Incorporating
ENVIRONMENTAL,
SOCIAL and GOVERNANCE (ESG)
Factors into FIXED INCOME
INVESTMENT
Georg Inderst and Fiona Stewart© 2018 The World Bank Group
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Citation: Inderst, G. and Stewart, F., Incorporating Environmental, Social and Governance (ESG)
Factors into Fixed Income Investment. World Bank Group publication, April 2018.
Photo Credits: IFC and World Bank Photo Libraries and ShutterstockTABLE of CONTENTSACRONYMS AND ABBREVIATIONSIIIACKNOWLEDGMENTSV

EXECUTIVE SUMMARY

VII

1. INTRODUCTION AND BACKGROUND

1

Definition of ESG Investing
Investor Motivations
ESG and Impact Investment Approaches

236

2. WHAT IS ESG ANALYSIS IN FIXED INCOME INVESTING?
Corporate Issuers
Sovereign Issuers
Other Debt and Securities

9
11
12
14

3. ESG AND FINANCIAL PERFORMANCE – MAIN RESEARCH FINDINGS
Corporate Bonds
Sovereign Bonds
Fixed Income Funds

17
17
19
19

4. ESG INVESTMENT TOOLS FOR FIXED INCOME
Credit Ratings and ESG
ESG Scores/Rankings
Country Scores
ESG Fixed Income Indices

23
23
24
26
27

5. HOW IS ESG BEING IMPLEMENTED BY FIXED INCOME INVESTORS?
Green, Social, Sustainable and Other Thematic Bonds
Passive Investing
Active Investing
ESG ‘Holistic’

31
32
35
36
36

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT|I6. MAIN TRENDS AND CHALLENGES
State of the Art
Issues with ESG Investing

39
39
40

7. CONCLUSIONS: FROM PROCESS TO IMPACT
Key Lessons for Investors
Ways Forward

45
45
46

APPENDICES

49

REFERENCES

55

Appendix 1: Institutions Interviewed for This Report
Appendix 2: ESG Criteria
Appendix 3: Characteristics of Fixed Income and Implications for ESG
Appendix 4: Structure of RobecoSAM’s Country Sustainability Framework
Appendix 5: Bloomberg Barclays MSCI ESG Fixed Income Family
ENDNOTES

49
50
51
52
53
61

BOXES
Box 1: ESG Investor Associations, Standards and Codes
Box 2: ESG and Regulation
Box 3: Climate Investing4
5
6

Box 4: EAPF’s Sustainable Investment and Carbon Targets

38

FIGURES
Figure 1: Impact Investment Drivers
8
Figure 2: Suitability of ESG Investment Strategies for Equity and Fixed Income Investing 10
Figure 3: Level of ESG Incorporation in Fixed Income
15
Figure 4: Main Research Findings
20
Figure 5: RobecosSAM ESG Weightings
27
Figure 6: Level of ESG Integration
32
Figure 7: Labelled Green Bond Market Volume by Type of Issuer
33
Figure 8: Labelled Green Bond Market Volume by Country
34
Figure 9: PGGM ESG Approach
37
TABLES
Table 1: Engagement for Equity and Bond Investors
Table 2: Screening Criteria for Different Types of Issuers
Table 3: MSCI ESG Key Issues for Companies
Table 4: Categories Available for Bespoke Screening
Table 5: ESG Strategies in Fixed Income (by Volume of Assets)

II | TABLE OF CONTENTS

11
13
25
28
31

Acronyms andAbbreviations
ABS

Asset-backed Securities

AI

Artificial Intelligence

AIGCC

Asia Investor Group on Climate
ChangeAIM

Affirmative Investment Management

ALM

Asset and Liability Management

AODP

Asset Owners Disclosure Project

CAT

Catastrophe Bonds

CCM

Convention on Cluster Munitions

CDP

Carbon Disclosure Project

CDS

ICGN

International
Corporate
Governance Network

ICMA

International Capital Market
Association

Credit Default Swap

IFC

International Finance Corporation

CFP

Corporate Financial Performance

IG

Investment-grade

CRA

Credit Rating Agency

IGCC

Investor Group on Climate Change

CSR

Corporate Social Responsibility

IIGCC

EAPF

Environment Agency Pension Fund

Institutional Investors Group on
Climate Change

EIB

European Investment Bank

ILS

ETF

Exchange Traded Funds

Insurancelinked Securities

ESG

Environmental, Social and Governance

IRIS

GBP

Green Bond Principles

Impact Reporting and Investment
Standards

GIC

Global Investor Coalition on Climate
ChangeJFSAJapan’s Financial Service Authority

LDI

Liability-driven Investment

GIIN

Global Impact Investing Network

MBS

Mortgage-Backed Security

GP

General Partner

OECD

GPIF

Government Pension Investment Fund

Organization for Economic
Co-operation and Development

GRI

Global Reporting InitiativePE

Private Equity

GSIA

Global Sustainable Investment Alliance

PRI

UN Principles of Responsible Investing

GSSB

Global Sustainability Standards Board

RI

Responsible Investing

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT

| III

III

SASB

Sustainability Accounting Standards
Board

SPV

Special Purpose Vehicle

SBP

Social Bond Principles

SRI

Socially Responsible Investment

SDGs

Sustainable Development Goals

TCFD

Task Force on Climate-related
Financial Disclosures

SDSN

Sustainable Development Solutions
NetworkTIPP

The Investment Integration ProjectSI

Sustainable Investing

UNEP

United Nations Environment
Programme

SIB

Social Impact Bonds

UNGC

UN Global Compact

IV | ACRONYMS AND ABBREVIATIONSAcknowledgmentsT

his research report is the result of apartnership between the World Bank Groupand Government Pension Investment Fund (GPIF)
of Japan, initiated by the World Bank Group’s President, Jim
Yong Kim, and GPIF’s Chief Investment Officer, Hiro Mizuno. The
aim is to collaborate on initiatives that promote strategies for including
environmental, social and governance (ESG) criteria in investment decisions acrossdifferent asset classes. Ultimately, the goal is to direct more capital towards sustainable
investments and leverage the private sector to achieve the scale of investment needed to meet
the Sustainable Development Goals.
The partnership reflects GPIF’s strategic
commitment to advancing the integration of ESG
considerations into all asset classes of its portfolio.
The research report is focused on integration of
ESG considerations for fixed income. From theWorld Bank Group side, the research contributes
to the commitment to maximizing finance fordevelopment and catalyzing the development
towards more sustainable capital markets.
The authors of the paper are Georg Inderst andFiona Stewart. Georg Inderst is an independent
Expert Consultant, specializing in green financeand infrastructure investment (Inderst Advisory,
London). Fiona Stewart is a Lead Finance Sector
Specialist in the Finance, Competitiveness andInnovation Global Practice of the World Bank.  
The authors would, in the first place, thank all theasset owners, investment managers, international
associations, private sector service providers andindividual experts for sharing their expertise andexperiences. In addition, Joaquim Levy, Managing
Director and World Bank Group CFO and Arunma
Oteh, Vice President, for spearheading this workwithin the World Bank Group; Heike Reichelt andAtiyah Curmally for leading the partnership with
GPIF, and the following for their support and input
to the study.  Alfonso Garcia Mora, John Gandolfo,
George Richardson, and Andrew Cross and SamuelMunzele Maimbo; and Jingdong Hua and Monish
Mahurkar for their active participation at the
stakeholder workshop . The authors are particularly
grateful to Colleen Keenan, Marcelo Jordan, Martijn
Regelink, Harun Dogo, Svetlana Klimenko, Berit
Lindholdt-Lauridsen and Alex Berg for their expert
input. Yoshiyuki Arima, Kenichiro Shiozawa andMisa Yanagi from the Tokyo office for all theirassistance – including arranging for the report tobe translated into Japanese. Aichin Lim Jonesfor graphic design and layout, Luidmila Uvarova

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT|Vand Nina Vucenik for knowledge management
and communications support, and Inna Remizova
and Leah Kusensela for being excellent research
assistants. The report benefited from commentsfrom peer reviewers including Akinchan Jain, Greg
Rosenberg, Eivind Oy, and Judith Moore. Finally,it has been a pleasure working with the GPIF team.

VI | ACKNOWLEDGEMENTS

We would like to thank Norihiro Takahashi andHiro Mizuno and for their support and leadership,
and Tetsuya Oishi, Genzo Kimura, Daiki Nishida,
and Keiji Watanabe for their helpful input andcollaboration. We look forward to continuing the
dialogue and working with them in future.

Executive Summary

Agrowing body of research shows thatEnvironmental, Social and Governance(ESG) factors are material credit risk for fixedincome investors. The evidence suggests that incorporating ESG
into fixed income investing should be part of the overall credit risk
analysis and should contribute to more stable financial returns. It also dispels
the myth that incorporating ESG means having to sacrifice financial returns. ESG
investing is increasingly becoming part of the mainstream investment process for fixedincome investors, as opposed to a specialist, segregated activity, often confined to green bonds.
Though fixed income has its own challenges withintegrating ESG issues, it is catching up fast with theequity space (particularly corporate and supranationalbonds but less - so far - sovereign issuers, assetbacked or private debt). Leading investors are goingfurther and viewing ESG not just as an aspect of risk
and return, but merging ESG and ‘impact’ investing.
This includes measuring the impact of their portfolios
on targeted environmental and social outcomes, andbeyond, such as mapping impact using the Sustainable
Development Goals (SDGs).
Different methods for applying ESG are being
adopted by fixed income investors: from purchasing‘labelled’ (green, social, and/or sustainable) bonds
and setting up or investing in ESG/SRI (Socially
Responsible Investment) funds; to following
ESG indices; to hiring ESG active managers; toincorporating and embedding ESG across thewhole investment process. This can be done byeither following the methodology of different

external service providers and /or by customizing
such products with the institutional investor’s own
philosophy and goals.
Yet, many investors find implementing ESG inpractice a challenge, which can be exacerbatedwhen it comes to their fixed income portfolios.
There are still no standard definitions of ESG– with diverse views particularly in the ‘social’area. Data – though improving and coming fromincreasingly varied sources – is still wanting
particularly in emerging markets. In fixed income,there are additional issues such as how to pursue
engagement with issuers (particularly sovereigns),
the role ESG plays in credit ratings, the lack of
choice of indices compared to the equity space, as
well as a dearth of specific ESG-focused products.
There are also challenges in the green bond markets
with demand outstripping supply. Conceptual workon ESG and fixed income also needs to go beyond
credit risk (such as the relationship of ESG issues
with liquidity and other market risks).

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| VII

ESG investing is developing from a purely processdriven to a more outcome-driven activity. Goingforward, first, initiatives to improve the breadth anddepth of ESG data should continue to be supported.
Second, more rigorous research on the relationshipbetween ESG factors and financial risks and returns
in fixed income is also required. Third, standards,

VIII | EXECUTIVE SUMMARY

principles and metrics for applying ESG and
impact investing can be refined to allow investors
to customize their approach from a robust basis.
Finally, more innovative, scalable products toaccommodate the growing demand for fixed income
sustainable investments could be developed.

1. Introduction

and backgroundC

apital markets play a vital role inchanneling investment into the economy tohelp drive growth and prosperity. Asset owners
and financial intermediaries are asked to contribute to financing
sustainable development that meets the need of the present, withoutcompromising the ability of future generations to meet their own needs.

Sustainable investment, including socially
responsible, ethical, and ESG (environmental,social and governance) investing, is increasingly
gaining a foothold in mainstream financial markets.
Globally, sustainable investments grew by a quarter
to $23 trillion over the last two years, according to
the Global Sustainable Investment Alliance (GSIA
2017). This equates to around one-quarter of‘professionally managed’ assets globally.1
ESG investing has been gathering attention since the1990s. From its origins in the equity markets withreligious, values-based or thematic (environmental)
investors, the movement spread with the launch of
the UN Principles of Responsible Investment (UN
PRI) in 2006 and was catalyzed for fixed income
with the issuance of labelled bonds by multilateralorganizations from 2007. The issue has received
renewed high-profile support in recent years throughthe European Commission’s High-Level Expert
Group on Sustainable Finance and the Financial
Stability Board’s (FSB) Task Force on Climaterelated Financial Disclosure (TCFD) initiative, as
well as public interventions by stakeholders suchas the Bank of England Governor Mark
Carney.2
Traditionally, the main focus of ESG investinghas been on equity markets. In recent years,
however, ESG has spread out increasingly to otherasset classes, in particular fixed income, giventhat bonds constitute a substantial percentage
of institutional investors’ assets.3 Considerable
academic and industry research has been conductedon the relationship between ESG investing andperformance in equity markets, but far less isavailable on its effect on the fixed income markets.
As a further development, many asset owners
are looking to increase investments that make apositive social and environmental impact on top of
their financial objectives. Some have also started
to re-assess their investment policies in the light ofclimate change risks and policies post Paris COP21,
as well as the 2015 UN Sustainable Investment
Goals (SDG). All assets, including fixed income,will increasingly be measured also by social andenvironmental outcomes and externalities.

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT|1This research report provides an overview onsustainable investing in fixed income that is developing
fast these days. It discusses the core areas of:• the specific nature and issues of ESG investing inthis asset class;• the rationale for ESG analysis in fixed income –including research findings;• ESG investment tools and ways of implementing
ESG strategies in fixed income;• on-going challenges to greater integration of ESG
into mainstream investing; and• suggestions for how to catalyze the further
adoption of ESG approaches.
The study builds on both research and practicalexperiences to date on ESG approaches for fixedincome portfolios. An extensive literature review
was conducted to inform the findings. It was notpossible to undertake new primary research for thispaper, but suggestions for further analysis are made.
The paper also includes findings which draw on thepractical experience of a number of stakeholders(asset owners, asset managers, data providers etc.)
who are integrating ESG factors into fixed income
investments and were interviewed and participatedin a workshop and roundtable discussions as partof this research project. Their insights are reflectedacross the paper, and their input is most appreciated.4
The focus of the report is primarily on the main fixedincome investment instruments, such as sovereign,supranational, and corporate bonds. Research
and application of ESG for other fixed income
investments (sub-sovereigns, covered bonds andother asset backed securities, private debt etc.) arestill very limited. However, thematic investments
such as green, social and sustainable bonds are
growing and are facilitating the integration of ESG
for fixed income. Therefore, the discussion is not
limited only to the labelled bond market, but is also
on incorporating ESG factors into fixed income
portfolios more broadly.

