A new kind of balancing act
“Our societies face a series of profound environmental and social challenges … While there is still time to act, the window of opportunity is finite and shrinking.”— Mark Carney, Governor of the Bank of England, 29 September 2015
It is a stark message, but one that is increasingly acknowledged. Incorporating Environmental, Social and Corporate Governance (ESG) criteria into decision-making processes is now seen as a function of good investing. ESG analysis looks into the current and past business practices of a company, and uses this view to measure potential risk based on the company’s environmental stewardship, its corporate governance, its support of social practices, and its financial performance.
“Sustainable investing” in its various guises has been a growing trend for many years. Yet it largely remained the preserve of experts in sustainability, notes Virginie Pelletier, Head of sustainable finance for Corporate and Institutional Banking at BNP Paribas. The ‘Paris Agreement’ that emerged from the December 2015 Conference of Parties (COP) 21 marked a tipping point.
“Almost 200 nations came together to pledge to limit global temperature rises to two degrees centigrade,” says Ms Pelletier. “The resulting attention, and the regulatory and legislative developments1 that will follow as states work to make good on their commitments, have transformed ESG issues into a C-suite level topic, and one that continues to gain momentum.”
Long-term asset owners are at the heart of this push. As part of the transition to a low carbon global economy, leading insurance companies and pension funds across Europe and the United States have made public pronouncements and signed agreements to decarbonise their investment portfolios. Growing governmental and public pressure is one reason. But there are also strong market-driven incentives propelling change.
Institutional investors, with their long-term fiduciary duties, are increasingly concerned about the financial risks “stranded assets” pose in a low carbon economic future. These stranded assets are notably fossil fuel reserves, and in particular coal.
“Today the world relies on fossil fuels, with coal representing about 40% of the energy mix. But globally we have a budget, that we can only burn fossil fuels up to a certain amount, after which we will go beyond a two-degree temperature rise,” explains Pelletier. “To stay below two degrees, companies will have to leave substantial reserves in the soil, so they will have no value. That is the risk.”
The risks faced by fossil fuel companies were starkly illustrated in April when Peabody Energy, the world’s largest privately owned coal producer, filed for bankruptcy protection in the United States. Slowing demand from China, competition from alternative sources (such as shale gas and renewables), and tougher environmental regulations and governmental pressure have all contributed to a slump in coal prices in recent years, which is hurting the industry.
However, the risk posed by stranded assets extends beyond the mining and utilities sectors, says Pelletier. “Climate change will be disruptive to the business models of many industries, not least automobiles, shipping and airlines.”
As well as tackling the risks within existing portfolios, investors have a front line role to play in driving the carbon transition. Technology to support the shift to a low carbon world and help companies meet their sustainability-related needs is already available, with more being developed. Trillions of dollars will be required in the coming decades though to continue financing this energy transition. Asset owners, with their long-term liability profiles and investment horizons, are well-positioned to channel assets towards these financing demands.
Banks likewise are seen as critical facilitators, and are under pressure to concentrate their direct financing and investment origination efforts accordingly.
“For example, at BNP Paribas our investment policies are governed by ESG-type rules that cover 12 sensitive sectors, such as coal, wood pulp and oil sands,” notes Pelletier. “At COP21 we announced we will double our financing of renewable energy. And many other banks around the world are making similar commitments.”
ESG issues will clearly become ever more central to governments, the public, corporates and the financial sector. The task confronting all investors is how best to cope with and flourish in this changing environment.
In December 2015, the Financial Stability Board set up a Task Force on Climate-related Financial Disclosures. The purpose of the group is to develop more consistent and useful practices that companies can employ to improve the climate-related risk information they provide to investors, lenders, insurers and other stakeholders. While voluntary, more effective reporting should lead to better informed investment, credit and insurance underwriting decisions. A final report, due at the end of 2016, will set out specific recommendations and guidelines.
Meanwhile, other standards and best practices are emerging to help practitioners integrate ESG considerations into investment processes, notes Madhu Gayer, Head of Asia Pacific, Investment Reporting and Performance with BNP Paribas Securities Services. “As investment professionals seek to bolster their risk management processes, the CFA Institute produced ‘Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals’ in October 2015 in support of investors looking to incorporate ESG considerations into investment analysis.”
The UN Environment Programme and Principles for Responsible Investment (PRI) Initiative also ran a series of consultations in Asia this year on institutional investors’ fiduciary duties. These ‘Fiduciary Duty in the 21st Century: Focus on Asia’ roundtables, were hosted by BNP Paribas and included discussions on how practitioners, regulators and key market stakeholders can integrate ESG into decision-making processes and promote sustainability. A report detailing the final recommendations will follow later in the year.
Then there is the question of how best to implement ESG considerations in practice.
The traditional approach has been to remove companies or sectors from portfolios through exclusionary screening. “However, the danger is that investors may be left with a severely restricted investment opportunity set,” says Gayer.
A more refined alternative is best-in-class screening – using ESG criteria to select the companies within a sector that have the best strategy to face these challenges.
Another option is ESG integration. Rather than simply excluding certain companies or sectors, ESG factors become infused into the entire fabric of an asset owner’s investment decision-making process, says Gayer. “It becomes the heart of firms’ financial analysis and investment policies, from selecting the investment universe through to choosing benchmarks and allying with asset managers qualified enough to manage and add value to this kind of mandate.”
Gayer identifies three fundamental steps to ESG integration: “The first is to set explicit, best practice ESG investment objectives. Firms then need to construct the right benchmark and portfolio. And after that they should monitor the results to create a virtuous feedback loop.” BNP Paribas supports this endeavour for investors through the recently launched “ESG Made Simple Guide”, a reference document assisting investors in their ESG integration journey.
Incorporating an extensive array of ESG factors that investors can use to better describe and understand the risks and opportunities in investee companies can only help firms make more informed, transparent judgements. But this depends on access to more granular data and an intuitive information portal to translate that data into decision-ready information. BNP Paribas is one of the first global custodians to develop an ESG risk management tool ESG Risk Analytics that allows investors to understand their ESG risks, exposure to controversies, business involvement and their carbon footprint, all online through the innovative DNA portal.
On 26 May 2016, PRI and UNEP – representing six major credit rating agencies – defined the so-called ‘Principles for Responsible Investment (PRI) Statement on ESG in Credit Ratings’. The group has pledged to integrate ESG criteria more systematically into their analysis of issuer creditworthiness.
Upstream service providers, such as custodians and market data vendors, can also play a valuable supporting role by providing tools and metrics. Stress-testing and reporting tools will be particularly crucial in enabling firms to monitor ESG-related risks, and to identify, stay informed about and report on the impact of their investments. For example, BNP Paribas has teamed with Avalerion Capital to develop a new climate change stress-testing approach. Solutions to fill these needs are already emerging, and more will follow.
Social and governance issues have long had a recognised role in investment processes. But now, with the science on climate change firmly established, environmental considerations are coming to the fore. The associated risks are complex and significant. However, by formulating a robust ESG framework, and integrating it into the fabric of their investment policies, investors will be well-placed to benefit from and contribute to the major opportunities that transitioning to a low carbon world will bring.
1. For example, Article 173 of the French law on “Energy transition for green growth” requires that institutional investors disclose in their annual report information on how ESG and climate change considerations are incorporated into investment policies and risk management.