Introducing the Green Economy

Investors have always looked at various elements for their investments in order to make the best choices and historically it was mainly a matter of returns. Responsible investments began in the 1960s as a social criterion, with investors excluding stocks involved in tobacco production or in the South African apartheid regime. For a long period of time, investors believed that ethical investments were reducing returns due to their nature. At the time, philanthropy was not known to be profitable. Furthermore, M. Friedman argued in the 70’s that the cost of behaving ethically would reduce returns.

However, due to the growing fears concerning climate change and new research (in particular Moskowitz’s in 1988) on the topic, Environmental, Social and Corporate Governance (ESG) factors became three leading criteria investors started looking at. ESG investing was given a shot in the arm when United Nations introduced the Principles on Responsible Investing (PRI) in 2006. The PRI has been signed by more than 2000 companies all over the world, including the main financial institutions such as Goldman Sachs, JP Morgan, Morgan Stanley or BlackRock and representing around $10.4 trillion out of the overall $89.6 trillion worldwide assets under management as of April 2018. The signatories have to commit to six voluntary principles such as, the incorporation of ESG issues into investment analysis and decision making and to increase disclosure about their environmental standards, their supply chains and their treatment of employees. ESG investing was even given a further push thanks to the Sustainable Development Goals (SDGs), a collection of 17 goals divided into 169 targets, set by United Nations in 2015 and to be achieved by 2030.

The same mainstream has been reached by Green Bonds, an investment solution that allows investors to generate profits while taking care of the planet’s health.

 

ESG investing

Nowadays many investors look at ESG factors to incorporate them into the investment process alongside with the traditional analysis. As you may have understood, now the approach to ESG investing is segmented into Environmental, Social and Governance factors. But those are only the three main criteria, whereas there are also subcategories for all of them. Regarding the Environment it could be divided into: climate change, natural resources, pollution & waste and environmental opportunities. The Social aspect mainly focuses on human capital, diversity, product liability, consumer protection and animal welfare. While Corporate Governance covers management structure, transparency, business ethics and employee relations.

Those factors can then be included in the investment process in two ways. Firstly, the “best in class” approach, focalizing into companies which within a sector have the best practices in term of sustainable development. Therefore, companies that are either polluting less or are having better social relations compared to companies in the same sector. Secondly, the “best in universe” approach, grouping companies that have the best sustainable development practices regardless of their sector of activity.

 

A growing trend

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During the past years we saw heavy inflows into ESG investments and an increasing demand for those (Social Responsible Investments, SRI, rose by 33% between 2014-2016, up to $8.72 trillion). According to various studies, this is just the beginning and it can be explained by three main reasons.

Firstly, as mentioned above, the world is changing. Investors are getting more and more aware of climate change and its implications. According to a survey of Morgan Stanley, millennials are two times more likely to invest in companies targeting social or environmental goals compared to the overall population. Furthermore, global sustainability challenge is introducing new risk factors for investors and may force them to re-evaluate their traditional investment approach preferring an ESG one. Secondly, because investors are changing. Quoting a study made by Accenture, in the next decades there should be a wealth transfer of $30 trillion from baby boomers to 90 million millennials, which should likely be translated into roughly $20 trillion put into ESG investing. And lastly, thanks to the evolution of data and analytics on this topic available in the market. Better data and transparency from the companies will allow ESG investors to have accurate and precise information for their investment process.

 

A new approach for financial returns

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As mentioned in the introduction, the main issue of ESG investing was the fear of lower returns, although some studies have proved the opposite. A recent MSCI study showed how companies with solid ESG practices have a lower cost of capital, lower volatility, and less bribery, corruption and fraud, in contrast to companies with poor ESG practices. The latter having higher cost of capital as well as higher volatility.

The graph above shows an analysis of the MSCI Emerging Market ESG Leader Index and the MSCI Emerging SRI Index returns compared to MSCI Emerging Markets Index. We can see that Companies with higher ESG ratings are usually associated with higher profitability, lower tail risk and lower systematic risk.

In order to invest in the right companies, asset managers are relying on more and more ESG rating agencies. Moreover, as the general demand is increasing, ESG indexes such as the Dow Jones Sustainability Index, the FTSE4Good Index, Bloomberg ESG data or the MSCI ESG Indices are rising in inflows.

 

Green Bond

A new initiative

Among the other market players, there is a non-profit organisation managing to mobilise a huge amount of money for climate change solutions. Its name is “Climate Bonds Initiative”, and the declared strategy is “to develop a large and liquid Green and Climate Bonds Market that will help drive down the cost of capital for climate projects in developed and emerging markets; to grow aggregation mechanisms for fragmented sectors; and to support governments seeking to tap debt capital markets”. By having a look its website, it is possible to figure out how its activities look like. Firstly, it manages the “Climate Bond Blog”, which is essentially a journal of record for relevant bond issuance including also some important industry updates, as well as drawing up a report concerning global outstanding bonds. The second workflow is related to developing trusted standards. The aim of these standards is to lead investors when making the right choice in order to tackle climate changes. Lastly, they provide policy proposals in the attempt to harmonise the work between governments, finance and industry.