Definition of ESG Investing
ESG investing incorporates environmental, social,and governance issues into the analysis, selection
and management of investments. Key issues forconsideration typically include:
E: climate change, carbon emissions, pollution,
resource efficiency, biodiversity;
S: human rights, labor standards, health &safety, diversity policies, community relations,development of human capital (health & education);
G: corporate governance, corruption, rule of law,
institutional strength, transparency.
Historically,
governance-related
investment
codes were probably first relevant for investment
strategies, with green and social issues, and moregenerally a view to sustainable investing, growing
in relevance over the last two decades. There aremany different, and more specific, definitions in themarket place. Appendix 2 shows a list of standard
ESG criteria applied by the CFA (2015), and forsovereign and corporate bonds by the UN Principles
of Responsible Investing (PRI) (2014), and thoseused in the IFC Performance Standards (2012) andCorporate Governance Methodology.
A definitive list of ESG issues does not exist – and it
looks impossible to agree on. Markets, technologies,
policies, values and social preferences change all
the time, and vary from region to region, country tocountry and even within countries.   Therefore, an
open and dynamic approach to defining “green” or“sustainable” investments is preferable – and is usedin this paper – embedded in a clear and transparent
governance framework (Inderst, Kaminker andStewart 2012).5
For fixed income, a survey by PRI (2017a) foundslightly more investors follow governance thansocial and environmental factors. Russell (2017)
also found that governance is widely being
considered the most important factor.
Other common terms in this context include
sustainable investing (SI), responsible investing2 | 1. INTRODUCTION AND BACKGROUND

(RI) and socially responsible investing (SRI). They
are often being used synonymously in the market
place. So does this report, for simplicity, being
aware that some industry practice and academia
differentiate these terms.
There are other related investment strategies witha somewhat different focus (such as long-term
investing, universal ownership6), or strategies thatconcentrate on a particular aspect of ESG (e.g. green,
climate change, social, ethical, religious investing).7
Finally, there is an increasing focus on non-financial
outcomes and externalities of investments. Impact
investing aims to generate a measurable, beneficial
social or environmental result alongside a financial
return.8 Blended finance is the strategic use ofdevelopment finance and philanthropic funds tomobilize private capital flows to emerging andfrontier markets (e.g. OECD 2018). The newly
developing SDG investing takes considerations ofissues beyond traditional ESG, using the United
Nations’ Sustainable Development Goals (SDGs)
as a framework.

Investor Motivations
Each investor has specific investment objectives
and strategy, its own legal mandate, and particular
expectations placed on it by its beneficiaries andthe society within which it operates. Therefore,
responsible investment has no singular motivation,and there is no single strategy or set of approaches
that is followed universally (Dimson et al. 2013).9
There are many investor questionnaires undertaken
on ESG, and they vary widely in many respects,
which may reflect different universes, concepts
and languages, among other reasons. Most surveys
confirm that ESG is most prevalent in listed
equities. According to CFA (2017), 45% of fixedincome investors integrate ESG analysis comparedto 76% for listed equities (and much fewer for otherasset classes). However, many investors plan toenhance ESG in the future in fixed income, private
assets and alternative asset classes. There areseveral drivers for this development: preferences ofmembers, clients and other stakeholders; increasingawareness of climate change risks and policies byinvestor boards; social and political concerns; legal
and regulatory changes; voluntary codes; fiduciary
duty; technology change and disruption; andreputational risks; public and peer pressure.

Financial and non-financial objectives
Institutional investors must be able to reconcile theiractions in terms of ESG issues with their obligations
to members, beneficiaries, policyholders and clients,and look to use their investments for a positive social
purpose. For most investors, the main objectives arefinancial results (e.g. risk-adjusted returns, liabilitymatching cash flows). Some investors also have nonfinancial objectives (e.g. ethical, religious, political,
cultural values and preferences) beside financial
objectives. ‘Reputational/ brand’ motivations canalso play a part. The potential trade-off between
financial return and ESG is still being debated byinvestors. This is not so clear, even in theory, andtherefore the debate is mostly driven by ‘beliefs’. On
the one hand, considering ESG as risk factors should
contribute to more stable returns over time. However,by narrowing the potential universe of investments,
ESG could lower returns. Further theoretical andempirical work on this issue – particularly for the
fixed income universe – is required.

Short-termism and long-term investing
The priority, or even exclusiveness, of financial
objectives does not preclude the considerationof non-financial factors in the analysis andmanagement of investments. This may lead to an
improved understanding of long-term trends. Assetowners are trying to move towards longer-term
investment frameworks than in the past.

ESG as risk factors vs ESG as aninvestment opportunity
Investor motivations are often driven by risk
management, i.e. the relevance of environmental,social or governance risks. The risk aspect isnaturally a main concern of insurance companies and

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT|3other low-risk investors. However, some investors
also look at ESG as an investment opportunity,seeking “alpha”. For example, ESG analysis may
improve the understanding of longer-term trends.
Some investors even find new investment targets in
the green and social space.
In practice, ESG investors can broadly be classified
into three groups:• For a large group of investors, the sole purpose
remains financial performance, but with a belief
that ESG factors have a material effect on
investment risks and returns.

• Increasingly investors seek to combine certain
non-financial objectives (e.g. ethical, religious,
political, cultural, societal values and preferences)
without hampering financial objectives.
• Certain investors are willing and able to sacrificesome or all financial return to achieve other social
or environmental benefits (impact/community
investing; charity investing).
There is plenty of general ESG guidance alreadyavailable for all types of investors, offered byvarious organizations (Box 1).

Box 1: ESG Investor Associations, Standards and Codes
Asset owners and investment managers haveformed or joined a range voluntary associations
and networks in the field of ESG, corporate
governance, climate change, and related issues.
There are also other voluntary codes many
investors comply with. Many of them are at thenational level (e.g. by pension fund organizations).
Here are some important international examples:

Responsible and sustainable investment

Green and climate change investment
Associations• Institutional Investors Group on Climate
Change (IIGCC)• Investor Group on Climate Change (IGCC)• Asia Investor Group on Climate Change(AIGCC)• GIC global platform• Ceres• UN Global Compact (UNGC)• UN Principles for Responsible Investment (PRI)• EuroSIF, UKSIF, USSIF, SIF Japan, ASrIA,RIA Canada, RIA Australasia, etc.
• Global Sustainable Investment Alliance (GSIA)• Equator Principles• International Capital Market Association(ICMA) Green Bond Principles (GBP) andSocial Bond Principles (SBP)

Initiatives

Corporate governance, accounting anddisclosure

Industry guides• International Corporate Governance Network(ICGN)• Global Reporting Initiative (GRI); Global
Sustainability Standards Board (GSSB)• Sustainability Accounting Standards Board(SASB)• The FSB Task Force on Climate-related
Financial Disclosures (TCFD)

4 | 1. INTRODUCTION AND BACKGROUND• Carbon Disclosure Project (CDP)• Asset Owners Disclosure Project (AODP)• Montreal Carbon Pledge• Portfolio Decarbonization Coalition• Action 100+

Impact investing• Global Impact Investing Network (GIIN)
Practical investor guidance on ESG investing canbe found in many publications by the industry andorganizations such as the CFA, PRI, SSF (2017),
BNP Paribas (2016). More specifically on fixedincome, see, e.g., PRI (2014), Klein (2015). For
guidance on climate change investing, including
the implications for fixed income, see, e.g., IIGCC(2015), Mercer (2015), Forum Ethibel (2017).

ESG and regulation
Regulation can be both a driver and a barrier for ESG
investing. For example, a relatively prescriptive
approach is being proposed in Europe, whilst
interpretations of regulation in Asia have been morevoluntary but supportive. In North America, a lack ofinterpretation around existing laws is still felt to be abarrier to further ESG integration by some investors.
Some main trends are summarized in Box 2.
The debate over whether ESG investing iscompatible with investors fiduciary duty10 has also

been developing over time. From initial rulings
requiring fiduciaries to only consider financial
returns when acting in the interest of beneficiaries,
interpretation developed so that considerationof other factors was not seen a fiduciary breach.
Guidance is now going a step further and insome cases requiring fiduciaries to incorporate
ESG factors into their investment decisions.
For example, the United Nations Environment
Programme (UNEP publication (UNEP 2015)concluded that: “failing to consider all long-term
investment value drivers, including ESG issues, isa failure of fiduciary duty”.

Box 2: ESG and Regulation
It is important to distinguish between ESGspecific regulation (e.g. for companies), investor
regulation, and other rules and laws that may affect
ESG investing positively or negatively. Investor
regulation may include funding and accounting
regulation, or even outright investment constraints
on certain asset classes and instruments.
Regulation also applies at different levels:
company, investment manager/fund, asset owner(e.g. PRI 2016a, Northern Trust 2015). OECD(2017) summarizes the main developments:• Regulatory frameworks for investment
governance rarely make explicit reference
to ESG issues, although this is changing in a
number of jurisdictions such as France, theNetherlands, Chile.
• Several countries have some form of ESG
reporting and disclosure requirements for investors(e.g. Australia, France, Germany, Sweden, UK).
• Regulatory frameworks for the most part do notprevent ESG integration, and other legislationor voluntary codes may encourage institutional
investors to take ESG factors into account (e.g.
USA, UK, South Africa, Ontario).
• However, institutional investors may lackclarity as to how ESG integration fits with theircountry’s legal, regulatory and other obligations.
Many asset owners considered fiduciary duty as
an obstacle to ESG integration but there seems
to be a shift from a “narrow” to “broader”
interpretations (OECD 2017).

• The EU High-Level Expert Group on Sustainable
Finance published several investor-related
proposals (EU 2018).   In 2018, The European
Commissions announced plans for establishingan EU taxonomy/classification system forsustainable activities, creating EU labels for green
financial products, clarifying fiduciary duties
of asset managers and institutional investors,
enhance corporate reporting, among others.
• In 2015, Article 173 of France’s law on ‘Energy
Transition for Green Growth’ introduced
mandatory climate change reporting for financial
institutions. This has been hailed as groundbreaking with potentially far reaching implications.
• Furthermore, many countries have stewardshipcodes, corporate disclosure codes or stock
exchange rules that cover governance and other
ESG issues. The Stewardship Code issued by
Japan’s Financial Services Authority (JFSA),
released in 2014 (revised 2017) is said to havebeen particularly influential, and indeed was
one of the drivers for the GPIF to adopt ESG
principles within their investment approach. In
addition, there are various principles and bestpractice guides available for governments andinvestors by international organizations such as
the UN and the OECD.
At the end of 2017, central banks and regulators
initiated a new Network on Greening the Financial
System, aimed at sharing supervisory practices
on climate change and other environmental risks.

INCORPORATING ENVIRONMENT, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT|5ESG and Impact Investment
Approaches

sector and factor biases in the portfolios. Suchissues need to be well managed.

Investors use a range of methods for bringing ESG
considerations into their decision-making. They
were traditionally applied to equity investments, but
are also being used for fixed income and other asset
classes. These methods are not mutually exclusive
and are often used in combination. Furthermore, thevarious ESG approaches can be implemented withactive or passive investment styles. ESG integration,
engagement and screening capture about 99% ofassets, with themed and impact investments making
up the remaining 1%.11

Active ownership/voting/engagement/
stewardship:

Negative/exclusionary screening:This involves excluding securities of specificactivities or industries (e.g. controversial weapons,
tobacco, fossil fuels) deemed unacceptable. Reasons
may be ethical, legal or other norms and standards(e.g. human rights, labor conditions, corruption).

Positive screening/best-in-classselection:
This is a positive selection or overweighting ofcompanies or countries with better or improving
ESG performance relative to sector peers. It can be
implemented on either the level of ESG measuresor their potential for change (ESG momentum).
An immediate concern with exclusions or best-inclass is the potential reduction of the investment
universe. Also, screening may lead to unintended

This refers to the practice of entering into a
dialogue with companies or countries on ESG
issues and exercising both ownership rights(including. voting) and “voice” (especially relevantin cases where investors do not have voting rights,
such as bondholders) to effect change. This is analternative to “exit”, i.e. selling off the investmentswith questionable practices, or divesting based on
specific issues (e.g. removing exposure to fossil
fuels as ‘stranded assets’). Some investors also liketo lobby for ESG themes more widely in politics.

ESG integration:
This is the systematic inclusion of ESG risks andopportunities in investment analysis, portfolio
construction and risk management. It is being
implemented in different ways across investment
organizations.12

Thematic investing:
A number of investment themes are based on ESG
issues, including clean technology, renewableenergy, energy efficiency, sustainable forestry andagriculture, water, education, health and diversity.
Climate investing more broadly is receiving
increasing attention (see Box 3).

Box 3: Climate Investing
Since Paris COP21, more investors have developed
practical climate change policies. They are often
simple green thematic investing or included in
traditional ESG policies. For some investors, they
go well beyond. They include, among others:• climate change scenario analysis in asset allocation;• measurement of carbon emission/carbon
footprint;

6 | 1. INTRODUCTION AND BACKGROUND• gradual decarburization targets for portfolios;• exclusions/underweight of particular industries/
companies (e.g. coal, fossil fuels);• energy efficiency targets (e.g. in real estate);• green infrastructure investments (e.g. clean
energy, climate change adaptation);• green and climate bonds;• divesting, and the concept of “stranded assets”.13

Impact investing:In general terms, this is investing with the intention
to generate and measure social and environmental
benefits alongside a financial return.14 Impact
investors typically set  outcome goals or targets ex
ante, make and monitor the investment and thenmeasure ex post results. They try to strike a balance
between an economic and social return – with avarying emphasis, depending on the specific impact
project/fund.
There are different approaches to impact investing.
The early developments were more in the way of“community investing”, i.e. investments by small
funds to help fund smaller social or environmental
projects in municipalities/regions. As a new
development, impact investing has spread also to
non-specialist investors. Mainstream investors
now feel urged to measure the ‘impact’ of theirportfolios, but are generally not mandated to giveup financial return.
There are various motivations behind this move,but two in particular standout (Figure 1). First is
the increasing influence of millennial investors.
According to a survey conducted in the UnitedStates by Morgan Stanley (The Economist 2017),
75% of millennials agreed that their investments
could influence climate change, compared with 58%
of the overall population. They are also twice as
likely as investors in general to invest in companies
that espouse social or environmental objectives.
As ‘The Economist’ article quotes: “boomers see
doing good as separate from investing; whereas
millennials don’t see how you could possibly
separate the two.”
Impact investing covers all asset classes, including
bonds (e.g. social impact bonds), private equity
and private debt (GIIN 2017). Returns can show
low correlations with mainstream asset classes asincome is typically not related to financial markets(SSF 2017).

Measuring “impact” is not an easy task. Many
investors are still not clear what appropriate metrics
should be for the measuring impact on E, S and G
individually, and collectively or indeed whether
there should be a ‘one size fits all’ approach. The
most advanced metrics in this respect appears to
be carbon emissions/footprint. GIIN developed
impact reporting and investment standards (IRIS),
i.e. a catalogue of performance metrics for various
sectors. New research is being undertaken in thisfield.15

SDG investing
The second major driver for impact investing has
been the publishing of the SDGs. In 2015, theUnited Nations approved the 17 SDGs and 169
individual targets. The SDGs were not primarily
made for investors but achievement of the Goals
recognizes the necessary contribution of all,including the private sector and investors. It is lessclear what these contributions look like for sucha broad range of targets. Sometimes it is easier
to address an SDG through investment decisions;sometimes it is easier to incorporate the SDG in
active ownership (PRI 2017b).
SDG-related investment is still in its infancy. The
analysis currently focuses on mapping investors
corporate holdings to a selection of the SDG.
Several investors such as the Dutch APG and
PGGM, or the Swedish AP2 are trying to workout investment possibilities associated with SDGs.
One of the commonly stated obstacles is thechallenge surrounding impact measurement. Some
organizations are working on investor-relevant
SDG impact indicators and metrics (e.g. DNB
2017, Trucost 2017). The Investment Integration
Project (TIIP) is a further initiative looking to help
investors map the link between the investments intheir portfolio and the SDGs (TIPP 2018).16

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT|7

Figure 1: Impact Investment Drivers
Investing forMillennials

Millennials Want to have an Impact
Percentage of Respondents Who Agree

My investment decisions
are a way to express mysocial, political, or
environmental values.
Millennials
67%
Gen X
44%
Baby Boomers
36%
69+ Years
34%

It is possible to achieve market
rate returns investing incompanies based on theirsocial or environmental impact.
73%
61%
58%
47%

Sustainable Investing
86%

61%

are “very
interested”
or “interested”
in sustainable
investinghave made atleast onesustainable
investment
action in thelast year

75%

84%

think theirinvestments
can influence
climatechangethink theirinvestments
can help fightpoverty

ImpactInvesting

SDG Impact Indicators
A Guide for Investors and Companies

Source: U.S. Trust Insights on Wealth and Worth, 2014, Harvard Business Review (October 3 2014), Morgan Stanley (on-line presentation
August 9 2017), Visual Capitalist (on-line presentation August 11 2017), and DNB (2017)8 | 1. INTRODUCTION AND BACKGROUND

2. What is ESG

Analysis in
Fixed Income
Investing?

