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[PODCAST] Diving into the world of ratings, ESG for fixed income and more

Updated: Mar 30, 2022

SFi Managing Partner Katy Yung had the pleasure of interviewing Mervyn Tang, Global Head of ESG Research at Fitch Ratings, in our first Practitioner Insights podcast. Listen here, or via Spotify, Apple podcasts or your preferred app:

In this podcast, we discuss latest developments in ESG for fixed income, from its role as part of a broader toolkit, to topical issues such as product innovation and engagement. A summary is provided below, followed by the full transcript.

There’s a huge demand from investors and others to understand these issues, and the research and the data providers that come out are just becoming increasingly sophisticated in their approaches to these risks.

  • ESG issues are complex and the sustainable finance solutions should directly address idiosyncratic bottlenecks. Fixed income, therefore, is a necessary part of an investor’s holistic toolkit.

  • ESG practices in equities have influenced the development of those in fixed income; key differences lie in:

    • the potential for use of proceeds ringfencing;

    • the wider market, with recent attention spreading to sovereigns and leverage loans, allowing ESG investors more broad-based access

  • Fitch Ratings has introduced the ESG Relevance Scores, an entity-by-entity scoring system designed to deliver transparency around how ESG issues affect credit ratings.

  • Dedicated ESG fixed income funds are growing rapidly, but the size of the market remains very small. This means that most green and social bonds are currently held by “mainstream” investors who may be indifferent to ESG labels.

  • COVID is topical in ESG, but it may be overly simplistic to view it as a singular ESG issue. The impact of COVID is multi-faceted with direct and indirect consequences. For example, it has brought a lot of governance issues to light.

  • Although the flurry of COVID bond issuance was met with scepticism, the speed of this development highlights the agility of the sustainable finance system, and testament to the significant strides we have made.

  • Similarly, the development of sustainability-linked bonds offer investors different channels to make an impact outside of use of proceeds, which is necessary in part because the gap to achieve SDG and climate change goals is large and complex.

  • Standardisation is happening, and there is emerging consensus around e.g. green issues, but the challenge is that sustainable finance as a whole is evolving quicker than the process of standardisation, which is quite often what happens in an evolving financial market.

  • Engagement practices for fixed income investors are evolving. This is especially relevant at the primary market level, but the whole process is becoming more systematic with some managers combining their equity and fixed income engagement efforts. Given the broader issuer base (e.g. sovereigns, securitisations), engagement in fixed income offer investors differentiated access from equities alone.

  • There is less focus on ESG among the general population in Asia, so the demand push really comes from two channels:

    • Foreign asset owners wishing to invest in Asia, as capital is increasingly globalised; and

    • Regulation – instead of a rise in dedicated ESG funds, what we are seeing is regulatory push for e.g. climate stress tests and better disclosures.

  • The development of ESG and the topics of focus in markets like Australia and Japan illustrate regional differences. There’s a lot of Asian nuance and we should expect a lot more domestic research and data.

  • Near-term, one of the key climate risks to investors may come from stress tests being pushed by Central Banks, the outcomes of which may drive loan reallocation and repricing.

  • Scenario analysis in climate risk is complex and foreign to many people, and the regulator may have an active role to help with guidelines, central bank reports and reporting requirements.

We’re moving from a world where these issues weren’t even discussed to being forefront in the media. Even if that is not always consensus, just having this dialogue is helpful.

Call Transcript: Katy: Let’s start by doing a bit of introduction. Tell us a bit about prior to your current role at Fitch Ratings. Can you share with us a bit of your personal journey to ESG, and whether you have a particular mission in your career trajectory?

Mervyn: Yes, absolutely. I actually started out in ESG as part of my first job in equity sales where we were basically supporting investors with global mandates on the SRI activities, usually SRI labeled funds. Back then, what we saw as SRI is very different to what ESG is now. SRI was very much about, say, screening for ethical issues or very thematic, so focus on stuff like water scarcity or climate change. Now ESG is much more about integrating sustainability into the investment process. There’s a lot more involved in terms of combining how sustainable issues with financial theory and how things ultimately affect financial and credit profiles. I left equity sales to go into government policy, I think, in part because I really wanted to just understand how policies work. I think in the midst of the financial crisis, working in a central bank, you really saw the pluming and mechanics of government policy. I ended up moving to Washington, DC as a liaison for the Bank of England just looking at Fed policy and other US economic policy agents. It wasn’t until I ended that role and end up becoming a Sovereign Credit Analyst at Fitch. Again, very policy-focused, but instead of working directly on government policy, I was analyzing government policy.

During that time, I got approached by a company called MSCI, which is one of the bigger ESG research houses, and they asked me, “Oh, do you want to work in ESG?” Actually, at that time, I was interested in the principles of sustainability. It’s something that I care about, but I thought my background wasn’t really that relevant. Actually, what they told me was, “We were looking for someone not so much of an ESG and environmental background, but someone with a financial background and an interest in ESG who could help start bringing all this together.” I think actually that’s where probably that personal journey and goal starts to become clearer in the sense that now we’re in a space which is evolving very quickly, and has no real theory to fall behind, like understanding how climate change affects finance and economics. It’s basically a new field. There’s very little precedent. Being able to be at the forefront of that is both intellectually stimulating and quite rewarding, and so I think kind of moving now. Now I head ESG research for Fitch globally. We’re a team of five in London and Hong Kong, which looks at cross-sector thematic issues. Things like climate change, data privacy, governance, a wide number of things. The idea, I think, to really think about this is climate change is really a systematic issue, and so it has a far-reaching impact across a wide variety of areas. I think, without understanding the different pieces, it’s very hard to find solutions to the problem. That’s where I find the field interesting.

