Sustainable Finance

Eccles and Stroehle Exploring Social Origins in the Construction of ESG Measures Working Paper (2018, WP)

→ ratings disagree because of technical differences in the approaches of data vendors → These differences result from: - diverse social origins of the data vendors (e.g., legal systems) - necessity for data vendors to create a unique profile/product →Propose a distinction between "values" and "value" based organizations → Data vendors' founding principles, legal status, or purpose strongly influence - Conception/definition of sustainability - Definition of materiality of ratings(single vs. double materiality) - The way ESG is measured

Costs and benefits of disclosure

Direct costs: Preparation, Dissemination, Certification Indirect costs: Propriprietary costs; Litigation costs (potential lawsuits); Real effects (disclosure requires action to be taken). Benefits of financial disclosure: Mitigate information asymmetries; predict future cash flows and co-variances; Increase investor awareness; more information on companies/sector due to information spillovers and transfers

Examples of ESG issues

Environmental. Conservation of the natural world. - Climate change and carbon emissions. - Air and water pollution. Social. Consideration of people & relationships. - Customer satisfaction. - Data protection and privacy. Governance. Standards for running a company. - Board composition. - Audit committee structure.

Rajna Gibson Brandon and P. Schmidt ESG Rating Disagreement and Stock Returns (2021, Financial Analyst Journal)

Study ESG rating disagreement for S&P 500 firms, 2010-2017 (and consequences) Seven different ESG scores from six data providers: Refinitiv, MSCI (KLD, IVA), Sustainalytics, Bloomberg, FTSE and Inrate

EU Technical Expert Group on Sustainable Finance (TEG)

The objective of the technical group is to work on four key areas: 1. EU classification system - the so-called taxonomy - allowing to determine whether an economic activity is environmentally sustainable 2. EU Green Bonds Standard 3, Benchmarks (for low-carbon investment strategies; climate benchmarks) 4. Disclosure

Guest lecture: Steven Tebbe, (Steering Group Member, Reporting Lab, EFRAG)

We need comparable and reliable information; Data must be based on evidence; Information is the lifeblood of financial markets, hence, ESG information is a must; There is a need to consolidate the currently fragmented approach; Corporate Sustainability Reporting Directive (CSRD) - Proposed by European Commission, drafted by EFRAG - sustainability matters under a double materiality perspective; - One-stop-shop for all ESG topics, providing reasonable information to all key stakeholders vs. capital markets only; - all large EU companies, that is, EU companies (including EU subsidiaries of non-EU parent companies); 250 < employees; total assets of €20 million; - If passed, results in ~ 50.000 entities reporting ESG information annually - CSRD was developed in 10 clusters, following the target architecture, organization of clusters around groups of draft ESG+ standards deliverables

Guest lecture Ethos on active ownership

- Institutional investors hold power to make change - Active ownership can be exercised through: Exercise of voting rights, direct dialogue, collaborative engagement, intervention at General Meeting, Shareholder resolution

Chatterji, Durand, Levine, and Touboul (2016, SMJ) focus on disagreement about social ratings (CSR)

1. Common theorization: Lack of a shared view of what it means for a firm to be socially responsible 2. Commensurability: Lack of agreement on metrics to use to measure CSR

Corporate carbon emissions measurement

Emissions are classified as direct or indirect → Direct: from sources that are owned or controlled by → Indirect: consequence of the activities of the reporting entity, but occur at sources owned or controlled by another entity. Scopes: Scope 1: All direct GHG emissions (from sources that are owned or controlled by the reporting entity) Scope 2: Indirect GHG emissions from consumption of purchased electricity, heat or steam. Scope 3: Other indirect emissions that occur in the value chain of the reporting company. - Relative emissions vs Absolute emissions - Intensities vs Quantities

Guest lecture on impact investing

Impact investing: - Debt or equity investments, cash deposits, bonds, guarantees, hybrids - Return must be at least a return of principal (interest free loan) - Excludes best-in- class, negative screenings, SRIs - Excludes donations and other forms of giving where no return is expected Investor perspective - Genuine belief that own investment portfolio ought to be aligned to ones values and aspirations - Change of mindset from risk adjusted optimal return strategies to impact generation strategies - Determine a set of parameters (impact area, return expectation, vehicle, time frame....) Investee perspective - Genuine belief that business ought to serve real needs of people with respect for the planet - Change of mindset from seeking purely finance oriented investors to seeking partners for impact - Get finance savvy , speak investor's speak and build business models that show investment readiness

What factors determine ESG rating quality? Rate the Raters 2019: Expert Views on ESG Ratings

The credibility of data sources; quality/disclosure of methodology; focus on relevant/material issues; experience/competence of research team; etc

Consideration of ESG by investors

Why do investors use ESG data? - ESG information is material to investment performance (managing risks) - We see it as an ethical responsibility; stakeholder demand; - When considering G is more relevant than E & S - To gain a fuller understanding of the companies in which they invest Why do investors not consider ESG issues? - Lack of comparability across firms - Lack of standards in reporting ESG information - The cost of gathering and analyzing ESG information - ESG information disclosed by firms is too general to be useful

Kotsantonis and Serafeim (2019, JACF) Four Things No One Will Tell You About ESG Data

Why do ratings disagree? 1. Inconsistencies in terms of how issuer companies report data 2. Benchmarking (or how peer groups are defined) 3. ESG data imputation

Krueger, Philipp, Zacharias Sautner, and Laura T. Starks. "The importance of climate risks for institutional investors." Review of Financial Studies (2020).

