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In mid-2017, Swiss Re, the world’s second largest re-insurance company, announced they had begun to integrate Environmental, Social and Governance (ESG) factors into their investment decision making processes. By the end of 2017, Swiss Re expects that all investment decisions impacting their entire USD130bn global portfolio will be based on ESG and related ethical factors.
Swiss Re’s decision did not occur in isolation. In the last three years, the impact of ESG factors on investment decision making has begun to move to the mainstream in the insurance, investment and finance sectors. This article canvasses some of the latest developments in this area.
Before analysing the benefits of ESG factors, it is important to understand what ESG actually is.
ESG factors cover a broad suite of external threats to the viability of a company or project. These threats range from pollution and child labour issues, to bribery and corruption issues. The Financial Times Lexicon, in a bid to provide a coherent definition for this nebulous concept, describes ESG factors as follows:
“ESG factors are a subset of non-financial performance indicators which include sustainable, ethical and corporate governance issues such as managing the company’s carbon footprint and ensuring there are systems in place to ensure accountability. Worldwide, lenders and investors are becoming increasingly aware of the impact that ESG risks can have on a company’s creditworthiness, which in turn can affect the overall attractiveness of the investment.”
The complex nature of ESG factors is highlighted by the recent decision of Westpac to cease lending to undeveloped or low energy coal mines, including Adani’s Carmichael coal project in Queensland. This follows earlier moves by the other major banks to cease lending to Adani, with NAB ruling this out in 2015, the same year that Commonwealth Bank ceased being an advisor to the Indian company, and ANZ effectively following in December 2016. Westpac’s change in heart was communicated as a decision based upon their own climate change scenario research. However, at the time, it was widely reported in the press that Westpac had been the target of campaigns by environmental protestors leading up to the decision, which may have fed into a negative perception among retail customers to the Adani coal mine.
ESG factors can often be unexpected and nuanced. Recently, it was noted that ESG factors could weigh on investments in the crypto-currency, Bitcoin. This is because Bitcoin mining requires servers to process algorithms which underpin the currency and so requires a lot of electricity. A noted market analyst commented, ‘we could end up in a situation within a few years where the electricity consumption of bitcoin mining would be equivalent to a country like Netherlands or Switzerland’.
Although all three ESG factors are important to assessing risk, they may attract different risk weighting for a particular investment decision depending on the nature of the investment and the prevailing economic, political and societal context. Understanding and isolating each of the factors can be difficult and this is why many financial sector companies are developing specialised ESG teams to inform their investment strategy. It should be noted that while the three factors can be viewed separately, they may also overlap - governance failings can underpin social problems, or global issues like climate change remediation require combined and coherent environmental, social and governance responses. Evaluating this blended model is not easy, as the 2017 Responsible Investment Benchmark Report noted:
“Defining and measuring ESG integration practices is challenging due to limited disclosure and a broad variation in depth of integration - from systematic implementation embedded into investment valuation practices and company engagement, to more ad hoc approaches.”
Social factors encapsulate a host of societal elements, including health and safety, community engagement, human rights, public perceptions and even animal welfare. Assessing and weighing social factors is not easy, as it essentially requires quantifying the public perception of an organisation, both from its own consumers and the wider public. One way to do this is to assess if the organisation can still rely upon its ‘social licence’ to operate.
Having a strong social licence means a company is considered trustworthy, which is often reflected through perceptions of a company’s brand. If a company repeatedly makes mistakes, is dishonest or is considered unethical they could lose their social licence and accordingly their brand is perceived poorly. The impacts of this are hard to measure, but heightened scrutiny and distrust are sure to follow.
Losing a social licence can become a critical, even existential, issue. For example, when BP faced scrutiny for environmental impacts caused by their operations in the Gulf of Mexico, it was temporarily banned from lucrative US government contracts. Following the ban, BP’s share price fell by 55%, and has never recovered to its pre-spill value.
However, social licenses are recoverable, as demonstrated by Volkswagen. Since criminally misleading consumers over carbon emissions from its vehicles, it has recovered to become the world’s largest car manufacturer.
