Investing for the Good – the Rise of ESG
- Elen Callahan, Head of Research, Structured Finance Association
Sustainable Investing is an investment discipline that integrates environmental, social and governance (ESG) considerations to the investment process. ESG incorporates a broad set of subjects which many groups have attempted to codify. The SEC defines the term ESG “as a broad set of subjects germane to businesses as defined by The Business Roundtable in its Statement of Purpose: customers, employees, suppliers, the community (environment), and shareholders.” Others have taken a more prescriptive approach. The Sustainability Accounting Standards Board (“SASB”), a foundation established to improve industry specific disclosure standards across financially material environmental, social and governance topics, has identified 26 sustainability-related business issues across five broad dimensions — Environmental, Social, and Governance, Human Capital and, Business Model and Innovation. SASB evaluates these business issues across 11 identified industries and provides industry-specific standards designed to assist companies in disclosing financially material, decision-useful sustainability information to investors.
The need to better define ESG metrics has been driven by growing number of socially conscious investors. The US SIF Foundation reports that at the start of 2020 $17.1 trillion of invested assets was attributable to sustainable investing. This represents “33 percent, or one in three dollars, of the $51.4 trillion in total US assets under professional management.” Globally, J.P. Morgan expects the ESG market to reach $45 trillion in assets under management by year-end 2020 with Europe and North America accounting for more than 90% of the market.
Morningstar: Sustainable ESG funds focus on “sustainability; impact; or environmental, social and governance (ESG) factors in its prospectus or other regulatory filings.”
The bulk of the ESG market at the moment is driven by equity products, which represent about half of the ESG assets under management, according to J.P. Morgan. Activity in impact investing in the fixed income market is limited for now and is dominated by green bonds, which fund projects with a positive environmental or climate impact. Issuance for green bonds reached $350 billion in 2020, an increase of 36% from 2019. Social bonds and sustainability bonds have also started to proliferate. Social bonds, which cleared $70 billion in 2020, up from $20 billion in 2019, focus on non-environmental impacts, such as socioeconomic advancement and empowerment, affordable housing, education, healthcare and essential infrastructure. Sustainability bonds are linked to both social and green initiatives.
Growth is driven not only by the rising awareness of ESG considerations but, importantly, by the solid performance relative to non-ESG products, dispelling a myth held by some investors hesitant to make the leap. In a September 2020 study, Deutsche Bank shows that actively managed US equity retail sustainable funds outperformed the S&P 500 by an average of 50 basis points and non-ESG funds by 60 basis points between 4Q 2018 and 2Q2020. Sustainable ESG funds grew by 6.20% during this period. Compare this to non-ESG funds which, during this same period, underperformed the S&P 500 by 10 basis points and saw a 5% reduction in share of the market. On the fixed income side, a study by Morgan Stanley shows that total returns of sustainable bond funds were consistent with traditional bond fund returns between 2004-2018. The study shows that sustainable funds were less risky than traditional funds during this period. “Starting in 2004 the downside deviation and the dispersion range of sustainable funds was significantly and consistently smaller than that of traditional funds.”
Myriad of differing disclosure requests demands standardization
As the interest in ESG has continued to rise, the need for standardized ESG disclosures, which are required to make the investment decision, has also risen. On May 14, 2020, the SEC Investor Advisory Committee Relating to ESG took the first important step by formally acknowledging that “despite a plethora of data, there is a lack of material, comparable, consistent information available upon which to base some of these decisions.” The SEC took particular note of the sheer number of third-party data providers that were active in the industry (over 125 as of 2016), the incompatibility of their criteria, and the uneven burden that data requests from these providers was placing on corporate issuers. Ever vigilant of uneven playing fields, the Committee concluded that large corporate issuers with greater resources were in a better position to fulfill the barrage of ESG data requests, while smaller corporate issuers would have a more difficult time doing so negatively impacting their ability to attract ESG investment dollars.