→ Climate risk is an increasingly important topic for investors → There are 3 types of risks: 1. Physical risks, 2. Regulatory risks, 3. Transition risks → Regulatory risks and Transition risks seem more material/important than the physical risks → Investors manage climate risks by analyzing portfolio firms' carbon footprint, stranded asset risk; general portfolio diversification; ESG integration, etc. → Divestment is the least frequently used approach

Stranded asset risk

→ In order to reach climate goals set out in the Paris Agreement, large proportion of existing fossil fuel reserves must remain in the ground. Third of oil reserves; half of gas reserves; more than 80% of known coal reserves (McGlade et al 2015). → The value implications of assets becoming 'stranded' might not be fully reflected in the value of companies that extract, distribute, or rely heavily on fossil fuels, which could result in a sudden drop if this risk were priced in/new regulation/change in demand or a shift. → Acknowledging stranded asset risk (write downs) by Shell, Total Energies, British Petroleum etc.

Dunn, J., Fitzgibbons, S., & Pomorski, L. (2017). Assessing Risk Through Environmental, Social and Governance Exposures. Journal of Investment Management. 40

→ Negative relation between risk and ESG → Stocks with best ESG (Quintile 5) have lower risk than stocks with worst ESG (Quintile 1) ESG correlated with certain stock-level characteristics → High ESG stocks tend to be larger; high quality (higher profitability, lower earnings variability, etc.); growth firms → ESG exposures help predict future risks as far as three to five years out. → Magnitude of the estimates increases with horizon: consistent with the idea that ESG risks materialize in the long term

Climate benchmarks

→ Old climate benchmarks: primarily built with objective of risk reduction → New climate benchmarks: 1. hedging climate transition risks (risk objective) 2. directing investments towards opportunities related to energy/climate transition (opportunity objective) → Two types of benchmarks pursuing similar objective, but differentiate with respect to level of restrictiveness & ambition: EU Climate transition benchmark (EU CTB) 1) Allow for greater diversification; 2) More suitable for core allocations of institutional investors; 3) Main users: asset owners (pension funds/(re-)insurance companies) protecting assets against investment risks related to climate change / transition to low-carbon economy Paris Aligned Benchmarks (PAB) 1) Stricter minimum requirements; 2) Highly ambitious climate-related investment strategies; 3) Main users: investors seeing more urgency to de-carbonize

Fund-level carbon ratings by CDP (Climetrics)

→ To examine the climate impact of an investment fund → Rating based on characteristics of: 1. Fund's portfolio holdings → Each company is scored by its current carbon footprint: represents a company's current impact in terms of greenhouse gas emissions & Climate management performance: forward-looking elements, such as emission reduction targets or an internal carbon price; actions taken on climate change 2. Asset manager → scored for their public action on integrating climate change into their governance and investment processes 3. Fund's investment policy → Identify and reward fund that has an explicit ESG mandate (ex. good environmental stewardship; enhanced integration of climate change factors into investment decision-making) In the end, Climetrics produces an overall rating

Global Sustainable Investment Alliance (GSIA): Global Sustainable Investment Review 2014, 2016, 2018

→ Total global sustainable and responsible investment assets in 2020: $35.3 trillion (up from $13.3 trillion in 2012, see GSIR, 2012) → Japan and Australasia has the highest compound annual growth rate (2014-2020) → Global Sustainable Investment Assets by Region 2020 → US and Europe has the lion's share → Growth of different strategies (2016-2020) → ESG integration and Positive/Exclusionary screenings are the most popular → Institutional investors would investing more in 2014 however now retail Investors have more assets in sustainable finance in 2020 → Asset Allocation in 2018 → Public equity (50%) vs Fixed income (36%)

Wong, C. and Petroy, E., 2020. Rate the Raters 2020: Investor Survey and Interview Results. SustainAbility.

→ providers similarly in terms of quality and usefulness - more highly "focus on material issues" as preferred future changes → compared to the survey of experts, investors rank → Investor Survey: 65% use ESG data at least once a week; they use it for the material info that is useful for investment performance = for financial reasons; they also use it to SUPPLEMENT organisation's other research on corporate ESG performance/risk; to SCREEN whole INVESTMENT UNIVERSE; they use the underlining data (GHG emissions) more than the whole overall ESG rating

Gibson Brandon, Krueger, and Schmidt, 2021 ESG Rating Disagreement and Stock Returns

→ESG disagreement varies strongly across industries →Average pairwise correlation highest in E, lowest in G →Ratings from some providers more correlated than others →Firms with higher ESG disagreement have: 1. Higher asset tangibility: less disagreement on the environmental dimension 2. More profitable firms: less disagreement (overall; environmental) 3. Firms without credit rating: more disagreement (overall; social) 4. Larger firms: more disagreement

Sustainability reporting standards

1. The Sustainability Accounting Standards Board (SASB) -->. developed a complete set of 77 industry standards for disclosure of financial material sustainability information (2018); Has two products: a) SASB Materiality Map® (issues that are likely to affect the financial condition) b) Industry-specific reporting standards; single materiality 2. The Global Reporting Initiative (GRI) --> 3 universal Standards; 33 topic-specific standards; sector-specific standards; covers range of impacts and stakeholders GRI follows a "double materiality" approach

Key features of sustainability reporting

1. Diversity of users and uses (not necessarily used for financial analysis) 2. Diversity of topics (variety of disclosures and reporting formats, making comparison and standardization difficult) 3. Diversity of objectives (wide range of interests and preferences; Interest/Incentives can change quickly) 4. Diversity in measurement (Issues not necessarily measurable in monetary terms) 5. Voluntary nature of sustainability activities (Activities related to sustainability most often go beyond what is required by law, regulations, and contracts) 6. Long-term horizon (long-term implications which can be difficult to quantify (e.g., climate) and which can be intangible (e.g., employee relations)) 7. Central role of externalities (Addressing externalities is one of the prime motivations for sustainability reporting using double materiality)