Social factors can also be fickle, as demonstrated by company brands that can retain a social licence, notwithstanding the underlying company’s less than favourable ESG footprint. A good example of this paradox is Dulux Paints, which comes in as the top five most trusted brands in Australia. This is despite its former parent company, Orica, having received a number of multi-million dollar environmental judgments against it in the past five years, including for mercury contamination of Sydney waterways.
Governance factors are often hard to quantify and a simple tick box approach does not mean the rating is reflective of the actual situation. When assessing the governance of a company, things to look at include board performance, compliance, reporting, decision processes and conflict policies.
Many organisations will have corporate governance policies and procedures. However this does not necessarily mean that those policies are being implemented. Boards can often generate minutes with little to no substance and directors can be disengaged or ill- informed of key commercial and operational risks to the business.
Assessing the effectiveness of a board of an organisation often requires detailed evaluation of individual board members, including understanding their past experiences and other commitments.
Further, failings in corporate governance can lead to civil and criminal proceedings being brought against the company and the individual directors, such as in the well-known Bell Group case, where famed personality Alan Bond’s resources group spectacularly collapsed, owing major debts to twenty different banks. One of the key issues in this case was whether the directors and company officers were across the details and whether they adequately discharged their governance duties, in the circumstances.
At a broader scale, ‘sovereign’ risk may be considered as a specific governance factor, that is, whether a nation’s government can be relied upon. This is particularly relevant when a government licence or authority is required to exploit or use a particular asset.
In recent times environmental factors have attracted the most attention due to increased public awareness of the impact of climate change on investment decisions. Extreme weather events and changing weather patterns are impacting risk assessments for organisations which are vulnerable to supply chain interruptions. These events can also damage infrastructure, and adversely impact the performance of long term investments in these assets. In addition, pollution and other environmental degradation can adversely affect the well-being of the population or lead to changes in weather patterns or biodiversity richness. These aspects are only now being considered as presenting material risks to business, not just in terms of social licence issues, but also as a material risk to the ecological integrity of the environment.
In a complicating factor, climate change responses can themselves sometimes increase the risk that formerly valuable assets, such as coal-fired power stations, which may become obsolete or non- performing well ahead of their useful life (becoming so-called stranded assets). Stranded asset risk may increase for many reasons including changes to social attitudes, emerging new technologies, and new government regulation. Oil and gas companies are likely to be the most affected by stranded asset risk, with the International Energy Agency estimating that over a trillion dollars of oil and gas assets will be abandoned by 2050 due to an imperative to respond to climate change.
The growing appreciation of ESG risk is underpinned by the USD59tr in assets now globally invested in accordance with the UN Principles for Responsible Investment (UN PRI), which are based on ESG factors.
This growth and change in the investment market is driven by a new generation of investors who recognise that investments with low ESG risks offer better potential returns. By way of illustration, a 2017 report by the Responsible Investment Association Australasia found that 77 Australian asset managers have declared their commitment to incorporating ESG into their funds. Furthermore, a white paper released in April 2017 by Hermes Investment Management found that companies with the widest credit default swap spreads are the ones with the weakest ESG credentials.
As demonstrated, there is growing momentum within the investment community to link ESG issues to performance and creditworthiness. While consideration of these issues was once considered niche, it is now becoming a mainstream investment decision filter applied by many, if not most, investors.
In the case of Swiss Re, Chief Investment Officer Guido Fuerer has commented that equities and fixed income products from companies and sectors with high ESG ratings have better risk- return ratios. In light of these views, Swiss Re did not believe they could continue to consider ESG as an add-on assessment, and instead focused on making an ESG risk assessment an integral part of their investment processes.
As more financial institutions and organisations incorporate ESG frameworks into their investment decision making processes, demand for good ESG investments will increase. The infrastructure and renewable energy sectors are well suited to feed this demand by providing a pipeline of highly rated ESG investment options in green projects.
For example, it has been estimated that over the next 15 years, approximately USD 93tr in funding will be required to build the low carbon infrastructure to enable the 2015 Paris Agreement signatories to deliver on their greenhouse emissions targets. The People’s Bank of China has also estimated that China alone will need to invest over USD1.5tr in green projects between 2016 and 2021 to meet its target.
