SRI needs to look at financial firms’ liabilities
The sustainable finance movement, when looking at banks and insurance companies, has so far focused mainly on assets rather than liabilities. But insuring or offering deposits for a particular activity is just as important as lending to or investing in it.
Socially responsible investors tend to judge the financial sector in the same way as they judge themselves: they look at where money is spent, not where it comes from.
It is said that the financial sector is important when it comes to pushing sustainability or socially useful initiatives, because it is these companies which determine where capital is put to work.
Valdis Dombrovskis, vice-president of the European Commission, alluded to this when announcing the Commission’s proposals on sustainable finance in May.
“We should put our money into projects that are compatible with our decarbonisation objectives and the fight against climate change,” he said. “The proposals presented today show that the European Union is committed to ensuring that our investments go in the right direction.”
But people and firms do not just look to take money from financial institutions; they want to put cash into them, too.
The failure to look at the liabilities side of firms was highlighted recently when Plenum Investments, a fund investing in catastrophe bonds and other insurance-linked securities (ILS), was awarded a sustainability certificate.
The certificate, an FNG Label, is from the Forum Nachhaltige Geldanlagen, the industry association promoting sustainable investment in Germany, Austria and Switzerland. The assessment is carried out by the Society for Quality Assurance of Sustainable Investments (GNG), a subsidiary of the FNG, with help from the University of Hamburg.
Plenum operates in a niche part of the financial world. By buying ILS, it takes on the risk of paying out claims for insured losses and receives a coupon for doing so. In essence, it replicates the liability side of an insurance company’s balance sheet.
To give Plenum the certificate, assessors had to ascertain that the fund had no more than 5% exposure to proscribed activities, such as arms manufacturing, fracking, oil sands, coal mining and significant coal power generation.
This involved determining exactly where the cash flows would go when a catastrophe bond was triggered: which parties on the ground had taken out an insurance policy.
This proved difficult. The awarders ultimately had to rely on deduction, looking at the breakdown of the different sectors covered and the volume of payments. Only large volumes from the industrial sector would feasibly be from the banned activities.
Those involved believe it shone a light on problems with the way insurers are assessed from an environmental, social and governance (ESG) perspective.
“The ESG community today approaches insurance companies very much from an asset-owner perspective,” said Dirk Schmelzer, head of portfolio management at Plenum. “They basically only look at one side of the balance sheet: where does the insurance company invest its premium income, loss reserves and so on?”
Roland Kölsch, managing director at the GNG, said: “The whole SRI industry must dramatically engage with insurers to increase transparency on underwriting income, as normally only insurers’ investment income can be screened for ESG issues and controversies, and not the premiums.”
Half the picture
For an example of SRI’s skewed attitude to insurers, look at how Australian insurance firm QBE was assessed when it issued a social bond last year.
The proceeds from the notes were used to invest in bonds issued by companies that had both signed up to the UN Women's Empowerment Principles and also were in the top 200 companies for gender equality, as ranked by Equileap.
Sustainalytics provided a second opinion, in which it discussed QBE's broader strategy on gender equality.
But this focused exclusively on the firm’s investment strategy and its internal business practices, ignoring the policies QBE underwrites.
Banks also focus predominantly on the asset side when marketing themselves as sustainable institutions.
UBI Banca, the latest to show off its sustainable bond framework, framed its sustainability approach mostly around its financing activities, rather than other banking services it offers like deposits.
This makes some sense. For banks, the more difficult, sensitive decision is to take risk on an organisation by lending it money. It is understandable campaigners have focused on this.
With insurers, the liability side is where the risk intelligence of the firm is focused. But the side of the insurance business most readily understood by other investors, when looking with an SRI lens, is the investing side.
However, insurance coverage is crucial for almost any kind of economic activity. So too is being able to put money in a safe account, and perhaps one that benefits from some form of deposit guarantee scheme.
Insurers and banks could easily tweak the direction of the economy by changing their criteria on whom they offer insurance and deposit services to, and at what cost.
Some already recognise this.
Axa XL, the new division of Axa focusing on large commercial property and casualty lines, said last month that it would no longer underwrite the construction and operation of coal plants, coal mines, oil sands extraction and pipelines, as well as Arctic drilling. It would also restrict its business with the tobacco and weapons industries.
Allianz said it would phase out its coverage of coal risks, but only by 2040.
Banks do come under lots of scrutiny for how they vet their customers. However, this tends to be in the areas of preventing sanctions breaches, money laundering and other criminal activity. Banks are not expected to take a broader ESG perspective to selecting their customers.
Banks and insurers can be pushed to forge a better world by using their liabilities and assets. Many in the SRI sector only seem to understand half of this.