Katy: Thank you for sharing that. It’s very interesting, especially with your public and private sector experience. Let’s segue into where we’re at now, especially you’ve mentioned about how rapidly the ESG space has developed. Can you tell us a bit about your personal worldview and also A macro backdrop of why ESG as an approach is increasing the important in the area of finance?

Mervyn: Yes. I think if we’re thinking about, say, just the amount of capital out there, I was looking at SIFMA numbers. I think there’s $101 trillion of global bonds outstanding, $74- 5 trillion in equity market cap globally. That’s a huge amount of capital. I think if we’re talking about some of the big ESG issues that the world faces, things like climate change, you need to redirect that capital in some way. I think that sustainable finance really just a system in the industry is trying to move that money towards those causes. Actually, when I’m thinking about my experience and going through, how you do that is really important, not just the desire to do it. If you’re thinking about trying to use your investment to fix a particular situation, let’s say, I want the world to move quicker towards a low carbon economy, so I want to encourage renewable investments. The main question then is, what’s constraining that investment? Is it a lack of availability of funding at the right tenor? If that’s the case, then you go through the bond market, and you try and find ways to either increase the tenor available in the market that wasn’t funded in some way, and then the availability of that funding. If we’re in a world where it’s a risk-sharing issue, it’s there’s not enough people who are willing to take on the risk of renewable projects, then it becomes an issue of equity or equity-linked instruments. How can I distribute that risk, or even in securitizations in some way? How can I get risk spread in a way which facilitates the added investment in renewables? It might not be that at all, so it could be the fact that some of these projects are just not economically viable in this particular environment policy and regulatory environment, then it might not be directly through the instruments that you’re financing, and it might be about engagement and other approach to shift policy. I think from a worldview perspective, there’s a lot of interest in sustainable finance now, but there’s a lot to be done to hone in to actually achieving some of the goals that people want to achieve.

Katy: Right. I think you’re already touched on the fact that across the different asset classes and also in policy areas, there are pockets of a lot to be done. Traditionally, in the fixed income space, I think it was a little bit slower to catch on. Equities was a bit earlier, because that was thought as more direct and relevant to investors. Could you tell us a bit about why ESG factors are material to fixed income investors and the space? Why should they care about this?

Mervyn: It’s interesting because people talk about the differences a lot, but there’s probably more commonalities than there are differences, because if we’re thinking about using ESG as a way to assess risk from those issues and manage risk-adjusted return, then if I’m thinking about a company, let’s say, something like Renault, the ESG issue of, let’s say, tightening vehicle emission standards is going to affect that company. Whether I’m a bondholder or a shareholder, that’s going to affect my investment. The same ESG issues are important for the same reasons. There are nuances with fixed income that makes the question a bit more complicated. One thing is that there’s variations in maturities or fixed maturities unlike equities, and so I have to consider a time horizon component to the risk that my investment faces. There’s also a difference in just the nature of the capital structure means that something that’s an earnings risk isn’t necessarily a credit risk, so I may have a one-off shock that hits my earnings, and so that does affect my DCF valuation of a stock. From a credit risk perspective, it could be very minor, maybe the company has huge amount of cash, the dent in the credit profile is just so minor. It doesn’t really affect the probability of default. You have to distinguish that in particular. I think when we talk about impact, I think the main difference with fixed income is this potential of defining the use of proceeds, which then leads to the creation of ideas like green bonds, social’s bonds, sustainability bonds, and that takes you to a different component. That doesn’t affect credit risk so much, but it does add another channel for how you could potentially think about impactful investment.

Katy: You touched on green bonds, and we’re going to go into that a bit later. Going back to your role and the research, so there’s a lot of ESG research out in the market these days. Could you share with us a bit about the differentiation among what your areas of research is providing for the landscape? Taking a step back, how does research play a role in what we’ve just talked about in terms of accelerating the development and pace of integrating ESG factors into all the different strategies and asset classes that you mentioned? Who would be your key audience?