The green finance sector will be a critical source of funding for these targets, and there is commentary to suggest that most of the heavy lifting will need to be done by the still nascent green bond market. Quite how this will be achieved remains to be seen. However there is cause for optimism with Moody’s recently predicting that the market in green bonds will reach ‘critical scale’ in 2017, estimating an AUD206bn annual volume (based on 2016 growth rates).
Recent examples of significant green bond issuances include a EUR7bn green bond, released in February 2017 by the French government which attracted nearly EUR23bn in bids. China has been very active in the market, recently overtaking the US as the global leader in green bond issuances, issuing USD36bn in 2016. With the country planning to invest USD360bn in renewables power generation alone by 2020, we expect to see the Chinese government entering the market more frequently, and in even more significant volumes.
Although government institutions have paved the way for the development of the green bond market, corporates are also following, with Apple issuing USD1.5bn in green bonds in 2016, and USD1bn in 2017. Momentum for green bond issuance is also building in Australia, which has seen an unprecedented number of issuers come to the market in 2017.
Strong investor appetite for green bonds is driven by a number of factors, including investor demand for ethical assets carrying lower risks than standard project financing opportunities.
In recognition of the importance of ESG risk factors to assessing the overall credit of a company, ratings agencies have been developing tools which allow investors to outsource their assessment of ESG risks, or at least to rely on a second opinion for these risks.
ESG evaluation tools have been developed by the rating agencies through two separate lenses. The first considers the impact of these risks on the probability of default and recoveries, which has led to the ratings agencies embedding ESG risk factors in their credit assessment methodologies. Moody’s and S&P have been the first movers in this area. The other lens considers ESG risk factors independent of credit risk, which has led to the creation of new stand-alone ESG assessment frameworks, including the S&P ESG Evaluation Tool.
S&P ESG Evaluation Tool
The general ESG assessment framework being developed by S&P will not result in a credit rating. Instead, it evaluates a company’s impact on the natural and social environment, governance mechanisms in place and any potential losses a company may face due to exposure to environmental/social risks. Once launched, This will be the first systematic and transparent rating agency framework for evaluating the implications of ESG risks on a company.
The development of standardised assessment tools such as these is seen to be critical to mainstreaming investments in green bonds.
In addition, these tools provide companies or projects seeking funding with information about the key factors that investors will look for when assessing investment opportunities. A summary of the S&P evaluation factors are summarised below.
|Environmental Risk Profile||
Issuers classified according to:
|Social Risk Profile||
Broken down into 4 main areas:
Management and Governance
This factor is evaluated using the same process applied to credit ratings, assessing issuers according to:
Environmental and Social Risk Management
This is a prospective assessment which evaluates the degree to which the issuer is proactively managing social and environmental risks, and the likelihood that current efforts will reduce the occurrence of potential relevant risks in the future.
The Equator Principles (EP) were originally drafted in 2003, but the most recent framework was adopted in 2013, and it was this framework that implemented environmental and social factors. The Equator Principles have been developed by over 80 financial institutions, including the four major banks in Australia, who have committed to applying them to all projects they finance. Although not developed by a credit rating agency, they are still very important because of the position they hold in the market.
The ESG factors underlying the Equator Principles include requirements for the borrower to perform due diligence on a project’s human rights impact, evaluate and report on greenhouse gas emissions and consider native title issues. If the borrower does not comply with the Equator Principles, the 80 plus lenders who have developed the Equator Principles will not finance the project.
The Equator Principles have been consistently applied by nearly every large global financial institution since they have been adopted. They have greatly increased the attention and focus on ESG factors, and their impact on creditworthiness.
ESG is not a new term. For over a decade, organisations have publicly discussed various ways to integrate ESG factors into their processes and decisions. Throughout this period, ESG was largely associated with corporate social responsibility and appeasing customers, rather than resulting in better financial decisions.
However, in 2017 ESG appears to have come of age. Practically every financial organisation now has an ESG policy and evaluation tools, as well as multiple ESG frameworks developed by credit agencies and third party financial groups. The 2017 difference appears to be that organisations are now fully appreciating that investments related to a poor social licence, lacklustre governance and unstainable environmental practices are simply not good business.