Investors typically engage with companies and other types of issuers to identify, monitor and manage risks to their investment returns. In signing up to the PRI, investors affirm that ESG factors can have a material impact on those returns.
In this chapter, we tackle the question of the materiality to investment returns of ESG risks, which can be less apparent to fixed income investors than they are to equity investors. We review the added value of engagement for investors and for corporations. We then explore the different motives fixed income investors typically give for engaging issuers, including:
- to gain better issuer disclosure relating to ESG factors;
- to influence how an issuer addresses specific ESG risks or value creation opportunities; and
- to maximise the positive ESG outcomes from their investments.
The materiality of ESG factors for bond investors
Bond investors are increasingly aware of the links between ESG performance and investment returns. Carbon-intensive business models, labour disputes and fraud can impact the credit risk of issuers through the issuers’ cash flows, operating costs, leverage, regulatory oversight and/or reputation. While a default is usually a worst-case scenario, there are intervening risks to investors, including credit rating downgrades and spread widening, which have the potential to impact investor returns. While a default is usually a worst-case scenario, there are intervening risks to investors, including credit rating downgrades and associated spread widening, which have the potential to impact investor returns over the short term.
Broadly speaking, ESG factors can affect the performance of a company’s bonds at different levels:
- Issuer/company specific risk: ESG factors affect a specific bond issue or issuer and not the market as a whole. Examples include regulatory compliance, social license to operate, and brand reputation. For example, the yield on the corporate debt of German car manufacturer Volkswagen rose and stayed high for a prolonged period of time in the aftermath of the 2015 emissions scandal.
- Sector/geographic risk: These stem from widerranging ESG factors affecting an entire industry or region, including regulatory and technological changes associated with the business activity the company is involved in, and/or to the markets it sources or sells to.
- Multi-sector/systemic risk: Some key emerging risks do not apply to a single sector alone but are the result of systematic interaction between sectors in response to poorly understood risks which may be mispriced. For example, data privacy and cyber security in the medical device industry (which collects patient data) create risks that are less well understood than in the managed care industry (which is where this data is often held). Taking a multi-sector view of data privacy and cyber security helps to understand where unpriced risk sits. Another example is stranded asset risk in the oil and gas sector. While it is most commonly discussed in terms of oil and gas issuers, it is present, but far less understood, for refiners, pipeline providers, service providers, engineering and service firms.
- Indirect exposure: Some ESG factors can affect investment returns indirectly. Resource scarcity, for instance, might add to inflationary pressures, prompting a tightening of monetary policy and a rise in the cost of capital which, coupled with adverse market conditions and poor liquidity, could prompt investment losses.
Analysis of ESG factors can therefore help investors form a more holistic view of a bond’s value, identify improving credit stories, or differentiate bonds with similar financial profiles. Some investors integrate ESG factors into their credit risk evaluation, but research teams do not label them as such. In other cases, investors have only recently started to incorporate ESG data into their research processes or view most ESG factors as immaterial.
Despite the technical challenges involved, some major credit rating agencies have started to increase their consideration of ESG factors in their credit risk analysis. For instance, Moody’s Investors Service, S&P Global Ratings and Fitch Ratings have all published papers outlining their approaches to ESG in their ratings since 2015, and have delivered further research and related case studies. To illustrate, Moody’s Investors Service assesses the implications of carbon reductions for its automotive sector credit ratings by focusing on the effect of several material risks judged to have a varying impact on key company rating factors, including the company’s market position, its overall leverage and liquidity, profitability and returns, and cash flows.
| Material risk factor | Highlights |
|---|---|
| Policy and regulatory uncertainty | Growing policy pressure, with increasing emissions-reducing regulatory targets, is considered a likely outcome. However, there is significant uncertainty over the scope and pace of policy implementation. |
| Direct financial effects | Pressure on margins and cash flows will increase as original equipment manufacturers are faced with the potential need to increase R&D and capital spending to develop emissions-reducing technologies. |
| Demand substitution and changes in consumer preferences | Changes in consumer preference leading to increased demand for alternative fuel vehicles (AFVs) and away from traditional auto platforms such as internal combustion engine (ICE) technology are possible. However, the pace of this change is also uncertain. |
| Risks of disruptive technological shocks | Risks of disruptive technological shocks exist as AFV technology achieves scalable solutions that become more cost competitive with ICE technology. But the forecasts for the speed of this transition and the rate of take-up vary widely, highlighting significant uncertainties. Nevertheless, we see the emergence of new competitors such as Tesla Motors and the interest of deep-pocketed technology companies such as Google. |
Analysis of ESG factors can identify opportunity as well as risk. For example, research shows that firms with strong corporate governance benefit from higher credit ratings and a lower cost of capital. A review in 2017 by S&P of how environmental and climate risks have affected global corporate ratings over a two-year period identified 717 cases where such risks were relevant to the rating, and 106 cases where they resulted in a change of rating, outlook, or a “CreditWatch” action. Of these 106 cases, 44% were positive and 56% negative in direction. This represents a shift from S&P’s 2015 review, where only 21% of environmental and climate-driven actions were positive, and 79% negative. S&P suggests that potential contributory factors include that more companies have mitigated environmental and climate risks, or that more are benefiting from various transition opportunities or from changes in environmental policy.
