstanding were investment. There is also an on-going debate on unlabelled climate-aligned bonds.28 The World whether ‘green’ projects from corporations with Bank Treasury alone has issued USD $10.2 billion broader investment objectives should qualify – some in 138 green bonds in 18 currencies. Despite the viewing this as a positive sign of change within recent growth rates, green bonds only constitute companies, others concerned that ‘green washing’ a small fraction of the overall global bond market could reduce the credibility of the market as a whole. volume of $90 trillion, i.e. about ½%. Second opinions on issuance, and stringent signals from market players will increasingly be necessary. There is an ongoing discussion about the definition Investors tend to hold green bonds over long of green bonds, and the setting of standards to periods, which raises the question of verification of facilitate credibility and transactions (Ehlers “greenness” over time – at a cost. and Packer 2017). The voluntary “Green Bond Principles” (ICMA 2017a) are widely used.29 Issuance is also spreading across a broader range of countries (figure 8). Figure 7: Labelled Green Bond Market Volume by Type of Issuer Annual Green Bond Issuance By Issuer Type 180 160 US$ Equivalent in Billions 140 Energy / Utility Companies 120 100 Corporates/Banks 80 Agency/State/Munis/ 60 Other Government 40 Multilateral Development 20 Banks (MDB) 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Source: Bloomberg and World Bank (as of December 31, 2017) INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 33 Figure 8: Labelled Green Bond Market Volume by Country 2017 Green Bond Issuance by Issuer Country of Origin 35 30 US$ Equivalent in Billions 25 20 15 10 5 0 China France SSA Netherlands Mexico US Germany Sweden Spain Other Source: Bloomberg and World Bank (as of December 31, 2017) There is also an on-going discussion on the pricing may not be farfetched when one considers the cost of green bonds. The question is whether green bonds issuers must put in to structure these bonds, monitor do and/ or should price the same as non-directed and undertake periodic reporting during the tenure use of asset bonds issues by the same company, or of the bond. On the other hand, investors too are whether there is a ‘greenium’ (i.e. green bonds have facing ongoing monitoring costs and low liquidity. a higher price/ lower yield than non-use of proceed counterparts. Green bonds rank pari passu (on equal footing) with bonds of the same rank from the same Social bonds issuer and there is normally no credit enhancement. Bonds labelled as ‘social bonds’ are thematic bonds Climate Bonds Initiative and International Finance that mirror the idea of green bonds. They are bond Corporation (IFC) with support from Rabobank, instruments where the proceeds are earmarked to Pax and Obvion conducted a detailed analysis of support new and/or existing social projects (ICMA green bond issuance for the period January 2016 to 2017b, IFC 2017). Criteria for their qualification March 2017 comparing ‘vanilla’ and green bonds, relate to both financial and social aspects. Social looking for any differences in pricing performance themed bonds are used to fund social housing, (CBI/IFC 2017). Some indicators have shown some education facilities, health care and other projects differences (e.g. some green bonds do price tighter that are either public sector or public–private than the Initial Price Talk when compared to some partnerships. ICMA also coordinate the Social Bond corporate vanilla bonds), but generally pricing is Principles and the Sustainability Bond Guidelines. very similar. This market is still nascent. At this stage concrete evidence to show or support that green bonds perform differently or better Social impact bonds than other categories of bonds is non-conclusive. There are also other financing developments such This could be attributed to the market still being as Social Impact Bonds (SIB), as launched in the immature and relatively small to provide a definite UK, USA, Netherlands, Japan and other countries position on the matter (secondary market trading (OECD 2015). SIBs are not bonds in the traditional is very thin). However, the idea of a “greenium” sense and do not offer a fixed rate of return. A social 34 | 5. HOW IS ESG BEING IMPLEMENTED BY FIXED INCOME INVESTORS? impact bond is a “pay for success” instrument, i.e. has also issued bonds connecting the issuance to a contract between a special purpose vehicle and SDGs.31 In 2018, the WBG also issued sustainable the government that commits to pay for improved development bonds to raise awareness for women’s’ social outcomes (and that also result in public and girls’ empowerment. Catastrophe risk bonds can sector savings), such as reduced recidivism rates also be seen as sustainable investment products.32 for prisoners. The WBG is leading with other innovative financial products, such as the Pandemic Emergency A number of foundations, charitable trusts and Financing Facility, as well as products supporting pension funds have taken an interest in SIBs, human capital investments and universal health care. alongside venture capitalists and other investors. There are currently nearly 100 SIBs in 19 countries, The World Bank and IFC, amongst others, are mobilizing more than £300m of investment into contributing to the work on further refining the tackling complex social issues such as refugee Green Bond Principles. Guidance is also being employment support, loneliness among the elderly, developed on social and sustainable bonds including rehousing and reskilling homeless youth, and as they relate to the SDGs. diabetes prevention. The potential social benefits of SIBs are considerable, but the transaction costs are high, and there are challenges in finding structures Passive Investing with incentives that are properly aligned, making Passive fixed income funds play an increasingly key rapid growth in issuance of SIBs unlikely. role in institutional portfolios. ESG has historically been first associated with active investing, e.g. Sustainable and SDG bonds with norm-based exclusions or an active selection of the best ESG-compatible stocks. More recently, Sustainable bonds include a wider range of green, however, the attention on ESG considerations in social, environmental, development impact, passive investing has been rising fast. microfinance bonds and loans, charity bonds and other debt instruments (European Impact Investing Pressure on large passive investment managers 2016). The World Bank, for example, communicates (such as Vanguard, BlackRock and State Street) that every project it finances is designed to achieve has been rising to increase their stewardship efforts, specific social and/or environmental impacts, especially by using their many votes in shareholder defined by indicators and respective results that are meetings and ongoing engagement with investee published and updated twice annually on the World companies.33 Passive asset owners can use active Bank website. All projects that are financed by ownership and engagement to manage their ESG World Bank bonds must fit with the organization’s risks. However, they need a policy and systems to goals to end extreme poverty and boost shared ensure that different investment managers do not prosperity, also naturally aligning such project take opposing positions while exercising active objectives with the SDGs. From 2018 on, all World ownership on behalf of the same asset owner. Bank (IBRD) bond documentation will include specific ‘Use of Proceeds’ language to explain how ESG in passive fixed income funds has, so far, been bond proceeds support sustainable development relatively little explored and used by investors. projects and programs. Fixed income indices can assist the development of low cost ESG strategies, e.g. screening via an In addition to their general issuance, the World Bank exclusionary index