Cut through the marketing spiel, and environmental, social and governance (ESG) investing comes down to risk and reward. Fundamentally, the less likely a company is to be hauled over the coals for polluting the environment or socially harmful practices, the lower the risk to its earnings.
After all, when businesses foul up, they face exceptional items such as fines and/or an underlying loss of profits due to new operational restrictions or reputational damage affecting sales. On the other side of the coin, if a business finds it more difficult to mitigate externalities (the costs to the environment and society of its activities), then investors should demand a higher rate of return to compensate for the risk of consequences down the line.
Is ESG uncertainty a risk to the financial system?
Banks are especially challenged, as both they and the companies they lend money to are under scrutiny. Unfortunately, with so little uniformity in the classification of ESG ratings, the weightings assigned to environmental, social and governance factors, or even the definition of these three umbrella categories, the material risks to banks are poorly defined and hard to monitor.
Focussing on the ‘E’ of environmental, a report in May by the Network for Greening the Financial System (NGFS), identified the challenges of developing a crucial risk framework. The network of initially eight central banks and supervisors (including the Bank of England, Banque de France, Deutsche Bundesbank and People’s Bank of China) was founded at the Paris One Planet Summit in December 2017, with a mission to support the transition to a sustainable economy.
The group – which has expanded rapidly across five continents since inception – publishes many free-to-read papers, sharing knowledge and experiences to help build the sustainability framework. The status report from May looked at the difficulty banks have in classifying environmental risk, splitting bank assets (loans, bonds and investments) into green, non-green and brown categories.
Institutions surveyed for the report demonstrated a lack of uniformity internationally and even within company divisions in deciding what was green or brown. While 45 per cent said they used internationally or nationally approved taxonomy, that still leaves big scope for difference thanks to quirks in index methodologies.
Banks creating their own risk assessments, with standalone methodologies used entirely or blended with other sources, only adds to disparities. The report gives the example of palm oil, the cultivation of which some banks view positively as a source of greener biofuel, but others cite as a cause of deforestation and endangering rare species. To add to the confusion, a bank’s investing arm may be assessing environmental risk differently from those in charge of its corporate loan book.
Major asset owners and asset managers who have signed up to initiatives such as the United Nations-backed Principles for Responsible Investing (PRI) have put pressure on banks to green their balance sheets. Although 57 per cent of respondents to the NGFS survey are undertaking such a commitment, the conclusion was that they were acting not on an attested method of risk differential between green and brown assets, but on a “more diffuse notion of risk”.
Commercial impetus for green loans
Assessing environmental risk incorrectly is material as it could result in write-downs of banks’ assets in a scandal. What’s worth noting, therefore, is the report's comment that many green loans have been issued seemingly to pave the way for banks to be involved in the lucrative business of issuing green bonds.
Formal guidelines provided by the Green Bond Principles are adhered to by many of the responding banks and some also cite Climate Bond Initiative verification (a group that advocates harnessing fixed-income markets to fight climate change). These guidelines go some way to improving standards, monitoring on capital markets and in investment portfolios, but the survey showed the banks are more inclined to defer to their internal risk monitoring when it comes to their loan books.
Another way the surveyed banks engage in green bonds is in an advisory capacity for large corporations looking to structure their own issuance. From the inconclusive results in the report, that almost seems to be a case of the blind leading the blind. Once again, though, commercial interests are leading the way.
Green bonds are only a $754bn slice of the $100tn bond market, but corporations added a further $259bn of self-styled green issues in 2019, says the Climate Bond Initiative. Green bonds will become more prominent in the capital structure of companies going forward, but at present they seem to be almost a boilerplate exercise to help companies look good.
In terms of their own investment arm portfolios, the NGFS report does highlight that banks are using strict exclusions to avoid investing in some of the worst pollutants, such as bonds related to coal mining. But, without better taxonomy of environmental risk – never mind how it should be integrated with social or governance concerns – the NGFS was unable to assess how financial institutions can identify signs of trouble. Given supposedly green assets are only likely to become more prevalent on banks’ balance sheets, prudential regulators must grasp the nettle.
Readers can access the full NGFS report here:
https://www.ngfs.net/sites/default/files/medias/documents/ngfs_status_report.pdf
