On the equity side, investors are signed up to stewardship codes that have improved corporate governance and they regularly exclude certain sectors such as fossil fuels, armaments and tobacco from their investment portfolios. Most importantly, numerous studies have shown that investing through an ESG lens leads to enhanced returns.
Embedding ESG into Market Infrastructure
One of the most exciting developments in international financial markets over the last decade has been the emergence of the green finance market.
From virtually nothing ten years ago, the market for green bonds has grown to USD 1 trillion of total outstanding issues, with around USD 250 billion of new issuance in 2019.
With all this being said, is it fair to say that ESG has already gone mainstream?
While it might be tempting to see the success of green bonds and say yes, on two levels the answer is unfortunately still no. “It is a fast-growing market with lots of opportunities,” says Sean Kidney, CEO of the Climate Bonds Initiative in London. “But to meet the requirements of the Paris Accords, we need to make it vast.”
Kidney points out that despite the market reaching almost USD 1 trillion in size, this is still only 1% of the total global bond market. “We need vast investment into low carbon solutions – maybe USD 90 trillion of CapEx between now and 2050. At the same time, investors need to shift their portfolios from negative and low-yielding assets into climate-positive assets.”
As well as a lack of scale, sustainable finance only really exists in the primary and investment markets. To really go mainstream, it needs to become embedded into the global financial architecture and infrastructure, the systems of settlement, clearing, collateral, capital and payments allowing the global financial markets to function.
The solution to this lies in three key areas: data consistency, taxonomy and regulation.
The EU’s work over the next six months in devising and standardizing an ESG taxonomy will be the foundation for embedding ESG issues into mainstream financial infrastructure. “The EU will come out with their taxonomy and regulations next year, which will force much more disclosure,” says Kidney.
Another regulatory milestone is expected next year when the Central Bank and Supervisors Network for Greening the Financial System (the NGFS) will publish a guide that will help central banks and other supervisors to measure climate risks in the financial system.
“We need to align the incentives for both the public and private financial systems,” says Ivan Odonnat, Deputy General Director for Financial Stability and Operations at the Banque de France in Paris (which runs the secretariat of the NGFS). “We want banks and companies to measure their own exposure to climate risks. Then we can make stress testing on climate risk as mainstream as stress testing on credit risk.”
Market participants also agree that much more needs to be done in order to take the new taxonomy, the new consistency of data and new regulations and embed them into the global market infrastructure in areas such as collateral, capital and securities lending.
“The new taxonomy and standards will be important, but there are still technical issues around securities lending and collateral,” says Andrew Dyson, Chief Executive Officer of ISLA, based in London.
“Securities finance is a rules-based standard, but we are crashing into the values-based world of ESG and it is hard to see how this works in practice.” One key question for Dyson is whether or not ESG funds will be able to even do securities lending. “They need to be able to do this in order to be both liquid and competitive.”
Some forward-thinking investment groups are already starting to find ways to align their overall ESG mandates with their market infrastructure activities. “We do both exclusion and engagement within our portfolios,” says Xavier Bouthors, Senior Portfolio Manager Treasury at NN Investment Partners in The Hague. “We have a strict exclusion list and strict criteria to help our investee companies’ transition. But we also feel that if you have a certain exclusion in your portfolio then you should not hold those securities as collateral as well.”
The key is that incentives and alignments must be such that they do not stand in the way of the development of sustainable finance. If there is a penalty – especially a financial penalty – on sustainable finance, it will hinder its ability to go mainstream. “Investors need to be able to manage a sustainable ESG strategy and still be able to participate in securities lending and repo,” says Bouthors, “and this needs sufficient liquidity so that there is real price discovery.”
The sustainable finance industry has come a long way in a short period of time, with numerous market players finding solutions, products and practices that work. But for it to develop to the next level it needs consistency, standardization and constant applicability. “At the end of the day, this is a systemic issue,” says the Banque de France’s Odonnat, “and we all need to work together to make it happen.”