or via an ESG tilted passive and IFC continue to be a major issuer of labelled portfolio. Investors are currently constrained by the and themed bonds. For example, in 2017, the first lack of choice in this field, as they may have different SDG equity-linked bonds were launched issued by ideas about ESG factors and methodologies. the World Bank working with BNP Paribas.30 HSBC INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 35 Exchange traded funds (ETF) are typically launched ESG ‘Holistic’ based on popular indices. The use of ETFs (but also mutual funds) is also rising in this space. MSCI Asset owners, especially larger ones, apply more (2018) found at least a dozen “self-labelled” ESG comprehensive sustainability strategies. The Fixed Income ETFs at the end of 2017. intention is a full integration of ESG across all steps in the investment process and all asset classes. Different in-house integration techniques are being Index customization / ‘Smart beta’ applied by different investors. Indexes can often be customized to reflect the specific needs or preferences of investors better. From an organizational perspective, ESG is often Investors can, alternatively, deviate from established the job of a few “specialists”. Some investors, indices by using an internal “passive plus ESG however, gear up the whole organization to ESG. overlay” approach. An immediate concern in Foremost, a ‘full’ ESG approach requires a clear relation to the increasing index customization in strategic plan, including at all levels of governance, this field is the lack of comparability of strategies, starting with the Board. In practice, various and performance by asset managers. Higher fees approaches have emerged: may also come with it. • Separate team of ESG specialists; “Smart beta” or “alternative beta” investing is • Integration of ESG expertise in analyst, portfolio a variation of passive, using an index that is not and risk management teams; weighted by market capitalization-weighted but • Confining ESG reporting resources in marketing/ by other risk factors, minimum volatility or equal PR/middle or back offices. weights. There are some ESG smart beta products in equity but not (yet) in fixed income. Looking at insurance companies, Swiss Re has recently implemented an ESG framework across asset classes for universe definition, performance Active Investing measurement and portfolio monitoring, and switched to ESG benchmarks for both equities ESG funds of all sorts have been mushrooming and fixed income (Swiss Re 2017). Examples of a in the asset management industry in recent years. comprehensive (and different) ESG strategy in the Active fund products are also growing in the fixed pension fund environment are PGGM and EAPF. income space (e.g. Pimco’s ESG Global Bond Fund; BlueBay or M&G ESG global high-yield bond funds). Specialist ESG asset managers, such PGGM as AIM (Affirmative Investment Management) and An example of such an implementation framework Trillium, are also growing. is the three-pillar approach by the asset manager PGGM, which manages funds on behalf of the largest Active managers use a variety of tools to develop pension funds in the Netherlands (Figure 9). The their ESG approach, all based on some form of framework uses six instruments (exclusions, ESG ESG scoring (see earlier section). Asset owners Integration, engagement, voting, legal proceedings can buy these products “off the shelf” but many and investing in solutions, including green bonds). also define bespoke ESG investment mandates for active investment managers. These can extend PGGM starts with a negative screening policy to all approaches of ESG investing, ranging from with investments in areas such as tobacco, types individual exclusions to best-in-class. A summary of weapons etc. excluded from all portfolios. In of guides on how to give mandate/ appoint external addition, three sustainability goals are embedded in asset managers is provided by the PRI (2013). the 2020 Strategic Policy. 36 | 5. HOW IS ESG BEING IMPLEMENTED BY FIXED INCOME INVESTORS? Figure 9: PGGM ESG Approach PGGM’s Instruments for Responsible Investment NO CHANGE YES Asia What We Do Not Want What We Want to Improve What We Want to Stimulate Direct exclusions Making companies and markets Creating social returns in the Controversial weapons more sustainable through ESG ares of: Tobacco integration, active ownership and Climate and environment collaboration with financial Water Exclusions after engagement on: service providers Health Human rights and social Food circumstances Instruments: Environment ESG integration (including ESG Instrument: Corporate governance Index) Investing in solutions Engagement Instrument: Voting Exclusions Legal proceedings Source: PGGM (2017) • Reduce carbon footprint by half: starting with assess private equity (PE) general partners’ (GPs) listed equity, using a largely passive approach integration of ESG into their process; renovation (Trucost data, ranking companies by carbon and energy efficiency improvement of direct intensity within sectors, divesting from companies real estate investments). ESG country rankings with the highest emissions per dollar revenue in are used for EM sovereign bonds holdings. carbon intensive sectors). The organization has Engagement is also starting to be used as a tool the ambition of rolling out same the approach on the fixed income side. to fixed income and private assets – but finding consistent data sources is still a challenge. Environment Agency Pension Fund (EAPF) • Quadruple volume of positive impact The UK pension scheme EAPF aims to integrate investments: this involves a separate portfolio management of ESG issues throughout the targeting 4 investment themes – climate, water, investment and funding strategy. This includes asset food security and health – with the target of allocation, mandate design, risk management, fund investing EUR 20 billion in these areas by manager appointment and monitoring, collaborative 2020. Green bonds as well as direct (private) engagement and reporting. Thinking about these investments are included in this portfolio. issues at a strategic level is critical (EAPF 2017a). • Further integrate ESG into the whole investment process: through due diligence, This includes especially areas such as engagement, selection and screening, with tools now used by all voting, environmental foot printing, carbon targets investment staff (not just a separate SRI team). For and metrics, and on dedicated green, social and other listed instruments, a passive + positive screening sustainable investments (Box 4). More specifically approach is used (best in class ESG overweighted on fixed income, EAPF introduced carbon foot vs. index using Sustainalytics and MSCI data). printing for its corporate bond portfolios in 2012, For private instruments, the approach is more followed by green bonds, and a ‘Buy & Maintain’ active (due diligence questionnaires are used to bond mandate (with a focus particularly on climate risk and corporate governance). (EAPF 2017b) INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 37 Box 4: EAPF’s Sustainable Investment and Carbon Targets Social and sustainable investment Social investment can be defined to include a wide spectrum of investment opportunities. The EAPF definition of social investment is an investment that addresses societal challenges but generates competitive financial returns. Societal challenges include all issues commonly regarded under social, environmental or governance headings. A wide definition of sustainable investments includes: • Social investments and those with significant revenues (in excess of 20%) involved in energy efficiency, alternative energy, water and waste treatment, public transport; • Property, infrastructure, agriculture or forestry investments with a low carbon or strong sustainability criteria; and • Companies (often equities and bonds) with progressive environmental, social or governance practices that may enhance investor value. The Fund has set itself the target to have over 25% of the Fund invested, across all asset classes, in such opportunities. Carbon targets In our policy we set ourselves three goals for 2020 to invest, decarbonize and engage and we are making good progress on all three. (EAPF 2017a) Climate Goals Progress Invest 15% of the Fund in low carbon, energy efficient and 10% invested with current commitments other climate mitigation opportunities. bringing it to 12.5%. Decarbonise the equity portfolio, reducing our exposure Coal is currently 65% less than our to ‘future emissions’ by 90% for coal and 50% for oil and baseline. gas by 2020 compared to the exposure in our underlying Oil and gas is currently 79% less than benchmark as at 31 March 2015. our baseline. Supported progress towards an orderly transition to a Active engagement across the industry low carbon economy through actively working with asset with a strong focus on working owners, fund managers, companies, academia, policy collaboratively. More information on our makers and others in the investment industry. website. 