Welcome to Talking Markets, a podcast series from PineBridge Investments. I'm your host Aurelia Sax, Deputy Head of Client Services EMEA at PineBridge. Every month we will cover our take on global politics and market trends. A sustainable business approach helps deliver results for companies, their employees, local communities, investors and the wider world. In this episode, John Bates, Head of Emerging Markets Credit Research and Co Chair of the ESG Investment Committee at PineBridge, will discuss the historical context of ESG adoption, and share his outlook on the evolution of ESG considerations in 2021 and beyond. With that, I would like to introduce you to John. John, welcome.
Thanks Aurelia. I'm going to talk a bit about ESG, which is a topic very dear to my heart because it was pretty uncool five years ago, but now it's the coolest thing on the planet, and is a very hot topic for investors going into 2021. ESG and sustainable investing is taking an incredibly important role in our business. And this is bound to continue into next year. We need to be very ready to adapt to the changes that are coming our way partly from our client demands but also from regulations that are coming and actually environmental, social and governance risks in fixed income should be pretty straightforward on the face of it. After all, we have a team of analysts that are crunching all the numbers, know their issues and are actually doing all of the work.
But there are barriers. Unlike equity investing, there are no voting rights to affect change in fixed income. Also, the whole concept of engagement, which is a relatively new concept to some, is harder to practice effectively and then moreover, prove in fixed income.
There are also many different sub asset classes in fixed income, like sovereign government agency, and also corporate bonds. This is why equity strategies account for about half of ESG aligned AUM compared to fixed income at about 36% of a total $31 billion in ESG aligned AUM globally.
So fixed income is seeing rapid growth. Citi did a survey of 100 clients recently and 71% of them are talking about ESG and ESG funds. ESG new issuance was $290 billion in 2019, rising to an expected $340 billion in 2020. But when you look at the product suite of what's out there at the moment, there are several strategies and evolutionary interpretations. There's a lot of ambiguity in this complex ecosystem, and lots of jargon and acronyms.
I did a quick survey of our investment teams’ interpretations of engagement, stewardship and escalation last year and the responses were extremely varied. Some of my other favourites are words like “materiality”, “impact investing”, “active ownership”,” activism”, “climate change mitigation”, “green-washing”, “triple bottom line”, and “thematic investing”, all of which are hugely open to interpretation.
In order to make some sense of all of this, we looked at the various existing approaches to ESG. It might be obvious, but just screening out the bad companies, or negative screening is the easiest way to apply an ESG filter to your investment universe. Increasingly though, this approach has stark limitations. Should a country or company with poor ESG characteristics be screened out of the portfolio. If the future trajectory looks more positive?
Should a Brazilian oil company with poor ESG scores be excluded, if it is evidencing that it is investing to improve its ESG profile for the future?
The other big problem with straightforward negative screening is that you lose the impact of engagement, which for a credit intensive team like ours, opens up plenty of scope for active engagement. So we went along the ESG integration route and this is actually the fastest growing approach.
The approach relies on the analyst team scoring the relative level of ESG risk between countries and companies. Importantly, it should follow that issuers with less ESG risk, should have better financial returns over time.
Also, the concept of corporate engagement and shareholder activism is growing fast, especially in fixed income, where we are expected to do a lot more than just vote with our feet. There are 1,000 reasons to embrace sustainable investing. But for issuers the cost of capital is the core reason for long term survival and growth.
There is a striking difference in cost of capital between the highest and the lowest quintile scored companies across sectors. And this is actually something that is more pronounced in emerging markets, compared to the globe. As ESG scoring becomes more mainstream, issuers will have to demonstrate better behaviour to hold on to their credit ratings and their funding costs. We can see fundraising becoming more targeted in the future as issuers seek to demonstrate that they are deploying funds to help areas of ESG transition in order to achieve this. Simply put, raising money for general corporate purposes may not be allowed in the future, as companies will have to declare exactly what they’re spending the money on.
We identified a number of myths or misconceptions within the ESG universe, which apply to both emerging markets and developed markets. One of the big myths is about risks being higher in emerging markets than developed markets. We came to the conclusion that EM and DM are exactly the same.
Most ESG failures are caused by human shortfall, normally caused by the desire to maximize profit, greed, and in most cases, the big DM ESG disasters have externalized impact on the globe as a whole and the big EM ESG disasters are the most headline worthy. In EM, we are seeing more large scale industrial and urban revolutions occurring at the same time, which poses risks for both EM and DM as corporations seek growth markets.
By 2025, half of the world's large companies will have emerging market headquarters. The best run companies in EM are already the best in the world. And also don't forget that the majority of EM is actually investment grade and consists of companies having international operations. A lot of them in DM. A high proportion are penalized for being in countries with poor macro economic dynamics, the so called “zip” or “postcode” effect.
So the goals for EM and DM are the same - to acknowledge the relevance of ESG factors in our decision making and to price ESG risks and opportunities correctly.
