Barbara Kingsolver’s novel ‘Flight Behaviour’ tells the story of monarch butterflies who cannot use their normal winter site in Mexico because of a warming climate. In the book an entimologist asks what is the use of saving a world that has no soul: “Continents without butterflies, to seas without coral reefs, he meant. What if all human effort amounted basically to saving a place for ourselves to park?” The financial industry has been looking for ways to help save the soul of the planet through sustainable investing, which considers environmental, social and governance (ESG) factors in portfolio selection and management. Socially responsible investment assets have been growing as academic studies have shown positive correlations between ESG and corporate financial performance, As a result, corporates are realising that incorporating sustainability into their business model can improve profitability and increasingly attract clients and capital.
In this Financial Markets Insights report, Dana Hanby of Health Equity Exchange and Allcot, Trevor Allen of BNP Paribas Securities Services, David Harris of the London Stock Exchange Group and FTSE Russell, Mike Sleightholme of SS&C Technologies, Wayne Sharpe of Carbon Trade eXchange and Adam Nethersole of Verne Global talk to The Realization Group’s Mike O’Hara and Shanny Basar about the growing impact of sustainability on business and society.
“1.5 Degrees” was lit up across the Eiffel Tower to celebrate COP 21 (1), the 2015 Paris climate conference, when 195 countries adopted the first universal, legally binding global climate deal. They agreed to keep global temperatures well below 2.0C above pre-industrial times and to endeavour to limit them even more, to 1.5C. The treaty encompassed both the business community and the financial services industry as rich countries agreed to help poorer nations by providing “climate finance” to adapt to climate change and switch to renewable energy.
The United Nations has been trying to involve finance in mitigating climate change since former UN Secretary-General Kofi Annan launched the Principles for Responsible Investment (PRI) with the largest institutional investors in 2006 in New York. This has been supported by academic research showing that “the business case for ESG investing is empirically very well founded” (2). As a result, institutional investors with nearly $60 trillion in assets under management have signed up to the PRI.
Socially responsible assets have been growing fast across the globe and reached $22.89 trillion at the start of 2016(3) according to the latest report from Global Sustainable Investment Alliance (GSIA).
Sustainable investing now consists of 26% of all professionally managed global assets, with more than half in Europe. However, the lack of independently verified sustainable data has led to some businesses being accused of “greenwashing”, marketing themselves as environmentally friendly while carrying out unsustainable practices. Stock exchanges, index providers such as FTSE Russell, sell side research providers and credit rating agencies are all working to provide more credible data.
In 2006 Al Gore, the former US Vice President, unexpectedly won an Oscar for his climate change documentary ‘An Inconvenient Truth’. Gore expects the US will meet the COP 21 commitments despite President Donald Trump pulling the country out of the agreement.
Dana Hanby, Founder of Health Equity Exchange, Chief Strategy & Business Development Officer at Allcot, and Former ICar & Ratings Chair at the Climate Markets and Investment Association (CIMA), which represents the climate, sustainable finance and services community, agrees. “Strictly speaking, the US still is obliged to comply to the Paris Agreement for the next four years,” continues Hanby. “In addition, companies are realising more and more that ESG has an impact on their bottom line and balance sheet.”
“Companies are realising more and more that ESG has an impact on their bottom line and balance sheet.”
Dana Hanby, Health Equity Exchange and Allcot
Hanby says that out of the 1,800 investors that have signed up to the PRI initiative, 10% are leading the field in applying the principles and 20% are trying to apply them. This leaves a ‘long tail’ of companies that are still rather ‘passive’ with the implementation. “Last year the respective numbers would have been 5% and 10%, so momentum is increasing.”
‘The Evolving Role of the Corporation in Society: Implications for Investors’, a study in the Calvert-Serafeim Series, concluded that firms making investment in material ESG issues outperformed peers in terms of profit margin growth(4). In addition, because stock prices are slow to incorporate ESG issues, investors can have time to take advantage of opportunities and generate higher returns.
The GSIA’s review found that the largest sustainable investment strategy globally, with $15 trillion in assets, was negative/exclusionary screening – which involves not investing in companies in certain industries such as coal, tobacco or arms. However, Hanby cites Hermes Investment Management as a fund manager who has successfully used an active approach to engage with companies on ESG issues.
