incorporating environmental, social and …documents.worldbank.org/.../pdf/125442-wp-public.pdf ·...

Incorporating ENVIRONMENTAL,

SOCIAL and GOVERNANCE (ESG)Factors into FIXED INCOME

INVESTMENTGeorg Inderst and Fiona Stewart

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© 2018 The World Bank Group

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Citation: Inderst, G. and Stewart, F., Incorporating Environmental, Social and Governance (ESG) Factors into Fixed Income Investment. World Bank Group publication, April 2018.

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | I

TABLE of CoNTENTS

| I

ACRONYMS AND ABBREVIATIONS III

ACKNOWLEDGMENTS V

EXECUTIVE SUMMARY VII

1. INTRODUCTION AND BACKGROUND 1Definition of ESG Investing 2Investor Motivations 3ESG and Impact Investment Approaches 6

2. WHAT IS ESG ANALYSIS IN FIXED INCOME INVESTING? 9Corporate Issuers 11Sovereign Issuers 12Other Debt and Securities 14

3. ESG AND FINANCIAL PERFORMANCE – MAIN RESEARCH FINDINGS 17Corporate Bonds 17Sovereign Bonds 19Fixed Income Funds 19

4. ESG INVESTMENT TOOLS FOR FIXED INCOME 23Credit Ratings and ESG 23ESG Scores/Rankings 24Country Scores 26ESG Fixed Income Indices 27

5. HOW IS ESG BEING IMPLEMENTED BY FIXED INCOME INVESTORS? 31Green, Social, Sustainable and Other Thematic Bonds 32Passive Investing 35Active Investing 36ESG ‘Holistic’ 36

II | TABLE OF CONTENTS

6. MAIN TRENDS AND CHALLENGES 39State of the Art 39Issues with ESG Investing 40

7. CONCLUSIONS: FROM PROCESS TO IMPACT 45Key Lessons for Investors 45Ways Forward 46

APPENDICES 49

REFERENCES 55

Appendix 1: Institutions Interviewed for This Report 49Appendix 2: ESG Criteria 50Appendix 3: Characteristics of Fixed Income and Implications for ESG 51Appendix 4: Structure of RobecoSAM’s Country Sustainability Framework 52Appendix 5: Bloomberg Barclays MSCI ESG Fixed Income Family 53

ENDNOTES 61

BOXES

Box 1: ESG Investor Associations, Standards and Codes 4Box 2: ESG and Regulation 5Box 3: Climate Investing 6Box 4: EAPF’s Sustainable Investment and Carbon Targets 38

FIGURESFigure 1: Impact Investment Drivers 8Figure 2: Suitability of ESG Investment Strategies for Equity and Fixed Income Investing 10Figure 3: Level of ESG Incorporation in Fixed Income 15Figure 4: Main Research Findings 20Figure 5: RobecosSAM ESG Weightings 27Figure 6: Level of ESG Integration 32Figure 7: Labelled Green Bond Market Volume by Type of Issuer 33Figure 8: Labelled Green Bond Market Volume by Country 34Figure 9: PGGM ESG Approach 37

TABLESTable 1: Engagement for Equity and Bond Investors 11Table 2: Screening Criteria for Different Types of Issuers 13Table 3: MSCI ESG Key Issues for Companies 25Table 4: Categories Available for Bespoke Screening 28Table 5: ESG Strategies in Fixed Income (by Volume of Assets) 31

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | III

ACroNymS ANd ABBrEviATioNS

ABS Asset-backed Securities AI ArtificialIntelligenceAIGCC AsiaInvestorGrouponClimate ChangeAIM AffirmativeInvestmentManagementALM AssetandLiabilityManagementAODP AssetOwnersDisclosureProjectCAT CatastropheBondsCCM ConventiononClusterMunitionsCDP CarbonDisclosureProjectCDS CreditDefaultSwapCFP CorporateFinancialPerformanceCRA CreditRatingAgencyCSR CorporateSocialResponsibilityEAPF EnvironmentAgencyPensionFundEIB EuropeanInvestmentBankETF ExchangeTradedFundsESG Environmental,SocialandGovernanceGBP GreenBondPrinciplesGIC GlobalInvestorCoalitiononClimate ChangeGIIN GlobalImpactInvestingNetworkGP GeneralPartnerGPIF GovernmentPensionInvestmentFundGRI GlobalReportingInitiativeGSIA GlobalSustainableInvestmentAllianceGSSB GlobalSustainabilityStandardsBoard

ICGN International Corporate GovernanceNetworkICMA InternationalCapitalMarket AssociationIFC InternationalFinanceCorporationIG Investment-gradeIGCC InvestorGrouponClimateChangeIIGCC InstitutionalInvestorsGroupon ClimateChangeILS Insurance- linkedSecuritiesIRIS ImpactReportingandInvestment StandardsJFSA Japan’sFinancialServiceAuthorityLDI Liability-drivenInvestmentMBS Mortgage-BackedSecurityOECD OrganizationforEconomic Co-operationandDevelopmentPE PrivateEquityPRI UNPrinciplesofResponsibleInvestingRI ResponsibleInvesting

III

IV | ACRONYMS AND ABBREVIATIONS

SASB SustainabilityAccountingStandards BoardSBP SocialBondPrinciplesSDGs SustainableDevelopmentGoalsSDSN SustainableDevelopmentSolutions NetworkSI SustainableInvestingSIB SocialImpactBonds

SPV SpecialPurposeVehicleSRI SociallyResponsibleInvestmentTCFD TaskForceonClimate-related FinancialDisclosuresTIPP TheInvestmentIntegrationProjectUNEP UnitedNationsEnvironment ProgrammeUNGC UNGlobalCompact

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | V

ACkNowLEdgmENTS

This research report is the result of apartnership between theWorldBankGroup(WBG)andGovernmentPensionInvestmentFund

(GPIF)ofJapan,initiatedbytheWorldBankGroup’sPresident,JimYongKim, andGPIF’sChief InvestmentOfficer,HiroMizuno.TheaimisfortheWorldBankandIFC–memberoftheWorldBankGroupfocusedontheprivatesector–andGPIFtocollaborateoninitiativesthatpromotestrategiesforincludingenvironmental,socialandgovernance(ESG)criteriaininvestmentdecisionsacrossassetclasses.Ultimately,thegoalistodirectmorecapitaltowardssustainableinvestmentsandleveragetheprivatesectortoachievethescaleofinvestmentneededtomeettheSustainableDevelopmentGoals.

The partnership reflects GPIF’s strategiccommitment to advancing the integrationofESGconsiderationsintoallassetclassesofitsportfolio.The research report is focused on integration ofESG considerations for fixed income. From theWorld BankGroup side, the research contributesto the commitment to maximizing finance fordevelopment and catalyzing the developmenttowardsmoresustainablecapitalmarkets.

The authors of the paper are Georg Inderst andFiona Stewart. Georg Inderst is an independentExpert Consultant, specializing in green financeand infrastructure investment (Inderst Advisory,London).FionaStewart is aLeadFinanceSectorSpecialist in the Finance, Competitiveness andInnovation Global Practice of the World Bank.Theauthorswould,inthefirstplace,thankalltheasset owners, investment managers, international

associations, private sector service providersand individual experts for sharing their expertiseand experiences. In addition, Joaquim Levy,ManagingDirector andWorldBankGroupCFO,Arunma Oteh, World Bank Treasurer and VicePresident, JingdongHua, IFCVice President andTreasurer,MonishMahurkah,IFCVicePresident,forspearheadingthisworkwithintheWorldBankGroup. Heike Reichelt and Atiyah Curmally forleadingthepartnershipwithGPIF,andthefollowingfor their support and input to the study:AlfonsoGarciaMora,JohnGandolfo,GeorgeRichardson,andAndrewCrossandSamuelMunzeleMaimbo.The authors are particularly grateful to ColleenKeenan, Marcelo Jordan, Martijn Regelink,HarunDogo,SvetlanaKlimenko,BeritLindholdt-Lauridsen and Alex Berg for their expert input.Yoshiyuki Arima, Kenichiro Shiozawa and MisaYanagifromtheTokyoofficeforalltheirassistance

VI | ACKNOWLEDGMENTS

–includingarrangingforthereporttobetranslatedintoJapanese.AichinLimJonesforgraphicdesignand layout, Luidmila Uvarova andNinaVucenikfor knowledge management and communicationssupport, and InnaRemizova andLeahKusenselaforbeingexcellent researchassistants.The reportbenefited from comments from peer reviewersincludingAkinchanJain,GregRosenberg,Eivind

Oy,andJudithMoore.Finally,ithasbeenapleasureworking with the GPIF team. We would like tothank Norihiro Takahashi and Hiro Mizuno andfortheirsupportandleadership,andTetsuyaOishi,GenzoKimura,DaikiNishida,andKeijiWatanabefor theirhelpful inputandcollaboration.We lookforward to continuing the dialogue and workingwiththeminfuture.

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | VII

ExECuTivE SummAry

A growing body of research shows thatEnvironmental, Social and Governance(ESG) factors are material credit risk for fixed

incomeinvestors.TheevidencesuggeststhatincorporatingESGintofixed income investing should be part of the overall credit riskanalysisandshouldcontributetomorestablefinancialreturns.ItalsodispelsthemyththatincorporatingESGmeanshavingtosacrificefinancialreturns.ESGinvestingisincreasinglybecomingpartofthemainstreaminvestmentprocessforfixedincomeinvestors,asopposedtoaspecialist,segregatedactivity,oftenconfinedtogreenbonds.

Though fixed income has its own challenges withintegratingESGissues,itiscatchingupfastwiththeequityspace(particularlycorporateandsupranationalbonds but less - so far - sovereign issuers, asset-backedorprivatedebt).LeadinginvestorsaregoingfurtherandviewingESGnotjustasanaspectofriskandreturn,butmergingESGand‘impact’investing.Thisincludesmeasuringtheimpactoftheirportfoliosontargetedenvironmentalandsocialoutcomes,andbeyond,suchasmappingimpactusingtheSustainableDevelopmentGoals(SDGs).

Different methods for applying ESG are beingadoptedbyfixedincomeinvestors:frompurchasing‘labelled’(green,social,and/orsustainable)bondsand setting up or investing inESG/SRI (SociallyResponsible Investment) funds; to followingESG indices; to hiring ESG active managers; toincorporating and embedding ESG across thewhole investment process. This can be done byeither following the methodology of different

external serviceprovidersand /orbycustomizingsuchproductswiththeinstitutionalinvestor’sownphilosophyandgoals.

Yet, many investors find implementing ESG inpractice a challenge, which can be exacerbatedwhen it comes to their fixed income portfolios.There are still no standard definitions of ESG– with diverse views particularly in the ‘social’area. Data – though improving and coming fromincreasingly varied sources – is still wantingparticularlyinemergingmarkets.Infixedincome,there are additional issues such as how to pursueengagementwithissuers(particularlysovereigns),the role ESG plays in credit ratings, the lack ofchoiceofindicescomparedtotheequityspace,aswellasadearthofspecificESG-focusedproducts.Therearealsochallengesinthegreenbondmarketswithdemandoutstrippingsupply.ConceptualworkonESGandfixedincomealsoneedstogobeyondcreditrisk(suchastherelationshipofESGissueswithliquidityandothermarketrisks).

VIII | EXECUTIVE SUMMARY

ESGinvestingisdevelopingfromapurelyprocess-driven to a more outcome-driven activity. Goingforward,first,initiativestoimprovethebreadthanddepthofESGdatashouldcontinuetobesupported.Second,morerigorousresearchontherelationshipbetweenESGfactorsandfinancialrisksandreturnsinfixedincomeisalsorequired.Third,standards,

principles and metrics for applying ESG andimpactinvestingcanberefinedtoallowinvestorsto customize their approach from a robust basis.Finally, more innovative, scalable products toaccommodatethegrowingdemandforfixedincomesustainableinvestmentscouldbedeveloped.

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 1

1. iNTroduCTioN ANd BACkgrouNd

Capital markets play a vital role inchanneling investment into the economy tohelp drive growth and prosperity. Asset owners

andfinancialintermediariesareaskedtocontributetofinancingsustainabledevelopment thatmeets theneedof thepresent,withoutcompromisingtheabilityoffuturegenerationstomeettheirownneeds.

Sustainable investment, including sociallyresponsible, ethical, and ESG (environmental,social and governance) investing, is increasinglygainingafootholdinmainstreamfinancialmarkets.Globally,sustainableinvestmentsgrewbyaquarterto$23trillionoverthelasttwoyears,accordingtotheGlobalSustainableInvestmentAlliance(GSIA2017). This equates to around one-quarter of‘professionallymanaged’assetsglobally.1

ESGinvestinghasbeengatheringattentionsincethe1990s.Fromitsoriginsintheequitymarketswithreligious,values-basedorthematic(environmental)investors,themovementspreadwiththelaunchoftheUNPrinciplesofResponsibleInvestment(UNPRI) in2006andwascatalyzed forfixed incomewiththeissuanceoflabelledbondsbymultilateralorganizations from 2007. The issue has receivedrenewedhigh-profilesupportinrecentyearsthroughthe European Commission’s High-Level ExpertGroup on Sustainable Finance and the FinancialStability Board’s (FSB) Task Force on Climate-relatedFinancialDisclosure (TCFD) initiative, aswell as public interventions by stakeholders such

as the Bank of England Governor MarkCarney.2

Traditionally, the main focus of ESG investinghas been on equity markets. In recent years,however,ESGhasspreadoutincreasinglytootherasset classes, in particular fixed income, giventhat bonds constitute a substantial percentageof institutional investors’ assets.3 Considerableacademicandindustryresearchhasbeenconductedon the relationship between ESG investing andperformance in equity markets, but far less isavailableonitseffectonthefixedincomemarkets.

As a further development, many asset ownersare looking to increase investments that make apositivesocialandenvironmentalimpactontopoftheir financial objectives. Some have also startedtore-assesstheirinvestmentpoliciesinthelightofclimatechangerisksandpoliciespostParisCOP21,as well as the 2015 UN Sustainable InvestmentGoals (SDG).All assets, including fixed income,will increasingly bemeasured also by social andenvironmentaloutcomesandexternalities.

2 | 1. INTRODUCTION AND BACKGROUND

This research report provides an overview onsustainableinvestinginfixedincomethatisdevelopingfastthesedays.Itdiscussesthecoreareasof:

• thespecificnatureandissuesofESGinvestinginthisassetclass;

• therationaleforESGanalysisinfixedincome–includingresearchfindings;

• ESGinvestmenttoolsandwaysofimplementingESGstrategiesinfixedincome;

• on-goingchallengestogreaterintegrationofESGintomainstreaminvesting;and

• suggestions for how to catalyze the furtheradoptionofESGapproaches.

The study builds on both research and practicalexperiences to date onESG approaches for fixedincome portfolios.An extensive literature reviewwas conducted to inform the findings. Itwas notpossibletoundertakenewprimaryresearchforthispaper,butsuggestionsforfurtheranalysisaremade.Thepaperalsoincludesfindingswhichdrawonthepractical experience of a number of stakeholders(assetowners,assetmanagers,dataprovidersetc.)whoareintegratingESGfactorsintofixedincomeinvestmentsandwereinterviewedandparticipatedin aworkshop and roundtablediscussions as partofthisresearchproject.Theirinsightsarereflectedacrossthepaper,andtheirinputismostappreciated.4

Thefocusofthereportisprimarilyonthemainfixedincomeinvestmentinstruments,suchassovereign,supranational, and corporate bonds. Researchand application of ESG for other fixed incomeinvestments (sub-sovereigns, covered bonds andotherassetbackedsecurities,privatedebtetc.)arestill very limited.However, thematic investmentssuch as green, social and sustainable bonds aregrowingandarefacilitatingtheintegrationofESGforfixed income.Therefore, thediscussion isnotlimitedonlytothelabelledbondmarket,butisalsoon incorporating ESG factors into fixed incomeportfoliosmorebroadly.

Definition of ESG InvestingESGinvestingincorporatesenvironmental,social,andgovernance issues into the analysis, selectionand management of investments. Key issues forconsiderationtypicallyinclude:

E: climate change, carbon emissions, pollution,resourceefficiency,biodiversity;S: human rights, labor standards, health &safety, diversity policies, community relations,developmentofhumancapital(health&education);G: corporate governance, corruption, rule of law,institutionalstrength,transparency.

Historically, governance-related investmentcodeswere probably first relevant for investmentstrategies,withgreenandsocial issues,andmoregenerallyaviewtosustainableinvesting,growingin relevanceover the last twodecades.There aremanydifferent,andmorespecific,definitionsinthemarketplace.Appendix2showsalistofstandardESG criteria applied by the CFA (2015), and forsovereignandcorporatebondsbytheUNPrinciplesofResponsible Investing (PRI) (2014), and thoseusedintheIFCPerformanceStandards(2012)andCorporateGovernanceMethodology.

AdefinitivelistofESGissuesdoesnotexist–anditlooksimpossibletoagreeon.Markets,technologies,policies, values and social preferences change allthetime,andvaryfromregiontoregion,countrytocountryandevenwithincountries. Therefore,anopenanddynamicapproachtodefining“green”or“sustainable”investmentsispreferable–andisusedinthispaper–embeddedinaclearandtransparentgovernance framework (Inderst, Kaminker andStewart2012).5

Forfixedincome,asurveybyPRI(2017a)foundslightly more investors follow governance thansocial and environmental factors. Russell (2017)also found that governance is widely beingconsideredthemostimportantfactor.

Other common terms in this context includesustainable investing (SI), responsible investing


(RI) and socially responsible investing (SRI).Theyareoftenbeingusedsynonymously in themarketplace. So does this report, for simplicity, beingaware that some industry practice and academiadifferentiatetheseterms.

There are other related investment strategies witha somewhat different focus (such as long-term investing, universal ownership6), or strategies thatconcentrateonaparticularaspectofESG(e.g.green, climate change, social, ethical, religious investing).7

Finally,thereisanincreasingfocusonnon-financialoutcomesandexternalitiesofinvestments.Impact investingaimstogenerateameasurable,beneficialsocialorenvironmentalresultalongsideafinancialreturn.8 Blended finance is the strategic use ofdevelopment finance and philanthropic funds tomobilize private capital flows to emerging andfrontier markets (e.g. OECD 2018). The newlydevelopingSDG investing takesconsiderationsofissues beyond traditional ESG, using the UnitedNations’ Sustainable Development Goals (SDGs)asaframework.

