23_trader_1BUS3600_CFA_PRI_Integration_ESG.pdf

ESG Integration Overview Book Value and Impairment Charge ESG factors can influence assets’ anticipated cash flow, such as by forcing long-term or permanent closure, and therefore alter the net present value of the assets. The impact is most likely to be a reduction, resulting in an impairment char...

ESG Integration Overview Book Value and Impairment Charge ESG factors can influence assets’ anticipated cash flow, such as by forcing long-term or permanent closure, and therefore alter the net present value of the assets. The impact is most likely to be a reduction, resulting in an impairment charge being made to bring the company’s book value down accordingly, and therefore reducing not only the asset value but also the company’s earnings for the year in which the noncash, one-off impairment charge is recorded on the income statement. Capital Expenditure A practitioner may believe that ESG factors will lead a company to decrease or increase its future capital expenditure. Terminal Value ESG factors could cause practitioners to believe that a company or its business line will not exist forever. In these cases, the practitioner might reduce the terminal value to a lower value or to zero, respectively. Beta and Discount Rate Adjustment Some practitioners adjust the beta or discount rate used in company valuation models to reflect ESG factors. This technique is ideal when there is an apparent ESG risk to the company, but it is difficult to price it into the company’s valuation. One approach used by practitioners is to run a peer analysis of companies within the sector and then rank them by an ESG factor(s). The practitioner can then increase/decrease the beta/discount rate for companies considered to possess high/low ESG risk, in turn reducing/increasing the fair value. ESG IN FIXED-INCOME ANALYSIS Originally, corporate bond practitioners adapted the materiality/sustainability frameworks and ESG techniques used by the equity practitioners in their firms. This approach still happens and is relevant today. More recently, ESG integration techniques applied by fixed-income practitioners have become more sophisticated; some practitioners have fully adapted their processes and analysis to integrate ESG factors. Additional aspects should be considered when analyzing ESG risks and opportunities in fixed-income investing as compared to equity investing. Bonds come in all shapes and sizes, with differing issuer types, credit quality, duration, payment schedules, embedded options, seniority, currencies, and collateral. Bond prices are strongly influenced by fundamentals, macroeconomic factors, interest rates, and liquidity, which require a multilayered analysis of credit risk, interest rate risk, yield curve risk, and liquidity risk. All these variables require a sound understanding of how ESG issues can affect a bond. For example, due to the long-term nature of ESG risks, short-dated bonds issued © 2018 CFA INSTITUTE. ALL RIGHTS RESERVED. 17 Guidance and Case studies for ESG Integration: Equities and Fixed Income by a company could be investible while the company’s long-dated bonds may not be, if the practitioner perceives that the ESG risk will not materialize within the next five years. Corporate Credit Analysis That the order of the frequency of impact of environmental, social, and governance issues on corporate bond prices and share prices is the same is not surprising. The material ESG issues for a company remain the same regardless of whether the investor is a shareholder or a bondholder. For example, health and safety remains a top ESG issue for mining companies and their owners and lenders (see Figure 1 for examples of ESG issues analyzed by equity and corporate bond investors). This is reflected in the approach used by some practitioners. Materiality/sustainability frameworks—a regularly reviewed list of sector-specific and/or country-specific ESG issues— are shared by corporate fixed-income practitioners and equity practitioners to identify material ESG issues. In instances where asset owners and investment managers deploy dedicated ESG teams, fixed-income and equity practitioners share this resource and use the same company ESG research. Other practitioners will adapt the materiality/sustainability frameworks used by equity teams where material issues can be different for corporate bond issuers (e.g., innovation management may be less relevant), especially when considering the duration of bonds. Practitioners use materiality/sustainability frameworks and company ESG research in their credit risk analysis. Few practitioners have looked at the impact of ESG issues on interest rate risk, yield curve risk, and liquidity risk. Practitioners assess the impact of ESG issues on a company’s ability to pay its debt obligations and liabilities. Their main approach is to use third-party ESG scores or proprietary ESG scores along with traditional credit analysis when making investment decisions. Some practitioners embed their company ESG research and scores into their internal credit assessments. When they do so, the ESG issues can influence credit assessments and investment decisions. FIGURE 