Global sustainable investments now exceed USD 30 trillion. Usually sustainable investment involves screening investments to avoid certain activities, such as tobacco, but increasingly environmental, social and governance factors are being integrated into investment analysis itself.

ESG integration involves a systematic analysis of all the material environmental, social and governance risks that companies face over the medium to long term. Much ESG research focuses on equity investors rather than bond investors, but we think fixed-income analysts should approach ESG differently to equity analysts, in several ways.

First, credit analysts mostly focus on avoiding losses whereas equity researchers look for potential gains. Second, while credit analysts look for specific issues such as legal or regulatory action, or consumer boycotts that might lead to a concrete credit event, equity analysts consider a wider range of ESG issues that could influence share prices.

Third, a company’s response to an ESG risk could favour or disadvantage bond investors over shareholders: credit analysts must thus discern not only the ESG risks but also evaluate how the firm might respond.

Good ESG analysis can identify emerging risks that threaten credit quality, as well as company-level preparedness to modify and deal with these challenges.

A two-year study of 9,000 corporate research updates found that nearly 8 per cent of credit downgrades involved environmental and climate factors such as the global warming-related issues that have affected European utility companies. The mining sector has also seen a substantial number of critical ESG-related events.

ESG investing is different from the longer-established socially-responsible investing, or SRI, which involves investing from an ethical viewpoint, avoiding sectors such as alcohol or gambling. By contrast, ESG analysis can improve returns by taking into account factors often left out of traditional investment analysis.

Green-bond investing has grown very rapidly in recent years but hitherto investors focus has been on how the bond’s proceeds are spent on environmentally-friendly projects whereas an ESG approach focuses on the entity issuing the bond. Firms do not need to be green to issue green bonds.

We use ESG analysis to uncover, sector-by-sector, risks or disruptions that could negatively impact yield spreads. However, good ESG analysis goes beyond attempting to discern emerging ESG risks. It requires identifying a transmission mechanism – typically a regulation or law – that might translate the risks into a meaningful credit impact.

Companies with strong corporate governance may be able to identify these emerging risks early. They may have procedures in place to ameliorate these unfolding dangers before they start impacting the firm’s credit fundamentals.

But ESG analysis involves more than just looking to future risks. Some risks are already working their way through different sectors, appearing as operational risk rather than event risk. How these factors will continue to impact firms must also be considered.

We think this analysis will become increasingly important as governments use regulation or permit regimes to make firms ‘internalise’ external factors like pollution.

We regard ESG analysis as an integral part of the investment process because of the insights it brings and the ESG-related credit-ratings applied to bonds. Increasingly, governments, central banks and regulators are urging asset managers, insurers and bankers to focus on climate change and consider ESG risks in their investment procedures.

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