Investor MotivationsEach investor has specific investment objectivesandstrategy,itsownlegalmandate,andparticularexpectations placed on it by its beneficiaries andthe society within which it operates. Therefore,responsibleinvestmenthasnosingularmotivation,andthereisnosinglestrategyorsetofapproachesthatisfolloweduniversally(Dimsonetal.2013).9

Therearemanyinvestorquestionnairesundertakenon ESG, and they varywidely inmany respects,which may reflect different universes, conceptsandlanguages,amongotherreasons.Mostsurveysconfirm that ESG is most prevalent in listedequities.According toCFA (2017), 45% of fixedincomeinvestorsintegrateESGanalysiscomparedto76%forlistedequities(andmuchfewerforotherasset classes). However, many investors plan toenhanceESGinthefutureinfixedincome,privateassets and alternative asset classes. There areseveraldriversforthisdevelopment:preferencesof

members,clientsandotherstakeholders;increasingawarenessofclimatechangerisksandpoliciesbyinvestorboards;socialandpoliticalconcerns;legalandregulatorychanges;voluntarycodes;fiduciaryduty; technology change and disruption; andreputationalrisks;publicandpeerpressure.

Financial and non-financial objectives

InstitutionalinvestorsmustbeabletoreconciletheiractionsintermsofESGissueswiththeirobligationstomembers,beneficiaries,policyholdersandclients,andlooktousetheirinvestmentsforapositivesocialpurpose.Formostinvestors,themainobjectivesarefinancialresults(e.g.risk-adjustedreturns,liability-matchingcashflows).Someinvestorsalsohavenon-financialobjectives(e.g.ethical,religious,political,cultural values and preferences) beside financialobjectives. ‘Reputational/ brand’ motivations canalso play a part. The potential trade-off betweenfinancial return and ESG is still being debated byinvestors.This is not so clear, even in theory, andthereforethedebateismostlydrivenby‘beliefs’.Ontheonehand,consideringESGasriskfactorsshouldcontributetomorestablereturnsovertime.However,bynarrowingthepotentialuniverseofinvestments,ESG could lower returns. Further theoretical andempiricalwork on this issue – particularly for thefixedincomeuniverse–isrequired.

Short-termism and long-term investing

The priority, or even exclusiveness, of financialobjectives does not preclude the consideration of non-financial factors in the analysis andmanagementof investments.Thismay lead to animprovedunderstandingoflong-termtrends.Assetowners are trying to move towards longer-terminvestmentframeworksthaninthepast.

ESG as risk factors vs ESG as an investment opportunity

Investor motivations are often driven by risk management, i.e. the relevance of environmental,social or governance risks. The risk aspect isnaturallyamainconcernofinsurancecompaniesand


otherlow-riskinvestors.However,someinvestorsalso look at ESG as an investment opportunity,seeking “alpha”.For example,ESGanalysismayimprove the understanding of longer-term trends.Someinvestorsevenfindnewinvestmenttargetsinthegreenandsocialspace.

Inpractice,ESGinvestorscanbroadlybeclassifiedintothreegroups:

• Fora largegroupof investors, thesolepurposeremainsfinancialperformance,butwithabeliefthat ESG factors have a material effect oninvestmentrisksandreturns.

Box 1: ESG Investor Associations, Standards and Codes

Asset owners and investment managers haveformedor joinedarangevoluntaryassociationsand networks in the field of ESG, corporategovernance, climate change, and related issues.There are also other voluntary codes manyinvestorscomplywith.Manyofthemareatthenationallevel(e.g.bypensionfundorganizations).Herearesomeimportantinternationalexamples:

Responsible and sustainable investment• UNGlobalCompact(UNGC)• UNPrinciplesforResponsibleInvestment(PRI)• EuroSIF, UKSIF, USSIF, SIF Japan, ASrIA,RIACanada,RIAAustralasia,etc.

• GlobalSustainableInvestmentAlliance(GSIA)• EquatorPrinciples• International Capital Market Association(ICMA) Green Bond Principles (GBP) andSocialBondPrinciples(SBP)

Corporate governance, accounting and disclosure• International Corporate Governance Network(ICGN)

• Global Reporting Initiative (GRI); GlobalSustainabilityStandardsBoard(GSSB)

• Sustainability Accounting Standards Board(SASB)

• The FSB Task Force on Climate-relatedFinancialDisclosures(TCFD)

Green and climate change investment Associations• Institutional Investors Group on ClimateChange(IIGCC)

• InvestorGrouponClimateChange(IGCC)• Asia Investor Group on Climate Change(AIGCC)

• GICglobalplatform• Ceres

Initiatives• CarbonDisclosureProject(CDP)• AssetOwnersDisclosureProject(AODP)• MontrealCarbonPledge• PortfolioDecarbonizationCoalition• Action100+

Impact investing• GlobalImpactInvestingNetwork(GIIN)

Industry guidesPracticalinvestorguidanceonESGinvestingcanbefoundinmanypublicationsbytheindustryandorganizationssuchastheCFA,PRI,SSF(2017),BNPParibas (2016).Morespecificallyonfixedincome,see,e.g.,PRI(2014),Klein(2015).Forguidanceonclimatechangeinvesting,includingtheimplicationsforfixedincome,see,e.g.,IIGCC(2015),Mercer(2015),ForumEthibel(2017).

• Increasingly investors seek to combine certainnon-financial objectives (e.g. ethical, religious,political,cultural,societalvaluesandpreferences)withouthamperingfinancialobjectives.

• Certaininvestorsarewillingandabletosacrificesomeorallfinancialreturntoachieveothersocialor environmental benefits (impact/communityinvesting;charityinvesting).

There is plenty of general ESG guidance alreadyavailable for all types of investors, offered byvariousorganizations(Box1).

INCORPORATING ENVIRONMENT, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 5

Box 2: ESG and RegulationIt is important to distinguish between ESG-specific regulation (e.g. for companies), investorregulation,andotherrulesandlawsthatmayaffectESG investing positively or negatively. Investorregulation may include funding and accountingregulation,orevenoutrightinvestmentconstraintson certain asset classes and instruments.Regulation also applies at different levels:company, investmentmanager/fund, asset owner(e.g. PRI 2016a, Northern Trust 2015). OECD(2017)summarizesthemaindevelopments:• Regulatory frameworks for investmentgovernance rarely make explicit referenceto ESG issues, although this is changing in anumber of jurisdictions such as France, theNetherlands,Chile.

• Several countries have some form of ESGreportinganddisclosurerequirementsforinvestors(e.g.Australia,France,Germany,Sweden,UK).

• Regulatoryframeworksforthemostpartdonotprevent ESG integration, and other legislationorvoluntarycodesmayencourageinstitutionalinvestorstotakeESGfactorsintoaccount(e.g.USA,UK,SouthAfrica,Ontario).

• However, institutional investors may lackclarityastohowESGintegrationfitswiththeircountry’slegal,regulatoryandotherobligations.ManyassetownersconsideredfiduciarydutyasanobstacletoESGintegrationbutthereseemsto be a shift from a “narrow” to “broader”interpretations(OECD2017).

• TheEUHigh-LevelExpertGrouponSustainableFinance published several investor-relatedproposals (EU 2018). In 2018, The EuropeanCommissions announced plans for establishingan EU taxonomy/classification system forsustainableactivities,creatingEUlabelsforgreenfinancial products, clarifying fiduciary dutiesof asset managers and institutional investors,enhancecorporatereporting,amongothers.

• In2015,Article173ofFrance’slawon‘EnergyTransition for Green Growth’ introducedmandatoryclimatechangereportingforfinancialinstitutions. This has been hailed as groundbreakingwithpotentiallyfarreachingimplications.

• Furthermore,manycountrieshavestewardshipcodes, corporate disclosure codes or stockexchangerulesthatcovergovernanceandotherESG issues. The Stewardship Code issued byJapan’s Financial Services Authority (JFSA),releasedin2014(revised2017)issaidtohavebeen particularly influential, and indeed wasone of the drivers for theGPIF to adoptESGprincipleswithin their investmentapproach. Inaddition, there are variousprinciples andbest-practice guides available for governments andinvestorsbyinternationalorganizationssuchastheUNandtheOECD.

Attheendof2017,centralbanksandregulatorsinitiatedanewNetworkonGreeningtheFinancialSystem, aimed at sharing supervisory practicesonclimatechangeandotherenvironmentalrisks.

ESG and regulation

RegulationcanbebothadriverandabarrierforESGinvesting. For example, a relatively prescriptiveapproach is being proposed in Europe, whilstinterpretationsofregulationinAsiahavebeenmorevoluntarybutsupportive.InNorthAmerica,alackofinterpretationaroundexistinglawsisstillfelttobeabarriertofurtherESGintegrationbysomeinvestors.SomemaintrendsaresummarizedinBox2.

The debate over whether ESG investing iscompatiblewithinvestorsfiduciaryduty10hasalso

been developing over time. From initial rulingsrequiring fiduciaries to only consider financialreturnswhenactingintheinterestofbeneficiaries,interpretation developed so that considerationof other factors was not seen a fiduciary breach.Guidance is now going a step further and insome cases requiring fiduciaries to incorporateESG factors into their investment decisions.For example, the United Nations EnvironmentProgramme (UNEP publication (UNEP 2015)concluded that: “failing to consider all long-terminvestmentvaluedrivers,includingESGissues,isafailureoffiduciaryduty”.


ESG and Impact Investment ApproachesInvestorsusearangeofmethodsforbringingESGconsiderations into their decision-making. Theyweretraditionallyappliedtoequityinvestments,butarealsobeingusedforfixedincomeandotherassetclasses.Thesemethodsarenotmutuallyexclusiveandareoftenusedincombination.Furthermore,thevariousESGapproachescanbeimplementedwithactiveorpassiveinvestmentstyles.ESGintegration,engagement and screening capture about 99% ofassets,withthemedandimpactinvestmentsmakinguptheremaining1%.11

Negative/exclusionary screening:

This involves excluding securities of specificactivitiesorindustries(e.g.controversialweapons,tobacco,fossilfuels)deemedunacceptable.Reasonsmaybeethical,legalorothernormsandstandards(e.g.humanrights,laborconditions,corruption).

Positive screening/best-in-class selection:

This is a positive selection or overweighting ofcompanies or countries with better or improvingESGperformancerelativetosectorpeers.ItcanbeimplementedoneitherthelevelofESGmeasuresortheirpotentialforchange(ESGmomentum).

Animmediateconcernwithexclusionsorbest-in-class is the potential reduction of the investmentuniverse.Also, screeningmay lead to unintended

sector and factor biases in the portfolios. Suchissuesneedtobewellmanaged.

Active ownership/voting/engagement/stewardship:

This refers to the practice of entering into adialogue with companies or countries on ESGissues and exercising both ownership rights(including.voting)and“voice”(especiallyrelevantincaseswhereinvestorsdonothavevotingrights,such as bondholders) to effect change.This is analternativeto“exit”,i.e.sellingofftheinvestmentswithquestionablepractices,ordivestingbasedonspecific issues (e.g. removing exposure to fossilfuelsas‘strandedassets’).SomeinvestorsalsoliketolobbyforESGthemesmorewidelyinpolitics.

ESG integration:

This is thesystematic inclusionofESGrisksandopportunities in investment analysis, portfolioconstruction and risk management. It is beingimplemented in different ways across investmentorganizations.12

Thematic investing:

AnumberofinvestmentthemesarebasedonESGissues, including clean technology, renewableenergy,energyefficiency, sustainable forestryandagriculture,water,education,healthanddiversity.Climate investing more broadly is receivingincreasingattention(seeBox3).

Box 3: Climate Investing

SinceParisCOP21,moreinvestorshavedevelopedpracticalclimatechangepolicies.Theyareoftensimple green thematic investing or included intraditionalESGpolicies.Forsomeinvestors,theygowellbeyond.Theyinclude,amongothers:• climatechangescenarioanalysisinassetallocation;• measurementofcarbonemission/carbonfootprint;

• gradualdecarburizationtargetsforportfolios;• exclusions/underweightofparticularindustries/companies(e.g.coal,fossilfuels);

• energyefficiencytargets(e.g.inrealestate);• greeninfrastructureinvestments(e.g.cleanenergy,climatechangeadaptation);

• greenandclimatebonds;• divesting,andtheconceptof“strandedassets”.13

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 7| 7

Impact investing:

Ingeneralterms,thisisinvestingwiththeintentiontogenerateandmeasuresocialandenvironmentalbenefits alongside a financial return.14 Impactinvestorstypicallysetoutcomegoalsortargetsexante, make and monitor the investment and thenmeasureexpostresults.Theytrytostrikeabalancebetween an economic and social return – with avaryingemphasis,dependingonthespecificimpactproject/fund.

Therearedifferentapproachestoimpactinvesting.Theearlydevelopmentsweremore in thewayof“community investing”, i.e. investments by smallfundstohelpfundsmallersocialorenvironmentalprojects in municipalities/regions. As a newdevelopment, impact investing has spread also tonon-specialist investors. Mainstream investorsnow feel urged to measure the ‘impact’ of theirportfolios,butaregenerallynotmandated togiveupfinancialreturn.

There are various motivations behind this move,but two in particular standout (Figure 1). First isthe increasing influence of millennial investors.According to a survey conducted in the UnitedStatesbyMorganStanley (TheEconomist2017),75% of millennials agreed that their investmentscouldinfluenceclimatechange,comparedwith58%of the overall population.They are also twice aslikelyasinvestorsingeneraltoinvestincompaniesthat espouse social or environmental objectives.As ‘TheEconomist’ article quotes: “boomers see doing good as separate from investing; whereas millennials don’t see how you could possibly separate the two.”

Impactinvestingcoversallassetclasses,includingbonds (e.g. social impact bonds), private equityand private debt (GIIN 2017). Returns can showlowcorrelationswithmainstreamasset classes asincomeistypicallynotrelatedtofinancialmarkets(SSF2017).

Measuring “impact” is not an easy task. ManyinvestorsarestillnotclearwhatappropriatemetricsshouldbeforthemeasuringimpactonE,SandGindividually, and collectively or indeed whetherthereshouldbea‘onesizefitsall’approach.Themost advancedmetrics in this respect appears tobe carbon emissions/footprint. GIIN developedimpactreportingandinvestmentstandards(IRIS),i.e.acatalogueofperformancemetricsforvarioussectors.New research is being undertaken in thisfield.15

SDG investing

Thesecondmajordriver for impact investinghasbeen the publishing of the SDGs. In 2015, theUnited Nations approved the 17 SDGs and 169individual targets. The SDGs were not primarilymade for investors but achievement of theGoalsrecognizes the necessary contribution of all,includingtheprivatesectorandinvestors.Itislessclear what these contributions look like for sucha broad range of targets. Sometimes it is easierto address anSDG through investmentdecisions;sometimes it is easier to incorporate the SDG inactiveownership(PRI2017b).

SDG-relatedinvestment isstill in its infancy.Theanalysis currently focuses on mapping investorscorporate holdings to a selection of the SDG.Several investors such as the Dutch APG andPGGM, or the SwedishAP2 are trying to workoutinvestmentpossibilitiesassociatedwithSDGs.One of the commonly stated obstacles is thechallengesurroundingimpactmeasurement.Someorganizations are working on investor-relevantSDG impact indicators and metrics (e.g. DNB2017, Trucost 2017). The Investment IntegrationProject(TIIP)isafurtherinitiativelookingtohelpinvestorsmapthelinkbetweentheinvestmentsintheirportfolioandtheSDGs(TIPP2018).16


Figure 1: Impact Investment Drivers

ImpactInvesting

SDG Impact IndicatorsA Guide for Investors and Companies75% 84%61%86%

are “very interested”or “interested” in sustainable investing

think theirinvestmentscan influenceclimatechange

think theirinvestmentscan help fightpoverty

have made atleast onesustainableinvestmentaction in thelast year

Millennials Want to have an Impact

Sustainable Investing

Investing forMillennials

44%

34%36%

67%Gen X

69+ YearsBaby Boomers

Millennials61%

47%58%

73%

My investment decisions are a way to express my social, political, or environmental values.

It is possible to achieve marketrate returns investing in companies based on their social or environmental impact.

Percentage of Respondents Who Agree

Source: U.S. Trust Insights on Wealth and Worth, 2014, Harvard Business Review (October 3 2014), Morgan Stanley (on-line presentation August 9 2017), Visual Capitalist (on-line presentation August 11 2017), and DNB (2017)


2. whAT iS ESgANALySiS iN

fixEd iNComE iNvESTiNg?

Since most ESG research has beenundertakenonequities,itislesscleartowhatextent, howandwhenESGconsiderations canbe

applied to fixed income investments.Applying ESG to otherassetclassesrequires adaptation(e.g.Johnson2017).Fixed incomemanagementconsistsof severalbuildingblocks, including theanalysisofinterestrates,inflation,creditqualityandliquidityrisks.Fixedincomeinvestmentisverymuchaquantitativeprocess.ManagersfinditdifficulttoincludeESGcriteriaintheirfinancialmodels,andmaythereforebemore‘resistant’toESG-relatedchange.17

There are a number of key differences betweenequities and fixed income, especially the focus ondownside capital risk and cash flow stability vs.upside,capitalappreciation:

• Creditworthinessandtheabilitytopaybackdebtarekey-therefore,thereisafocusoncreditanddefaultrisk

• Asymmetricaldownside riskvs.upsidepotentialoffixedincomeinvestments;

• Duration(fixedincomeinvestmentshaveafiniteperiodvs.equityholdingswhichcanbeperpetual);

• Position in capital structure, and with differentlayers(e.g.senior,subordinateddebt,hybrid);

• Trading of fixed income products largely OTC/off-market;

• The difference between bondholder rights andshareholderrights;

• The importance of sovereign, sub-sovereign,supranationalandagencyissuers;

• Different analytical approaches (e.g. duration,yieldcurve,spreadmanagement);

• The specifics of asset-backed securities, projectbondsandotherinstruments;

• The high share of institutional participation incorporatebondissuance;

• Theuseofbondsinlong-termliabilitymanagementbyinsurancecompaniesandpensionfunds;

• Issues around market capitalization-weightedindices(withheavyweightstodebt-riddenissuers);

• Therisingimportanceofprivatedebt in investorportfolios.