Mervyn: I guess when we talk about ESG, ESG means a lot of things to different people, so there’s no common definition. When someone undertakes an ESG strategy, it can be for a variety of reasons. It could be, I want to minimize negative impact and increase the positive impact of my investment with maybe some threshold level of risk-adjusted return. It could be, I am just looking at these ESG issues because I think they’re really important. They have significant financial implications, but I only care about ESG in the context of improving that with suggested return. That’s more of a return focus. Some people will do a bit of both, and sometimes a line of how much impact is worth relative to return isn’t that clear. Now, maybe it’s easy to take an example of something like climate change, because an investment can affect climate change in terms of if the company you’ve invested in has high carbon emissions and is contributing to climate change, or it could be affected by climate change. My investment could be affected by regulation, or it could be affected by natural disasters. Often it can be aligned, but not always. We’ve transitioned risk. It’s a bit clearer because if I am a high Carbon Intensive Company or high carbon intensity company, the regulation that’s coming in response to the negative environmental impact that I have will end up costing me. The environmental impact I have, it’s aligned with the environmental impact on my company. If we’re talking about physical risk, it’s a bit different because I might just be a country that has a huge coastal border, more prone to natural disasters, but it’s not my actions that are causing the risks that I’m facing. That’s when you end up potentially differentiating how you allocate your portfolio if you have an impact perspective versus a risk perspective. Now, for us as a credit rating agency, we focus on credit risk, which is an even more specialist component. It’s important for ESG investors or investors in general, who are thinking about ESG and how they should think about it in the credit context. Even if they’re not purely thinking about it in credit context, they need to understand when an ESG issue is more related to impact and just for the sustainability, and when it becomes a credit issue. If you take something like let’s say high carbon intensity regulation leads to carbon pricing, that potentially leads the costs of the company. You can’t actually decide for that cost without looking at the broader credit profile, because it potentially what we’ve seen actually in real life in Europe is that higher carbon costs when regulation came and gets passed through in wholesale electricity prices. Actually, my customers are actually the ones who are bearing that higher carbon cost, not me. In a credit context, you could have a situation where carbon regulation or carbon pricing affects a company with lower carbon intensity than a higher carbon intensity just in terms of the business model and the geographical structure of an entity. I think that’s where a credit rating agency can offer more insights because we have a broader understanding of this credit profile, which is harder for, I think, ESG third-party providers to be able to do.

Katy: Thank you, Mervyn. Moving on to some questions related to the overall approach. Can you give us a quick overview on the various approaches that institutional fixed-income investors are incorporating ESG into the strategies across issuer types and asset classes?

Mervyn: Yes. I think in many ways, the way Fixed Income Investors are incorporating ESG is similar to how equity investors are doing it. Actually what you find is a lot of asset managers started out integrating with ESG and equity portfolio, and then translated that into fixed income. Now, this is okay for certain parts. In terms of, I think we talked about ESG investors having different objectives. A lot of the objectives can be applied to fixed income in the same way. If I’m more focused on impact, perhaps I might want to minimize negative impact. Then I go through a screening approach where I might omit certain sectors like tobacco or controversial weapons. Fixed income can get a bit more complicated because you might have a subsidiary or a parent, and there might be entities that, let’s say, I have a green energy company operating as a subsidiary of a parent with a much larger energy profile including fossil fuel. How do I do that? There’s still a few question marks around that, but the ultimate principle of negative screening is the same. Similarly, I think the positive impact side. Maybe I only invest in companies that have green or certain ESG or sustainable revenue sources that may be renewable energy or it may be an education in the hospital or something like that. Again, you have this maybe complexity in fixed income around parents and subsidiaries, maybe things like collateral which maybe changes the credit profile, but like the use of proceeds, that’s still things you have to consider there. For risk-return and focus investors, that’s where more the ESG integration process comes in, and it’s about, okay, how do I assess ESG risks and how they impact my company from a financial credit perspective. Again, the approach is the same. It’s just maybe the types of risks that I look at might slightly differ. I might care more about tail risks that have a big impact than I have about minor earnings impacts. The main difference, I think, as I mentioned before with bonds, is that you define the use of proceeds. This allows from an impact perspective for you to say for an investor to track well, what they’re financing. The issues, which we can discuss a bit later around fungibility of capital. How much can you really ringfence use of proceeds? It is something that’s different for bond versus equities. I think the other part is that within what we call fixed income, there’s a lot of wider set of asset classes. You have sovereigns, you have securitizations, you have all kinds of, or you can convertible instruments, you can have all kinds of different things. The question is, how do you incorporate ESG in that context? For example, when we look at securitizations, you don’t have a board in the same way or the same governance concept. You start thinking more about transactions and collateral structure and other issues. I think the overall approach is similar. It’s just when you get to dig down into the detail, I think just, I end up doing things slightly differently.

Katy: Thank you. That’s very interesting. Let’s go into a bit that is more relevant to our conversation, which is ESG and credit risk and ratings as well. In this context, we understand that Fitch’s approach of incorporating ESG into credit risk and rating. You recently launched ESG relevant scores. As I understand it, these are ESG scores at the issuer level, which is meant to show how it impacts or could impact the credit ratings. Fitch has shared some of that data in the public domain, added on top of it. You have published some of your own opinions about how ESG issues might be relevant or material to issue a specific credit rating. This sounds very exciting. Can you tell us a bit more?

Mervyn: Yes. I think a lot of this started with the UN PRI transparency and credit rating initiative that was launched in 2016. That initiative really was a movement as ESG was being adopted by more and more investors. There was a push for credit ratings to be more transparent. Investors wanted to understand, okay, how do we look at ESG issues in credit ratings? The initial response from a lot of rating agencies was, Oh, we look at these issues. It’s just, we only mention them if the materials. If there’s a natural disaster that shifts your credit profile, of course, we’re going to talk about it.

