Sustainability: A question of Incentives - BNP Paribas CIB
 
Tuesday 08 December 2015

A combination of government intervention and private sector engagement to move ESG objectives forward in Asia


ESG (Environmental, Social and Governance) is a hot topic - but standards are often easier to adopt in theory than in practice.

The enforcement of ESG standards by national governments is a vital political force in raising awareness about the importance of the environmental and social impact of business, as well as the importance of high quality governance.

In the US, the SEC requires all firms that file standardised annual reports to include details of climate-change risks judged to be 'material' to their earnings. It is not alone: CDP, originally the Carbon Disclosure Project, a body that collects environmental information for investors, reckons that more than half the firms listed on 31 of the world's largest stock exchanges publish this type of data, often through listing requirements.

But regulatory reporting standards may not always be effective at incentivising individual companies to improve their footprint. A recent Harvard Business School 1 found little improvement in corporate disclosure following the introduction of mandatory sustainability reporting requirements in several of the countries it surveyed.

In the worst case scenarios, weakly monitored mandatory schemes turn ESG reporting into the sort of ineffective box-ticking exercise that once plagued risk management initiatives.
In the best cases, however, it is usually industry that is paving the way.
Three examples focused in the Asia-Pacific region help demonstrate the benefits of industry led ESG initiatives - and reveal the barriers to implementation.

Global campaign, local engagement

At first sight, Australia appears to be the exception that proves the rule: the government has pledged to cut global emissions by 19% by 2030, based on levels from the year 2000 (it is worth noting that it represents a 30% cut based on 2005 levels). But explicit requirements on companies have so far been left largely up to individual sectors and players to enact.

Most recently, in November, twelve Australian firms became signatories to the We Mean Businesscampaign, an initiative driven by 412 - and counting - of the world's largest companies and investors. The campaign lays out seven goals, including putting an internal price on carbon and adopting so-called 'science-based' emissions targets. The targets employ the latest climate science to determine how much to cut emissions in order to support the '2°C global goal' - to limit the increase in average world surface temperature to 2 degrees Celsius since the beginning of the industrial revolution.

The signatories comprise energy firms, but also banks, including ANZ and Commonwealth Bank (CBA), as well as a major telecommunications business. The We Mean Business pledges extend beyond a firm's own environmental footprint. Two of the seven commitments - removing commodity-driven deforestation from all supply chains by 2020, and producing 100% of electricity from renewable sources - deal specifically with the supply chain.

In the financial sector, increasingly, requirements are being written into lending and investment agreements. Today, at least 33 Australian asset owners support the integration of ESG into investment analysis and wider decision-making processes. In November, CBA pledged to apply comprehensive environmental risk management frameworks to its investment decision making in its wealth and asset management businesses.

Australia shows the capacity for individual firms to respond when a government provides a wider commitment to moving an ESG agenda forward. Global industry-led initiatives - such as We Mean Business - provide a way of both coordinating and measuring engagement.

Government as guard dog

The example of Indonesia's palm oil industry shows how industry and government initiatives can come into conflict.

This autumn, the illegal burning of forests and agricultural land throughout the country once more covered many Southeast Asian nations in an acrid haze in what has become a divisive annual event. This environmental catastrophe forced the closure of neighbouring Malaysia's schools for two days in early October and led tens of thousands of Malaysians and Indonesians to seek medical attention for respiratory problems.

By September, with dry weather set to fuel the fires further, the Indonesian government had revoked the permits of four palm oil companies suspected of burning forest to clear it for palm plantations, forcing them to halt production and raising the prospect of criminal charges. In the meantime, unilateral action by foreign companies is already punishing suspected companies from abroad. Following a popular outcry in Singapore, ten paper firms pledged to stop sourcing wood from Indonesian suppliers suspected of illegal burning.

In a twist of events, in October the government asked the major palm oil producers to in fact withdraw their pledges to the UN to stop all deforestations. Their logic: adhering to the new standards would put many small industry players out of business, choosing to put a sustainable economy over environmental sustainability.


Government as driving force


In Malaysia, recent pension fund moves are building on the momentum set forth by government initiatives.

ESG reporting has been mandatory for all listed companies since 2007, but recently major investors have become more active: in its latest budget, the government promised measures to raise the profile of listed firms' with highly socially responsible practices.
Major Malaysian investors, including the pension fund Employees Provident Fund and the Armed Forces Fund, have recently taken a lead by adopting ESG standards into investment guidelines.
This move will create challenges for some sectors where companies are slow to improve standards. In such cases, strict screening may mean that a fund is left owning the lion's share of remaining stocks, which increases concentration risk and puts ESG investing at odds with risk management and performance objectives.

This is a special challenge for large asset owners in developing countries. But it is worth addressing given how influential moves by asset owners can be.

For example, AUM by signatories to the UN-backed Principles for Responsible Investment (PRI) now stands at more than USD 59 trillion. Over half of the externally managed funds of these asset owner signatories are subject to ESG integration, and 71% have asked companies to integrate ESG information into their financial reporting. Meanwhile, the investor-led Portfolio Decarbonisation Coalition has pledged to decarbonise USD 100 billion in institutional equity investments.

ESG stress testing

Exactly what ESG information should be reported is therefore an increasing concern for investors. And a common question from our clients has to do with designing an effective ESG process to take engagement beyond formulating a set of nebulous goals.

Our work has recently focused on developing a specific framework for ESG stress testing. The investment industry is used to modeling the impact of a sudden blow out in credit spreads on a fixed income portfolio. Our new model of ESG scenario analysis applies familiar techniques to model the effect, for example, of a sudden increase in the price of carbon emissions. Bringing familiar analytical techniques to this new area helps clients understand the effect on both assets and liabilities of such a scenario.

[1] Harvard Business School August 2014 The Consequences of Mandatory Corporate Sustainability Reporting: Evidence from Four Countries, Ioannis Ioannou, George Serafeim


Madhu Gayer
Heading of Investment Reporting & Performance for Asia Pacific at BNP Paribas Securities Services
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