There are implications of these differences forESGinvestinginfixedincomecomparedtoequityanalysis (seeAppendix 3 for an overview by thePRI2014):

10 | 2. WHAT IS ESG ANALYSIS IN FIXED INCOME INVESTING?

• Engagementpolicieswilllookdifferentforequityandbondholders;

• Sovereign (along with sub-sovereign andsupranational)issuersarefundamentallydifferentfromcorporateissuers;

• Eventriskscandominateissuers’creditworthinessanddowngrades;

• In fixed income, liquidity can suddenly dry upevenforlargeissues;

• Riskanalysisneedstoapplytovariouscorporatelevels (holding company, subsidiaries, specialpurposevehicles(SPVs),originators);

• Bonds can be complex contracts (e.g. attachedcovenants,embeddedoptions),alsoinrelationtoESGrisks;

• Concentrationriskrisesforissuerswithmultiplesecurities;

• Debt-related benchmarks may be even moreproblematic from an ESG perspective (e.g. therelationship between a highdebt load andpoorgovernance/institutions);

• Fixedincomeindicesaremoredifficulttocompile(asfixedincomeindicesincludemultiplebondsperissuer,multipleissuerspercorporatefamily,privatecompanieswheredata ishard togather,and non-corporate entities, covered bonds andotherasset-backedsecuritiesetc.).

The relevance of the various ESG approachesvariesacrossassetclassesandacrosstypesoffixedincomesecurities,althoughviewsseemtodifferonthis. Ngo (2016), e.g., finds significant scope forintegration but limited scope for other strategieswithsovereignissuers(Figure2).SSF(2017)alsodistinguishesbetweenactiveandpassivecorporates,butcomestoratherdifferentconclusions.

Figure 2: Suitability of ESG Investment Strategies for Equity and Fixed Income Investing

Source: Ngo (2016)

Equity Versus FIxed Income Investing

ESG investment strategies/asset class

Ethical (negative/exclusions) screening

Norms-based screening

ESG integration

ESG engagement/activism

ESG best in class

ESG (positive/thematic) investing

Equities Significant scope

Significant scope

Significant scope

Significant scope

Significant/some scope


Fixed income: corporates

Some scope Some scope Significant scope

Some/limited scope

Limited scope


Fixed income: sovereigns

Limited scope

Some scope Significant scope

Limited scope

Limited scope

Limited scope


Wenow lookat thevarious typesof securities inmoredetail.

Corporate IssuersCorporate governance factors (e.g., a company’saccountability, risk management and directorindependence)havestronglinkstocreditstrength.Goodcorporategovernanceshouldleadtoahighercredit rating and lower cost of debt, and viceversa.Well-managed companies tend to be morealigned with bondholder interests, and corporatetransparencykeepsbondholdersbetterinformedofexposureandmanagementofrisk.

Poor environmental or social management mayleadtolowercreditratingsandhighercostofdebt.ThematerialityofEandSfactorsvaryconsiderablyacross sectors and industries. For example,environmentalissuesareoftenrelevantinenergy,utilities, resources and other heavy industries.Water stress is likely to be material for certainsectors, such as extractives, food and beverage,andagriculturalcompanies.Forairlinecompanies,fuel efficiency may be a key environmental andfinancialmetric.

ESG investing for corporate bonds is closelyrelated to established ESG process for listedequities. For example, exclusion lists and ESGscreenstendtobeverysimilar.However,therearesomesignificantdifferences.

Bondholder rights

As lenders of capital and not owners of shares,bondholders generally have fewer obviousopportunities to engage with companies, such asexercising voting rights and speaking at AGMs.However, bondholders can, in specific situations,demandtransparency.Theycanconsiderengagementduringinvestorroadshows,atdebtreissuanceandincollaborationwithotherbondholders(Table1).Bondissuers repeatedlycome to themarket; therefore,anewdebtissuancecanbeagoodtimearoundESGissues.Onthoseoccasions,itispossibletodemandborrowerdisclosureofinformationonESGrisk.

Itcanbearguedthatbondholders,insomeaspects,mayactuallybemorepowerfulthanequityholders.In market conditions such as currently wherecompaniesarebuyingbackratherthanissuingnewshares, equity investors ultimately have the powerof divesting their holdings is an engagement isunsuccessful. Bond holdings, by way of contrast,frequentlyhavetoberefinancedatmaturity.Atthatpoint,thebondholderpotentiallyhasalotofleverageoverthecompanyif theychoosenottoreinvestoronlytoprovidecapitalatmuchhigherrates.

In practice, investors have shown differentapproaches to bondholder engagement that rangefrom – the predominant – passivity to aggressiveactivism used by some hedge funds (Celik et al.2015). It should not be overlooked, though, thatbondholders’ interests may be conflicting withshareholderinterests,especiallyintheshortterm.

Table 1: Engagement for Equity and Bond Investors

Source: Aberdeen (2017)

Product Feature Equity Bond

Dialogue ü ü

Request for increased transparency ü ü

Media ü ü

Buy and sell holdings ü ü

Voting ü X


Duration management

Different ESG factors will present greater risksover different time periods. In the short term,investors face a greater threat from the fallout oflow-frequency,high-impacteventssuchasextremeweatheror industrialdisasters.Longer term,ESGtrends such as demographic changes and climatechange,are likely tohavea significant impactonbondyields,buttheextentofthisismoreuncertain.

Liquidity

Liquiditytendstodryupwhenneededmost,i.e.attimesofcrisis,leadingtoexpensiverestructuringsof portfolios. Liability-driven investment (LDI)strategieshavetypicallylong-timehorizons.Abuy-and-holdstrategyforinvestinginrelativelyilliquidbonds requires consideration of all pertinent riskfactors-ESGandothers-overtherelevantperiod.

Low liquidity of bonds can also be a potentialthreat against apoorcompany.The saleofbondsby one investor can lead to price volatility, andsubsequently, tohighercostsofcapital forsuchacompany.

High yield bonds

Specific segments are potentially more exposedto ESG risks. For example, high-yield issuerstend to be smaller; many are private companiesand, therefore, do not have to report the sameinformationoroperatetothesamestandards.Theyaremorelikelytohaveunconventionalgovernancestructures that may be misaligned with creditorinterests. The amount of leverage used by highyield issuersmakes bondholders a critical sourceofcapitalalongsideequityownersandcanprovidemeaningful opportunities for engagement withcompanymanagementteams(Aristotle2016).

Private placements

They tend to have low transparency, largeticket sizes, long maturities, and are difficult todivest. However, large creditors may be able tonegotiatemore favorable covenants and reportingrequirementstoaddressESGconcerns.

Sovereign IssuersAnalysisofcompanyandsovereigncreditworthinessis markedly different in all aspects of ESG. Thepolitical and institutional system,macroeconomicdevelopment,andgovernmentpoliciesplayakeyroleinassessingacountry’sabilityandwillingnessto repay itsdebton time.Therelationshipof riskandreturninsovereigninstrumentsiscomplex,andnotlinear(Schroders2017a).

IntermsofG,amongthecrucialfactorsaretheruleof law, the strength of the country’s institutions,political stability, regulatory consistency andcorruption. Energy/water/other resource reservesand management, as well as green/climatechange policies are of varying importance forcreditworthinessacrosscountriesandperiods.

Social factors tend to be given greaterweight byanalysts than environmental factors because oflinksbetweenpoliticalstability,governanceandacountry’sabilitytoraisetaxesormakereforms.Keysocialfactorsincludehumanrights,laborstandards,educationsystem,healthcare,anddemographics.

TherearepronounceddifferencesintheapplicationofESGinvestmentapproachestosovereignbonds,andtheycanbepoliticallysensitive.Forexample,itimpliesthepossibleexclusionofwholecountryissuancesbasedonbeingoutsideofcertaintreatiesorconventions(Table2).Awidespreadpracticeisto overweight “good” countries and underweight“bad”countriesbasedonanESGscoringsystem.


Table 2: Screening Criteria for Different Types of Issuers

Source: PRI (2014)

Naturally, engagement with sovereigns is quitedifferent from engaging with companies, andundertaken less in practice. Investors may seeka dialogue with regulators, policy-makers andstandard-setters (including officials from treasurydepartments, government agencies and debtmanagement offices). The “size gap” betweeninvestorandissuermayevenbemoreofanissuehere than with large corporations. Collaborationsbetween investors may be particularly useful inbondholderengagements.

ESG information on governments is availablefromUNbodies,theOECD,CIAWorldFactbook,Transparency International, the World Bankand similar organizations. Certain segments ofsovereignbondsrequireparticularattention.

Emerging market debt

Many investorsfind thatESG factors tend to beparticularlyusefulintheassessmentofemergingand frontier market bonds. Political and socialdevelopmentsareoftendifficulttograsp,andtheymaynot be fully reflected in credit ratings or incurrent market prices. Regulatory frameworksand transparency can be poor. Issuers may befollowingtheIFC’sPerformanceStandardsortheEquatorPrinciples.

Sub-sovereign issuers

States, regions, cities and other entities can issuebonds at a sub-sovereign level. Municipal bondsareaverysizeablemarket(ofaboutUS$4tn)inthe

Screening Approach Corporate Criteria Government Criteria Financial Sector Criteria

Ethical/reputation screens

Revenue derived from:• Tobacco• Controversial weapons• Nuclear energy• Pornography• Arms• Gambling• Alcohol• Animal testing

• Adherence to international standards on human rights and environmental issues (see below)

• Use of capital punishment

• Financing or ownership of business activities listed under corporate criteria (on left)

• Origination of ABS financing business activities listed under corporate criteria (on left)

• Predatory lending• Aggressive tax avoidance schemes or consultancy

Norms, standards and international laws

• Illegal activites• Export controls• International Labour Organisation conventions

• UN Global Compact Standards

• Trade embargoes• US, EU, UN sactions• ILO conventions• Human rights conventions

• Montreal Treaty• Kyoto Protocol• World Governance Indicators

• Ottawa Treaty (anti-personnel mines)

• Convention on Cluster Munitions (CCM)

• Export controls• Whistle-blower policy• Regulatory compliance• Community Reinvestment Act (US)

• IFC Performance Standards

• Equator Principles• International sanctions


USA,andusedinothercountries.Localgovernmentbondscanbedividedinto twocategories:generalobligationbondsbackedbytaxinflows,andrevenuebondsbackedbyrevenues fromaspecificprojectsuchastollroads.Suchinstrumentsareoftenusedforeconomicinfrastructure(e.g.transport,energy,water,waste)orsocial infrastructure(e.g.schoolsand hospitals). Local and project-specific ESGfactorscomeintoplay.

Supranational issuers

Supranationalorganizations,suchastheWorldBank(IBRD),IFC,AsianDevelopmentBank,EuropeanInvestmentBank,EuropeanBankforReconstructionandDevelopment,regularlyissuebondstofinancedevelopment–relatedprojectsandbusinesses.Theseorganizations are typically considered low risk,with good ESG practices and issue investment-grade (AAA)bonds.Asa result,ESGanalysisonsupranationalstendstobemorefocusedontheiruseofproceeds rather thanon thecreditworthinessoftheissueritself.Supranationalhaveissuedlabelledbondssuchasgreen,socialand/orsustainablebondstoraiseawarenessforcertaintypesofdevelopmentprograms and priorities, responding to investorinterestininvestingforpurpose.

Other Debt and SecuritiesThere is a range of other fixed income securitiesin investor portfolios, often issued by banks orfinancialsectorcompanies.

Asset-backed securities (ABS)

ESGanalysisofABSneedstocapturerisksrelatingtotheoriginatorofthesecurities,theservicerandthe ‘cover pool’ of assets, respectively. Investorsshould also consider how ESG factors mightaffectthefinancialsustainabilityof‘assetpools’orstandalone projects covering the security, such asautoloansandmortgages.Insomecases,investorsfocusontheuseofproceedsforaparticularABSissued(monitoringthecompositionandchangesinthepoolofassets).

Covered bonds

Covered bonds ae a particular type of ABS,predominantlyfinancingresidentialmortgagesandpublic-sectorloans.AswithABS,investorsshouldconsider ESG risks relating to the issuer and thesustainability of the assets themselves. If a bankseizesadefaultedissuers’assets,italsotakesonitsliabilities,whichmayincludefines,ongoinglegalcostsandenvironmentalclean-ups.

Insurance-linked securities

Insurance-linked securities (ILS) are financialinstrumentstiedtocertainriskevents,e.g.weather.Catastrophe bonds (CAT bonds) are risk-linkedsecuritiesthattransferaspecifiedsetofrisksfrom(re)insurance companies to investors. There is anatural connotation to climate change risks here,and, asproceedsareused to rebuildcommunitiesafter disasters, a link is sometimes also made tosocialinvesting.

Structured products

There are many other structured fixed incomeproductsthatarebeingusedininvestorportfolios.Theytypicallycarryaugmentedrisksofcomplexityandtransparency.ThemappingofESGfactorswillbeparticularlytricky.

Private debt

Private equity appeared much later on the ESGradar screen than listed equity.Privatedebt playsan increasing role in the portfolios of insurancecompanies and pension funds, e.g. corporate,realestateand infrastructure loans.Thishasbeenspurredbyalengthyperiodoflowinterestratesandbythepartialwithdrawaloftraditionalbanksfromlonger-term lending following tighter regulation(e.g.BaselIII).Asforallprivateassets, thereareaugmented issues of liquidity and transparency.ThereisstilllittleexperienceonthesideofinvestorsontheconnectiontoESGissues.


Tosummarize,ESGinvestinginthefixedincomespace is gradually catching up with equities -althoughitisfacingitsownchallenges.Itismoreadvancedforcorporatebondswhere,forexample,engagementteamsareworkingacrossassetclassesand interacting with companies where they have

debt aswell as equityholdings.A surveybyPRI(2017a) finds corporate bonds are better coveredthan sovereign bonds by ESG analysis, whilesecuritizedassetsarefarbehindinthisrespect–butmoreresearchanddevelopmentscanbeexpectedintheseotherclasses(Figure3).

Figure 3: Level of ESG Incorporation in Fixed Income

Source: Authors


3. ESg ANd fiNANCiAL PErformANCE

– mAiN rESEArCh fiNdiNgS

Many studies have been published withthepurpose to establish an empirical linkbetweenESGandfinancial indicators.Muchof

theresearchfocusinthepastwasonequitiesbutmorestudiesrelevantforfixedincomehavebeenundertakeninrecentyears.18

A comprehensive survey article summarizesthe results of 2,200 primary and review studies(Friede et al. 2015). Roughly 90% of studies findanonnegativerelationbetweenESGandcorporatefinancialperformance(CFP).However,thefindingsaremore neutral/mixed for ‘portfolio studies’, i.e.using portfolio data19 (including ESG funds andindices)ratherthansinglefirmdata.Thereareonlya comparatively small number of studies for non-equityassetclasses.“Theshareofpositivevotesforthe36analyzedbondstudiesstandsat63.9%–with13neutralormixedfindings(36.1%).”(p.222)

How do ESG factors influence the financialperformanceoffixedincomeinvestments?

Thevariousresearcherstakedifferentapproaches,anduseverydifferentmethodologies,datasetsandtimeframes.Theytrytogiveabetterunderstandingon a number of key questions of the relationshipbetweenESGfactorsand:

• costofcapital(debtandequity);• creditrisks;creditspreads;• creditratings;

• default risk; credit default swap(CDS)spreads;

• bondpriceperformance;yields;• marketrisk;• companyvalue;• country economic growth and other macrovariables;

• otherproxyvariablesforperformance.

Fixed income investors are particularly interestedintherelationshipbetweenESGandcreditrisk,i.e.howenvironmental,socialandgovernancefactorsmayaffectcreditworthiness.Therearetwofurtherstrandsofresearchasstudiestypicallyconcentrateoneithercompanies/corporateissuersorcountries/sovereign issuers.The formerappears tobemoreadvanced while the latter had been surprisinglyoverlookedforalongtime.

Corporate BondsSeveral studies have looked at the relationshipbetween corporate bond performance and ESG.Herearesomeexamplesofindustryandacademicresearch.

18 | 3. ESG AND FINANCIAL PERFORMANCE – MAIN RESEARCH FINDINGS

Barclays (2015, 2016) studied the impact ofESGon theperformanceofUS investment-gradecorporate bonds (between 2007 and 2015) andfound that a high ESG rating results in a smallbutsteadyperformanceadvantage.Theeffectwasstrongest for a positive tilt towards the G factor,whilefavoringissuerswithastrongEandSratingwasnotdetrimental tobondreturns.Also, issuerswithhighGscoresexperiencedlowerincidenceofdowngradesbycreditratingagencies.

InadifferentapproachtopricingESGrisk,Hermes(2017)relatesitsproprietarymeasureofESGrisk–theQESGScore–forcompaniestocreditdefaultswap (CDS) indices. Companies with the lowestQESGScorestendtohavethewidestCDSspreadsandbroadestdistributionsofaverageannualCDSspreads.Moreover,creditratingsdonotaccuratelyreflect ESG risks and thereby do not serve as asufficientproxyforESGrisk.

Insight Investment (2016) looks at one particularapproach, i.e., exclusions, in a corporate bondportfolio.Broadethical screensare likely tohavea minimal effect on long-term returns but morefocused screens could have a larger impact. Thedirection of impact – i.e. whether the exclusionsleadtoperformancebeingbetterorworsethantherelevantindex–cannotbepredicted.

For corporate bond issuers, good/bad ESGmanagementcorporatesocialresponsibility(CSR)behavior is rewarded/penalized by lower/higherbond yield spreads, according to research byOikonomouetal. (2014).Similar resultsapply tobond ratings. In their research, Bauer and Hann(2010) conclude that environmental concerns areassociated with a higher cost of debt financingand lower credit ratings, and that proactiveenvironmentalpracticesareassociatedwithalowercostofdebt.

