It’s all in the Balance

Why sound investing means incorporating ESG criteria into decision-making

A stark warning, but one that investors are increasingly acknowledging. Incorporating Environmental, Social and Corporate Governance (ESG) criteria into decision-making processes is now seen as a function of good investing. ESG analysis looks into a company’s past and present business practices and measures potential risk based on environmental stewardship, corporate governance, support of socially responsible practices and financial performance.

A new sense of urgency

While the trend towards ‘sustainable investing’ in its various guises has been growing for many years, it has largely remained the preserve of experts in sustainability, notes Virginie Pelletier, Head of Sustainable Finance for Corporate and Institutional Banking at BNP Paribas.

The ‘Paris Agreement’ that emerged from the December 2015 Conference of Parties (COP) 21 marked a tipping point: “Almost 200 nations came together to pledge to limit global temperature rises to two degrees centigrade,” Pelletier says. “The regulatory and legislative developments that will follow as states work to make good on their commitments have transformed ESG issues into a C-suite topic, and one that will gain momentum.”

Asset owners lead the way

Long-term asset owners are at the heart of this push. As part of the transition to a low-carbon global economy, leading insurance companies and pension funds across Europe and the United States have made public pronouncements and signed agreements to decarbonise their investment portfolios. Governmental and public pressure is one reason, but strong, market-driven incentives are also propelling change. Institutional investors, with their long-term fiduciary duties, are increasingly concerned about the financial risks that ‘stranded assets’ pose in a low-carbon economic future. These stranded assets are notably fossil fuel reserves, and in particular coal.
 
“Today the world relies on fossil fuels, with coal representing about 40% of the energy mix. But globally we have a budget, which means that we can only burn fossil fuels up to a certain amount, after which we will go beyond a two-degree temperature rise,” Pelletier explains. “To stay below two degrees, companies will have to leave substantial reserves in the soil, so they will have no value. That is the risk.”

The risks faced by fossil fuel companies were starkly illustrated in April 2016 when Peabody Energy, the world’s largest privately-owned coal producer, filed for bankruptcy protection in the US. Slowing demand from China, competition from alternative sources (such as shale gas and renewables), tougher environmental regulations and government pressure have all contributed to a slump in coal prices in recent years, which is hurting the industry.
 
However, the risk posed by stranded assets extends beyond the mining and utilities sectors, Pelletier says: “Climate change will be disruptive to the business models of many industries, not least automobiles, shipping and airlines.”

Financing the future

As well as tackling the risks within existing portfolios, investors have a front line role to play in driving the carbon transition. Technology to support the shift to a low carbon world and help companies meet their sustainability-related needs is already available, with more being developed. Trillions of dollars will be required in the coming decades though to continue financing this energy transition. Asset owners, with their long-term liability profiles and investment horizons, are well-positioned to channel assets towards these financing demands. Banks likewise are seen as critical facilitators, and are under pressure to concentrate their direct financing and investment origination efforts accordingly.

“For example, at BNP Paribas our investment policies are governed by ESG-type rules that cover 12 sensitive sectors, such as coal, wood pulp and oil sands,” notes Pelletier. “At COP21 we announced we will double our financing of renewable energy. And many other banks around the world are making similar commitments.”

Acclimatising to the new environment

ESG issues will clearly become ever more central to governments, the public, corporates and the financial sector. The task confronting all investors is how best to cope with and flourish in this changing environment.

In December 2015, the Financial Stability Board set up a Task Force on Climate-related Financial Disclosures. The purpose of the group is to develop more consistent and useful practices that companies can employ to improve the climate-related risk information they provide to investors, lenders, insurers and other stakeholders. While voluntary, more effective reporting should lead to better informed investment, credit and insurance underwriting decisions. The Task Force published its draft recommendations for climate-related financial disclosure in December 2016 and is now running a consultation. Its final recommendations will be published in July 2017.
Meanwhile, other standards and best practices are emerging to help practitioners integrate ESG considerations into investment processes, notes Madhu Gayer, Head of Asia Pacific, Investment Reporting and Performance with BNP Paribas Securities Services. “As investment professionals seek to bolster their risk management processes, the CFA Institute produced ‘Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals’ in October 2015 in support of investors looking to incorporate ESG considerations into investment analysis.”
The UN Environment Programme (UNEP) and Principles for Responsible Investment (PRI) Initiative also ran a series of consultations in Asia in 2016 on the fiduciary duties of institutional investors. These Fiduciary Duty in the 21st Century: Focus on Asia roundtables were hosted by BNP Paribas and included discussions on how practitioners, regulators and key market stakeholders can integrate ESG into decision-making processes and promote sustainability.