Green, social, and sustainability linked bonds

1. Green bonds → use of proceeds to finance or re-finance [...] eligible green projects {vetted by EU Taxonomy, clean transport, biodiversity conservation projects}; Fixed-income securities that raise capital for use in projects or activities with specific climate purpose 2. Social bonds → proceeds used for social projects only (e.g., pandemic COVID-19 related, housing, gender equality, education, housing) 3. Sustainability bonds → proceeds used for a combination of green and social projects (e.g., SDG or general ESG related) 4. Transition bonds → proceeds used to finance climate transition activities at the issuer or project level 5. Sustainability-Linked-Bonds(SLBs) → More flexibility in use of proceeds; Any type of bond instrument for which the financial and/or structural characteristics can vary depending on whether the issuer achieves predefined sustainability/ESG objectives

Different forms of Sustainable Investment

1. Screening - Negative/exclusionary screening & Norms-based screening: Avoid securities of companies or countries on the basis of moral values; standards and norms; product (tobacco; fossil fuels); conduct (ILO, UNICEF) Origins of exclusionary screening → Religious Investing Investors can use MSCI ACWI Select Global Norms and Criteria Index; MSCI Emerging Markets ESG Leaders Index (Companies with high ESG performance relative to their sector peers) - Positive/best-in-class screening: Investing preferentially in companies with better or improving ESG performance relative to sector peers; Example of Domini Social investments (Fund): conducts in-depth social and environmental research on all holdings. Only companies that meet Domini's Global Investment Standards are eligible for investment by the Fund. ESG Integration - Systematic and explicit inclusion of ESG; Does not necessarily require peer group benchmarking; overweighting leaders and underweighting the laggards. Example of Valuation of Mining companies and ESG Risks: Does the company use environmental indicators (ISO 14001 etc); what are the health and safety indicators → In the valuation model you take into account ESG risks, good management of ESG = apply a lower discount rate Effective management of ESG risks can significantly reduce operational risk, resulting in a lower discount rate (cost of equity capital) Impact/community investing Predominant in private markets E and S impact that is measurable + that generates a financial return Investing with the disclosed intention to generate and measure social and environmental benefits alongside a financial return; MEASURABLE impact (generate jobs in underserved markets; build environmentally friendly care homes for the elderly to sustain an aging population Often made in private markets; Expected to generate a financial return on capital and, at a minimum, a return of capital (i.e., 0 % financial return) Example of Rise Fund → managed by TPG (USA) entrepreneurs operating in low-income communities/emerging markets; private equity investment; uses impact assessment model to measure and quantify social and environmental impact throughout the whole private equity investment cycle (sourcing; investment and exit); Impact assessment aligned with the UN Sustainable Development Goals Sustainability themed investing - Predominant in public markets Addresses specific sustainability issues such as climate change, agriculture, clean energy; food, etc - Example of Pictet Water Funds → investing at least two-thirds of its total assets in the shares of companies operating in the water sector worldwide; or, by using MSCI ACWI Sustainable Impact Index (social impact; environmental impact criteria) Corporate engagement, shareholder action, or active ownership - Engage with companies in order to change corporate policies (e.g. convince firms to stop doing business in a certain geographic area) - Active ownership actions ⇒ vote in shareholder general meetings, write a letter to the company; meet with company representatives; file shareholder resolution; attempt to gain a BoD seat; file a complaint with the regulator/authority; news coverage

MSCI

MSCI ESG Ratings Framework: 1. Research-driven insights; 2. Tools for institutional investors (e.g., indices and portfolio risk and performance analytics) MSCI ESG Sustainable Impact Metrics: identifies companies that provide products and services that contribute to attaining the UN Sustainable Development Goals; Estimate companies' revenue exposure to these sustainable impact solutions (how much revenue is derived from products and services related to the 5 themes)

Gibson, Glossner, Krüger, Matos, and Steffen (2021, WP) Do Responsible Investors Invest Responsibly?

Majority of institutional stock investors now publicly committed to sustainability through initiatives like Principles of Responsible Investment (PRI)

Mandatory disclosure

Mandatory sustainability disclosure entails adoption of formal ESG reporting standards; Full guidance on definitions of materiality thresholds, information content, and reporting formats; mandatory disclosures contribute to comparability and cohesiveness of sustainability data.

Take a couple of minutes to brainstorm on the five most important pieces of sustainability information that should be included in every firm's sustainability disclosures?

Must include sustainability objective, investment policy and strategy, KPIs, resources and governance, and investor stewardship. Single materiality information or double materiality information. A firm must disclose details of the extent to which the sustainability objective has, or may have, impacted the financial return of the product. A firm must disclose details of the plausible, purposeful, and credible link between the product's sustainability objective's and environmental and/or social outcomes.

Bernow, S., J. Godsall, B. Klempner, and C. Merten. 2019. More than values: The value-based sustainability reporting that investors want. McKinsey & Company.

Problems with current, mostly voluntary sustainability reporting: - ESG/sustainability information is not readily useable by investors, because of a lack of comparable information - 50% of SEC-registered companies provide only fairly generic or boilerplate sustainability information in their regulatory filings

Thomson Reuters ESG approach

Provide two types of scores 1) Thomson Reuters ESG Scores - measures the company's ESG performance based mainly on company-reported data 2) Thomson Reuters ESG Combined Score (ESGC) - overlays the Thomson Reuters ESG Score with ESG controversies: a more accurate evaluation of the company's sustainability They use CSR reports; news sources (unstructured data; developing countries)

European Union Sustainable Finance Action Plan

Purpose is to steer finance for sustainable development via 10 specific actions through 3 blocks via a set of new regulations: 1. Reorienting capital flows towards a more sustainable economy 2. Mainstreaming sustainability in risk management 3. Fostering transparency and long-termism Example → Action 1: Establishing an EU classification system for sustainable activities Subsidiaries of Swiss companies that are in EU have to comply with the EC regulations

Dimson et al (2015): Corporate engagement and shareholder value

Question: Analyze 2,152 ESG engagements by one large institutional investor with U.S. public companies (1999-2009) by asking them if ESG related shareholder engagements create shareholder value Results: - Successful engagements generate shareholder value - Successful engagements increase stock prices (horizon of 12 months) - Unsuccessful engagements no effect - In particular successful engagements on corporate governance and climate change issues generate subsequent increases in shareholder value

Dimson, E., Karakaş, O., & Li, X. (2015). Active ownership. Review of Financial Studies, 28(12), 3225-3268.