In July 2017 Hermes says that its Global Equity ESG Fund has outperformed the MSCI World AC Index during its three-year life. Geir Lode, Head of Hermes Global Equities, said in a report:
“Our research shows that companies with leading corporate governance practices typically outperform their worst-governed peers by 30 basis points each month, and that investing in companies with better social and environmental impacts does not inhibit performance.”(5)
Hanby says that the CMIA is at the forefront of getting investors working with governments
and intergovernmental organisations on sustainability. “We are working with the private sector
to help achieve the aims of the Paris Agreement and in helping investors translate climate investment policies into best practice and actions for investment decisions”.
Hanby believes that it is important for all companies to connect sustainability to their front-line business. This is often not straightforward as available ESG information and disclosures are still an analogue activity in the digital era.”
She adds that decisions need to be made also in regards to framing the issue. She gives the example of the UK’s RBS winning ‘Bank of the Year’ in the Better Society Awards 2017 for JUMP, its employee engagement programme to improve sustainability. In 2016 the programme generated a 5% average electricity reduction and the bank expects to save £3m in energy costs in 2017(6). This is fantastic and should be encouraged in all companies, however it is important to remember what the Sustainability Accounting Standard Board defines as material for banks. These are issues related to financial inclusion and capacity building; transparent information; customer privacy and a number of other Governance issues. She believes that proper framing of ESG issues that are material and identification of direct links of ESG to the core business can give companies competitive edge.
In 2001, FTSE Russell, the index business owned by the London Stock Exchange Group, launched FTSE4Good to boost socially responsible investment. Since then the business has been developing ESG information for investors and launched guidance in February 2017 for global issuers on good ESG reporting in both equities and fixed income(7).
David Harris, Group Head, Sustainable Business at the London Stock Exchange Group and ESG Director at FTSE Russell, believes standardised ESG reporting is becoming increasingly relevant. “Financial reporting has been developing for more than 100 years whereas sustainable reporting is only 15 to 20 years old,” he says. “However, to deal with many of the huge sustainability challenges the world faces, we can’t afford for this to take 100 years too.”
FTSE Russell launched its Green Revenues data model in 2016 which was a new green industry classification for listed companies based on audited reported revenues from goods, products and services that help society to adapt to, mitigate or remediate the impact of climate change, resource depletion or environmental erosion. The model calculates a Green Revenues factor score for each company, which is the ratio of green revenues to total revenues. In order for the data and the Green Revenues data model to be credible, an independent committee chaired by Jack Ehnes, CEO of US pension giant CalSTRS, meets twice a year to review the industry classification system and taxonomy.
“We saw there was a lot of demand, not just for indexes, but also to measure, understand and capture the transition to these new green industrial sectors at a granular level.”
David Harris, London Stock Exchange Group and FTSE Russell
“We saw there was a lot of demand, not just for indexes, but also to measure, understand and capture the transition to these new green industrial sectors at a granular level broken down by company across each green sub-sector,” adds Harris. “This led to the development of our Green Revenues work stream, which was a huge piece of work as we built up a database from scratch over three years. We now cover 99% of the investable market universe.”
Some large funds are using this data to reallocate assets, and pension funds want to reduce their exposure to companies with high carbon assets while increasing exposure to companies with greater levels of green economy revenues. “So there is now a huge incentive for companies to better report their green revenue segments and the effort now is for all of us in the industry to get that message out so that companies understand this,” Harris says.
Harris says the growth rate of ESG investing is phenomenal and says it is accelerating, and the next phase is the world of passive investments. FTSE Russell has coined the term ‘smart sustainability’ for indexes which are not based purely on market capitalisations but on other factors such as dividends or, in this case, ESG considerations.
For example, in 2016 the UK’s Legal & General Investment Management launched the Future World Fund, which includes a three-pronged climate ‘tilt’(8). The global equity fund tracks an index which has been specifically designed to reduce exposure to companies with worse-than-average carbon emissions and fossil fuel assets, and increase exposure to companies that generate revenue from low-carbon opportunities. HSBC Bank UK Pension Scheme, one of the largest UK corporate pension funds, chose the fund as the equity default option in its defined contribution scheme.