38 | 5. HOW IS ESG BEING IMPLEMENTED BY FIXED INCOME INVESTORS? Main trends 6. and Challenges State of the Art T he main trends for ESG in fixed income investing can be summed up this way: • There are a number of fundamental differences for • ESG for fixed income is ESG in fixed income, in particular the relevance catching up with equity – of sovereign issuers, and the focus on downside other/alternative asset classes are capital risks. following, too. • More academic and industry research on fixed • Fixed income-specific ESG investment tools income-related ESG issues has been undertaken such as ESG scores/rankings for companies and over the last few years – this is likely to continue. countries are being developed more intensively Overall, it is still early days for research on – both by commercial providers and inside asset financial performance, and even more on non- management organizations. financial performance, of ESG in fixed income. • Work in the sovereign space is lagging corporate • It is now more widely accepted that ESG markets. Other areas of fixed income, such as factors can constitute material credit risk, and private debt, covered bonds or asset backed incorporating ESG factors in the investment securities, have little coverage, so far. process does not mean sacrificing return. • Implementation strategies for ESG in fixed • More investors are trying to understand the link income vary widely. They range from thematic between ESG issues and traditional credit ratings, investments (mostly green bonds), passive as well as ESG and credit spreads. ESG investing, active ESG mandates or in- • New “motivators” since 2015 include climate house strategies, to full integration into fixed change, the UN SDGs and a changing attitude income portfolios – with investors also using a of some regulators (e.g. reporting, disclosure) combination of these approaches. towards “sustainability”. • ESG indices are being used for both passive • ESG investing is growing fast, and is becoming and active strategies, and they use mostly part of mainstream investing for many pension exclusionary screens or ESG-tilted weightings. funds, insurance companies, sovereign wealth However, investors are currently constrained by funds and other asset owners. the lack of choice in this field – more indices are in development. INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 39 • Some advanced investors have developed, physical risks, on biodiversity and natural capital, or are developing, a ‘holistic’ ESG approach etc. Such issues are even more difficult in the social across all asset classes, the entire investment/ and human rights territory. Competing concepts risk management process, and the whole asset in the market place are more likely to allow for management organization. dynamic adjustments and quality competition in • Focus on environmental and social outcomes is a fast-moving world. In this dynamic process, increasing (e.g. carbon emissions, social impact). transparency and good governance are essential. More investors are seeking new territories in “impact investing” or sustainable investment There are pros and cons of setting ‘official strategies also with fixed income instruments. standards’. It looks premature for regulators to set full ESG standards at this juncture, if ever • Investors, especially index investors, are coming possible. More promising is to expect specific under more scrutiny (also in fixed income) for regulation at company/sector/project level, e.g. their ESG efforts, especially corporate (non) on carbon emissions, environmental footprint, engagement), as well as their environmental and energy efficiency, governance practices, workplace social impact. standards, and similar. Furthermore, disclosure • Investors are using the SDGs framework to focus requirements will tighten for both investee their investments for purpose that is aligned with companies and investors. As social issues – which the SDGs. by their nature are less consensual - become more embedded into the investment process Customization and standardization customization will remain, but consensus around frameworks is needed to provide a robust basis What is becoming clear as ESG integration emerges for ESG incorporation (and keep costs affordable). and becomes more widespread practice is the Over time, more robust methodologies would balance which institutional investors are having to provide a better footing for ESG information, and strike between ‘standardization and customization’. deliver better inputs in the models used by the Many investors are increasingly looking to develop investment industry. bespoke strategies to reflect their own philosophy and investment goals. The many different concepts allow for a customization of ESG investment Issues with ESG Investing strategies, indices and portfolios. However, this goes at the cost of comparability of performance. Even with the growing body of research, increasing product offerings and developing methodologies by On the other hand, a widespread complaint is leading investors, a number of issues with ESG are on the lack of agreed ESG “standards”. Many being debated in the industry and in academia. This investors also would like to see standardized ESG poses a series of challenges for fund managers and definitions, stock lists, indices etc. in order not to asset owners. have to “re-invent the wheel”, and to save costs of customization. Some observers would also fear Many investors remain concerned about ESG- opportunistic “standards-shopping”. related investing for assorted reasons (Mooji 2017). Important impediments to the use of ESG As noted earlier, a definitive list of ESG issues does information are the different reporting standards not exist – and it looks impossible to agree on. Even and as a result lack of comparability (Amel-Zadeh within the comparatively advanced discussion and Serafeim 2017). According to a survey of 500 of “green” there are major areas of dispute, e.g. investors globally (Schroders 2017b), performance on nuclear, biofuels. Across experts, there is also and transparency are the greatest challenges. a varying emphasis on processes and products, Difficulty in risk measuring/managing and costs supply and disposal chains, on footprinting or are also mentioned, as is the lack of belief in “sustainable investments” (Figure 10). 