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1 Workshop Supplement Written for: FIA Students and Grads Written by: Heike Reichelt, Head of Investor Relations and New Products The World Bank Treasury Original Release date: April 2016 More about the author: Heike Reichelt is Head of Investor Relations and New Products at the World Bank. The World Bank borrows between USD billion annually in the international capital markets. Her team s responsibilities include managing relationships with bond investors and rating agencies, and developing new debt products for investors such as for climate change mitigation and adaptation through products like World Bank Green Bonds. Her team performs similar functions for the International Finance Facility for Immunisation (IFFIm), for which the World Bank acts as treasury manager. Heike plays a key role in the World Bank s outreach to the sustainable and impact investing community in Europe and the US. She has also been a part of the World Bank Treasury's Sovereign Investments Partnerships Program for central banks. Heike has 20 years of experience in finance including the areas of export finance and capital markets. Before joining the World Bank in 2000, she held various positions in the German development agency Kreditanstalt fuer Wiederaufbau (KfW), and worked at European commercial banks. This Course Supplement was created for our FIA students and CFIP graduates to enhance the learning experience. For additional information about our programs, contact us! Special thanks to the World Bank team for their contribution! 1

2 Fixed Income Academy Virtual Workshop Supplemental Report Introduction to Sustainable and Responsible Impact Investing By: Heike Reichelt, Head of Investor Relations and New Products We often hear reference to socially responsible investing, sustainable investing, impact investing, or investing based on ESG criteria meaning environment, social and governance criteria. What do these terms mean? Why are we hearing so much about it these days - in the media and at conferences? Why do investors even care about social, environment and governance issues and what should you know? This Virtual Workshop training session hopes to answer some of those questions. Investment finance for fixed income portfolio managers is based on calculations using data on coupon, yield and maturity combined with credit and market expectations or projections. Some of those concepts already aren t black and white, but if you include SRI and ESG, it is even less straightforward. There are many variations and different expectations and interpretations of key aspects, making an SRI or ESG analysis even less black and white. Hopefully, we will spark your interest to learn more and find ways to apply some of these concepts in your daily work. In general, SRI and ESG investing refers to investment strategies that incorporate social, environmental and governance factors in their assessment. In most cases, investors include ESG to improve financial returns. ESG factors are considered relevant for financial returns for example with ESG investing investors focus on assessing investments based on potential risks and opportunities from environmental, social and governance aspects. This is more common with equity investing where investors see immediate effects on the share price (and that s where these concept originated), but also relevant for fixed income investors because how companies do in these areas affects their funding costs and the price of their bonds in the secondary market where investors may want to sell bonds. But in many cases these ESG factors are also included in the assessment because they are aligned with the investors expectations of making a positive contribution to society with their investments, and / or limiting the negative impacts to society for example by excluding investments in companies that support things like alcohol, tobacco, gambling and weapons especially the production of cluster bombs. There are differences in how people refer to the various strategies but like the concepts, the definitions aren t black and white either. Investors including these concepts in their investment process will differ in the way they do it, but essentially they are trying to limit risks in their investments that come from ESG factors and use their analysis to take 2

3 advantage of opportunities and they are showing with their investments that they value social and environmental returns in addition to financial returns. The term "socially responsible investing" is sometimes used narrowly to refer to strategies that try to avoid harm by excluding certain types of companies in an investment portfolio, through negative screening lists. The term has also included strategies that promote shareholder advocacy and community investing. The most common negative screens include alcohol, tobacco, gambling and weapons especially the production of cluster bombs. Because negative screening reduces diversification of portfolios and that term was seen as giving up returns, the term sustainable and responsible investing or sustainable and responsible impact investing is becoming more popular to refer to the broader approaches that can include both a negative screening approach as well as more proactive practices such as impact investing seeking investment opportunities that don t only avoid doing harm, but seek to make a positive impact beyond that, and include shareholder advocacy and community investing. There are also terms like ethical investing, social investing, mission-related investing, holistic investing, and values-based investing all with the same core principles but at slightly different ends of the spectrum in terms of how much investors value social / environmental returns in addition to financial returns. Who uses what terminology also depends on where you are geographically in the UK, investors refer to ethical investing and in the US more to sustainable investing. ESG investing is widely used in Continental Europe and describes approaches where investors include environmental, social and governance criteria in their investment decisions, often using a best-in-class approach to maintain broad diversification but choose the best companies relative to their peers. They use ESG analysis either their own, from a third party provider, or a combination of the two, as part of their overall assessment. It can be an initial filter, an overlay, or just an additional piece of analysis for portfolio managers. What does incorporating ESG mean? ESG factors offer portfolio managers added insight into the quality of a company's management, culture, risk profile and other characteristics. Portfolio managers that incorporate ESG successfully into their analysis try to identify companies that do better than others in their industry and are focused on managing their company to yield sustainable results not just quick, short-term profits. A company's ESG activities can positively and negatively impact its financial performance over the long term and thus the value of its share price, its funding costs in the primary market or price of its bonds in the secondary market. Here are some examples of what s behind the E, S and G. 3

