It’s 11:30 a.m. … do you know where your ESG strategy is?
This is only half in jest.
Professionals from all sides of the market have put a lot of thought into formulating and interpreting environmental, social and governance (ESG) strategies, but not enough attention has been paid to the development of good definitions in this realm. Professionals in the market have hoped the issue would resolve itself organically. But while sustainable investing and ESG have become commonplace in conversation, the lack of consistent standardization results in confusion and inability to benchmark efforts.
New global green, social and sustainable issuance hit $1.6 trillion in 2021 — a 100% increase from 2020 — but the industry is overdue to develop agreed upon language that organizes the many datasets, standards, sources and analytics available in the marketplace. This problem is pervasive in fixed income, and particularly acute in municipal finance due to the many ways that sustainable investing standards correlate to an industry defined by extensive project, entity and security detail.
Today, most asset managers have developed an ESG strategy, but each reflects a different approach dictated by internal standards and accessible data. For example, some use green-labeled bonds or the ICMA framework; others use climate models to manage risk exposures which may not have been built into traditional models. Some reflect on board diversity or internal recycling practices, while others claim through corporate branding that ESG is factored into “everything” they do. The one common thread is the language used to characterize these approaches: ESG strategy.
We can no longer use ESG as the single phrase to represent all the ways market participants think about sustainable investing. We don’t call all eating establishments restaurants, rather we use a taxonomy to help consumers match the product with the need — cafes, delis, fast food, bars, fine dining, etc. — and those terms communicate a spectrum of convenience, cost, accessibility and other considerations to diners.
ESG investing has grown complex enough that it’s time we recognize what strategy or product is best suited for a given situation. This is a crucial first step for the market to establish long-needed standards and guide utilization into the effective outcomes we all wish to see. (As the term ESG is used for both this growing industry and as a category in it, I will refer to the broader industry as ‘sustainable investing,’ not to be confused with sustainability bonds, etc.).
Leaders have begun to recognize this issue. At the GFOA’s MiniMuni Conference in October 2021, MSRB CEO Mark Kim said “the MSRB appreciates that there is a difference between ESG-related disclosures and the labeling and marketing of bond deals,” and a recent post (ESG Investing, Some Thoughts, December, 2021) on the blog, The Public Purse, proposed two distinct sides of investing in ESG — avoiding risk of climate-related impacts and proactivity to mitigate climate change influencing activities.
Meanwhile, the Principles for Responsible Investment put out a paper in July 2021, ESG Integration in Sub-Sovereign Debt: The US Municipal Bond Market, which specifically called out ESG risk integration as the core focus, differentiating from the alternative thematic and investor screening approaches to ESG, which will be discussed separately. Similarly, an excellent paper by Michael Cosack and Henry Shilling entitled Rapid Growth in ESG Funds Calls for Adoption of Standards urged the adoption of six categories to define the landscape of sustainable investing: Exclusionary Investing, Impact Investing, Thematic Investing, ESG Integration, Values-based Investing and Engagement/Proxy Voting.
Building upon the above research, I propose to consolidate the latter set of strategies from six to four categories, recognizing that inclusionary and exclusionary investing are simply inverse approaches to Values-Based Investing, and Engagement/Proxy Voting is not relevant enough to fixed income. This leaves the following four strategies to encompass fixed income sustainable investing:
- ESG Integration: The integration of E, S and G factors into the risk analysis of a given investment
- Thematic Investing: An investment strategy relying on unifying concepts relating to environmental or social dynamics, and the basis for now-common green bonds, social bonds, etc.
- Values-Based Investing: An investment strategy driven by the deliberate inclusion or exclusion of guiding ethical, religious, social or environmental principles
- Impact Investing: Investments geared toward the achievement of measurable environmental and/or social impact
A closer look reveals these four strategies speak to a well-defined spectrum of strategic attributes addressing security and entity dynamics, as well as direct and indirect financial considerations. Sustainable investing discussions run the gamut from evaluating risks behind what is securing a loan, to the operational practices and intentionality of an entity, to the use of proceeds on a security. Meanwhile, these sustainable investment strategies also speak to an entire spectrum of direct and indirect financial factors related to collateral stream, entity and project. This two-dimensional grid of attributes viewed through the lens of the proposed four categories of sustainable investing creates an organizational foundation that functions as a map for the various manifestations of the sustainable investing landscape, or the Sustainable Investment Map (SIM):
The SIM uses two axes to position investment strategies against the security versus entity and direct versus indirect financial implications. The x-axis, from left to right, establishes where the funds are coming from (security), to who is borrowing the money (entity), to what the funds are being used for (security). The y-axis is a spectrum of financial implication, with direct on top and indirect on bottom.
Stated in more fixed income-oriented terminology, these strategies speak to the evaluation of the underlying entity (non-CUSIP) and the security (CUSIP) spectrum — what is securing the repayment of the loan and what are the proceeds of the loan going toward? CUSIP-level evaluations are simply about sources versus uses, which are realized through disparate strategies when accounting for sustainable investing practices. Meanwhile, the sustainable investing strategies also speak to varying degrees of direct and indirect financial considerations, which are usually (but not always) inherent in the sustainable investing strategy. They are a spectrum, not a binary.