Beyond Investment Management
Amine Bel Hadj Soulami, Global Head of Sustainable Investments at BNP Paribas’ Global Markets, Financial Institutions Coverage and BNP Paribas Securities Services
 
Sustainable awareness spreads across the economy, creating new demands from the financial industry. Green bonds – bonds issued to finance the development of  climate-related or environmental projects – are on the rise. So are responsible indices, which are made of ESG-vetted stocks, and custom financing solutions. BNP Paribas recently participated in a major renewable energy financing programme for an Iberian municipality which wanted to upgrade its street lighting to environmentally-friendly LED technology. The wining proposal featured a repayment based on the environmental savings resulting from the new LED lighting. Sustainable finance is not a passing fad: solutions which take into account sustainability factors are increasingly being demanded by corporate and institutional clients.

Rebalancing portfolios

Then there is the question of how best to implement ESG considerations in practice.
The traditional approach has been to remove companies or sectors from portfolios through exclusionary screening; however, as Gayer points out: “The danger is that investors may be left with a severely restricted investment opportunity set.”
 
A more refined alternative is best-in-class screening that issuing ESG criteria to select the companies in a sector that have the best strategy to face these challenges.
 
Another option is ESG integration. Rather than simply excluding certain companies or sectors, ESG factors are infused into the entire fabric of an asset owner’s investment decision-making process. “This becomes the heart of firms’ financial analysis and investment policies,” Gayer says, “from selecting the investment universe through to choosing benchmarks and allying with asset managers qualified to manage and add value to this kind of mandate.”

Lost in ESG? We have the right guide for you
The concept of Environmental, Social and Corporate Governance (ESG) broadly captures efforts by asset owners to be responsible investors. To dispel any confusion about what “ESG” really encompasses, BNP Paribas Securities Services has published the ESG Made Simple Guide.
 
The guide gives a clear definition of ESG and sketches a foundation on which institutional investors can build a strong ESG investment structure. It offers a practical approach to integrating ESG into the investment decision-making process, not least by outlining the building blocks of ESG analytics, such as data and scoring. 

Three Steps

Gayer identifies three fundamental steps to ESG integration: “The first is to set explicit, best-practice ESG investment objectives. Firms then need to construct the right benchmark and portfolio. After that they should monitor the results to create a virtuous feedback loop.”
 
Incorporating an extensive array of ESG factors that investors can use to better describe and understand the risks and opportunities in investee companies can only help firms make more informed, transparent judgments – but doing so depends on access to more granular data and an intuitive information portal to translate that data into decision-ready information.
 
BNP Paribas is one of the first global custodians to develop an ESG risk management tool, ESG Risk Analytics, that allows investors to understand their ESG risks. This includes exposure to controversies, business involvement and their carbon footprint, all online through the innovative DNA portal.
 
In May 2016, PRI and UNEP defined the Principles for Responsible Investment (PRI) Statement on ESG in credit ratings. The group has pledged to integrate ESG criteria more systematically into their analysis of issuer creditworthiness.
 
Upstream service providers, such as custodians and market data vendors, can play a valuable supporting role by providing tools and metrics. Stress-testing and reporting tools will be particularly crucial in enabling firms to monitor ESG-related risks and to identify, stay informed of and report on the impact of their investments.
 
For example, BNP Paribas has teamed with Avalerion Capital to develop a new climate change stress-testing approach. Solutions to fill these needs are already emerging, and more will follow.

Conclusion

Social and governance issues have long had a recognised role in investment processes. But now, with the science on climate change firmly established, environmental considerations are coming to the fore. The associated risks are complex and significant.
However, by formulating a robust ESG framework, and integrating it into the fabric of their investment policies, investors will be well-placed to benefit from and contribute to the major opportunities that transitioning to a low carbon world will bring.

[1]. For example, Article 173 of the French law on “Energy transition for green growth” requires that institutional investors disclose in their annual report information on how ESG and climate change considerations are incorporated into investment policies and risk management.