4 E - Environment - an analyst would assess the company s activities to see how they are avoiding potential environmental liabilities and minimizing reputational risk, and using resources like water and energy efficiently to reduce costs. S - Social an analyst would, for example, analyze workplace issues (diversity, health and safety, human rights) to assess potential costs from lower productivity, staff turnover, potential litigation, etc. and the quality and safety of their products again, this could reduce risk of litigation and reputational risk. G - Governance this may be the term where it is most difficult to imagine what s behind it. But research into whether integrating ESG in the assessment actually does add value, seems to be most conclusive on this one aspect, with several high-profile examples of company failures that investors incorporating ESG had excluded from their portfolios because of concerns with how the company was managed. When assessing the G, analysts assess executive compensation, a company s culture, openness in reporting and communication, board accountability and diversity, to see whether interests of stakeholders and management are aligned and whether there is potential for a crisis sand reputational risk. As I said, investors that use ESG analysis either do their own research, use the analysis from a third party provider, or a combination of the two, as part of their overall assessment. It can be an initial filter, an overlay, or just an additional piece of analysis for portfolio managers. I hope that gives you an impression of the different terms there are, and an idea of how they differ even if the core principles are similar. I d like to spend a bit of time to talk about Social Impact Bonds, since people sometimes refer to Social Impact Bonds in the context of SRI investing. But they are very different. Social Impact Bonds aren t actually bonds or fixed income instruments. They are pay for performance social development financing schemes that address a very specific challenge in society and try to use a financing mechanism that shares the risk of success between several parties. A Social Impact Bond (SIB) is a multi-party, pay-for-performance contract in which a government pays investors financial returns based on impact created in that government s jurisdiction by a social impact organization. The most famous example is a SIB pilot in the UK. It was aimed at getting private investors involved in financing a program in the UK that was aimed at reducing prisoner recidivism. The return investors achieved from their investment was linked to how successful the project was. Social Impact Bonds are a model mostly supported by foundations and are very different from the types of investing that this module is covering. We could spend much more time on the definitions and make this a very academic discussion, but because even experts use them in slightly different ways, I will just leave it at that. I m based in the US and was introduced to SRI here, so for me, I use SRI meaning 4

5 Sustainable and Responsible Impact Investing as the overall term and sometimes specifically ESG investing when referring to strategies that incorporate these factors primarily to reduce risk. Why are investors using SRI and ESG concepts in their investments? Not all investors are using them for the same reasons. There is a basic spectrum: At the one end are those investors that are exclusively focused on maximizing financial returns and consider ESG only because they expect it to protect their investments from risks that traditional financial analysis may miss or because they think they will be able to find opportunities that will create sustainable, long-term returns. At the other end are those investors that place a bigger value on the environmental and social benefits of an investment and in some cases are willing to take a financial performance risk if there are greater and more direct social and environmental benefits. At this end you may find individuals who believe it is their responsibility to invest their assets in a way that maximizes the likelihood they will contribute to a more sustainable future. And most investors are somewhere in-between. Don t get too hung up about the definitions. At the end of the training module there s a list where you can find more resources for publications that go into more detail, but if you analyze them carefully you will also find contradictions and overlap in how they define the terms. Just find an approach that helps you start to integrate some of the concepts and over time you will see what works best for you. Why do different types of investors include ESG and SRI concepts in their investments? Overall, all of them include these factors as a way to reduce risks and seek opportunities based on improved analysis. They also focus on ESG issues to support their core business strategy and ensure they live up to their values, demonstrating responsibility in their decision-making and interactions with stakeholders in society. The closer the investors are to their stakeholders or asset owners and the more specific they are in what their values are, the broader and deeper or intense their use of these concepts will be. Asset managers incorporate SRI and ESG principles as their core or part of their approach, generally to attract clients looking for that type of asset management service. In the US, well-known examples include Calvert, Pax, Trillium, and an example for an investor focused only on sustainable fixed income investing is Breckinridge. Pension funds are aligning their investments to the requests of their stakeholders, but of course mainly focused on minimizing risks to make sure they can meet their liabilities and aren t underfunded. They include ESG because they believe that organizations that manage Environmental, Social and Governance (ESG) factors effectively are more likely to create sustainable value over the long-term than those that do not. Well-known examples include CalStrs and TIAA-Cref. 5

