ESG survey: Fifty shades of green

ESG is no longer an afterthought – but opinions and standards still vary

It's a watershed moment in the world of international finance and business. When first conceived, the concept of environmental, social and governance (ESG) was relegated to the realms of left-wing fantasy and idealism. Those on the inside saw it as an indulgence, a nice-to-have but largely unnecessary luxury that came with a premium.

But the last couple of years have seen a fundamental sea change – quite literally – and with it an extraordinary explosion of ESG activity. Global Sustainable Investment Alliance statistics suggest that as much as $31 trillion of managed assets in the world today touch ESG criteria in some way.

Across the board, ESG has shifted. What was once a concern only for those who actively want to change the world is seemingly now going mainstream.

"We are absolutely not seeing peak ESG. This is a secular moment; a cyclical change. The change that we have seen over the last decade has been quite dramatic," says Audrey Choi, chief sustainability officer at Morgan Stanley in New York. "We started in ESG because we had a conviction, a material view, that there was something the financial market could do to come and service other causes, environmental protection and communities."

"In the last couple of years it has gone from pushing water uphill to drinking from a hydrant of demand. Everyone thinks this is critically important," she adds. "ESG investments made up less than one in every $10 when we started in professional management – now it's one in every $4 in the US, and one in $3 globally."

With this explosion in popularity has come a need for standardisation, for transparency, and, inevitably, for regulation. Concepts such as greenwashing – firms rubber-stamping regular investment instruments as green or sustainable to achieve the benefits without taking the necessary steps – mean this now-multitrillion dollar industry can no longer be left to police itself.

Piecing the vast patchwork of ESG concerns and issues together is an ongoing puzzle for the financial industry.

With this in mind, IFLR has spent the past month polling ESG specialists, risk heads and legal counsel at investment banks and asset managers in an attempt to gain a full, previously unprecedented snapshot of the current state of the industry.

Eighty percent of respondents to the corresponding survey – the first of its kind – agree that a lack of standardisation significantly increases the chances of greenwashing and similar practices.

Changing investor appetite, too, means asset managers and banks are no longer able to ignore ESG. This has led to a massive growth in strategy, private counsel, external data vendors and third party principle-setters across the industry.

A theme that quickly emerged when IFLR first began this process was that we and so many others could only really touch the surface: ESG is, by definition, so incredibly broad, as the chart in figure one suggests.

Justine Leigh-Bell, deputy CEO and director of market development at the Climate Bonds Initiative, agrees that there are just too many different iterations of ESG, with little to no consensus. "ESG has unfortunately become marketing for basically anyone who can hold on to an ESG flag," she says, continuing to say that she's not sure how many in the industry actually measure ESG. "It would take 150 key performance indicators (KPIs) to measure the E, the S and the G comprehensively. It's really tough to measure what we put in the S bucket alone – and what does governance actually look like?"

It would take 150 KPIs to measure the E, the S and the G comprehensively

So if ESG looks like one thing to one company or investor and another thing entirely to the next, perhaps the biggest task is coming up with a common language. As ESG considerations are increasingly embraced by nontraditional impact-focused companies, many struggle to know exactly what they should be insuring, covering, measuring or reporting. The same can be said for investors.

"If they don't have an ESG policy firms are frowned upon, but there is still a lot of refinement and shaping that needs to be done to find what's beneath that. That is the challenge," adds Leigh-Bell.

To kick the survey off we first asked respondents exactly what areas their firm is involved in. In an attempt to reflect the huge range of issues under the ESG umbrella, options ranged from waste and pollution to board structure – but we could have gone on.

Climate management, emission reduction, and corruption and bribery were the three most popular choices, with more than half of respondents selecting each one.

Other popular options were diversity, energy and efficiency, shareholders rights, and sustainable finance.

Next we asked exactly how much their firm has embraced the ESG movement. In line with general expectations, around two-thirds of respondents' firms have clearly established ESG-related policies in place.

