SPECIAL REPORT:ESG
As companies try to respond, they struggle to identify strategies and methods to measure success
by Amy Guthrie
On a clear day, the volcanos south of Mexico City are visible from the Polanco offices of DEG, a division of German development bank KfW that invests in private sector companies in emerging markets.
But clear days are rare in the Mexican capital, which is often cloaked in smog. A recent pollution emergency, caused by raging forest fires, turned the sky of the capital even darker than usual and bathed the city in an acrid smell. Residents were warned to stay indoors and plug gaps under doors with damp cloths.
“You just need to look around,†says Johannes Goderbauer, director of DEG’s representative office in Mexico. “Climate change is a fact, and we should be treating it as such.â€
A growing number of investors agree. And they’re not just looking at a company’s environmental record. The Odebrecht scandal highlighted corruption concerns in Latin America, prompting many investors to evaluate a company’s governance structure. Similarly, such issues as workplace diversity increasingly weigh on investment decisions.
“The market is calling out for clarity. People are confused by these overlapping labelsâ€
—Neil Gregory, head of thought leadership, IFC
Embracing so-called ESG principles (Environment, Social, Governance) in investment decisions is still in its infancy in Latin America—even more here than in developed markets around the globe. For some investors, employing ESG reflects their own social consciousness. Others, however, include ESG factors as part of overall risk assessments, believing that proactive companies will be better prepared to tackle future regulations that could adversely affect their investments.
Regardless of motive, many believe that the growing acceptance of ESG by institutional investors is bound to impact the marketplace. In a survey of investors and analysts in the Americas published by the CFA Institute in 2018, 48% of respondents said governance issues affected share prices in 2017and 54% said it would impact equity valuations by 2022. Similarly, 13% said environmental issues influenced bond yields in 2017. But 30% predicted yields would be affected by 2022.
Companies are as equally divided as investors. Some, like Mexico’s Grupo Bimbo, have long incorporated ESG principles into their corporate strategies. Others give the trend lip service.
“It would be great if regulation accompanied this movement,†says MarÃa Laura Tinelli, founder of Acrux Partners, a Buenos Aires-based advisory firm focused on fostering impact investments in South America. Regulations could help spread adoption by smaller firms of goals such as the elimination of single-use plastics. “The problem is that, especially in Latin America, the governments don’t exactly enforce the rules.â€
But many companies are increasingly being forced to respond to ESG issues or ignore an entire category of potential investors. BNP Paribas recently announced that it was transforming all of its active funds into sustainable portfolios. In early September, Denmark’s $20 billion MP Pension fund said it was dumping its shares in the 10 biggest oil companies, including Petrobras, claiming that the companies were not living up to goals set out in the Paris climate accord.
Michael Fitzgerald, a partner at law firm Paul Hastings, who has advised clients in Latin America for decades, sees a growing awareness of the need to act among corporations with significant environmental footprints. “The major companies in Latin America, especially the extractive industries that produce significant greenhouse gasses, have recognized the threat of global warming and are intent on doing something about it,†he says.
Despite the proliferation of consultants and other so-called experts, there isn’t a single authority or global industry set of standards on ESG. How to build a corporate strategy around ESG, much less measure success, leaves many senior managers puzzled.
That uncertainty isn’t stopping the marketplace. Insurance companies now price climate variations into their models. And ratings agencies seek to measure the impact of longer- term events on credit. Rising temperatures and extreme weather events have stoked a perception of heightened risk for credit, investment and even the viability of individual companies.
At the same time, financial firms are offering a wider menu of new ESG-friendly instruments, like green bonds, sustainable loans and impact investments. Some exchange-traded funds promise clean energy and others offer a hedge against water scarcity.
“We still believe we can have both return and positive impacts. They should not be in conflict necessarilyâ€
—Johannes Goderbauer, director, DEG Mexico
Companies can also try to qualify for inclusion in one of the growing number of sustainability stock indexes. MSCI, the world’s largest provider of indexes, is expanding its focus on ESG. Local stocks markets in countries such as Brazil and Mexico also have their own ESG indexes with criteria that companies must meet to be included. The next step could involve getting pension funds in countries such as Chile and Mexico to adopt ESG guidelines.
As ESG principles gain wider acceptance, a growing amount of global assets claim to be aligned with these goals. But Neil Gregory, head of thought leadership at the IFC, says guidelines are important to avoid “impact-washing†— a term used to describe investments touted as having positive environmental or other results without actually addressing ESG issues in any meaningful way.
