The application of ESG risk analysis within fixed income credit was discussed at an LGC roundtable event sponsored by Insight Investment. Nic Paton reports
William Bourne, principal, Linchpin IFM
Jill Davys, assistant director, investments and finance, West Midlands Pension Fund
Joshua Kendall, ESG analyst, Insight Investment
Sherilee Mace, institutional business development director, Insight Investment
Peter Moon, director, Hartnup Consulting
Karen Shackleton, senior adviser, M J Hudson Allenbridge
Rory Sullivan, responsible investment adviser
Dawn Turner, chief executive officer, Brunel Pension Partnership (roundtable chair)
We are now more than two years on from Bank of England governor Mark Carney’s famous speech warning of a looming crisis in the financial sector unless companies do more to spell out how vulnerable (or not) they are to climate change. We are also, of course, much the same period on from the Paris Climate Change agreement, even if US participation remains something of an open question.
For Local Government Pension Scheme funds working through the profound transition that is pooling, ESG (environmental, social and governance) investing and RI (responsible investment) remain very much live’ issues. Pooling, for starters, has brought with it new requirements and responsibilities to address ESG and stewardship activities.
More widely, could LGPS funds be missing a trick from an investment perspective? ESG tends to be most commonly discussed within the context of equities but could larger pooled funds especially be doing more to measure, evaluate and price ESG (and ESG risk) within the fixed income space so as to maximise return in what is, after all, the world’s largest asset class?
To explore this, and chew around wider questions regarding the application of ESG risk analysis within fixed income credit, LGC in February brought together a high-level panel of LGPS fund managers and advisers, in association with Insight Investment.
Roundtable chair Dawn Turner, chief executive officer at Brunel Pension Partnership, opened the proceedings by asking Joshua Kendall, ESG analyst at Insight Investment, to outline how funds should be best approaching pricing ESG within fixed income.
“There seems to be a potential lag when it comes to bonds in particular,” she said. “If you’re doing it on a long-term basis then, clearly, at some point of time it catches up. So, how you deal with that? Do you feel that pricing mechanisms are good enough and quick enough?”
“That is a very big question,” said Mr Kendall. “We look at ESG for risk purposes. We believe ESG can be material for a credit. In other words, if we believe ESG risks are great, that needs to be incorporated into the price of the bond. If you’re getting compensated in terms of risk levels and pricing then, arguably, that could be a credit you add to a portfolio. If you believe the ESG risks are not being compensated, you would not.”
“That is a completely objective approach,” said Peter Moon, director at Hartnup Consulting and former adviser to Teesside Pension Fund. “Would you try to encourage companies with bad ESG practices to fall into line by engaging with them?”
“There are two steps. One is understanding the ESG risks and incorporating them,” said Mr Kendall. “The other is where we take a position and look at questions such as: is this an ESG risk that we should be engaging on, and do we have an opportunity to engage? Do we have good access to management, do we have a large position, do we expect it to be a very short-term position? All of those factors we have to consider.”
“I would want to find a manager who was trying to improve business practices, because that would represent better value,” said Karen Shackleton, senior adviser at MJ Hudson Allenbridge and an independent adviser to Islington, Hounslow, Camden and Warwickshire pension funds. “But when comparing what you’re doing with another manager, how do I judge who is doing the better job?”
If you’re getting compensated in terms of risk levels and pricing then, arguably, that could be a credit you add to a portfolio
Joshua Kendall, Insight Investment
“That comes down to the quality of the process,” said Mr Kendall. “Have we got an effective process for tracking performance on engagement with companies and document the ESG decisions that we make? Insight, for example, has a central database where all the engagement activities are kept. The results are published in our annual report. And in those you can see we’ve engaged with more than 100 companies on ESG factors. We have case studies on where we’ve actually sought improvement in performance as a fixed income investor.”
“How much do people take this into account when they are buying bonds? What sort of return are you going to get? How do you move ESG up the agenda for the organisation, but also for the investors you are liaising with?” asked Jill Davys, assistant director, investments and finance at West Midlands Pension Fund, a member of the LGPS Central pool.
“For me, the biggest driver of change is our clients, without question. It is the clients holding us to account on ESG that is going to force the change,” agreed Mr Kendall. “It is very easy for us to say we have a process and we can demonstrate results but if you’re going to do that on a more systematic basis you need the external accountability to make that happen faster and more effectively.”