Herve Duteil, Americas chief sustainability officer at BNP Paribas, says that both the investment banking and asset management arms of his firm have a huge set of policies that have been developed over the past 15 years. Among these is a new sustainability strategy policy, which sits above more specific frameworks for transitions, equality, and enhanced corporate engagement attitudes.

Do the right thing

When it comes to ESG investing, one question that often prompts a good debate is why firms choose to enter into the arena at all. So we asked respondents: what, in their own personal view, is the single main driver for your firm's desire to embrace the ESG trend? Half opted for 'a desire to do the right thing', with a further 30% suggesting it was to ensure that the firm future-proofed its investment strategy. As Emily Chew, global head of ESG research and integration at Manulife Investment Management explains, her firm's key drivers for adoption of ESG integration is twofold: one, the firm belief that it enhances investment processes; and two, because of client demand for more transparency surrounding how ESG affects investments. "We believe that robust ESG integration helps us to deliver attractive risk-adjusted returns to our clients over the long term," she says. "We recognise that our client's needs in this area are expanding, and their own stakeholders are demanding sustainable investing practices, so we view this as consistent with our commitment to help clients achieve their goals." Investors are considering how ESG impacts the overall operational and commercial strategy, and the issue of climate-based risk. It's not just a backward-looking view of performance last year, but the intentions to change and how that impacts the ability to do business and create value. "One of the biggest trends we are seeing right now is that sustainability is no longer just an initiative, it's now core to company strategy, and that really is the crux of the solutions we are creating," says Dan Shurey, VP for sustainable finance at ING. Those benefits can be in the form of reduced cost of funding, which is desired by participants who will also anticipate a greater pool of investors when an issuance is social, green, or under any other label resonating with a particular segment of investors. "If you go back to the early days of corporate social responsibility for banks, or the ESG risk management framework which started in the early 2000s, the first impulse was not to do bad, to reduce or prevent harmful behaviours with environmental or social initiatives," said Duteil. "Mitigating liability or reputational risk were the first drivers of the ESG framework," he added. The second is client demand. Institutional clients have objectives and targets they need to meet; wealth managers regularly approach Wild with particular topics and ideas that they want to see reflected in their assets. "It also has to do with the new generation and the ongoing transfer of wealth from older generations. It's fantastic to see how committed young people generally are to not just maintaining the quota, but to contributing to society and leaving more than just wealth behind."

When creating its policy, BNP Paribas began with eight sustainability sectors: mining, defence, nuclear energy, unconventional oil and gas, coal-fired power plants, agriculture, palm oil and pulp and paper, as well as a full exclusion of tobacco.

Those policies typically take two years to establish, and require input from various stakeholders, from nongovernmental organisations (NGOs) to key clients to scientists to bankers, explains Duteil.

"Within those policies we have a set of industry requirements, and if clients are in any way involved in any of those fields it will result in full exclusion of the company, as well as any parents or subsidiaries. We can't provide any kind of service to them, anywhere in the world," he says. "We then have additional evaluation criteria, to qualify our perception of companies and potentially put them on a monitoring list. Our investment decisions also always integrate these factors."

ZSL leads the way

Animal conservation charity the Zoological Society of London (ZSL) provides another shade in the spectrum of ESG. The charity runs the SPOTT initiative, which calls for increased transparency in commodity sectors to promote sustainable production and trade through ESG assessments of producers in the palm oil, timber and natural rubber sectors. "These forest-impact commodities represent significant risk to the environment and people if they are managed unsustainably," says Oliver Cupit, manager of business and biodiversity at SPOTT. "The cultivation and extraction of soft commodities is contributing to 80% of tropical deforestation. This is significant because tropical forests are also home to 80% of the world's species." Investors can use the assessments to find the ranked performance of producers in the palm oil, timber and rubber sectors. "We focus on encouraging companies to be transparent about production practices to achieve better benchmarking across the sectors," he adds. ESG is a process and a journey, and companies are all moving at a different pace. "We have to make sure that we don't get caught up rushing too far ahead and end up leaving companies behind," says Oliver Withers, head of conservation finance and enterprise at ZSL. "The reality is, very often, it's the companies with the most negative biodiversity impact that are left behind." Achieving transparency around companies' policies is the first step. The second is verification. "If a company is transparent that's fantastic, but how do we then ensure it's doing what it said it would do?" asks Withers. "Verification is not something that we, as a sector, have cracked completely yet – but we have to hold these companies to account."