Question: → Analyze 2,152 ESG engagements by one large institutional investor with U.S. public companies (1999-2009) by asking them if ESG related shareholder engagements create shareholder value Results: → Successful engagements generate shareholder value → Successful engagements increase stock prices (horizon of 12 months) → Unsuccessful engagements no effect → In particular successful engagements on corporate governance and climate change issues generate subsequent increases in shareholder value

Guest lecture Impaakt SA on impact assessment

Rules to consider - Impact does not equal intentions or future goals - Differentiating ethics from impact → good ethics or good governance does not necessarily mean good impact - Go beyond CSR → use sources outside of the company's CSR report - Go beyond remediation → Always describe and quantify the broader impact first, before mentioning the remediation initiative launched by the company. - Avoid allegations or assumptions → proven facts only; reliable sources; no bashing/glorifying

Flammer (2015) on causal impact on financial performance / shareholder value

- Analyzed a sample of 2,729 environmental and socially related shareholder "close-call" proposals/resolutions (1997-2012) - "Close-call" resolutions are resolutions that pass or fail by a small margin of votes at the annual meetings - Abnormal stock price reaction on the day of close 'pass' votes (also "treatment group") compared to close 'fail' votes (also "control group") gives an idea about the causal effect - Firms in which proposals pass --> higher operating performance in the years following the vote; higher labor productivity and sales growth; cater to customers that are responsive to sustainable practices; higher employee satisfaction - Shareholder value gains are larger for companies with relatively poor environmental and social policies prior to the vote

Climate related topics

- Climate risk is an increasingly important topic for investors There are 3 types of risks: 1. Physical risks, 2. Regulatory risks, 3. Transition risks - Regulatory risks and Transition risks seem more material/important than the physical risks (Krueger et al 2020) - Investors manage climate risks through analyzing carbon footprint of portfolio firms; analyzing stranded asset risk; general portfolio diversification; ESG integration, etc. - Divestment least frequently used approach

Magnitudes of sustainable investment

- Emerging view among investors that accurate valuations and proper risk management require consideration of ESG issues. - Increasingly, managers use ESG criteria to- identify risks that are not adequately addressed by traditional investment analysis- better predict financial performance - Use of ESG criteria to identify opportunities to invest in businesses that are involved in addressing sustainability challenges (e.g., energy efficiency, green infrastructure, clean fuels, etc.) - incorporating ESG criteria in part because of legislative mandates - Unsustainable public companies divest to private companies their unsustainable activities as private companies face less scrutiny

Friede et al., 2015 study on the relation between ESG and financial performance

- Friede et al. (2015) aggregate scientific evidence based on more than 2,000 published scientific primary studies on the relation between financial performance and ESG - Overall evidence points to a slightly positive relation between ESG and financial performance - Systematically analyzed vote-count studies and meta-analyses of primary studies - Overall evidence points to a slightly positive relation between ESG and financial performance; 90% find non-negative relationship; weighted correlation between financial performance and ESG 0.15 - No single category exhibits a stronger relation to financial performance, perhaps slightly stronger relation for E and G than for S - More positive findings in studies focused on emerging markets

Why it is difficult to establish correlation between ESG and financial performance?

- Measurement error: Difficult to accurately measure ESG in absence of coherent and legally binding reporting standards, which could give rise to "spurious correlations" - Portfolio studies such as comparing non-ESG and ESG mutual funds are problematic because they mix several factors management fees; the skill of the fund manager; the investment approach of the fund manager (example: a mixture of negative; screening and positive screening).

The Carbon Disclosure Project (CDP)

- Most comprehensive database on corporate responses to climate change via questionnaires on climate change related information from corporations on behalf of investors (since 2003) - Questionnaire contains questions from three pillars → Management; Risks & Opportunities; Emissions

Dunn, Fitzgibbons, and Pomorski (2017) on relation between risk and ESG

- Negative relation between risk and ESG - Stocks with best ESG (Quintile 5) have lower risk than stocks with worst ESG (Quintile 1) ESG correlated with certain stock-level characteristics • High ESG stocks tend to be larger; high quality (higher profitability, lower earnings variability, etc.); growth firms - ESG exposures help predict future risks as far as three to five years out. - Magnitude of the estimates increases with horizon: consistent with the idea that ESG risks materialize in the long term

What is sustainable finance?

