Financial Materiality and Sustainable Investment
While recent weeks have been marked by the takeover of sustainable finance actors by more traditional financial actors (the takeover of the environmental, social and governance (ESG) rating agency Vigeo by the traditional credit rating agency Moody’s in April 2019 and the takeover of Beyond Ratings by the London Stock Exchange Group in June 2019), a historical analysis of sustainable finance and its evolution can help to explain this consolidation phase. Indeed, the purpose of this insight is to show that the evolution of the socially responsible investment (SRI) field led to an integration of this paradigm by traditional finance. We will explain the first phase of SRI (a.k.a. sustainable investment or SI) as an answer to investors preference by an institutional approach (i), then the integration of sustainability in core investing strategy through financial materiality (ii), and, finally, why this consolidation phase can lead SRI to become an important weapon in the fight against climate change (iii).
SUSTAINABILITY AS AN ANSWER TO INVESTORS PREFERENCE
When we address the issue of SRI, a first question concerns the genesis of this paradigm. In a very interesting paper, Avetisyan and Hockerts (2016) address it from an institutional point of view. As highlighted by the authors, traditionally firms acting in free markets have been subjected to two distinct sets of institutional logics: (i) legal norms, such as legislation and regulation issued by policy makers; (ii) market norms, such as the primacy of profit optimization. Since the 1980s, “the notion of corporate social responsibility (CSR) has given rise to a competing institutional logic that requires firms to also abide by norms other than those dictated by the law or the market”. In this way, “stakeholders such as employees, local communities and the natural environment have been identified as being legitimately involved in creating the normative context in which firms act”. In this institutional change towards a CSR paradigm, investors have played an important role. Indeed, as noted by the authors, “while traditionally investors were seen as only being interested in protecting their profits, it has become obvious that investors themselves can act as drivers of institutional change towards CSR. The practice of SRI aims to change the institutional context for firms by allowing investors to employ negative and positive screens that penalize firms which do not abide by CSR norms while benefiting firms that do.” Then, in this emerging phase of SRI, the financial impact of sustainability factors was mainly led by investor preferences and values.
As a response to this institutional change, ESG rating agencies emerged, providing investor-solicited and issuer-solicited scoring services, focusing on ESG criteria. At the same time, the investment universe affected by this trend expanded progressively, to include not only corporate but also sovereign and public issuers.
In response to the need to screen such issuers according to their sustainability performance, Beyond Ratings developed the ESG Factor-In methodology. Applied to the sovereign asset class, this approach makes it possible to identify, with regards to a given level of economic development, the relative performance of the sovereign in environmental, social and governance terms.
Figure 1: An example of ESG performance assessment: Beyond Ratings ESG Factor-In Methodology
SUSTAINABILITY AND FINANCIAL PERFORMANCE
While the first step in SI focused on investors preference due to the emergence of a competing institutional logic or paradigm, a second step built on the potential impact of ESG factors on the financial performance, arguing that non-financial factors can affect profitability (Lins et al., 2017). In the case of credit risk by example, the preamble of the third Principles for Responsible Investment (PRI) report (2019) states that institutional investors have “a duty to act in the best long-term interests of [their] beneficiaries. In this fiduciary role, [they] believe that environmental, social and governance (ESG) issues can affect the performance of investment portfolios.” Among the six principles adopted by this UN-supported organization and institutional members (credit rating agencies (CRAs) and institutional investors), is the first one states that the members “will incorporate ESG issues into investment and decision-making processes”. Indeed, if the basic aim of a credit rating is assessing whether an issuer can reimburse its debt, there is a rising demand to include ESG factors, where material to credit risk. Moody’s takeover of Vigeo reflects this desire to integrate sustainability factors in traditional credit risk assessment.
In this inclusive approach of risk scoring, Beyond Ratings developed the Sovereign Risk Monitor Methodology, integrating sustainability factors in a Sustainability Profile accounting for a half of the aggregate sovereign risk score. This Sustainability Profile was built by identifying sustainability factors material to credit risk through an empirical approach.
Figure 2: An example of ESG integration in sovereign risk: Beyond Ratings Sovereign Risk Monitor Methodology
As highlighted in a study co-authored by Hermes Investment and Beyond Ratings (2019), there is a strong relationship between sovereign spreads and this Sustainability Profile, thus illustrating the financial materiality of sustainability factors.
Figure 3: The relationship between implied sovereign CDS spreads and ESG scores
“THE CLIMATE CRISIS IS OUR WORLD WAR III. IT NEEDS A BOLD RESPONSE”
If that (mainly empirical) second approach has highlighted the financial materiality of the sustainability factors through the impact on financial performance (and no longer due solely to investor preferences), it failed to fully address the main upcoming challenge: climate change. Indeed, as noted by Capelle-Blancard et al. 2019 and Hermes Investment / Beyond Ratings study, the Environmental factors group is the less significant among the ESG issues in terms of financial materiality. This non-significance of environmental factors comes from the traditional empirical approach based on the observation of historical data. This failed to take into account emerging risks, such as future impact of climate change.
In order to overcome this caveat, Beyond Ratings is developing a Sovereign Physical Climate Risk methodology, with first results expected by the end of 2019. The aim of this approach is, through a fundamentals-based sovereign default model, to compute the expected marginal probability of default due to climate change. This approach is foundedon the hypothesis of impact of climate physical risk on growth rate, supported by the academic literature (Hsiang and Jina, 2014). This will allow investors to properly assess potential impacts of climate change on their portfolio investment performance.
The aim of this third stream if twofold: (i) meeting the needs of investors to better understand an emerging risk such as climate change; (ii) enabling investors to effectively price climate risk, which will allow an efficient allocation of financial resources and contribute to tackling the climate crisis. In a way, one could think that the acquisition of Beyond Ratings by the London Stock Exchange Group fits in this approach.
The future will tell us if we succeeded in making our modest contribution to this “World War III” …
 Avetisyan, E; Hockerts, K. (2016). The Consolidation of the ESG Rating Industry as an Enactment of Institutional Retrogression. Business Strategy and the Environment
 Lins, K; Servaes, H; Tamayo, A. (2017). Social capital, trust and firm performance: The value of corporate social responsibility during the financial crisis. The Journal of Finance.
 Principles for Responsible Investment. (2019). ESG, credit risk and ratings: Part 3 – From disconnects to action area.
 Hermes Investment and Beyond Ratings. (2019). Pricing ESG risk in sovereign credit.
 Stiglitz, J. (2019). The climate crisis is our third world war. It needs a bold response. The Guardian.
 Capelle-Blancard, G; Crifo, P ;Diaye, M-A (2019). Sovereign bond yield spreads and sustainability: An empirical analysis of OECD countries. Journal of Banking & Finance
 Hsiang, S; Jina, A. (2014). The causal effect of environmental catastrophe on long-run economic growth: Evidence from 6,700 cyclones. NBER Working Paper.