Bonds: ESG principles increasingly pronounced in investments

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on December 18, 2017 - December 24, 2017.
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Adhering to environmental, social and corporate governance (ESG) principles in investing has become more than just a tick-box exercise. It is now forming the basis of most investment decisions, say experts.

As the evidence increasingly shows that investment funds that adopt ESG principles in their strategies tend to outperform those that do not by a significant margin, investors are feeling more than vindicated, says Madhu Gayer, head of investment analytics for Asia at BNP Paribas Securities Services, in Singapore. 

“When we first started looking at investment analysis several years ago, it was very much from the classic mix of risk-reward basis and fundamental ratios. But this has changed dramatically in the last three to four years,” he adds.

“It has changed because there is a big focus on ESG and sustainability on the part of our clients. The questions they ask us are very much driven by ESG practices. These questions are also driving us in terms of capital allocation, asset allocation and risk management.”

Gayer says investors are not only concerned about the returns they will get, but also the core practices of the investee companies. These investors are mostly large institutions such as pension funds that manage more than €580 billion (RM2.8 trillion) in assets globally.

“A pension fund came to us a few years ago and said it had an issue with what its investee companies were doing. The fund wanted to know what the business models of these companies were and what risks they were taking. When we pointed out that these queries sounded a lot like ESG-related topics, it said, ‘Absolutely, because we are a responsible investor,’” says Gayer. 

He adds that the net returns of the pension fund have since improved as it now has better risk management practices in place. The fund is able to research its companies and gauge the performance of its investee companies better.

These are crucial steps for us as institutional investors as the repercussions of non-compliance with ESG standards is bound to have an explicit impact on investments, says Gayer. “It also helps to avoid controversies. Let’s say a company or an investment has got itself into a spot of bother [once the media highlights the issue]. That has an immediate impact on share prices and maybe a longer-term impact on funding, too. 

“With the ESG standards in place, we are able to highlight this to our client. If I had not been aware of this, I would have invested and then wondered three months later where my income stream had disappeared to. 

“So, that is where we have seen the benefit of sustainability or ESG. It is really helping, not only in risk mitigation but also in future-proofing the investment. For long-term investments and long-term capital allocation, what happens tomorrow or the next few weeks matter less as these investors have a 10-year horizon or longer.”

 

Not just a fad

While critics argue that the outperformance of ESG indices may take a back seat if commodity prices recover, ESG strategies will continue to see progress, regardless of the circumstances, says Gayer.

“I will be amazed if it is just a fad. It is because we are talking about very large institutions committing and changing what they are. And they don’t do this easily,” he points out. 

For example, Japan’s Government Pension Investment Fund (GPIF) — the largest of its kind in the world, with US$1.3 trillion (RM5.3 trillion) under management — has selected three ESG indices to track for about ¥1 trillion  (RM36 billion) of Japanese equity investments. “It has the ultimate long-term horizon, which is about 100 years,” says Gayer. 

He adds that the steps taken by the GPIF help build an ESG-conscious ecosystem as it also requires industry bodies such as asset managers and rating agencies to also adopt these strategies. “This means everyone in that ecosystem changes. And you have to because that is where the money is moving now and you have no choice.”

Mushtaq Kapasi, chief representative for Asia-Pacific at the International Capital Market Association (ICMA), stresses that ESG-based investments are a trend that is here to stay. “The trend is towards mitigation of climate change and environmental problems are front and centre. This is driving green bond issuances. There is huge demand for clean energy and green projects. So, I think the trend will continue as a matter of global policy,” he adds.

“We are also seeing the financial risk of not doing anything. So, investors are pricing in the long-term financial risks from the effects of climate change such as the value of stranded assets and damage to infrastructure.

“Whether or not you believe in saving the environment, these are risks investors will be facing over the next few years.”

Kapasi says the future demographics — millennials specifically — have a greater consideration for ethics, governance and social implications of their investments. “There has been a change in the conceptual way of thinking about investments — which incorporates ESG factors into the decision process. These are major trends, almost demographic trends, that will not be rolled back.”

Gayer and Kapasi spoke to Personal Wealth on the sidelines of the inaugural Asean Capital Market Conference in Kuala Lumpur last month, where the Asean Green Bond Standards (AGBS) were launched. 

The AGBS is intended to provide additional guidance on the implementation of the green bond principles, as well as to enhance transparency, consistency and uniformity of green bonds issued in the region by member nations. The AGBS label is to be only used for issuers and projects in the region and specifically excludes fossil fuel-related projects.

 

AGBS puts Asean on the map 

In the case of green bonds, Kapasi says the demand continues to grow even though many are cynical about such investments. 

He points out that the AGBS gives legitimacy to the market, helping to identify what green bonds are and to reduce confusion over new issues in the market. “It cannot be emphasised enough how difficult it is to get 10 countries — with very different economies, securities markets, levels of development and political systems — to agree on regional standards for a product such as green bonds. It shows a real commitment to the overall goal, which is increasing infrastructure investment, helping solve environmental problems and helping to get the financial system integrated with environmental considerations.”

As for the outlook for green bonds, Gayer says his team’s analysis shows that the volatility of green bonds is roughly the same as that of plain-vanilla bonds. “The question is, if I wanted to exit my plain-vanilla bonds and get into green bonds, would it cost me anything? I would be taking on a little more active risk, but I would also get outperformance. So, the investment would pay off on a risk-adjusted basis.” 

Kapasi says the green bond market is still relatively small. “We are talking about US$130 billion of issuances in 2017. But by most estimates, the international plain-vanilla bond market is about US$10 trillion,” he points out.

“While that shows how small the green bond market is, it also shows how much potential there is. However, if you take a really long-term view, there may well be a day when ESG considerations are embedded in every issuance.”