Risk and returns
“For equity investors, and certainly for me, ESG risks are all about getting better returns,” emphasised William Bourne, principal at Linchpin IFM, who advises both the East Sussex and Nottinghamshire pension funds. “What is the proposition that you make to investors? If I’m an investor wishing to invest in ESG-supported funds, are you saying I am going to feel better? Are you saying – with actual data to show – that I’ll get better returns?”
“We’ve always said that ESG is about risk management; it is about materiality,” answered Mr Kendall. “The reason we don’t invest in a company for ESG reasons is we think that credit is going to lose value. In our buy-and-maintain strategies, which is a sizeable book of long-term assets, you can count on one hand the number of issuers with the lowest ESG rating. That’s because we’re very sensitive to ESG over the long term. In particular, we are inclined to view governance factors as critical over a multi-year period.
“For more active positions, we have to look at the industry and think, over the next two to three years, are ESG factors likely to be so material that I am unlikely to get my principal back? We’re not doing this because we want to be eco-warriors; we’re not doing this because we have a particular moral or ethical agenda. It’s because, simply, we like to price up risk; we like to price up materiality; and then we combine the two and make a judgement call,” he added. “Of course, for segregated mandates, clients may ask us to implement a strategy that reflects their own moral and ethical principles.”
Influence of investors
The conversation turned to the influence that fixed income investors can apply to bond issuers. The influence and clout that large, pooled funds could bring to the table in this context could be significant, argued Rory Sullivan, a responsible investment adviser working with Insight Investment.
“Can fixed income investors influence bond issuers? The reality is that engagement is much more likely to be effective when investors work together towards a common agenda,” he said. “This requires asset owners to step up to the plate and demand that their asset managers engage with investee companies. One of the benefits of pooling is that it is easier for pension funds to co-ordinate and to put their weight together on a change agenda, if that is what they want to do.”
But one of the challenges within fixed income is you don’t have votes, highlighted Mr Bourne. “Investors do have influence,” said Mr Sullivan. “To be frank, fixed income investors have used the absence of voting rights as an excuse for inaction for far too long. Fixed income investors do have influence but they need to be prepared to use that influence.”
Integrating ESG analysis
There remains a wider question around resourcing and capacity, said Mr Moon. “How do you manage to number-crunch all this stuff on ESG, which is related to quite a large bond portfolio, and keep yourselves abreast of it at the same time and keep up to date? It’s hard enough to do it when you’re looking at a relatively concentrated equity portfolio.”
Insight Investment’s Mr Kendall emphasised it wasn’t necessarily about having massive teams number-crunching. “There is often a view that ESG is siloed or added on at the end to an investment process. But we have always said that the best way we get value from ESG is for the credit analysts to be analysing ESG risk, rather than an ESG specialist like me.
“The credit analysts are responsible for looking at the ESG assessments and incorporating them into our credit notes. If there is a low ESG score, credit analysts have to speak to the company to understand the risks identified, to get clarity around what’s driving those low ratings, and whether they will or can hang over the company in the future. Because ESG analysis starts and ends with the credit analysts, we can demonstrate how it is incorporated in the fundamental assessments that produce for a company.
“Insight’s credit analysts are also ESG analysts; I may be the lead ESG analyst but it is not my responsibility to hand-hold or undertake fundamental assessments myself. I think a lot of investors out there need to be conscious of the fact you don’t need a big ESG team to integrate these risk factors into investment decision-making,” he added.
Having someone who really knows, who is your own specialist, can make such a difference
Dawn Turner, Brunel Pension Partnership
Having someone internal who knows and understands ESG – and who can sniff out ‘greenwash’ – was also emphasised by panellists. Mr Sullivan, for example, asked Ms Turner to reflect on her experiences evaluating ESG in her former role at the Environment Agency Pension Fund.
“Obviously, you have to ask the question about ESG integration within an investment manager’s processes in the first place,” Ms Turner said. “Is it there, how is it weighted, how do you demonstrate it is truly integrated? You have to ask questions on their investment process. You look at what they say about their ESG team and what they say about their process, what they have done with the team, how many there are and where they sit.
“On engagement, we often asked them to give us a normal story and a not-so-normal or not-so-good story. It was about evaluating their honesty and transparency, and how they have been engaging. Having someone who really knows, who is your own specialist, can make such a difference.
“Finally, it is worth recognising there are some out there who have not got what you’d call an ESG team because it is perfectly integrated. Sometimes not having a team means that it is truly integrated.”
