Q1: When ESG is mentioned much of the focus falls on Environment issues such as climate change and resource scarcity. But in the current economic climate, there has been a greater focus on other factors such as companies’ labour practices, diversity and other governance matters.
    How do you see this trend developing both in terms of investor requirements and corporate strategy?

    The Covid-19 epidemic has brought a shift in investor focus on how companies treat their employees, suppliers and customers. The ‘Social’ factors in ESG reporting are now coming to the fore, with investors recognizing that the long-term success of companies also depends on the long-term success of one of their most important resources – their employees.

    ESG investors measure human capital based on a variety of corporate disclosures, including diversity, inclusion or workforce compensation. Companies at the forefront of social dialogue will for instance disclose the number of minority, women and disabled people in the workforce. Investment managers may use these disclosures to screen out companies that do not meet certain thresholds, such as the proportion of minority and women representation in management.

    It is worth recognizing that diversity disclosures tend to be dominated by gender, due to a lack of reporting in other areas. The ‘Black lives matter’ campaign and protests has brought renewed urgency to the issues of diversity and inclusion.

    There are many advantages for companies that support and promote a diverse and inclusive workplace culture, including greater creativity and innovation. Studies have shown that companies with more diverse leadership tend to have larger innovation revenues.

    We have also seen increased appetite for ESG-products which focus on social factors, such as Covid-19 bonds, where proceeds are earmarked to address impact of the outbreak. According to S&P, USD50 billion of COVID alleviation bonds were sold in the first half of 2020, more than double the volume of social bond issuance in the whole of 2019.

    The crisis has heightened the importance of issues such as employees’ physical and mental health. It has also strengthened the focus on the broader role and purpose of businesses in society. As governments consider policies to support a ‘green and sustainable’ recovery, social issues such as re-skilling and delivering a ‘just’ transition will remain critical.

    Q2: ESG factors play an important part in investment decisions, be they used for screening and selection or more fundamentally as an integral component of long term value creation. However, there is a lack of consistency in how some companies are viewed by different investors and ESG ratings agencies, there is also a lack of a consistent format or comprehensive requirements for reporting ESG performance. What can and are corporates doing to close this gap? Is it primarily an issue of communication or is there more fundamental issue that need to be addressed?

    The industry is becoming increasingly aware of the benefits of sustainable investing, but investors need to know that the ESG information that they are receiving is accurate. Due to a lack of standardization in disclosure and assessment metrics, this is unfortunately still a work in progres. Using the recent example of Wirecard and its ‘missing USD2 billion’, it is clear that the assurance of ESG screening as a means for investors to avoid costly scandals is heavily dependent on the specific ESG criteria followed by the rating agencies. For instance, both MSCI and Sustainalytics, two of the most widely used ESG data providers, rated Wirecard in the mid-tier risk category and as a result some of the main ESG ETFs held the Wirecard stock. In this regard, differing methodologies can yield very different outcomes: Insight Investment, a London-based fixed-income fund manager, gave Wirecard its lowest ESG score because its assessment model prioritises governance and accounting concerns.

    More standardized ESG disclosure and more transparent communication on material risks and opportunities that a company identifies from ESG themes would diminish the over-reliance on ratings. In our experience, ratings are one input in investors’ ESG analysis. If companies opt not to disclose, they are letting other parties set the narrative.

    For issuers that are resource-strapped, we strongly recommend prioritising disclosure on the recommendations of the TCFD (Task Force on Climate-related Financial Disclosures), as well as the sector-specific metrics suggested by SASB (Sustainability Accounting Standards Board) as a critical mass of investors, regulators, and other stakeholders have coalesced around these two frameworks.

    Currently, when compared with the entire size of respective markets, ESG-linked products are only small, but they are growing fast

    Q3: Moving on to financial developments, there are more and more ESG-linked products available to raise funding for specific or more general purposes. At present these are still a relatively small proportion of the total market. How do you see these products developing over the next few years and how should corporates best position themselves for these developments?

    ESG-linked products are becoming increasingly popular. They can be classified in three broad categories. Firstly, sustainable use of proceeds – when the proceeds of a bond issue or a loan are earmarked or used for a specific purpose such as renewable energy, smart grids, green buildings, clean transportation, climate change adaption or reduction of pollution. This is an area of significant growth, with trillions of dollars of annual investments required over the foreseeable future to support the implementation of the Paris Agreement. The shift from fossil sources of energy to renewables is a critical component of this transition. Renewable energy will expand by 50 per cent by 2025. The market is now largely competitive without government subsidies and in most geographies materially cheaper than new fossil fuel power capacity. In addition to renewables, significant growth is expected in infrastructure for electric mobility, rail, energy storage, hydrogen, carbon capture and grid upgrades. More than 50 per cent of this investment will take place in Asia, more than 2/3 in emerging markets.

