(An op-ed based on this blog, co-authored by Chris Pinney and Ed Waitzer, was published in The Globe and Mail on August 10, 2021. Read it here.)
To read the headlines, you could easily be forgiven for thinking that ESG integration in capital markets is now fully underway, as the value of global assets applying environmental, social and governance data to drive investment decisions has soared to $40.5 trillion and now represents more than a third of the $95 trillion equity market in 2020. In reality, this good news hides an inconvenient truth: almost all of the current focus of ESG integration in capital markets is on equity investment in public markets, leaving aside credit markets and debt financing.
When it comes to debt financing, a 2020 BBVA Global Markets Research report estimated that the current size of the green, social and sustainable bond market is now approaching $1 trillion. While this sounds impressive, it is a drop in the bucket in the $128 trillion bond market that services private firms and sovereign debt and where some of the world’s largest sustainability challenges reside. Without addressing this debt financing challenge, it is hard to see how we will be able to claim that ESG integration in capital markets has made a meaningful difference in terms of sustainability.
For example, when it comes to climate, a 2017 study by the Carbon Disclosure Project notes that over 70% of greenhouse gasses are emitted by just 100 companies. Of these 100, 38 are private or state-owned companies that account for 41.07%* of emissions globally, while 62 publicly traded companies, including familiar public companies like Exxon and Shell, account for 27.93% of emissions. The private or state-owned corporations, while not participating in equity markets, are active participants in credit markets that have little or no ESG consideration or oversight. A further complication is that without integration of ESG in the debt servicing side of a large financial firm, real progress on ESG can easily be stymied. A senior investment manager noted that his firm had been actively engaging with a portfolio company on ESG issues and found that this led the company to divest some of its most problematic greenhouse gas-producing subsidiaries. He later discovered these subsidiaries were then bought by a private equity firm using debt financing through the credit window of his own firm.
Debt financing is not only an issue in terms of climate, but also equally important in the context of human rights, with many large institutional investors buying sovereign and corporate bonds of countries with well-known human rights violations. The UNEP Finance Initiative identifies a list of 42 high-risk countries of concern for human rights, including Russia, China, Saudi Arabia, Egypt, Vietnam and many other emerging markets countries where most large institutional investors and global banks purchase sovereign and state-owned corporate bonds. More than 37 percent of the bonds in the JPMorgan EMBI index are issued by countries currently classified as “not free” by human rights campaign group Freedom House and in the ESG version of the EMBI, the percentage is only marginally less.
Another study by ShareAction in 2020 found that only 4% of 75 of the world’s largest asset managers had a dedicated human rights policy document covering all of their AUM, and 84% of investors did not at the time of the survey have a policy excluding sovereign bonds issued by countries involved in human rights violations.
Addressing ESG integration in debt financing is without a doubt a highly complex challenge, as investment managers are pressed to balance financial returns for their clients from the superior yields of emerging market bonds against ESG considerations. As a spokesperson for AllianceBernstein, a leader in ESG integration in equities, noted in a recent FT article on this issue, no country it does business in “demonstrates policies, strategies and actions that are 100 percent ideal or responsible.” Others go further, saying it is not the business of investors to determine what kind of government is best for a country.
What is clear is that without ESG integration across asset classes, and in particular debt financing, both to nations and state-owned enterprises, meaningful further progress on climate, human rights and other key sustainability issues is unlikely.
* Aramaco, which publicly trades less than 2% of its stock, is classified as a private company for the purpose of this article.