23 November 2020
Andrew Epsom, insurance client solutions director at Royal London Asset Management, considers the continuing trend towards ESG investing in credit, but highlights that in many cases the approaches being adopted may not result in either the environmental or financial outcomes that insurers are seeking.
When they look back on the market environment for 2020, insurers will undoubtedly remember the huge sell-offs in the spring and subsequent recoveries. I hope that they will also remember that this hugely disruptive period has significantly accelerated interest in the integration of environmental, social and governance (ESG) factors into investment decision-making.
This was an area where insurers were already ahead of most other investor types, not least with the increasing regulatory responsibilities around recognising climate-related risks having been signposted for some time. However, we recognise that for many, ESG integration within their investments is not easy – particularly within fixed income assets.
While it is tempting to think about ESG risk as a further overlay to portfolios, this misses the point when it comes to credit investing. Credit investing has an asymmetric pay-off profile – and therefore credit analysis and research should focus on what could cause a company to default on coupon or principal repayments. ESG factors shouldn't be looked at just because of the rise of sustainable investing, but because credit analysis should focus on anything that could impact returns: credit research that doesn't include ESG factors is flawed credit research and will lead to sub-optimal outcomes.
Evolution of ESG investing in credit
Historically, when investors wanted to consider ESG factors, they were typically thinking about equities. In some ways, this is a natural bias – equity holders are owners of a business and can therefore influence it more easily. At the same time, it is simpler to think about equities as these are a company level asset. If you buy shares in a company it is for the whole company, but bonds can be issued from parent and subsidiary companies, and proceeds raised can be ring-fenced for certain activities while coupons can be paid from ring-fenced assets or cashflows. This is undoubtedly more complex, and reflects why ESG data is much more widely available for equities than credit, but this gives greater opportunities to add value through a robust research process.
A good example of this is UK utilities which are long-tenor and in a high impact sector. A number of UK utilities are not listed on equity markets and there are often complicated ownership structures and as such, there is limited third party research. At the same time, it is sometimes possible to lend to one part of a utility (for instance the part that invests in wind farms) while keeping those funds away from another (for instance the part of the same company that runs nuclear power stations). With limited differentiation in terms of the price of debt, truly targeted ESG analysis is critical in terms of reducing risk without compromising longer term portfolio returns.
How much do you pay for convenience?
Many investors are increasingly utilising ESG scores or ratings as a mechanism for filtering the available universe of securities and monitoring exposures over time. However, we are naturally sceptical around labelling that takes the complexity of most bonds and wraps it in a neat little package. These ESG ratings can be compared with more traditional credit ratings, which are not always understood nor used properly. Credit rating agencies give an opinion on the risk of default at a point in time, but investors also need to have an ongoing view on an issuer's progress with an understanding of recovery if coupons are not paid.
With the current focus on climate risk management, 'green' bonds are now receiving particular attention. At one level, the concept is beyond reproach. As a bridgehead to get investors and issuers considering and elevating critical environmental issues, they have undoubtedly been a success and the market has delivered exponential growth in issuance. However, there are concerns around the green labelling of some bonds that might not deliver the environmental outcome that investors are expecting. Given the vast majority of green labelled issuance is unsecured, the associated lack of direct control and visibility around proceeds often causes us concern. As cash is fungible, there is the very real risk that proceeds can be used to finance other, potentially less wholesome, assets and businesses.
ESG in fixed income – delivering superior outcomes
The significant additional investment already made into ESG-focused fixed income is a positive affirmation that insurers are taking their responsibilities in this area seriously. However, many of the mechanisms used to implement ESG are sub-optimal – be it through not integrating ESG risks coherently into the wider credit risk framework, or through an over-reliance on ESG ratings and green labelling.
By contrast, effective and authentic integration can only be beneficial in improving the integrity of lending decisions and, as a consequence, the sustainability of insurance company asset portfolios.