- Not one single definition; Many different forms - "In the EU's policy context sustainable finance is understood as finance to support economic growth while reducing pressures on the environment and taking into account social and governance aspects." Sustainable finance is typically about: i) long-term ii) incorporating ESG issues or other sustainability considerations into decision-making; valuation of assets

Principles for Responsible Investment (PRI)

- Proposes guidelines (a set of principles) to help signatory institutions [Asset owners, Investment managers, or Service providers] enhance their incorporation of ESG considerations via conferences, reports, thought leadership, training - 3000+ signatories Gibson, R., Glossner, S., Krueger, P., Matos, P., & Steffen, T. (2021). Responsible Institutional Investing Around the World. Working Paper. - Negative Screening, Integration, and Engagement are the most prevalent RI strategies among PRI signatories -> European PRI signatories: more Screening -> Asia Pacific PRI signatories: more Engagement -> Screening & Integration most prevalent (note: strategies are not mutually exclusive) -> Screening most prevalent in Europe(strategies are not mutually exclusive)

Guest lecture by Lombard Odier on Sustainable Investment

- Transition to sustainability will affect 95% of our investment universe - Tests to assess the investment? Non-sustainable investments vs sustainable investments - Research is at the heart of Lombard Odier's efforts to identify sustainable activities, companies

Sustainability linked bonds (SLBs)

- Use of proceeds for predefined environmental projects not a precondition of an SLB - Payment structure of SLBs contingent on issuer attaining KPI targets over pre-specified time period Berrada et al 2022 - KPI targets are not limited to environmental issues (can cover general environmental, social, and/or governance issues); yet KPI targets mostly related to environmental issues (Industrials, Materials, and Utilities); - Mostly issued by European and U.S. institutions

Relation between risk and ESG

- fewer studies examine the direct link between risk and ESG - Neglecting ESG: higher exposure to risk (a wider range of potential outcomes); Example - with high levels of emissions during a manufacturing process --> exposed to potential future legislation that might impose a carbon tax - Using ESG to predict risk in the distant future - academics & practitioners cannot for sure say that there is a high ESG score = high financial returns - short term financial losses in order to establish ESG can bring positive correlation in the long run - academic studies are differentiated on the firm level (Analyze if measures such as return on equity, return on assets, cash flows, cost of capital, or stock returns depend on ESG) vs portfolio level (Study performance differences between ESG and traditional mutual-funds)

Sustainability measurement approaches

Conduct (processes, behavior): Aims at quantifying the sustainability of a company through the quality of a firm's environmental, social, and governance (ESG) policies Examples: Has more focus on environmental damage, respect for human rights in the supply chain, employee satisfaction, health, and safety record, etc. Products: Increasing interest in quantifying whether a firm's product contributes to SDGs; For assessment -> MSCI ESG Sustainable Impact Metrics (product contribution to SDGs); FTSE Green Revenues (revenues from green business areas, Hydro, energy efficiency, etc) Examples: clean energy, water sanitation, pollution prevention, contribution to access to education, fossil fuels, tobacco/alcohol products. Sustainability conclusions can depend on whether you are assessing conduct vs product

FTSE Russell's Green Revenues

Data that allows identifying companies that generate revenues from environmentally oriented products and services (=green revenues); (e.g., preventing environmental degradation, adapting to climate change, etc.)

Green bonds & Corporate Green bonds

Green bonds - A bond used in green finance whereby the proceeds are earmarked towards environmental-related products. - Greenness of issuer not important; Greenness of assets/projects matter - Large variety of issuer types - Supranational; Sovereigns; Local governments; Government-backed entities; Development banks; Non-financial corporates, etc. - Frameworks for assessment: Green Bond Principles; Climate Bonds Initative; EU Taxonomy - 80% of green use of proceeds (UoP) went to Energy, Transport, and Buildings related projects Example: Apple's green bonds' purpose 1. Reduce company's impact on climate change (renewable energy sources; energy efficiency in facilities, products, and supply chain) 2. Promote the use of safer materials in products and processes 3. Conserve natural resources Corporate Green bonds (article by Flammer 2020) - Corporate green bond issuance has increased strongly - Both financial and non-financial corporations issue green bonds - Issuance more prevalent in environmentally sensitive industries - Global, yet corporations from a few select countries dominate the corporate green bond market (France, China, Netherlands, US, Mexico, Germany) - Environmental performance improves after issuance - Positive stock market reaction on days corporate green bonds are issued - Financial performance improves after the issuance

Sustainability disclosure

Information can be found in Annual reports; Separate sustainability reports; SASB, GRI, TCFD, CFSB + EFRAG, IFRS, ISSB voluntary standards are used for reporting. Two approaches to sustainability reporting: 1. Narrow approach/Single materiality ("give investors what they want") -> reporting that focuses on issues relevant to investors and financial materiality 2. Wide approach/Double materiality ("Drive change via reporting") -> reports how the company impacts the environment and society, including the externalities it causes

Mandatory disclosure in U.S. stock markets

Securities and Exchange Commission (SEC) 10-K form, Financial information = cornerstone of corporate disclosures; 10-K contains all information that is material to investors; Balance sheet, income, and cash flow statements: Sales, Profits, Cash Flow, Assets, Liabilities, etc. Problems with current, mostly voluntary sustainability reporting: 1) ESG/sustainability information is not readily useable by investors, because of a lack of comparable information 2) 50% of SEC-registered companies provide only fairly generic or boilerplate sustainability information in their regulatory filings; A report by SASB (2017) finds 83% of companies registered with the SEC disclose some sustainability information in their regulatory filings SEC requires to publish material information -> "firms required to "describe any known trends or uncertainties that have had or [...] will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations" Securities and Exchange Commission (SEC): U.S. federal agency responsible for enforcing federal securities laws and regulating the securities industry as well as U.S. stock and options exchanges through various mandatory SEC forms → this a corner stone for corporate disclosures Financial information is disclosed in standardised way, unlike Sustainability data Disclosures are also mandatory to report annually for non-U.S. and non-Canadian companies that have securities trading in the U.S. Material information (definition from securities law): information presenting "a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available." (U.S. Supreme Court, TSC Indus. V. Northway, Inc., 426U.S. 438 (1976)). Material information (definition from accounting standards): "Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity." (Source: International Accounting Standards Board. The Conceptual Framework for Financial Reporting 2010. IFRS, 2010) 10-K Form ⇒ Item 3 - legal proceedings; Items 9 - 14: Corporate Governance, Compensation, Auditor and accounting-related information Strict requirements as to what financial information needs to be disclosed on a regular basis: Balance sheet, income, and cash flow statements: Sales, Profits, Cash Flow, Assets, Liabilities, etc

ESG data providers

There is a very extensive list of ESG data providers and no exhaustive list of ESG issues; ESG issues are often interlinked; can be measured yet it can be difficult to assign an exact monetary value; Large variety and heterogeneity of data providers

Jouvenot, V., & Krueger, P. (2020). Reduction in corporate greenhouse gas emissions under prescriptive disclosure requirements.