Same with governance issues that we’ve looked at for a very long time. Yes, we talk about ESG issues if it’s material. As part of this, I think it became clear that investors wanted more. They not only wanted to know what is material, but also what’s not material explicitly. They want to understand why it’s not material if it’s not material. Is it because the impact is managed in some way, is the impact outside of a time horizon that you believe can be useful to forecast? There must be some issues that might be immaterial for a particular reason. I think what investors want to do is, oh, they want to understand and want credit ratings to be more transparent, so they can make their own opinion on some of these ESG issues, because not everyone has the same view on climate change, water scarcity and a host of different issues. As part of that, what we did was we wanted to systematically incorporate ESG into our description of credit rating.

We created this system called ESG Relevance Scores which is an entity-by-entity scoring system. In every credit rating review, our analysts would assign these ESG scores as a way of explaining how different ESG issues affected their credit rating decision. Now, the interesting thing is, when we started this process, and we get this question a lot from investors like, how much does climate change or environmental issues– What’s the weight of that in your credit rating? Or, what’s the weight of governance issues? What we found is not that simple, because if you take something like climate change, it can materialize into the credit profile in a host of different ways. It could be the fact that regulation was tightening in a specific manner. It could be that banks and asset managers are pulling away from that entity, leading to a financing cost impact. There’s a whole lot of different transmission channels.

Then, even in a sector, an individual entity may vary in terms of how they’re exposed to ESG risks. If we’re talking about, let’s say, something like a Volkswagen. The emissions scandal definitely had a big impact in terms of the fine that the company faced, but if we looked at the business position of the entity, the reputational risk seems to have been limited. In terms of market share and brand positioning, it wasn’t as affected as you might have if you were a smaller, less diversified operator. Similarly, as an investment grade entity without many financing difficulties to start with, they were able to absorb those fines without a huge impact on their financing flexible. If you were an auto manufacturer which is much weaker or negative cash flows, your ability to absorb that fine would be much less. When we start to think about this, actually it makes sense for us to just go, “Oh, okay, this is how much any ESG issues affects credit ratings.” We can just pinpoint to when an issue is important and then we’ll write about it in a more qualitative manner, how that issue is important and how it’s incorporated into our assessment. This is how this scoring system really materialized.

Katy: That’s really interesting, especially the increasing discussion and linkages between how these issues work and impacting it, so it may not be as simple as one would think, that you could assign certain weightings and scores. Could you share, again, these ESG scores? How credit ratings have fared or moved during COVID? Are there any specific cases that you want to highlight?

Mervyn: Yes, I think it’s interesting because you find that some entities or some companies would classify COVID as an ESG issue in itself. We don’t think about it in that way, because the way we think about ESG issues, they’re more long term structural trends. Often, more long term structural trends, so social preferences are shifting in a way which is– like putting pressure on the affordability of drug prices, or pressuring pricing of drugs because of worries about affordability. It could be just a climate regulation-type thing in the long term, because of the way the economy’s transitioning towards something more low carbon. COVID, for us, when we think about this, even though COVID had a huge impact on credit rating, so just the impact on both liquidity and rising leverage has led to a lot of negative rating actions. We don’t classify that as an ESG related action per se. It’s an economic shock that drove these credit rating actions. That’s not to say COVID doesn’t have an impact on ESG issues, because what we found is– Let’s take, just the whole world is having weaker balance sheets. If we’re thinking even governments. Governments at this point, a lot of governments say the EU have been, as part of their recovery packages, putting green conditionalities and other sustainability aspects into those recovery packages. That can potentially provide a boost to green investment, but at the same time, for a lot of economies which have faced a really big dent on their balance sheet because of COVID, their ability to make those policy decisions might be challenged. Same with corporates, because if you’re thinking about corporates, again, there’s been rising leverage and balance sheets have been impacted. If I’m an entity trying to manage my ESG risk, let’s say something like a miner operating in LatAm, water scarcity’s been an issue that we’ve been focusing on considerably. To deal with water scarcity, I need to invest in CapEx to be able to manage the lack of water. I might build a desalination plant, I might need to use that– pump the water from that desalination plant to my mine. That all costs quite a lot, and so in a world where my balance sheet is more impaired, my ability to finance those investments could be challenged. We think COVID has a multitude of impacts on, really, ESG issues. I think the more common ones discussed is the increase in remote working, the changes in how buildings would likely operate in the future, and offices will likely operate in the future. There’s a huge lot of social impact, but again, just simply having COVID as an ESG issue, it probably isn’t the most useful for how the industry works. In terms of specifics, what we found is that we do see COVID potentially exacerbating governance issues, and you’ve seen various cases of that. In a world where things are fine, it’s easier to– not high, but it’s less easy for governance issues to materialize. If I have issues of accounting, if I have issues with the way my group structure works, it doesn’t actually materialize until crisis conditions hit. Then suddenly, when COVID hit, you see situations where a parent might draw cash from a subsidiary, meaning that the governance issues in a group structure perspective, which has been a weakness all along, suddenly materializes. Or, if I’ve a weakness in my ba– If I’ve not been transparent about my accounting, suddenly the real impact of that lack of transparency is materialized when COVID hits. I think where we do see COVID having an impact on credit ratings through ESG, is often through governance.