S

ince most ESG research has been
undertaken on equities, it is less clear to what
extent, how and when ESG considerations can beapplied to fixed income investments. Applying ESG to otherasset classes requires  adaptation (e.g. Johnson 2017). Fixed income
management consists of several building blocks, including the analysis ofinterest rates, inflation, credit quality and liquidity risks. Fixed income investment
is very much a quantitative process. Managers find it difficult to include ESG criteria intheir financial models, and may therefore be more ‘resistant’ to ESG-related change.17
There are a number of key differences between
equities and fixed income, especially the focus on
downside capital risk and cash flow stability vs.
upside, capital appreciation:• Creditworthiness and the ability to pay back debt
are key - therefore, there is a focus on credit anddefault risk
• Asymmetrical downside risk vs. upside potentialof fixed income investments;• Duration (fixed income investments have a finite
period vs. equity holdings which can be perpetual);• Position in capital structure, and with different
layers (e.g. senior, subordinated debt, hybrid);• Trading of fixed income products largely OTC/
off-market;• The difference between bondholder rights andshareholder rights;• The importance of sovereign, sub-sovereign,supranational and agency issuers;• Different analytical approaches (e.g. duration,yield curve, spread management);• The specifics of asset-backed securities, projectbonds and other instruments;• The high share of institutional participation incorporate bond issuance;• The use of bonds in long-term liability management
by insurance companies and pension funds;• Issues around market capitalization-weighted
indices (with heavy weights to debt-ridden issuers);• The rising importance of private debt in investor
portfolios.
There are implications of these differences for
ESG investing in fixed income compared to equity
analysis (see Appendix 3 for an overview by the
PRI 2014):  

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT|9• Engagement policies will look different for equity
and bond holders;• Sovereign (along with sub-sovereign andsupranational) issuers are fundamentally different
from corporate issuers;• Event risks can dominate issuers’ creditworthinessand downgrades;• In fixed income, liquidity can suddenly dry up
even for large issues;• Risk analysis needs to apply to various corporate
levels (holding company, subsidiaries, special
purpose vehicles (SPVs), originators);• Bonds can be complex contracts (e.g. attachedcovenants, embedded options), also in relation to
ESG risks;• Concentration risk rises for issuers with multiple
securities;• Debt-related benchmarks may be even more
problematic from an ESG perspective (e.g. therelationship between a high debt load and poor
governance/institutions);• Fixed income indices are more difficult to compile(as fixed income indices include multiple bonds
per issuer, multiple issuers per corporate family,
private companies where data is hard to gather,and non-corporate entities, covered bonds andother asset-backed securities etc.).
The relevance of the various ESG approaches
varies across asset classes and across types of fixedincome securities, although views seem to differ on
this. Ngo (2016), e.g., finds significant scope for
integration but limited scope for other strategies
with sovereign issuers (Figure 2). SSF (2017) also
distinguishes between active and passive corporates,
but comes to rather different conclusions.

Figure 2: Suitability of ESG Investment Strategies for Equity and Fixed Income
Investing
Equity Versus FIxed Income Investing

ESG
investment
strategies/asset
class

Ethical(negative/
exclusions)screening

Normsbased
screening

ESG
integration

ESG
engagement/
activism

ESG best in
class

ESG
(positive/
thematic)
investing

Equities

Significant
scope

Significant
scope

Significant
scope

Significant
scope

Significant/some scope

Significant/some scope

Fixed income:corporates

Some scope

Some scope

Significant
scope

Some/limited
scope

Limitedscope

Significant/some scope

Fixed income:sovereigns

Limitedscope

Some scope

Significant
scope

Limitedscope

Limitedscope

Limitedscope

Source: Ngo (2016)10 | 2. WHAT IS ESG ANALYSIS IN FIXED INCOME INVESTING?

We now look at the various types of securities inmore detail.

Corporate Issuers
Corporate governance factors (e.g., a company’s
accountability, risk management and director
independence) have strong links to credit strength.
Good corporate governance should lead to a higher
credit rating and lower cost of debt, and viceversa. Well-managed companies tend to be morealigned with bondholder interests, and corporatetransparency keeps bondholders better informed of
exposure and management of risk.
Poor environmental or social management may
lead to lower credit ratings and higher cost of debt.
The materiality of E and S factors vary considerablyacross sectors and industries. For example,
environmental issues are often relevant in energy,
utilities, resources and other heavy industries.
Water stress is likely to be material for certain
sectors, such as extractives, food and beverage,
and agricultural companies. For airline companies,
fuel efficiency may be a key environmental andfinancial metric.
ESG investing for corporate bonds is closely
related to established ESG process for listed
equities. For example, exclusion lists and ESG
screens tend to be very similar. However, there aresome significant differences.

Bondholder rights
As lenders of capital and not owners of shares,
bondholders generally have fewer obvious
opportunities to engage with companies, such as
exercising voting rights and speaking at AGMs.
However, bondholders can, in specific situations,demand transparency. They can consider engagement
during investor roadshows, at debt reissuance and incollaboration with other bondholders (Table 1). Bondissuers repeatedly come to the market; therefore, a
new debt issuance can be a good time around ESG
issues. On those occasions, it is possible to demandborrower disclosure of information on ESGrisk.
It can be argued that bondholders, in some aspects,
may actually be more powerful than equity holders.
In market conditions such as currently wherecompanies are buying back rather than issuing newshares, equity investors ultimately have the powerof divesting their holdings is an engagement is
unsuccessful. Bond holdings, by way of contrast,
frequently have to be refinanced at maturity. At thatpoint, the bondholder potentially has a lot of leverageover the company if they choose not to reinvest or
only to provide capital at much higher rates.
In practice, investors have shown different
approaches to bondholder engagement that range
from – the predominant – passivity to aggressive
activism used by some hedge funds (Celik et al.
2015). It should not be overlooked, though, thatbondholders’ interests may be conflicting withshareholder interests, especially in the short term.

Table 1: Engagement for Equity and Bond Investors
Product Feature

EquityBond

Dialogueüü

Request for increased transparency

ü

ü

Media

ü

ü

Buy and sell holdingsüüVotingü

X

Source: Aberdeen (2017)

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 11

Duration management

Private placements

Different ESG factors will present greater risks
over different time periods. In the short term,
investors face a greater threat from the fallout of
low-frequency, high-impact events such as extreme
weather or industrial disasters. Longer term, ESG
trends such as demographic changes and climatechange, are likely to have a significant impact onbond yields, but the extent of this is more uncertain.

They tend to have low transparency, large
ticket sizes, long maturities, and are difficult todivest. However, large creditors may be able tonegotiate more favorable covenants and reporting
requirements to address ESG concerns.

Liquidity
Liquidity tends to dry up when needed most, i.e. attimes of crisis, leading to expensive restructuringsof portfolios. Liability-driven investment (LDI)
strategies have typically long-time horizons. A buyand-hold strategy for investing in relatively illiquidbonds requires consideration of all pertinent risk
factors - ESG and others - over the relevant period.
Low liquidity of bonds can also be a potential
threat against a poor company. The sale of bondsby one investor can lead to price volatility, andsubsequently, to higher costs of capital for such a
company.

High yield bonds
Specific segments are potentially more exposed
to ESG risks. For example, high-yield issuers
tend to be smaller; many are private companies
and, therefore, do not have to report the same
information or operate to the same standards. They
are more likely to have unconventional governancestructures that may be misaligned with creditor
interests. The amount of leverage used by highyield issuers makes bondholders a critical sourceof capital alongside equity owners and can provide
meaningful opportunities for engagement withcompany management teams (Aristotle 2016).

12 | 2. WHAT IS ESG ANALYSIS IN FIXED INCOME INVESTING?

Sovereign Issuers
Analysis of company and sovereign creditworthinessis markedly different in all aspects of ESG. The
political and institutional system, macroeconomic
development, and government policies play a keyrole in assessing a country’s ability and willingness
to repay its debt on time. The relationship of risk
and return in sovereign instruments is complex, andnot linear (Schroders 2017a).
In terms of G, among the crucial factors are the ruleof law, the strength of the country’s institutions,political stability, regulatory consistency andcorruption. Energy/water/other resource reserves
and management, as well as green/climatechange policies are of varying importance for
creditworthiness across countries and periods.
Social factors tend to be given greater weight byanalysts than environmental factors because oflinks between political stability, governance and acountry’s ability to raise taxes or make reforms. Keysocial factors include human rights, labor standards,
education system, health care, and demographics.
There are pronounced differences in the applicationof ESG investment approaches to sovereign bonds,
and they can be politically sensitive. For example,
it implies the possible exclusion of whole country
issuances based on being outside of certain treaties
or conventions (Table 2). A widespread practice isto overweight “good” countries and underweight“bad” countries based on an ESG scoring system.

Table 2: Screening Criteria for Different Types of Issuers
Screening Approach

Corporate Criteria

Government Criteria

Financial Sector Criteria

Ethical/reputation
screens

Revenue derived from:• Tobacco• Controversial weapons• Nuclear energy• Pornography• Arms• Gambling• Alcohol• Animal testing• Adherence tointernational standards
on human rights andenvironmental issues(see below)• Use of capital
punishment• Financing or ownershipof business activities
listed under corporate
criteria (on left)• Origination of ABS
financing businessactivities listed under
corporate criteria (on left)• Predatory lending• Aggressive tax
avoidance schemes or
consultancy

Norms, standards andinternational laws

• Illegal activites• Export controls• International Labour
Organisation
conventions• UN Global Compact
Standards• Trade embargoes• US, EU, UN sactions• ILO conventions• Human rights
conventions• Montreal Treaty• Kyoto Protocol• World GovernanceIndicators• Ottawa Treaty (antipersonnel mines)• Convention on Cluster
Munitions (CCM)• Export controls• Whistle-blower policy• Regulatory compliance• Community
Reinvestment Act (US)• IFC PerformanceStandards• Equator Principles• International sanctions

Source: PRI (2014)

Naturally, engagement with sovereigns is quite
different from engaging with companies, andundertaken less in practice. Investors may seeka dialogue with regulators, policy-makers andstandard-setters (including officials from treasury
departments, government agencies and debt
management offices). The “size gap” between
investor and issuer may even be more of an issue
here than with large corporations. Collaborations
between investors may be particularly useful inbond holder engagements.
ESG information on governments is available
from UN bodies, the OECD, CIA World Factbook,
Transparency International, the World Bankand similar organizations. Certain segments ofsovereign bonds require particular attention.

Emerging market debt
Many investors find that ESG factors tend to beparticularly useful in the assessment of emerging
and frontier market bonds. Political and social
developments are often difficult to grasp, and they
may not be fully reflected in credit ratings or incurrent market prices. Regulatory frameworks
and transparency can be poor. Issuers may befollowing the IFC’s Performance Standards or theEquator Principles.

Sub-sovereign issuers
States, regions, cities and other entities can issue
bonds at a sub-sovereign level. Municipal bonds
are a very sizeable market (of about US$4tn) in the

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 13

USA, and used in other countries. Local government
bonds can be divided into two categories: generalobligation bonds backed by tax inflows, and revenue
bonds backed by revenues from a specific projectsuch as toll roads. Such instruments are often used
for economic infrastructure (e.g. transport, energy,
water, waste) or social infrastructure (e.g. schools
and hospitals). Local and project-specific ESG
factors come into play.

Supranational issuers
Supranational organizations, such as the World Bank(IBRD), IFC, Asian Development Bank, European
Investment Bank, European Bank for Reconstruction
and Development, regularly issue bonds to financedevelopment–related projects and businesses. These
organizations are typically considered low risk,
with good ESG practices and issue investmentgrade (AAA) bonds. As a result, ESG analysis on
supranationals tends to be more focused on their useof proceeds rather than on the creditworthiness of
the issuer itself. Supranational have issued labelledbonds such as green, social and/or sustainable bonds
to raise awareness for certain types of development
programs and priorities, responding to investor
interest in investing for purpose.

Other Debt and Securities
There is a range of other fixed income securities
in investor portfolios, often issued by banks orfinancial sector companies.

Asset-backed securities (ABS)
ESG analysis of ABS needs to capture risks relating
to the originator of the securities, the servicer andthe ‘cover pool’ of assets, respectively. Investors
should also consider how ESG factors might
affect the financial sustainability of ‘asset pools’ or
standalone projects covering the security, such as
auto loans and mortgages. In some cases, investors
focus on the use of proceeds for a particular ABS
issued (monitoring the composition and changes in
the pool of assets).

14 | 2. WHAT IS ESG ANALYSIS IN FIXED INCOME INVESTING?

Covered bonds
Covered bonds ae a particular type of ABS,
predominantly financing residential mortgages andpublic-sector loans. As with ABS, investors should
consider ESG risks relating to the issuer and thesustainability of the assets themselves. If a bankseizes a defaulted issuers’ assets, it also takes on its
liabilities, which may include fines, ongoing legal
costs and environmental clean-ups.

Insurance-linked securities
Insurance-linked securities (ILS) are financial
instruments tied to certain risk events, e.g. weather.
Catastrophe bonds (CAT bonds) are risk-linked
securities that transfer a specified set of risks from(re)insurance companies to investors. There is anatural connotation to climate change risks here,
and, as proceeds are used to rebuild communities
after disasters, a link is sometimes also made tosocial investing.

Structured products
There are many other structured fixed income
products that are being used in investor portfolios.
They typically carry augmented risks of complexity
and transparency. The mapping of ESG factors will
be particularly tricky.

Private debt
Private equity appeared much later on the ESG
radar screen than listed equity. Private debt plays
an increasing role in the portfolios of insurancecompanies and pension funds, e.g. corporate,
real estate and infrastructure loans. This has been
spurred by a lengthy period of low interest rates andby the partial withdrawal of traditional banks fromlonger-term lending following tighter regulation(e.g. Basel III). As for all private assets, there areaugmented issues of liquidity and transparency.
There is still little experience on the side of investors
on the connection to ESG issues.

To summarize, ESG investing in the fixed income
space is gradually catching up with equities although it is facing its own challenges. It is moreadvanced for corporate bonds where, for example,
engagement teams are working across asset classes
and interacting with companies where they havedebt as well as equity holdings. A survey by PRI(2017a) finds corporate bonds are better covered
than sovereign bonds by ESG analysis, while
securitized assets are far behind in this respect – butmore research and developments can be expected inthese other classes (Figure 3).