    The second category relates to products targeted at financing some of the sustainable development goals, including alleviation of the social and economic consequences of the COVID-19 pandemic, gender, health, etc. This area is growing fast due to a surge in Covid-19 bond issuance, which could top USD100 billion by end of 2020 according to AXA Investment Managers. From an environmental perspective, a case study is HSBC’s green trade financing deal which enabled Paul Y Engineering Group (PYE) to construct a green building for student residence in HK – this led to HSBC winning the HK ESG award.

    The third category links a financing or an investment to ESG performance, such as sustainability-linked loans or derivatives linked to an ESG equity index. This family of products is one of the fastest-growing areas - issuance of "sustainability-linked loans" (SLL) increased nearly 250 per cent year on year in 2019 (FT). In a SLL, interest paid by the borrower is linked to selected sustainability key performance indicators (KPI), which can be, for example, carbon emissions or a more generic ESG (environmental, social and governance) target. Companies that achieve their sustainability targets benefit from favorable interest rates, while a failure to do so will lead to higher rates. SLLs create a strong alignment between financing and sustainability objectives.

    Currently, when compared with conventional markets, ESG-linked products remain limited in size, but they are growing fast. Products are evolving from green bonds to a more diverse range including other Use-of-Proceed bonds, derivatives and KPI-linked products. Key challenges to the development of ESG-linked products include data issues, reduced ability to trade large sizes and questions around risk management. Yet as these markets grow, the gap been ESG-linked products and more mainstream products will gradually reduce.

    Q4: Is the rise of ESG investment a global phenomenon? Are there any regional difference?

    For the last few years, HSBC has been conducting a survey of investors and issuers' attitudes towards ESG. In last year's edition, we surveyed 1,000 issuers and investors from 15 core countries. The results reveal certain regional differences in attitude.

    Asian investors take ESG investing increasingly seriously. In fact, 58 per cent of them believe they can improve investment returns or reduce risk by considering ESG, which is greater than the global average of 54 per cent. 13 of the 14 main Asian exchanges are now members of the Sustainable Stock Exchange Initiative and the International Organization of Securities Commissions (IOSCO) has "set out the importance for issuers" to disclose ESG information. The Hong Kong Stock Exchange's ruling on "comply or explain" ESG information also came into force on 1 July 2020. Driven by policy, China has implemented some of the world's most innovative green finance initiatives and is very active in pushing for global progress.

    In the Middle East, progress has not been as fast as in other regions but the situation could evolve rapidly. 77 per cent of Middle Eastern investors reported that obstacles are holding them back from fully pursuing ESG investing. The region's biggest hurdles are lack of ESG data comparability between issuers, shortage of expertise and/or qualified staff and lack of demand from client.

    In contrast, more investors in Europe than anywhere else care about environmental and social issues, because 'society expects it' — 63 per cent, compared to the global average of 48 per cent. There is heavy external pressure in Europe to take account of society and the environment and therefore it stands out as the only region where a majority of investors (53 per cent) always factor ESG considerations into investment decisions. Thanks to the new EU taxonomy introduced in 2020, which defines the criteria to determine whether an economic activity is environmentally-sustainable, investors in Europe can make more informed decisions to channel investment into sustainable activities.

    The Americas is an interesting case. Over 90 per cent of issuers in the Americas have strategies in place for reducing their environmental impacts and ensuring they have a positive impact on society. However, despite strong affirmation that environmental and social issues matter, market participants are polarized in how they act on it and American investors report the highest level of confusion over ESG terminology among their clients (59 per cent say over half of their clients are confused). Therefore, unsurprisingly, the Americas ranks lowest globally on the extent to which investors use impact goals and metrics as part of investment decision making (only 17 per cent vs 30 per cent global average). Recently in June 2020, the US Department of Labor ("DOL") issued a proposed rule on fiduciary requirements under the federal pension law that applies to the selection and monitoring of ESG investment in retirement plans, which requires a substantially heightened level of scrutiny when selecting or retaining ESG-based funds. This could hinder ESG integration in retirement products.

    Nevertheless, a global consensus is growing – 64 per cent of investors globally now view environmental and social issues as very important, while fewer than 1.5 per cent treat them as unimportant. There is no denying that ESG investment has moved into the mainstream.

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