Hsu and Cheng (2015) found that sociallyresponsible firms usually perform better in termsof their credit ratings and have lower credit risk(in termsof loanspreads,defaults).PositiveESG

ratings are associated with reduced financial riskwhile negative ESG performance scores lead toincreasedfinancialdistress.InvestorsrespondmoretopositiveESGratings.20

In contrast,Amiraslani et al. (2017) detected norelationshipbetweencorporatesocialresponsibilityand bond spreads over the period 2005-2013.However, during the 2008-2009 financial crisis,high-CSRfirmsbenefitedfromlowerbondspreads.HoepnerandNilsson(2017a)arguethatbondsissuedbycompanieswith“nostrengths,noconcerns,andno controversies” significantly outperform themarket. These findings are particularly strong intimesofmarketturmoil.

Infrastructure bonds are a growing segmentin investor portfolios. Kiose and Keen (2017)testedthefinancialrisk implicationsofsocialandenvironmental risk factors.Carbon emissions andindependentdirectorson theboardare significantinthisrespect.

A review of research for investment grade (IG)corporatesbyAllianz(2017a)summarizes:

• Within investment grade bonds, issuers withmaterial ESG risks and persistently low ESGscoresaretobeavoided(alsofortailrisks);

• ExpectedESGmomentum(positiveornegative)maynotbefullypricedintothemarkets;

• Anexclusionfilterseemstoleadtonosignificantperformanceimpairment.

Therearecontrastingviews.Cantinoetal.(2017)conclude, fromtheir reviewofESGandfinancialcapital structure, that there is some consensus onthe positive effect of ESG on the cost of equity.However, “results concerning the relationshipbetweenESGsustainabilityanddebtfinancingareambiguousandnoclear-cutdefined”(p.124).Inhistheses, Bektić (2018) argues that the conclusionsonESGfactors incorporate level returnsarestillmixedandthereforepremature.

INCORPORATING ENVIRONMENT, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT | 19

Sovereign BondsInsovereigndebtanalysis,inadditiontoassessingan issuer’s ability to repay its debt, investorsare using ESG information to assess an issuer’swillingnesstorepay.Todate,mostoftheattentionhasbeenongovernancefactors,suchasinstitutionalstrengthandpoliticalrisks.

OneofthefewacademicresearchpaperstostudytherelationshipbetweenESGandsovereignbondperformance isCapelle-Blancard et al. (2017). Ina comprehensive analysis of OECD sovereigns,it concludes that countries with good ESGperformance tend to have less default risk andthuslowerbondspreads.Moreover,theeconomicimpactisstrongerinthelong-run,suggestingthatESG performance is a long-lasting phenomenon.The environmental dimension appears tohavenofinancialimpactwhereasgovernanceweighsmorethansocialfactors.

New industry research had been undertaken onsovereignbonds,muchofitfocusedonESGandcredit ratings.Allianz (2017b)findsevidence thatESGriskfactorsarenotfullyreflectedinsovereigncredit ratings. Bad governance is a key risk,followed by social risks. Tail risk may be bettermitigated through ESG factor integration intosovereignissuercreditanalysis.

Sustainalytics(2017a)revealsapositivecorrelationbetween countries’ ESG and credit rating agency(CRA)ratings,andtheirESGmomentumandGDPpercapitagrowth.BlendingCRAratingswithESGscoresandmomentummayhelpidentifycountriesthatareundervaluedorovervalued.

OtherindustryresearchfocusesonESGandcreditspreads.Lazard(2017)estimatestheportionoftheyield spread attributable to ESG considerations.A strong relationship between a country’s ESGstandardsanditscreditworthiness/costofborrowingisparticularlydiscernibleinemergingmarkets.

High institutional quality is widely seen as animportant factor for sovereign creditworthiness.

Research by international institutions providessome evidence. For example, using a data setof 90 countries, Qian (2012), shows that stronginstitutions are associated with fewer sovereigndefault crises. In addition, when institutions areweak,amorepolarizedgovernmenttendstodefaultmoreoften.

Several individual governance factors suchas corruption or transparency have also beenscrutinized in this context. For example, UnionInvestment (2014) considers corruption a keyindicatorofsovereigncreditstrengthinfundamentalevaluations because of the relationship betweenfraud,taxavoidance,financialmanagementandanissuer’sabilitytorepayitsdebtobligations.Therearestrongcorrelationsbetweencorruptionandthenumberofsovereigndefaults.ChoiandHashimoto(2017) show that data transparency policyreforms, reflected in subscriptions to the IMF’sData Standards Initiatives, reduce the spreads ofemergingmarketsovereignbonds.

Fixed Income FundsSome researchers looked at the performance ofESG/SRIfixed income fundsand fundmanagers.Forexample,Henke(2016)detectedthatduringtheperiod2001–2014,sociallyresponsiblebondfundsoutperformed by half a percent annually. This ismainlyduetotheexclusionofcorporatebondissuerswithpoorcorporatesocialresponsibilityactivities.Outperformanceisespeciallylikelytooccurduringrecessionsorbearmarketperiods.LeiteandCortez(2016)detectcyclicalpatterns:EuropeanSRIfundsprovidesomeprotectioninmarketdownturns,butotherwisetheverdictismixed.

HoepnerandNilsson(2017b)investigatedtheESGengagement activities of fixed income managers.Funds from fund management companies notinvolved in ESG engagement activities performsignificantly worse indicating the materiality ofESG expertise and ESG engagement in fixedincomeinvestments.


Figure 4: Main Research Findings

Source: Authors

ESG factors are material credit risk

Incorporating ESG factors does not mean having to sacrifice return

In summary, there has been a growing researcheffort to analyze the relevance of ESG factors infixedincome.Whilstthemethodologyforindividualstudies varies greatly and may be questioned,overall, the growing body of research supports amore widely held view that: 1) ESG factors canconstitutematerialcreditrisk,and2)incorporatingESG factors does not mean having to sacrificingreturn(Figure4).Therearesomeinterestingearlyresultsinthisprocessbutmuchmorewillneedtobedone.PRI(2017a)producedsome‘takeaways’atthisjuncture:

• Bothacademicandmarketresearchsupportsthenotion that there is a linkbetweenESG factorsandthecreditriskofaborrower;

• Mostacademicresearchisbasedoncreditratingstomeasure credit risk and very few papers usealternative measures (such as credit defaultswaps);

• Anecdotal observation of defaults, particularlyof investment-grade corporates, highlightthat governance has a clearer link to corporatefailures, while environmental and social issuesaremoredifficulttocapture;

• Academic research exploring the link betweenESGfactorsandsovereigncreditworthinessislesswell supported. Nevertheless, there is evidenceontheimpactofESGfactorsonmacroeconomicvariablesandpotentialgrowth.

Itisimportanttoqualifytheimportanceofresearchfindings to date, and their application in theinvestmentpractice:

• Most of the ESG research use past data. Pastresultsmaynotholdinfuture.Investmentpolicycannot solely rely on a “majority vote” of pastresearchresults.

• Difficulty in back testing some of the resultsgivenlimitedhistoricaldata.

• Research typically finds correlation, and notnecessarilycausality(DB2012);

• ThereisstilllittleunderstandingandconsistencyabouthowESG“factors”relatetotheestablishedfactors in asset pricing models, such as value/growth,size,liquidity;

• Thestructureofeconomiesandmarketschangesover time,andsodopolicies. Investorsneed tomakedecisionslookingforward;


• There may be (selection, data, size and other)biasesatwork.AsESGresearchmatures,itwillfacestrongerscrutiny;

• Research on ESG in fixed income is still verylimited;

• Mostofitisfocusedoncreditrisks.ThereisstilllittleanalysisoftherelationshipofESGfactorson market risks, inflation, liquidity, maturity,termstructuresandyieldcurves,incomestability,totalreturns,andotherrisks/opportunitiessuchasdefaultriskorrecoveryrates;

• Implementation costs (e.g. for transactions,management,reporting)needtobeconsidered;

• Investorsareadvisedtoapplytheirownadditionalresearchandinsights;

• Differentreportingstandardsresultsinalackofcomparabilitybetweenfindings.

Finally,someobserversfeelthat–whilecertainlyrelevant – financial performance has receivedtoo much attention in recent times compared toconceptual research and empirical evidence onextra-financialperformances(e.g.Capelle-BlancardandMonjon2012).Overall,itisstillearlydaysforresearchonfinancialperformance,andevenmoresofornon-financialperformance,ofESGinfixedincome.

MorerobustresearchisneededonthelinkbetweenESG and financial performance of fixed incomeinvestments. Further academic, as opposed toindustry studies are needed, looking at the linkbetween fixed income and ESG factors usingtransparent methodologies, over longer timeperiods, across a broader range of fixed incomeassetsandcountries.Consideringfactorsotherthancredit risk is required to provide a solid base ofevidenceasESGfixedincomeinvestingbecomesmoremainstream.


4. ESg iNvESTmENT TooLS for

fixEd iNComE

A number of tools have been created overtimetoassistinvestorsintheanalysisofESGrisksandopportunities.Here, too,fixedincomeis

lagging equities.21 Nonetheless, a number of ESG frameworkshavebeendevelopedinrecenttimesforbonds,inparticularESGscores22 andrankingsforcompanies,countriesandotherissuesaswellasESGfixedincome indices. First, an immediate question arising is, howESG relates to thetraditionalcreditratingsthatareacoreelementintraditionalfixedincomemanagement.

Credit Ratings and ESGAdiscussionisongoingontheextenttowhichESGfactorsarerelevantforcreditrisks,andinparticularcredit ratings. Some investors have asked for aclarification of the role of ESG factors in creditratings,ordemandanexplicit integrationofESGbycreditratingagencies(CRA)(PRI2017a).23

ESG incorporation

AllmajorratingagenciessaytheyalreadyincorporateESGconsiderationsintheirtraditionalanalysis(S&PGlobalRatings2017,Moody’s2017,FitchRatings2017).At the same time, they are deepening andwidening the researchofESG topics, in particularonclimatechangerisks.Theyalsowanttoimprovecommunicationonthesematters.

Materiality

“Fitch Ratings’ criteria and analysis incorporateenvironmental, social and governance (ESG) risk

factors, but only where they are relevant to theassessmentofcreditrisk.”(FitchRatings2017,p.1)“Ourobjectiveisnottocaptureallconsiderationsthatmaybe labelledgreen,sustainableorethical,but rather those that have a material impact oncreditquality.”(Moody’s2017,p.3)

Time horizon

The focus is not on an exact time frame but on“the most forward-looking view that visibilitypermits” (Moody’s 2017, p.3). S&Ps forecastsgenerallycoveratimehorizonofuptotwoyearsfor speculative-grade corporate entities (that is,those rated ‘BB+’ and below), and nomore thanfive years for investment-grade entities, but theycangolonger.Forexample,forEfactorsthataffectsovereignratings,thetimehorizonis5-10years.

Sectors

ESGthemesvarywidelyacrosssectors.AccordingtoMoody’s,forexample,14sectorshaveelevated

24 | 4. ESG INVESTMENT TOOLS FOR FIXED INCOME

credit exposure to carbon regulations. S&Pcounted106 cases in theperiod2015-2017whenenvironmentalandclimateriskswereakeyreasonfor a rating action, most notably in the energy,resourcesandvehicleindustries.

Sovereign issuers

For all CRAs, different sets of ESG factors arerelevantforcorporate,sovereignandotherissuers.Forsovereigns,S&PconsidersESGfactorsinthecontextoftheassessmentofinstitutionalqualityandgovernanceeffectiveness,butalsosocialcohesion,climate change and other key factors. Moody’snames 5 key ESG trends for sovereigns: countrycompetitiveness,governmenteffectiveness,controlof corruption, rule of law or physical climatechange.ForFitch,governanceindicatorshavethegreatestweightingforsovereignratings.

Overall, credit ratings can only partially accountfor long-term sustainability risks,mainly becauseof the focusonmateriality for credit riskand therelativelyshorttimehorizon.Othermethodologieshave been developed to compensate for thatlimitation,but falloutside thecredit ratingspace.SomeinvestorswouldliketheCRAtoextendtheirESGoutput,including:

• longertimehorizonsforratings;• separateE,SandGfactors;• moreextensiveESGdisclosures;• anESGratingalongsidethetraditionalcreditrating.

CRAshavestartedtodevelopseparateassessmentsspecifically for environmental and ESG risks.On example of a specialist “E” product for apopular financial instrument is Moody’s GreenBondsAssessment.24 In2016,S&PpublishedtwoproposalsforapotentialnewESGevaluationtoolaswellasforagreenbondscoringframework,bothseparatefromtraditionalcreditratings.

ESG Scores/RankingsGenerally speaking, an ESG score is measure ofenvironmental, social, and governance factors.

Each ESG category has numerous underlyingfactors that are analyzed and ranked, and thencombinedinanaggregateESGscoreforasector,regionandanoverallportfolioscore.ThescoringmethodsandweightingsfortheE,theSandtheG,andtheunderlyingfactorsmayvaryacrosssectorsandcountries.

The most common ESG scores are at the microlevel and provide somemeasure of a company’sESG performance. There are also country-levelESG scores that complement traditional methodsof assessing a country’s long-term economicprospects, creditworthiness as well as potentialreputationalrisks.

There are external, commercial providers of ESGscores.Althoughthemethodologiesarequantitative,the assessments are inherently qualitative. Someinvestorsthereforealsosetupin-house,proprietaryESG scoring systems, overlaying externalinformationwith their own analysis.According toRussell(2017),52%oftherespondentfixedincomemanagersutilize third-partyvendorsexclusively toobtain ESG scores. 35% utilize external vendorswith an in-house ESG analysis overlay. 15% onlyuseinternalanalysis.ThetwomarketleadersinfixedincomearecurrentlySustainalyticsandMSCI,withinvestors and product providers overwhelminglyrelyingonthesesources.

Sustainalytics

Sustainalytics’ ESG scores give individual pointsforcompanies’E,SandGelements (0-100).Theoverall ESG score provides an absolute measureof a company’s ESG performance as well as itsrelative position within an industry. The set ofissues and specific weights vary by industry; atleast 70 indicators in each industry are covered(Sustainalytics2017b).

Forsovereignbondinvestors,thereisalsoacountryESGscorethatisbasedon36third-partyindicatorsthatshouldcomplementtraditionalmacroanalyses.ItresultsincountryscoresforE,SandGseparately,andanoverallESGscore(0-100).Finally, there is


a country ESG rating ranging fromA to E that isallocatedonsetstandarddeviationsfromtheaverage.

MSCI

MSCIESGRatings identify10ESGthemeswith37keyESGissueswherecompaniescanfacelargeenvironmental or social externalities. Corporategovernanceisassessedforallcompanies,whereasthe rating model determines the most financiallysignificant environmental and social issues foreachsub-industry(Table3).Itrankscompanieson

a7-point‘AAA’to‘CCC’scaleaccordingtotheirexposure to industry-specificESG risks and theirability tomanage those risks relative to peers.AdetaileddescriptionisgiveninMSCI(2017a).

The MSCI ESG Government Ratings assessesgovernment and certain government-relatedissuers.Countriesareratedona7-point‘AAA’to‘CCC’scaleandreflecthowcountries’exposureto,andmanagement of, ESG risk factorsmay affectthelong-termsustainabilityoftheireconomies.TheESGfactorsforgovernmentbondsincludepolitical

Table 3: MSCI ESG Key Issues for Companies27

3 Pillars 10 Themes 37 Key IssuesEnvironment Climate Change • Carbon Emissions

• Product Carbon Footprint• Financing Environmental Impact

• Climate Change Vulnerability

Natural Capital • Water Stress• Biodiversity & Land Use

• Raw Material Sourcing

Pollution & Waste • Toxic Emissions & Waste• Packaging Material & Waste

• Electronic Waste

Environmental Opportunities

• Opp’s in Clean Tech• Opp’s in Green Building

• Opp’s in Renewable Energy

Social Human Capital • Labor Management• Health & Safety

• Human Capital Development

• Supply Chain Labor Standards

Product Liability • Product Safety & Quality• Chemical Safety• Financial Product Safety

• Privacy & Data Security• Responsible Investment• Health & Demographic Risk

Stakeholder Opposition • Controversial SourcingSocial Opportunities • Access to Communications

• Access to Finance• Access to Health Care• Opp’s in Nutrition & Health

Governance Corporate Governance* • Board*• Pay*

• Ownership*• Accounting*

Corporate Behavior • Business Ethics• Anti-Competitive Practices• Tax Transparency

• Corruption & Instability• Financial System Instability

Source: MSCI (2017a)* Corporate Governance carries weight in the ESG Rating model for all companies. Other Key Issues are assessed on an industry-specific basis.


risks, human rights and environmental issues.Asa practical example, Swiss Re (2017) applies aconceptofminimumESGratingstandardsintheirassetliabilitymanagement(ALM)approach.

Other providers

There are several more specialist services on themarket of company ESG scores of some sort,includingRepRisk,ISS-Ethix,Bloomberg,ThomsonReuters/Eikon.25VeriskMaplecroft,VigeoEirisandOekom Research also offer a sustainability ratingalso for countries. Beyond Ratings and severalFrenchbankshaveannouncedplansforafirstcreditratings agency to systematically integrate ESGfactors into financial ratings and provide investorswithan“augmentedassessmentofcreditworthiness”in2018. Inpractice, investorsoftenusemore thanoneexternalproviderofESGscores.

Sustainability rating for funds

ESG ratings for funds have been introducedby a number of companies, including MSCI,Barron’s and Corporate Knights. One example,theMorningstarSustainabilityRatingisameasureof how well the companies held by a fund aremanaging their ESG risks and opportunitieswhen compared with similar funds. It is basedon company-level ESG data from Sustainalytics.Scores are aggregated to a portfolio ESG scoreusing an asset-weighted average of all coveredsecurities (equity and fixed-income). Funds aresorted into five normally distributed groups (1-5stars).

However,criticismhasbeenleviedthattheanalysisbehind the ratings does not fully reflect the trueESGlevelofintegrationorimpactofthefunds.Forexample,norecognitionisgiventoinvestorseffortson shareholder engagement and public advocacy.Furthermore, there is no considerationof the realimpactandmanagerswithspecificimpact-focusedmandates–includingthoseoperatinginemergingmarketsordevelopingcountries–canbepenalized(e.g.,Krosinsky2018).26

Country ScoresIn addition, several fund managers and assetowners have developed their own ESG scoringsystems,orvariationsusing rawdata fromMSCIor Sustainalytics in a different way, especially atcompany level.Herearesomeexamples forESGcountryscores.Developedcountriestypicallyfarebetterthanemerging,frontiermarkets-especiallywhenlookingat‘levels’ratherthan‘changes’.Thisraises serious questions on ESG analysis in thesovereignspace.