1: EXAMPLES OF ESG ISSUES ANALYZED BY EQUITY INVESTORS AND CORPORATE BOND INVESTORS GOVERNANCE ISSUES SOCIAL ISSUES ENVIRONMENTAL ISSUES Business integrity Shareholder rights Executive pay Audit practices Board independence and expertise Fiduciary duty Transparency/accountability Related-party transactions Dual-class share structures Tax practices Human rights Employee relations Skilled labor Health and safety Diversity Customer relations Product responsibility Climate change Biodiversity Energy resources and management Biocapacity and ecosystem quality Air pollution Natural resources Water resources and pollution 18 WWW.CFAINSTITUTE.ORG ESG Integration Overview On a lesser scale, the impact of ESG issues is being quantified by practitioners in portfolio construction processes and fundamental credit analysis. Portfolio construction tools would examine how ESG issues are influencing macroeconomic and market factors. The impact on the portfolio is through the weighting of sectors and companies. Through fundamental credit analysis, key credit ratios are adjusted for ESG issues. Practitioners assess these ratios to understand whether the creditworthiness of the company is deteriorating or improving and ultimately, to see the potential impact on credit ratings and credit spreads. Sovereign Credit Analysis As compared to their use with corporate bonds, ESG integration practices in sovereign debt are less widespread. The current low adoption of ESG integration by sovereign-debt practitioners is due in part to the lack of understanding of how to integrate ESG issues into sovereign debt. Unlike some corporate bond practitioners, sovereign-debt practitioners are not able to simply borrow techniques and materiality/sustainability frameworks from their fellow equity practitioners, which might speed up the integration process. Extensions to existing frameworks or additional frameworks drawn up for country-specific factors are likely needed. The lack of understanding may be exacerbated by the difficulties expressed by practitioners with sourcing ESG data on countries as compared to sourcing company data, especially environmental data (see Figure 2 for sources of ESG data used by sovereign debt investors). This makes it more difficult for practitioners to assess the absolute and relative FIGURE 2: EXAMPLES OF ESG DATA SOURCES FOR SOVEREIGN CREDIT ANALYSIS Freedom House—Freedom in the World survey Reporters without Borders—World Press Freedom Index Forum for a new World Governance—Worldwide Governance Index Bündnis Entwicklung Hilft—The World Risk Index Transparency International—Corruption Perceptions Index World Bank—Ease of Doing Business Index United Nations Development Program—Human Development Index Fund for Peace—Fragile State Index Organisation for Economic Co-operation and Development—Better Life Index International Labour Organization—labor and health and safety statistics Access Initiative and World Resources Institute—Environmental Democracy Index Natural Resource Governance Institute—Resource Governance Index Yale University—Environmental Performance Index World Energy Council—Energy Trilemma Index International Monetary Fund—country reports EU—country reports US Central Intelligence Agency—World Factbook ESG research providers Credit rating agencies © 2018 CFA INSTITUTE. ALL RIGHTS RESERVED. 19 Guidance and Case studies for ESG Integration: Equities and Fixed Income FIGURE 3: EXAMPLES OF ESG ISSUES ANALYZED BY SOVEREIGN DEBT INVESTORS GOVERNANCE ISSUES SOCIAL ISSUES ENVIRONMENTAL ISSUES Institutional strength Corruption Regime stability Rule of law Security Regulatory effectiveness and quality Accounting standards Freedom of the press Political and civil liberties Human rights Education and human capital Health levels Political freedoms Demographic change Employment levels Life expectancy Social exclusion and poverty/ income disparity Trust in society/institutions Crime and safety Food security Effects of climate change Water resources and pollution Biodiversity Energy resources and management Biocapacity and ecosystem quality Air pollution Natural disasters Natural resources ESG performance of a country and in turn, convert the ESG data/analysis into meaningful indicators to support their ESG integration practices. Another reason for the lower usage of ESG in sovereign credit analysis relates to the CFA-PRI survey finding that suggests that ESG issues are less material for sovereign debt compared to their impact on shares and corporate bonds (see Table 2). Practitioners may believe that ESG issues do not impact sovereign debt prices and therefore ESG integration is not applicable. However, the CFA-PRI survey did indicate that governance issues, social issues, and environmental issues are impacting prices (see Figure 3 for examples of ESG issues analyzed by sovereign debt investors). As highlighted earlier, the respondents believe that social issues more frequently affect sovereign debt prices than environmental issues (see Table 2). Practitioners are more likely to analyze social information on a country than environmental information, especially as the time scale of social issues is more aligned with the