Figure 3: Level of ESG Incorporation in Fixed Income

Source: Authors

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 15

16 | 2. WHAT IS ESG ANALYSIS IN FIXED INCOME INVESTING?

3. ESG and Financial

Performance– Main Research
Findings

M

any studies have been published withthe purpose to establish an empirical link
between ESG and financial indicators. Much of
the research focus in the past was on equities but more studies
relevant for fixed income have been undertaken in recent years. 18

A comprehensive survey article summarizes
the results of 2,200 primary and review studies(Friede et al. 2015). Roughly 90% of studies finda nonnegative relation between ESG and corporate
financial performance (CFP). However, the findings
are more neutral/mixed for ‘portfolio studies’, i.e.
using portfolio data19 (including ESG funds andindices) rather than single firm data.  There are only
a comparatively small number of studies for nonequity asset classes. “The share of positive votes forthe 36 analyzed bond studies stands at 63.9% – with
13 neutral or mixed findings (36.1%).” (p. 222)
How do ESG factors influence the financial
performance of fixed income investments?

• default risk; credit default swap
(CDS) spreads;• bond price performance; yields;• market risk;• company value;• country economic growth and other macro
variables;• other proxy variables for performance.
Fixed income investors are particularly interested
in the relationship between ESG and credit risk, i.e.
how environmental, social and governance factors
may affect creditworthiness. There are two further
strands of research as studies typically concentrateon either companies/corporate issuers or countries/
sovereign issuers. The former appears to be moreadvanced while the latter had been surprisingly
overlooked for a long time.

The various researchers take different approaches,and use very different methodologies, data sets andtime frames. They try to give a better understanding
on a number of key questions of the relationshipbetween ESG factors and:Corporate Bonds• cost of capital (debt and equity);• credit risks; credit spreads;• credit ratings;

Several studies have looked at the relationshipbetween corporate bond performance and ESG.
Here are some examples of industry and academic
research.

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 17

Barclays (2015, 2016) studied the impact of
ESG on the performance of US investment-grade
corporate bonds (between 2007 and 2015) andfound that a high ESG rating results in a small
but steady performance advantage. The effect wasstrongest for a positive tilt towards the G factor,
while favoring issuers with a strong E and S rating
was not detrimental to bond returns. Also, issuerswith high G scores experienced lower incidence ofdowngrades by credit rating agencies.
In a different approach to pricing ESG risk, Hermes(2017) relates its proprietary measure of ESG risk
– the QESG Score – for companies to credit default
swap (CDS) indices. Companies with the lowest
QESG Scores tend to have the widest CDS spreads
and broadest distributions of average annual CDS
spreads. Moreover, credit ratings do not accuratelyreflect ESG risks and thereby do not serve as asufficient proxy for ESG risk.
Insight Investment (2016) looks at one particularapproach, i.e., exclusions, in a corporate bondportfolio. Broad ethical screens are likely to havea minimal effect on long-term returns but more
focused screens could have a larger impact. The
direction of impact – i.e. whether the exclusions
lead to performance being better or worse than therelevant index – cannot be predicted.
For corporate bond issuers, good/bad ESG
management corporate social responsibility (CSR)
behavior is rewarded/penalized by lower/higher
bond yield spreads, according to research by
Oikonomou et al. (2014). Similar results apply tobond ratings. In their research, Bauer and Hann
(2010) conclude that environmental concerns areassociated with a higher cost of debt financing
and lower credit ratings, and that proactive
environmental practices are associated with a lower
cost of debt.
Hsu and Cheng (2015) found that socially
responsible firms usually perform better in termsof their credit ratings and have lower credit risk
(in terms of loan spreads, defaults). Positive ESG

ratings are associated with reduced financial risk
while negative ESG performance scores lead toincreased financial distress. Investors respond more
to positive ESG ratings.20
In contrast, Amiraslani et al. (2017) detected no
relationship between corporate social responsibility
and bond spreads over the period 2005-2013.
However, during the 2008-2009 financial crisis,high-CSR firms benefited from lower bond spreads.
Hoepner and Nilsson (2017a) argue that bonds issuedby companies with “no strengths, no concerns, andno controversies” significantly outperform themarket. These findings are particularly strong intimes of market turmoil.
Infrastructure bonds are a growing segment
in investor portfolios. Kiose and Keen (2017)
tested the financial risk implications of social andenvironmental risk factors. Carbon emissions andindependent directors on the board are significant
in this respect.
A review of research for investment grade (IG)
corporates by Allianz (2017a) summarizes:• Within investment grade bonds, issuers withmaterial ESG risks and persistently low ESG
scores are to be avoided (also for tail risks);• Expected ESG momentum (positive or negative)
may not be fully priced into the markets;• An exclusion filter seems to lead to no significant
performance impairment.
There are contrasting views. Cantino et al. (2017)conclude, from their review of ESG and financial
capital structure, that there is some consensus on
the positive effect of ESG on the cost of equity.
However, “results concerning the relationshipbetween ESG sustainability and debt financing are
ambiguous and no clear-cut defined” (p. 124). In histheses, Bektić (2018) argues that the conclusions
on ESG factors in corporate level returns are still
mixed and therefore premature.

18 | 3. ESG AND FINANCIAL PERFORMANCE – MAIN RESEARCH FINDINGS

Sovereign Bonds
In sovereign debt analysis, in addition to assessing
an issuer’s ability to repay its debt, investors
are using ESG information to assess an issuer’s
willingness to repay. To date, most of the attention
has been on governance factors, such as institutional
strength and political risks.
One of the few academic research papers to study
the relationship between ESG and sovereign bondperformance is Capelle-Blancard et al. (2017). In
a comprehensive analysis of OECD sovereigns,
it concludes that countries with good ESG
performance tend to have less default risk andthus lower bond spreads. Moreover, the economic
impact is stronger in the long-run, suggesting that
ESG performance is a long-lasting phenomenon.
The environmental dimension appears to have nofinancial impact whereas governance weighs morethan social factors.
New industry research had been undertaken on
sovereign bonds, much of it focused on  ESG andcredit ratings. Allianz (2017b) finds evidence that
ESG risk factors are not fully reflected in sovereign
credit ratings. Bad governance is a key risk,
followed by social risks. Tail risk may be better
mitigated through ESG factor integration intosovereign issuer credit analysis.
Sustainalytics (2017a) reveals a positive correlation
between countries’ ESG and credit rating agency(CRA) ratings, and their ESG momentum and GDP
per capita growth. Blending CRA ratings with ESG
scores and momentum may help identify countries
that are undervalued or overvalued.
Other industry research focuses on ESG and credit
spreads. Lazard (2017) estimates the portion of theyield spread attributable to ESG considerations.
A strong relationship between a country’s ESG
standards and its creditworthiness/cost of borrowing
is particularly discernible in emerging markets.
High institutional quality is widely seen as animportant factor for sovereign creditworthiness.

Research by international institutions provides
some evidence. For example, using a data setof 90 countries, Qian (2012), shows that strong
institutions are associated with fewer sovereigndefault crises. In addition, when institutions are
weak, a more polarized government tends to default
more often.
Several individual governance factors suchas corruption or transparency have also been
scrutinized in this context. For example, Union
Investment (2014) considers corruption a key
indicator of sovereign credit strength in fundamental
evaluations because of the relationship between
fraud, tax avoidance, financial management and anissuer’s ability to repay its debt obligations. There
are strong correlations between corruption and thenumber of sovereign defaults. Choi and Hashimoto(2017) show that data transparency policy
reforms, reflected in subscriptions to the IMF’s
Data Standards Initiatives, reduce the spreads ofemerging market sovereign bonds.

Fixed Income Funds
Some researchers looked at the performance of
ESG/SRI fixed income funds and fund managers.
For example, Henke (2016) detected that during theperiod 2001–2014, socially responsible bond funds
outperformed by half a percent annually. This ismainly due to the exclusion of corporate bond issuerswith poor corporate social responsibility activities.
Outperformance is especially likely to occur during
recessions or bear market periods. Leite and Cortez(2016) detect cyclical patterns: European SRI funds
provide some protection in market downturns, butotherwise the verdict is mixed.
Hoepner and Nilsson (2017b) investigated the ESG
engagement activities of fixed income managers.
Funds from fund management companies not
involved in ESG engagement activities perform
significantly worse indicating the materiality of
ESG expertise and ESG engagement in fixedincome investments.

INCORPORATING ENVIRONMENT, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 19

Figure 4: Main Research Findings

Incorporating ESG factors
does not mean having to sacrifice return

ESG factors are material
credit risk

Source: Authors

In summary, there has been a growing research
effort to analyze the relevance of ESG factors in
fixed income. Whilst the methodology for individual
studies varies greatly and may be questioned,
overall, the growing body of research supports amore widely held view that: 1) ESG factors canconstitute material credit risk, and 2) incorporating
ESG factors does not mean having to sacrificing
return (Figure 4). There are some interesting early
results in this process but much more will need to
be done. PRI (2017a) produced some ‘takeaways’
at this juncture:• Both academic and market research supports thenotion that there is a link between ESG factors
and the credit risk of a borrower;• Most academic research is based on credit ratings
to measure credit risk and very few papers use
alternative measures (such as credit default
swaps);• Anecdotal observation of defaults, particularlyof investment-grade   corporates, highlightthat governance has a clearer link to corporate
failures, while environmental and social issues
are more difficult to capture;• Academic research exploring the link between
ESG factors and sovereign creditworthiness is lesswell supported. Nevertheless, there is evidence
on the impact of ESG factors on macroeconomic
variables and potential growth.
It is important to qualify the importance of researchfindings to date, and their application in theinvestment practice:• Most of the ESG research use past data. Past
results may not hold in future. Investment policy
cannot solely rely on a “majority vote” of past
research results.
• Difficulty in back testing some of the results
given limited historical data.
• Research typically finds correlation, and notnecessarily causality (DB 2012);• There is still little understanding and consistency
about how ESG “factors” relate to the establishedfactors in asset pricing models, such as value/
growth, size, liquidity;• The structure of economies and markets changes
over time, and so do policies. Investors need tomake decisions looking forward;

20 | 3. ESG AND FINANCIAL PERFORMANCE – MAIN RESEARCH FINDINGS• There may be (selection, data, size and other)biases at work. As ESG research matures, it will
face stronger scrutiny;• Research on ESG in fixed income is still very
limited;• Most of it is focused on credit risks. There is still
little analysis of the relationship of ESG factors
on market risks, inflation, liquidity, maturity,
term structures and yield curves, income stability,  
total returns, and other risks/opportunities such as
default risk or recovery rates;• Implementation costs (e.g. for transactions,management, reporting) need to be considered;• Investors are advised to apply their own additional
research and insights;• Different reporting standards results in a lack ofcomparability between findings.

Finally, some observers feel that – while certainly
relevant – financial performance has received
too much attention in recent times compared toconceptual research and empirical evidence on
extra-financial performances (e.g. Capelle-Blancard
and Monjon 2012). Overall, it is still early days forresearch on financial performance, and even more
so for non-financial performance, of ESG in fixedincome.
More robust research is needed on the link between
ESG and financial performance of fixed income
investments. Further academic, as opposed toindustry studies are needed, looking at the link
between fixed income and ESG factors usingtransparent methodologies, over longer time
periods, across a broader range of fixed income
assets and countries. Considering factors other thancredit risk is required to provide a solid base ofevidence as ESG fixed income investing becomes
more mainstream.

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 21

22 | 3. ESG AND FINANCIAL PERFORMANCE – MAIN RESEARCH FINDINGS

4. ESG Investment

Tools for
Fixed IncomeA

number of tools have been created overtime to assist investors in the analysis of ESG
risks and opportunities. Here, too, fixed income islagging equities.21 Nonetheless, a number of ESG frameworks
have been developed in recent times for bonds, in particular ESG scores22
and rankings for companies, countries and other issues as well as ESG fixedincome indices. First, an immediate question arising is, how ESG relates to the
traditional credit ratings that are a core element in traditional fixed income management.

Credit Ratings and ESG
A discussion is ongoing on the extent to which ESG
factors are relevant for credit risks, and in particularcredit ratings. Some investors have asked for aclarification of the role of ESG factors in credit
ratings, or demand an explicit integration of ESG
by credit rating agencies (CRA) (PRI 2017a).23

ESG incorporation
All major rating agencies say they already incorporate
ESG considerations in their traditional analysis (S&P
Global Ratings 2017, Moody’s 2017, Fitch Ratings2017). At the same time, they are deepening andwidening the research of ESG topics, in particularon climate change risks. They also want to improve
communication on these matters.

Materiality“Fitch Ratings’ criteria and analysis incorporate
environmental, social and governance (ESG) risk

factors, but only where they are relevant to theassessment of credit risk.” (FitchRatings 2017, p.1)
“Our objective is not to capture all considerations
that may be labelled green, sustainable or ethical,
but rather those that have a material impact on
credit quality.” (Moody’s 2017, p.3)

Time horizon
The focus is not on an exact time frame but on“the most forward-looking view that visibility
permits” (Moody’s 2017, p.3). S&Ps forecasts
generally cover a time horizon of up to two years
for speculative-grade corporate entities (that is,
those rated ‘BB+’ and below), and no more than
five years for investment-grade entities, but they
can go longer. For example, for E factors that affectsovereign ratings, the time horizon is 5-10 years.

Sectors
ESG themes vary widely  across sectors. According
to Moody’s, for example, 14 sectors have elevated

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 23

credit exposure to carbon regulations. S&P
counted 106 cases in the period 2015-2017 whenenvironmental and climate risks were a key reason
for a rating action, most notably in the energy,
resources and vehicle industries.

Sovereign issuers
For all CRAs, different sets of ESG factors are
relevant for corporate, sovereign and other issuers.
For sovereigns, S&P considers ESG factors in thecontext of the assessment of institutional quality andgovernance effectiveness, but also social cohesion,
climate change and other key factors. Moody’s
names 5 key ESG trends for sovereigns: countrycompetitiveness, government effectiveness, control
of corruption, rule of law or physical climatechange. For Fitch, governance indicators have thegreatest weighting for sovereign ratings.
Overall, credit ratings can only partially accountfor long-term sustainability risks, mainly becauseof the focus on materiality for credit risk and therelatively short time horizon. Other methodologies
have been developed to compensate for that
limitation, but fall outside the credit rating space.
Some investors would like the CRA to extend their
ESG output, including:• longer time horizons for ratings;• separate E, S and G factors;• more extensive ESG disclosures;• an ESG rating alongside the traditional credit rating.
CRAs have started to develop separate assessments
specifically for environmental and ESG risks.
On example of a specialist “E” product for a
popular financial instrument is Moody’s Green
Bonds Assessment.24 In 2016, S&P published two
proposals for a potential new ESG evaluation tool
as well as for a green bond scoring framework, both
separate from traditional credit ratings.

ESG Scores/Rankings
Generally speaking, an ESG score is measure ofenvironmental, social, and governance factors.