40 | 6. MAIN TRENDS AND CHALLENGES Figure 10: Sustainability Challenges for Investors Overall North America Europe Latin America Asia Performance concerns 44% 42% 47% 37% 45% Lack of transparency and reported data 41% 33% 44% 34% 45% Difficulty measuring and managing risk 28% 29% 26% 26% 31% Cost 23% 28% 22% 26% 21% Investment committee is not comfortable making sustainable investments 14% 6% 14% 23% 18% Other 11% 12% 9% 6% 13% I do not believe in sustainable investments 20% 22% 15% 29% 23% Source: Schroders (2017b) ESG critiques • Who regulates ‘sustainability’, and how? Questions about both ESG-specific regulation It is worthwhile to briefly reiterate some of the and investor regulation that affects ESG investing more principled reservations and criticism of ESG (e.g. fiduciary duties); such as: • Too much ESG “box ticking” on the side of • Lack of clarity around the ESG terminology; companies and asset managers;34 vagueness of ‘sustainability’; • Given the rising demand for climate change/ESG • Stakeholders in different sectors (investors vs. products, too much “green-washing” or “ESG- economists vs. environmentalists) are using washing”; different terminology and not communicating • Does ‘sustainability’ investing facilitate or well across disciplines; distract from essential climate change investing? • Potential trade-off between ESG factor (Some governments prefer ‘sustainable finance’ preferences and investment performance; over ‘green finance’); • Possible reduction of investment universe, with • Cost issues (e.g. charges for ESG data providers, lack of diversification; certification or in-house expertise; higher management fees?); • Need to clarify existing regulation, fiduciary duty; • Questions about the effectiveness of governance codes/ESG policy (e.g. financial crisis; executive • Who defines the “values” and how? Concerns compensation and poor corporate oversight; over the growing ‘oligopolistic role’ of external ecological disasters). agencies or service providers; INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 41 ESG implementation in general ESG in fixed income Once a decision in the direction of ESG is made, ESG investing in fixed income poses some there are a broad range of questions on the additional challenges. implementation (see, e.g., Hawley 2017): • Connection between ESG and credit ratings and • Exact definition of ESG factors; is it too static – credit spreads are adjustments needed over time? • Mismatch of time horizon for fixed income • Diverging analytical approaches; detailed investments and period over which ESG factor methodologies (e.g. weightings of E, S and G, or materialize (as these can be short-term, but often of sub-factors)35 represent long-term trends) • Conflicting signals from E, S and G on individual • The relationship of ESG and other risks/ companies/countries opportunities (e.g. market, liquidity) • Limited transparency of ESG scores/ • How to organize “engagement” for bondholders, methodologies (“black boxes”) especially for small investors and with sovereign • Time lag of information (“behind the curve”) issues • Disclosure and reporting issues with underlying • Political sensitivities with sovereign (sub- investee companies/countries sovereign) bonds (e.g. exclusion of countries) • Whether broader supply chain considerations • Limited availability of underlying country data should be taken into account? (also suitability? comparability? timeliness?) • What is the progress in terms of ESG outcomes • How to capture momentum as opposed to static and appropriate metrics? level of ESG for companies and particularly countries • Problem of scale/ resources for smaller institutional investors, particularly in EMs • Lack of ESG research coverage for high-yield, emerging market and private debt • Investment (im-)practicality of SDG goals. • Lack of competition in ESG fixed income indices • Long time horizon over which ESG factors can materialize vs. short-term performance • Awareness of (implicit or explicit) factor biases measurement of asset managers. in ESG investing As ESG investing is spreading more widely, most • The effect of ESG on long-term strategies and asset managers feel the need to become more active asset-liability management (ALM) in this field. However, the reality is often detached • Whether to measure ESG by issuer or issuance? from the image sought, especially outside equities. • Organizational issues (e.g. building ESG fixed For fixed income, as the Russell survey (2017) income expertise; different ESG company experts revealed, “there often is a wide gap in what the survey for stocks and bonds?). respondents claim they do regarding ESG integration and what is actually happening”(p. 4). “Overall, we Progress on data observed that ESG factor consideration appears to be not as a dominant driver in investment decision but One of the main concerns of investors is ESG data. rather as a supplemental piece of information at best The concerns are mainly two-fold:36 as a part of credit analysis.” (p. 1) • Lack of available data; timeliness; coverage of regions/market segments/instruments;37 42 | 6. MAIN TRENDS AND CHALLENGES • Quality of data inputs (inconsistencies; reduce costs vs. intensive analytical approaches, incompleteness; reliance on self-reported data; and provide more real-time data, which is important subjective and unaudited information; obvious for investors tying to adapt policy and other tools. errors). Much more basic environmental and other data are In terms of quantity, reporting initiatives are available now than only one or two decades ago. improving the depth, breadth and consistency Combined with artificial intelligence (AI) and or corporate reporting on ESG factors. The machine learning techniques, real time evidence for launch of the TCFD is a response to this call for investors is becoming more obtainable. more and better information. As of March 2018, over 250 organizations have expressed their New data providers, such as True Value Labs and support for the TCFD, and the first examples of Arabesque,38 are providing ‘sustainable quants’ organizations taking steps to report in line with based services, using big data and machine learning the recommendations of the TCFD (e.g. Unilever, tools to go beyond corporate disclosure-based E, S, HSBC and SwissRe) have already been seen. The G information. MSCI and other data providers are IFC has developed a Disclosure & Transparency noting that an increasing number of their clients are Toolkit to support corporates in emerging markets quants.39 Already, a number of investors, including enhance their ESG reporting. An IFC project is also pension funds such APG40 and PensionDanmark, currently underway to adapt the IFC Performance are testing and implementing artificial intelligence/ Standards and Corporate Governance Methodology robotics for certain processes. However, investors into a framework which can be used by capital are also aware that “big data” may also imply “big market investors. The World Bank is also working risks”. Issues such as cyber-crime, data ownership, on a reporting framework to map project outcomes theft and misuse have already show massive and impact to SDG indicators. financially relevance Importantly, the issue is not just about data quantity. Data availability and quality also need to improve Much more progress is needed in terms of data to support better ESG integration into sovereign quality and relevance as an input to investment bond analysis. The national level data used is decision-making. The bar is being raised for limited, and particularly suffers from significant corporate disclosure by regulators and stock time lags. Initiatives are underway to improve exchanges. More investor ESG disclosure is being the National Capital Accounting of countries (to introduced in many places. Specialist services support financial accounting), but this is yet to are growing to make the best use of such data in become widespread. Work on the ‘Human Capital’ a competitive market. Crucially, more conceptual and other indices may provide a more holistic work will need to be done on defining ESG and framework for sovereign and social analysis (Lange SDG metrics, and especially on how to define and et al. 2018). There is still a need for governments measure the impact of portfolios. to provide better basic environmental and social data – with faster