Few asset classes have undergone transformative growth comparable to that of ESG (environment, social, governance) as financial institutions increasingly apply ESG criteria to their investment decision-making processes. So strong has the momentum been that in less than three years, assets in the sustainable investment marketplace have risen by 34 per cent, and now exceed USD30 trillion.1 Experts are predicting that flows into ESG-linked assets will continue to accelerate. This outpouring of investor interest is partly ascribed to the superior returns offered by ESG securities relative to non-ESG instruments, with 80 per cent of studies indicating that prudent sustainable practices have a positive influence on performance.2

    Evolving attitudes to risk management have also been a pivotal driver behind ESG’s growth. A failure by companies to incorporate climate change risks into their business models – for example – is now seen by many financial institutions as a red flag. Investors need to be fully assured that the companies in their portfolios have made preparations to transition away from a high carbon economy to a low carbon economy, and are sufficiently insulated against the amplified threat of physical damage to infrastructure (as a result of increased regularity of flooding and wildfires); potential litigation risk and disruption to existing supply chains.

    Investors and regulators tackle the issue head on

    Industry leaders at HSBC’s 2019 Financial Institutions Conference recently said investors are also taking a stand on sustainability issues, a trend which is leading to accelerated flows into green securities. Millennials – in particular – are likely to play an instrumental role in ESG’s growth over the next two decades. For instance, MSCI is already predicting that millennials will allocate roughly between USD15 trillion and USD20 trillion into US-domiciled ESG investments, an amount that would broadly double the size of the US equity market.3 In addition to retail investors, major financial institutions – including Japan’s Government Investment Pension Fund (GPIF) and Norway’s USD1 trillion sovereign wealth fund (SWF) have also adopted robust positions as they look to reduce climate change risk in their portfolios.

    Simultaneously, regulators have become more proactive on ESG. The Financial Stability Board’s (FSB) Task Force on Climate Related Financial Disclosures (TCFD) has certainly had its intended effect insofar as more companies are now reporting on their climate related financial information.4 While the TCFD is voluntary, the EU is working on its own set of sustainability proposals, which will require institutions to factor sustainability risks into their investment decisions. Furthermore, policymakers are also creating an EU classification system – or taxonomy – outlining a set of harmonised criteria for determining whether an economic activity is environmentally sustainable,5 in what should bring about more clarity on ESG to institutions. Despite these regulatory initiatives encouraging greater transparency about ESG, frictions remain and it is something which the industry is looking to iron out.

    Getting to the bottom of the data

    Data – or deficiency of – is a huge barrier to ESG investing. Firstly, a number of data providers apply their own bespoke methodologies when making ESG assessments, which means there is an absence of harmonisation in the actual measurements. Institutions have also pointed out that it can be difficult to obtain ESG data on companies in certain markets. And finally, there are notable divergences in ESG data quality as it applies to bonds versus equities. Whereas it is quite straightforward to qualify whether a fixed income issue adheres to ESG values, institutions do not devote that much attention to the ESG credentials of the actual issuer, in marked contrast to equity investors. This is simply because there is a lot less ESG data coverage of bond issuers (i.e. governments) in comparison to listed companies.

    Even the FSB concedes that while ESG disclosures have improved as a result of the TCFD, more work is still needed.6 If underlying ESG data is not robust, institutions will naturally find it harder to measure and benchmark the impact of their sustainable investments. Again, this absence of standards could spark greenwashing, whereby organisations claim to be sustainable when they are not. Experts have suggested that as little as USD3 trillion of the overall assets purporting to be sustainable actually meet strict ESG criteria.7 In response, data quality and auditability needs improvement if institutions are to have confidence in the sector. By standardising the ways in which data is aggregated and calculated – facilitated by initiatives like the EU’s taxonomy - ESG investing will be strengthened and enriched.

    1 Bloomberg (June 7, 2019) Green finance is now $31 trillion and growing
    2 Robeco (January 9, 2019) The link between ESG and performance
    3 MSCI (February 12, 2019) ESG investing is here to stay
    4 FSB (June 5, 2019) TCFD report finds encouraging progress on climate related financial disclosures but also need for further progress to consider financial risks
    5 EC (May 24, 2018) Sustainable finance: Making the financial sector a powerful actor in fighting climate change
    6 FSB (June 5, 2019) TCFD report finds encouraging progress on climate related financial disclosures but also need for further progress to consider financial risk
    7 Financial Times (June 13, 2019) Green bond investors cite benefits of ESG sector

    Rethinking Capital Structure Series (Part 2)
    An overview of how select KPIs vary across sectors and the corresponding approaches to risk management
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