In 2017 the largest global pension fund in the world chose three ESG indices as benchmarks, including one which interestingly focuses on gender diversity. Norihiro Takahashi, president of Japan’s Government Pension Investment Fund, says in a statement: “GPIF expects that the selected ESG indices incentivize Japanese companies to improve their ESG evaluations and enhance enterprise values in the long term. If overseas investors focusing on ESG with long term horizon follow, the investment returns of Japanese equities are likely to improve.”(9)
Other institutional investors are aiming to double investment in ESG-driven strategies over the next two years, according to a survey Great Expectations: ESG – What’s next for asset owners and managers, from BNP Paribas Securities Services in May 2017.(10)
Asset managers and owners expect their investment in ESG alternative assets, including hedge funds, infrastructure, real estate and private equity and debt, to increase by a fifth in two years according to the survey. In contrast ESG in public equities in developed markets is expected to fall by a quarter over the same period.
Trevor Allen, Product Specialist, Investment Risk and Performance at BNP Paribas Securities Services says: “Perhaps in contrast with common perception, alternative asset classes are becoming increasingly ‘ESG aware’. Recent initiatives such as the Global Real Estate Sustainability benchmark and the PRI’s responsible investment due diligence questionnaire for hedge funds, are starting to have an impact and bring much needed transparency for investors.”
In order to improve transparency Mike Sleightholme, Managing Director, Funds Services at SS&C Technologies Holdings, a global provider of financial services software and software-enabled service, says the increasing interest in ESG means funds need to report new data on the investments underlying their portfolios.
“ESG is a growth area in general, not necessarily just directly from green banks.”
Mike Sleightholme, SS&C Technologies
In May 2017 the NY Green Bank selected SS&C Technologies to help meet its aim of increasing the availability of capital for clean energy projects in New York State. Bill Stone, Chairman and Chief Executive Officer at SS&C Technologies, said in a statement: “The capital markets for renewable energy and energy efficiency demands highly structured financial expertise, in turn demanding greater operational efficiency of the underlying infrastructure.”(11)
SS&C Technologies is also the biggest provider of fund administration services to the alternatives industry and clients can range from liquid hedge funds to traditional private equity funds, and complex credit vehicles. “ESG is a growth area in general, not necessarily just directly from green banks,” adds Sleightholme. “Many different types of funds are investing in this space including hedge funds, private equity, and infrastructure funds.”
As the demand for sustainable investing has grown, so have suspicions of businesses making dubious environmental claims or “greenwashing’ , a term coined by environmentalist Jay Westerveld in 1986, following a surfing trip to Fiji.
This chimes with the BNP Paribas Securities Services survey which found that more than half of respondents believe that the lack of robust data is the most significant barrier to ESG adoption – although the good news is that only 15% believe this will remain a barrier in two years’ time. Allen says: “The ability to model the impact of climate change on balance sheets needs a new set of skills so smart data, artificial intelligence and ESG specialists will step in. We expect to see both managers and owners really ramping up their tech and personnel capabilities to address these needs in the coming years.”
As well as concerns over the quality of data, there are worries over the lack of data for emerging markets and the difficulty of making comparisons across regions or sectors. However in June 2017 regulators published voluntary, consistent disclosure recommendations for companies to provide information to investors, lenders and insurance underwriters about their climate-related financial risks.(12)
“The ability to model the impact of climate change on balance sheets needs a new set of skills so smart data, artificial intelligence and ESG specialists will step in.”
Trevor Allen, BNP Paribas Securities Services
As clients look to increase their ESG exposure, funds need additional data on their underlying investments in order to achieve their objectives. SS&C Technologies administers a ‘security master database,’ that holds all the attributes on the underlying investments. Funds can slice and dice the information in the database to customise reports to meet the needs of their own investors and track investment performance in different ways, such as against an ESG index. Sleightholme says: “If there is an index that people want to benchmark themselves against, we can absolutely do that. It usually requires us to take a data feed in from the underlying index provider, so that we can track the historical and current index performance.”
Depending on its contract, SS&C Technologies can actively monitor and validate a portfolio against an investment mandate, based on the data flags, but otherwise funds can self-report underlying investments as green. Sleightholme says funds have been increasingly adding more data related to sustainability or ESG. “I wouldn’t say it’s been a groundswell, but we have certainly seen more traditional funds investing in these areas because they see good returns, as well as dedicated funds that are specifically marketing themselves in this space,” he continues.
Carbon markets could play an important part in meeting the aims of the Paris agreement. The UN has long tried to boost the use carbon credits which allow countries and companies that are big greenhouse gas emitters to buy spare units from those that produce less pollution.
