How the ESG* analyst should think – A green bond second opinion does not replace ESG research
We discuss with many investors and are surprised that some of them think they do not need ESG risk and opportunity research for their green bond or social bond holdings. We also get this impression from some asset manager websites and marketing material. This is only reflecting shallow understanding of ESG research, and a lacking understanding of the conceptually important difference between ESG risk and impact.
This is part of a larger problem, where some investors think ESG risks are not relevant for companies with positive impact on the environment. As if a positive impact is an allowance to be a “bad citizen” on other factors (like polluting supply chain) or some kind of a guarantee of being “good citizen” for everything else. Both are serious mistakes.
In the following, when talking about green bonds, it also works for social bonds. ESG risk in the following also includes ESG opportunities.
There are two typical cases. Either a company where the full perimeter of the activities qualifies or a company where only a part of the activities qualifies for green bond financing.
In the first case where the full scope of a company’s activities qualifies for the green bond framework’s requirements, too many investors consider this as “so good” that there is no reason to dig further with ESG research. For the second case, more investors see that ESG research is required, but far from all.
Even some companies themselves do not seem to understand this, as we sometimes see a lot of communication around green bond frameworks and positive impact, while at the same time we see very poor Corporate Social Responsibility (CSR) reporting for the same companies.
This must change; these are not in any way substitutes.
What is the contribution of ESG research and what is it not?
ESG research’s first target is to identify all the material ESG risks of a company and the risk mitigation conducted by the management. It uses a wide range of information sources combined with an ESG analyst’s knowledge and ends up with an assessment of the residual ESG risk of the company. It does not research instruments, like green bonds, as it does not make sense. It does not necessarily detail the impact on environmental objectives and cannot be used as a tool to qualify investee companies as sustainable investments as defined by the EU.
What is the contribution of a green bond framework and a second opinion, and what is it not?
A green bond framework defines how a company can use the financing sourced through the green bond. It sets measurable requirements and defines the reporting for this. This to make clear for investors what they are financing and to be transparent how this is measured and reported. It may be used as a tool to classify investments as sustainable by the EU. A second opinion is an “independent” assessment of the green bond framework. “Independent” here only meaning external, as the company pays for the assessment of their own green bond framework. It is in no way an assessment of the company’s residual ESG risks.
Other elements to keep in mind
A non-impact investor integrating ESG risks properly may end up with some of the same investment decisions as an impact investor. ESG risk integration may well lead to the conclusion that a company with impact (whether direct or as enablers or transition companies) is addressing that way ESG risks that would otherwise be “too big” for the company. This could be stakeholder pressure for changing the company business being too risky for the company to ignore. Examples are Shell and, as seen more recently, western world large consumer companies with business in Russia.
Money is fungible, so be it the green bond money only can be used for projects qualifying for the requirements of the green bond framework, but that leaves “more” of the existing financing and all future profits from the green bond framework activities for the “non-green bond framework” activities of the company. So, in that sense green bond financing is also helping the company with their overall financing including, for some, at a total lower cost. Whether you invest in a specific company’s green bond or another, you will therefore be exposed to the same ESG risk! An example here is a shipping company issuing green bonds to finance building of vessels with new technology permitting a transition to lower GHG and other emission.
The current green bond standard is not the same as the EU green bond standard. This is important to keep in mind as this may have an impact on what qualifies as sustainable investment relative to the Sustainable Finance Disclosure Regulation (SFDR). An itchy topic here for large mortgage covered green bond programs is national building standards versus the EU green bond standards. For some countries, like for instance Norway, this is a problem. Will it lead to two levels of green bond, where only the EU green bond will qualify as sustainable investments?
Conclusion – Green bond second opinion vs ESG research
It is very important to distinguish between ESG risk and impact. They do not have the same starting point, neither the same purpose. The first is about understanding all the material residual extra-financial risks of a company and the second is narrowing the scope down to how the company activities (eventually parts of) have an impact on the world around it. The first is part of the fiduciary duty owed by the asset manager to the asset owners and the second is an option to choose by the asset owner. They are not regulated by the same articles in the EU Sustainable Finance Disclosure Regulation either, ESG risks and opportunity research is regulated by SFDR Art 6 (ESG risk integration in investment decisions), and impact claims are regulated by SFDR Art 9. Note that all funds are regulated by SFDR Art 6.
Green bond frameworks and second opinions, and ESG research do not serve the same purpose and are not substitutes.
SFDR Art 6 gets far too little attention currently, and it may be too late when the national FSA knock on the door for an audit. It is time to ensure all holdings are ESG researched and that proper ESG risk integration processes are in place!