Fifty shades of green

Disparate investment and regulatory approaches towards environmental, social and governance investing are ramping up complexity for investment managers and advisers. What progress has been made in establishing a taxonomy for sustainable activities?
by Paul Bryant


The Global Sustainable Investment Alliance (GSIA) – using a broad definition of ‘sustainable investing’ that includes seven prominent strategies, from ‘negative screening’ through to ‘ESG integration’ (see first boxout) – says in its 2018 review that sustainable investing assets in Europe reached US$14tn (49% of total managed assets) and US$12tn in the US (26% of total managed assets).

This move towards sustainability has been a relatively recent affair, particularly outside Europe. In 2018, sustainable investments in Europe were 25% higher than in 2014; in the US, 83%; in Australia and New Zealand, 408%, and in Japan, a massive 27,513%.

Jon Williams, partner, sustainability and climate change at PwC, says: “It was only a few years ago when many pension funds and asset managers were primarily focused on things such as their 90-day returns against benchmarks and how to cope with low interest rates. There was a prevailing attitude of including an ESG product just in case a client asks for one. But having just one sustainable product that is a small part of your offering simply isn’t good enough anymore. ESG has to be integrated more broadly into all investment products.”

Differing sustainable investment strategies

Negative/exclusionary screening – the exclusion from a fund or portfolio of certain sectors, companies or practices based on specific ESG criteria

2. Positive/best-in-class screening – investment in sectors, companies or projects selected for positive ESG performance relative to industry peers

3. Norms-based screening – screening of investments against minimum standards of business practice based on international norms, such as those issued by the OECD, ILO, UN and UNICEF

4. ESG integration – the systematic and explicit inclusion by investment managers of environmental, social and governance factors into financial analysis

5. Sustainability themed investing – investment in themes or assets specifically related to sustainability (for example, clean energy, green technology or sustainable agriculture)

6. Impact/community investing – targeted investments aimed at solving social or environmental problems, and including community investing, where capital is specifically directed to traditionally underserved individuals or communities, as well as financing that is provided to businesses with a clear social or environmental purpose

7. Corporate engagement/shareholder action – the use of shareholder power to influence corporate behaviour, including through direct corporate engagement (such as communicating with senior management and/or boards of companies), filing or co-filing shareholder proposals, and proxy voting that is guided by comprehensive ESG guidelines

Source: The Global Sustainable Investment Alliance 

But, according to Richard Burge, senior partner and founder of ESG Validation, an agency serving investors: “People in the investment sector are struggling. They want to do more sustainable investing, but are finding it difficult because there’s a general lack of ESG data, no consistency across company disclosure of ESG data, and because it’s really hard to define what sustainable investing is. It is not a binary choice between good and bad ESG credentials. Investors are faced with 50 shades of green.”

Governments and regulators are making efforts to address some of these inconsistencies in company disclosure and channel even more capital into sustainable investments. Progress is good in some areas such as green bonds, but it’s early days in other areas, such as establishing a common multinational language that defines exactly what sustainable activities are. This leaves the investment sector with a broad and complex set of guidelines, rules and regulations to navigate.

Coordinated goals

On a multinational government level, progress has been made in recent years regarding coordinating sustainability goals, with 2015 proving to be a watershed year.

At a UN Summit in September 2015, world leaders adopted the 2030 Agenda for Sustainable Development (2030 Agenda), which outlines 17 Sustainable Development Goals and 169 specific targets to hit to attain the goals.

The E of ESG, and climate change in particular as an environmental concern, received a further boost later in 2015 when at the Paris Climate Conference (COP21), the Paris Agreement was reached to combat climate change, setting a long-term target of keeping the increase in global average temperature to well below 2°C above pre-industrial levels, and to pursue an aspirational target of 1.5°C above pre-industrial levels. According to the UN, 185 parties had ratified the convention by 29 September 2019.

Multinational bodies, most notably the Principles for Responsible Investment (PRI) association and the Task Force on Climate-related Financial Disclosures (TCFD), are working to bridge the gap between ambitious goal setting and actual investment decisions – but they do rely on the voluntary cooperation and commitment of the private sector.