RobecoSAM

RobecoSAM’s is one of the more transparentcountrysustainabilityframeworks.Itevaluates65countries(22developedand43emergingmarkets).Standardizedscoresandindicatorweightsresultinacountrysustainabilityscorerangingfrom1to10(RobecoSAM,2015).The framework isbasedon17environmental,socialandgovernanceindicators(each of which is based on various data series,or sub-indicators). They are grouped in the threeE,S,&Gdimensions,whichreceiveaweightof15%,25%and60%ofthetotalscore,respectively(Figure 5 and Appendix 4). The selection andweightings of the indicators was primarily basedon their financial relevance for the assessment ofsovereignbondmarkets.ThelistiscurrentlybeingledbyfourNordicstates,Switzerland,CanadaandAustralia.

DZ Bank

DZ Bank developed a sustainability rating forcountriesthatcombinesanESGmethodology(withraw data from Sustainalytics) with an economicsustainability dimension, i.e. a four-dimensionalEESGanalysismodel.TheweightingofEfactorsis 20%, S 30%, G 30% and economic factors30%. Countries are grouped into “sustainable”,“transformation states” and “unsustainable”. Thecurrent list is being led by Nordic and middleEuropeanstates(DZBank2015).


Candriam

Candriam’sESGcountryanalysisisbasedonfour‘capital ‘domains to cover all theUnitedNationsSDGs: Human Capital, Natural Capital, SocialCapitalandEconomicCapital.Thesefourequallyweightedfactorshaveanumberofsub-factors.Theoverall ESG score includes components for boththelevelandtrend.

TheCandriamESGCountryreport(2017)analyzed123 countries (35 advanced and 88 emergingeconomies). 74 countries were categorized asinvestible and 49 as non- investible. Of the 35advanced economies analyzed, only Greece wasconsidered non-investable. Of the 88 emergingeconomies (which have a lower inclusionthreshold),40wereclassifiedasinvestableand48non-investable.

Similar approaches have been developed byother investment houses, including BY Mellon/Standish(2016),amongothers.GlobalEvolution,NeubergerBerman(2013)andLazard (2017)areexamplesofESGscoringmodelsthatconcentrateonemergingmarkets.

SDG scores

The Bertelsmann Stiftung and the SustainableDevelopmentSolutionsNetwork(SDSN)developedan SDG Index. Its scores signify a country’sposition between the worst (0) and best (100)outcomes.The2017 index is ledby10Europeancountries, followedbyJapan(Bertelsmann2017).No application of SDG scores to fixed income isknowntodate.

ESG Fixed Income IndicesInvestment managers usually organize theirinvestmentsaroundestablishedinvestmentindices.Theyaretypicallyusedasperformancebenchmarksin active investing and for replication in passiveinvesting.Many fixed income indices are offeredby global or local index providers, and they alldifferinseveralrespects.SomeinvestorsliketouseindicesthatincorporateESGriskandexposuresinsomeform.

However, unlike equities, not many ESG indicesarecurrentlyavailable forfixed income.ThiscanpartlybeexplainedbythefactthatESGintegrationisnewerinthefixedincomefieldthaninequities

Figure 5: RobecosSAM ESG Weightings27

Source: RobecosSAM

G60%

S25%

E15%

ESG Weights in the CSR, from Environmental Factors to Social Unrest and Aging Populations

Environmental StatusEnergyEnvironmental RiskSocial IndicatorsHuman DevelopmentSocial UnrestLiberty & InequalityCompetitivenessPolitical RiskAgingInstitutionsSix Other Factors

10%2.5%2.5%10%10%5%

10%10%10%10%5%

15%


(whichwas initiallydrivenby shareholdervotingand stewardship). In addition, more data isavailable on public companies than other debtissuers, particularly non-corporate entities. Asnoted,theindexcompilersarealsotheprovidersofESGdata,whichclientsthenusetobuildtheirownmethodologies.Finally,theremayalsobe‘cultural’reasons, especially the fixation on traditionalquantitativeanalysisinfixedincome.

Barclays MSCI

In 2013, Barclays and MSCI (now BloombergBarclays MSCI) co-produced a new family ofrules-basedfixedincomebenchmarkindices.TheyreflectthreedifferentESGincorporationstrategies(MSCI2017b)(Appendix45formoredetail):

• Socially Responsible Investment (SRI) indicesnegatively screen out issuers from existingBarclays indices that may be involved inbusinesslinesoractivitiesthatareinconflictwithinvestmentpolicies,values,orsocialnorms(e.g.controversialweapons).Theycanbecustomizedfurther for exclusion of specific issues (e.g.Catholicvalues)(Table4)

• Sustainabilityindicesusesector-specificpositiveESGscreenstoadjustweightsinthedirectionof“best-in-class” peers. Issuers must have MSCIESGratingsofBBBorhigher.

• ESG-weighted indices use MSCI ESG ratingslevels and momentum to adjust or tilt indexweightswithinanexistingBarclaysfixedincome

index. This allocation rule is meant to rewardissuers that exhibit stronger ESG fundamentals,aswellasthosethataredemonstratingimprovingfundamentals.

These indexes are available for corporate andaggregate (corporate plus sovereign) but –interestingly - not for sovereign only benchmarkindexes.Therearesub-indexesfordifferentregions,maturities,currency-hedged,etc.

S&P Dow Jones

• The S&P ESG Sovereign Bond Index family,startedin2015,isbasedonstandardcap-weightedsovereign bond indices but tilts the countryweights towards more sustainable countries,based on RobecoSAM’s Country SustainabilityRanking(S&PDowJonesIndexes2017).

• Incorporating long-term sustainability as adimension of credit analysis aims to serve asan additional, risk-reducing tool, especiallygiventhatcap-weightedbondindicesarehighlyexposed to highly indebted and therefore riskycountries.Currently,thereisonlyonesuchindexavailable:TheS&PESGPan-EuropeDevelopedSovereignBondIndex.

Other providers

• Several other index providers are currentlyworkingonESGfixedincomeindices(e.g.FTSE

Table 4: Categories Available for Bespoke ScreeningAbortion & contraceptives Defense & weapons Nuclear power

Adult Entertainment Gambling Pork

Alcohol Genetic engineering Predatory lending

Animal welfare Global norms Religious values

Board diversity Global sactions Stem cell

Child labor Human rights TobaccoSource: MSCI (2017b)


expectedtolaunchin2018/19,UBSareworkingonsettingupsustainableindicesformultilateraldevelopmentbankbonds).

Green bond indices

• Since 2014, various providers created indices toexclusivelycovergreenbonds.Eligibilitycriteriaforinclusion,methodologiesandcoveragediffer.Someexamples:

• BankofAmericaMerrillLynchGreenBondIndex;• BarclaysMSCIGreenBondIndex;• S&PGreen Bond Index andGreen Project BondIndex;

• SolactiveGreenBondIndex;• ChinaBondChinaGreenBondIndex.

Low carbon indices

• Low carbon or carbon-efficient indices havebeen on the market for equities for some timebutare lesscommonforbonds. In2016,anewSolactiveSPGEuroIGLowCarbonBondIndexwas launched. The index covers investmentgrade corporate bonds of companies that arelessdependenton fossil fuels relative tohighercarbon-emittingpeers.


5. how iS ESg BEiNg imPLEmENTEd

By fixEd iNComE iNvESTorS?

ESG investing is being implemented invery differentways by investmentmanagersand asset owners.Different typesof investorswill

naturally have different approaches, according to their size(smaller institutions will be able to do less in-house), regulatoryframework (which can impose greater restrictions according to financialsector,geographiclocationetc.),natureofbusiness(someinstitutionsaredrivenmorebyALMconsiderationsthanalphareturns)etc.

Asa stylizeddescription, it can takeplaceatanyof these levels of investment operation, or anycombination:policy,investmentprocess,products,underlying assets (e.g. companies), marketing/publicrelationsandreporting.

ESG investing infixed income is developing fastthese days.As a snapshot, a survey of 109 fixedincomemanagersbyRussell(2017)foundthat68%ofmanagershaveintegratedESGsomehowintotheinvestmentprocess.However,thismeansdifferentthings to different people, and there are questionmarksovertherealimplementationsofar.

WhichESGstrategiesaremostcommonlyappliedby investors? For fixed income, a survey by PRI(2017a) finds integration ahead of screening andthematicinvesting.Only6%ofmanagers(byassets)use all three approaches (Table 5). Furthermore,corporatebondsarebettercoveredthansovereignbondsbyESGanalysis,whilesecuritizedassetsarefarbehindinthisrespect.

Table 5: ESG Strategies in Fixed Income (by Volume of Assets)

Combined FI Approaches in US$TRN

Screening alone $2.3

Thematic alone $0.1

Integration alone $9.6

Screening + integration strategies $5.8

Thematic + integration strategies $0.1

Screening + thematic strategies $0.4

All three strategies combined $1.4

No incorporation strategies applied $2.3

Grand total (actively managed) $21.9Source: PRI (2017a)

32 | 5. HOW IS ESG BEING IMPLEMENTED BY FIXED INCOME INVESTORS?

Forsomeinvestors,ESGinvestingislimitedtotheuse of ESG products (such as green bonds or anSRIfund).Otherinvestorshavedecidedtofollowpassively an ESG index for some asset classes.Many asset owners are going down the route ofselecting active ESG managers or developingactive ESG in-house strategies for certain assetclasses.Finally,thereisa‘holistic’approachwithfull integration across all asset classes and riskmanagement (Figure 6). Here, the focus is onspecificapplicationsforfixedincome.

How thesedifferent approaches toESG investingare being applied by different categories of assetowners and other investors is a topic whichdeservesfurtherresearch.Likewise,thesuccessofthedifferentapproachesandtoolsisatopicwhichthisoverviewpaperhasnotbeenabletodelveinto,butalsowouldbeworthyoffurtherstudy.

Green, Social, Sustainable and Other Thematic BondsThematicbondsor labelledbondsarebondswithproceeds earmarked to specific themes, sectors

or projects. In the ESG context, by far the mostpopular are “green bonds” and “climate bonds”,but thematic “social bonds” and “SDG bonds”have also been developing in recent years. Fundmanagers also offer thematic green or socialbond fund vehicles (e.g. the IFC/Amundi PlanetEmergingGreenOnegreenbondfundforemergingmarkets, Threadneedle’s UK Social Bond Fund,AIM/LombardOdierGlobalClimateBondFund).

AlthoughgrowinginimportanceandrecognizedasacatalystfortheintegrationofESGintofixedincomeportfolios,thelabelledbondmarketisstilltiny–lessthan0.1%ofthetotalglobalbondmarket.

Green bonds

Green Bonds are defined as fixed-incomesecurities that raise capital to support projects oractivities with specific climate or environmentalsustainability purposes. Multilateral institutionslike the European Investment Bank (EIB) andWorld Bank led the issuance in the green bondmarket.Greenmunicipal,stateandcorporategreenbonds followed, and high yield green bonds arestartingtodevelop.

Figure 6: Level of ESG Integration

Source: Authors

Labeled Bonds

ESG ‘Holistic’(in-houseintegration

across all asset classes)

ESG‘Passive’(via index)

ESG ‘Active’(mandate

with specialistmanager)


There are four types of green bonds: standardrecourse-to-the-issuer debt obligation, non-recourse-to-the-issuerdebtobligation,greenprojectbond and green securitized bond (covered,ABS,MBSetc.).Proceedsaremostcommonlyallocatedtorenewableenergyprojects,suchaswindfarms,orcleanerformsofpublictransport.

The labelled green bondmarket has taken off inrecentyears(Figure7).In2017,over$160billionwas issued, with over U$200 billion in greenbonds already issued between 2007 and 2016(WorldBank).Afurther$700bnoutstandingwereunlabelled climate-aligned bonds.28 The WorldBankTreasuryalonehasissuedUSD$10.2billionin 138 green bonds in 18 currencies.Despite therecent growth rates, green bonds only constituteasmallfractionoftheoverallglobalbondmarketvolumeof$90trillion,i.e.about½%.

Thereisanongoingdiscussionaboutthedefinitionof green bonds, and the setting of standards tofacilitate credibility and transactions (Ehlersand Packer 2017). The voluntary “Green BondPrinciples” (ICMA 2017a) are widely used.29

The “Climate Bonds Standard and CertificationScheme”providessector-specificeligibilitycriteriaforassetsandprojectsthatcanbeusedforclimatebonds and green bonds (CBI 2016). Green bondassessmentsareundertakenbycompaniessuchasSustainalytics, VigeoEiris and Oekom Research,Moodys, Cicero and Trucost (now part of S&PDowJonesIndexes).

As the popularity and interest in the green bondmarket rises, issuers are increasingly stretchingtheboundaryofwhatqualifiesasagreenorsocialinvestment. There is also an on-going debate onwhether ‘green’ projects from corporations withbroaderinvestmentobjectivesshouldqualify–someviewing this as a positive sign of change withincompanies, others concerned that ‘green washing’couldreducethecredibilityofthemarketasawhole.Secondopinionson issuance,andstringent signalsfrommarketplayerswillincreasinglybenecessary.Investors tend to hold green bonds over longperiods,whichraisesthequestionofverificationof“greenness”overtime–atacost.

Issuanceisalsospreadingacrossabroaderrangeofcountries(figure8).

Figure 7: Labelled Green Bond Market Volume by Type of Issuer

Source: Bloomberg and World Bank (as of December 31, 2017)

Annual Green Bond Issuance By Issuer Type

2012 2017201620152014201320112010200920082007

6080

100

160140120

02040

180

Energy / Utility Companies

Multilateral Development Banks (MDB)

Agency/State/Munis/Other Government

Corporates/Banks

US$ E

quiva

lent in

Billi

ons


Thereisalsoanon-goingdiscussiononthepricingofgreenbonds.Thequestioniswhethergreenbondsdo and/ or should price the same as non-directeduseofassetbondsissuesbythesamecompany,orwhetherthereisa‘greenium’(i.e.greenbondshaveahigherprice/loweryieldthannon-useofproceedcounterparts.Greenbondsrankpari passu(onequalfooting)withbondsofthesamerankfromthesameissuerandthereisnormallynocreditenhancement.ClimateBondsInitiativeandInternationalFinanceCorporation (IFC) with support from Rabobank,Pax and Obvion conducted a detailed analysis ofgreenbondissuancefortheperiodJanuary2016toMarch2017comparing ‘vanilla’andgreenbonds,lookingforanydifferencesinpricingperformance(CBI/IFC2017).Someindicatorshaveshownsomedifferences(e.g.somegreenbondsdopricetighterthantheInitialPriceTalkwhencomparedtosomecorporate vanilla bonds), but generally pricing isverysimilar.

Atthisstageconcreteevidencetoshoworsupportthat green bonds perform differently or betterthan other categories of bonds is non-conclusive.This could be attributed to themarket still beingimmatureandrelativelysmalltoprovideadefiniteposition on thematter (secondarymarket tradingis very thin).However, the idea of a “greenium”

maynotbefarfetchedwhenoneconsidersthecostissuersmustputintostructurethesebonds,monitorandundertakeperiodicreportingduringthetenureof thebond.On theotherhand, investors too arefacingongoingmonitoringcostsandlowliquidity.

Social bonds

Bondslabelledas‘socialbonds’arethematicbondsthatmirrortheideaofgreenbonds.Theyarebondinstrumentswhere the proceeds are earmarked tosupportnewand/orexistingsocialprojects(ICMA2017b, IFC 2017). Criteria for their qualificationrelate to both financial and social aspects. Socialthemed bonds are used to fund social housing,educationfacilities,healthcareandotherprojectsthat are either public sector or public–privatepartnerships.ICMAalsocoordinatetheSocialBondPrinciplesandtheSustainabilityBondGuidelines.Thismarketisstillnascent.

Social impact bonds

TherearealsootherfinancingdevelopmentssuchasSocial ImpactBonds (SIB),as launched in theUK,USA,Netherlands,Japanandothercountries(OECD2015).SIBsarenotbondsinthetraditionalsenseanddonotofferafixedrateofreturn.Asocial

Figure 8: Labelled Green Bond Market Volume by Country

Source: Bloomberg and World Bank (as of December 31, 2017)

51015

30

2520

0

35

Mexico OtherSpainSwedenGermanyUSNetherlandsSSAFranceChina

2017 Green Bond Issuance by Issuer Country of Origin

US$ E

quiva

lent in

Billi

ons


impactbondisa“payforsuccess”instrument,i.e.a contract between a special purpose vehicle andthegovernmentthatcommitstopayforimprovedsocial outcomes (and that also result in publicsector savings), such as reduced recidivism ratesforprisoners.

A number of foundations, charitable trusts andpension funds have taken an interest in SIBs,alongside venture capitalists and other investors.Therearecurrentlynearly100SIBsin19countries,mobilizing more than £300m of investment intotackling complex social issues such as refugeeemploymentsupport,lonelinessamongtheelderly,rehousing and reskilling homeless youth, anddiabetesprevention.ThepotentialsocialbenefitsofSIBsareconsiderable,butthetransactioncostsarehigh,andtherearechallengesinfindingstructureswith incentives that are properly aligned,makingrapidgrowthinissuanceofSIBsunlikely.

Sustainable and SDG bonds

Sustainablebondsincludeawiderrangeofgreen,social, environmental, development impact,microfinancebonds and loans, charitybonds andotherdebtinstruments(EuropeanImpactInvesting2016).TheWorldBank,forexample,communicatesthateveryprojectitfinancesisdesignedtoachievespecific social and/or environmental impacts,definedbyindicatorsandrespectiveresultsthatarepublishedandupdatedtwiceannuallyontheWorldBank website. All projects that are financed byWorldBankbondsmustfitwiththeorganization’sgoals to end extreme poverty and boost sharedprosperity, also naturally aligning such projectobjectiveswiththeSDGs.From2018on,allWorldBank (IBRD) bond documentation will includespecific‘UseofProceeds’languagetoexplainhowbond proceeds support sustainable developmentprojectsandprograms.