The second myth or misconception is about data and availability of data. There are shortfalls in data, especially in EM, but for fixed income rather than specific EM considerations. EM represents a vast investable universe incorporating over 70 countries and the traded debt markets have a market cap of over $22 trillion. Yet EM represents only 7% of global bond indices. So you just need a strong bottom up approach with an analyst team fully engaged with the issuers in order to get the data.
In our day to day life, we screen out about four fifths of new issues in our process before we even put coverage in place on an issuer. In EM we have 12 analysts covering about 400 names, each having the full suite of ESG data. Over 90% of the companies have IFRS financials and public stock market listings. Over 95% have credit ratings from the leading three agencies, and 65% of our coverage falls into investment grade. So we don't feel short-changed on the data.
The next myth is do markets price ESG factors? One of the biggest anomalies is that ESG factors are not necessarily in sync with credit ratings, owing to the countries’ ceilings imposed on the ratings of some of the issuers.
Aside from that, valuations in EM are rather multifaceted. Take the power sector or utility sector in CEEMEA region. South Africa's national power company has the lowest credit ratings, the highest spread versus its sovereign and the highest risk ESG factors - that all make sense.
Meanwhile, the Russian state gas company has the highest credit rating but also high risk ESG scores and yet the lowest spread versus its sovereign. There are several reasons for this, including the macroeconomic picture, the standalone credit profile, as well as the government support for these entities. But the ESG factors shine through as a separate indicator away from credit metrics and credit fundamentals.
The next myth is all about returns. Do ESG factors influence returns? Strong evidence suggests that ESG frameworks provide an extra layer of protection, especially in periods of market stress. We've seen this evidence in equities as well as in fixed income. In the equity space, the MSCI Emerging Markets Leaders Index has shown similar return performance to an equivalent non-ESG index, but with much lower volatility. In fixed income, we've run various model portfolios which show there's very little impact on returns when we exclude lower-rated ESG scoring issuers.
This is partly explained by the relatively high quality of credit and ESG profiles of the names in the investable universe. JP Morgan's ESG Corporate CEMBI excludes about 23% of issuers in the standard CEMBI Broad Diversified Index.
Taking out these higher risk issuers creates an essentially green index that's less volatile, but generally the return profiles are similar.
For a similar return profile therefore, the greener index is clearly preferable. With high yield default rates at sub 3% in emerging markets, one would need to chop out quite a large proportion of the universe to make a notable impact on returns, while volatility only decreases.
The final myth is all about green bonds. Green bond issuance hit record levels in the fourth quarter of 2018 and first quarter of 2019, bringing the global green bond universe up to $430 billion, over 10 times the level that it was in 2013.
Only 12% are tradable internationally and this is still only a tiny 0.4% of the global market. China, France and Germany are the major green bond issuers, but these are generally not openly traded. For emerging market, green bonds are therefore insignificant at this stage.
PineBridge has actually quite a long history of ESG. It's actually in our DNA. PineBridge evolved from AIG, where we already embraced ESG philosophies as early as 2007, when we produced our first sustainability report. Cut to where we are right now and we've got our first UNPRI rating of A+, which is the highest possible score and puts us in the top quartile of asset managers.
This reflects that we have a strong integrated process to investment analysis and also, among other things, that we report our activities and progress. Reporting is something that's really important for next year, because the regulations particularly European regulations, are stipulating that we're going to have to report lots of different engagement activities and stewardship and so forth.
I mentioned earlier that we have an integrated framework for ESG. Our ESG scores sit right next to our traditional bottom-up fundamental analysis metrics, enabling us to house all of the data in a centralized database, enabling us to filter the scores by country or sector.
We also now have ESG scores linked directly to the portfolio management screens, so that specific guideline directed screening of portfolios by ESG scores can now take place. Even before our coverage late level screening processes, we also vet every new issue.
From the 28th of January this year, our participation rate has been only 17% out of 822 new issues vetted. Of the 83 new issues that we did not participate in, 51% of those were due to valuations and 27 were due to ESG specific reasons.
As we push into next year, we have our integrated ESG scores within our process, but the scores themselves are not driving the security selection. We think this is likely to happen in layers.
Firstly, ESG scores as a risk factor embedded within the financial analysis model. The second layer, is where ESG scores act as an actual filter. So considering ESG factors on a par with financial considerations, this can create positive screening to identify the best in class issuers and create overweights in the highest scoring issuers.
This also creates the ability to track momentum via changes in scores over time and captures those that are making the most improvement. The final layer is then that there is scope to further use individual E, S, and G scores to create a more targeted approach.
So I've talked a little bit about where we came from. I've talked about some of the myths and misconceptions of ESG investing. And I've also touched on where we might be going in 2021 and beyond i.e. the ESG scores will not only be part of the process, but will actually lead security selection in the future for ESG strategies.
So in conclusion, we think that ESG scores are going to be more than just part of the investment process, but actually a more dominant factor in determining security selection and portfolio construction. Thanks for listening.
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