In practice, this strategy almost entirely lives on the Source of Repayment side of the CUSIP spectrum, and — almost by definition — on the Direct side of the Financial Impact axis. This puts this strategy in the upper left side of the grid.
As most industry credit analysts and rating agencies would attest, an ESG Integration strategy has existed for far longer than people realize, particularly for the ‘G’. And while elements of ESG Integration have been commonplace for some time, the increasing availability of data and analytics has vaulted ESG Integration to the most adopted sustainable investing strategy today. Further, a sustainable investing strategy that speaks to factors with a direct financial impact contributes to the high adoption rate for municipal professionals, aligning well with the fiduciary requirement implied (or mandated) in the process of buying and managing credit exposures.
Examples of ESG Integration strategy are flood risk models for property evaluation or taxation value for a given area.
This strategy is predominantly defined by the project — or Use of Proceeds — associated with the securities, but can speak to elements of the underlying entity as well, e.g. a municipal housing authority. Depending on the nature of the project or entity, the unifying concept underlying the strategy has varying implications on Direct versus Indirect Financial Impact, and falls somewhere in between, exhibiting minimal correlation. This puts this strategy in the middle right of the grid.
In fixed income, Thematic Investing has captured the majority of the ESG attention since the first green bonds roughly 10 years ago. It has grown to include a wide range of verifiers, certifications, and standards from organizations such as the International Capital Markets Association (ICMA) and the Climate Bonds Initiative (CBI), but also from self-labeling efforts. Thematic Investing is mostly confined to the fixed income markets – and the municipal market in particular — due to the heavy reliance on project-based disclosures behind security offerings.
To date, Thematic Investing has had little crossover with the ‘G’ in ESG due to its heavy association with Use of Proceeds, but early-stage ideas have begun emerging around disclosure practices. Thematic Investing could span direct and indirect financial impacts, for example, green bonds that adopt resiliency measures to protect the habitat of an endangered species or green bonds that address stormwater control during flash flooding in an urban environment.
This strategy centers almost exclusively on the principles of the underlying entity and is therefore typically non-CUSIP driven. The strategy remains fairly neutral as it relates to a specific financial impact but leans toward indirect given the personal nature of the values it reflects. This puts this strategy in the lower middle of the grid.
Elements of Values-Based Investing strategies have existed in various forms for years in fixed income. This strategy leads in the broader corporate markets, across equity and fixed income, focusing on the core principles of the underlying entity. Further, this strategy offers a broader approach than sustainable investing, as the principles can go beyond E, S and G, with religious oriented funds being the most prominent example. The subjectivity of this strategy is higher than ESG Integration or Thematic Investing, creating a greater need for standardization and agreement on how it is used as a sustainable investing vehicle while being applied more categorically than quantitatively.
Examples of the current use in the municipal space is the portfolio exclusion of tobacco-related securities or avoiding coal-fired power plants.
This strategy represents an engagement in progressing towards ‘E’ and ‘S’ goals, and has little to no overlap with ‘G’ considerations. Given the actionable nature of achieving progress, Impact Investing heavily skews toward project based and therefore the Use of Proceeds side of the CUSIP spectrum. However, these actions aren’t necessarily manifest through a given financial instrument, allowing Impact Investing to also exist at the non-CUSIP level. As impact is measured against a broader standard of progress, this strategy predominantly carries an Indirect Financial Impact on a specific underlying security or entity. This concentrates this strategy in the lower right of the grid.
The concept of impact investing has been loosely defined since the early days of ESG and is often used interchangeably with sustainable investing. While elements of Values-Based and Thematic Investing can certainly overlap with Impact Investing, the element that defines – and challenges – the execution of an impact strategy is both a standard for how to define progress and the subsequent ability to positively influence it. Intentionality is not enough, measurable outcomes against a defined baseline is required, making this strategy the hardest to adopt today and where we will likely see the most growth in the future. There is no shortage of demand for Impact Investing, but very little process infrastructure exists today to support it.
One example of how Impact Investing is utilized today is through sustainability-linked bonds, where the performance of a financial instrument is tied to a positive outcome in sustainability, otherwise known as ‘E’ and ‘S’. Another is the use of UNSDGs, which represent a broad framework to define positive global environmental and social progress.
These four fixed income categories for sustainable investing give industry professionals a framework for aligning their goals, strategies and needs. It directs attention to the corresponding layer of the financial instrument, allowing investment professionals to seek entity level data, risk data and project data to complete their analysis. It creates a measurable approach for prudent decision making, matching the interests of clients, and contributing to goals that go beyond the scope of the investment itself.
Moreover, these positional definitions have guiding structural implications for the development of strategy. Horizontally, efforts on the CUSIP spectrum place a heavier burden on robust surveillance and ongoing analytics, while entity-oriented strategies might require a heavy dose of historical analytics but less reliance on future surveillance. Vertically, it’s no surprise that the higher the strategy’s position on the Direct Financial Impact axis, the easier it is to adopt and align with existing risk management-oriented investment mandates due to the underlying implied fiduciary requirement in fixed income and better quantification. That’s not to say the ease of adoption erodes its value; rather, the rewards of operating at the lower end of the spectrum may require additional effort, standard setting and shared quantifiable measurement, which in turn might point us in the direction of the next frontier of standard setting.