Katy: Thank you, Mervyn. That’s very interesting color. One quick follow up is, given these, what is happening in the backdrop is evolving very quickly, how often do you update these ESG scores, and on a bigger level, how is this approached filling what’s missing in the market at the moment, and do you think this is where the rest of the industry is moving towards?

Mervyn: We made it systematic. As part of every rating decision, which is typically at least once a year, there will be ESG scores that are approved by the committee as part of the credit rating. Now, whether this is how the industry moving, I think there’s a lot of different aspects to ESG that I mentioned. I think there’s a huge number of data providers trying to fill many, many different voids. Some are focused on climate risks, some are focused on supply chain issues, some are more holistic looking at ESG performance. What we offer, in terms of what’s missing in the market, is that link between ESG issues and credit ratings, and this transparent framework for investors to really understand some of these ESG issues in the credit context. I don’t think it’s where everyone in the market will move, because it’s something that’s much more focused for what a credit rating agency would do. What we’ll see, just in general, is that there’s a huge demand from investors and others to understand these issues, and the research and the data providers that come out are just becoming increasingly sophisticated in their approaches to these risks.

Katy: Now let’s move on to the next section where we do a deeper dive into the different asset classes, but before we start, let’s talk a little bit about the market. Given where we are in the cycle, and a lot of uncertainty globally around the pandemic, Mervyn, where have you seen the biggest demand and uptake for ESG integrated fixed income strategies? Just as an example, we’ve observed a rapid rise of COVID bonds in the market. There were around 240 billion issued in the past five months, and over half of those issuances were out of Asia Pacific. Could you share with us a bit more on what you’re seeing in the market?

Mervyn: Yes. I guess maybe one way to think about ESG is that there are dedicated ESG funds, and then there’s asset managers integrating ESG across all their assets, whether they’re labeled ESG or not labeled ESG. It’s worth distinguishing this because where you see probably the biggest movements is how asset managers are integrating ESG into assets that are not labeled as ESG, and I think it started off with, say equities, is move to fixed income, and then now increasingly to other asset classes, like leveraged loan, structure finance in the fixed income space. The idea of this, I think you mentioned, we’re in a part of a cycle where there can be hard for yield where there’s a lot of volatility and uncertainty, and in some ways, this whole ESG process is designed to identify potential risks that may not be easily captured in financial indicators, and so governance, I think I mentioned before, that’s probably one of those issues that become increasingly important in a world where there’s a lot of uncertainty, a lot of volatility. If I’m going into higher yield spaces, let’s say I’m moving towards emerging markets, the potential for governance issues is higher. If you look at governance issues, there’s more variation within emerging markets, there’s potentially more pitfalls that you can fall into. ESG, as part of the integration approach, that would look at governance more carefully, as part of that emerging market analysis. That’s different to say, demand for a specific instrument. I think it is also worth mentioning that one of the reasons why people are doing this is that asset owners are pushing asset managers very heavily to integrate ESG. What we’re seeing is that there’s a lot of mandates from asset owners now that basically assess the ESG framework of an asset manager as part of that mandate. If we’re talking about demand, I think that’s what’s driving that part of the ESG.

When we talk about, say the specific dedicated ESG funds like ESG strategy, or it could be a screening type strategy, SRI style, it could be a green bond fund. Those are actually quite small in terms of size. They are growing at record numbers. Before COVID could potentially slow sustainable fund launches, but it seems to be still at record pace, so there’s momentum behind this movement, but we’re talking about something that starts at a fairly small percentage. If we’re talking about green and social bonds, for example, actually most of those are actually held by non-dedicated investors, so they’re mainstream investors who may be indifferent to whether an instrument is labeled green or social or sustainable. It is worth bearing in mind that we’re talking about something that starts from a small size. COVID bonds are interesting because it demonstrates what sustainable finance system is trying to do, at least what part of the sustainable finance system is trying to do. It’s trying to direct capital towards specific causes, and just the speed of that rising of COVID bond market, I think highlights just the agility of the system to divert capital now. This rise in this market, the labeling, the analytical process sets up asset managers to understand these bonds, they wouldn’t have happened if the green and social bond infrastructure wasn’t in place, and that’s good. That also highlights challenges though because I think there’s been a lot of criticism of COVID bonds in the sense that the use of proceeds can be over defined, so quite often, it’s just earmarked for some recovery package. The time horizon is a bit more complicated because quite often you have COVID bonds which are longer in maturity than the relief measures that they are trying to support. I think one investor talked about what happens at the end of the use of proceeds, which is a common problem with green bonds in the sense of what’s reporting like over the life of the bond after issuance. It highlights some of the challenges, but at the same time, I think it just shows the agility of the sustainable finance system and being able to target financing.