“The market is calling out for clarity,†says Gregory. “People are confused by these overlapping labels.â€
The IFC has drafted global impact investing principles to provide greater transparency, credibility and discipline to the concept, starting with criteria for what type of investment makes a positive impact. Measurable targets and independent verification help ensure that ESG efforts yield genuine results, such as energy savings and gender equality. DEG is among some 60 fund managers with $350 billion under management that have signed onto those principles.
The toughest principle to comply with, says Gregory, is one that calls for independent verification of public disclosures by investors. Investors who adhere to the principles are expected to articulate each year the contributions that their investments will make to society at large.
Some sectors provide more bandwidth for claims of investments with positive impacts, such as education, healthcare, renewable energy and affordable housing. Mining is another matter. Yet positive results can be measured in many ways. Investors that put money into a dirty company to clean it up, Gregory says, sometimes construe their involvement as a “positive†impact.
Many companies choose debt instruments as a way to demonstrate their ESG credentials. The most popular category involves green bonds that focus on environmental issues. Moody’s Investors Service estimates that around $200 billion in green bonds will be issued this year, but mostly in Europe and Asia.
A newer product known as sustainable, or green, loans can potentially reach a broader swathe of the market. The idea is to directly align financing costs to the sustainability performance of a company. This can be done via discounts on interest rates, offering an incentive to lessen negative impacts on the environment or community. Interest rates on the credit fall when the company hits certain pre-established targets like reductions in energy consumption.
“The clients that have shown significant interest in this type of product are clearly committed to improving their ESG,†says Eddy Lacayo, head of Latin America corporate loans at BBVA. “It’s in their governance, the strategy of the company, and how they see themselves in the future.â€
BBVA has been actively promoting sustainable loans. The Spanish bank aims to mobilize €100 billion ($110 billion) for green finance, sustainable infrastructure products, social entrepreneurship and financial inclusion through 2025. As of December, the bank had extended €12 billion toward that goal.
So far, BBVA claims four sustainable loans in Latin America. In July, the Spanish bank acted as sole sustainability agent, joint bookrunner and lead arranger on a $1.1 billion revolving credit agreement for Mexican real estate company Fibra Uno that targets reductions in electricity consumption and greenhouse gas emissions by the company.
Fitzgerald, who represented BBVA on the Fibra Uno deal, says an independent monitor is assigned during the life of the loan to make sure that the company meets greenhouse gas emissions standards. If the standards are not met and independently verified, the interest rate on the loan will increase.
This step of independent verification gives sustainable loans like that of Fibra Uno more legitimacy than some other financings that Fitzgerald says often “seem to stretch the limits of credulity in ESG impact in order to qualify for the financing baskets that major investors have for these types of loans.†Independent monitoring firms such as Vigeo Eiris, which was acquired by Moody’s in April, and Sustainalytics track that performance and provide ESG ratings for issuances.
In November, Vigeo provided an ESG rating for a $70 million, three-year green loan that BBVA extended to Peru’s Ferreycorp, a company that distributes heavy construction equipment in South America. The loan terms are contingent on Ferreycorp hitting specific goals in corporate governance, environmental sustainability and social impact.
Other types of ESG investments are also gaining acceptance. Latin America’s first “gender bond†debuted in August: a $50 million issuance from Banistmo, Panama’s largest bank, to finance small and medium-size enterprises led by women in Panama. IDB Invest structured and bought 100% of that bond. Vigeo analyzed the bond structure as well as the bond’s contribution to sustainability and alignment, using the Social Bond Principles published by the International Capital Market Association.
Some bankers are hoping to create a market for so-called “transition†bonds that allow brownfield companies to demonstrate their commitment to green principles. Brazilian beef producer Marfrig sold $500 million in 10-year transition bonds In July. The proceeds are being used to develop more sustainable ranching practices.
Shareholders may have the most influence on companies. Equity investors like DEG —which has deployed around €350 million in Mexico — can get closer to companies and persuade them to move soft objectives like electricity consumption from the “wish list†to the “urgent†basket.
Goderbauer recalls the satisfaction of being sent an electric bill that showed a dramatic decrease in energy consumption for a retailer that DEG had helped acquire solar panels. That decision resulted in money saved, a boost to the bottom line and a positive impact on the environment.
“That is where the two axes come perfectly together,†says Goderbauer. “We still believe we can have both return and positive impact. These goals should not necessarily be in conflict.â€