The UN-backed PRI works across the ESG remit and is set up to attract institutional investor signatories. According to its website, it “works to understand the investment implications of ESG issues and to support signatories in integrating these issues into investment and ownership decisions”. It requires signatories to commit to six core principles (see second boxout).  As at 15 November 2019, the number of investor signatories had grown to 2,698 in the PRI (up from around 1,000 in 2012) and combined, has US$82tn of assets under management.

The TCFD, set up by the Financial Stability Board, has a narrower remit, to focus on climate issues and develop voluntary, climate-related financial risk disclosures for use by companies. According to its website, “The work and recommendations of the TCFD are aimed at helping companies understand what financial markets want from disclosure in order to measure and respond to climate change risks and encourage firms to align their disclosures with investors’ needs.”

Commitment of signatories to the PRI

As institutional investors, we have a duty to act in the best long-term interests of our beneficiaries. In this fiduciary role, we believe that environmental, social and corporate governance issues can affect the performance of investment portfolios (to varying degrees across companies, sectors, regions, asset classes and through time). We also recognise that applying these Principles may better align investors with a broader objective of society. Therefore, we commit to the following:

Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.

Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.

Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.

Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.

Principle 5: We will work together to enhance our effectiveness in implementing the Principles.

Principle 6: We will each report on our activities and progress towards implementing the Principles.

Source: PRI Association

But it is left to nation states (or supra-national bodies such as the EU) to facilitate mandatory initiatives in favour of sustainable investment, and enforcement.

Disparate regulation

According to the June 2019 Morningstar report, The evolving approaches to regulating ESG investing: “Over 170 ESG-related regulatory measures were proposed globally in 2018 – more than in the prior six years combined. And more than 80% of the measures target institutional investors rather than companies or issuers.”

The 'EU Commission action plan on financing sustainable growth' is probably the most ambitious regulatory project, and due to the sheer number of institutions that will fall under its remit, the most significant that the investment sector needs to look out for. No firm timetable for its implementation is available yet – the European Commission (EC) originally said it would report on plans for implementation during 2019 – but according to Reuters, parts of the plan have now been delayed until 2022.

Valdis Dombrovskis, EC vice-president for euro and social dialogue, also in charge of financial stability, financial services and Capital Markets Union, outlined the first four legislative proposals at a PRI keynote speech in June 2018.

The first four legislative proposals of the plan include:

  1. establishing a single classification system or taxonomy to provide common definitions for what is green and what is not
  2. extending the disclosures and duties of asset managers and institutional investors – obliging them to integrate ESG factors into their risk processes
  3. creating a new category of carbon-related benchmarks to help investors better understand the relative carbon impact of their investments
  4. obliging investment advisers to ascertain the sustainability preferences of retail investors (by means of a suitability test) and offer matching investment products.

In the UK, the government released its Green finance strategy in July 2019, which includes a proposal for all listed companies and large asset owners to disclose in line with the recommendations of the TCFD by 2022. It also notes that mandatory reporting will be considered.

Compared to the US, Europe is often considered to be an ESG leader, partly because it is at the forefront of regulation in this area. However, PwC's Jon Williams cautions against jumping to over-simplistic conclusions. He says: “There is huge momentum in the US, and people don’t always appreciate the power of individual states under the US federal system, nor the impact they can have because of their sheer size. Remember that one of the most progressive states, California, is actually the fifth largest economy in the world.”
"The shift to a low-carbon economy will present some of the best investment opportunities"

And in China, early moves to promote ESG investing and impose ESG regulation are also well underway. The State Council’s 2016 13th Five-Year Plan prioritises green development and outlines plans for improvements across the ESG spectrum. And The People’s Bank of China has issued guidelines for establishing a green financial system, and has a regulatory framework for onshore green bonds, green lending and a green industry classification system.

All asset classes

Jon says equities have tended to attract the most attention when it comes to ESG investing, although in recent years, fixed income has also taken off.

