ESG Evolution: Addressing the analytical shortfall – an introduction

25 February 2020

John BriggsHead of Strategy, Americas

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Alvaro VivancoHead of LatAm Strategy and Macro Analysis

John RobertsUS Rates Strategist

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ESG Evolution Addressing The Analytical Shortfall

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Filling an analytical shortfall for ESG

While the concept of selective investment has been around for decades, interest in Environmental, Social, and Governance issues (ESG) has skyrocketed in recent years. Changing social values, regulatory developments, political initiatives and climate change responses are only a few of the reasons why ESG awareness is here to stay.

Why ESG issues are financial consideration for investments 

For some, ESG issues are understood as non-financial considerations for investments. But for us, the financial materiality of ESG issues and their impact on markets and investments is a key area we’re interested in. However, we have found a noticeable lack of in-depth analysis of how ESG developments impact capital market behaviour on a broader scale. Admittedly, there is a lot more available on equities, but for ESG and fixed income there is very little.  So we’ve set out to address this gap.

While environmental, social, and governance considerations have been behind investment decisions for a long time, in recent years there has been a push to formally define these terms and make them specific and measurable.

Taking ESG considerations and criteria into evaluating potential investments is a critical way for investors to manage risks, invest their values and find new opportunities. Indeed, we believe that for all companies and all industries, not just those where ‘green’ issues are primary (e.g. solar investment for an energy company), governance is one area where firms can increase their ESG profile.

There is a noticeable lack of in-depth analysis of how ESG developments impact capital market behaviour on a broader scale

Existing analysis offers a narrow perspective

In this inaugural paper introducing our series examining ESG, we offer a preview into how we deliver deep ESG analysis from a macro perspective on topics that are materially important to investments.

We believe most of the existing analysis focuses too highly on green, social or other ESG bonds themselves, which is still currently a narrow perspective. Indeed, while a growing market, currently there are only roughly $650 billion in green bonds outstanding.

Putting the spotlight on ratings and their impact on fundamentals

Instead of contributing to this crowded space on a narrow angle, we intend to analyse the much broader question of how a company or industry’s ESG ratings (and change thereof) impact their credit performance from a market perspective.  That is, we intend to bring a more rigorous analysis to how ESG considerations affect the roughly $14 trillion overall corporate bond market. We feel that this will offer valuable insights to both corporations and investors, as it focuses less on specific ESG investments (green bonds, social bonds, etc.) and more on a broader approach to ESG issues as well as how ESG ratings can impact their overall asset profile (equity outperformance, lower debt funding costs, for example).

We intend to bring a more rigorous analysis to how ESG considerations affect the roughly $14 trillion overall corporate bond market.

Quantifying the actual impact of changes in ESG ratings on financial performance

ESG ratings and credit default swap spreads

Considering the trends and shortcomings of the existing analyses, there is ample scope to quantify the actual impact of changes of ESG ratings on financial performance.  In our first quantitative take, we examine whether upgrades and downgrades of ESG ratings (assigned by MSCI) for a particular company are correlated with out/under performance of financial credit default swap (CDS) spreads versus peers.

The idea is to control for all additional factors impacting spreads by focusing on the differences with a control group. Based on data coverage, to begin with we intend to use the MSCI ESG ratings and 5-year CDS spreads in euro or US dollar, depending on the group. Given the large sample available, we expect to get statistically significant results that can shed light on the actual impact of changes of EGS ratings on a company’s CDS spreads within an industry, or impact across industry, for example.

Case study: CDS spreads compress in European automobile industry 2016-2017

As a teaser, below we look at the specific rating changes and their impact on spreads in the European automobile industry between 2016 and 2017, allowing us to control for the overall market environment.

A rating update saw an 82 basis point compression

Rating upgrades see wider compression in spreads

Companies with an ESG rating upgrade experienced a significantly larger compression of CDS spreads versus companies that maintained their ESG rating (Figure 1).

On average, a rating update saw an 82 basis point compression, while maintaining a rating saw a spread compression of only 43 basis points (bps) – nearly half that of a rating update. Conversely, companies that saw their rating downgraded experienced a much smaller CDS compression (only 16bps) over the same time frame.

While this very small sample makes it difficult to draw broader conclusions, we expect to expand this analysis over the next several issues in this series. We aim to bring a more rigorous analytical approach to this expanding field, and showing both investors and corporations how changes in their ratings impacts market pricing of their respective assets. Beyond this, we see scope to expand the analysis across industry, currency and even into the sovereign space. 


