Grading goodness: judging shades in the SRI market
The rapid growth of sustainable finance, particularly in fixed income, has meant standards and sustainability reviews have proliferated, leaving baffled investors to assess their assets against an ever-expanding list of acronyms. Regulators are preparing to wade in with their own definitions, but some fear this will stifle the market’s progress. Owen Sanderson reports.
Sustainable finance is all about proof. Investors want to know they’re allocating capital not just to investments that will prove profitable, but to investments with an ethical, or at least sustainable, dimension. But not all investors have the same set of values.
Investors can consider carbon emissions, gender equality, ecosystem preservation, water systems, ocean exploitation, democracy, human rights or a combination of everything — defining “good investment” is no easier than defining “good” itself.
Some providers of capital have very clear ideas on the subject — charities, churches, universities under pressure to divest. But others are raising new funds with an ethical dimension, and need to use their sustainability credentials to advertise themselves.
This can mean anything from merely screening out the morally dubious to actively pushing for each investment to make a positive impact — and across a bewildering array of factors.
Around this burgeoning investor universe is a wide variety of organisations aiming to offer definitions of socially responsible investing (SRI), or environmental, social and governance investing (ESG), or impact investment, or tools to help investors measure the impact they’re having.
The big beasts of the capital markets — the regulators — are also starting to weigh in, particularly on green finance, where the urgency of tackling climate change means green capital markets have to scale quickly.
Chinese and Indian regulators have already laid out their versions of what constitutes green bonds, and the European Union is about to follow suit, with green bond standards, aligned to the Paris Agreement, meant to show which bonds are compatible with a path to 2C of warming.
Some fear, however, that regulatory action will prove bureaucratic and stifling and homogenise a market which is rapidly growing and innovating.
What sort of standard?
Delve into sustainable finance for a moment and you quickly need a taxonomy for the taxonomies.
Sustainable finance has principles, guidelines, external reviews, green ratings and an official EU Taxonomy in development. Investors and index providers use these standards but add their own definitions to meet their own goals.
The asset class, too, can determine which standards are useful. Ethical and ESG investing has a longer history in the equities market than in fixed income, and is usually applied to whole companies rather than individual securities. The advent of ESG in fixed income over the last decade has brought a new discipline of asset-level assessments.
Green bond investors, can use the Climate Bonds Initiative’s list of green bonds to limit their investment universe, and assess their assets for compliance with the International Capital Market Association’s Green Bond Principles.
At an individual asset level, they can examine the second opinion given at the time of issuance, as well as any extra issuer disclosures, and may seek help from Moody’s or Standard & Poor’s, both of which offer green bond assessments.
When the EU publishes its taxonomy of sustainable business activities, investors will also be able to see where their investments fit into this.
Sean Kidney, chief executive of the Climate Bonds Initiative, who was a member of the Commission’s High Level Expert Group (HLEG) on Sustainable Finance, says the taxonomy, when it arrives, will complement rather than supersede existing methods of assessing green bonds.
“The idea and model we’re approaching — let’s call it an investment grade hurdle,” he says. “It’s trying to identify investments which are compliant with the Paris Agreement, and there’s lots of room for interpretation and argument beyond that.
“Most markets benefit from commoditisation. As long as it’s not making it too stupidly difficult, there are thousands of issuers out there, some of them uncertain about how issuing a green bond is achieved. The taxonomy will help them look at the market and see its benefits. It makes it much easier for issuers, and acts as a useful support for investors.”
There’s certainly widespread agreement that sustainable finance could handle more standardisation, but some see risks in a potentially rigid classification.
“It’s not going to be a small step. The EU is behind it, and it’s going to be a strong commitment to better transparency,” says Marcus Pratsch, head of sustainable investment research at DZ Bank. “But I hope there’s not too much over-regulation. Also, the current discussion is only one part, the green and environmental. We also need to talk about the social things.”
He continues: “Too much standardisation and regulation is not good for the market, but we do at least need to find a common language. The ICMA initiatives in the bond market are a good middle ground that avoid being too prescriptive.”
Kidney acknowledges that the EU taxonomy is moving more slowly on other areas of sustainable finance, including social, but points out that action on climate change is far more urgent.