24 | 4. ESG INVESTMENT TOOLS FOR FIXED INCOME

Each ESG category has numerous underlying
factors that are analyzed and ranked, and then
combined in an aggregate ESG score for a sector,
region and an overall portfolio score. The scoring
methods and weightings for the E, the S and the G,
and the underlying factors may vary across sectors
and countries.
The most common ESG scores are at the microlevel and provide some measure of a company’s
ESG performance. There are also country-level
ESG scores that complement traditional methodsof assessing a country’s long-term economic
prospects, creditworthiness as well as potential
reputational risks.
There are external, commercial providers of ESG
scores. Although the methodologies are quantitative,
the assessments are inherently qualitative. Some
investors therefore also set up in-house, proprietary
ESG scoring systems, overlaying external
information with their own analysis. According to
Russell (2017), 52% of the respondent fixed income
managers utilize third-party vendors exclusively toobtain ESG scores. 35% utilize external vendors
with an in-house ESG analysis overlay. 15% only
use internal analysis. The two market leaders in fixedincome are currently Sustainalytics and MSCI, withinvestors and product providers overwhelmingly
relying on these sources.

Sustainalytics
Sustainalytics’ ESG scores give individual points
for companies’ E, S and G elements (0-100). The
overall ESG score provides an absolute measureof a company’s ESG performance as well as its
relative position within an industry. The set ofissues and specific weights vary by industry; atleast 70 indicators in each industry are covered(Sustainalytics 2017b).
For sovereign bond investors, there is also a country
ESG score that is based on 36 third-party indicatorsthat should complement traditional macro analyses.
It results in country scores for E, S and G separately,
and an overall ESG score (0-100). Finally, there isa country ESG rating ranging from A to E that isallocated on set standard deviations from the average.

MSCI
MSCI ESG Ratings identify 10 ESG themes with37 key ESG issues where companies can face large
environmental or social externalities. Corporate
governance is assessed for all companies, whereas
the rating model determines the most financiallysignificant environmental and social issues foreach sub-industry (Table 3). It ranks companies on

a 7-point ‘AAA’ to ‘CCC’ scale according to their
exposure to industry-specific ESG risks and theirability to manage those risks relative to peers. A
detailed description is given in MSCI (2017a).
The MSCI ESG Government Ratings assesses
government and certain government-related
issuers. Countries are rated on a 7-point ‘AAA’ to‘CCC’ scale and reflect how countries’ exposure to,and management of, ESG risk factors may affectthe long-term sustainability of their economies. The
ESG factors for government bonds include political

Table 3: MSCI ESG Key Issues for Companies27
3 Pillars
Environment

SocialGovernance

10 Themes

37 Key Issues

Climate Change• Carbon Emissions• Product Carbon Footprint• Financing Environmental
Impact• Climate Change
Vulnerability

Natural Capital• Water Stress• Biodiversity & Land Use• Raw Material Sourcing

Pollution & Waste• Toxic Emissions & Waste• Packaging Material &Waste• Electronic Waste

Environmental
Opportunities• Opp’s in Clean Tech
• Opp’s in Green Building• Opp’s in Renewable Energy

Human Capital• Labor Management• Health & Safety• Human Capital
Development• Supply Chain Labor
Standards

Product Liability• Product Safety & Quality• Chemical Safety• Financial Product Safety• Privacy & Data Security• Responsible Investment• Health & Demographic Risk

Stakeholder Opposition• Controversial Sourcing

Social Opportunities• Access to Communications• Access to Finance• Access to Health Care
• Opp’s in Nutrition & HealthCorporate Governance*• Board*• Pay*• Ownership*• Accounting*Corporate Behavior• Business Ethics• Anti-Competitive Practices• Tax Transparency• Corruption & Instability• Financial System Instability

Source: MSCI (2017a)* Corporate Governance carries weight in the ESG Rating model for all companies. Other Key Issues are assessed on an industryspecific basis.

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 25

risks, human rights and environmental issues. Asa practical example, Swiss Re (2017) applies aconcept of minimum ESG rating standards in theirasset liability management (ALM) approach.

Other providers
There are several more specialist services on themarket of company ESG scores of some sort,
including RepRisk, ISS-Ethix, Bloomberg, Thomson
Reuters/Eikon.25 Verisk Maplecroft, VigeoEiris andOekom Research also offer a sustainability rating
also for countries. Beyond Ratings and several
French banks have announced plans for a first credit
ratings agency to systematically integrate ESG
factors into financial ratings and provide investors
with an “augmented assessment of creditworthiness”
in 2018. In practice, investors often use more than
one external provider of ESG scores.

Sustainability rating for funds
ESG ratings for funds have been introduced
by a number of companies, including MSCI,
Barron’s and Corporate Knights. One example,
the Morningstar Sustainability Rating is a measureof how well the companies held by a fund aremanaging their ESG risks and opportunities
when compared with similar funds. It is basedon company-level ESG data from Sustainalytics.
Scores are aggregated to a portfolio ESG scoreusing an asset-weighted average of all covered
securities (equity and fixed-income). Funds are
sorted into five normally distributed groups (1-5stars).
However, criticism has been levied that the analysis
behind the ratings does not fully reflect the true
ESG level of integration or impact of the funds. For
example, no recognition is given to investors efforts
on shareholder engagement and public advocacy.
Furthermore, there is no consideration of the real
impact and managers with specific impact-focused
mandates – including those operating in emerging
markets or developing countries – can be penalized(e.g., Krosinsky 2018).26

26 | 4. ESG INVESTMENT TOOLS FOR FIXED INCOMECountry Scores
In addition, several fund managers and asset
owners have developed their own ESG scoring
systems, or variations using raw data from MSCIor Sustainalytics in a different way, especially atcompany level. Here are some examples for ESG
country scores. Developed countries typically farebetter than emerging, frontier markets - especiallywhen looking at ‘levels’ rather than ‘changes’. This
raises serious questions on ESG analysis in thesovereign space.

RobecoSAM
RobecoSAM’s is one of the more transparent
country sustainability frameworks. It evaluates 65
countries (22 developed and 43 emerging markets).
Standardized scores and indicator weights result ina country sustainability score ranging from 1 to 10(RobecoSAM, 2015). The framework is based on
17 environmental, social and governance indicators(each of which is based on various data series,
or sub-indicators). They are grouped in the three
E, S, & G dimensions, which receive a weight of15%, 25% and 60% of the total score, respectively(Figure 5 and Appendix 4). The selection andweightings of the indicators was primarily basedon their financial relevance for the assessment ofsovereign bond markets. The list is currently being
led by four Nordic states, Switzerland, Canada andAustralia.

DZ Bank
DZ Bank developed a sustainability rating forcountries that combines an ESG methodology (withraw data from Sustainalytics) with an economic
sustainability dimension, i.e. a four-dimensional
EESG analysis model. The weighting of E factors
is 20%, S 30%, G 30% and economic factors
30%. Countries are grouped into “sustainable”,“transformation states” and “unsustainable”. The
current list is being led by Nordic and middle
European states (DZ Bank 2015).

Figure 5: RobecosSAM ESG Weightings27
ESG Weights in the CSR, from Environmental Factors to Social Unrest and Aging Populations

E
15%
S
25%
G
60%

Environmental Status
EnergyEnvironmental Risk
Social Indicators
Human Development
Social Unrest
Liberty & Inequality
Competitiveness
Political Risk
Aging
Institutions
Six Other Factors

10%
2.5%
2.5%
10%
10%
5%
10%
10%
10%
10%
5%
15%

Source: RobecosSAM

Candriam

SDG scores

Candriam’s ESG country analysis is based on four
‘capital ‘domains to cover all the United Nations
SDGs: Human Capital, Natural Capital, Social
Capital and Economic Capital. These four equallyweighted factors have a number of sub-factors. The
overall ESG score includes components for boththe level and trend.

The Bertelsmann Stiftung and the Sustainable
Development Solutions Network (SDSN) developed
an SDG Index. Its scores signify a country’s
position between the worst (0) and best (100)outcomes. The 2017 index is led by 10 European
countries, followed by Japan (Bertelsmann 2017).
No application of SDG scores to fixed income is
known to date.

The Candriam ESG Country report (2017) analyzed
123 countries (35 advanced and 88 emerging
economies). 74 countries were categorized as
investible and 49 as non- investible. Of the 35
advanced economies analyzed, only Greece wasconsidered non-investable. Of the 88 emerging
economies (which have a lower inclusion
threshold), 40 were classified as investable and 48
non-investable.
Similar approaches have been developed byother investment houses, including BY Mellon/
Standish (2016), among others. Global Evolution,
Neuberger Berman (2013) and Lazard (2017) are
examples of ESG scoring models that concentrateon emerging markets.

ESG Fixed Income Indices
Investment managers usually organize theirinvestments around established investment indices.
They are typically used as performance benchmarksin active investing and for replication in passive
investing. Many fixed income indices are offeredby global or local index providers, and they all
differ in several respects. Some investors like to use
indices that incorporate ESG risk and exposures insome form.
However, unlike equities, not many ESG indices
are currently available for fixed income. This canpartly be explained by the fact that ESG integrationis newer in the fixed income field than in equities

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 27

(which was initially driven by shareholder voting
and stewardship). In addition, more data isavailable on public companies than other debt
issuers, particularly non-corporate entities.   Asnoted, the index compilers are also the providers of
ESG data, which clients then use to build their own
methodologies. Finally, there may also be ‘cultural’reasons, especially the fixation on traditional
quantitative analysis in fixed income.

These indexes are available for corporate andaggregate (corporate plus sovereign) but –interestingly - not for sovereign only benchmark
indexes. There are sub-indexes for different regions,maturities, currency-hedged, etc.

Barclays MSCIS&P Dow Jones

In 2013, Barclays and MSCI (now Bloomberg
Barclays MSCI) co-produced a new family ofrules-based fixed income benchmark indices. They
reflect three different ESG incorporation strategies(MSCI 2017b) (Appendix 45 for more detail):• The S&P ESG Sovereign Bond Index family,
started in 2015, is based on standard cap-weighted
sovereign bond indices but tilts the country
weights towards more sustainable countries,
based on RobecoSAM’s Country Sustainability
Ranking (S&P Dow Jones Indexes 2017).

• Socially Responsible Investment (SRI) indicesnegatively screen out issuers from existing
Barclays indices that may be involved inbusiness lines or activities that are in conflict withinvestment policies, values, or social norms (e.g.
controversial weapons). They can be customized
further for exclusion of specific issues (e.g.
Catholic values) (Table 4)• Sustainability indices use sector-specific positive
ESG screens to adjust weights in the direction of“best-in-class” peers. Issuers must have MSCIESG ratings of BBB or higher.
• ESG-weighted indices use MSCI ESG ratingslevels and momentum to adjust or tilt index
weights within an existing Barclays fixed income

index. This allocation rule is meant to reward
issuers that exhibit stronger ESG fundamentals,
as well as those that are demonstrating improving
fundamentals.

• Incorporating long-term sustainability as adimension of credit analysis aims to serve as
an additional, risk-reducing tool, especiallygiven that cap-weighted bond indices are highly
exposed to highly indebted and therefore risky
countries. Currently, there is only one such index
available: The S&P ESG Pan-Europe Developed
Sovereign Bond Index.

Other providers• Several other index providers are currently
working on ESG fixed income indices (e.g. FTSE

Table 4: Categories Available for Bespoke Screening
Abortion & contraceptives

Defense & weapons

Nuclear power

Adult Entertainment

Gambling

Pork

Alcohol

Genetic engineering

Predatory lending

Animal welfare

Global norms

Religious values

Board diversity

Global sactions

Stem cell

Child labor

Human rights

TobaccoSource: MSCI (2017b)

28 | 4. ESG INVESTMENT TOOLS FOR FIXED INCOME

expected to launch in 2018/19, UBS are working
on setting up sustainable indices for multilateraldevelopment bank bonds).

Green bond indices• Since 2014, various providers created indices to
exclusively cover green bonds. Eligibility criteria forinclusion, methodologies and coverage differ. Some
examples:• Bank of America Merrill Lynch Green Bond Index;• Barclays MSCI Green Bond Index;• S&P Green Bond Index and Green Project Bond
Index;• Solactive Green Bond Index;• ChinaBond China Green Bond Index.

Low carbon indices• Low carbon or carbon-efficient indices havebeen on the market for equities for some time
but are less common for bonds. In 2016, a new
Solactive SPG Euro IG Low Carbon Bond Index
was launched. The index covers investment
grade corporate bonds of companies that areless dependent on fossil fuels relative to higher
carbon-emitting peers.

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 29

30 | 4. ESG INVESTMENT TOOLS FOR FIXED INCOME

5. How is ESG

being Implemented
by Fixed Income
Investors?

E

SG investing is being implemented invery different ways by investment managers
and asset owners. Different types of investors will
naturally have different approaches, according to their size
(smaller institutions will be able to do less in-house), regulatory
framework (which can impose greater restrictions according to financial
sector, geographic location etc.), nature of business (some institutions are driven
more by ALM considerations than alpha returns) etc.

As a stylized description, it can take place at anyof these levels of investment operation, or any
combination: policy, investment process, products,
underlying assets (e.g. companies), marketing/public relations and reporting.

Table 5: ESG Strategies in Fixed
Income (by Volume of Assets)
Screening alone$2.3

ESG investing in fixed income is developing fastthese days. As a snapshot, a survey of 109 fixedincome managers by Russell (2017) found that 68%
of managers have integrated ESG somehow into theinvestment process. However, this means different
things to different people, and there are question
marks over the real implementation so far.

Thematic alone$0.1

Integration alone$9.6

Screening + integration strategies$5.8

Thematic + integration strategies$0.1

Screening + thematic strategies$0.4

Which ESG strategies are most commonly applied
by investors? For fixed income, a survey by PRI(2017a) finds integration ahead of screening andthematic investing. Only 6% of managers (by assets)
use all three approaches (Table 5). Furthermore,
corporate bonds are better covered than sovereign
bonds by ESG analysis, while securitized assets are
far behind in this respect.

All three strategies combined$1.4

No incorporation strategies applied$2.3

Grand total (actively managed)$21.9

Combined FI Approaches in US$TRN

Source: PRI (2017a)

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 31

For some investors, ESG investing is limited to theuse of ESG products (such as green bonds or an
SRI fund). Other investors have decided to follow
passively an ESG index for some asset classes.
Many asset owners are going down the route of
selecting active ESG managers or developing
active ESG in-house strategies for certain asset
classes. Finally, there is a ‘holistic’ approach withfull integration across all asset classes and risk
management (Figure 6). Here, the focus is on
specific applications for fixed income.
How these different approaches to ESG investing
are being applied by different categories of asset
owners and other investors is a topic which
deserves further research. Likewise, the success ofthe different approaches and tools is a topic which
this overview paper has not been able to delve into,
but also would be worthy of further study.

Green, Social, Sustainable and Other
Thematic Bonds
Thematic bonds or labelled bonds are bonds withproceeds earmarked to specific themes, sectors

or projects. In the ESG context, by far the mostpopular are “green bonds” and “climate bonds”,
but thematic “social bonds” and “SDG bonds”
have also been developing in recent years. Fundmanagers also offer thematic green or social
bond fund vehicles (e.g. the IFC/Amundi Planet
Emerging Green One green bond fund for emerging
markets, Threadneedle’s UK Social Bond Fund,
AIM/ Lombard Odier Global Climate Bond Fund).
Although growing in importance and recognized as acatalyst for the integration of ESG into fixed income
portfolios, the labelled bond market is still tiny – lessthan 0.1% of the total global bond market.