UK → the first country to introduce mandatory reporting of greenhouse gas emissions for stock market listed companies. Must report i. Absolute quantity of emissions in metric tons of CO2; ii. Emission intensity; iii. Scope 1 & 2. As a result, there is a stronger increase in the availability of GHG emissions data for the UK than European firms after the law takes effect + stronger reduction in GHG emissions

Regulatory Developments regarding Disclosure (UK example)

UK → the first country to introduce mandatory reporting of greenhouse gas emissions for stock market listed companies. Must report i. Absolute quantity of emissions in metric tons of CO2; ii. Emission intensity; iii. Scope 1 & 2. As a result, there is a tronger increase in availability of GHG emissions data for UK than European firms after law takes effect + stronger reduction in GHG emissions

Construct your own ESG rating/evaluation from scratch

What are the goals you would pursue with your evaluation? 1. Separate research teams for E, S & G indicator/data research 2. Open to cooperation to achieve coherent methodology - Where do you put your focus: Products? Processes? we do them both; multifunctional companies that provide products and fair phones Would you focus on ESG as a whole or focus on sub-dimensions? specialization for each factor weighted the same What data sources and methods would you choose and why? primary sources (annual reports; secondary (NGO, academia, we focus on credibility; we provide recommendations to improve ESG

SASB. 2017c. The state of disclosure 2017: An analysis of the effectiveness of sustainability disclosure in SEC filings.

→ 83% of companies registered with the SEC disclose some sustainability information in their regulatory filings → 50% of SEC-registered companies provide fairly generic or boilerplate sustainability information in their regulatory filings Disclosure of quantitative metrics is still rare in regulatory filings → Large-cap firms in Europe (who have equity listed on U.S. markets) appear to have more effective sustainability disclosure: - Foreign private issuers (20-F filers) produced not only more but also and higher-quality disclosures than did domestic issuers (10-K filers). - driven by practices in Europe

Friede, G., Busch, T., & Bassen, A. (2015). ESG and financial performance: aggregated evidence from more than 2000 empirical studies. Journal of Sustainable Finance & Investment, 5(4), 210-233

→ Aggregate scientific evidence based on more than 2,000 published scientific primary studies on the relation between financial performance and ESG → Overall evidence points to a slightly positive relation between ESG and financial performance → Systematically analyzed vote-count studies and meta-analyses of primary studies → Overall evidence points to a slightly positive relation between ESG and financial performance; 90% find non-negative relationship; weighted correlation between financial performance and ESG 0.15 → No single category exhibits a stronger relation to financial performance, perhaps slightly stronger relation for E and G than for S → More positive findings in studies focused on emerging markets

Christensen, H.B., Hail, L. and Leuz, C., 2021. Mandatory CSR and sustainability reporting: economic analysis and literature review.

→ Sustainability reporting: the measurement, disclosure, and communication of information about ESG and sustainability topics, including activities, risks and policies → Sustainability reporting standards: a mandate for reporting on ESG or sustainability issues (e.g., a requirement to follow a specific set of reporting standards); Standards that govern how to report and disclose ESG information

Berg, F., Kölbel, J. F. and Rigobon, R.: 2020, Aggregate Confusion: The Divergence of ESG Ratings. Working Paper

→ Analysis of ESG ratings from six different providers → Identified three sources of ESG divergence: scope divergence (raters use different categories), measurement divergence (raters measure the same categories differently) weight divergence (raters give a different weight to the subcategories in the aggregation process). → Most of the difference result from differences in measurement and scope (weight divergence seems to play a minor role) → Measurement divergence in part driven by a rater effect - Firms receiving a high rating in one category receive a high rating in all other categories - Structural reasons for measurement divergence: division of labor of ESG analysis by firm (not category)

Flammer, C. (2015). Does corporate social responsibility lead to superior financial performance? A regression discontinuity approach. Management Science, 61(11), 2549-2568.

→ Analyzed a sample of 2,729 environmental and socially related shareholder "close-call" proposals/resolutions (1997-2012) → "Close-call" resolutions are resolutions that pass or fail by a small margin of votes at the annual meetings → Shareholder value gains are larger for companies with relatively poor environmental and social policies prior to the vote → Firms in which proposals pass: Higher operating performance in the years following the vote; Hhigher labor productivity and sales growth; Cater to customers that are responsive to sustainable practices + higher employee satisfaction

Benchmark regulation

→ Benchmarks (e.g., SP500, SMI, DAX) have an indirect but important impact on investors: many investors rely on benchmarks for portfolio allocation and measurement of financial performance. + benchmarks are there to evaluate the investment's climate objectives → Main objectives of new climate benchmark directive (TEG Climate Benchmarks) : i. Allow comparability of climate benchmark methodologies while leaving benchmarks' administrators (e.g., FTSE Russel, MSCI, etc.) with flexibility in terms of methodology ii. Provide investors with tools that are aligned with investment strategy iii. Increase transparency on investors' impact in terms of climate change and energy transition iv. Dis-incentivize greenwashing

Low Carbon Indexes/Defining the Carbon Exposure of each security (MSCI example)

→ Broadly diversified index but with a lower carbon exposure than overall stock market (different industries together), like a best in-class portfolio → The MSCI World Low Carbon Target Index is based on the MSCI World Index, its parent index, and includes large and mid-cap stocks across 23 Developed Markets (DM) countries*. The Index is a benchmark for investors who wish to manage potential risks associated with the transition to a low carbon economy. The index aims for a tracking error target of 0.3% (30 basis points) while minimizing the carbon exposure. By overweighting companies with low carbon emissions (relative to sales) and those with low potential carbon emissions (per dollar of market capitalization), the index reflects a lower carbon exposure than that of the broad market.

