Short-term Markets Tackling the Long-term Issue of ESG

ESG covers a wide range of issues encompassing the notion that a business has a social responsibility to look after people and the planet.

The combination of these social elements and, increasingly, regulatory imperatives, means that many businesses have been taking ESG factors into consideration in recent years, fuelling the growth of the green bond market and putting a clearer focus on the ESG aspects for their treasurers.

But the market is far from mature. “While we have seen some entries into this space, overall green, sustainability-linked, and social short-term issuance, such as commercial paper (CP), remains negligible to date,” notes Fayvilevich. Fitch Ratings identified just 15 ESG CP programmes at the end of H1 21, although there are some developments on the asset- backed commercial paper side coming through.

In an ESG investment context, where treasurers will have most direct involvement, decisions can help support or undermine the people and planet imperative. Indeed, the term ‘impact investing’ was coined to highlight the power of investor actions to make a difference. ‘Doing the right thing’ while maintaining healthy profitability has become a leading message, and many businesses today understand that failure to actively address ESG as part of their public persona can bring reputational harm. Much of the commercial world is reaching a point where, as an investor bloc, it is demanding that products and portfolios demonstrate ESG credibility without harming returns.

Growing up

The incorporation of ESG factors within an investment product still has an element of subjectivity. However, the view that certain investments can make a difference has seen ESG investing continuing to gain traction in all regions.

In EMEA, the investment product set is now relatively well established. And while LaRocco notes the US market “is still in its infancy”, its providers are exploring “many different and innovative ways” in which investors can begin tailoring their investment portfolio strategies to incorporate ESG elements. The raising of ESG consciousness, and the response of market providers, is bringing it to the fore as an investment solution of interest. Indeed, many more investors, he notes, “are beginning to ask more questions and expect answers, even in the money market liquidity space”.

Today, the way portfolios, and indeed the general movement towards ESG, are structured, ensures there is motivation to meet ESG criteria. “From an investor perspective, the market enables corporates to have a positive input, voting with their dollars on which outcomes they see as most appropriate going forward,” notes LaRocco.

Indeed, he adds that the capital markets are already beginning to penalise – through higher yields on certain instruments – companies that cannot demonstrate appropriate ESG credentials and this will only continue. As this thinking gathers momentum, he feels it will ultimately hurt the performance of businesses that do not meet agreed standards, and reward those that do.

Stronger definition

What’s always been needed to drive further uptake is more robust regulation that removes uncertainty around where investors are putting their money. Indeed, across the wider ESG investment space, the task of comparison is a challenge without standardisation. In turn, this presents a challenge around the quality and quantity of data available to corporate treasurers.

To this end, the European Commission has recently adopted final regulatory technical standards for the Sustainable Finance Disclosure Regulation (SFDR). SFDR will increase the availability and comparability of information provided on European funds, including MMFs, explains Fayvilevich. From January 2023, these will apply to financial market participants when disclosing sustainability-related information.

The information should help investors make more informed choices. However, Fayvilevich warns that the current wide variance in ESG data and methodologies may still mean there are material differences between Article 8 MMFs (those that promote environmental or social features and investment in companies with good governance practices, versus Article 9 MMFs which specifically target sustainable activities, and Article 6 MMFs which do not integrate any kind of sustainability factor. See box on page 19 for more detail).

The advent of SFDR has proved a fillip for the availability of ESG short-term cash investment options, says Fayvilevich. Fitch Ratings recently estimated that 42%1 of European MMFs are classified as Article 8 under SFDR, making this sub-set a significant minority in the overall European MMF landscape. But these Article 8 MMFs offer an array of different approaches to ESG, thus presenting investors both with choice – which is a positive – but also a problem: there may still be material differences in the way any two SFDR Article 8 MMFs approach ESG.

“Broadly speaking, most of these funds pursue ‘exclusionary’ approaches,” explains Fayvilevich. “They narrow down the investible universe based on ESG characteristics and then select from that universe based on credit, liquidity and yield considerations. However, exactly how the investment universe is narrowed down can vary widely.”

Alternatively, some investment managers may pursue integration techniques, which permit higher or lower issuer exposures based on ESG (and fundamental) considerations. Managers may also establish processes of engagement (also known as stewardship), aiming to improve portfolio companies’ identified weaknesses relating to ESG factors, or simply to make businesses aware that their ESG performance is factored into decision-making for funds’ purchase of short-term issuance. This is information that investors must process to be able to make an informed choice.