Green bonds
Green Bonds are defined as fixed-income
securities that raise capital to support projects oractivities with specific climate or environmental
sustainability purposes. Multilateral institutions
like the European Investment Bank (EIB) andWorld Bank led the issuance in the green bondmarket. Green municipal, state and corporate green
bonds followed, and high yield green bonds arestarting to develop.

Figure 6: Level of ESG Integration

Labeled
Bonds

ESG‘Passive’(via index)

ESG ‘Active’(mandatewith
specialist
manager)

Source: Authors

32 | 5. HOW IS ESG BEING IMPLEMENTED BY FIXED INCOME INVESTORS?

ESG ‘Holistic’(in-house
integration
across all asset
classes)

There are four types of green bonds: standard
recourse-to-the-issuer debt obligation, nonrecourse-to-the-issuer debt obligation, green projectbond and green securitized bond (covered, ABS,
MBS etc.). Proceeds are most commonly allocatedto renewable energy projects, such as wind farms,
or cleaner forms of public transport.
The labelled green bond market has taken off inrecent years (Figure 7). In 2017, over $160 billion
was issued, with over U$200 billion in green
bonds already issued between 2007 and 2016
(World Bank). A further $700bn outstanding were
unlabelled climate-aligned bonds.28 The WorldBank Treasury alone has issued USD $10.2 billion
in 138 green bonds in 18 currencies. Despite therecent growth rates, green bonds only constitutea small fraction of the overall global bond market
volume of $90 trillion, i.e. about ½%.
There is an ongoing discussion about the definitionof green bonds, and the setting of standards tofacilitate credibility and transactions (Ehlers
and Packer 2017). The voluntary “Green Bond
Principles” (ICMA 2017a) are widely used.29

The “Climate Bonds Standard and Certification
Scheme” provides sector-specific eligibility criteria
for assets and projects that can be used for climate
bonds and green bonds (CBI 2016). Green bondassessments are undertaken by companies such as
Sustainalytics, VigeoEiris and Oekom Research,
Moodys, Cicero and Trucost (now part of S&P
Dow Jones Indexes).
As the popularity and interest in the green bondmarket rises, issuers are increasingly stretching
the boundary of what qualifies as a green or social
investment. There is also an on-going debate onwhether ‘green’ projects from corporations withbroader investment objectives should qualify – someviewing this as a positive sign of change withincompanies, others concerned that ‘green washing’
could reduce the credibility of the market as a whole.
Second opinions on issuance, and stringent signals
from market players will increasingly be necessary.
Investors tend to hold green bonds over long
periods, which raises the question of verification of“greenness” over time – at a cost.
Issuance is also spreading across a broader range ofcountries (figure 8).

Figure 7: Labelled Green Bond Market Volume by Type of Issuer
Annual Green Bond Issuance By Issuer Type180
US$ Equivalent in Billions

160
140

Energy / Utility Companies

120

Corporates/Banks

100
80

Agency/State/Munis/
Other Government

6040Multilateral Development
Banks (MDB)

20
02007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Source: Bloomberg and World Bank (as of December 31, 2017)

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 33

Figure 8: Labelled Green Bond Market Volume by Country
2017 Green Bond Issuance by Issuer Country of Origin
US$ Equivalent in Billions

35
30
25
20
15
10
5
0

China

FranceSSA

Netherlands Mexico

US

Germany

Sweden

Spain

Other

Source: Bloomberg and World Bank (as of December 31, 2017)

There is also an on-going discussion on the pricing
of green bonds. The question is whether green bonds
do and/ or should price the same as non-directed
use of asset bonds issues by the same company, or
whether there is a ‘greenium’ (i.e. green bonds havea higher price/ lower yield than non-use of proceedcounterparts. Green bonds rank pari passu (on equal
footing) with bonds of the same rank from the same
issuer and there is normally no credit enhancement.
Climate Bonds Initiative and International FinanceCorporation (IFC) with support from Rabobank,
Pax and Obvion conducted a detailed analysis ofgreen bond issuance for the period January 2016 to
March 2017 comparing ‘vanilla’ and green bonds,
looking for any differences in pricing performance(CBI/IFC 2017). Some indicators have shown somedifferences (e.g. some green bonds do price tighter
than the Initial Price Talk when compared to some
corporate vanilla bonds), but generally pricing isvery similar.
At this stage concrete evidence to show or support
that green bonds perform differently or better
than other categories of bonds is non-conclusive.
This could be attributed to the market still being
immature and relatively small to provide a definite
position on the matter (secondary market trading
is very thin). However, the idea of a “greenium”

may not be farfetched when one considers the costissuers must put in to structure these bonds, monitor
and undertake periodic reporting during the tenureof the bond. On the other hand, investors too arefacing ongoing monitoring costs and low liquidity.

Social bonds
Bonds labelled as ‘social bonds’ are thematic bondsthat mirror the idea of green bonds. They are bond
instruments where the proceeds are earmarked tosupport new and/or existing social projects (ICMA2017b, IFC 2017). Criteria for their qualification
relate to both financial and social aspects. Social
themed bonds are used to fund social housing,education facilities, health care and other projects
that are either public sector or public–private
partnerships. ICMA also coordinate the Social Bond
Principles and the Sustainability Bond Guidelines.
This market is still nascent.

Social impact bonds
There are also other financing developments suchas Social Impact Bonds (SIB), as launched in the
UK, USA, Netherlands, Japan and other countries(OECD 2015). SIBs are not bonds in the traditional
sense and do not offer a fixed rate of return. A social

34 | 5. HOW IS ESG BEING IMPLEMENTED BY FIXED INCOME INVESTORS?

impact bond is a “pay for success” instrument, i.e.
a contract between a special purpose vehicle andthe government that commits to pay for improvedsocial outcomes (and that also result in public
sector savings), such as reduced recidivism rates
for prisoners.
A number of foundations, charitable trusts andpension funds have taken an interest in SIBs,
alongside venture capitalists and other investors.
There are currently nearly 100 SIBs in 19 countries,
mobilizing more than £300m of investment into
tackling complex social issues such as refugee
employment support, loneliness among the elderly,
rehousing and reskilling homeless youth, anddiabetes prevention. The potential social benefits of
SIBs are considerable, but the transaction costs are
high, and there are challenges in finding structureswith incentives that are properly aligned, making
rapid growth in issuance of SIBs unlikely.

Sustainable and SDG bonds
Sustainable bonds include a wider range of green,social, environmental, development impact,
microfinance bonds and loans, charity bonds andother debt instruments (European Impact Investing2016). The World Bank, for example, communicatesthat every project it finances is designed to achieve
specific social and/or environmental impacts,
defined by indicators and respective results that are
published and updated twice annually on the WorldBank website. All projects that are financed byWorld Bank bonds must fit with the organization’s
goals to end extreme poverty and boost sharedprosperity, also naturally aligning such project
objectives with the SDGs. From 2018 on, all WorldBank (IBRD) bond documentation will include
specific ‘Use of Proceeds’ language to explain howbond proceeds support sustainable development
projects and programs.
In addition to their general issuance, the World Bankand IFC continue to be a major issuer of labelled
and themed bonds. For example, in 2017, the first
SDG equity-linked bonds were launched issued by
the World Bank working with  BNP Paribas.30 HSBC

has also issued bonds connecting the issuance to
SDGs.31 In 2018, the WBG also issued sustainable
development bonds to raise awareness for women’s’and girls’ empowerment. Catastrophe risk bonds canalso be seen as sustainable investment products.32
The WBG is leading with other innovative financial
products, such as the Pandemic Emergency
Financing Facility, as well as products supporting
human capital investments and universal health care.
The World Bank and IFC, amongst others, arecontributing to the work on further refining theGreen Bond Principles. Guidance is also being
developed on social and sustainable bonds including
as they relate to the SDGs.

Passive Investing
Passive fixed income funds play an increasingly keyrole in institutional portfolios. ESG has historically
been first associated with active investing, e.g.
with norm-based exclusions or an active selectionof the best ESG-compatible stocks. More recently,
however, the attention on ESG considerations inpassive investing has been rising fast.
Pressure on large passive investment managers(such as Vanguard, BlackRock and State Street)has been rising to increase their stewardship efforts,
especially by using their many votes in shareholder
meetings and ongoing engagement with investee
companies.33 Passive asset owners can use active
ownership and engagement to manage their ESG
risks. However, they need a policy and systems toensure that different investment managers do nottake opposing positions while exercising active
ownership on behalf of the same asset owner.
ESG in passive fixed income funds has, so far, been
relatively little explored and used by investors.
Fixed income indices can assist the developmentof low cost ESG strategies, e.g. screening via an
exclusionary index or via an ESG tilted passive
portfolio. Investors are currently constrained by thelack of choice in this field, as they may have different
ideas about ESG factors and methodologies.

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 35

Exchange traded funds (ETF) are typically launchedbased on popular indices. The use of ETFs (but alsomutual funds) is also rising in this space. MSCI(2018) found at least a dozen “self-labelled” ESG
Fixed Income ETFs at the end of 2017.

Index customization / ‘Smart beta’
Indexes can often be customized to reflect the
specific needs or preferences of investors better.
Investors can, alternatively, deviate from establishedindices by using an internal “passive plus ESG
overlay” approach. An immediate concern in
relation to the increasing index customization inthis field is the lack of comparability of strategies,
and performance by asset managers. Higher fees
may also come with it.
“Smart beta” or “alternative beta” investing isa variation of passive, using an index that is notweighted by market capitalization-weighted but
by other risk factors, minimum volatility or equal
weights. There are some ESG smart beta products
in equity but not (yet) in fixed income.

Active Investing
ESG funds of all sorts have been mushroomingin the asset management industry in recent years.
Active fund products are also growing in the fixedincome space (e.g. Pimco’s ESG Global Bond
Fund; BlueBay or M&G ESG global high-yieldbond funds). Specialist ESG asset managers, suchas AIM (Affirmative Investment Management) andTrillium, are also growing.
Active managers use a variety of tools to develop
their ESG approach, all based on some form of
ESG scoring (see earlier section). Asset owners
can buy these products “off the shelf” but many
also define bespoke ESG investment mandates
for active investment managers. These can extend
to all approaches of ESG investing, ranging fromindividual exclusions to best-in-class. A summaryof guides on how to give mandate/ appoint external
asset managers is provided by the PRI (2013).

ESG ‘Holistic’
Asset owners, especially larger ones, apply morecomprehensive sustainability strategies.   Theintention is a full integration of ESG across all
steps in the investment process and all asset classes.
Different in-house integration techniques are being
applied by different investors.
From an organizational perspective, ESG is often
the job of a few “specialists”. Some investors,
however, gear up the whole organization to ESG.
Foremost, a ‘full’ ESG approach requires a clear
strategic plan, including at all levels of governance,starting with the Board. In practice, various
approaches have emerged:• Separate team of ESG specialists;• Integration of ESG expertise in analyst, portfolio
and risk management teams;• Confining ESG reporting resources in marketing/
PR/middle or back offices.
Looking at insurance companies, Swiss Re has
recently implemented an ESG framework acrossasset classes for universe definition, performancemeasurement and portfolio monitoring, andswitched to ESG benchmarks for both equities
and fixed income (Swiss Re 2017). Examples of acomprehensive (and different) ESG strategy in thepension fund environment are PGGM and EAPF.

PGGM
An example of such an implementation frameworkis the three-pillar approach by the asset manager
PGGM, which manages funds on behalf of the largest
pension funds in the Netherlands (Figure 9). The
framework uses six instruments (exclusions, ESG
Integration, engagement, voting, legal proceedings
and investing in solutions, including green bonds).
PGGM starts with a negative screening policy
with investments in areas such as tobacco, types
of weapons etc. excluded from all portfolios.   Inaddition, three sustainability goals are embedded in
the 2020 Strategic Policy.

36 | 5. HOW IS ESG BEING IMPLEMENTED BY FIXED INCOME INVESTORS?

Figure 9: PGGM ESG Approach
PGGM’s Instruments for Responsible Investment
CHANGE

What We Want to Improve

What We Want to Stimulate

Direct exclusions
Controversial weapons
TobaccoMaking companies and markets
more sustainable through ESG
integration, active ownership andcollaboration with financial
service providers

Creating social returns in theares of:
Climate and environment
Water
HealthFoodWhat We Do Not Want

Exclusions after engagement on:
Human rights and social
circumstances
Environment
Corporate governance





YES

Asia

NO






Instruments:
ESG integration (including ESG
Index)Engagement
VotingLegal proceedings

Instrument:
Investing in solutions

Instrument:
Exclusions

Source: PGGM (2017)• Reduce carbon footprint by half: starting withlisted equity, using a largely passive approach(Trucost data, ranking companies by carbon
intensity within sectors, divesting from companies
with the highest emissions per dollar revenue incarbon intensive sectors). The organization has
the ambition of rolling out same the approach
to fixed income and private assets – but finding
consistent data sources is still a challenge.

Environment Agency Pension Fund (EAPF)• Quadruple volume of positive impact
investments: this involves a separate portfolio
targeting 4 investment themes – climate, water,food security and health – with the target ofinvesting EUR 20 billion in these areas by
2020. Green bonds as well as direct (private)
investments are included in this portfolio.

The UK pension scheme EAPF aims to integratemanagement of ESG issues throughout theinvestment and funding strategy. This includes asset
allocation, mandate design, risk management, fundmanager appointment and monitoring, collaborative
engagement and reporting. Thinking about theseissues at a strategic level is critical (EAPF 2017a).

• Further integrate ESG into the wholeinvestment process: through due diligence,
selection and screening, with tools now used by all
investment staff (not just a separate SRI team). For
listed instruments, a passive + positive screening
approach is used (best in class ESG overweighted
vs. index using Sustainalytics and MSCI data).
For private instruments, the approach is more
active (due diligence questionnaires are used toassess private equity (PE) general partners’ (GPs)integration of ESG into their process; renovationand energy efficiency improvement of direct
real estate investments). ESG country rankings
are used for EM sovereign bonds holdings.
Engagement is also starting to be used as a toolon the fixed income side.

This includes especially areas such as engagement,
voting, environmental foot printing, carbon targets
and metrics, and on dedicated green, social and othersustainable investments (Box 4). More specificallyon fixed income, EAPF introduced carbon footprinting for its corporate bond portfolios in 2012,
followed by green bonds, and a ‘Buy & Maintain’
bond mandate (with a focus particularly on climate
risk and corporate governance). (EAPF 2017b)

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 37

Box 4: EAPF’s Sustainable Investment and Carbon Targets
Social and sustainable investment
Social investment can be defined to include a wide spectrum of investment opportunities. The EAPF
definition of social investment is an investment that addresses societal challenges but generates
competitive financial returns. Societal challenges include all issues commonly regarded under social,environmental or governance headings.
A wide definition of sustainable investments includes:• Social investments and those with significant revenues (in excess of 20%) involved in energy
efficiency, alternative energy, water and waste treatment, public transport;• Property, infrastructure, agriculture or forestry investments with a low carbon or strong sustainability
criteria; and• Companies (often equities and bonds) with progressive environmental, social or governance practices
that may enhance investor value.
The Fund has set itself the target to have over 25% of the Fund invested, across all asset classes, in suchopportunities.