delivery. Satellite data is being New technology is helping tackle the data challenge used by the World Bank and other institutions to by adding both depth and breadth to ESG sources. track proxies for ‘E’ and ‘S’ measures through data This goes beyond using standard, self-reported such as environmental degradation and poverty corporate data to incorporate ‘big data’ and new measures. information sources, such as satellites. It can also INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 43 44 | 6. MAIN TRENDS AND CHALLENGES 7. Conclusions: from Process to Impact Key Lessons for Investors T here are a number of key lessons for investors: From single steps to a full organizational to achieve with ESG (if at approach all)? And how? There is often an excessive focus on sustainability and Many investors – both asset owners and asset financial performance, and too little regard managers – have taken some single steps into ESG for performance in terms of E, S and G. Though investing into their fixed income portfolios, e.g. by arguably harder to measure, these considerations buying a SRI fund or a green bond, SRI engagement are also important for fixed income holdings. teams working on fixed income as well as equity holdings, subscribing to ESG organizations or producing ESG marketing/compliance literature. From input to outcomes – from process to impact Such single steps are often indeed the main options In the past, ESG investing has been mainly concerned for smaller investors. Larger investors, however, to with inputs (e.g. finding ESG data, products) and progress, need to take a full organizational approach internal processes (e.g. ESG analysis, compliance). (starting at board level), devote in-house analytical While this process will continue, in future, more resources and apply appropriate aspects of ESG efforts will go into the ESG output, including: strategies in parallel, including incorporation across fixed income holdings. • becoming clearer about how to conceptualize ESG outcomes; Clear objectives • working hard to find appropriate ESG metrics; Clarity about the objectives is paramount. Some • getting a handle on the environmental and social investors (and academics) primarily try to chase impact across portfolios, including fixed income a few extra basis points via (changeable) ESG holdings; product/strategy outperformance. Instead, more • determining how to measure and communicate efforts should go into setting ESG investment ESG impact beyond labelled bonds; and objectives: What is this particular asset owner trying • mapping portfolios and SDG outcomes. INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 45 Ways Forward First, the on-going initiatives to improve the data upon which the ESG analysis and tools ESG investing is developing from a purely process- are based should continue to be supported. driven to a more outcome-driven activity. This Corporate reporting initiatives are having results, is true for all holdings, including fixed income. with attention increasingly spreading to emerging The concerns outlined above show that, whilst market issuers. Likewise, evidence from new data great strides have been made to incorporate ESG sources (big data, satellite data etc.) needs to be factors into fixed income investments, and across tested for robustness and materiality to include and investors’ portfolios, more needs to be done to truly bring a real-time dimension to ESG analysis of mainstream this approach and have material impact. sovereign bonds. In addition to investors themselves, a range of Second, more rigorous research on the stakeholders have a role to play to achieve the relationship between ESG factors, financial risk goal of mainstreaming ESG into fixed income and returns in fixed income is also required. investments: Further, academic studies are needed, looking at the link between all aspects of fixed income, E, S and • Governments need to provide more timely, G factors, using transparent methodologies, longer accurate national data on ESG and development time periods, and a broader range of fixed income issues, as well as financial national accounting to assets and countries. inform analysis of their sovereign issuance; • Corporations need to continue to improve their Third, frameworks for applying this ESG reporting on ESG as well as financial factors to data should continue to be refined. Having better assess their debt as well as equity issuance; standardized, international frameworks brings confidence to investors that ESG analysis is being • Multilateral development banks have an placed on a robust footing. This will allow them to important catalytic, intermediary and capacity further include this analysis into their mainstream building role to play on labelled bond issuance, investing across asset classes, whilst adding and impact measurement more broadly; customization on top to reflect their own beliefs • The international associations should strive and goals. in their thought leadership and the provision of robust evidence to support the mainstreaming of Finally, more innovative, sustainable investment ESG investment in all asset classes, and work products are needed – as evidenced by the appetite towards common frameworks. for green bonds. They should be scalable and more • Service providers should continue to improve diverse in order to become meaningful portions of their ESG methodologies and analysis, pushing investors’ asset allocation and benchmarks. The for more timely, accurate and extensive growing sustainable bond issuance – supported by information to base this on – and they in turn the data and frameworks discussed – will allow need to be pushed by investors to increase the investors to channel their portfolios and measure quality of their products, particularly in the fixed impacts on their chosen goals. More can be done income space. to devise structured and other products to meet this demand. As with green bonds, supranational • The academic community can provide new issuers are helping pave the way forward to grow ideas, new metrics and critical evaluation, with sustainable bond markets through their own bond gaps in fixed income analysis particularly needing issuance and by mapping out impact reporting to be filled. models and transparency and disclosure standards together with partners like ICMA. Further work is needed in four areas: 46 | 7. CONCLUSIONS: FROM PROCESS TO IMPACT Next Steps Frameworks Continue to support the refining the green/social/ Suggested next steps for the World Bank Group, sustainable bond principles and impact reporting GPIF and their partners include: (including alignment with SDGs) for investors through the Executive Committee chaired by ICMA National Reporting • Test IFC’s ESG framework for EM corporate • Encourage and support use of National Capital issuers with institutional fixed income investor Accounting, including in developing economies partners. • Explore how to provide more accessible, accurate, timely E, S, G risk and impact indicators for Products investors to incorporate into their analysis – in • Work with sovereigns, sub-sovereigns to support cooperation with stakeholders their interest in issuance of labelled bonds through • Conduct research into materiality and advisory work incorporation of E, S, G risk and impact factors • Provide advisory to emerging market issuers on in sovereign bond analysis increasing transparency in measuring and tracking • Provide opportunities for investors to engage on impact for financed projects – for labelled and E,S,G issues with sovereign issuers non-labelled bonds • Increase engagement with investors on sustainable Corporate and Impact Reporting use of proceeds for all bonds issued and related • Step up engagement with international initiatives impact reporting, to expand and broaden the (GRI, SASB) and investors to promote and market (by issuer, issuance type, broader range of develop standard corporate reporting