Being able to bring more people, knowledge and expertise to bear on this process could, again, give larger, pooled funds an edge, emphasised Ms Davys. “I think this is where pooling offers real potential.”
A question raised by Sherilee Mace, institutional business development director at Insight Investment, was whether there was a standard or a template that funds could follow. “Maybe it would help over time, as we get more comfortable, if there was some sort of benchmark to go by when it came to considering ESG risks and integration? If one of your funds did not have any idea about ESG, at least it would have a starting point.”
Ms Turner highlighted that the LGPS and the Local Government Association have produced guidance, though this was still in draft form at the time of the discussion in February. Mr Kendall also pointed out that Insight published in March a climate risk model, ranking businesses on their climate change-related risks and opportunities, and how they are positioning themselves for the transition to a low-carbon economy.
“This is the very first index of how companies in the fixed income world are performing from the carbon risk management perspective. We’re looking at the framework as recommended by the Task Force for Climate-related Financial Disclosure: governance, risk management strategy, targets and metrics, combining that into a rating and making a judgement call as to whether a company is managing those risks well or not,” he said.
ESG risk analysis
With time running out, Ms Turner asked panellists what their takeaway – their one –nugget – from the discussion would be.
“For me, it is about how you incorporate ESG into your fixed income process. I’ve always looked at it much more from an equities perspective,” said Mr Bourne.
“I’d echo that,” added Ms Davys. “I think people are now starting to think much more about how they put ESG into fixed income, and alternatives as well. Perhaps they have been focusing on equities simply because they have been such a large proportion of their assets.”
“The pooled funds have some very good people leading their responsible investment efforts. They need to be empowered and challenged to deliver change, in particular in relation to fixed income,” argued Mr Sullivan.
“For me, it is the point about ESG in a fixed income portfolio being about risk management. That is a really important takeaway. The other thing is the climate risk model, which sounds really, really interesting,” said Ms Shackleton.
“Joshua Kendall’s explanation of how the ESG process can become embedded with individual credit analysts is really important and I think begins to ring the death-knell of ‘let’s bolt on an ESG fund here or there’,” added Mr Moon.
“We are all likely to be held accountable for more relevant ESG material issues over the next few years from this pooling exercise, and so I think this conversation is a long time overdue,” concluded Mr Kendall.
This roundtable discussion was sponsored by Insight Investment. The topic was agreed by LGC and Insight Investment. The report was commissioned and edited by LGC. See LGCplus.com/Guidelines for more information.
The next step for fixed income investors
Sherilee Mace, institutional business development director, Insight Investment
Responsible investment in fixed income has come into sharp focus for Local Government Pension Scheme funds. The potential benefits for long-term risk management, and initiatives from authorities and regulators, are driving them to expect more from their bond portfolios – and are leading asset managers to develop new tools.
How has responsible investment evolved?
Responsible investment used to focus on avoiding companies that did not meet minimum standards. Today, it typically means investing that considers a broader range of risks over both the short and long term, and engagement with issuers to encourage them to make positive changes.
For bond investments, considering a broader range of risks typically means credit analysts looking at environmental, social and governance factors. This can help fixed income investors identify long-term value in companies, while at the same time anticipating risks which could lead to credit downgrades, price volatility and widening credit spreads.
As for engagement, equity investors, by voting, can have a direct say in matters that affect long-term performance. However, fixed income investors can also have significant influence: companies need finance, and in that context, bondholders’ views are crucial. As bondholders, Insight has been able to directly influence issuers to make material positive changes – such as convincing a major listed company to make its financial disclosures more transparent.
Aside from the potential benefits for risk management, regulatory change and new initiatives are also leading to a sharpened focus on responsible investment approaches. In England and Wales, the LGPS (Management and Investment of Funds) Regulations 2016 included guidance on responsible investing. More recent initiatives include the Financial Stability Board’s Task Force on Climate-related Financial Disclosures and the European Commission’s Action Plan for Sustainable Growth.
New tools being developed
Such factors are leading our LGPS clients to consider how best to pursue a responsible investment approach, and we are developing tools to support their strategies. This year, we were the first investment manager to develop a climate risk model to help us assess how corporate debt issuers are managing the long-term risks presented by climate change. It ranks more than 1,800 issuers according to how they manage such factors, and applies a framework in line with guidance from the task force.
Responsible investment is no longer a niche interest but investing responsibly takes skill and a holistic approach to a portfolio. LGPS funds and investment managers will need to work closely to make the most of the opportunities it can present.