While bottom-up research capabilities are critical to identifying investment risks and opportunities, the growing role that data plays in assessing an issuer’s suitability for inclusion in an ESG-oriented strategy should not be overlooked. For managers looking to integrate ESG at scale, standardized data used to rate and rank issuers across ESG factors is now a crucial part of the investment process. However, data are often incomplete, uneven, and dated. More importantly for fixed income investors, which typically invest at both the parent and operating company levels, most companies are currently only assessed at the parent company level. This means potentially penalizing strong ESG issuers for activities conducted by a parent or its affiliates, which could ultimately lead to higher costs of capital even for businesses that perform well on ESG factors.
The early pioneers of ESG investing were almost exclusively equity investors, and ESG fund AUM remains heavily weighted toward equities (Figure 1). One legacy of this origin story is that most data vendors assess companies at the holding company, rather than operating company, level. This makes sense for equity investors as shares are only listed for the parent company, and if a company is acquired, its shares are replaced by cash or are converted to the acquiring company’s shares. Through this lens, an equity investor should only care about the aggregate ESG factors at the parent company level.
ESG Fund AUM is Heavily Weighted Towards Equities
Morningstar. Percent of total net assets in sustainable funds at quarter end. Note: Reflects Morningstar defines a strategy as a "Sustainable Investment" if it is described as focusing on sustainability; impact; or environmental, social, and governance, or ESG; factors in its prospectus or other regulatory filings
However, this isn’t the case for fixed income investors. Subsidiaries, or operating companies, often issue their own debt, separate from the debt issued by the parent, or holding company. From an ESG perspective, this raises the possibility of penalizing a subsidiary for the environmental performance of the parent or its other subsidiaries.
The Opco Penalty
The impacts of this data limitation are uneven across sectors, but it is particularly problematic in the utility sector where holding companies will often own numerous operating companies (opcos). For example, an ESG fund could be forced to sell a low emissions gas and electric utility company after being acquired by a larger utility company with higher emissions. As the aggregated emissions intensity of the holding company rises above a certain pre-defined threshold, compliance rules meant to screen out companies that perform poorly on ESG factors require that the bonds of the low emissions gas and electric subsidiary must now be sold.
If the point of ESG investing is to help companies transform their business models to be more “green” or socially conscious, shouldn’t we aim to lower the cost of capital for the parts of a business that perform well on ESG factors? After all, why should we restrict capital to a pure-play hydroelectric company simply because its parent also owns a thermal coal generation plant in a different subsidiary? This same concept underpins the labeled bond market, where investors look for deals where the proceeds are earmarked for green or social investments.
This is becoming more important as ESG becomes a greater focus for electric utility companies. In cases where opcos are not evaluated separately, management teams are not being appropriately rewarded for investing significant capital in their pure-play transmission and distribution (T&D) subsidiaries—an integral component of the transition to a lower carbon economy. In some cases, the data vendors do not cover individual opcos for the historical reasons noted above, sometimes it is because utility companies provide limited ESG disclosures at the opco level, and other times they cover an opco but are using outdated information. When data providers do not evaluate low-emissions opcos separately from the family that may own emissions-intensive fossil fuel plants, they penalize these lower emissions businesses.
The fact that “green” operating companies are being penalized for activities conducted by their affiliates significantly hampers fixed income investors’ ability to integrate ESG risks and promote ESG impact. This is especially true for larger asset managers with billions of dollars under management and thousands of issuers in their coverage universe, which must rely on data aggregators in order to integrate ESG at scale. This is particularly the case when employing automated compliance screens, which rely on external ESG data to protect clients from accidentally holding an issuer that isn’t aligned with their ESG strategy.
The Bottom Line
If the ESG market is to be transformed at scale, more nuanced data that caters to different types of investors are needed. In many cases, the ESG data vendors are the gatekeepers of that data. But they too are hamstrung by the information made available in corporate disclosures. The best way forward is to encourage companies to report environmental and social performance data broken out across their issuing subsidiaries. Active managers have a leg up as they can seek out and evaluate opco-level information that might not be available through the data providers. PGIM Fixed Income, for example, actively engages with issuers to get opco-level data and is already incorporating this into our ESG Impact Ratings. However, this information must be publicly disclosed and available through the most widely used data platforms if we are to help companies transform their business models to become more “green” by lowering the cost of capital for the parts of business that rank high on ESG factors.
All the Credit, Ep. 36
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Fixed on ESG, Ep. 11
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The Renaissance of Higher Yields
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Fixed on ESG, Ep. 10
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All the Credit, Ep. 35
Jan 24, 2023