15 August 2022

Addressing murkiness in ESG data

In the second part of this Insurance Asset Risk/ Schroders roundtable, insurers discuss the challenge of data availability across environmental, social and governance factors when investing in sovereign debt

Attendees:

Anand Rajagopal, head of public annuity asset origination, Aviva UK Life
Catherine Chen, responsible investment manager, Royal London Group
Hetal Patel, head of climate investment risk, Phoenix Group
Jean-Francois Coppenolle, investment director - climate and ESG, Abeille Assurances
Paul Grainger, head of global fixed income & currency, Schroders
Marcus Jennings, fixed income strategist, Schroders
Thor Abrahamsen, senior investment risk analyst, Gard

Chaired by Vincent Huck, editor, Insurance Asset Risk

Vincent Huck: The lack of data echoes Thor's comment about this being murky. Is this opinion shared by everyone?

Anand Rajagopal: While there is some murkiness in data, we make best efforts to pick up on the industry know-how, and that's not just through the financial market participants. It's also about staying informed of the climate science and the research at various leading universities. Notre Dame is one example, but you have MIT, Yale, and a number of institutions that have done considerable work in climate research and monitoring of Sovereigns and who have dedicated research departments.

The latter have made conscious efforts to building an understanding of sovereigns' efforts on forward-looking climate ambitions and how performance would look like under various economic, social and other pathways.

Yes, there is market evidence that 'G' and 'S' in terms of price discovery and liquidity discovery have had more of an impact versus 'E'. But, when you think about the insurer balance sheet, we have to match liability cash flows and we have to minimise the risk of downgrade/default and the risk of being struck with "stranded" assets. And, clearly, part of that has to do with how the 'G' and the 'S' are rightly aligned in terms of our direction of travel.

Within net-zero ambitions, we have a weighted average carbon intensity reduction metric with corresponding milestones, for e.g., a portfolio-level 25% reduction by 2025, and by 60% by 2030 per our TCFD disclosures vs. 2019 levels. That requires that our investment strategy ensure that any investments carried out – be it corporate, Sovereign or elsewhere – take us in the Net zero direction of travel.

So, the focus is on credit due diligence and valuation work that a credit analyst does have to carry out here. Pertinently, there are also frequent debates between ESG specialists and Sovereign analysts/PMs on the formal country review process.

Some typical ESG-related questions that we are trying to answer here include

  • 'Is investing in this sovereign or sovereign-linked entity taking us in that direction of travel?' 'Or is it going to take us away from that direction of travel? If so, is there a transition pathway in place?'
  • 'If there is a transition pathway in place, are there specific ways for us to express our investment appetite, i.e., through green or sustainability-linked bond issuances which typically have clear KPIs vis-à-vis climate change goals.'
  • 'From an ESG perspective, is it better to invest in country at a sovereign level, or will the country move forward more rapidly if we focus on the companies operating in the country/jurisdiction?'

Thor Abrahamsen: I just want to say that the comment that was made earlier about how we don't want to penalise emerging market countries because they have their industrial revolution later than us, I think that goes to the heart of what we're trying to do here.

What is the goal of ESG investing in sovereigns? Is it to encourage countries to do the right thing?

Because the goal as fixed income investors is a) to make money hopefully, but b) also to balance out liabilities. But you don't look necessarily at the fixed income book as the place where you're going to make most of your returns. It becomes more of liability and risk management tool.

And then looking at that from the perspective of how to allocate the portfolio in an ESG-compliant manner, for sovereigns, if the goal here is to make the world a better place, then you would invest more in bonds or countries which are doing the right thing - but for emerging markets bonds that may be difficult if they are penalised for current development

Over time, if an emerging country becomes universally lauded as a green country, and interest rates becomes stable and the currency becomes stable, then it become less interesting for fixed income investors who look to EM debt to drive returns.

The value lies in supporting countries who are trying to do the right thing. But then for investors it becomes a completely different question in terms of allocation.

Marcus Jennings: One thing we're very acutely aware of is that under many traditional quantitative frameworks emerging markets score pretty poorly across 'E', 'S' and 'G'. But if you look at why that is the case on the environmental side for example, it's because of physical risks.

Because of their geographical location and the composition of their economies which are highly dependent on agriculture and therefore weather, they are more at risk, economically-speaking, from climate change as a result of physical risks increasing over time. But that is not the fault of emerging markets. This is something that the developed markets have created as a problem. So they score poorly through no fault of their own, but because of this externality.

Looking at the net-zero policies of both DM and EM economies - and yes the data at the moment is patchy and over time hopefully it will get better to truly assess a mark-to-market whether both DM and EM economies are sticking to their word in respect to carbon reductions over time - But what we didn't want to do is just rule out emerging markets because, say, they have a net-zero target at 2075 instead of 2050.

So, we decided to have a look at their policies; are they credible? At what stage are they? Is it just a pledge that's been put in place – because talk is cheap really. Anyone can throw out a pledge.