The added value of engagement
Engagement implies a two-way dialogue with companies, rather than a process of micro-management. On the one hand, investors have an opportunity to explain their expectations of corporate management in general and in relation to managing ESG risks and opportunities in particular, as well as to encourage actions to preserve longterm value. Engagement can also help investors become better informed to make investment decisions.
On the other hand, companies can provide clarifications on their strategy and the relationship between ESG factors, their business model and financial performance, as well as receive early warnings on emerging risks and best practices. Recent academic research shows the mechanisms through which engagement creates value for both investor and issuer.
| Value creation dynamics | Investors | Corporations |
|---|---|---|
| Communicative: Exchanging information |
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| Learning: Producing and diffusing knowledge |
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| Political: Deriving political benefits |
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Engagement to improve ESG disclosure
ESG data for investment decision-making can be sourced directly from the issuer: from their firm-wide corporate reporting and/or ESG risk factors included in any prospectus with regard to specific bond issuances. It can also be sourced from third parties, including data suppliers, brokers, rating agencies and industry associations.
However, corporate transparency and the third-party ESG research coverage available to fixed income investors can be poor relative to that available to public equity investors. This is especially true for smaller issuers, which are not subject to the disclosure requirements of public companies (often with non-investment grade ratings), or those issuing debt privately.
In high yield, for example, only 20% of issuers in the Barclays Global High Yield Index reviewed and confirmed MSCI’s summary of the data it uses for their ESG scores, dropping to just 3% for privately-owned companies in the index. This may mean that the ratings are based on data which is not as representative as it could be, and reinforces the limited levels of ESG disclosure in this market. Where data is available, the relevance to bondholders is often not well-articulated or understood. For example, governance issues such as executive pay and board diversity may be considered material by shareholders, but may not be sufficiently material to an issuer’s credit strength to feature in an investor’s credit research.
As a result, the most common reason fixed income investors currently give for engaging is to improve their understanding of an issuer’s exposure to specific ESG risks and value creation opportunities, as well as how they are planning to manage those.
Engagement to manage and mitigate financial risks
Investors may prefer engagement to alternative strategies – such as divestment – which leave them with no stake and no potential to help drive responsible corporate practices. By engaging with issuers, fixed income investors encourage behaviour designed to improve credit risk metrics and drive sustainable long-term investment returns. Naturally, bond investors may use ESG analysis as an information advantage and choose to exit a position before the wider market becomes aware of a material issue.
Engagement to maximise positive ESG outcomes
Minimising risks and maximising ESG opportunities frequently represent two sides of the same coin. While one investor may choose to divest from certain carbon-intensive sectors to manage its exposure to more stringent carbon regulation, another might engage with issuers in those sectors to shift their business models to be less carbonintensive. Viewed this way, engagement has the potential not only to protect investor returns, but also to contribute to the “broader objectives of society” mentioned in the preamble of the six Principles.
The 17 UN Sustainable Development Goals (SDGs) – which are intended to guide the global community’s sustainable development priorities from now until 2030 and seek to “stimulate action […] in areas of critical importance for humanity and the planet” – are increasingly seen as a useful framework for considering these broader objectives. Some investors report that the SDGs help them define or categorise positive outcomes from their engagement activities.
For many investors, current engagement activity is focused on thematic investments such as green bonds, social bonds and, more recently, SDG bonds. By issuing such bonds – where proceeds are allocated to projects which address specific issues such as climate change or other SDGs – issuers voluntarily commit to ongoing monitoring and reporting in accordance with voluntary process guidelines for issuing green bonds, such as the Green Bond Principles. If issuer reporting does not meet investor expectations, they may engage to ensure the proceeds are used for their intended purpose and clarify the sustainability credentials of those projects. With demand for green bonds increasing rapidly, many asset managers are actively engaging issuers to encourage further issuance.
For example, to ensure that the bonds in its green bond portfolio meet KfW’s minimum requirements, the German development bank engages with issuers before an investment is undertaken. Its process also requires an ongoing monitoring of the green bond reporting of all issuers.
If the reporting does not meet its requirements, the firm will engage with the issuer. A detailed overview of how an investor engages with green bond issuers can be found in BNP Paribas Asset Management’s contribution to PRI’s ESG Engagement for Fixed Income Investors case study series.
A number of investors interviewed for this report noted that green bond issuers tend to be more willing to engage on ESG and provide better access to management. As a result, the PRI expects that a growing green bond market will trigger more systematic engagement practices in relation to both green and plain vanilla bonds. Better connections between the various internal functions of an issuer (for example between ESG research, environment, finance, treasury and investor relations) and more proactive consultation by issuers about investor needs or concerns will make this process a lot easier.
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ESG Engagement for Fixed Income Investors
April 2018
ESG engagement for fixed income investors
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