BNP Paribas has what it calls an aggressive unconventional oil and gas policy: the firm will not finance companies that are currently involved in the exploration, production, transportation, trading or marketing of oil or gas extraction from shale.

The bank is not alone, though, in that it has seen several versions of such policies over the years. "We are in the third version of our coal policy. In the second version in 2015, we excluded the financing of thermal coal assets, whether mining or electricity generation," he says.

Recently, the bank updated this to cease funding for companies still working in thermal coal in the EU by 2030, and 2040 in the rest of the world.

Daniel Wild, global head of ESG strategy at Credit Suisse, says that over the last couple of years his bank has developed a more comprehensive strategy that not only concerns the asset management and development aspects, but is also applied to the rest of the bank.

"We are formulating our policies around some of the most pressing industry topics, always keeping in mind that we have several options available. We can either stay away from certain issues by excluding controversial firms, or we can engage with them to induce positive change, or directly support solutions that contribute to the sustainable development goals," he says. "Providing transparency on ESG is the starting point for our clients, to know where they stand. We haven't solved all the issues, but we are highly committed to systematically integrating ESG into everything we do," he adds.

In September, Credit Suisse announced the launch of a new asset management business to cover around $100 billion of assets by the end of 2020 with sustainability integration.

For all firms working in this space, accusations of talking the talk but failing to walk the walk have a fairly constant presence. "The challenge with 'greenwashing' is that it's evolving along with the expectations of investors," says Victor Van Hoorn, head of financial services at Hume Brophy, which works closely with financial services firms on reputation management. "An asset manager may think it has a great ESG policy, but clients and policymakers expect more – they expect the ability to demonstrate a positive impact."

It seems that simple ESG products that enable firms to exclude controversial companies such as tobacco or oil producers are no longer enough.

2. Does your firm have an ESG policy on the companies it invests in?	3. Does your firm have its own in-house screening for ESG?

4. What, in your personal view, is the single main driver for your firm’s desire to embrace the ESG trend?	5. What, in your view, is the biggest obstacle to growth in the sector?

Next we asked if respondents handled their own ESG screening or if they hired third-party vendors to do that work for them. Operations such as Sustainalytics and MSCI ESG Research provide data about companies based on ESG performance for those without in-house capabilities. Only 25% of respondents manage this process in-house.

Anne van Riel, head of sustainable finance, Americas at Dutch bank ING, says her firm performs its own assessments through its environmental and social risk (ESR) team. "We think a single screen will not get the true picture – we know our clients best," she explains.

But ING is in the minority – largely because of the high costs associated with acquiring the data in the first place, which can make in-house screening prohibitive for some. "It might sound like you can point a machine at the internet and get what you need, but it's more problematic than that because there's not a lot of agreement around which standard to use," says Richard Mattison, CEO at Trucost ESG Analysis, part of S&P Global.

If you want to link a loan for a new tech company, you have to look at the proportion of professional women in that company

There are multiple tools in the market all competing with each other, meaning the standard is generally high. Third-party vendors are able to collect, clean, scrub and normalise information, for asset managers to use however they wish.

"They can then use it to create their own screening protocols, tailored to their investment strategy, enabling firms to differentiate," he says.

Credit Suisse use different sets of third-party research and data. "The landscape is obviously quite diverse – which is understandable. There are no global standards, and providers may have different views on materiality and objectives," says Wild.