investment horizon for sovereign debt. The more-readily available social data also makes it easier for practitioners to integrate social issues into their sovereign credit analysis. Despite these challenges, practitioners are integrating ESG issues into their sovereign credit analysis. The majority are making qualitative assessments of ESG issues through the use of third-party research and/or internal research; these assessments then inform their investment decisions. Quantifying ESG issues in sovereign credit analysis is not widespread and is practiced less than when performed with corporate credit analysis. It tends to be performed by feeding ESG research and/or scores into the credit analysis of an issuer, which can cause adjustments to credit ratings or internal credit assessments. Another common approach to sovereign credit analysis is to analyze ESG issues through portfolio construction tools. ESG issues can then influence allocations to regions and countries, providing underweight, neutral, and overweight signals. As well as analyzing the impact of ESG on a country’s ability to pay its debt obligations, practitioners have used ESG information to assess a country’s willingness to pay its debt obligation. For example, an investment manager who believes a link is present between a 20 WWW.CFAINSTITUTE.ORG ESG Integration Overview country’s level of corruption and its willingness to pay might use that link as justification to adjust country credit ratings and outlooks that they believe do not reflect the level of corruption in those countries. Municipal Credit Analysis ESG Integration Practices The sub-sovereign bond market is composed of any level of government below the national or central government. This includes relevant bodies from regions, provinces, states, or municipalities that issue bonds. The US sub-sovereign market consists of mainly munipical bonds. At approximately $3.85 trillion in size, the US municipal bond market represents most of the global municipal bond market.3 ESG factors have long been used to determine a bond’s credit quality in the municipal space and to identify financial risks in a municipality’s operations or for a particular public project. The quality of the issuer’s governance and management practices are typically a constant in credit analysis for any municipal bond issuer. Practitioners look at overall transparency and reporting, corruption levels, sound budgetary practices, and responsible use of debt (e.g., close monitoring of long-term pension liabilities and principal maturities, implementation of affordable capital plans, strong financial controls). They might view a management team that provides robust disclosure in a positive light relative to its peers. Sound governance can also be assessed for those issuers who think beyond immediate budgetary needs and make investments intended to strengthen the economic success and social inclusiveness of their communities, as inclusive communities should exhibit stronger creditworthiness and lower risk for practitioners. As such, municipal borrowings that provide social benefits may offset the negative impact of temporarily weak finances. For both general obligation and revenue bonds, chronic social and environmental problems can affect the issuer’s ability to raise revenues from taxes or other types of income. For example, low high school graduation rates, high violent crime rates, lack of affordable housing stock in the community, and high unemployment rates could result in long-term credit stress. Environmental factors such as the region’s air quality and associated health risks for its constituents, the quality of public infrastructure such as wastewater treatment plants, or the long-term impact of climate change can all pose potential risks to macro factors that may affect an issuer’s ability to repay its debt. Overall, some practitioners find that the more a municipality’s purpose or public project aligns with the environmental and social needs of its constituents, the more likely it is that it will repay the bond. For project revenue bonds, practitioners may also integrate additional ESG factors based on the underlying use of the proceeds (e.g., giving more weight to environmental factors for electric and water utilities, to social factors for education, and to healthcare issuers). Because of the limited coverage of this asset class by third-party research providers, practitioners often use discretion to determine materiality and integrate ESG factors through the fundamental research process. Practitioners in the municipal market may SIFMA US Quarterly Highlights 1Q ’18, April 2018. https://www.sifma.org/wp-content/uploads/2018/04/ US-Quarterly-Highlights-2018Q1-2018-04-06-SIFMA.pdf 3 © 2018 CFA INSTITUTE. ALL RIGHTS RESERVED. 