Wayne Sharpe, CEO & Founder of Carbon Trade eXchange (CTX), says that after attending the UN climate change conference in Bali in 2007 he realised there were no entrepreneurs involved in the carbon market and decided to use his experience to bridge the gap between financial markets and the environment.
He had previously launched an electronic online auction platform Bartercard and says that during his travels expanding the business he began to notice the impact of climate change. CTX was launched in 2009 to provide a venue for transparent spot trading in the voluntary carbon market, which had previously depended on opaque over-the-counter transactions. Sharpe says: “We were the first exchange to use cloud technology which was then brand new and provided unlimited bandwidth, more security and access from anywhere using the internet.”
“We were the first exchange to use cloud technology which was then brand new and provided unlimited bandwidth, more security and access from anywhere using the internet.”
Wayne Sharpe, Carbon Trade eXchange
In April 2017 the United Nations and and CCTX announced a collaboration to make it easier for global companies worldwide to easily purchase UN Carbon Offsets online. Sharpe says: “This is the final switch to trigger the carbon market.”
Buyers and sellers join the exchange as members and agree to standardised legal and commercial terms. Contracts are created and exchanged electronically in real-time as buyers must have funds at the exchange to trade, guaranteeing that sellers are paid. Sharpe says CTX aims to provide a trusted carbon offset benchmark, so investors can create funds, exchanges can create indices, and banks can create derivatives. Niclas Svenningsen from the UNFCCC, says in a statement: “The agreement will also support projects under the United Nations Clean Development Mechanism to reach a wider audience for monetising their CERs and thereby fund continues emission reduction activities.”(13)
One company that has put sustainability at the heart of its business model is Verne Global, which located its data center In Iceland due to the country’s 100% green energy profile.
Adam Nethersole, Senior Director at Verne Global says: “Iceland provides them with a genuine solution to any company, including those in financial services, that has a remit or an interest in becoming more sustainable.”
“With both data and data centers expected to continue their phenomenal rise, the issue of the carbon output of data is only going to become more of a pressing problem.”
WAdam Nethersole, Verne Global
Nethersole explains that many data centers are providing green certified energy, but this energy is still produced from a fossil fuel grid and the green proportion is largely based on fluctuating solar and wind. He says: “Iceland is the only developed market in the world that currently produces 100% of its power from green sources because of its geothermal and hydroelectric resources. If you were to look at the carbon footprints of the main data hubs, then Iceland can dramatically reduce carbon footprint.”
He cites car manufacturer BMW, who saved 3,200 tons of carbon in the development of their i Series and the equivalent of 1.6 million litres of fuel by moving data to Iceland. Nethersole stresses that using a data center in Iceland does not mean sacrificing performance or compromising on any of the factors that influence an enterprise when deciding where to host data. “In terms of the site selection, the number one priority is the basics of connectivity. The availability of power and sustainability is second,” he says. “If you can get your first priorities and the site is completely sustainable, without a premium, then it is an obvious win-win.”
Nethersole continues that companies, including financial institutions, are increasingly thinking of sustainability as one of the key benchmarks in terms of site selection as it becomes more important to their board, customers, and shareholders. He says: “Five years ago, it was just seen as a bolt-on public relations tool, but I think that is definitely changing.”
He explains that the financial services sector is a large proportion of the client base of the data center industry, whose carbon emissions now exceed the aviation sector. Citihub analysis has estimated that the data center operations of large financial services firms account for between 25 and 35% of their total greenhouse gas emissions. As their use of data will only increase, Iceland has a further advantage as year-round ambient air temperatures provide free cooling, which improves energy efficiency, reduces emissions and cuts building costs.
Nethersole adds: “With both data and data centers expected to continue their phenomenal rise, the issue of the carbon output of data is only going to become more of a pressing problem.”
It is clear that there is growing momentum and interest in ESG investing, and many factors point to the positive impact it can have on financial performance. The firms that are able to prove to investors that they are taking all necessary steps to improve their green credentials, will no doubt be the ones who reap the benefits in the long term. Like the monarch butterflies in Kingsolver’s novel, they will be the ones who take wing and survive.
2 https://institutional.deutscheam.com/content/_media/K15090_Academic_Insights_UK_EMEA_RZ_Online_151201_Final_ (2).pdf