6 Insurance companies try to understand and consider environmental, social and governance (ESG) issues in their approaches because they enable them to reduce risks in underwriting, claims and investment portfolios. Examples here include Allianz, AXA and Zurich Insurance. Is SRI or ESG investing a separate asset class? Basically, an asset class is a group of securities that have similar financial characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations. The three main asset classes are equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments). I don t consider SRI investing to be a separate asset class as some others do. I think it just describes approaches that are more long-term in nature and focus on a more sustainable future, by incorporating these concepts into the regular assessment and process. This can be done for all asset classes like public equity, private equity, fixed income, cash, and alternative investments like real estate, commodities, infrastructure, forestry etc. As I mentioned, concepts of SRI and ESG in investing have historically been more prevalent in public equity investing. Impact investing has been more prevalent in private equity and with direct investments for example microfinance investments benefitting specific communities. For fixed income, although there have been some exceptions, the concept hasn t been widely used until relatively recently. Here are some fixed income examples: Municipal bonds and bonds issued by corporates with high ESG scores: Just like for equity investing, in general, investors seeking fixed income investment opportunities that fit with their SRI or ESG strategies can assess bonds issued by any type of issuer including municipals and corporates that rate highly based on ESG factors to see if they consider them to be eligible investments, and use negative screening approaches to exclude certain sectors. And because of their purpose to finance things like schools, water systems, sustainable transportation, and environmental projects etc., many municipal bonds are considered eligible for SRI investors. Other examples include bonds issued by multilateral development banks like the World Bank (officially called International Bank for Reconstruction and Development IBRD). These organizations have been issuing bonds in the international capital markets for decades and using the proceeds to finance programs with a social focus. Because of the overall purpose of the financing and the safeguards or ESG criteria - that the World Bank follows, these can be considered as fixed income options for SRI or ESG-focused investors. Bonds issued by the World Bank support sustainable development programs in sectors like agriculture supporting food security, health and social services, as well as education, energy and water. However, until recently, most investors who buy World 6

7 Bank bonds haven t focused on their social purpose they purchased them based on credit and financial aspects. Another example frequently mentioned includes bonds issued by the International Finance facility for Immunization (IFFIm) these bonds are used to support vaccination programs and efforts to strengthen health systems that support vaccination in the poorest countries. Over the last few years, green bonds or thematic bonds have been getting a great deal of attention. Green bonds were first issued by entities like the World Bank to give investors the opportunity to specifically support programs that address climate change and other environmental challenges. Since then, this concept of earmarking financing for specific purposes has been used by many different types of issuers, including corporates who can more directly link their financing to its social and environmental purpose. Again, people are referring to green bonds as an asset class, but in my opinion it is just part of the fixed income asset class and even just a sub group of sustainable bonds. Why are we hearing so much about SRI and ESG? There s a shift in thinking about the responsibility everybody even corporations have towards society and a sustainable future. Recognizing this has been trickling into investment behavior historically in equities and other asset classes, but increasingly also in fixed income. Products are favored that more closely connect the source of investment with its social and environmental purpose. As the volumes of assets being managed according to some of the concepts described above have been growing, the media and others are also taking note. According to the US SIF s 2014 report, over USD 6.5 trillion is managed incorporating sustainable, responsible and impact investing concepts. That s almost 20% of total assets that are being managed by individual and institutional investors (including asset managers, pension funds, insurance companies and corporations) in the US. That number is increasing rapidly asset managers have been saying that their biggest inflows have been from clients seeking to investor their funds according to some form of SRI concept and ESG criteria. According to the EuroSIF s 2014 report, approx. Euro 10 trillion is managed according to some sort of ESG principles in Europe, mostly by large institutional investors that have adopted integration strategies or screening of specific criteria such as climate change factors across their portfolios. Since large asset owners like pension funds now include ESG in their investment process, bonds now represent over 40% of SRI assets. What is included as SRI or ESG investing differs in the US and Europe, so it s difficult to compare the statistics. But regardless of the current statistics what s very clear is that the trend is growing also for fixed income. For the next generation of fixed income portfolio managers, including the concepts introduced in this training module will just become part of the traditional assessment it won t be anything separate or new. 7

8 Suggested Resources US SIF Annual Trends Report, 2014 ( European SRI Study 2014 ( From SRI to Sustainable Investing by Joseph F. Keefe, President & CEO, Pax World Management LLC ( Impact Investing: Transforming How We Make Money While Making a Difference by Antony Bugg-Levine and Jed Emerson CDC Toolkit on ESG for fund managers: Adding value through effective environmental, social and governance (ESG) management The World Bank Treasury Investor Website: and Sustainable Investing: We hope you found this resource useful. To learn more about FIA, the Certified Fixed Income Practitioner Program, and other FIA Products and Services, call us!