Inadditiontotheirgeneralissuance,theWorldBankand IFC continue to be amajor issuer of labelledand themedbonds.For example, in2017, thefirstSDGequity-linkedbondswere launchedissuedbytheWorldBankworkingwithBNPParibas.30HSBC

has also issued bonds connecting the issuance toSDGs.31 In2018, theWBGalso issuedsustainabledevelopmentbondstoraiseawarenessforwomen’s’andgirls’empowerment.Catastropheriskbondscanalso be seen as sustainable investment products.32 TheWBGisleadingwithotherinnovativefinancialproducts, such as the Pandemic EmergencyFinancing Facility, as well as products supportinghumancapitalinvestmentsanduniversalhealthcare.

The World Bank and IFC, amongst others, arecontributing to the work on further refining theGreen Bond Principles. Guidance is also beingdevelopedonsocialandsustainablebondsincludingastheyrelatetotheSDGs.

Passive InvestingPassivefixedincomefundsplayanincreasinglykeyroleininstitutionalportfolios.ESGhashistoricallybeen first associated with active investing, e.g.withnorm-basedexclusionsoranactiveselectionofthebestESG-compatiblestocks.Morerecently,however, the attention on ESG considerations inpassiveinvestinghasbeenrisingfast.

Pressure on large passive investment managers(such as Vanguard, BlackRock and State Street)hasbeenrisingtoincreasetheirstewardshipefforts,especiallybyusingtheirmanyvotesinshareholdermeetings and ongoing engagement with investeecompanies.33 Passive asset owners can use activeownership and engagement tomanage their ESGrisks.However,theyneedapolicyandsystemstoensure that different investmentmanagers do nottake opposing positions while exercising activeownershiponbehalfofthesameassetowner.

ESGinpassivefixedincomefundshas,sofar,beenrelatively little explored and used by investors.Fixed income indices can assist the developmentof low cost ESG strategies, e.g. screening via anexclusionary index or via an ESG tilted passiveportfolio.Investorsarecurrentlyconstrainedbythelackofchoiceinthisfield,astheymayhavedifferentideasaboutESGfactorsandmethodologies.


Exchangetradedfunds(ETF)aretypicallylaunchedbasedonpopularindices.TheuseofETFs(butalsomutual funds) is also rising in this space.MSCI(2018)foundatleastadozen“self-labelled”ESGFixedIncomeETFsattheendof2017.

Index customization / ‘Smart beta’

Indexes can often be customized to reflect thespecific needs or preferences of investors better.Investorscan,alternatively,deviatefromestablishedindices by using an internal “passive plus ESGoverlay” approach. An immediate concern inrelation to the increasing index customization inthisfieldisthelackofcomparabilityofstrategies,and performance by asset managers. Higher feesmayalsocomewithit.

“Smart beta” or “alternative beta” investing isa variation of passive, using an index that is notweighted by market capitalization-weighted butbyotherriskfactors,minimumvolatilityorequalweights.TherearesomeESGsmartbetaproductsinequitybutnot(yet)infixedincome.

Active InvestingESG funds of all sorts have been mushroomingin theassetmanagement industry in recentyears.Activefundproductsarealsogrowinginthefixedincome space (e.g. Pimco’s ESG Global BondFund; BlueBay or M&G ESG global high-yieldbondfunds).SpecialistESGassetmanagers,suchasAIM(AffirmativeInvestmentManagement)andTrillium,arealsogrowing.

Activemanagersuseavarietyoftoolstodeveloptheir ESG approach, all based on some form ofESG scoring (see earlier section). Asset ownerscan buy these products “off the shelf” but manyalso define bespoke ESG investment mandatesforactiveinvestmentmanagers.Thesecanextendtoall approachesofESG investing, ranging fromindividual exclusions tobest-in-class.Asummaryofguidesonhowtogivemandate/appointexternalassetmanagersisprovidedbythePRI(2013).

ESG ‘Holistic’Asset owners, especially larger ones, applymorecomprehensive sustainability strategies. Theintention is a full integration of ESG across allstepsintheinvestmentprocessandallassetclasses.Differentin-houseintegrationtechniquesarebeingappliedbydifferentinvestors.

Fromanorganizationalperspective,ESG isoftenthe job of a few “specialists”. Some investors,however,gearup thewholeorganization toESG.Foremost, a ‘full’ ESG approach requires a clearstrategicplan,includingatalllevelsofgovernance,starting with the Board. In practice, variousapproacheshaveemerged:

• SeparateteamofESGspecialists;• IntegrationofESGexpertiseinanalyst,portfolioandriskmanagementteams;

• ConfiningESGreportingresourcesinmarketing/PR/middleorbackoffices.

Looking at insurance companies, Swiss Re hasrecently implemented an ESG framework acrossasset classes for universe definition, performancemeasurement and portfolio monitoring, andswitched to ESG benchmarks for both equitiesandfixedincome(SwissRe2017).Examplesofacomprehensive(anddifferent)ESGstrategyinthepensionfundenvironmentarePGGMandEAPF.

PGGM

Anexampleofsuchanimplementationframeworkis the three-pillar approach by the asset managerPGGM,whichmanagesfundsonbehalfofthelargestpension funds in the Netherlands (Figure 9). Theframework uses six instruments (exclusions, ESGIntegration, engagement, voting, legal proceedingsandinvestinginsolutions,includinggreenbonds).

PGGM starts with a negative screening policywith investments in areas such as tobacco, typesofweapons etc. excluded from all portfolios. Inaddition,threesustainabilitygoalsareembeddedinthe2020StrategicPolicy.


• Reduce carbon footprint by half:startingwithlisted equity, using a largely passive approach(Trucost data, ranking companies by carbonintensitywithinsectors,divestingfromcompanieswiththehighestemissionsperdollarrevenueincarbon intensive sectors). The organization hasthe ambition of rolling out same the approachtofixedincomeandprivateassets–butfindingconsistentdatasourcesisstillachallenge.

• Quadruple volume of positive impact investments: this involves a separate portfoliotargeting4 investment themes– climate,water,food security and health – with the target ofinvesting EUR 20 billion in these areas by2020. Green bonds as well as direct (private)investmentsareincludedinthisportfolio.

• Further integrate ESG into the whole investment process: through due diligence,selectionandscreening,withtoolsnowusedbyallinvestmentstaff(notjustaseparateSRIteam).Forlistedinstruments,apassive+positivescreeningapproachisused(bestinclassESGoverweightedvs. index using Sustainalytics andMSCI data).For private instruments, the approach is moreactive (duediligencequestionnaires areused to

assessprivateequity(PE)generalpartners’(GPs)integrationofESGintotheirprocess;renovationand energy efficiency improvement of directreal estate investments). ESG country rankingsare used for EM sovereign bonds holdings.Engagementisalsostartingtobeusedasatoolonthefixedincomeside.

Environment Agency Pension Fund (EAPF)

TheUKpension schemeEAPF aims to integratemanagement of ESG issues throughout theinvestmentandfundingstrategy.Thisincludesassetallocation,mandatedesign,riskmanagement,fundmanagerappointmentandmonitoring,collaborativeengagement and reporting. Thinking about theseissuesatastrategicleveliscritical(EAPF2017a).

Thisincludesespeciallyareassuchasengagement,voting,environmentalfootprinting,carbontargetsandmetrics,andondedicatedgreen,socialandothersustainableinvestments(Box4).Morespecificallyon fixed income, EAPF introduced carbon footprinting for itscorporatebondportfolios in2012,followedbygreenbonds,anda‘Buy&Maintain’bondmandate(withafocusparticularlyonclimateriskandcorporategovernance).(EAPF2017b)

Figure 9: PGGM ESG Approach

Source: PGGM (2017)

AsiaYESCHANGENOWhat We Want to Improve What We Want to StimulateWhat We Do Not Want

PGGM’s Instruments for Responsible Investment

Making companies and markets more sustainable through ESG integration, active ownership and collaboration with financial service providers

Instruments:� ESG integration (including ESG Index)� Engagement� Voting� Legal proceedings

Creating social returns in the ares of:� Climate and environment� Water� Health� Food

Instrument:� Investing in solutions

Direct exclusions� Controversial weapons� Tobacco

Exclusions after engagement on:� Human rights and social circumstances� Environment� Corporate governance

Instrument:� Exclusions


Box 4: EAPF’s Sustainable Investment and Carbon TargetsSocial and sustainable investment

Socialinvestmentcanbedefinedtoincludeawidespectrumofinvestmentopportunities.TheEAPFdefinition of social investment is an investment that addresses societal challenges but generatescompetitivefinancialreturns.Societalchallengesincludeallissuescommonlyregardedundersocial,environmentalorgovernanceheadings.

Awidedefinitionofsustainableinvestmentsincludes:

• Social investments and those with significant revenues (in excess of 20%) involved in energyefficiency,alternativeenergy,waterandwastetreatment,publictransport;

• Property,infrastructure,agricultureorforestryinvestmentswithalowcarbonorstrongsustainabilitycriteria;and

• Companies(oftenequitiesandbonds)withprogressiveenvironmental,socialorgovernancepracticesthatmayenhanceinvestorvalue.

TheFundhassetitselfthetargettohaveover25%oftheFundinvested,acrossallassetclasses,insuchopportunities.

Carbon targets

Inourpolicywesetourselvesthreegoalsfor2020toinvest,decarbonizeandengageandwearemakinggoodprogressonallthree.(EAPF2017a)

Climate Goals Progress

Invest 15% of the Fund in low carbon, energy efficient and other climate mitigation opportunities.

10% invested with current commitments bringing it to 12.5%.

Decarbonise the equity portfolio, reducing our exposure to ‘future emissions’ by 90% for coal and 50% for oil and gas by 2020 compared to the exposure in our underlying benchmark as at 31 March 2015.

Coal is currently 65% less than our baseline.Oil and gas is currently 79% less than our baseline.

Supported progress towards an orderly transition to a low carbon economy through actively working with asset owners, fund managers, companies, academia, policy makers and others in the investment industry.

Active engagement across the industry with a strong focus on working collaboratively. More information on our website.


6. mAiN TrENdS ANd ChALLENgES

State of the Art

ThemaintrendsforESGinfixedincomeinvestingcanbesummedupthisway:

• ThereareanumberoffundamentaldifferencesforESGinfixedincome,inparticulartherelevanceofsovereignissuers,andthefocusondownsidecapitalrisks.

• More academic and industry research on fixedincome-relatedESGissueshasbeenundertakenoverthelastfewyears–thisislikelytocontinue.Overall, it is still early days for research onfinancial performance, and even more on non-financialperformance,ofESGinfixedincome.

• It is now more widely accepted that ESGfactors can constitute material credit risk, andincorporating ESG factors in the investmentprocessdoesnotmeansacrificingreturn.

• MoreinvestorsaretryingtounderstandthelinkbetweenESGissuesandtraditionalcreditratings,aswellasESGandcreditspreads.

• New “motivators” since 2015 include climatechange, the UN SDGs and a changing attitudeof some regulators (e.g. reporting, disclosure)towards“sustainability”.

• ESGinvestingisgrowingfast,andisbecomingpart ofmainstream investing formany pensionfunds, insurance companies, sovereign wealthfundsandotherassetowners.

• ESGforfixed income iscatching up with equity –other/alternative asset classes arefollowing,too.

• Fixed income-specific ESG investment toolssuchasESGscores/rankingsforcompaniesandcountries are being developedmore intensively–bothbycommercialprovidersandinsideassetmanagementorganizations.

• Workinthesovereignspaceislaggingcorporatemarkets. Other areas of fixed income, such asprivate debt, covered bonds or asset backedsecurities,havelittlecoverage,sofar.

• Implementation strategies for ESG in fixedincome varywidely.They range from thematicinvestments (mostly green bonds), passiveESG investing, active ESG mandates or in-house strategies, to full integration into fixedincome portfolios –with investors also using acombinationoftheseapproaches.

• ESG indices are being used for both passiveand active strategies, and they use mostlyexclusionary screens or ESG-tilted weightings.However, investorsarecurrentlyconstrainedbythelackofchoiceinthisfield–moreindicesareindevelopment.

40 | 6. MAIN TRENDS AND CHALLENGES

• Some advanced investors have developed,or are developing, a ‘holistic’ ESG approachacross all asset classes, the entire investment/risk management process, and the whole assetmanagementorganization.

• Focusonenvironmental and socialoutcomes isincreasing(e.g.carbonemissions,socialimpact).More investors are seeking new territories in“impact investing” or sustainable investmentstrategiesalsowithfixedincomeinstruments.

• Investors,especiallyindexinvestors,arecomingunder more scrutiny (also in fixed income) fortheir ESG efforts, especially corporate (non)engagement),aswellastheirenvironmentalandsocialimpact.

• InvestorsareusingtheSDGsframeworktofocustheirinvestmentsforpurposethatisalignedwiththeSDGs.

Customization and standardization

WhatisbecomingclearasESGintegrationemergesand becomes more widespread practice is thebalancewhichinstitutionalinvestorsarehavingtostrikebetween‘standardizationandcustomization’.Manyinvestorsareincreasinglylookingtodevelopbespokestrategies to reflect theirownphilosophyandinvestmentgoals.Themanydifferentconceptsallow for a customization of ESG investmentstrategies, indices and portfolios. However, thisgoesatthecostofcomparabilityofperformance.

On the other hand, a widespread complaint ison the lack of agreed ESG “standards”. ManyinvestorsalsowouldliketoseestandardizedESGdefinitions,stock lists, indicesetc. inordernot tohave to “re-invent the wheel”, and to save costsofcustomization.Someobserverswouldalsofearopportunistic“standards-shopping”.

Asnotedearlier,adefinitivelistofESGissuesdoesnotexist–anditlooksimpossibletoagreeon.Evenwithin the comparatively advanced discussionof “green” there are major areas of dispute, e.g.on nuclear, biofuels.Across experts, there is alsoa varying emphasis on processes and products,supply and disposal chains, on footprinting or

physical risks,onbiodiversityandnaturalcapital,etc.Suchissuesareevenmoredifficultinthesocialand human rights territory. Competing conceptsin the market place are more likely to allow fordynamic adjustments and quality competition ina fast-moving world. In this dynamic process,transparencyandgoodgovernanceareessential.

There are pros and cons of setting ‘officialstandards’. It looks premature for regulators toset full ESG standards at this juncture, if everpossible. More promising is to expect specificregulation at company/sector/project level, e.g.on carbon emissions, environmental footprint,energyefficiency,governancepractices,workplacestandards, and similar. Furthermore, disclosurerequirements will tighten for both investeecompaniesandinvestors.Associalissues–whichby their nature are less consensual - becomemore embedded into the investment processcustomization will remain, but consensus aroundframeworks is needed to provide a robust basisforESGincorporation(andkeepcostsaffordable).Over time, more robust methodologies wouldprovideabetterfootingforESGinformation,anddeliver better inputs in the models used by theinvestmentindustry.

Issues with ESG InvestingEvenwiththegrowingbodyofresearch,increasingproductofferingsanddevelopingmethodologiesbyleadinginvestors,anumberofissueswithESGarebeingdebatedintheindustryandinacademia.Thisposesaseriesofchallengesforfundmanagersandassetowners.

Many investors remain concerned about ESG-related investing for assorted reasons (Mooji2017). Important impediments to the use ofESGinformation are the different reporting standardsandasaresultlackofcomparability(Amel-ZadehandSerafeim2017).Accordingtoasurveyof500investorsglobally(Schroders2017b),performanceand transparency are the greatest challenges.Difficulty in risk measuring/managing and costsare also mentioned, as is the lack of belief in“sustainableinvestments”(Figure10).


ESG critiques

It is worthwhile to briefly reiterate some of themoreprincipledreservationsandcriticismofESGsuchas:

• Lack of clarity around the ESG terminology;vaguenessof‘sustainability’;

• Stakeholders in different sectors (investors vs.economists vs. environmentalists) are usingdifferent terminology and not communicatingwellacrossdisciplines;

• Potential trade-off between ESG factorpreferencesandinvestmentperformance;

• Possible reductionof investment universe,withlackofdiversification;

• Need to clarify existing regulation, fiduciaryduty;

• Who defines the “values” and how? Concernsover thegrowing‘oligopolistic role’ofexternalagenciesorserviceproviders;

• Who regulates ‘sustainability’, and how?Questions about both ESG-specific regulationandinvestorregulationthataffectsESGinvesting(e.g.fiduciaryduties);

• Too much ESG “box ticking” on the side ofcompaniesandassetmanagers;34

• Giventherisingdemandforclimatechange/ESGproducts, too much “green-washing” or “ESG-washing”;

• Does ‘sustainability’ investing facilitate ordistractfromessentialclimatechangeinvesting?(Some governments prefer ‘sustainable finance’over‘greenfinance’);

• Costissues(e.g.chargesforESGdataproviders,certification or in-house expertise; highermanagementfees?);

• Questionsabouttheeffectivenessofgovernancecodes/ESGpolicy(e.g.financialcrisis;executivecompensation and poor corporate oversight;ecologicaldisasters).

Figure 10: Sustainability Challenges for Investors

Source: Schroders (2017b)

EuropeOverall North America AsiaLatin America

I do not believe insustainable investments

Other

Investment committee is not comfortablemaking sustainable investments

Cost

Difficulty measuringand managing risk

Lack of transparencyand reported data

Performance concerns

20%

11%

14%

23%

28%

41%

44%

15%

9%

14%

22%

26%

44%

47%

23%

13%

18%

21%

31%

45%

45%

29%

6%

23%

26%

26%

34%

37%

22%

12%

6%

28%

29%

33%

42%


ESG implementation in general

Onceadecision in thedirectionofESG ismade,there are a broad range of questions on theimplementation(see,e.g.,Hawley2017):

• ExactdefinitionofESGfactors;isittoostatic–areadjustmentsneededovertime?

• Diverging analytical approaches; detailedmethodologies(e.g.weightingsofE,SandG,orofsub-factors)35

• ConflictingsignalsfromE,SandGonindividualcompanies/countries

• Limited transparency of ESG scores/methodologies(“blackboxes”)

• Timelagofinformation(“behindthecurve”)• Disclosureandreporting issueswithunderlyinginvesteecompanies/countries

• Whether broader supply chain considerationsshouldbetakenintoaccount?