Disagreement of ESG scores

→ Chatterji et al (2016) 1. Common theorization: Lack of a shared view of what it means for a firm to be socially responsible; 2. Commensurability: Lack of agreement on metrics to use to measure CSR → Eccles and Stroehle (2018, WP) argue that ratings disagree because of technical differences in the approaches of data vendors These differences result from diverse social origins of the data vendors (e.g., legal systems) the necessity for data vendors to create a unique profile/product → Kotsantonis and Serafeim (2019, JACF): 1. Benchmarking (or how peer groups are defined) 2. ESG data imputation (what to do when there is no data so you estimate the firm, country, market - The average pairwise correlation is highest in E, lowest in G; - Ratings from some providers are more correlated than others; - ESG disagreement varies strongly across industries; - Lack of a shared view of what it means for a firm to be socially responsible; - Commensurability: Lack of agreement on metrics to use to measure CSR' - Diverse social origins of the data vendors (e.g., legal systems) as well as the need to be a 'unique' data vendor; - Inconsistencies in terms of how issuer companies report data; - Scope/Measurement/Weight divergence; - Rater effect (Firms receiving a high rating in one category receive a high rating in all other categories); - Different interpretations of information; - Due to the subjective nature (opinions/bias) of ESG information, disclosure expands opportunities for different interpretations of information.

Flammer, C. (2021). Corporate green bonds. In Journal of Financial Economics (Vol. 142, Issue 2, pp. 499-516).

→ Corporate green bond issuance has increased strongly → Both financial and industrial corporations issue green bonds; industrials have the larger share of corporate firms → Issuance more prevalent in environmentally sensitive industries → Global, yet corporations from a few select countries dominate the corporate green bond market (France, China, Netherlands, US, Mexico, Germany) → Environmental performance improves after issuance → Positive stock market reaction on days corporate green bonds are issued → Financial performance improves after the issuance → Positive stock market reaction when green bond issuance is announced: Stock markets expect green bonds to contribute to shareholder value creation → Improvements in long-term value and operating performance following issuance → Improvements in environmental performance following the green bond issuance (Conduct-based environmental ratings improve; CO2 emissions decreased) → Financial and environmental benefits stronger (for certified green bonds (Climate Bonds Initiative), in industries where environmental issues more material (SASB), for first-time issuers)

Wong, C. and Brackley, A., 2019. Rate the Raters 2019: Expert views on ESG ratings. SustainAbility.

→ Credibility of data sources remains the top factor → The credibility of data sources; quality/disclosure of methodology; focus on relevant/material issues; experience/competence of research team; etc are factors that determine ESG rating quality → Increase in perceived importance of (i) focus on material issues and (ii) research team experience → Corporates are interested in the methodology → Decrease in perceived importance of disclosure of methodology → Ratings provider perceived as providing highest quality ratings → Robeco's ESG ratings business acquired by S&P in 2019

Taskforce on Climate-Related Financial Disclosures (FSB-TFCD)

→ Financial Stability Board (FSB) established the TCFD to develop recommendations for more effective climate-related disclosures. → TCFD recommends that organizations provide climate-related financial disclosures in their mainstream (i.e., public) annual financial filings. Designed to solicit decision-useful, forward-looking information on potential impacts of climate change by taking into consideration different climate-related scenarios, including a 2°C or lower scenario. → The disclosures related to the Strategy and Metrics and Targets are subject to an assessment of materiality. → Brings climate related issues (future) into the present hrough scenario analysis → Strong focus on risks and opportunities related to the transition to a lower carbon economy → Larger companies are more likely to disclose TCFD-aligned info; Strong regional & industry variation in disclosure → Benefits of TCFD → Increased awareness and understanding of climate-related risks and opportunities within the company resulting in better risk management and more informed strategic planning → Structured around thematic areas that represent core elements of how organizations operate: 1. Governance: The organization's governance around climate-related risks and opportunities 2. Strategy: The actual and potential impacts of climate-related risks and opportunities on the organization's businesses, strategy, and financial planning 3. Risk Management: The processes used by the organization to identify, assess, and manage climate-related risks 4. Metrics and Targets: The metrics and targets used to assess and manage relevant climate-related risks and opportunities

EU Taxonomy Regulation

→ Incentive: Create a framework for establishing a unified EU classification system of sustainable economic activities (the Taxonomy) → The activity has to contribute substantially to at least one of the six EU environmental objectives: 1) climate change mitigation; 2)climate change adaptation; 3) sustainable use and protection of water and marine resources; 4) transition to a circular economy, waste prevention and recycling; 5) pollution prevention and control; and 6) protection of healthy ecosystems. → Do not do significant harm to any of the other five EU environmental objectives (DNSH); → Comply with minimum social safeguards; → Comply with technical screening criteria ("substantial" contribution and "DNSH"). Cement example: Defining a threshold that the cement activity cannot surpass in order to comply with the EU Taxonomy

EU Green Bond Standard, core components of EU Green Bond Standard

→ June 2019 TEG report on GBS proposes creation of a voluntary, non-legislative EU Green Bond Standard to promote a more unified market in the Eu for green bonds + EU standard becoming the market reference → Proposed core components of EU Green Bond Standard: 1. Alignment with EU-taxonomy 2. Publication of a Green Bond Framework 3. Mandatory reporting on (i) use of proceeds ("allocation report") and (ii) environmental impact ("impact report") 4. Mandatory verification by third party: (i) before/at the time of issuance and (ii) after full allocation of raised funds

The Economics of Sustainability Linked Bonds Tony Berrada, Leonie Engelhardt, Rajna Gibson Brandon, Philipp Krueger (2022)

→ KPI targets mostly related to environmental issues → Mostly issued by European and U.S. institutions → Most issuance by firms with strong impact on environment (Industrials, Materials, and Utilities)

Gibson, R., Glossner, S., Krueger, P., Matos, P., & Steffen, T. (2021). Responsible Institutional Investing Around the World. Working Paper.