Katy: Yes, clearly we’re seeing the market broadening and diversifying away from just traditional green bonds. You touched on COVID bonds, and now we’ve seen in the market a variety of sustainable bonds, which are either labeled as transition bonds, SDG bonds, social bonds. Picking up on a specific example, which is Enel, an Italian energy company, they issued the first SDG linked bond in 2019. What’s new about this structure is first this bond replaced their original green bond program, and the general corporate purpose bond is tied to KPIs where the company on the group level pledge to increase their renewables from 48% to 55% in 2021, and if they don’t achieve that, there’s a penalty clause to it where the coupon would increase by 25 bps. This deviates from the traditional green bond space you mentioned about use of proceeds is now not ring-fenced or tied to specific projects. On that end, could you comment on how you view the development of issuance as such, where these are not tied to specific use of proceeds. On the flip side, though, there is more skin in the game because the company is pledging on the corporate level in terms of achieving certain targets, and they have 25 basis points penalty if they don’t achieve that. Do you think this is part of the transition that is necessary to achieve the overall SDG goals and address climate change? Yes, there’s a lot packed in there. What are some of your thoughts?

Mervyn: Maybe I’ll answer this question a bit more broadly because a lot of the innovations you talk about in terms of transition social bonds are still use of proceeds concept. They are just different types of use of proceeds where absolutely sustainability linked bonds is different. It’s about a bond where the interest is tied to the sustainability performance of a company measured in some way, like with the Anabond bond, it’s linked to specific targets. We’ve also seen sustainability linked loans and bonds linked to third party ratings to specific quantitative indicators. There’s a lot of these instruments out there. I think what the evolution of these instruments really reflect is the question of what am I trying to do when I invest in sustainable finance instrument, how am I trying to cause an impact? I think many feel that use of proceeds have certain benefits, but is it the best way of doing so? Just because my bond is earmarked for specific green or social project, am I actually causing an impact? Am I reducing the financing costs of that project? Am I making a change in some way? I think for the sustainability link mechanism, it tries to solve something a bit different. It tries to create incentives for a company to achieve certain sustainability goals. That may be what you want to do if that’s incentive is what’s needed. Then analysis of those structures from an impact perspective is more about, okay, what are these targets? Are they ambitious or are they going to be made anyway? How does the penalty mechanism work? What does that change? You see a lot of evolution really in the sustainable finance space. I believe the IFC put out a note on the safe forest link bonds about securitising forest assets in a way to give incentives for governments to manage forest and deforestation issues. You’re seeing stuff like alternative capital in the green bond space still linked to the use of proceeds, but you can potentially move to something that was like say something like a green regulatory capital concept. There’s a lot of ways that sustainable finance is outside of use of proceeds, in part because there’s actually a lot of different issues that might need to be addressed if you want to achieve SDG and climate change goals.

Katy: In a way, I think we would expect more of this innovation and instruments coming out to the market and on the flip side, I think investors have certain pockets of market, there’s some fears about impact washing affecting the market. How do you see this play out and how are investors and regulators responding to this?

Mervyn: It’s interesting when we say impact washing, I think it actually can apply to a whole lot of different things around the sustainable finance chain or along the sustainable finance chain. The first thing would be okay, “Do the projects that my proceeds are directed towards actually have an impact?” That’s where things like taxonomies come in, where it’s like, “Ah, okay,” and the government and investors and whatnot decide, “Okay, what should be defined? What should at least be set as the minimum bar for what can be defined as sustainable?” Even that can have a lot of debates, things like nuclear, things like large scale hydropower, and there’s not necessarily a common view on what should be in green and sustainable and taxonomy. Now, the use of proceeds is one part then if the question is, how are those ESG bonds structured? Are they structured in a way which I can understand the impact? Are they ring-fenced properly? Are they reported on after issuance? That’s why things like green bond standards and market standards become more important. I think you’re seeing regulation and rules around some of these issues. Then there’s the bigger question, moving beyond the use of proceeds side is even if I have a company investing in the green project, if it’s fossil fuel heavy is that actually– Am I ultimately having a negative impact because capital can be fungible? I am contributing to a company that maybe has a green project, but perhaps has a poor strategy from a climate change perspective. That part hasn’t been so much dealt with, with regulation, what we see with investors doing is, “Okay, maybe if I have a green bond fund or a green bond criteria I may also look at the issuer to understand what the ESG profile of the issuer is, and not just the use of proceeds, I might have hurdles for both.” I think then the bigger question which you’ve tackled before is, “Are use of proceeds even the right approach for impact?” When I’m investing in green bond, how much impact do I have or should I be thinking about other instruments which is more direct impact, like the sustainability-linked notes? That is less impact washing and more just a question mark of how much impact my investment actually would have. I think as you go down that list you can find, okay, well, if you’re trying to narrow down what impact your investment has, it becomes quite a complicated set of questions from the technical to the more philosophical.

Katy: Yes, sounds like as an investor, it’s also clarifying what your objectives are if impact is one of your goals and how deep and specific you want to go. There’s a lot of questions that can be asked around what the credit profile is, what are the ESG scores? The structures and all that moving on to next topic is around you touched on that on standards and the standardization of standards. Picking green bonds as an example since it’s developing most quickly even though as you mentioned, it’s not a big part of the market at the moment. What we’ve seen in Asia is the PBOC and National Development and Reform Commissions recently updated their guidelines in June, bringing China’s framework closer to international norms, for example, removing clean coal projects into its definition. What are your thoughts around this development?

