How Are Investors Addressing Article 173 for the Sovereign Asset Class?

How Are Investors Addressing Article 173 for the Sovereign Asset Class? Authors: Guillaume Emin guillaume.emin@beyond-ratings.com Hilary Norris hilary.norris@beyond-ratings.com With investors in France required to release reporting on the requirements of Article 173 this year, Beyond Ratings has decided to take a closer look at how asset owners and asset managers have responded to this reporting requirement for the sovereign asset class. Key Findings: Most investors have started publishing an intermediate-to-advanced level of reporting in compliance with Article 173, based on a sample of 36 representative asset owners and managers in France (large and medium) The sovereign asset class is referenced in 55% of ESG strategies in our sample Two thirds of the investors in our sample have conducted a carbon footprint, and more than 20% of them already report on the sovereign asset class Several investors are planning to extend their reporting based on internal analysis that they are already conducting and developing More work is needed to develop Article 173 compliancy and find the right balance between a simple approach and deeper analysis of sovereigns I. Background The French Energy Transition law, Article 173 1 strengthens mandatory climate disclosure requirements for asset managers and is the first piece of legislation to introduce mandatory climate reporting requirements for institutional investors. It requires all institutional investors in France to report on how they integrate Environmental, Social, and Governance (ESG) factors into their investment policies, as well as to report on how they address climate-related risks in their investment decisions. The law does, however, provide some flexibility in that investors are required to comply or explain and investors are free to choose the most appropriate reporting methodology for them. This law is noteworthy as it strengthens the need for reporting across all asset classes, including sovereign bonds. Government debt typically represents a considerable portion of institutional investors portfolios, and yet responsible investing reporting on this asset class is often overlooked 2. However, with growing momentum for increased financial disclosure on climate-related risks (see, for example, the TCFD Recommendations Report, G20 Hamburg Climate and Energy Action Plan for Growth, etc.), the sovereign asset class is becoming an increasingly important subject in ESG research and climate disclosure. 1 LOI n 2015-992 du 17 août 2015 relative à la transition énergétique pour la croissance verte 2 See, for example PRI (2017) Shifting Perceptions. ESG, Credit Risk and Ratings Part I State of Play, p 7. www.beyond-ratings.com 1

II. Methodology This report seeks to evaluate climate reporting and disclosure on the sovereign asset class amongst major asset owners and asset managers operating in France. Reports 3 from a total of 36 investors (including pension funds, insurance companies, and asset managers) 4 were examined, which were chosen based on their size 5 and the existence of sovereign bonds in their asset portfolios. A full list of the companies retained for this study can be found in Annex. A review was performed on the documents that sought to identify the following aspects: Whether an overall ESG investment policy/strategy was communicated, and if so, whether it addressed the sovereign asset class; Whether a carbon footprint for the investment portfolio was communicated, and if so, what kind of analysis was made and whether the sovereign asset class was addressed; The percentage and/or assets covered in ESG analysis/carbon footprint measuring; To what extent 2 alignment was addressed by the different actors; Whether any trends could be identified in terms of plans for the future. Research for this report has sought to be as comprehensive and objective as possible. However, some qualitative judgements have been made to assess some specific cases, based on information that was available during the research for this study. It is also possible that certain elements may not have been identified, for example in the case of investors that have not yet communicated on internal analyses. The present report focuses on reported information. III. Findings Article 173 requires asset owners and asset managers to disclose information on their exposure to carbon- and climate-related risk, in particular the GHG (greenhouse gas) emissions associated with their investment portfolio, and their alignment with the energy and environmental transition strategies. As mentioned, this information may be published in the organisation s annual report or in a dedicated document that indicates Article 173 compliance. Most asset owners and managers have published a stand-alone report dedicated to demonstrating their compliance with Article 173, with the majority of these reports made public in May, June or July of 2017. 3 Article 173 reporting may be published in a dedicated document or in the company s annual report. 4 List including about two thirds of asset owners and one third of asset managers. 5 Sources: AODP Project, Willis Towers Watson World 500 www.beyond-ratings.com 2