But for others, this extra level of standardisation could be damaging.
“Taxonomies sound great, lovely word, but there are a lot of them knocking about already,” says Andrew Parry, head of sustainable investing at Hermes Investment Management.
“Do we need the bureaucratic arm of a government telling us what good looks like? It doesn’t seem to me to be right.”
Parry says a regulatory taxonomy could remove the importance of investors interpreting and assessing sustainability, and encourage them to simply replicate a defined index of sustainable products without properly engaging with companies.
Standards in something
While the taxonomy might not be universally welcome, more standardisation in language and disclosure from issuers, and a less complex market for standards and ratings, would surely help.
“The external review market is vast and quite fragmented,” says Rahul Ghosh, senior vice-president, ESG and green bonds, at Moody’s. “Approaches are broadly overlapping in some instances, in others not, but they all share a common goal of providing investors with increased transparency around green bond offerings with the aim of mitigating the risk of greenwashing. Looking ahead, we may see a consolidation of the external review market for green bonds.”
Parry says: “It’s not easy, it’s quite mystifying at the moment, you’ve got SRI, ESG, SDG, enough acronyms to play a good game of scrabble with. Its behoves our industry to simplify the language and to help clients understand the lens with which we’re looking at the world.”
In green bonds, most issuers pay for an external review from a second party opinion provider such as Cicero, Vigeo or Sustainalytics, and may also obtain a green bond assessment from Moody’s, or a green evaluation from S&P.
Both rating agency methodologies mix process factors, such as quality of disclosure and management of proceeds, with the actual final use of proceeds.
“The second party opinion is something the issuer is paying for, and when you pay for something, you don’t really expect it to be bad. It can be very helpful to add some additional data, assess the issue and the use of proceeds. But it has to be a two stage assessment. You need to take your own view as well,” says Pratsch.
There is, however, little or no standardisation among the second opinion providers and in general corporate sustainability disclosures.
Pratsch adds: “The most important data is from the issuers themselves, and it ideally needs to be in the language of the financial markets. In the past, there was lots of prose and lots of information, but very little of it was useful. We need data in figures, information linking the material business of the company to sustainability.”
It is easy for investors, and the market at large, to aspire to better disclosure, but it is harder to achieve it in practice.
Ghosh gives the example of a renewable energy plant, with measurable, carbon saving power output, compared with the difficulty of measuring the carbon saved by a green securitization backed by thousands of loans against energy-efficient homes, or a sovereign green bond which funds intangibles such as subsidies.
Disclosure itself, particularly at an instrument level, can also be a distraction from looking at the bigger pictures.
Parry says that companies in sectors such as tobacco and oil, which have long histories of ethical scrutiny from investors, frequently have better disclosures than ‘pure play’ companies in sustainable sectors like renewable energy. Larger companies generally disclose better than small ones, because they can devote more resources to it.
That ought to help companies with these characteristics tick more boxes in various rating schemas, and appear stronger in the green assessments.
Tensions like this are typical of sustainable financing. Is the issuer’s overall business or its sustainable activities more important? Is purity more important — or progress?
“It’s important to understand where green financing sits in the overall issuer context, look at the governance behind green bonds, and see how it aligns with the issuer’s business and sustainability credentials,” says Ghosh. “But it’s also important that the green bond market is used to turn brown balance sheets green and serve the transition to a low carbon economy — our green bond assessments refer to the bonds themselves, not the company as a whole.”
It’s tempting, given these tensions, to push the decision back to the ultimate providers of capital.
Culture, tradition, and even religion will give different end investors different views about how to approach sustainable finance, and the capital markets have to cater for that.
“It’s the investor that has to make the final decision on what is sustainable, but this can vary quite substantially,” says Pratsch. “When I talk to specialists like the church banks, there are a lot of exclusions, alcohol, tobacco, arms, and nuclear power, but often, for French investors, nuclear power is considered sustainable.”
But, done right, standardisation ought to boost the sustainable finance market, by making it easier for new entrants to navigate, from issuer and investor sides alike. Standards and ratings might be confusing, but they’re an essential foundation for the market’s growth.