Investors have long used environmental, social and governance (ESG) factors to filter and select equities. ESG isn’t quite as established in the fixed income space, but bond and other fixed income investors are expected to increasingly embrace ESG in the coming years. That means managers and investors may turn to data and research providers like MSCI ESG Research for information to use in their investment decisions.
MSCI ESG Research’s products and tools are designed to help institutional investors, asset managers and investment consultants that want to integrate ESG factors into their investment process, identify ESG-driven investment risks and opportunities that conventional analysis may miss, or screen companies for alignment with an investor’s values.
CleantechIQ spoke to Annie Chor Joyce, vice president of ESG client coverage at MSCI, about how the demand for ESG in fixed income is growing, what it means for asset managers and investors, and how it differs from ESG analysis for equities. Here’s an edited transcript of that conversation.
How are fixed income asset managers approaching ESG? Is there a standardized approach?
We’ve seen fixed income asset managers deepen their ESG integration over the last few years and managers increasingly ask to better understand our ESG Ratings framework to unpack how to assess relevant ESG factors.
There isn’t one standardized approach to ESG integration given the multiple variables involved in the integration process – financially relevant key issues for specific industries, time horizon, and data availability. The approach will also vary depending on how deeply a firm is integrating ESG in its investment process. You have some firms who take more of an ad hoc reporting approach – they might have an internal dedicated section for ESG commentary, for instance. There are other managers who have an internal blended score, which might take into consideration data from ESG providers like MSCI ESG Research, and integrate this with their own internal framework and analysis to create an ESG “house view” on companies.
Thinking about the ‘E’ in ESG, what kind of growth are you seeing for green and other environmentally focused bonds?
As corporates continue to issue green, social, and sustainability bonds to find new inroads to access investor capital, that growth has really taken off in the last five years or so. For instance, between the end of 2015 and 2019, the market value of the constituents of the Bloomberg Barclays MSCI Global Green Bond index grew six-fold, from $60 billion to $372 billion (Source: Bloomberg)
Meanwhile, distinct from green, sustainability and social bonds, which ringfences the use of proceeds for specific initiatives, we’ve also seen the emergence of ESG-linked loans and bonds, where the loan terms are tied to performance toward an ESG target. The volume of issuance here doubled from 2018 to 2019, to reach $100 billion. (Source: https://www.msci.com/www/blog-posts/green-bonds-growing-bigger-and/01775697227)
As we shift towards a lower-carbon economy, climate change and sustainability continue to remain high on the agenda of investors and corporates.
What’s driving this increased interest in climate solutions?
Some of it is coming from emerging regulations, such as the EU’s Sustainable Finance Disclosure Regulation (SFDR), and calls to align portfolios to the Paris Agreement to keep global temperature rise to below 2 degrees Celsius. Furthermore, we’re seeing the implementation of mandatory TCFD reporting for PRI signatories. All of this can potentially put pressure on managers to more deeply assess and understand the effects of ESG issues, particularly environmental, within their portfolios.
We’ve also seen this at the country level, for example, with the UK, France and Germany’s goals to phase out coal-fired power plants in the coming decades. Or the recent news from Japan and the Republic of Korea to reduce emissions to net-zero by 2050. These macro trends can have an impact on a manager’s portfolio, particularly the implications on stranded assets, and a company’s bottom line.
In addition to thinking about these transitional risks, when we talk about moving toward a low-carbon economy, we’ve also heard from managers that they are also thinking about how their portfolios are impacted as they align to different temperature scenarios, and to understand the implication of the physical risks, such as extreme heat, flooding and cyclones.
Managers have far more data points today, with ESG providers like MSCI ESG Research focusing on physical risk models, such as our Climate Value at Risk. With more data points available, managers are better able to apply scenario and stress tests.
How are fixed income managers using ESG ratings and underlying data points?
For MSCI, our ESG ratings and the underlying data points are utilized in different ways. It really depends on a fixed income manager’s ESG integration approach, and what they are evaluating.
We offer both an industry-relative ESG score and, separately, an absolute, top-level ESG score. The difference between these two scores can be useful. To take just one example, let’s look at our Water Stress Score, which assesses the risk to a company and its operations from possible water shortages, rising water costs, or other issues. Water stress can be very important to an oil and gas company, but it’s not going to be as relevant to, say, a bank. On the other hand, for a bank, data and privacy security is very important, but those data points aren’t as relevant when you’re assessing an oil and gas company.
Basically, the absolute and the industry-relative scores may each provide useful differentiation when looking at top- and bottom-scored companies. It’s up to a manager to choose one over the other, depending on how they’re trying to support their own tailored approach.
For an institutional investor who is more interested in idiosyncratic risk or tail risk, they may want to look at the absolute ESG score. Whereas for investors looking to identify ESG outperformance, irrespective of how risky a particular industry might be, they might prefer to look at the industry-relative score.
How does ESG in fixed income differ from ESG in the equity space?
In the equity space, when you own equity, you have voting rights and engage through proxy voting and shareholder activism. Shareholder engagement is not relevant for bondholders since they don’t own a company’s shares, however, companies do have a need to refinance. So as fixed income investors continue to integrate ESG into their investment process, we are seeing more and more companies being open to having those engagement conversations.
Expectations for fixed income managers may not be the same as their equity counterparts. There are inherent differences in the structure, and the investment objectives, between these asset classes, which has an implication on how ESG is integrated.
If you think about investment objectives, for equities, you’re predominantly seeking alpha and upside return potential. Whereas fixed income practitioners are typically more focused on downside risk mitigation, which is a different way of viewing companies in a portfolio.
From an ESG perspective, what we see as most important for fixed income is likely governance. So that might have a higher weighting for a fixed income manager than an equity manager, who might focus on different parts having more to do with upside possibilities.
There are acknowledged challenges in ESG reporting for fixed income. While an equities investment analysis is based on a single security per issuer, a fixed income issuer may have multiple issuances with different maturities, which affect the duration of a portfolio. Additionally, a fixed income portfolio can span from corporate credit to other sub-asset classes including securitized products, leveraged loans, municipal bonds – which are not all covered from a ESG ratings perspective due to the unique characteristics of the different markets.
Although ESG in equity investing is more fine-tuned, as more data and tools are available for fixed income managers, the stronger and more holistic is the ESG assessment of fixed income strategies.