→ Negative Screening, Integration, and Engagement are the most prevalent RI strategies among PRI signatories → European PRI signatories: more Screening → Asia Pacific PRI signatories: more Engagement → Screening & Integration are most prevalent (note: strategies are not mutually exclusive) → Screening is most prevalent in Europe(strategies are not mutually exclusive)

Surveys on ESG ratings: Rate the Raters 2019: Expert Views on ESG Ratings

→ Rating agency has an index and hence can be biased towards certain firms → ESG ratings have consistent ratings themselves too; no spikes in the ordering of the highest credibility → when controversies are high ⇒ rating providers correlate more after that? → regulation on disclosure standardization is needed; → Providers use public sources first then questionnaires → MSCI example; first inquire info then publicly available data, make an ESG rating soup then → corporates are interested in the methodology → Investor Survey: 65% use ESG data at least once a week; they use it for the material info that is useful for investment performance = for financial reasons; they also use it to SUPPLEMENT organisation's other research on corporate ESG performance/risk; to SCREEN whole INVESTMENT UNIVERSE; they use the underlining data (GHG emissions) more than the whole overall ESG rating

Amel-Zadeh, A., & Serafeim, G. (2018). Why and How Investors Use ESG Information: Evidence from a Global Survey. Financial Analysts Journal, 74(3), 1-17.

→ Reasons to consider ESG information when making investment decisions ESG information is material to investment performance; Growing client/stakeholder demand; Such policy to be effective in bringing about change at firms; Part of investment product strategy; An ethical responsibility; Anticipate it to become material in the near future; Formal client mandates → Reasons to NOT consider ESG information when making investment decisions There is no stakeholder demand for such a policy; Lack access to reliable nonfinancial data; ESG information is not material to investment performance; we believe such policy to be ineffective in inducing change at firms; it would violate our fiduciary duty to our stakeholders; such information is not material to a diversified investment portfolio; including such information is detrimental to investment performance

CFA Institute, (2015), Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals

→ Survey of CFA institute members on ESG issues (CFA institute: a global association of investment professionals.) → The relative importance of E, S, and G: Governance (64%); Environment (50%); Social (49%). → Why consider ESG issues? To help manage investment risks; Clients/investors demand it; ESG performance is a proxy for management quality; It's my fiduciary duty; To help identify investment opportunities; My firm derives reputational benefit; Regulation requires it → Why NOT consider ESG issues? Lack of demand from clients/ investors; These issues are not material--no added value; Lack of information/ data Insufficient knowledge of how to consider these issues; Inability to integrate ESG info in my quantitative models; Not relevant to my job; Market practices require me to focus on short-term performance

Firm level disclosure: European Union Sustainable Finance Disclosure Regulation (EU SFDR)

→ The regulation calls for disclosures at both the entity-level (i.e., at the level of the parent company) and financial product-level (i.e., ETF, mutual funds, etc.) → The introduction of the disclosure requirements was split into Level 1 and Level 2 Level 1: → The most visible and impactful element of the Level I disclosure regulation was the classification of funds and investment mandates in three categories (Article 6, 8 and 9 funds). All funds are required to provide some ESG disclosure, as per Article 6, while Article 8 and Article 9 funds will be asked to provide more detailed ESG information to investors Article 6 funds ("grey"): financial products that do not promote their environmental social or governance (ESG) characteristics Article 8 funds ("light green"): financial products that promote, among other characteristics, environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices Article 9 funds ("dark green"): financial products that have sustainable investment as its objective Level 2 → Level II kept the fund classification in place, but introduced a notable update in the form of a stricter interpretation of what constitutes a wholly sustainable investment (i.e., Article 9 fund, what it actually is ); → Introduces more extensive reporting requirements (known as 'SFDR RTS') in the form of mandatory metrics on ghg emission, other impacts etc → Stricter interpretation of Article 9 funds, only funds that do one of the following can be considered Article 9: 1. Have a positive impact under an SDG Framework which measures the contributions that companies make to the Sustainable Development Goals 2. Funds that set a specific carbon reduction objective and use a Paris-Aligned Benchmark or a Climate Transition Benchmark 3. Funds that make investments in green, social, and sustainability bonds → Level II introduces mandatory reporting of Principles Adverse Impact (PAI) Indicators, a set of environmental, social, and governance indicators and metrics, for example carbon emissions; water emissions, biodiversity impacts; social violations, and gender parity on the board. PAI is targeted for corporate, sovereign, and real estate holdings.

Corporate Sustainability Disclosure Regulation (CSRD)

→ new EU legislation requiring all large companies to publish regular reports on their environmental and social impact activities. It helps investors, consumers, policymakers, and other stakeholders evaluate large companies' non-financial performance.

Christensen, Serafeim, and Sikochi (2021) Why is Corporate Virtue in the Eye of the Beholder? The Case of ESG Ratings

→ provide evidence that more ESG disclosure is associated with higher ESG Rating disagreement → Idea: Due to the subjective nature of ESG information, disclosure expands opportunities for different interpretations of information - Absence of disclosure, data providers are more likely to agree because they use similar rules of thumb and imputation techniques. - With higher levels of disclosure, data providers need to make a judgment about whether the disclosure means good or bad performance