Carbon targets
In our policy we set ourselves three goals for 2020 to invest, decarbonize and engage and we are making
good progress on all three. (EAPF 2017a)
Climate Goals

Progress

Invest 15% of the Fund in low carbon, energy efficient andother climate mitigation opportunities.

10% invested with current commitments
bringing it to 12.5%.

Decarbonise the equity portfolio, reducing our exposure
to ‘future emissions’ by 90% for coal and 50% for oil andgas by 2020 compared to the exposure in our underlying
benchmark as at 31 March 2015.

Coal is currently 65% less than ourbaseline.
Oil and gas is currently 79% less thanour baseline.

Supported progress towards an orderly transition to a
low carbon economy through actively working with asset
owners, fund managers, companies, academia, policy
makers and others in the investment industry.

Active engagement across the industry
with a strong focus on working
collaboratively. More information on our
website.

38 | 5. HOW IS ESG BEING IMPLEMENTED BY FIXED INCOME INVESTORS?

6. Main trends

and Challenges
State of the ArtT

he main trends for ESG in fixed income investing
can be summed up this way:

• There are a number of fundamental differences for
ESG in fixed income, in particular the relevanceof sovereign issuers, and the focus on downside
capital risks.

• ESG for fixed income iscatching up with equity –other/alternative asset classes arefollowing, too.

• More academic and industry research on fixedincome-related ESG issues has been undertakenover the last few years – this is likely to continue.
Overall, it is still early days for research on
financial performance, and even more on nonfinancial performance, of ESG in fixed income.

• Fixed income-specific ESG investment tools
such as ESG scores/rankings for companies andcountries are being developed more intensively– both by commercial providers and inside asset
management organizations.

• It is now more widely accepted that ESG
factors can constitute material credit risk, andincorporating ESG factors in the investment
process does not mean sacrificing return.
• More investors are trying to understand the link
between ESG issues and traditional credit ratings,
as well as ESG and credit spreads.
• New “motivators” since 2015 include climatechange, the UN SDGs and a changing attitude
of some regulators (e.g. reporting, disclosure)
towards “sustainability”.
• ESG investing is growing fast, and is becoming
part of mainstream investing for many pension
funds, insurance companies, sovereign wealthfunds and other asset owners.

• Work in the sovereign space is lagging corporate
markets. Other areas of fixed income, such asprivate debt, covered bonds or asset backed
securities, have little coverage, so far.
• Implementation strategies for ESG in fixedincome vary widely. They range from thematicinvestments (mostly green bonds), passive
ESG investing, active ESG mandates or inhouse strategies, to full integration into fixedincome portfolios – with investors also using a
combination of these approaches.
• ESG indices are being used for both passive
and active strategies, and they use mostly
exclusionary screens or ESG-tilted weightings.
However, investors are currently constrained by
the lack of choice in this field – more indices are
in development.

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 39

• Some advanced investors have developed,
or are developing, a ‘holistic’ ESG approachacross all asset classes, the entire investment/risk management process, and the whole asset
management organization.
• Focus on environmental and social outcomes isincreasing (e.g. carbon emissions, social impact).
More investors are seeking new territories in“impact investing” or sustainable investment
strategies also with fixed income instruments.
• Investors, especially index investors, are coming
under more scrutiny (also in fixed income) for
their ESG efforts, especially corporate (non)engagement), as well as their environmental andsocial impact.
• Investors are using the SDGs framework to focus
their investments for purpose that is aligned with
the SDGs.

Customization and standardization
What is becoming clear as ESG integration emerges
and becomes more widespread practice is thebalance which institutional investors are having to
strike between ‘standardization and customization’.
Many investors are increasingly looking to develop
bespoke strategies to reflect their own philosophy
and investment goals. The many different concepts
allow for a customization of ESG investment
strategies, indices and portfolios. However, thisgoes at the cost of comparability of performance.
On the other hand, a widespread complaint ison the lack of agreed ESG “standards”. Many
investors also would like to see standardized ESG
definitions, stock lists, indices etc. in order not tohave to “re-invent the wheel”, and to save costsof customization. Some observers would also fear
opportunistic “standards-shopping”.
As noted earlier, a definitive list of ESG issues does
not exist – and it looks impossible to agree on. Even
within the comparatively advanced discussionof “green” there are major areas of dispute, e.g.
on nuclear, biofuels. Across experts, there is also
a varying emphasis on processes and products,
supply and disposal chains, on footprinting or

40 | 6. MAIN TRENDS AND CHALLENGES

physical risks, on biodiversity and natural capital,
etc.  Such issues are even more difficult in the socialand human rights territory. Competing concepts
in the market place are more likely to allow for
dynamic adjustments and quality competition ina fast-moving world. In this dynamic process,transparency and good governance are essential.
There are pros and cons of setting ‘official
standards’. It looks premature for regulators to
set full ESG standards at this juncture, if everpossible. More promising is to expect specificregulation at company/sector/project level, e.g.
on carbon emissions, environmental footprint,
energy efficiency, governance practices, workplace
standards, and similar. Furthermore, disclosure
requirements will tighten for both investee
companies and investors. As social issues – whichby their nature are less consensual - become
more embedded into the investment process
customization will remain, but consensus aroundframeworks is needed to provide a robust basis
for ESG incorporation (and keep costs affordable).  
Over time, more robust methodologies would
provide a better footing for ESG information, anddeliver better inputs in the models used by theinvestment industry.

Issues with ESG Investing
Even with the growing body of research, increasing
product offerings and developing methodologies byleading investors, a number of issues with ESG arebeing debated in the industry and in academia. Thisposes a series of challenges for fund managers andasset owners.
Many investors remain concerned about ESGrelated investing for assorted reasons (Mooji2017). Important impediments to the use of ESG
information are the different reporting standards
and as a result lack of comparability (Amel-Zadeh
and Serafeim 2017). According to a survey of 500
investors globally (Schroders 2017b), performanceand transparency are the greatest challenges.
Difficulty in risk measuring/managing and costs
are also mentioned, as is the lack of belief in“sustainable investments” (Figure 10).

Figure 10: Sustainability Challenges for Investors
Overall

North America

Performance concerns

44%

42%

47%

37%

45%

Lack of transparency
and reported data

41%

33%

44%

34%

45%

Difficulty measuringand managing risk

28%

29%

26%

26%

31%

Cost

23%

28%

22%

26%

21%

Investment committee is not comfortablemaking sustainable investments

14%

6%

14%

23%

18%

Other

11%

12%

9%

6%

13%

I do not believe insustainable investments

20%

22%

15%

29%

23%

EuropeLatin America

Asia

Source: Schroders (2017b)

ESG critiques
It is worthwhile to briefly reiterate some of themore principled reservations and criticism of ESG
such as:• Lack of clarity around the ESG terminology;
vagueness of ‘sustainability’;• Stakeholders in different sectors (investors vs.
economists vs. environmentalists) are using
different terminology and not communicating
well across disciplines;• Potential trade-off between ESG factor
preferences and investment performance;• Possible reduction of investment universe, withlack of diversification;• Need to clarify existing regulation, fiduciary
duty;• Who defines the “values” and how? Concerns
over the growing ‘oligopolistic role’ of external
agencies or service providers;• Who regulates ‘sustainability’, and how?
Questions about both ESG-specific regulationand investor regulation that affects ESG investing(e.g. fiduciary duties);• Too much ESG “box ticking” on the side ofcompanies and asset managers;34• Given the rising demand for climate change/ESG
products, too much “green-washing” or “ESGwashing”;• Does ‘sustainability’ investing facilitate or
distract from essential climate change investing?
(Some governments prefer ‘sustainable finance’over ‘green finance’);• Cost issues (e.g. charges for ESG data providers,certification or in-house expertise; higher
management fees?);• Questions about the effectiveness of governancecodes/ESG policy (e.g. financial crisis; executive
compensation and poor corporate oversight;
ecological disasters).

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 41

ESG implementation in general

ESG in fixed income

Once a decision in the direction of ESG is made,there are a broad range of questions on theimplementation (see, e.g., Hawley 2017):

ESG investing in fixed income poses some
additional challenges.

• Exact definition of ESG factors; is it too static –are adjustments needed over time?

• Connection between ESG and credit ratings andcredit spreads• Diverging analytical approaches; detailed
methodologies (e.g. weightings of E, S and G, orof sub-factors)35• Mismatch of time horizon for fixed income
investments and period over which ESG factor
materialize (as these can be short-term, but often
represent long-term trends)• Conflicting signals from E, S and G on individualcompanies/countries• The relationship of ESG and other risks/
opportunities (e.g. market, liquidity)• Limited transparency of
methodologies (“black boxes”)• How to organize “engagement” for bondholders,
especially for small investors and with sovereignissues

ESG

scores/• Time lag of information (“behind the curve”)• Disclosure and reporting issues with underlying
investee companies/countries• Whether broader supply chain considerations
should be taken into account?
• What is the progress in terms of ESG outcomes
and appropriate metrics?
• Problem of scale/ resources for smaller
institutional investors, particularly in EMs• Investment (im-)practicality of SDG goals.
• Long time horizon over which ESG factors
can materialize vs. short-term performancemeasurement of asset managers.
As ESG investing is spreading more widely, mostasset managers feel the need to become more activein this field. However, the reality is often detachedfrom the image sought, especially outside equities.
For fixed income, as the Russell survey (2017)
revealed, “there often is a wide gap in what the survey
respondents claim they do regarding ESG integration
and what is actually happening”(p. 4). “Overall, weobserved that ESG factor consideration appears to be
not as a dominant driver in investment decision but
rather as a supplemental piece of information at best
as a part of credit analysis.” (p. 1)

42 | 6. MAIN TRENDS AND CHALLENGES• Political sensitivities with sovereign (subsovereign) bonds (e.g. exclusion of countries)• Limited availability of underlying country data(also suitability? comparability? timeliness?)• How to capture momentum as opposed to staticlevel of ESG for companies and particularly
countries• Lack of ESG research coverage for high-yield,
emerging market and private debt
• Lack of competition in ESG fixed income indices• Awareness of (implicit or explicit) factor biases
in ESG investing• The effect of ESG on long-term strategies andasset-liability management (ALM)• Whether to measure ESG by issuer or issuance?
• Organizational issues (e.g. building ESG fixedincome expertise; different ESG company experts
for stocks and bonds?).

Progress on data
One of the main concerns of investors is ESG data.
The concerns are mainly two-fold:36• Lack of available data; timeliness; coverage ofregions/market segments/instruments;37

• Quality of data inputs (inconsistencies;
incompleteness; reliance on self-reported data;
subjective and unaudited information; obvious
errors).
In terms of quantity, reporting initiatives are
improving the depth, breadth and consistency
or corporate reporting on ESG factors. The
launch of the TCFD is a response to this call for
more and better information. As of March 2018,
over 250 organizations have expressed theirsupport for the TCFD, and the first examples oforganizations taking steps to report in line withthe recommendations of the TCFD (e.g. Unilever,
HSBC and SwissRe) have already been seen. The
IFC has developed a Disclosure & Transparency
Toolkit to support corporates in emerging markets
enhance their ESG reporting. An IFC project is also
currently underway to adapt the IFC PerformanceStandards and Corporate Governance Methodology
into a framework which can be used by capital
market investors. The World Bank is also working
on a reporting framework to map project outcomes
and impact to SDG indicators.
Importantly, the issue is not just about data quantity.
Much more progress is needed in terms of data
quality and relevance as an input to investment
decision-making. The bar is being raised forcorporate disclosure by regulators and stock
exchanges. More investor ESG disclosure is being
introduced in many places. Specialist services
are growing to make the best use of such data in
a competitive market. Crucially, more conceptual
work will need to be done on defining ESG and
SDG metrics, and especially on how to define andmeasure the impact of portfolios.
New technology is helping tackle the data challenge
by adding both depth and breadth to ESG sources.
This goes beyond using standard, self-reported
corporate data to incorporate ‘big data’ and new
information sources, such as satellites. It can also

reduce costs vs. intensive analytical approaches,and provide more real-time data, which is importantfor investors tying to adapt policy and other tools.
Much more basic environmental and other data are
available now than only one or two decades ago.
Combined with artificial intelligence (AI) andmachine learning techniques, real time evidence forinvestors is becoming more obtainable.
New data providers, such as True Value Labs andArabesque,38 are providing ‘sustainable quants’based services, using big data and machine learning
tools to go beyond corporate disclosure-based E, S,
G information. MSCI and other data providers arenoting that an increasing number of their clients arequants.39 Already, a number of investors, including
pension funds such APG40 and PensionDanmark,are testing and implementing artificial intelligence/robotics for certain processes. However, investors
are also aware that “big data” may also imply “bigrisks”. Issues such as cyber-crime, data ownership,
theft and misuse have already show massive
financially relevance
Data availability and quality also need to improve
to support better ESG integration into sovereign
bond analysis. The national level data used islimited, and particularly suffers from significant
time lags. Initiatives are underway to improve
the National Capital Accounting of countries (tosupport financial accounting), but this is yet tobecome widespread. Work on the ‘Human Capital’and other indices may provide a more holistic
framework for sovereign and social analysis (Langeet al. 2018). There is still a need for governments
to provide better basic environmental and social
data – with faster delivery. Satellite data is being
used by the World Bank and other institutions totrack proxies for ‘E’ and ‘S’ measures through datasuch as environmental degradation and poverty
measures.

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 43

44 | 6. MAIN TRENDS AND CHALLENGES

7. Conclusions:from Process
to Impact

Key Lessons for Investors

There are a number of key lessons for investors:

From single steps to a full organizational
approach
Many investors – both asset owners and asset
managers – have taken some single steps into ESG
investing into their fixed income portfolios, e.g. bybuying a SRI fund or a green bond, SRI engagement
teams working on fixed income as well as equity
holdings, subscribing to ESG organizations or
producing ESG marketing/compliance literature.
Such single steps are often indeed the main options
for smaller investors. Larger investors, however, toprogress, need to take a full organizational approach(starting at board level), devote in-house analyticalresources and apply appropriate aspects of ESG
strategies in parallel, including incorporation acrossfixed income holdings.

to achieve with ESG (if atall)? And how? There is often an
excessive focus on sustainability andfinancial performance, and too little regard
for performance in terms of E, S and G. Thougharguably harder to measure, these considerations
are also important for fixed income holdings.

From input to outcomes – from process to
impactIn the past, ESG investing has been mainly concernedwith inputs (e.g. finding ESG data, products) andinternal processes (e.g. ESG analysis, compliance).
While this process will continue, in future, more
efforts will go into the ESG output, including:• becoming clearer about how to conceptualize
ESG outcomes;

Clear objectives• working hard to find appropriate ESG metrics;

Clarity about the objectives is paramount. Some
investors (and academics) primarily try to chasea few extra basis points via (changeable) ESG
product/strategy outperformance. Instead, more
efforts should go into setting ESG investment
objectives: What is this particular asset owner trying• getting a handle on the environmental and social
impact across portfolios, including fixed income
holdings;• determining how to measure and communicate
ESG impact beyond labelled bonds; and• mapping portfolios and SDG outcomes.