21 Guidance and Case studies for ESG Integration: Equities and Fixed Income depend more strongly on credit ratings agency research, and may integrate ESG factors by expanding their view to include environmental indicators that capture local and regional resource challenges. Structured Credit Analysis ESG Integration Practices In addition to bonds issued by governments and companies, the fixed-income market includes securities backed, or collateralized, by a pool of financial assets, such as mortgages, accounts receivable, or automobile loans. Practitioners are just starting to consider how to systematically integrate ESG factors into structured credit analysis, largely because ESG data coverage is less readily available for some of the transaction parties, including the special purpose vehicles that issue the securities, and the inherent complexity of assessing underlying asset pools that may run into the thousands. The integration process typically seeks to capture risks at several levels: at the transaction level, relating to the originator/ servicer/issuer of the securities; at the “collateral” or “cover” pool of underlying assets; and sometimes, informing a view on the overall deal structure. Some practitioners give more weight to the originator, others to the credit quality of the underlying asset pool. The approach varies for different types of securitized investments depending on whether the issue is government backed, and with respect to the overall composition/asset concentration levels of the loan portfolio. At the transaction level, ESG analysis plays an important role in determining the true risk-adjusted credit profile of a securitization through an understanding of the corporate governance strategy of each of the parties associated with the deal. For example, practitioners may review the lending practices of the financial institutions that are originating the securitization, prioritizing those with clearly stated guidelines for underwriting and a positive record of servicing loans, and avoiding those with predatory practices, poor risk management and regulatory compliance track records, and any conduct failings that could lead to litigation risks and other adverse consequences for loan enforceability. Strong governance practices cover transparency of management (e.g., publicly listed companies with audited, detailed financial statement disclosures, whose management team communicates regularly with investors), executive compensation, and board independence (e.g., a diverse board with appropriate controls). Practitioners may also evaluate whether the parties are using securitization as a method of exit or risk transfer, or as a funding source in which they will continue to participate. At the asset pool, or collateral, level, practitioners consider how ESG factors may affect the financial sustainability of the asset pools, such as auto loans and mortgages.4 Although the analysis can differ between different asset pools, the objective remains the same—to understand if any ESG risks exist that would inhibit the asset pool from performing as expected, and to accurately value those risks. PRI 2014, Fixed Income Investor Guide. https://www.unpri.org/fixed-income/fixed-income-investorguide/30.article 4 22 WWW.CFAINSTITUTE.ORG ESG Integration Overview Depending on the nature of the collateral, ESG analysis may be given more focus. Consider these examples: When analyzing securities backed by power assets or power contracts, practitioners may focus on the environmental risk profile of the underlying assets (e.g., the source of power generation). ■■ When analyzing securities backed by commercial or residential properties, practitioners may consider environmental factors on either a specific property or a corporate level, given the increasing impact of environmental regulation faced by property owners in some markets. As such, practitioners can analyze the energy efficiency of a property portfolio in relation to standards such as the UK’s Energy Performance Certificate (EPC) or the US Leadership in Energy & Environmental Design (LEED) certification program. ■■ When analyzing securities backed by auto loans, environmental and governance failings such as the 2015 automotive sector emissions testing deception are assessed as a material risk to the value of the automobiles in auto loan/lease securitizations. ■■ When analyzing securities backed by general consumer/credit card loans, practitioners tend to consider societal risks, such as discriminatory and predatory lending and aggressive and deceptive marketing practices, as material factors. ■■ Quantifying ESG issues in structured credit analysis is limited to the extent that it helps identify securities with mispriced prepayment assumptions, which may trade at a discount relative to intrinsic value. For example, servicers that aggressively target borrowers for refinances or servicers that have streamlined procedures for refinances may be avoided, or valued less when bonds are trading at a premium. Qualitative analysis focusing on conducting thorough due diligence of parties to the transaction may ensure no red flags are present among those associated with deals, while looking through the underlying assets may assist with monitoring the performance of the deal for as long as the practitioner is invested in the security. Many of the practices mentioned in this section are demonstrated by analysts, portfolio managers, and investors, who share how they integrate ESG into their analysis and to tell their stories of ESG integration. © 2018 CFA INSTITUTE. ALL RIGHTS RESERVED. 23