credit quality etc.) to scale up the market. • Continue work with TCFD, including on climate- • Support products that help to raise awareness for related scenario analysis and assessment by pressing development issues such as environment, financial institutions gender, human capital, universal health care and • Encourage corporate sustainability benchmarks other themes that enable sustainable prosperity aligned with SDGs for all generations • Work with institutional investors and others to In the end, investing is about dealing with develop and refine reporting on impact from opportunities and uncertainties – this not different sustainable development investments (such as for for ESG investing. ESG issues constitute a major IFC Social Bonds and World Bank Sustainable challenge for asset owners and asset managers but Development Bonds) and their alignment with the also provide new – financial and social - opportunities. SDGs, that can be used as a model for reporting Governments can set better frameworks and provide by other issuers better as well as faster data to facilitate progress. International and industry organizations can help • Promote the use of the IFC Disclosure & with basic, general guidance. Market competition Transparency Toolkit for EM corporates and will continue to drive the provision of ESG data, design customized capacity building activities tools, strategies and products, and this should also targeting specific countries or sectors improve the quality of investments over time. INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 47 48 | 7. CONCLUSIONS: FROM PROCESS TO IMPACT Appendices Appendix 1: Institutions Interviewed for This Report Asset managers and institutional investors: Affirmative Investment Management (AIM) TIAA Investments Amundi Trillium Asset Management APG UBS BlackRock Zurich Insurance Group BNY Mellon Asset Managers North America Rating agencies, data providers, Breckinridge Capital Advisors standard setters: CalSTRS Arabesque Columbia Threadneedle Investments De Nederlandsche Bank Deutsche Asset Management IPE Everence /Praxis Mutual Funds FTSE Russell Folksam Moody’s Global Evolution MSCI MN PRI Neuberger Berman R&I Information Japan Nippon Life Insurance RobecoSAM OP Trust S&P PGGM Sustainalytics PIMCO Trucost Schroders Verisk Maplecroft INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 49 Appendix 2: ESG Criteria Institution E S G CFA (2015) Climate change and carbon Customer satisfaction Board composition emissions Air and water pollution Data protection and privacy Audit committee structure Biodiversity Gender diversity Bribery and corruption Deforestation Employee engagement Executive compensation Energy efficiency Community relations Lobbying Waste management Human rights Political contributions Water scarcity Labor standards Whistleblower schemes PRI (2014) Carbon intensity Demographics Institutional strength (Sovereign Water stress Education and human capital Corruption issuers) Energy resources and Health levels Regime stability management Natural disasters Political and press freedoms Rule of law Biocapacity and ecosystem Human rights Financial reporting quality Pollution Labor standards Regulatory effectiveness Biodiversity Social exclusion Adherence to conventions Agriculture Income inequality International relations PRI (2014) Environmental Demographics Business integrity (Corporate Climate change Human rights Shareholder rights issuers) Biodiversity Employee relations Incentive structure Energy resources and Health and safety Audit practices management Biocapacity and ecosystem Diversity Board independence & quality expertise Air pollution Customer relations Fiduciary duty Water scarcity and pollution Product responsibility Transparency /accountability IFC (2012) Risk Management Labor Commitment Resource Efficiency Community Health and Board structure Safety Pollution Prevention Resettlement Control environment Emergency preparedness Indigenous People Transparency and disclosure and response Biodiversity Cultural heritage Minority shareholders Stakeholder engagement Source: 50 | APPENDICES Appendix 3: Characteristics of Fixed Income and Implications for ESG Characteristics of Fixed Income Responsible Investment Actions Potential downside outweighs potential upside – focus Focus on the contribution of ESG factors to financial is on risk, low volatility and preservation of capital more downside – in particular, significant event risks and than on growth opportunities. systemic risks that can affect issuer creditworthiness. Most prominent of these should be governance. Lenders have a contractual relationship with borrowers; • To manage risk, use any opportunity to engage they are not owners. Debt holders don’t vote at issuers on ESG factors of concern (e.g., in run-up to AGMs, and access to management can be relatively issuance). infrequent. • Collaborate with other bondholders for more effective engagement. • Vote on governance concerns during debt restructurings. Multi-layered analysis (e.g., yield spread and yield Develop robust yet streamlined processes to help curve analysis). analysts identify and manage ESG risks effectively. Multiple issuer types (e.g., corporate, government, ESG analysis varies for different issuers; metrics, financial sector, and supranational). criteria weighting and engagement approach vary. There is no one-size-fits-all. Multiple instruments (e.g., structured products and Analyse ESG-related risks to issuer creditworthiness as ABS). well as to asset cover pools and originators. • Debt issued as public or private instruments. RI approach varies relative to availability of ESG • Debt issued as investment grade or high yield. information, engagement opportunities, investor influence and access to management. Private/high- yield securities may represent higher risk but offer more opportunity for engagement and outperformance. Different capital structure levels – senior, subordinated, Subordinated debt holders face financial downside hybrid etc. before senior debt holders do, making them more sensitive to impacts from ESG risk. Debt instruments have fixed durations covering Consider whether different durations will affect the different periods. materiality of ESG to creditworthiness (e.g., will carbon regulation impact three- and ten-year bonds the same?). Private companies can issue listed/public debt. Coverage of ESG data for private companies is relatively poor – weaker regulations on reporting for private companies. Weaker issuing requirements but longer issuing periods Greater concentration of risk for private placements for private placements. requires closer consideration of ESG risks; a longer issuing period allows for this. Debt can be issued by subsidiaries and special Consider exposure and management of ESG risks by purpose vehicles (SPV). parent company, subsidiary and originator. Multiple outstanding debt securities issued by a single Consider concentration of ESG risk related to single issuer. issuers across multiple securities. Fixed income analysis can be heavily reliant on Address need for consistent and comparable ESG quantitative factors. metrics that are easy ‘plug-ins’ for existing research models. Source: PRI (2014) INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 51 Appendix 4: Structure of RobecoSAM’s Country Sustainability Framework Country Dimension Sustainability Sub-indicator Level Indicator Level Level Score For each country, various data series on a number of For each indicator, relative Each dimension The country sustainability sub-indicators are collected, totaling over scores ranging from 1 to weight is the sum score is the 250 data series. These sub-indicators cover the 10 are calculated. Each of the indicator weighted sum of following areas: indicator is also assigned a weights within standardized predefined weight. the respective indicator scores. dimension. Emissionsn Biodiversity Environmental Status (10%)* Environmental