Measuring to Manage: Evaluating ESG Risk In Corporate Debt
Standish has developed the Standish ESG risk score system, which provides absolute assessments of ESG risk that can be compared across issuers and sectors.
Stephan Bonte, CFA
Director of Sustainable Inv
esting
Measuring To Manage:
Evaluating ESG Risk In
Cor
porate Debt
June 2016
f
Increased investor interest in sustainability issues is being met with
increased disclosure by bond issuers and others of information about
environmental, social and governance risks.
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Standish has developed a proprietary risk scoring system that uses that
information to objectively assess the ESG exposure of individual issuers,
sectors and portfolios.
A familiar cliché holds that that “you can only manage what you can measure”, and fixed
income managers have long based investment decisions on quantitative measurements
of risk factors. Chief among these are the so-called five c’s of credit—character, capacity,
capital, collateral and conditions. But while these factors, combined with balance sheet
and cash flow analysis, provide valuable insight into potential downside risks, they give an
incomplete picture of an issuer’s environmental, social and governance (ESG) risk exposure.
Fortunately, the increasing interest in investment strategies that consider ESG factors is
being met with increasing disclosure by corporate bond issuers about their exposures, goals
and policies relating to those sources of potential risk. The Governance and Accountability
Institute reports that 81% of S&P 500 companies published a corporate sustainability
report in 2015, up from fewer than 20% in 2011. Meanwhile, organizations including Ceres,
the Sustainability Accounting Standards Board and the Carbon Disclosure Project are
encouraging companies to increase disclosure and are advocating for the standardization of
the information that is disclosed. Also helping to increase the amount and quality of ESG-
related information are data aggregators and rating services such as MSCI, Sustainalytics
and Oekom who cover an increasingly vast universe of issuers.
David Morse, CFA
Director of Investment Grade Credit
2
Identifying data that
could materially
affect the market’s
perception
of an issuer’s
creditworthiness
within the
investment
horizon is critically
important.
T
he
S
Tandi
Sh
eSG
ri Sk
Score
While increased data and transparency provide tools for managers to better understand ESG risk,
the way in which the data is put to work matters even more. Identifying data that could materially
affect the market’s perception of an issuer’s creditworthiness within the investment horizon is
critically important. With this goal in mind, Standish has developed the Standish ESG risk score
system, which provides absolute assessments of ESG risk that can be compared across issuers
and sectors. It combines, with relative weights set by Standish’s investment team, the exposure
and management scores that MSCI gives each issuer for up to 32 ESG-related issues. Issuer- and
Portfolio-level ESG Analytics are available to portfolio managers and credit analysts, providing
meaning and understanding beyond raw data.
Successful portfolio management requires measuring and prioritizing the many factors likely to
impact financial performance. Some of these metrics such as contribution to duration, contribution
to spread duration and option-adjusted spreads are commonly understood industry standards.
They are imperfect, but they provide a basis for communication, identifying trading opportunities
and allocation changes. Their relevance and comparability across issuers and sectors makes
them valuable. To incorporate ESG risk factors into this common language and the risk/reward
assessment process, the Standish investment team created an ESG risk metric. It includes not just
information that could materially affect the market’s perception of an issuer’s creditworthiness,
but information that is specific to fixed income assets. For example, an issuer’s investments in
promising–but unproven–green technologies may provide upside for shareholders, but those may
be irrelevant to its Standish ESG risk score because they do not benefit fixed income investors
more concerned about downside protection than with upside potential. With this principle in mind,
the Standish investment team focuses primarily on four issues within each of the three pillars of
environmental, social and governance risk:
Source: Standish. For illustrative purposes only.
At the beginning of the investment process, team members compile information on an issuer
including ratings, balance sheet structure, revenue and cost/investment trends, cash flows/
liquidity and credit spreads. All of these measures vary among issuers and industries but must
be comparable. While these metrics don’t always provide a complete picture of an issuer’s
creditworthiness, they provide a commonly understood body of knowledge for discussions
between strategists, credit analysts, portfolio managers and traders.
Some of the ESG data and ratings providers’ methods are less relevant and comparable than our
scoring system requires. For instance, some focus on “best in class” approaches, where issuers
are compared to their peers. These approaches create potential blind spots when ESG risks are
assessed across sectors. Other data providers focus on narratives which help provide context, but
may reflect values or concerns that the provider views as important, but that we may not.
The results of this additive, issue-by-issue process are ESG risk scores that are fully transparent
and allow credit analysts or portfolio managers to challenge the underlying data; for example,
by subtracting risks that are largely priced in or mostly already addressed. This chart shows the
average Standish ESG risk scores in each sector of the Barclays US Credit Corporate Index.
3
The Standish ESG
risk score is an
absolute measure
of risk and as such
is different from
the “best-in-class”
approaches to
evaluating ESG
risk exposure
which we view as
complementary
types of ratings.