Dr Christopher Kaminker, head of sustainable investment research and strategy at Lombard Odier Investment Managers, says market forces are the strongest driver behind the shift to sustainable investing: “It simply makes economic sense. We believe the scale and speed of some ‘sustainability’ trends, such as the shift to a low-carbon economy, will present some of the best investment opportunities. Conversely, ignoring factors like climate risk could expose investors to losses if investee companies are impacted by climate-related physical damage (such as flooding), competitive disruption (such as renewable energy providers undercutting fossil fuel energy providers on a cost basis), or litigation risks.”

Some investment managers, such as Lombard Odier, conduct their detailed ESG analyses in-house with proprietary models that draw on raw data from external providers. However, a more ‘mechanistic’ reliance on external ESG ratings is more common. Many investors simply buy data from MSCI, for example, which produces ESG ratings for over 7,000 companies. The culmination of the MSCI process is a ‘letter’ rating, similar to a credit rating, with companies or securities being assigned anything from CCC (an ESG laggard), through to AAA (an ESG leader). MSCI also highlights its research showing how ESG affects valuation and financial performance.

To arrive at a company’s rating, MSCI calculates the weighted average of 37 Key Issue scores, normalised for the investment sector. These include environmental factors, such as toxic emissions and waste, social factors, such as supply chain labour standards, and governance issues, such as tax transparency).

When it comes to bonds, Christopher Kaminker says the Green Bond Principles (GBP), are probably the most successful market-led initiative in the ESG space and that these have become the de facto market standard around the world. The International Capital Market Association established the GBP in 2014 (and has updated them a few times since). According to the Climate Bonds Initiative (a not-for-profit organisation working to increase the size of the green bond market) and HSBC, global green bond issuance reached US$180bn in 2018, up from just over US$40bn in 2015.

The GBP are voluntary process guidelines that recommend transparency and disclosure and promote integrity in the green bond market. According to Christopher, they have been such a success that many countries and regions around the world have adopted some form of the GBP, including the EC (Green Bond Standard); a number of Chinese authorities – the People’s Bank of China (Chinese Green Bond Endorsed Project Catalogue), the China Securities and Regulatory Commission, and the National Development and Reform Commission; the ASEAN Capital Markets Forum (ASEAN Green Bond Standards); India’s SEBI Green Bond Guidelines; and others.

More Chinese bonds are also conforming to international definitions of ‘green’, with 74% of Chinese green bonds conforming in 2018, up from 66% in 2016The Chinese green bond market is a particularly important one. From a near standing start in 2015, it became the largest green bond issuing country in 2016, issuing US$3bn of bonds by value, a 35% share of total global issuances, according to the report CBI: China green bond market 2018. By 2018, issuances were still growing but China had fallen back into second place behind the US, with US$43bn issued, a 24% market share. More Chinese bonds are also conforming to international definitions of ‘green’, with 74% of Chinese green bonds conforming in 2018, up from 66% in 2016 – local Chinese green bond standards allow for projects such as retrofits of fossil fuel power stations and clean coal and coal efficiency improvement projects, whereas international standards such as those of the Climate Bonds Initiative do not.

Investment sector challenges

Jon believes the biggest challenge is probably going to be one of building sufficient capacity and new skills to deal with the additional and more complex workload.

More specialists will be needed as ESG integration becomes more commonplace, but Jon thinks ESG will also need to be embedded into mainstream training and qualification programmes. Examples of this would include the CISI’s Professional Refresher module on Ethical and Sustainable Investment or the Green Finance Certificate, delivered in partnership with the Chartered Banker Institute.

He says advisers and investment managers will need to undergo training to understand clients’ sustainability requirements and how investment products can be designed and matched to those needs: “Regulators should not underestimate the amount of training that will be required to equip sector participants. They are currently clued up on economic metrics, but many can’t engage on issues such as climate change. And they will have to. The sector is going to need to be able to identify how, and explain to clients, in the mid to long run, their investments impact climate change and social or economic development.”

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Published: 15 Nov 2019
  • Wealth Management
  • Bonds
  • The Review
  • US
  • Task Force on Climate-related Financial Disclosures
  • sustainable investing
  • Regulation
  • Principles for Responsible Investment
  • Paris Agreement
  • green investing
  • green finance
  • green bonds
  • ESG
  • climate change
  • China

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