Energy Use Energy Sources Energy (2.5%) (15%) Exposure to Environmental Risks Risk Mitigation Environmental Risk (2.5%) Human Welfare Work and Equality Social Indicators (10%) Social Education Life Expectancy Human Development (10%) (25%) Confidence in Government Local Job Market Social Unrest (5%) Country Rights and Liberties Inequality Liberty & Inequality (10%) Sustainability Score Human Capital and Innovation Physical Capital Competitiveness (10%) Internal Risks and Inefficiencies External Conflicts Political Risk (10%) Management of Public Goods Policy Responses Effectiveness (2.5%) Protection of Property Rights Judicial System Rule of Law (2.5%) Governance Democratic Participation Civil Society Accountability (2.5%) (60%) Corruption Level Transparency/Policies Corruption (2.5%) Terrorism and Political Crimes Government Stability Stability (2.5%) Competition / Liberalization Business Regulations Regulatory Quality (2.5%) Demographic Profile Age-related Policies Aging (10%) Monetary Policy Independence Other Institutions Institutions (5%) *Predefined indicator weight Source: RobecoSAM (2015) 52 | APPENDICES Appendix 5: Bloomberg Barclays • Bloomberg Barclays MSCI Sustainability MSCI ESG Fixed Income Family Indexes positively screen issuers from existing Bloomberg Barclays parent indices based on Bloomberg, a global leader in fixed income MSCI ESG Ratings, which are a “best in class” indexing, and MSCI, the world’s largest provider assessment of how well an issuer manages ESG of ESG (environmental, social, and governance) risks relative to its industry peer group. ESG equity indices and research, have collaborated on the Ratings are available for corporate, sovereign, development of a family of rules-based benchmark and government-related issuers. The minimum indices that incorporate measures of ESG risk and threshold applied to Bloomberg Barclays flagship exposures. indices is an ESG rating of BBB or better. • Bloomberg Barclays MSCI Socially Responsible The Bloomberg Barclays MSCI ESG Fixed (SRI) Indexes negatively screen out issuers from Income Indexes includes a range of investment- existing Bloomberg Barclays parent indices that grade aggregate and corporate index benchmarks may be involved in business lines or activities addressing the evolving needs of institutional that conflict with investment policies, values or investors, who increasingly aim to incorporate ESG social norms. These indices use MSCI Business considerations into their strategic asset allocation. Involvement Screening Research (BISR) and MSCI ESG Controversies to identify exposure to Broad Indexes screened issues. • Bloomberg Barclays MSCI ESG-Weighted Thematic Indexes Indexes use MSCI ESG Ratings and MSCI ESG Ratings momentum to overweight/underweight • Bloomberg Barclays MSCI Green Bond Indexes issuers within an existing Bloomberg Barclays offer investors an objective and robust measure parent index. These indices include the full of the global market for fixed income securities universe of index eligible securities and then issued to fund projects with direct environmental apply tilts to the natural market value weights in benefits. An independent research-driven favor of higher rated/positive momentum issuers methodology is used to evaluate index-eligible and against lower rated/negative momentum green bonds to ensure they adhere to established issuers. Green Bond Principles and to classify bonds by their environmental use of proceeds. 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In terms of regions, Europe leads with about $12trillion, followed by North America ($9.8 trillion), Australia/New of institutional Zealand ($0.5 trillion) and Asia ($0.5 trillion). investors’ portfolios. GSIA gathers results from regional sustainable In 2017, pension funds investment groups around the world, tracking of the seven largest markets has professionally managed funds that use an allocation of 27% in fixed income, responsible investing criteria. It includes i.e. about $11 trillion out of $41 trillion total impact investment and environmental, social, assets. In Japan, the allocation was twice as governance funds as well as portfolios that high (56%) (Willis Towers Watson 2018). simply exclude weapons manufacturers or Insurance companies tend to have even more gambling companies. conservative asset allocations in many places, not the least for regulatory reasons. 2. Mr. Carney has called climate change “The Tragedy of the Horizon”, because the impacts 4. For a list of institutions interviewed see of climate change will be felt beyond the Appendix 1. The intention was not to undertake a traditional horizons of most actors (investors, comprehensive survey of institutional investors regulators, policymakers) and impose a and their service providers, but to learn from cost on future generations that the current some of the stakeholders who are known to generation has no direct incentive to fix. He be leading in this area. A more comprehensive has therefore argued that ensuring that the mapping of institutional investor approaches to financial system is resilient to the low carbon the different ESG tools could be an interesting transition and enabling the system to efficiently follow on to this report. Further analysis on the finance the transition should be in the financial success of the different approaches in practice policymakers’ clear interest. (Speech 29 is also warranted. September 2015). 5. The concept of ‘sustainability’ comes from 3. Global bond markets have a market capitalization environmental economics and is rooted in of about $90 trillion, higher than listed equities. the idea that ‘human capital’ can substitute Bonds also constitute a substantial proportion ‘natural capital’ (“Hartwick’s rule”). The INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 61 ‘strong’ interpretation of the term assumes 10. Fiduciary duty is the requirement that those that “human capital” and “natural capital” are who manage other people’s money act in their complementary, but not interchangeable. The beneficiaries’ interests, rather than serving their concepts arose from the work of Robert Solow own interests. and John Hartwick in the 1970s. The policy interpretation of this work came out of the 11. According to the categorization of GSIA (2017), Brundtland Commission (1987) and is the basis ESG integration ($7.5 trillion), engagement/ for the idea of ‘sustainable development’. shareholder action ($5.9 trillion), norms-based screening ($4.4 trillion) and positive screening 6. The universal owner hypothesis is based on the ($0.9 trillion) are the most widespread strategies idea that there is “no place to hide” as (negative) across all asset classes. Impact/community externalities of investee companies will affect investing and sustainability themed investing portfolio returns sooner or later in some form, capture only about $100 billion, i.e. 0.5% of e.g. taxes, insurance premiums, inflated input sustainable assets, each. prices or the physical cost of disasters. The UNEP use the following definition: “Universal 12. PRI publishes a series of case studies by fixed Owners are large institutional investors income investors, and on ESG engagement in which have highly-diversified and long-term fixed income. https://www.unpri.org/about/pri- portfolios that are representative of global teams/investment-practices#FICS capital markets”. 