Figure 1: A test case on the European auto sector: Changes in CDS spreads versus change in ESG ratings

Source: MSCI ESG Ratings, NatWest Markets

A test case on the European auto sector: Changes in CDS spreads versus change in ESG ratings

ESG Investor Survey: What are clients telling us?

In the fourth quarter of 2019, NatWest Markets carried out a survey among 50+ investors with assets under management of more than $16 trillion to gauge their approach to ESG investment (see Figure 2). There were six major takeaways that really stood out for us in the Desk Strategy team with our macro analysis lens:

  • 31% of respondents, the top response, felt that a “lack of reliable ESG data” is a key barrier for them, despite the increased attention to ESG strategies (and a key motivation for our approach).
  • The rise of ESG/Sustainable Investment strategies is driven by a range of factors, with strategic and financial considerations being key motivators.
  • 50% of survey participants said that ESG ratings/data impact their investment decisions. However, the lack of reliable ESG data is seen as a meaningful impediment to investing sustainably.
  • Investor appetite continues to grow for environmental and sustainability-related assets, with demand across all sub-sectors of the debt capital markets including subordinated capital.
  • Almost 60% of respondents indicated that their organisation's ESG strategy is not consistently applied across investments. Clearly the application of ESG strategies remains diverse within firms and across investment jurisdictions.
  • Improving the quality of sustainability reporting (e.g. through alignment to TCFD recommendations) is considered a key step for issuers looking to demonstrate their commitment to sustainability.

These six takeaways will be key drivers in the topics and questions we intend to answer throughout this series.

For the full survey results, please view here.


Figure 2: Results from the ESG Investor Survey

Source: NatWest Markets Global ESG Investor Survey 2019

Results from the ESG Investor Survey
Results from the ESG Investor Survey
Results from the ESG Investor Survey

Do better ESG metrics actually improve asset performance?

It varies...

When it comes to performance of ESG as an asset class, despite the rising interest and increasing investment flows into ESG – the results have been mixed.  Granted, performance information is still somewhat limited, particularly on the fixed income side, and there are several ways of slicing returns. 

For example, MSCI took an interesting approach to analyse by sector the impact of ESG by exploring the equity performance across the three core pillars (see figures 3, 4, and 5).  What stands out is not just the out- or under-performance of sectors based on their calculated score, but how it varies across the three pillars in addition to by sector.  Note: there is a noticeable lack of analysis from a macro level on fixed income performance related to ESG, hence our desire to fill that space. We think it will be particularly important to move beyond simply excluding low scoring ESG sectors.


Figure 3: MSCI score return impact: 5-year total equity return- Environmental

Source: Factset, MSCI

Figure 4:  MSCI  score return impact: 5-year total equity return- Social

Source:  Factset, MSCI

Figure 5:  MSCI score return impact: 5-year total equity return- Governance

Source:  Factset, MSCI

How can borrowers best leverage their ESG exposure to access cheaper capital?

There is a great deal of high level analysis of trends in ESG, but, in our view, little in depth analysis on how a company’s ESG considerations impact the overall performance of their financial assets. The question then becomes ‘how can borrowers best leverage their ESG exposure to access cheaper capital?’ This is the void we seek to fill.

In our upcoming research, we see many angles to tackle a broad set of issues.  For instance, some questions we seek to answer are:

  • What is the role of ESG factors in determining borrowing costs for corporate issuers, through different channels, while taking into account the traditional drivers of spreads?
  • Is the ESG impact coming mostly from the demand perspective (i.e. more ESG investments that hurt and benefit certain industries) or from improved corporate balance sheets?
  • Has this impact changed over time, and it is different across industries?
  • Is there a particular benefit from jumping from one point to another in the ESG spectrum, i.e. does the effect increase /decrease after a certain threshold?
  • Is there a difference between European and North American issuers?
  • Do investors reward equity or fixed income more for better ESG ratings?
  • Among sovereign borrowers, and especially in emerging markets, how can governments best position to benefit from the increased role of non-financial investment considerations? Further, how can dialogue between policy makers and investors shape these decisions in the future?

Despite the recent progress and attention, ESG themes are still at infancy and the direction of upcoming research will play a key role in determining its trajectory.  We think that we are at a point where some sensible trends and conclusions, along the lines described above, can be drawn. We look forward to exploring them in our upcoming pieces and welcome any feedback along the way. 

Read more

For our latest ESG thought leadership and industry updates, visit the NatWest Markets website and check out some of our highlights below:

> ESG/Sustainability