Sustainable Investing Opinion Briefs – January 15, 2019

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Opinions Briefs coverage:  Moody’s Investors publication of a cross-sector rating methodology explaining the firm’s general principles for assessing ESG risks in credit analysis globally, a Barron’s article entitled “Forgive and Forget?” in which Lewis Braham poses the question:  How long does it take to forgive a company for egregious behavior?, a regulation being proposed by the EU that would require advisors to integrate “client’s ESG preferences” when conducting suitability assessments, and the launch of ESG Relevance Scores by Fitch Ratings.

January 9, 2019 – Fitch Ratings is not the only credit rating agency to adopt a more explicit approach for tackling ESG risks in the assessment of creditworthiness (Refer to January 7 note).  Moody’s Investors and S&P Ratings have both been proactive in this area for some years.  On January 9, Moody’s published another research article on this subject, this one a cross-sector rating methodology that explains the firm’s general principles for assessing environmental, social and governance (ESG) risks in its credit analysis globally.  According to this document, Moody’s seeks “to incorporate all material credit considerations, including ESG issues, into ratings and to take the most forward-looking perspective that visibility into these risks and mitigants permits.” In the methodology article, Moody’s describes the general principles at the core of its approach to analyzing ESG issues for all sectors. It sets out a broad conceptual framework to consider current and developing ESG risks that can affect credit quality for issuers and transactions in all sectors. The materiality, time horizon and credit impact of ESG issues vary widely, according to Moody’s. Issuers’ fundamental credit strengths or vulnerabilities can mitigate or exacerbate credit impacts. In some cases, ESG considerations can be a credit strength. Where ESG issues are meaningful for credit profiles, Moody’s indicates that it will incorporate them into its ratings analysis in a variety of ways.  As noted below, our view is that the engagement of rating agencies is a positive and important step in the process of mainstreaming of ESG risk analysis into fixed income.  In addition to adding clarity and transparency into the credit ratings process at each rating agency, each in its own way, these steps will, over time, help clarify the meaning of ESG and resolve some of the unique challenges associated with applying ESG to fixed income instruments, including the question of issuer versus issue, the impact of seniority, external support or backstops, time horizon, and coverage, to mention a few.

January 7, 2019- In a Barron’s article entitled “Forgive and Forget?” Lewis Braham poses the question:  How long does it take to forgive a company for egregious behavior? In the article Braham notes that while many financial experts claim that investing should be apolitical for professional investors with socially responsible or environmental, social, and governance, or ESG, mandates, the answer isn’t simple. For them, there is an implicit problem with putting profits before people or the planet, and when a company, which may still be a good financial investment, does something terrible, it must redeem itself to justify owning it.  The author offers several examples, including Allianz, the German insurance company that had figured in the history of the Nazi era between 1933 and 1945.  Another, more current example, involves the case of Wells Fargo (WFC).  The firm was embroiled in several scandals that extended over a multi-year period and led to concerns regarding Wells Fargo’s corporate governance, ethics as well as customer and worker treatment.  Yet, Wells Fargo continues to be held by some sustainable funds.  In either case, the question posed is how much time must elapse and positive shifts in corporate policy are enough before sustainable investors should consider investments in stocks and/or bonds of the company.  The author concludes that “at some point, investors must forgive if a company has truly moved on.”  This is a valid question without clear cut answers.  Perhaps an important starting point, it seems to us, is to view the issuer or issue through the lens of the sustainable investing strategy or approach being pursued by the investor.  For example, values-based investors who follow a socially responsible investing mandate and employ negative screening or exclusionary approach, the decision will more likely depend on the nature of the corporate transgression, the actions taken on the part of the issuer to address the concerns, including any compensation paid to aggrieved parties, and the results observed with the benefit of follow-on monitoring.  On the other hand, for investors who integrate ESG into investment decisions, the emphasis will be weighed on economic and financial considerations that must account for the consequences of the company’s behavior in terms of financial and reputational outcomes and their impact on the firm’s future cash flows and earnings.

January 7, 2019 – A regulation is being proposed by the European Commission that would require advisors in the EU to integrate “client’s ESG preferences” when conducting suitability assessments.  As reported in Money Marketing by Daniela Esnerova, the proposed regulation is designed to “ensure’ that client’s sustainability preferences are taken into account.  Currently, client sustainability assessments “usually do not include ESG issues” in Europe.   The proposed regulation would apply to asset managers, pension funds, insurance companies and financial advisors doing business in the EU.  We think that it is only a matter of time before such a regulation is introduced for consideration domestically.  We also think that for US domestic retail fund markets, the requirements would more likely take the form of disclosure statements.  However, we expect that such a requirement is not likely until the market for sustainable funds matures more.

January 7, 2019 – Fitch Ratings, the credit rating agency, announced the launch of a new integrated scoring system which shows how environmental, social and governance (ESG) factors impact individual credit rating decisions.  Initially applicable to some 1,500 non-financial corporate ratings, the scoring system will be extended to banks, non-bank financial institutions, insurance, sovereigns, public finance, global infrastructure and structured finance. According to the press release issued by Fitch, the new ESG Relevance Scores transparently and consistently display both the relevance and materiality of ESG elements to the rating decision. They are sector-based and entity-specific.  According to Andrew Steel, Global Head of Sustainable Finance, Fitch Ratings “…actively engaged with investors and other market participants to understand what they want to see from credit rating agencies before devising the new relevance scores. Our focus is purely on fundamental credit analysis and so our ESG Relevance Scores are solely aimed at addressing ESG in that context. The scores do not make value judgements on whether an entity engages in good or bad ESG practices, but draw out which E, S, and G risk elements are influencing the credit rating decision. We have taken a fully integrated approach to ESG which will see the scores being done by our existing analytical teams rather than centrally. “Our scores will enable investors to agree or disagree with the way in which we have treated ESG at both an entity and a sector level, assist them in making their own judgements about credit rating impact, and enable them to fully discuss all aspects of the credit with our analytical teams. No other CRA currently offers this level of granularity or transparency with respect to the impact of ESG on fundamental credit. “The initial analysis of our corporate portfolio has generated over 22,000 individual E, S and G scores for our publicly rated entities. Initial results show that 22% of our current corporate ratings are being influenced by E, S or G factors, with just under 3% currently having a single E, S or G sub-factor that by itself led to a change in the rating. There are significant variances by market classification (developed markets vs emerging markets) as well as by geography and sector, and our analysts are looking forward to discussing the detail with both issuers and investors.”

We believe this is yet another important step forward in addressing ESG in fixed income.  In general, applying ESG risks and opportunities to bonds as contrasted to equities is more difficult due to the structure, complexity and diverse nature of bonds.  For example, considerations such as whether to evaluate the issuer or the issue and the impact of time horizon on the risk profile of bonds given various maturities introduce higher levels of complexity for bond ESG evaluators. Also, unlike widely-held public and more actively traded equity and debt securities that are typically issued by individual issuers for which ESG scores, rankings or ratings are more likely to be available via third parties, this is may not be the case for private firms, smaller issuers or issuers in emerging markets.  Fitch Ratings’ systematic approach should advance the process of addressing these issues and help to accelerate the ESG integration in fixed income.

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