There is also a lack of ESG ratings standardisation to add to their challenge. The correlation between traditional credit ratings from major providers is high, whereas the correlation between ESG ratings is low, notes Fayvilevich. To put that into numbers, researchers at MIT estimated the correlation between traditional credit ratings at 0.92 and for ESG ratings at 0.61.

“As traditional, regulated, credit-rating agencies such as Fitch Ratings, through its Sustainable Fitch division, become more present in the ESG rating space, more comparability and consistency should emerge in the ESG rating space,” comments Fayvilevich. Nonetheless, he adds, “differences are likely to persist, given the additional complexity that ESG MMF providers typically operate proprietary ESG scoring approaches that incorporate external data and ratings to some extent”.

Getting creative

Regulations such as SFDR are intended to bring some clarity to the ESG investment space, despite the noted shortcomings. Without robust rules, provenance of products in any market can fall short of expectations. When it does, accusations of greenwashing may be levelled at both provider and investor. “It’s a disingenuous marketing tactic that exploits the goodwill of ESG without demonstrating the principles of social responsibility,” states LaRocco.

With public awareness of greenwashing high and rising, and product and portfolio information ever more accessible, perhaps the wider investment industry will become self-policing in this respect. However, the liquidity space has been doing this for some time anyway.

The early movement of NTAM around ESG indicated to LaRocco that MMFs ultimately contain either exclusively government securities, or they have a high percentage of financial institutions (FIs), all of which he feels are “generally good corporate actors”.

While this is a positive, it was becoming clear that there were very few differences in the composition of ESG-led credit funds. With typically high-ESG-scoring FIs as the main focus of these funds (constituting up to 95% in some funds), the sustainability point was arguably being missed.

“The industry had to take a step back. Investors wanted to see some differentiation; they wanted to see greater rewards for the best actors, and greater incentivisation for the bad actors to improve,” explains LaRocco. This spurred the creativity needed in the money market industry to achieve wider ESG-driven objectives.

With almost eight years of engagement under its belt, NTAM has been credited in the US as a pioneer of ESG in the domestic money fund space, says LaRocco. Crane Data acknowledges it as the first to create an innovative share class supporting a partnership with a minority-and women -owned financial services firms in some of its US-only MMFs with its Siebert Williams Shank option. “These special share classes have taken off, resonating with investors more over the past couple of years, with volumes rising from hundreds of millions of dollars initially, to reaching a peak close to 10 billion earlier this year. This is one of the largest AUMs for a specific ESG money market strategy,” he comments. “It really is a privilege to have such a long-standing partnership with Siebert Williams Shank and
have a solution for investors looking to align their financial objectives with their community values.”

MMFs: still different

The current general lack of diversification of investible sectors in the liquidity space does not necessarily put it a step behind the wider industry, but participants wanting to make an impact are encouraged to adopt a different approach, says LaRocco. Is investor demand for more than just public debt or government funds increases, so players such as NTAM have clearly responded with new and creative asset classes.

The emergence of innovative new share classes, and the opportunity in some cases to direct fees to causes that resonate with corporate ESG goals, demonstrates a growing capacity to make a positive difference that is unique to the liquidity space.

However, as the wider ESG market continues to grow, so it becomes incumbent upon investors, including treasurers, to make more informed choices. The comparability of products has been a challenge for the money market industry because there are different ways to express the nature of good being done. Currently, it is relatively easier to make a comparison for a core bond fixed-income mandate because typically these products provide benchmarks, notes LaRocco. “For the money market industry, it’s difficult to compare a firm that has a minority broker share class with one that opts to support an organisation focused on combating racial injustice.”

Asking the right questions

Comparing ESG products, especially in the liquidity space, still has an element of ‘buyer beware’. While large organisations may have the resources to thoroughly research a broader set of ESG options than their smaller counterparts, the latter could start by seeking out providers with a strategy that best reflects their own ESG philosophy and impact goals. “This will give some comfort that they are dealing with a genuine provider, and that they don’t necessarily need to look too deeply within the portfolio to validate its credibility,” says LaRocco.

Nonetheless, understanding the difference between providers and their products will ensure ESG goals are properly met. “As with much in life, the devil is in the detail,” comments Fayvilevich. “Relying on an MMF’s SFDR Article alone does not provide full assurance that the MMF in question will meet investor ESG requirements,” he states.

To conclude, he proposes a relatively simple analytical framework to help treasurers narrow down their selection.

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