Essentially, the majority of firms take in external research and data from a range of sources, then form their own opinions and strategies.

That's significant because just a couple of years ago, most users not only bought the data but the opinions too, from one or several third-party data providers.

"It makes sense to dig deeper, to look into the raw data behind ESG scores from different sources, then draw our own conclusions to add value for our clients," adds Wild.

Given the upward trajectory of ESG investment – and statistics that show that younger generations are, on the whole, far keener on impact investing than their parents – it's likely that in a few more years, ESG considerations will have centre stage in global finance.

In the same way that firms cannot issue loans, bonds, derivatives or anything else for that matter without first looking at the credit rating of the company, the same could ring true for that company's ESG performance.

"Data standardisation and aggregation will determine how quickly that happens," says Deutil. "Financings are now increasingly referencing sustainability performance targets – so a sustainability-lined loan for a new tech company might reference GHG emission intensity, privacy data breaches, or proportion of women engineers, for instance. Granular data is increasingly needed in a variety of sectors, but it also needs to be comparable," he says. Forty percent of respondents feel that the biggest impediment to growth in the ESG sector is a lack of access to historical data. This might sound relatively straightforward, but it's not. Many companies are still not yet creating such data, let alone providing it for legacy transactions.

"Among investors and financial institutions there is still a lack of consensus as to what it means to be sustainable or green," says van Riel. "Every good story has a negative side, and data – or the lack of it – is a big impediment to growth."

Wild agrees. "Another obstacle is the landscape of data and resource providers," he says. "You have to find your way through the jungle of data and figure out what is material, as well as what was measured, because there are no global standards on reporting."

When it comes to individual company reporting, it's important for investors to take things with a pinch of salt.

Alongside that are regulators insisting on clear and transparent reporting on each fund, be it retail or institutional. "It is coming – what's blocking it is not so much a lack of appetite, but a lack of understanding as to what to do first," says Mattison.

"For a midsized asset manager without a dedicated ESG team, what do you actually do?" he asks. "Of course larger asset managers have teams who actually wish to access raw information and come to their own opinions, but what's really lacking at the moment is a simple way for the mass market to integrate ESG into their investments."

6. Is regulation the most suitable way to monitor ESG?	7. What is the best approach to standardising ESG?

8. Does a lack of standardisation or regulation increase the risk of talking the talk but not walking the walk (ie greenwashing)?

There are a number of organisations working to develop global standards. Well-known frameworks like the climate bond certification from the Climate Bonds Initiative, Green Bond Principles (GBP) from the International Capital Markets Association (ICMA), or the Green Loan Principles from the Loan Syndications and Trading Association (LSTA) offer issuers across a variety of sectors recognisable products and standardisations, in areas such as use of proceeds and ongoing monitoring.

They are all slightly different. ICMA, for instance, focuses largely on the E and the S, by providing issuers with green and social bond principles, sustainability bond guidelines and a variety of supporting documentation and voluntary principles.

A free market of ideas is good, but regulation should set the standard for reporting and transparency

"You get a commitment about how the funds are being used, and dedicated reporting. This reporting focuses on the impact that has been achieved in the past in terms of rebalancing, or the future for new projects," says Nicholas Pfaff, managing director at ICMA, secretary to the GBP and member of the EU Technical Expert Group on Sustainable Finance. "From a creditor point of view you are looking at the issuer's overall balance sheet; from that or a credit perspective there's no difference between a green or a mainstream bond."

For an investor, these principles identify projects with dedicated reporting and a focus on impact. "If you're an investor managing an ESG portfolio, that's what you're looking for," he adds.

Both the GBP and the sustainability-linked loan principles are voluntary, high-level frameworks that offer a standard or recognisable structure. In the interest of consistency, Climate Bonds Initiative worked closely with ICMA when developing its principles.