Mervyn: I guess in terms of when people talk about standardization, I think what the aim with standardization is to have more clarity about “what does it mean to invest in a green bond?” If there’s different definitions of what a green bond is across regions, it’s much harder to build a market through that and have investors really understand that. I think linked to that, if I can define standardized, what it means to invest in a green bond, it will become clearer what it means if I invest in a green bond fund so if I do invest in the green bond fund, what is the nature of that? What are the projects that I’m financing? That’s really the aim of standardization. I think first to have clarity of meaning and then once you have clarity of meaning it’s easy to build an infrastructure around to accommodate that market. Now, I think the issue with definitions in the ESG space is what’s sustainable to one person or region is not necessarily sustainable to the other. Green is a little bit easier because I think if you look at global universal consensus, I think there’s a lot of acceptance that renewables are a good thing and there’s a lot of support on increasing green investment. Where you get a bit of debate is stuff like I mentioned, like nuclear or like hydropower, there’s a biodiversity impact. Those can still be ironed out. I think where it has become challenging is that the sustainable finance as a whole is evolving quicker than the process of standardization, which is quite often what happens in an evolving financial market. Now, we talked about transition bonds and social bonds before. Now, I think it becomes much harder to have an agreement on what should be a transition bond, because I think some of the market that object to a transition bond argue that they are a distraction from the overall low carbon efforts. Instead of cleaning up fossil fuel, they would rather straight jump to renewables because that is what the urgent action is needed. If I am in an economy, which is very fossil fuel reliant, I may have more sympathy towards a gradual transition of fossil fuel towards– Or at least reducing the carbon intensity of fossil fuel sources if my economy is very heavily dependent on that, and so especially when we’re starting to get a world where things like banking regulation, prudential regulation is using concepts of green or brown to dictate policy, the debate of what gets put as brown because of the potential penalties involved is going to become under greater scrutiny. Social becomes an even bigger bar because social can fit so many different things and social priorities across the world can be very different. I think the SDGs is probably where you have more consensus in the same way I think where there’s more acceptance of the SDG goals, but SDG doesn’t necessarily fit everything under the social umbrella.

Katy: Sounds like it’s going to continue to evolve. One other topic that we want to touch on is around engagement. Again, traditionally this has happened within the equity space but we’re also seeing a lot of pickup with amongst fixed-income investors who are actively using engagement as a tool, as a toolkit as well, what do you think is the potential here and how can they do more? What are some of the areas that they can advance on in terms of engagement with the corporates, or the sovereigns?

Mervyn: I think engagement has kind of understandably been limited compared to equity, in part because you don’t have ownership and you don’t have voting rights in the same way so the channels are different. I think it is interesting that FI engagement has increased, in part because ESG has become more important part of asset managers frameworks, but also and I mean, it’s finding an impact where you’re getting more particularly in the primary market for fixed income investors where engagement can be more effective, a lot of repeat issuers and there needs to be a continual relationship between the investor and issuer for continued refinancing. I think the data from UNPRI, and they did a survey on this, I think this was 2019 indicated that I think 76% of signatories had engaged in at least one bond issuer in their portfolio, but only 24% engaged in at least a quarter of their AUM. I think a lot of companies are at least engaging one or two issuers, a few issuers, but it’s less so is being applied across a wide range of portfolio. I think that number is probably going to expand because the engagement process can become more systematic. What we hear from a lot of asset managers is they’re starting to combine some of the engagement efforts so having the equity investors at the equity team work with their credit team and do joint engagement work. I mean, the interesting part, which I think you kind of touched on is and with the increasing focus on engagement in FI engagement, engagement is reaching areas that didn’t have engagement before because they didn’t really have equity so things like sovereigns and securitizations. It’s a somewhat different process, I mean, dealing with the government is quite very different to dealing with companies. You’re seeing some examples of that and investor action around deforestation in Brazil. There’s a lot of media coverage in terms of how that’s affected and their government’s decision on policy. I think what you’ll see is, with the expansion of ESG integration across a wider set of things like leverage finance, sovereigns and you will have more and more entities coming and having to deal with engagement compared to before.

Katy: Let’s move on into a little bit more on the Asia space. We spoke a lot around many different topics, from green bonds to transition bonds, impact washing, standardization of standards and engagement. How does this development and the ESG credit market in Asia specifically compare to the rest of the world? Have you seen any areas where Asia is more developing or there are nuances that might be a little bit different from the rest of the world?

Mervyn: Yes, absolutely. I think even within Asia there is a huge amount of variation in how ESG is being adopted. Maybe the main difference, and I use Asia broadly, excluding some places like Australia and Japan, one of the big difference is that ESG focus of the general population is probably less in Asia. We’re talking about the retail investors space that demand and focus on ESG is much more limited. Where you see ESG are being pushed in Asia is through two channels. One is foreign asset owners investing in Asian funds. Those asset owners are coming with mandates which effectively require an ESG framework and process in place for it even to apply to those mandates. As part of this kind of globalization of capital, Asian fund managers and investment firms are building ESG frameworks so that they can cater to this global capital.