• WhatistheprogressintermsofESGoutcomesandappropriatemetrics?

• Problem of scale/ resources for smallerinstitutionalinvestors,particularlyinEMs

• Investment(im-)practicalityofSDGgoals.• Long time horizon over which ESG factorscan materialize vs. short-term performancemeasurementofassetmanagers.

AsESG investing is spreadingmorewidely,mostassetmanagersfeeltheneedtobecomemoreactiveinthisfield.However, therealityisoftendetachedfromthe imagesought,especiallyoutsideequities.For fixed income, as the Russell survey (2017)revealed,“thereoftenisawidegapinwhatthesurveyrespondentsclaimtheydoregardingESGintegrationandwhatisactuallyhappening”(p.4).“Overall,weobservedthatESGfactorconsiderationappearstobenotasadominantdriverininvestmentdecisionbutratherasasupplementalpieceofinformationatbestasapartofcreditanalysis.”(p.1)

ESG in fixed income

ESG investing in fixed income poses someadditionalchallenges.

• ConnectionbetweenESGandcreditratingsandcreditspreads

• Mismatch of time horizon for fixed incomeinvestments and period overwhich ESG factormaterialize(asthesecanbeshort-term,butoftenrepresentlong-termtrends)

• The relationship of ESG and other risks/opportunities(e.g.market,liquidity)

• Howtoorganize“engagement”forbondholders,especiallyforsmallinvestorsandwithsovereignissues

• Political sensitivities with sovereign (sub-sovereign)bonds(e.g.exclusionofcountries)

• Limited availability of underlying country data(alsosuitability?comparability?timeliness?)

• Howtocapturemomentumasopposedtostaticlevel of ESG for companies and particularlycountries

• Lack of ESG research coverage for high-yield,emergingmarketandprivatedebt

• LackofcompetitioninESGfixedincomeindices• Awarenessof (implicitorexplicit) factorbiasesinESGinvesting

• The effect of ESG on long-term strategies andasset-liabilitymanagement(ALM)

• WhethertomeasureESGbyissuerorissuance?• Organizational issues (e.g. building ESG fixedincomeexpertise;differentESGcompanyexpertsforstocksandbonds?).

Progress on data

OneofthemainconcernsofinvestorsisESGdata.Theconcernsaremainlytwo-fold:36

• Lack of available data; timeliness; coverage ofregions/marketsegments/instruments;37


• Quality of data inputs (inconsistencies;incompleteness; reliance on self-reported data;subjective and unaudited information; obviouserrors).

In terms of quantity, reporting initiatives areimproving the depth, breadth and consistencyor corporate reporting on ESG factors. Thelaunchof theTCFD is a response to this call formore and better information.As ofMarch 2018,over 250 organizations have expressed theirsupport for the TCFD, and the first examples oforganizations taking steps to report in line withtherecommendationsof theTCFD(e.g.Unilever,HSBCandSwissRe)havealreadybeenseen.TheIFC has developed a Disclosure & TransparencyToolkittosupportcorporatesinemergingmarketsenhancetheirESGreporting.AnIFCprojectisalsocurrentlyunderwaytoadapt theIFCPerformanceStandardsandCorporateGovernanceMethodologyinto a framework which can be used by capitalmarketinvestors.TheWorldBankisalsoworkingonareportingframeworktomapprojectoutcomesandimpacttoSDGindicators.

Importantly,theissueisnotjustaboutdataquantity.Much more progress is needed in terms of dataquality and relevance as an input to investmentdecision-making. The bar is being raised forcorporate disclosure by regulators and stockexchanges.MoreinvestorESGdisclosureisbeingintroduced in many places. Specialist servicesaregrowing tomake thebestuseof suchdata ina competitivemarket. Crucially,more conceptualworkwill need to be done on defining ESG andSDGmetrics,andespeciallyonhowtodefineandmeasuretheimpactofportfolios.

NewtechnologyishelpingtacklethedatachallengebyaddingbothdepthandbreadthtoESGsources.This goes beyond using standard, self-reportedcorporate data to incorporate ‘big data’ and newinformationsources,suchassatellites. Itcanalso

reduce costs vs. intensive analytical approaches,andprovidemorereal-timedata,whichisimportantforinvestorstyingtoadaptpolicyandothertools.Muchmorebasicenvironmentalandotherdataareavailablenow thanonlyoneor twodecades ago.Combined with artificial intelligence (AI) andmachinelearningtechniques,realtimeevidenceforinvestorsisbecomingmoreobtainable.

Newdataproviders,suchasTrueValueLabsandArabesque,38 are providing ‘sustainable quants’basedservices,usingbigdataandmachinelearningtoolstogobeyondcorporatedisclosure-basedE,S,Ginformation.MSCIandotherdataprovidersarenotingthatanincreasingnumberoftheirclientsarequants.39Already,anumberofinvestors,includingpension funds suchAPG40 and PensionDanmark,aretestingandimplementingartificialintelligence/robotics forcertainprocesses.However, investorsarealsoawarethat“bigdata”mayalsoimply“bigrisks”.Issuessuchascyber-crime,dataownership,theft and misuse have already show massivefinanciallyrelevance

Dataavailabilityandqualityalsoneedtoimproveto support better ESG integration into sovereignbond analysis. The national level data used islimited, and particularly suffers from significanttime lags. Initiatives are underway to improvethe National CapitalAccounting of countries (tosupport financial accounting), but this is yet tobecomewidespread.Workonthe‘HumanCapital’and other indices may provide a more holisticframeworkforsovereignandsocialanalysis(Langeetal.2018).Thereisstillaneedforgovernmentsto provide better basic environmental and socialdata –with faster delivery.Satellite data is beingused by theWorldBank and other institutions totrackproxiesfor‘E’and‘S’measuresthroughdatasuch as environmental degradation and povertymeasures.


7. CoNCLuSioNS: from ProCESS

To imPACT

Key Lessons for Investors

Thereareanumberofkeylessonsforinvestors:

From single steps to a full organizational approach

Many investors – both asset owners and assetmanagers–havetakensomesinglestepsintoESGinvestingintotheirfixedincomeportfolios,e.g.bybuyingaSRIfundoragreenbond,SRIengagementteamsworkingonfixed incomeaswell as equityholdings, subscribing to ESG organizations orproducingESGmarketing/complianceliterature.

Suchsinglestepsareoftenindeedthemainoptionsforsmallerinvestors.Largerinvestors,however,toprogress,needtotakeafullorganizationalapproach(startingatboardlevel),devotein-houseanalyticalresources and apply appropriate aspects of ESGstrategiesinparallel,includingincorporationacrossfixedincomeholdings.

Clear objectives

Clarity about the objectives is paramount. Someinvestors (and academics) primarily try to chasea few extra basis points via (changeable) ESGproduct/strategy outperformance. Instead, moreefforts should go into setting ESG investmentobjectives:Whatisthisparticularassetownertrying

to achieve with ESG (if atall)?Andhow?Thereisoftenanexcessivefocusonsustainabilityandfinancialperformance,andtoolittleregardforperformanceintermsofE,SandG.Thougharguably harder to measure, these considerationsarealsoimportantforfixedincomeholdings.

From input to outcomes – from process to impact

Inthepast,ESGinvestinghasbeenmainlyconcernedwith inputs (e.g. finding ESG data, products) andinternalprocesses(e.g.ESGanalysis,compliance).While this process will continue, in future, moreeffortswillgointotheESGoutput,including:

• becoming clearer about how to conceptualizeESGoutcomes;

• workinghardtofindappropriateESGmetrics;• gettingahandleontheenvironmentalandsocialimpactacrossportfolios,includingfixedincomeholdings;

• determining how to measure and communicateESGimpactbeyondlabelledbonds;and

• mappingportfoliosandSDGoutcomes.

46 | 7. CONCLUSIONS: FROM PROCESS TO IMPACT

Ways ForwardESGinvestingisdevelopingfromapurelyprocess-driven to a more outcome-driven activity. Thisis true for all holdings, including fixed income.The concerns outlined above show that, whilstgreat strides have beenmade to incorporateESGfactors intofixed income investments, and acrossinvestors’portfolios,moreneedstobedonetotrulymainstreamthisapproachandhavematerialimpact.

In addition to investors themselves, a range ofstakeholders have a role to play to achieve thegoal of mainstreaming ESG into fixed incomeinvestments:

• Governments need to provide more timely,accuratenationaldataonESGanddevelopmentissues,aswellasfinancialnationalaccountingtoinformanalysisoftheirsovereignissuance;

• CorporationsneedtocontinuetoimprovetheirreportingonESGaswellasfinancialfactors tobetterassesstheirdebtaswellasequityissuance;

• Multilateral development banks have animportant catalytic, intermediary and capacitybuildingrole toplayon labelledbond issuance,andimpactmeasurementmorebroadly;

• The international associations should strivein their thought leadership and theprovisionofrobustevidencetosupportthemainstreamingofESG investment in all asset classes, and worktowardscommonframeworks.

• Service providers should continue to improvetheir ESGmethodologies and analysis, pushingfor more timely, accurate and extensiveinformation to base this on – and they in turnneed to be pushed by investors to increase thequalityoftheirproducts,particularlyinthefixedincomespace.

• The academic community can provide newideas, newmetrics and critical evaluation,withgapsinfixedincomeanalysisparticularlyneedingtobefilled.

Furtherworkisneededinfourareas:

First, the on-going initiatives to improve the data upon which the ESG analysis and tools are based should continue to be supported.Corporate reporting initiatives are having results,with attention increasingly spreading to emergingmarketissuers.Likewise,evidencefromnewdatasources (big data, satellite data etc.) needs to betestedforrobustnessandmaterialitytoincludeandbring a real-time dimension to ESG analysis ofsovereignbonds.

Second, more rigorous research on the relationship between ESG factors, financial risk and returns in fixed income is also required. Further,academicstudiesareneeded,lookingatthelinkbetweenallaspectsoffixedincome,E,SandGfactors,usingtransparentmethodologies,longertimeperiods,andabroaderrangeoffixedincomeassetsandcountries.

Third, frameworks for applying this ESG data should continue to be refined. Havingstandardized, international frameworks bringsconfidencetoinvestorsthatESGanalysisisbeingplacedonarobustfooting.Thiswillallowthemtofurther includethisanalysis into theirmainstreaminvesting across asset classes, whilst addingcustomization on top to reflect their own beliefsandgoals.

Finally, more innovative, sustainable investment products are needed – as evidenced by the appetite for green bonds.Theyshouldbescalableandmorediverseinordertobecomemeaningfulportionsofinvestors’ asset allocation and benchmarks. Thegrowingsustainablebondissuance–supportedbythe data and frameworks discussed – will allowinvestors to channel their portfolios andmeasureimpactson their chosengoals.Morecanbedoneto devise structured and other products to meetthis demand.As with green bonds, supranationalissuersarehelpingpavethewayforwardtogrowsustainablebondmarkets through theirownbondissuance and by mapping out impact reportingmodelsand transparencyanddisclosurestandardstogetherwithpartnerslikeICMA.


Next Steps

Suggested next steps for theWorld BankGroup,GPIFandtheirpartnersinclude:

National Reporting

• Encourage and support use ofNational CapitalAccounting,includingindevelopingeconomies

• Explorehowtoprovidemoreaccessible,accurate,timely E, S, G risk and impact indicators forinvestors to incorporate into their analysis – incooperationwithstakeholders

• Conduct research into materiality andincorporationofE,S,Griskandimpactfactorsinsovereignbondanalysis

• ProvideopportunitiesforinvestorstoengageonE,S,Gissueswithsovereignissuers

Corporate and Impact Reporting

• Stepupengagementwithinternationalinitiatives(GRI, SASB) and investors to promote anddevelopstandardcorporatereporting

• ContinueworkwithTCFD,includingonclimate-related scenario analysis and assessment byfinancialinstitutions

• Encourage corporate sustainability benchmarksalignedwithSDGs

• Work with institutional investors and others todevelop and refine reporting on impact fromsustainabledevelopmentinvestments(suchasforIFC Social Bonds andWorldBank SustainableDevelopmentBonds)andtheiralignmentwiththeSDGs,thatcanbeusedasamodelforreportingbyotherissuers

• Promote the use of the IFC Disclosure &Transparency Toolkit for EM corporates anddesign customized capacity building activitiestargetingspecificcountriesorsectors

Frameworks

Continue to support the refining the green/social/sustainable bond principles and impact reporting(including alignment with SDGs) for investorsthroughtheExecutiveCommitteechairedbyICMA

• Test IFC’s ESG framework for EM corporateissuers with institutional fixed income investorpartners.

Products

• Workwithsovereigns,sub-sovereignstosupporttheirinterestinissuanceoflabelledbondsthroughadvisorywork

• Provideadvisorytoemergingmarketissuersonincreasingtransparencyinmeasuringandtrackingimpact for financed projects – for labelled andnon-labelledbonds

• Increaseengagementwithinvestorsonsustainableuseofproceedsforallbondsissuedandrelatedimpact reporting, to expand and broaden themarket(byissuer,issuancetype,broaderrangeofcreditqualityetc.)toscaleupthemarket.

• Supportproductsthathelptoraiseawarenessforpressingdevelopmentissuessuchasenvironment,gender,humancapital,universalhealthcareandother themes that enable sustainable prosperityforallgenerations

In the end, investing is about dealing withopportunities and uncertainties – this not differentfor ESG investing. ESG issues constitute a majorchallenge forassetownersandassetmanagersbutalsoprovidenew–financialandsocial-opportunities.Governmentscansetbetterframeworksandprovidebetter as well as faster data to facilitate progress.International and industry organizations can helpwith basic, general guidance. Market competitionwill continue todrive theprovisionofESGdata,tools,strategiesandproducts,andthisshouldalsoimprovethequalityofinvestmentsovertime.

48 | 7. CONCLUSIONS: FROM PROCESS TO IMPACT


APPENdiCES

Appendix 1: Institutions Interviewed for This Report Asset managers and institutional investors:AffirmativeInvestmentManagement(AIM)AmundiAPGBlackRockBNYMellonAssetManagersNorthAmericaBreckinridgeCapitalAdvisorsCalSTRSColumbiaThreadneedleInvestmentsDeutscheAssetManagementEverence/PraxisMutualFundsFolksamGlobalEvolutionMNNeubergerBermanNipponLifeInsuranceOPTrustPGGMPIMCOSchroders

TIAAInvestmentsTrilliumAssetManagementUBSZurichInsuranceGroup

Rating agencies, data providers, standard setters:

ArabesqueDeNederlandscheBankIPEFTSERussellMoody’sMSCIPRIR&IInformationJapanRobecoSAMS&PSustainalyticsTrucostVeriskMaplecroft

50 | APPENDICES

Appendix 2: ESG CriteriaInstitution E S G

CFA (2015) Climate change and carbon emissions

Customer satisfaction Board composition

Air and water pollution Data protection and privacy Audit committee structureBiodiversity Gender diversity Bribery and corruptionDeforestation Employee engagement Executive compensationEnergy efficiency Community relations LobbyingWaste management Human rights Political contributionsWater scarcity Labor standards Whistleblower schemes

PRI (2014) (Sovereign issuers)

Carbon intensity Demographics Institutional strengthWater stress Education and human capital Corruption Energy resources and management

Health levels Regime stability

Natural disasters Political and press freedoms Rule of lawBiocapacity and ecosystem quality

Human rights Financial reporting

Pollution Labor standards Regulatory effectivenessBiodiversity Social exclusion Adherence to conventionsAgriculture Income inequality International relations

PRI (2014) (Corporate issuers)

Environmental Demographics Business integrityClimate change Human rights Shareholder rightsBiodiversity Employee relations Incentive structureEnergy resources and management

Health and safety Audit practices

Biocapacity and ecosystem quality

Diversity Board independence & expertise

Air pollution Customer relations Fiduciary dutyWater scarcity and pollution Product responsibility Transparency /accountability

IFC (2012) Risk Management Labor CommitmentResource Efficiency Community Health and

SafetyBoard structure

Pollution Prevention Resettlement Control environmentEmergency preparedness and response

Indigenous People Transparency and disclosure

Biodiversity Cultural heritage Minority shareholdersStakeholder engagement

Source:


Appendix 3: Characteristics of Fixed Income and Implications for ESGCharacteristics of Fixed Income Responsible Investment Actions

Potential downside outweighs potential upside – focus is on risk, low volatility and preservation of capital more than on growth opportunities.

Focus on the contribution of ESG factors to financial downside – in particular, significant event risks and systemic risks that can affect issuer creditworthiness. Most prominent of these should be governance.

Lenders have a contractual relationship with borrowers; they are not owners. Debt holders don’t vote at AGMs, and access to management can be relatively infrequent.

• To manage risk, use any opportunity to engage issuers on ESG factors of concern (e.g., in run-up to issuance).

• Collaborate with other bondholders for more effective engagement.

• Vote on governance concerns during debt restructurings.

Multi-layered analysis (e.g., yield spread and yield curve analysis).

Develop robust yet streamlined processes to help analysts identify and manage ESG risks effectively.

Multiple issuer types (e.g., corporate, government, financial sector, and supranational).

ESG analysis varies for different issuers; metrics, criteria weighting and engagement approach vary. There is no one-size-fits-all.

Multiple instruments (e.g., structured products and ABS).

Analyse ESG-related risks to issuer creditworthiness as well as to asset cover pools and originators.

• Debt issued as public or private instruments.• Debt issued as investment grade or high yield.

RI approach varies relative to availability of ESG information, engagement opportunities, investor influence and access to management. Private/high-yield securities may represent higher risk but offer more opportunity for engagement and outperformance.

Different capital structure levels – senior, subordinated, hybrid etc.

Subordinated debt holders face financial downside before senior debt holders do, making them more sensitive to impacts from ESG risk.

Debt instruments have fixed durations covering different periods.

Consider whether different durations will affect the materiality of ESG to creditworthiness (e.g., will carbon regulation impact three- and ten-year bonds the same?).

Private companies can issue listed/public debt. Coverage of ESG data for private companies is relatively poor – weaker regulations on reporting for private companies.

Weaker issuing requirements but longer issuing periods for private placements.

Greater concentration of risk for private placements requires closer consideration of ESG risks; a longer issuing period allows for this.