So, one thing that we've been conscious of, and what we look for in terms of our investable country set, is actually that country has thought about that transition, has put some sort of work behind it, and actually has published some sort of transition pathway plan.

Hetal Patel: That's quite a thoughtful approach, very much aligned with the 'just transition theme', and if we consider what are we trying to achieve with integrating ESG? At Phoenix Group our approach always is to first think about sustainability-related risk, ESG risk, as a way of addressing risk and resilience to try and improve a portfolio resilience first and foremost, to optimise that risk-return we can deliver for our policyholders. And as a by-product if you've put in a good structure then you can have a positive impact for the world as well.

Paul, Marcus, how do you think about the whole ESG piece, especially with respect to sovereigns, do you see it as a means of mitigating risk? Do you see it as an alpha driver? Does it drive changes in your holdings, for example what is happening now with Russia, or more broadly other emerging markets would ESG drive changes in allocation in sovereigns?

Paul Grainger: It's both. As a fiduciary we have two roles. One is the same as you for your policyholders - we have to deliver return for our clients, deliver alpha. Also, we want to mitigate the risk. The mitigation of risk within sustainability is probably the slightly easier part of it because it's probably clearer where the downsides are.

Under our framework because we use civil liberties and freedom, Russia was un-investable within our sustainable universe.

Alpha is much more nuanced. Within developed markets, the alpha side is probably slightly harder because it's much harder to disentangle if the alpha is coming from a change of monetary policy, a change of traditional fiscal policy, a change of environmental fiscal policy, a change of social fiscal policy?

Within EM we're in nascent stages of how the emerging world is moving on to this.

The key part of this is we have to be clear internally about what we're looking for, what we're expecting the outcome from each part of our analysis; but also externally, we need to be really clear in communicating that with our clients, no matter what institution they are, what we're thinking, where we see the opportunities, where we see the risks.

The biggest part of sustainability going forward is going to be communication between asset managers and their clients.

Marcus Jennings: To Thor's point, what are we trying to achieve out of all of this? If you're trying to do good in the world but also have a fiduciary duty to make money, are these competing ideas? On the sovereign side at least, and over the long run, I don't think they are. And certainly investors in the equity and credit space would say that if you have a company with a better ESG score, it would probably lead to better profitability in the long run. They aren't incompatible.

On the other hand, materiality is something that needs to be discussed more in sovereign ESG, i.e., the concept of these risks coming to fruition and impacting bond prices.

They're quite slow-moving risks. The data we have is very slow-moving. But we should be acutely aware of how material these risks will be and when they they'll come to fruition, even if timing these is particularly hard.

So it's a combination of the two really: alpha driver and having an impact.

Catherine Chen: Our sovereign holdings are around €20bn and the majority of them is actually UK-centric. So, relatively speaking, emerging market exposure is quite low, and we are less concerned about that.

However, we announced our climate change pledge last year. And that has led us to ask around 25 asset managers managing our assets about their climate change transition plan. Some of them are working diligently and others have replied that they don't do much, because they expect issuers to reach net-zero by themselves through their climate change pledge or Nationally Determined Contributions (NDCs), which from a portfolio construction level mean they don't have to do much – this argument is quite optimistic in my view.

So we've looked to prove or disproof this argument and decided to look at all our security holdings, which is 8,000 security holdings across different asset classes, to see how many invested issuers hold climate pledge. We found that 29% of them have a climate pledge whether it is net-zero, Paris alignment or SBTI. And of course that is just the pledge, our analysis hasn't factored in the credibility behind it, i.e. actions they have in place to achieve it.

So here you see some of the challenges we face. That's why we have our stewardship meetings with all the asset managers on a quarterly basis just to understand their plan. But in the meantime, I'm still looking for a proper matrix from our end to monitor or to understand how actively we need to decarbonise in the remit of equity, corporate or sovereign bonds.

Jean-Francois Coppenolle: The comments around murkiness of data are spot on. On the 'S' and 'G', we probably have some quite good transparent and robust data that allows us to compare countries and on the environmental aspect it's more difficult to get actual data because there's a time lag on the data that is naturally quite backward-looking.

We know that one issue when looking at countries' commitments is whether they are sufficient and also the willingness to implement them. Another challenge is potential changes in policies, for example, the carbon border adjustment mechanism that the EU is setting - kind of a tax on carbon-intensive imports - so there's all these elements that are changing quite quickly.

There are a number of metrics one can use to asset the carbon footprint of the sovereign portfolio: carbon intensity by average, or by median, household revenue, absolute carbon emission, sovereign's import/exports.... And some of them will be by nature backward-looking, but the objective is really to have a holistic view of the sovereign portfolio.

And then if you think about this question of weighting the 'E' versus the 'S' versus the 'G', this will depend on each investor's appetite and values, as well as the impact they want to have on the real world.

For that reason, it's really important to have a very well documented and transparent framework of how we are intending to manage our sovereign portfolio in line with the sustainability outcome we want to have. Objectives, processes and data need to be aligned. 

This is the second part of the Insurance Asset Risk/Schroders roundtable. To view the first part, please click here