By Nigel Marsh, Investment Manager at Kingswood
But green’s the colour of spring
And green can be cool and friendly-like
And green can be big like an ocean
Or important like a mountain
Or tall like a tree
When green is all there is to be
It could make you wonder why
But why wonder, why wonder?
I’m green and I will do fine
No, not the words of some environmental activist but of Kermit the Frog released all the way back in 1970. This song also had the title of ‘Its Not Easy Being Green’ however many Governments, companies and individuals are turning towards environment friendly polices as we have never seen before. The growth in green investments has seen a huge increase over the last few years and according to Morninstar’s Q2 Global Investment Fund Flows there is now just over a trillion dollars under management. In bond markets direct issuance increased to $237 billion from $146 billion in 2018. This is mainly through corporate issuance but Governments are catching up quickly. Recently we have seen Germany and Sweden issue green bonds and the UK authorities are studying this. The EU is making green and social bonds a priority of its pandemic recovery fund. Meanwhile, there is a lot of media coverage in this area now all suggesting that the investor appetite is huge and will be growing.
The environment friendly asset class, if we can call it such, covers a wide range of green investing making it a very grey area. This is one of the biggest challenges faced by the environment, social or governance (ESG) fund sector as investors have different interpretations of what constitutes green and there is little transparency. Companies can issue green debt whilst not necessarily being able to stand an ESG rating. Who classifies a company’s environmental actions and then who accounts for the success and failure of these policies? Then there is offsetting where even the worst polluting company can pay away some of their damaging actions by investing into green projects. Regulators are chasing to catch up and put definitions in place but at the moment the market is far outpacing these efforts.
Although this socially responsible area is currently ill-defined it is easy to see why investing into companies that have strong ESG scores are becoming so popular. Those companies with higher ESG scores are defining best practice which in turn sets a level for others so that they can strive to achieve. It protects employee health and wellbeing as well as ensuring that management are allowing decent corporate structures to be set in place. The current pandemic has unwittingly highlighted the impact our everyday actions has on the world around us as, for example, we saw how pollution cleared during lockdown.
These changes in investor awareness mean ESG is now a core investment and all the signs indicate it will not only remain so but will continue to build strongly and become foremost in mainstream portfolios. ESG criteria can also help investors avoid companies that pose a greater financial risk due to bad environmental and governance practises which may lead to higher regulation costs. In the past there was little chance to structure a diverse portfolio because there were few ESG investment opportunities. Now, however, there is a lot more depth to the market including a wide range of investment grade and government backed offerings.
So how does a company obtain an ESG rating? What is measured and how are results targeted and is there any conformity or proportionality between the providers? There are many elements that ESG rating agencies look at to combine and then to provide a score. This can range from anti-competitive practises to water stress and a lot in between. Here at Kingswood, for our ESG Bond Fund, we look at taking constituents from one index which weights firstly on ESG considerations and gives extra weighting to issuers with improving ESG scores. This gives a set of standards and conformity to our process and as the weightings within the index are adjusted on a monthly basis we feel confident that we have exposure to the most environment friendly companies. The index will typically look at about 1,000 data points across the 3 elements that go into an ESG rating, these include how employees are cared for within an organisation through to how diverse the shareholder list is, as well taking into account the effects that management policies would have on the environment.
When looking at and comparing green bond offerings it is important to remember that the normal considerations as in any ‘normal’ bond fund, of course, still apply. The most important being, is a particular company going to be able to service its debt, by paying its dividends in full and on time, and much more importantly be able to repay the capital at maturity. Other considerations include how diverse a portfolio is and which sectors they would be investing into? What is the average weighted rating and how liquid are the investments? Again at Kingswood the index we utilise only selects investment grade bonds, those with a rating of BBB-, and higher and are therefore seen to have the best ability to honour their obligations. We rules out any bonds that do not have at least £300m in issuance ensuring very high levels of liquidity. It is important to consider, especially given the current and ongoing ultra-low interest rate environment, the maturity band that you are investing into. Is the risk and reward equation worthwhile? Is the additional risk undertaken by investing into long duration bonds worth the additional return that it generates? There comes a tipping point for each investor where the reward is just not worth the risk.
So what is in it for us? Well the obvious, it has to be right that investing in environmentally friendly companies is a more responsible use of funds especially as we see more of the damaging effects that climate change has on the world. ESG highlights the companies that manage with good governance including how they handle staff, customers and inequality. Also is it not likely that a management more focused on social responsibility will lead to increased longer term business performance? This view is supported by work that suggests following an ESG investment policy actually benefits returns. Morningstar, after examining long term performance data, have calculated that 6 out of 10 funds have delivered higher returns than their conventional counterparts. Further they suggest that 73% of the ESG Indices they follow have outperformed non-ESG equivalents since inception. The future’s bright, the future’s green!