Contribution to Standish ESG Risk Score by Sector
Source: Barclays, MSCI, Standish as of 3/31/16
0
1
2
3
4
5
6
Standish ESG Risk Score (0-10, 10 is riskiest)
Climate Change
Natural Capital
Pollution/Waste
Human Capital
Product Liability
Corp Governance
Corp Behavior
Corporate behavior and corporate governance (red colors in the charts) are governance factors and
are considered material across sectors—as would be expected for a pillar that is closely related to
“character,” one of the five c’s of credit.
The contribution of environmental (green colors) and social (blue) factors to ESG risk varies greatly
from sector to sector. The energy and utility sectors have high exposure to environmental risks. Less
obviously, the entire transportation sector—not just airlines—also has exposure to climate change, a
risk not necessarily captured by “carbon intensity” metrics.
The technology sector has relatively high social risk exposure in the areas of keeping a highly skilled
and competitive workforce engaged (human capital) and exposure to privacy and security risks
(product liability). Financials also have significant exposure to social factors especially in the banking,
insurance, and brokerage subsectors where trust is a cornerstone of the business model.
T
he
S
Tandi
Sh
eSG
Score
ver
SuS
be
ST
-
in
-
cla
SS
Scorin
G
The Standish ESG risk score is an absolute measure of risk and as such is different from the “best-in-
class” approaches to evaluating ESG risk exposure which we view as complementary types of ratings.
The chart below shows how individual issuers in the Barclays US credit corporate index rank both
on the MSCI weighted average ESG Score and the Standish ESG risk score. The MSCI scores use a
best-in-class approach and are plotted along a vertical axis where 0 is worst in class and 10 is best.
The Standish ESG risk scores are plotted on the horizontal axis with 0 having the least exposure to
ESG risk and 10 the most. While there is a correlation between both ratings because best-in-class
issuers tend to have less absolute ESG risk, the Standish ESG risk score clearly provides additional
information about which issuers have, in our view, significant exposure to ESG risks.
MSCI Weight Average Score vs. Standish ESG Risk Score for Barclays US Corporate Index
Source: Barclays, MSCI, Standish as of 3/31/16
0
1
2
3
4
5
6
7
8
9
10
012345678910
MSCI WA Score (0-10, 10 is best-in-class)
Standish ESG Risk Score (0-10, 10 is riskiest)
"Worst-in-class" but low risk
"Best-in-class" but high risk
"Best-in-class" and low risk
"Worst-in-class" and high risk
4
The increasing
abundance and
transparency
of information
regarding ESG
risk has many
implications for
both fixed income
investors and issuers
alike.
Combining these two complementary measures may provide useful, objective metrics for investors
who are wary of relying solely on a single approach to risk assessment. For example, investors
concerned about climate change may not want to divest from all fossil fuel-related issuers because
they believe that the more forward-thinking companies may play roles in promoting renewable
energy. Those with this perspective would prefer to invest only in best-in-class energy companies
while divesting from the worst and investing instead in sectors with less environmental risk
exposure.
The increasing abundance and transparency of information regarding ESG risk has many
implications for both fixed income investors and issuers alike. As consumers, regulators and
investors increasingly consider ESG factors in their purchasing, rulemaking, and capital allocation
decisions, the distinctions between best- and worst-in-class companies are likely to become more
pronounced. We believe the Standish ESG risk score provides a useful, objective assessment of ESG
externalities than may be internalized and eventually may become one of the many drivers of an
issuer’s credit performance.
The comments provided herein are a general market overview and do not constitute investment advice, are not predictive of any
future market performance, are not provided as a sales or advertising communication, and do not represent an offer to sell or a
solicitation of an offer to buy any security. Similarly, this information is not intended to provide specific advice, recommendations
or projected returns of any particular product of Standish Mellon Asset Management Company LLC (Standish). These views are
current as of the date of this communication and are subject to rapid change as economic and market conditions dictate. Though
these views may be informed by information from publicly available sources that we believe to be accurate, we can make no
representation as to the accuracy of such sources nor the completeness of such information. Please contact Standish for current
information about our views of the economy and the markets. Portfolio composition is subject to change, and past performance is
no indication of future performance.
BNY Mellon is one of the world’s leading asset management organizations, encompassing BNY Mellon’s affiliated investment
management firms, wealth management services and global distribution companies. BNY Mellon is the corporate brand for The
Bank of New York Mellon Corporation. Standish is a registered investment adviser and BNY Mellon subsidiary.
WPJUNE201662116BR
Standish Mellon Asset Management Company LLC
Boston
• Pittsburgh
• San Francisco
Standish Mellon Asset Management (UK) Limited
www.standish.com
• info@standish.com
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