III.1. Level of Detail in Reporting The level of detail disclosed in published reports varies considerably. While some organisations go as far as outlining emissions reductions objectives for their investment portfolios, others have only just begun to integrate ESG indicators into their investment policies and strategies. This does not appear to be connected to the size or type of actor (asset owner or asset manager) based on the list of investors we covered. In general, we noted a gradual approach to ESG integration, with several levels of reporting depth/detail: 1. No reporting: as companies are required to comply or explain, investors are not obliged to report if they provide reasons for not doing so. 2. Limited reporting: companies have outlined their ESG strategy but have not chosen to explore carbon footprint measurement or other carbon/climate-related metrics 3. Intermediate reporting: Companies have both an outlined ESG strategy and have conducted at least a partial carbon footprint measurement on their investment portfolios 4. Advanced reporting: Companies integrate ESG into their investment strategies across their portfolios to include at least corporate and sovereign assets, and some of them have conducted advanced climate-related risk analysis such as 2 scenario alignment. As Graph 1 indicates, most companies do include ESG and carbon-/climate-related issues in their reporting (31). A majority of companies currently explicitly account for carbon-/climaterelated risks, through carbon footprint measurement and more advanced analyses (24). Graph 1 Levels of Article 173 Reporting Depth 18 16 16 14 12 10 8 6 5 7 8 4 2 0 Group 1: No Reporting Group 2: Limited Reporting Group 3: Intermediate Reporting Group 4: Advanced Reporting Source: Beyond Ratings www.beyond-ratings.com 3

III.2. Inclusion of the Sovereign Asset Class in ESG Reporting While all the organisations retained in our study invest in sovereign bonds, not all address the sovereign asset class in their Article 173 reporting. Of the 31 organisations that have published their ESG strategy in detail (Groups 2 + 3 + 4), just over half of them (17) make specific reference to the sovereign asset class. The level of reporting depth varies among these 17 investors (i.e. limited, intermediate or advanced reporting 6 ), but most of them have conducted at least partial carbon footprint measurements (Group 3 or 4). When the sovereign asset class is not included, this may be explained in some cases by a gradual approach to ESG integration, as many of the organisations have integrated ESG analysis on some but not all of their investment portfolios. Graph 2 Inclusion of Sovereign Asset Class in ESG Reporting 14 17 Source: Beyond Ratings Includes Sovereign Asset Class in ESG Reporting No Mention of Sovereigns/Sovereign Not Included Common ways to account for ESG factors in sovereign bonds include: screening/exclusion (e.g. based on whether the country has signed/ratified certain international treaties), country scores (which may be based on internal analysis or from information from one or several third-party research providers), and/or qualitative analysis. 6 Group 2, Group 3 or Group 4. www.beyond-ratings.com 4

III.3. Carbon Footprint Metrics 24 out of the 36 organisations retained for this study communicate the carbon footprint of their investment portfolios in their Article 173 conformity reporting (Groups 3 + 4). While Article 173 calls for companies to disclose how their investments contribute to an energy transition, the regulation does not impose measurement methodologies, and the comply or explain approach allows companies to refrain from carbon footprint measurement and disclosure but in this case, must explain why. Three of the companies that do not currently disclose carbon metrics relating to their investments indicated that they are planning to do so in the coming one to three years, and it is highly probable that other companies have similar plans. Graph 3 Communication of Investment Portfolio Carbon Footprint 12 24 Source: Beyond Ratings Carbon Footprint Reported No Carbon Footprint Reported Of the companies that do measure and disclose carbon footprint information, one third of them include the sovereign asset class in their footprint reporting, with 8 of the 24 accounting for government debt in their carbon footprint analyses (Group 4). Most of these organisations appear to have chosen to measure CO2 intensity using country GDP as a denominator, which has the advantage of allowing for simple aggregation methods. In some cases, however, GHG emissions data are analysed based on the value of investments. Choosing to account for sovereign debt in carbon footprint reporting appears to demonstrate deep interest in climate reporting and ESG investing as most of these companies discussed the alignment of their portfolio with a 2 scenario, with several of them conducting or considering analyses of 2 scenario alignment levels. Several investors also spoke of investing in green bonds as a specific ESG strategy. www.beyond-ratings.com 5