The second side is regulation. We’re seeing a lot of things on regulation about Central bank and government policies. Green investment has been in the strategies, especially in the strategies of a lot of governments. There is push for more disclosure, there’s a push for a better management of that risk. That’s much more gone through the process of ESG integration. Instead of having dedicated ESG funds, things like climate stress test, for example are being pushed by central banks to manage climate risk, better reporting of ESG disclosure from companies so that those risks can be assessed better. That’s much more of a regulatory-driven push than necessarily it’s a retail or kind of general population demand. If you look at different parts of Asia, then that’s different areas of focus. In Australia, green and social bonds, and particularly sustainable linked instruments is much much more in focus and so there’s a lot of innovation coming out in that part of the world. There’s less of a focus on say something like that ESG integration to trying to manage ESG from a risk-return perspective that I talked about. In Japan, there is a particular push by GPIF as one of the major asset owners. There is a lot of focus on ESG issues particularly I think in Japan, with Abenomics there’s a lot of focus on a few specific areas. Gender diversity and gender empowerment is a big part of the ESG story in Japan.

Similar with governance reforms where governance has been a perpetual question that has been asked in Japan. I think it’s interesting, because if we then narrow it down to ESG risks, I think one of the big question marks for a lot of investors is still, “How much does this really matter from a risk-return perspective if I invest in an ESG fund or not?” What there’s been a lot of debate about whether ESG frameworks, how applicable are they in Asian contexts versus the rest of the world? If I’m only investing in Japan, if cross shareholdings are the norm, how effective is some of the more westernized government structures in my investment process? There’s a lot of Asian nuance. It’s why we see a lot more research and a lot more data that is coming out domestically to tackle some of these kind of more local issues.

Katy: Thank you for that very insightful, nuanced market recap across Asia Pacific. It’s interesting that different countries are picking up on this topic in slightly different ways. Maybe zoning on into closer to us at SFI, we’re familiar with some of the encouraging signs around climate recent reporting by the local regulators. Could you also share with us a bit about what you’re seeing specifically in terms of policy action in markets like Hong Kong and Singapore and what do you believe the near-term implications of such policies would be to institutional investors?

Mervyn: I think one of the big pressures in terms of climate risk is from a financial stability perspective through central banks. The Task Force on Climate-related Financial Disclosures TCFD very much pushed the idea of scenario analysis and stress testing. The Monetary Authority of Singapore issued guidance on environmental risks and management for banks. HKMA had similar guidelines for financial institutions. It’s important because I think a lot of these risks are very much systemic financial risks. One of the big challenges is to understand what will potentially happen to the financial system if some of these risks materialize in whatever time frame?

Now, I think this matters for investors because if the outcome of the stress test is actually there’s a lot more climate risk in financial institution portfolios than initially expected there might be a repricing of that risk. There might be a reallocation of the loan book and portfolios to reflect that risk and a repricing. That can mean for those entities that are more exposed to climate risk, they might face higher cost of capital or even the inability to insure or kind of various business challenges. If I’m an investor, I have to understand both how that affects my investment in that company and also how that affects my investment in banks and really just whatever my instruments are. I think, the interesting thing with scenario analysis in climate risk is really hard because there’s a huge amount of complexity in just understanding how the risk works. It’s even harder in the sense that the balance of transition risk and physical risk depends on different policy scenarios, so it’s very hard right now to get– Okay, what is the global policy scenario going to be? We know that policy will move probably towards some tightening, but we don’t know by how much. There’s kind of things like asset agreement pledges and whatnot, but they are not necessarily clear what that path is. What that means is there’s a focus of understanding. If your portfolio is heavily exposed to physical risk and we are potentially in a scenario where there’s limited regulation and physical risk rises significantly, what does that look like versus what does my portfolio look like if there’s a sudden global consensus on tightening carbon pricing or introducing carbon pricing? How is my portfolio exposed? I think balancing some of that is very new to a lot of people and so that’s something where things like guidelines, reports from central banks, reporting requirements from exchanges, all of that help to ultimately build what you need to understand these risks.

Katy: Right. That’s great. I think we covered a lot. I certainly learned a lot in this podcast going from your own career trajectory and your background to the backdrop of why looking at ESG risks matters in the fixed income space. We talked about the moving trends around ESG relevance scores and credit rating, delving into specific asset classes as well moving beyond green bonds and lastly, a bit around the trends that you’re seeing in Asia and also amongst the policy and regulation. To wrap up, maybe, Mervyn, you could share with us, what are your personal hopes and objectives in this space for the rest of 2020?

Mervyn: I think the hope in this space is- I think the ultimate goal is getting financing to the right environment or social objectives. There can be different environments and social objectives, but at the same time creating a financial system and an industry that supports and facilitates that I think requires a lot of careful work. I think I mentioned before that sustainable finance is evolving rapidly. I think my goal and the personal objective is being part of the group of people involved, who are helping it steer towards what you think is the right direction. I’m sure there’s going to be a lot of debate on that, but I think we’ve just a number of changes. Having these conversations and dialogues, bouncing these ideas back and forth through podcasts and other mediums help. We’re moving from a world where these issues weren’t even discussed to being forefront in the media. Even if that is not always consensus, just having this dialogue is helpful. Having more of these dialogues would probably be part of that goal.

Katy: On that note, thank you very much, Mervyn, for your time. Take care.

Mervyn: Thank you.

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