The SEC has recommended applying a uniform ESG disclosure guideline, administered by the SEC, to level the playing field between small and large corporate issuers. A uniform reporting policy would support investors as well as it would facilitate ESG comparisons across investments. The SEC reasons that under this structure, information would be provided directly from the corporate issuer to market participants through company filings, rather than through third parties.
We saw similar concerns expressed in response to the imposition of Rule 17g-5 in the securitization market. The rule was created to strengthen and clarify the analysis of securitized investments. Unlike the fragmented current environment surrounding ESG, in the case of 17g-5 there is a uniform rule applied across issuers. However, the financial and resource commitment of complying with the rule is significant and has been more easily absorbed by larger, well-capitalized companies. The SEC announced earlier this year that, after discussions and comments from industry participants, Rule 17g-5 will undergo reevaluation based on the commentary received. While the rule is well-intentioned and meant to make the credit rating process more transparent, the debate surrounding the burden to comply with the rule as well as the rule’s actual effectiveness could serve as a good roadmap for the SEC as it begins to codify and implement its ESG reporting requirements.
Integrating ESG into securitization
The application of ESG principles into securitization has been challenging primarily because there so many levels where ESG principles can be applied. Take the example of a residential solar company. If an investor wanted to invest in a residential solar company they could participate through a stock offering, a corporate bond offering, or a securitization. Using the SASB materiality map as guide, “Environmental” considerations are deemed relevant for most solar-related industries within the Renewable Resources and Alternative Energy sector, however, Social and Governance are not considered relevant. We could directly apply Environmental considerations when examining the merits of a stock or bond offering since both security types invest directly into the issuing company. However, should these same considerations apply when examining the securitization of solar assets? In the securitization of solar assets, investors are paid back from the cash flow generated by leases or loans extended by the solar company to households, is it more appropriate then to categorize securitizations of solar assets under the “Financials” sector as defined by the SASB guide? Under the Financial sector, however, Environmental factors are not considered relevant at all, but Social and especially Governance considerations as applied to third-party services are considered pertinent. In other words, in a securitization should ESG be evaluated at the corporate, transaction or pool level? Or some combination of all three? Additionally, should ESG credit be assessed on a negative (i.e. not causing a negative ESG impact) or affirmative basis (i.e. mitigating negative ESG issues)? These are just some of the questions that structured finance investors are evaluating for their various investment portfolios and third-party service providers, such as standard setting and certification firms, are considering for their review processes.
Despite challenges, structured finance practitioners are enthusiastic about ESG engagement. According to our recent SFA survey, 81% of securitization issuers incorporate ESG into their corporate business practices. Additionally, half of the responders that did not have such practices in place already have plans to do so by 2021. And while 94% of ABS issuers indicated they do not currently report ESG information in their securitization transactions, 38% are currently evaluating or developing how to report this information. On the investor side, 60% indicated that their firms applied an ESG framework to ALL investment decisions, and 35% do for certain funds and portfolios. Nearly all investors (95%) indicated that client demand was driving their participation in ESG investing.
If 2020 was a catalyst year, then 2021 will be the year of progress
At SFA, we believe that the unprecedented volatility that has come to define 2020 is expected boost flows into ESG investments even more. The coronavirus pandemic may be the “wake-up call that accelerates the need for a different approach to investing, as parallels have been drawn between the unforeseen risks of pandemic and issues such as climate change.” Calls to address racial injustice and the widespread institutionalization of diversity and inclusion initiatives across corporate America may provide further structure to the Social and Governance components of ESG. With the incoming Biden administration and a Democratic Congress, we expect to see significantly more regulatory and legislative development in the ESG sector.
In December 2020, SFA convened an esteemed set of champions within ESG, impact investing, sustainability and structured finance at the SFA’s second annual ESG in Structured Finance Symposium. During the two-day symposium structured finance thought leaders shared ideas in assessing and applying ESG factors to securitizations and looked at other ESG-friendly asset classes that could benefit from the securitization technology. As ESG moves steadily from fringe to mainstream, SFA will continue to convene and guide the industry with the goal of building a robust ESG market in structured finance.