How close are investors to conquering the final ESG frontier?

They've convinced corporate bond issuers to take ESG seriously, now investors are turning their attention to sovereigns

When modern sustainable investment analysis was in the early development stages, few realised how useful a comprehensive ESG audit could be to identifying the future problems facing companies.

As the examination of environmental, social and governance metrics became more commonplace, it was initially equity investors who realised companies with a broad awareness of ESG factors were more likely to be able to anticipate future regulatory, societal and sector-specific headwinds.

Over time, the number of equity analysts charting the link between ‘good ESG’ and share price behaviours has broadened considerably.

Humble beginnings

In 2010, the catchily-named United Nations Environment Programme Finance Initiative’s Asset Management Working Group, released the paper entitled “Translating ESG into sustainable business value” in which it underscored the importance of incorporating ESG factors into the “fundamental financial analysis” of companies. The group said the financial crisis had highlighted the need to do so.

Five years on, Oxford University and Arabesque Partners published a paper building on this work, entitled “From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance.”

The paper concluded that there was a “remarkable correlation between diligent sustainability business practices and economic performance.” This conclusion has since become a widely held belief across investor circles in Europe and many parts of Asia and North America.

More recently, commentators have suggested that the stock of ESG-aware companies may also possess other qualities beyond pure economic outperformance. After the bout of equity market nervousness in December 2018, The Wall Street Journal’s sister title, MarketWatch charted that the top performing ESG stocks typically witnessed lower volatility than those companies that had weaker ESG scores. A more technical analysis of the link between ESG and stock performance has been conducted by MSCI – available here.

As greater numbers of asset managers started to formally integrate ESG scoring into their investment processes as a metric to anticipate future stock performance, they also stated to up their levels of engagement with companies in which they invest. The initial threats were that they would sell shares if companies didn’t improve, but ‘stewardship’ techniques have since become more sophisticated, including long-term engagement plans and voting against board initiatives with which they do not agree.

Until relatively recently, it was always considered that shareholders were better placed to harness ESG demands to their advantage than their fixed income counterparts. But that view has also changed.

Corporate awareness

In 2014, the UN-backed Principles for Responsible Investment published a comprehensive fixed income guide, which outlined why ESG was also significant for bond investors too.

At the time, major fixed income asset management specialists such as BlueBay Asset Management and Zurich Insurance, admitted that fully integrating sustainable investment metrics was something new.

“For us, systematically factoring in ESG is a relatively new area,” BlueBay’s former head of risk and performance, Dominique Kobler (who left in 2017) said at the time.

But things have changed rapidly over the past five years and BlueBay has been one of the most vocal fixed income specialists championing the virtues of an integrated ESG investment approach in bond investing. The company is a member of several UN PRI working groups, including the prominent fixed income group, and has fully integrated several ESG assessments into the company’s standard investment process over the past year.

At the end of 2017, the company’s head of ESG investment risk, My-Linh Ngo wrote “While equity holders might be known for their influence at board meetings, bond holders also hold power.”

Ms Ngo noted that issuers “continually return to bond markets” and wish to do so at the lowest possible cost. This, she said is where bond investors hold power when it comes to ESG.

“They are only able to do this if investors trust in the ability and willingness of the issuer to meet their obligations, giving lenders the potential power to work societal and environment improvements into issuance contracts over time.”

Throughout the European asset management market, the inclusion of ESG analysis of corporate issuers has certainly become more commonplace. Aberdeen Standard, Fidelity International and Pimco are among the household names to have introduced processes to better analyse the sustainable credentials of corporate bond issuers.

Investor intrigue about the relationship between ESG and corporate bonds has also stimulated a flurry of fund launches, according to figures reported by ESG Clarity’s sister title, Expert Investor at the end of last year.

Citing research from Cerulli Associates, Expert Investor concluded that “the variety and scope of sustainable bond funds available to fund selectors is set expand considerably over the next five years.”

The final frontier

But while asset managers have successfully developed techniques for assessing and engaging with corporate issuers, they have been less successful when it comes to sovereign states. The reason, historically, was said to be relatively simple – that investors will always hold far less influence that that of a country’s electorate.

There was thought to be little incentive, therefore, for sovereign states to take notice of moaning asset managers putting forward concerns about human rights, or corruption. But two recent studies suggest that they might be wrong.

A report from Hermes Investment Management, released at the start of July, identified that “countries with the lowest ESG scores have, on average, the widest credit default swap spreads”. It also found a “positive correlation between sovereign ESG scores and sovereign credit ratings. These findings echoed those in a separate, independent study by BlueBay Asset Management, released three months earlier.

Both reports show that there could be an incentive for sovereign issuers to listen to asset managers and their investors. After all, if sovereign issuers can improve their credit ratings, future borrowing may be cheaper, and they will see an improvement in their risk profile. Should the lowest scorers start to improve, this would, potentially, lead to a wider pool of investors being willing to lend in future.

Historically, those investors who brought concerns to sovereign issuers about their human rights or corruption records have been waved away. But, if the latest reports are anything to go by, it seems that the carrot (of cheaper and more abundant future borrowing) may ultimately prove to be more useful that the stick.