"ICMA was involved in the working group; it was done intentionally because we wanted to leverage what had been accepted as the gold standard in the market or arbitrage between loans and bonds," says Leigh-Bell. "There shouldn't be daylight between what the products look like, and that's how we structured the framework."

One issue is that these frameworks are voluntary by their very nature. This creates a catch-22 for investors. If they want predictability and clear, prescriptive rules, there is a school of thought that believes this will stifle innovation. But in the absence of them, progress is arguably also stifled – and reputations are at risk.

"The various frameworks are designed to observe the integrity of loans while still promoting the innovation and flexibility around the product to let them grow," said Tess Virmani, associate general counsel and senior vice president at LSTA. "Sustainability-linked loans in particular could take on lots of different forms – there's no use of proceeds determinant, so we wouldn't want to stifle the creativity or innovation that could come in this space by being too prescriptive."

When it comes to ESG, there's regulation, and then there's regulation. "There are certain necessary regulations, like environmental rules to make sure the industry maintains certain standards," says van Riel. "But if you are talking about ESG in terms of the extra mile, there are guidelines and industry-led initiatives that are better suited to the market than overall regulations."

Most of the initiatives already in place are industry or investor-led. The European Commission, however, is on the verge of introducing the first ever sustainable finance taxonomy, which hopes to spur investment by creating clearer definitions around sustainability. "It also comes with a downside: if you box it in too much it won't please everyone, or will forego innovation in certain areas," adds van Riel.

There is a lot of work in Europe being done to create a rulemaking process that would define ESG taxonomy in Europe to set out what's expected from firms. "Given the end of the mandate of the Technical Expert Group on Sustainable Finance in December 2019, an agreement on the green taxonomy could come soon,"says Eurex's global head of product design Vassilis Vergotis.

This is a market that has high standards of best practice and has organised itself remarkably to date

The EU's taxonomy, which sets it apart from other jurisdictions that have taken a more industry-led approach, is widely expected to be a game-changer, but as ever, regionalised regulation fails to take into account the global nature of financial services.

When it comes to regulatory approaches, unsurprisingly, respondents were divided. The vote was split fairly evenly between local regulation, global regulation, and global standards or guidelines (such as the GBP).

"As an industry it's important to maintain a certain credibility and make sure that those standards are strict enough and enforceable enough to work for everyone," says van Riel.

Regulation can help in many ways, for example when it comes to the standardisation of reporting. This would likely drastically improve the quality of the data available overnight.

"Regulation should set the boundary conditions to address the uncovered external costs of business activities, but not prescribe the ultimate solutions, because honestly, we often don't know them," says Wild. "Particularly in the climate space there are many possibilities: is it carbon sequestration, is it alternative energy, is it energy efficiency, is it nuclear power, or a combination of all of those? It's still too early to know what's needed."

In another scenario, regulation might look to impose proportions on investment portfolios: firms must have a certain fraction of funds invested in wind farms, for instance.

"A free market of ideas is good, but regulation should set the standard for reporting and transparency," adds Wild. "Carbon tax instruments are just one example, but regulators should be setting standards in other ways too to drive investors in the right direction. By doing so they can play a very important role."

One thing is clear: hardly anyone is entirely clear on the various shades of ESG. Global expectations are good, as long as they are consistent. Green bond principles are good, but how are they connected to social bond principles, or transition bond principles?

Another interesting point is that there are exceptions, like China, where ESG is fully legislated for. In other cases, it's mandatory to receive a rubber-stamp from an external reviewer for all projects or transactions.

"In our guidelines it is highly recommended to use external advice, especially on environ-mental issues, but it is not mandatory. Because some large multilaterals have in-house capabilities for validating projects and don't necessarily need external organisations," says Pfaff.

Regulation makes sense when it fixes a problem that exists – but when it comes to ESG, many feel the market is just not there yet.

"For the moment the market is functioning well," adds Pfaff. "This is a market that has high standards of best practice and has organised itself remarkably to date. This is not a dysfunctional market."