Debt can be issued by subsidiaries and special purpose vehicles (SPV).

Consider exposure and management of ESG risks by parent company, subsidiary and originator.

Multiple outstanding debt securities issued by a single issuer.

Consider concentration of ESG risk related to single issuers across multiple securities.

Fixed income analysis can be heavily reliant on quantitative factors.

Address need for consistent and comparable ESG metrics that are easy ‘plug-ins’ for existing research models.

Source: PRI (2014)

52 | APPENDICES

Appendix 4: Structure of RobecoSAM’s Country Sustainability Framework

� Rights and Liberties Liberty & Inequality (10%)� Inequality

� Monetary Policy Independence Institutions (5%)� Other Institutions

� Demographic Profile Aging (10%)� Age-related Policies

� Competition / Liberalization Regulatory Quality (2.5%)� Business Regulations

� Terrorism and Political Crimes Stability (2.5%)� Government Stability

� Corruption Level Corruption (2.5%)� Transparency/Policies

� Democratic Participation Accountability (2.5%)� Civil Society

� Protection of Property Rights Rule of Law (2.5%)� Judicial System

� Management of Public Goods Effectiveness (2.5%)� Policy Responses

� Internal Risks and Inefficiencies Political Risk (10%)� External Conflicts

� Human Capital and Innovation Competitiveness (10%)� Physical Capital

� Emissionsn Environmental Status (10%)*� Biodiversity

� Exposure to Environmental Risks Environmental Risk (2.5%)� Risk Mitigation

� Energy Use Energy (2.5%)� Energy Sources

� Human Welfare Social Indicators (10%)� Work and Equality

� Confidence in Government Social Unrest (5%)� Local Job Market

� Education Human Development (10%)� Life Expectancy

Governance(60%)

Environmental(15%)

Social(25%)

CountrySustainability

Score

Indicator LevelDimensionLevel

CountrySustainabilityScoreSub-indicator Level

For each indicator, relativescores ranging from 1 to10 are calculated. Eachindicator is also assigned apredefined weight.

Each dimension weight is the sum of the indicatorweights within the respective dimension.

The country score is theweighted sum ofstandardized indicator scores.

For each country, various data series on a number ofsustainability sub-indicators are collected, totaling over 250 data series. These sub-indicators cover the following areas:

*Predefined indicator weight

Source: RobecoSAM (2015)


Appendix 5: Bloomberg Barclays MSCI ESG Fixed Income FamilyBloomberg, a global leader in fixed incomeindexing, and MSCI, the world’s largest providerof ESG (environmental, social, and governance)equityindicesandresearch,havecollaboratedonthedevelopmentofafamilyofrules-basedbenchmarkindices that incorporatemeasuresofESG risk andexposures.

The Bloomberg Barclays MSCI ESG FixedIncome Indexes includes a range of investment-grade aggregate and corporate index benchmarksaddressing the evolving needs of institutionalinvestors,whoincreasinglyaimtoincorporateESGconsiderationsintotheirstrategicassetallocation.

Broad Indexes

• Bloomberg Barclays MSCI ESG-WeightedIndexesuseMSCIESGRatingsandMSCIESGRatings momentum to overweight/underweightissuers within an existing Bloomberg Barclaysparent index. These indices include the fulluniverse of index eligible securities and thenapplytiltstothenaturalmarketvalueweightsinfavorofhigherrated/positivemomentumissuersand against lower rated/negative momentumissuers.

• Bloomberg Barclays MSCI SustainabilityIndexes positively screen issuers from existingBloomberg Barclays parent indices based onMSCIESGRatings,whicharea“bestinclass”assessmentofhowwellanissuermanagesESGrisks relative to its industry peer group. ESGRatings are available for corporate, sovereign,and government-related issuers. The minimumthresholdappliedtoBloombergBarclaysflagshipindicesisanESGratingofBBBorbetter.

• BloombergBarclaysMSCISociallyResponsible(SRI)IndexesnegativelyscreenoutissuersfromexistingBloombergBarclaysparentindicesthatmay be involved in business lines or activitiesthat conflictwith investmentpolicies, valuesorsocialnorms.TheseindicesuseMSCIBusinessInvolvement Screening Research (BISR) andMSCIESGControversiestoidentifyexposuretoscreenedissues.

Thematic Indexes

• BloombergBarclaysMSCIGreenBondIndexesoffer investors an objective and robustmeasureof theglobalmarketforfixedincomesecuritiesissuedtofundprojectswithdirectenvironmentalbenefits. An independent research-drivenmethodology is used to evaluate index-eligiblegreenbondstoensuretheyadheretoestablishedGreenBondPrinciplesandtoclassifybondsbytheirenvironmentaluseofproceeds.

Source: MSCI (2017b)

54 | APPENDICES

5. how iS ESg BEiNg imPLEmENTEd

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Aberdeen (2017), Doing ‘the right thing’ andmaking money. ESG and the corporate bondinvestor.AberdeenStandardInvestments.

Allianz (2017a), ESG in Investment GradeCorporateBonds.AllianzGlobalInvestors.

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Amel-Zadeh,A.andSerafeim,G.(2017),WhyandHow Investors Use ESG Information: EvidencefromaGlobalSurvey.

Amiraslani,H.,Lins,K.,Servaes,H.,Tamayo,A.(2017), The Bond Market Benefits of CorporateSocialCapital.ECGIFinanceWorkingPaperNo.535/2017.

Aristotle (2016), ESG Integration in High YieldPortfolios.WhitePaper.

Arjaliès,D.andBansal,P.(2018),Beyondnumbers:How investmentmanagers accommodate societalissuesinfinancialdecisions.OrganizationalStudies(forthcoming).

Barclays(2015),ESGRatingsandPerformanceofCorporateBonds.QuantitativePortfolioStrategy.

Barclays (2016),Sustainableinvestingandbondreturns.ImpactSeries01.

Bauer, R. andHann,D. (2010), CorporateEnvironmental Management and Credit Risk.WorkingPaper,MaastrichtUniversity.

Bektić, D. (2018), Factor-based PortfolioManagement with Corporate Bonds. Thesis,TechnischeUniversität,Darmstadt.

Bertelsmann (2017), SDG Index andDashboardsReport2017.BertelsmannStiftungandSDSN.

BlackRock(2016),ExploringESG:APractitioner’sPerspective.

BNP Paribas (2016), Environmental, Social andCorporate Governance (ESG): A Duty and anOpportunity.AGuideforDutchPensionFunds.

Brundtland Commission (1987), Our CommonFuture. World Commission on Environment andDevelopment.

Candriam(2017),CandriamESGCountryReport.


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ENdNoTES

1. Approximately three-quarters of these assetsare held by institutional and one-quarter byretail investors. In terms of regions, Europeleads with about $12trillion, followed byNorthAmerica ($9.8 trillion), Australia/NewZealand($0.5trillion)andAsia($0.5trillion).GSIAgathersresultsfromregionalsustainableinvestmentgroupsaround theworld, trackingprofessionally managed funds that useresponsible investing criteria. It includesimpact investment and environmental, social,governance funds as well as portfolios thatsimply exclude weapons manufacturers orgamblingcompanies.

2. Mr. Carney has called climate change “TheTragedyoftheHorizon”,becausetheimpactsof climate change will be felt beyond thetraditionalhorizonsofmost actors (investors,regulators, policymakers) and impose acost on future generations that the currentgeneration has no direct incentive to fix. Hehas therefore argued that ensuring that thefinancialsystemisresilient to the lowcarbontransitionandenablingthesystemtoefficientlyfinancethetransitionshouldbeinthefinancialpolicymakers’ clear interest. (Speech 29September2015).

3. Globalbondmarketshaveamarketcapitalizationofabout$90trillion,higherthanlistedequities.Bondsalsoconstituteasubstantialproportion

of institutionalinvestors’ portfolios.In 2017, pension fundsof the seven largestmarkets hasan allocation of 27% infixed income,i.e.about$11trillionoutof$41trilliontotalassets. In Japan, the allocation was twice ashigh (56%) (Willis Towers Watson 2018).Insurance companies tend to have evenmoreconservativeassetallocations inmanyplaces,nottheleastforregulatoryreasons.

4. For a list of institutions interviewed seeAppendix1.Theintentionwasnottoundertakeacomprehensivesurveyofinstitutionalinvestorsand their service providers, but to learn fromsome of the stakeholders who are known tobeleadinginthisarea.AmorecomprehensivemappingofinstitutionalinvestorapproachestothedifferentESGtoolscouldbeaninterestingfollowontothisreport.Furtheranalysisonthesuccessofthedifferentapproachesinpracticeisalsowarranted.

5. The concept of ‘sustainability’ comes fromenvironmental economics and is rooted inthe idea that ‘human capital’ can substitute‘natural capital’ (“Hartwick’s rule”). The

62 | ENDNOTES

‘strong’ interpretation of the term assumesthat“humancapital”and“naturalcapital”arecomplementary, but not interchangeable. TheconceptsarosefromtheworkofRobertSolowand John Hartwick in the 1970s. The policyinterpretation of this work came out of theBrundtlandCommission(1987)andisthebasisfortheideaof‘sustainabledevelopment’.

6. Theuniversalownerhypothesisisbasedontheideathatthereis“noplacetohide”as(negative)externalitiesof investeecompanieswillaffectportfolioreturnssoonerorlaterinsomeform,e.g. taxes, insurance premiums, inflated inputprices or the physical cost of disasters. TheUNEPusethefollowingdefinition:“UniversalOwners are large institutional investorswhich have highly-diversified and long-termportfolios that are representative of globalcapitalmarkets”.

7. CorporateSocialResponsibility(CSR)relatesto companies’ management approaches.It considers the economic, social andenvironmentalimpactforallstakeholders.CSRis again a conceptwithmany definitions andpractices. Double/triple bottom line also adda social and environmental dimension to thefinancialone.

8. ‘Outcome’and‘impact’canareoftenusedassynonyms in this context. They can also bemeaningfully conceptualized as ‘outcome’referring to afinite, shorter term change, and‘impact’asbroader,longer-termeffectsthataremoredifficulttomeasureobjectively(Harding2018).

9. According to a survey of investmentprofessionals by Amel-Zadeh and Serafeim(2017),relevancetoinvestmentperformanceisthemost frequentmotivation for use of ESGdata followed by client demand and productstrategy, bringing change in companies, andthenethicalconsiderations.

10. Fiduciary duty is the requirement that thosewhomanageotherpeople’smoneyactintheirbeneficiaries’interests,ratherthanservingtheirowninterests.

11. AccordingtothecategorizationofGSIA(2017),ESG integration ($7.5 trillion), engagement/shareholderaction($5.9trillion),norms-basedscreening($4.4trillion)andpositivescreening($0.9trillion)arethemostwidespreadstrategiesacross all asset classes. Impact/communityinvesting and sustainability themed investingcapture only about $100 billion, i.e. 0.5% ofsustainableassets,each.

12. PRIpublishesaseriesofcasestudiesbyfixedincomeinvestors,andonESGengagement infixedincome.https://www.unpri.org/about/pri-teams/investment-practices#FICS

13. Stranded assets are assets that suffer frompremature write-downs or conversion toliabilities.Someexpertsconsidercoalandotherfossilfuelsaspotentialforphysical,economicandregulatoryreasons.

14.AccordingtoGlobalImpactInvestingNetwork,thepracticeof impact investinghas fourcorecharacteristics: (1) investors intend to havea social and/or an environmental impact, (2)investmentsareexpectedtogenerateafinancialreturnoncapitaland,ataminimum,areturnofcapital,(3)investmentsaretogeneratereturnsthatrangefrombelowmarkettorisk-adjustedmarket rate, and (4) investors are committedto measuring and reporting the social andenvironmentalimpacts.

15.An example is a combined academic andindustry effort (Vörösmarty et al. 2018) todevelop‘context-basedmetricsforinvestmentdecisionsthattrytocaptureoutputs,outcomesand impact in the environment and publichealth.


16.For further details see Dr. Bob EcclesForbes article March 11, 2018, ‘MeasuringInvestors’ Contributions to The SustainableDevelopment Goals’, which maps SASB’sfactorstospecificSDGs.

17.Arjales and Bansal (2018) find that bondmanagers are trying to quantify and“financialize”ESGdata in theirmodelswhileequity managers can live more easily with a‘creative friction’ between financial numbersandanysortofESGinformation.

18. For an investor-related literature overviewonESG in equities, and more general, see, e.g.Dimsonetal.(2013).

19.The result for portfolio studies is commentedby the authors: “It is important to be awarethat the results of these (to date about 150studies)areoverlaidbyvarioussystematicandidiosyncraticrisksinportfoliosand,inthecaseofmutualfunds,byimplementationcosts.”

20.ThesefindingsrelatetotheworkofKhanetal.(2015),whichfindsthatfirmswithgoodratingson material sustainability issues significantlyoutperform firms with poor ratings on theseissues. In contrast, firms with good ratingson immaterial sustainability issues do notsignificantlyoutperformfirmswithpoorratingson the same issues.The authorsnote that theresults “have implications for assetmanagerswho have committed to the integration ofsustainabilityfactorsintheircapitalallocationdecisions.”(p.1)

21. Summit (2017), Douglas et al. (2017), e.g.,give an overview for equities.Mooji (2017a)found 218 ESG initiatives, of which 57 forESGratings,38forESGrankings,57forESGindexes.Mostofthemconcentrateonequities.

22. Someprovidersusetheterm“ESGratings”buttheterm“ESGscore”ispreferredtoavoidconfusionwithtraditionalcreditratings.ESGrankingsaretypicallybasedonanESGscoringsystem.

23.UN PRI have an on-going project looking atthistopicin-depth.Furtheranalysisandresultsare due out during 2018, which the authorswouldencourage readerswhoare looking forfurtherdetailonthisareatofollow.

24.Theassessment(GB1-GB5)isdistilledfrom5broadfactorswithanumberofsub-factors:useof proceeds, ongoing reporting, organization,management of proceeds, disclosure on useofproceeds.Proceedsaretobeusedforcleanwater, sustainable land use, waste and watermanagement,cleantransportation,biodiversityconservation,renewableenergy,climatechangeadaptation,orenergyefficiency.

25.MSCItookoverKLDResearchandAnalyticsin 2010 and Governance Holdings (GMIRatings)in2014.

26. Such findings have been supported by otherpartiesthoughtheirownin-houseresearch.

27.Thecountrysustainabilityscoredoesnottaketheannualchangeintoaccount,itisbasedonthecurrentlevel.ThechangevsthepreviousscoreisonlytakenintoaccountforthecalculationofthecountrygradesusedintheESGsovereignbondindex.

28.Labelledgreenbondsarelabelledas‘green’bythe issuer and are financing green assets andprojects.Unlabelledbut still ‘climate-aligned’bonds are issued by entities enabling a lowcarboneconomybutarenotlabelled‘green’.

29.The Green Bond Principles (GBP) arevoluntary process guidelines that recommendtransparency and disclosure and promoteintegrity in the development of the GreenBond market by clarifying the approachfor issuance of a green bond.TheGBP havefour core components:1.UseofProceeds,2.ProcessforProjectEvaluationandSelection,3.ManagementofProceeds,4.Reporting.

64 | ENDNOTES

30.The bonds directly link returns to the stockmarket performance of companies in theSolactive Sustainable Development Goals(SDGs)World Index. The index includes 50companiesthatarerecognizedindustryleaderson environmentally and socially sustainableissues, or that dedicate at least 20% of theiractivitiestosustainableproducts.

31.TheproceedsofeachHSBCSDGBondwillbeusedtofinanceinwholeorinpart,businessesand projects that promote any of the selectedsevenSDGs.

32. Since 2007, the World Bank Treasury hasdelivered $3.9 billion in catastrophe risktransactions—including more than $2 billionsince July 2017. IBRD cat bonds have beenrecognized as sustainable investments forinvestors active in the insurance-linkedsecurities(ILS)market.

33.BlackRock CEO Larry Finks’s 2017 AnnualLetter to CEOs outlining a new approach tocorporateengagementhasbeenmuchquoted.https://www.blackrock.com/corporate/en-no/investor-relations/larry-fink-ceo-letter

34.As the Economist (2017) article lays out:“Moneymanagers’deepening loveaffairwithsustainable investment stems not fromwarm,fuzzy ideas about doing good. Formost it isa commercial choice.Thatworries someSRIpurists, who fear that “mainstreaming” willleadsomefundmanagerstoputanethicalglossonconventionalinvestments.”

35. See,e.g.,Khan(2017).Intermsofconsistency,indescribing theirESG investment approach,QIC (2017), for example note that: “Inpractice,MSCIandSustainalyticsratingsoftendisagreewitheachother.Whenmeasuringthe

relationship between ESG ratings of the twoproviders,wefoundpositivebutlowcorrelationsacross all threedimensions aswell as for thecompositerating.Thisisnotsurprising,giventhedifferencesinmethodology.Tosumup:Likecorporate bond ratings, ESG ratings shouldnot be considered as a simple commodity.Ratingsfromdifferentproviderscarrydifferentinformation and can potentially suggestdifferent portfolio management decisions. Attheendoftheday,investorsandassetownersneedtodotheirownworktoreachtheirownconclusions rather than reflexively followingtheanalysisofproviders.”(p.5)

36.A lack of robustness and consistency behindmuch of the data lies behind these concerns.Forexample, someof thedataused toassessclimateriskuseassumptionsbasedonwhatarerandomevents.Thismeansthat theportfolioscreatedbasedonthatdataarenotlessaffectedbyclimaterisk.

37. See, e.g., BlackRock (2016) that mentions“survey fatigue”. Mooji (2018) reportswidespread “reporting fatigue”, poor qualityofinformationandlackoftransparencyintheESGindustrythatiscounterproductive.

38.Arabesque,a“quant”assetmanager thatusesESGdata,examines thesustainabilityofover7,000oftheworld’slargestlistedcompanies.Itstechnologycombinesover200ESGmeasureswith other data points (such as news storiesfrom50,000sources)torankcompanies.

39. SeeFinancialTimesJanuary2016,‘Quantsarethenewethicalinvestors’.

40. In 2018, APG took over the data analyticsteam for sustainable investing from DeloitteNederland.

incorporating environmental, social and …documents.worldbank.org/.../pdf/125442-wp-public.pdf ·...

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