Graph 4 Sovereign Asset Class Included in Carbon Footprint Reporting 8 16 Source: Beyond Ratings Carbon Footprint Includes Sovereign Asset Class Carbon Footprint Excludes Sovereign Asset Class However, it should be noted that these figures do not fully reflect the actual extent of carbon footprint analyses conducted by investors. A statistical bias comes from the fact that several organisations that have started analysing their sovereign carbon footprints have not yet started reporting on them. The share of carbon footprints that include the sovereign asset class is, thus, expected to continue increasing. Overall, the current context suggests in our view a strong trend towards a broad compliance level of investors with the requirements of Article 173, taking into account the need to apply carbon and climate analyses beyond the scope of corporate assets. Given the technical issues at stake in carbon footprint reporting for government debt 7, it is not surprising that most of the companies that investigated sovereign carbon footprint reporting relied on a third-party research provider for data and methodologies. Given the wide scope of issues involved in ESG or carbon/climate analysis, and the relatively small workforce that tends to be dedicated to this issue within an organisation, relying on a specialised third-party provider can be an efficient way to develop and measure the appropriate reporting methodology for carbon footprint reporting. 7 E.g. factors to be taken into account: CO2 trade flows (imported CO2, exported CO2), scope of emissions (public or public and private consumption/production), etc. www.beyond-ratings.com 6

IV. Recommendations Based on this analysis and our experience and expertise, we propose the following recommendations to go further with Article 173 compliancy and the sovereign asset class. 1. The sovereign asset class is important and needs to be included more extensively in ESG and carbon risk analyses. At Beyond Ratings, we believe that sovereign debt is a key asset class that should be systematically included in ESG and carbon analyses. Not only does the sovereign asset class usually account for a significant share of investments, but the role of governments is crucial when it comes to climate challenges. For investors, including sovereign assets in ESG integration can therefore allow for a more comprehensive analysis of long-term risk drivers and can highlight new investment opportunities. 2. Indicators that allow for aggregation or comparison with data for corporates should be promoted for a coherent approach to ESG/climate risk integration ESG analysis on sovereign assets need to be comparable in order to be useful to investors. To promote a coherent approach towards ESG integration and climate risk analysis, investors should favour those that allow for aggregation or at least comparison across all asset classes. 3. There is a need to develop energy transition and physical climate risk indicators that go beyond carbon footprint measurements While carbon footprint measurement can provide valuable information for climate risk, no indicator is perfect, and it is not without shortcomings. Carbon footprints are often a first step towards a more comprehensive approach to energy transition and climate risk. Portfolio alignment with a 2 or other temperature scenario can provide richer information about the kinds of climate-related risks an investor could face, for example. 4. There is a need to make carbon footprint measurement more sophisticated and to allow it to account for multiple criteria Carbon footprint indicators for sovereign assets cannot be reduced to a single number, as they must take into account several dimensions, such as: Carbon trade: imported vs exported CO2 Scope of analysis: public vs private sector Data gaps: estimated vs actual data 5. Over the long term, there will be a need to harmonise methodologies and find the right balance between a simple approach and deeper analysis in carbon footprint measurement for the sovereign asset class While ESG integration research on sovereign debt has historically been overlooked, this is changing, and several actors are developing more advanced methodologies to address www.beyond-ratings.com 7