13. Stranded assets are assets that suffer from 7. Corporate Social Responsibility (CSR) relates premature write-downs or conversion to to companies’ management approaches. liabilities. Some experts consider coal and other It considers the economic, social and fossil fuels as potential for physical, economic environmental impact for all stakeholders. CSR and regulatory reasons. is again a concept with many definitions and practices. Double/triple bottom line also add 14. According to Global Impact Investing Network, a social and environmental dimension to the the practice of impact investing has four core financial one. characteristics: (1) investors intend to have a social and/or an environmental impact, (2) 8. ‘Outcome’ and ‘impact’ can are often used as investments are expected to generate a financial synonyms in this context. They can also be return on capital and, at a minimum, a return of meaningfully conceptualized as ‘outcome’ capital, (3) investments are to generate returns referring to a finite, shorter term change, and that range from below market to risk-adjusted ‘impact’ as broader, longer-term effects that are market rate, and (4) investors are committed more difficult to measure objectively (Harding to measuring and reporting the social and 2018). environmental impacts. 9. According to a survey of investment 15. An example is a combined academic and professionals by Amel-Zadeh and Serafeim industry effort (Vörösmarty et al. 2018) to (2017), relevance to investment performance is develop ‘context-based metrics for investment the most frequent motivation for use of ESG decisions that try to capture outputs, outcomes data followed by client demand and product and impact in the environment and public strategy, bringing change in companies, and health. then ethical considerations. 62 | ENDNOTES 16. For further details see Dr. Bob Eccles 23. UN PRI have an on-going project looking at Forbes article March 11, 2018, ‘Measuring this topic in-depth. Further analysis and results Investors’ Contributions to The Sustainable are due out during 2018, which the authors Development Goals’, which maps SASB’s would encourage readers who are looking for factors to specific SDGs. further detail on this area to follow. 17. Arjales and Bansal (2018) find that bond 24. The assessment (GB1-GB5) is distilled from 5 managers are trying to quantify and broad factors with a number of sub-factors: use “financialize” ESG data in their models while of proceeds, ongoing reporting, organization, equity managers can live more easily with a management of proceeds, disclosure on use ‘creative friction’ between financial numbers of proceeds. Proceeds are to be used for clean and any sort of ESG information. water, sustainable land use, waste and water management, clean transportation, biodiversity 18. For an investor-related literature overview on conservation, renewable energy, climate change ESG in equities, and more general, see, e.g. adaptation, or energy efficiency. Dimson et al. (2013). 25. MSCI took over KLD Research and Analytics 19. The result for portfolio studies is commented in 2010 and Governance Holdings (GMI by the authors: “It is important to be aware Ratings) in 2014. that the results of these (to date about 150 studies) are overlaid by various systematic and 26. Such findings have been supported by other idiosyncratic risks in portfolios and, in the case parties though their own in-house research. of mutual funds, by implementation costs.” 27. The country sustainability score does not take 20. These findings relate to the work of Khan et al. the annual change into account, it is based on the (2015), which finds that firms with good ratings current level. The change vs the previous score on material sustainability issues significantly is only taken into account for the calculation of outperform firms with poor ratings on these the country grades used in the ESG sovereign issues. In contrast, firms with good ratings bond index. on immaterial sustainability issues do not significantly outperform firms with poor ratings 28. Labelled green bonds are labelled as ‘green’ by on the same issues. The authors note that the the issuer and are financing green assets and results “have implications for asset managers projects. Unlabelled but still ‘climate-aligned’ who have committed to the integration of bonds are issued by entities enabling a low sustainability factors in their capital allocation carbon economy but are not labelled ‘green’. decisions.” (p. 1) 29. The Green Bond Principles (GBP) are 21. Summit (2017), Douglas et al. (2017), e.g., voluntary process guidelines that recommend give an overview for equities. Mooji (2017a) transparency and disclosure and promote found 218 ESG initiatives, of which 57 for integrity in the development of the Green ESG ratings, 38 for ESG rankings, 57 for ESG Bond market by clarifying the approach indexes. Most of them concentrate on equities. for issuance of a green bond. The GBP have four core components: 1. Use of Proceeds, 2. 22. Some providers use the term “ESG ratings” but the Process for Project Evaluation and Selection, 3. term “ESG score” is preferred to avoid confusion Management of Proceeds, 4. Reporting. with traditional credit ratings. ESG rankings are typically based on an ESG scoring system. INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 63 30. The bonds directly link returns to the stock relationship between ESG ratings of the two market performance of companies in the providers, we found positive but low correlations Solactive Sustainable Development Goals across all three dimensions as well as for the (SDGs) World Index. The index includes 50 composite rating. This is not surprising, given companies that are recognized industry leaders the differences in methodology. To sum up: Like on environmentally and socially sustainable corporate bond ratings, ESG ratings should issues, or that dedicate at least 20% of their not be considered as a simple commodity. activities to sustainable products. Ratings from different providers carry different information and can potentially suggest 31. The proceeds of each HSBC SDG Bond will be different portfolio management decisions. At used to finance in whole or in part, businesses the end of the day, investors and asset owners and projects that promote any of the selected need to do their own work to reach their own seven SDGs. conclusions rather than reflexively following the analysis of providers.” (p. 5) 32. Since 2007, the World Bank Treasury has delivered $3.9 billion in catastrophe risk 36. A lack of robustness and consistency behind transactions—including more than $2 billion much of the data lies behind these concerns. since July 2017. IBRD cat bonds have been For example, some of the data used to assess recognized as sustainable investments for climate risk use assumptions based on what are investors active in the insurance-linked random events. This means that the portfolios securities (ILS) market. created based on that data are not less affected by climate risk. 33. BlackRock CEO Larry Finks’s 2017 Annual Letter to CEOs outlining a new approach to 37. See, e.g., BlackRock (2016) that mentions corporate engagement has been much quoted. “survey fatigue”. Mooji (2018) reports https://www.blackrock.com/corporate/en-no/ widespread “reporting fatigue”, poor quality investor-relations/larry-fink-ceo-letter of information and lack of transparency in the ESG industry that is counterproductive. 34. As the Economist (2017) article lays out: “Money managers’ deepening love affair with 38. Arabesque, a “quant” asset manager that uses sustainable investment stems not from warm, ESG data, examines the sustainability of over fuzzy ideas about doing good. For most it is 7,000 of the world’s largest listed companies. Its a commercial choice. That worries some SRI technology combines over 200 ESG measures purists, who fear that “mainstreaming” will with other data points (such as news stories lead some fund managers to put an ethical gloss from 50,000 sources) to rank companies. on conventional investments.” 39. See Financial Times January 2016, ‘Quants are 35. See, e.g., Khan (2017). In terms of consistency, the new ethical investors’. in describing their ESG investment approach, QIC (2017), for example note that: “In 40. In 2018, APG took over the data analytics practice, MSCI and Sustainalytics ratings often team for sustainable investing from Deloitte disagree with each other. When measuring the Nederland. 64 | ENDNOTES