At this point, someone could ask why there was the necessity to give birth to such a specific organisation. The answer lies in the overpowering rise of the abovementioned securities known as “Green Bonds”. These are issued by financial institutions, governments or companies allowing investors to receive their own returns but at the same time to contribute financing climate and environmental projects, and there is nothing else more right to do. In order to be labelled as Certified Green Bond, a security must undergo a strict process, at the end of which an Approved Verifier submit an assurance report to confirm that the bond meets the Climate Bonds Standard’s requirements. However, the Climate Bonds Standard Board has the final word. Certifications can be split in Pre-Issuance and Post-Issuance Certification, and they are available for asset related to specific sectors, currently including Solar Energy, Wind Energy, Geothermal Energy, Marine Renewable Energy, Water Infrastructure, Low Carbon Transport & Low Carbon Building. Nevertheless, other assets related to different sectors can be published after being approved by the Climate Bonds Standard Board. After the Post-Issuance verification, issuer’s duties are not over, since it is asked to provide the Climate Bonds Secretariat with annual reports with the purpose of keeping the compliance with the requirements.

 

2018 figures

Since their inception, Green Bonds have represented an unstoppable phenomenon that has seen the greatest global institutions as major players. The first socially-responsible fixed income security (€600m) has been issued in 2007 by the European Investment Bank, followed one year later by the World Bank, which issued the first Green Bond in history (€400m).

From 2008 on, a great work has been done in order to enhance the process, achieving relevant results. If we have a look again at a document from Climate Bonds Initiative, the 2018 Green Bond Market Summary, we can find some interesting figure that can help us understanding why last year has been exceptional concerning the green economy. Global green bond issuance reached $167.3bn in 2018, a figure that represents a 3% increase on 2017. Specifically, there have been 1,543 green bond issues from 320 issuers from 44 countries. The largest single green bond has been issued by Belgium with €4.5bn. USA has occupied the top spot in the bond issuance rankings for countries, followed by China and France. These three countries have already been ranked in the same positions in the previous years, and put together they have accounted to roughly $80bn issued in 2018. Consequently, it is easy to understand why the largest global issuer is an American company (Fannie Mae, $20.1bn), and the second one is Chinese (Industrial Bank Co, $9.6bn).

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Source: Climate Bond Initiative – 2018 Green Bond Market Summary

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Source: Climate Bond Initiative – 2018 Green Bond Market Summary

In addition, also Emerging Markets are playing a key role in the sector. With the contribution of Supranational Development Banks, EM accounted to the 31% of the total issuance. Obviously, China leads the group with 78% of EM’s issuance. Thanks to the introduction of the ASEAN Green Bond Standards, issuer from Thailand and Indonesia joined the market, with the latter becoming the first sovereign bond issuer from Asia in March 2018. On the European side instead, Poland, Iceland, Lithuania and Slovenia have been the major contributors.

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Source: Climate Bond Initiative – 2018 Green Bond Market Summary

 

Outlook 2019

Fortunately, also the outlook for 2019 seems to be positive according to Moody’s Investors Service. Indeed, the rating company has forecast green bond issuance to increase up to $200bn globally, representing a year-on-year growth of c.20%. The driving factors will be the increased use of the United Nations’ Sustainable Development Goals (SDG), as well as the “heightened commitment to addressing climate change”. Moreover, not only just an overall increase is expected, but also a consistent diversification in terms of sector, region and use of proceeds. Lastly, the fact that it will be easier to qualify a project as green is going to be beneficial for the growth of the sector as well.

However, not only Green Bonds market is about to explode in 2019, but also Social and Sustainability Bonds are pushing to reach a recognised position. With the birth of the SDG frameworks in 2018, investors are now able to decide where to channel their money to bonds financing green projects or to those financing social ones. According to CBI, Sustainability Bonds issuance has risen up to $21bn, a figure representing a 114% growth over 2017. Considering these trends, it is reasonable to point out that 2019 will be the year of a great consecration.

 

It’s just the beginning

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The investors’ change of mindset is shifting the world from a sole return-driven perspective to a more ethical and sustainable way of investing. This process is clearly helped by the implementation of new regulations by the United Nations and financial institutions. This is taking time and energy; and there is still a lot to do. As a study of PIMCO illustrates, although a lot of companies have a high level of awareness of the SDGs, only few are setting quantitative targets, letting us think that many are struggling to translate well-intentioned resolutions into action.

A key challenge is to develop an agreed set of performance indicators that shows a company’s target and progress. This would be extremely important for investors, in order to compare the SDG contribution of companies. We encourage financial institutions and private investors to do so and to keep on making investments in a more responsible way (obviously with the objective of delivering returns).

Is all this going to lead to a permanent change in investors’ mentality or are we just witnessing a fancy, but temporary, trend?

 

Authors: Federico Giorgi, Thomas Bauzon

 

Supervisor: Carmen Alvarez

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