some of the complexities of this asset class. Greater research is bringing about innovations and a diversity in available methodologies, which allows investors greater flexibility in finding the type of reporting that is best suited to their needs. However, in order for carbon footprint reporting to be meaningful, some degree of comparability between methodologies seems necessary and this should develop in the future. Carbon footprint methodologies should thus allow for greater transparency and clarity in investor decisions. About Beyond Ratings Incorporated in 2014, Beyond Ratings is an independent financial services provider dedicated to the sovereign asset class. Our advanced methodologies integrate long-term drivers such as energy and climate issues into financial materiality, allowing our clients to identify new risk factors and investment opportunities. We offer augmented credit risk assessment, ESG integration, and advanced carbon footprint methodologies. With global coverage, we work with a variety of client profiles, including pension funds, asset managers, insurance companies, development banks, and more. www.beyond-ratings.com 8

V. Annex Table 1 List of Investors Retained in the Study (By alphabetical order) Company Type* 1 AG2R AO 2 Allianz AO 3 Amundi AM 4 Aviva AO 5 Axa Group AO 6 BNP AM (IM) AM 7 CAVP AO 8 CCR AO 9 CDC AO 10 CMIC AM AM 11 CNP AO 12 Covéa AM 13 Crédit Agricole Assurance AO 14 Crédit Mutuel AO 15 EDRAM AM 16 ERAFP AO 17 FRR AO 18 Garance AO 19 Generali AO 20 Groupama AO 21 Groupe LCF Rothschild AM 22 Groupe SMA AO 23 Humanis AO 24 Ircantec AO 25 La Française AM AM 26 LBP AM AM 27 Lyxor AM 28 Macif AO 29 MAIF AO 30 Mirova AM 31 Natixis AM AM 32 Natixis Assurances AO 33 NEA AO 34 Ofi AM AM 35 Scor AO 36 Swiss Life AO Source: Beyond Ratings www.beyond-ratings.com 9

LIST OF GRAPHS Graph 1 Levels of Article 173 Reporting Depth... 3 Graph 2 Inclusion of Sovereign Asset Class in ESG Reporting... 4 Graph 3 Communication of Investment Portfolio Carbon Footprint... 5 Graph 4 Sovereign Asset Class Included in Carbon Footprint Reporting... 6 LIST OF TABLES Table 1 List of Investors Retained in the Study... 9 OUR SERVICES Beyond Ratings offers a broad range of services to the financial industry to assess risks related to energy, climate and all categories of natural and non-natural capital: Energy-Climate Sovereign Risk: Assess the financial impacts & creditworthiness of energy and climate risks Sovereign Carbon Footprints: Measuring the carbon footprint of your sovereign bonds and portfolios ESG Sovereign Factor-IN: ESG adjusted financial ratings for 160 countries Tailored services: Custom Risk Research, Indices For more information contact: BEYOND RATINGS T: +33 (0)9 86 27 57 57 E: contact@beyond-ratings.com Beyond Ratings 2017 Disclaimer provision: [ ] BEYOND RATINGS shall have no liability to the user or to third parties, for the quality, accuracy, timeliness, continued availability or completeness of any data or calculations contained and/or referred to in this communication nor for any special, direct, indirect, incidental or consequential loss or damage which may be sustained because of the use of the information contained and/or referred to in this communication or otherwise arising in connection with the information contained and/or referred to in this communication, provided that this exclusion of liability shall not exclude or limit any liability under any law or regulation applicable to BEYOND RATINGS that may not be excluded or restricted. [ ] Please find the full disclaimer provision for Beyond Ratings analysis on: http://www.beyondratings.com/disclaimer-provision-for-beyond-ratings-analysis/ Photo credit via Visualhunt/CC BY-SA (cover page): Credit 1: CECAR - Climate and Ecosystems Change Adaptation R; Credit 2: Tony Webster; Credit 3: Kiefer.; Crédit 4: NASA Goddard Photo and Video www.beyond-ratings.com 10