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 45

Ways Forward
ESG investing is developing from a purely processdriven to a more outcome-driven activity. Thisis true for all holdings, including fixed income.
The concerns outlined above show that, whilst
great strides have been made to incorporate ESG
factors into fixed income investments, and acrossinvestors’ portfolios, more needs to be done to truly
mainstream this approach and have material impact.
In addition to investors themselves, a range ofstakeholders have a role to play to achieve thegoal of mainstreaming ESG into fixed income
investments:• Governments need to provide more timely,
accurate national data on ESG and development
issues, as well as financial national accounting to
inform analysis of their sovereign issuance;• Corporations need to continue to improve theirreporting on ESG as well as financial factors tobetter assess their debt as well as equity issuance;• Multilateral development banks have an
important catalytic, intermediary and capacity
building role to play on labelled bond issuance,
and impact measurement more broadly;• The international associations should strivein their thought leadership and the provision ofrobust evidence to support the mainstreaming of
ESG investment in all asset classes, and work
towards common frameworks.
• Service providers should continue to improvetheir ESG methodologies and analysis, pushingfor more timely, accurate and extensive
information to base this on – and they in turnneed to be pushed by investors to increase thequality of their products, particularly in the fixedincome space.
• The academic community can provide newideas, new metrics and critical evaluation, withgaps in fixed income analysis particularly needing
to be filled.
Further work is needed in four areas:

46 | 7. CONCLUSIONS: FROM PROCESS TO IMPACTFirst, the on-going initiatives to improve thedata upon which the ESG analysis and tools
are based should continue to be supported.
Corporate reporting initiatives are having results,
with attention increasingly spreading to emerging
market issuers. Likewise, evidence from new data
sources (big data, satellite data etc.) needs to betested for robustness and materiality to include andbring a real-time dimension to ESG analysis ofsovereign bonds.
Second, more rigorous research on therelationship between ESG factors, financial risk
and returns in fixed income is also required.
Further, academic studies are needed, looking at thelink between all aspects of fixed income, E, S and
G factors, using transparent methodologies, longer
time periods, and a broader range of fixed income
assets and countries.
Third, frameworks for applying this ESG
data should continue to be refined. Having
standardized, international frameworks brings
confidence to investors that ESG analysis is being
placed on a robust footing. This will allow them tofurther include this analysis into their mainstream
investing across asset classes, whilst adding
customization on top to reflect their own beliefs
and goals.
Finally, more innovative, sustainable investment
products are needed – as evidenced by the appetite
for green bonds. They should be scalable and morediverse in order to become meaningful portions ofinvestors’ asset allocation and benchmarks. The
growing sustainable bond issuance – supported by
the data and frameworks discussed – will allow
investors to channel their portfolios and measure
impacts on their chosen goals. More can be done
to devise structured and other products to meetthis demand. As with green bonds, supranational
issuers are helping pave the way forward to growsustainable bond markets through their own bondissuance and by mapping out impact reporting
models and transparency and disclosure standards
together with partners like ICMA.

Next Steps
Suggested next steps for the World Bank Group,
GPIF and their partners include:

National Reporting• Encourage and support use of National Capital
Accounting, including in developing economies• Explore how to provide more accessible, accurate,
timely E, S, G risk and impact indicators forinvestors to incorporate into their analysis – incooperation with stakeholders• Conduct research into materiality andincorporation of E, S, G risk and impact factors
in sovereign bond analysis• Provide opportunities for investors to engage on
E,S,G issues with sovereign issuers

Corporate and Impact Reporting• Step up engagement with international initiatives(GRI, SASB) and investors to promote anddevelop standard corporate reporting• Continue work with TCFD, including on climaterelated scenario analysis and assessment byfinancial institutions• Encourage corporate sustainability benchmarksaligned with SDGs
• Work with institutional investors and others todevelop and refine reporting on impact fromsustainable development investments (such as for
IFC Social Bonds and World Bank Sustainable
Development Bonds) and their alignment with theSDGs, that can be used as a model for reportingby other issuers• Promote the use of the IFC Disclosure &Transparency Toolkit for EM corporates anddesign customized capacity building activities
targeting specific countries or sectors

Frameworks
Continue to support the refining the green/social/sustainable bond principles and impact reporting(including alignment with SDGs) for investors
through the Executive Committee chaired by ICMA
• Test IFC’s ESG framework for EM corporate
issuers with institutional fixed income investor
partners.

Products• Work with sovereigns, sub-sovereigns to support
their interest in issuance of labelled bonds throughadvisory work
• Provide advisory to emerging market  issuers on
increasing transparency in measuring and tracking
impact for financed projects – for labelled andnon-labelled bonds• Increase engagement with investors on sustainable
use of proceeds for all bonds issued and related
impact reporting, to expand and broaden themarket (by issuer, issuance type, broader range ofcredit quality etc.) to scale up the market.
• Support products that help to raise awareness forpressing development issues such as environment,
gender, human capital, universal health care andother themes that enable sustainable prosperity
for all generations
In the end, investing is about dealing with
opportunities and uncertainties – this not different
for ESG investing. ESG issues constitute a major
challenge for asset owners and asset managers but
also provide new – financial and social - opportunities.
Governments can set better frameworks and provide
better as well as faster data to facilitate progress.
International and industry organizations can help
with basic, general guidance. Market competition
will continue to drive the provision of ESG data,
tools, strategies and products, and this should also
improve the quality of investments over time.

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 47

48 | 7. CONCLUSIONS: FROM PROCESS TO IMPACT

Appendices
Appendix 1: Institutions Interviewed
for This Report
Asset managers and institutional investors:
Affirmative Investment Management (AIM)

TIAA Investments

Amundi

Trillium Asset Management

APG

UBS

BlackRock

Zurich Insurance GroupBNY Mellon Asset Managers North America
Breckinridge Capital Advisors
CalSTRS
Columbia Threadneedle Investments
Deutsche Asset Management
Everence /Praxis Mutual Funds
FolksamGlobal Evolution
MN
Neuberger Berman
Nippon Life Insurance
OP Trust
PGGM
PIMCO
SchrodersRating agencies, data providers,standard setters:
ArabesqueDe Nederlandsche BankIPE
FTSE Russell
Moody’s
MSCI
PRI
R&I Information Japan
RobecoSAM
S&P
Sustainalytics
TrucostVerisk Maplecroft

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 49

Appendix 2: ESG Criteria
Institution
CFA (2015)

PRI (2014)(Sovereignissuers)

PRI (2014)(Corporate
issuers)

IFC (2012)

E

S

G

Climate change and carbon
emissionsCustomer satisfaction

Board composition

Air and water pollution

Data protection and privacy

Audit committee structure

Biodiversity

Gender diversity

Bribery and corruption

Deforestation

Employee engagement

Executive compensation

Energy efficiency

Community relations

Lobbying

Waste management

Human rights

Political contributions

Water scarcity

Labor standards

Whistleblower schemes

Carbon intensity

Demographics

Institutional strength

Water stress

Education and human capital

Corruption

Energy resources andmanagement

Health levels

Regime stability

Natural disasters

Political and press freedoms

Rule of law

Biocapacity and ecosystem
quality

Human rights

Financial reporting

Pollution

Labor standards

Regulatory effectiveness

Biodiversity

Social exclusion

Adherence to conventions

Agriculture

Income inequality

International relations

Environmental

Demographics

Business integrity

Climate change

Human rights

Shareholder rights

Biodiversity

Employee relations

Incentive structure

Energy resources andmanagement

Health and safety

Audit practices

Biocapacity and ecosystem
quality

Diversity

Board independence &expertise

Air pollution

Customer relations

Fiduciary duty

Water scarcity and pollution

Product responsibility

Transparency /accountability

Risk Management

Labor

Commitment

Resource Efficiency

Community Health and
SafetyBoard structure

Pollution Prevention

Resettlement

Control environment

Emergency preparedness
and response

Indigenous People

Transparency and disclosure

Biodiversity

Cultural heritage

Minority shareholders
Stakeholder engagement

Source:50 | APPENDICESAppendix 3: Characteristics of Fixed Income and Implications for ESG
Characteristics of Fixed Income

Responsible Investment Actions

Potential downside outweighs potential upside – focus
is on risk, low volatility and preservation of capital morethan on growth opportunities.

Focus on the contribution of ESG factors to financial
downside – in particular, significant event risks andsystemic risks that can affect issuer creditworthiness.
Most prominent of these should be governance.

Lenders have a contractual relationship with borrowers;
they are not owners. Debt holders don’t vote at
AGMs, and access to management can be relatively
infrequent.

• To manage risk, use any opportunity to engage
issuers on ESG factors of concern (e.g., in run-up toissuance).
• Collaborate with other bondholders for more effective
engagement.
• Vote on governance concerns during debt
restructurings.

Multi-layered analysis (e.g., yield spread and yield
curve analysis).

Develop robust yet streamlined processes to help
analysts identify and manage ESG risks effectively.

Multiple issuer types (e.g., corporate, government,
financial sector, and supranational).

ESG analysis varies for different issuers; metrics,
criteria weighting and engagement approach vary.
There is no one-size-fits-all.

Multiple instruments (e.g., structured products andABS).

Analyse ESG-related risks to issuer creditworthiness aswell as to asset cover pools and originators.

• Debt issued as public or private instruments.
• Debt issued as investment grade or high yield.

RI approach varies relative to availability of ESG
information, engagement opportunities, investor
influence and access to management. Private/highyield securities may represent higher risk but offer more
opportunity for engagement and outperformance.

Different capital structure levels – senior, subordinated,hybrid etc.

Subordinated debt holders face financial downside
before senior debt holders do, making them moresensitive to impacts from ESG risk.

Debt instruments have fixed durations covering
different periods.

Consider whether different durations will affect themateriality of ESG to creditworthiness (e.g., will carbon
regulation impact three- and ten-year bonds thesame?).

Private companies can issue listed/public debt.

Coverage of ESG data for private companies isrelatively poor – weaker regulations on reporting forprivate companies.

Weaker issuing requirements but longer issuing periods
for private placements.

Greater concentration of risk for private placements
requires closer consideration of ESG risks; a longer
issuing period allows for this.

Debt can be issued by subsidiaries and special
purpose vehicles (SPV).

Consider exposure and management of ESG risks byparent company, subsidiary and originator.

Multiple outstanding debt securities issued by a single
issuer.

Consider concentration of ESG risk related to single
issuers across multiple securities.

Fixed income analysis can be heavily reliant on
quantitative factors.

Address need for consistent and comparable ESG
metrics that are easy ‘plug-ins’ for existing researchmodels.

Source: PRI (2014)

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 51

Appendix 4: Structure of RobecoSAM’s Country Sustainability Framework

Sub-indicator Level

Indicator Level

For each country, various data series on a number ofsustainability sub-indicators are collected, totaling over
250 data series. These sub-indicators cover thefollowing areas:

For each indicator, relativescores ranging from 1 to
10 are calculated. Eachindicator is also assigned apredefined weight.

Emissionsn

Biodiversity

Environmental Status (10%)*Energy UseEnergy Sources

Energy (2.5%)

Exposure to Environmental Risks Risk Mitigation

Environmental Risk (2.5%)



Human WelfareWork and Equality

Social Indicators (10%)



EducationLife Expectancy

Human Development (10%)

Confidence in GovernmentLocal Job Market

Social Unrest (5%)



Rights and LibertiesInequality

Liberty & Inequality (10%)



Human Capital and Innovation

Physical CapitalCompetitiveness (10%)

Internal Risks and InefficienciesExternal Conflicts

Political Risk (10%)

Management of Public Goods

Policy Responses

Effectiveness (2.5%)

Protection of Property Rights



Judicial System

Rule of Law (2.5%)



Democratic Participation



Civil Society

Accountability (2.5%)

Corruption Level

Transparency/Policies

Corruption (2.5%)



Terrorism and Political Crimes



Government Stability

Stability (2.5%)

Competition / Liberalization

Business Regulations

Regulatory Quality (2.5%)



Demographic Profile

Age-related Policies

Aging (10%)

Monetary Policy Independence

Other Institutions

Institutions (5%)

*Predefined indicator weightSource: RobecoSAM (2015)52 | APPENDICES

Dimension
Level
Each dimension
weight is the sumof the indicatorweights within
the respective
dimension.

Country
Sustainability
Score
The country
score is theweighted sum of
standardized
indicator scores.

Environmental(15%)

Governance(60%)

Country
Sustainability
Score

Governance(60%)

Appendix 5: Bloomberg Barclays
MSCI ESG Fixed Income Family
Bloomberg, a global leader in fixed income
indexing, and MSCI, the world’s largest providerof ESG (environmental, social, and governance)
equity indices and research, have collaborated on thedevelopment of a family of rules-based benchmark
indices that incorporate measures of ESG risk andexposures.
The Bloomberg Barclays MSCI ESG Fixed
Income Indexes includes a range of investmentgrade aggregate and corporate index benchmarks
addressing the evolving needs of institutional
investors, who increasingly aim to incorporate ESG
considerations into their strategic asset allocation.

Broad Indexes• Bloomberg Barclays MSCI ESG-Weighted
Indexes use MSCI ESG Ratings and MSCI ESG
Ratings momentum to overweight/underweight
issuers within an existing Bloomberg Barclays
parent index. These indices include the fulluniverse of index eligible securities and thenapply tilts to the natural market value weights infavor of higher rated/positive momentum issuers
and against lower rated/negative momentum
issuers.

• Bloomberg Barclays MSCI Sustainability
Indexes positively screen issuers from existing
Bloomberg Barclays parent indices based on
MSCI ESG Ratings, which are a “best in class”
assessment of how well an issuer manages ESG
risks relative to its industry peer group. ESG
Ratings are available for corporate, sovereign,and government-related issuers. The minimum
threshold applied to Bloomberg Barclays flagshipindices is an ESG rating of BBB or better.
• Bloomberg Barclays MSCI Socially Responsible(SRI) Indexes negatively screen out issuers fromexisting Bloomberg Barclays parent indices that
may be involved in business lines or activities
that conflict with investment policies, values orsocial norms. These indices use MSCI BusinessInvolvement Screening Research (BISR) and
MSCI ESG Controversies to identify exposure toscreened issues.

Thematic Indexes• Bloomberg Barclays MSCI Green Bond Indexes
offer investors an objective and robust measureof the global market for fixed income securities
issued to fund projects with direct environmental
benefits. An independent research-driven
methodology is used to evaluate index-eligible
green bonds to ensure they adhere to establishedGreen Bond Principles and to classify bonds by
their environmental use of proceeds.

Source: MSCI (2017b)

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 53

54 | APPENDICES

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Endnotes
1. Approximately three-quarters of these assets
are held by institutional and one-quarter byretail investors. In terms of regions, Europe
leads with about $12trillion, followed by
North America ($9.8 trillion), Australia/New
Zealand ($0.5 trillion) and Asia ($0.5 trillion).
GSIA gathers results from regional sustainable
investment groups around the world, tracking
professionally managed funds that use
responsible investing criteria. It includes
impact investment and environmental, social,governance funds as well as portfolios that
simply exclude weapons manufacturers or
gambling companies.
2. Mr. Carney has called climate change “TheTragedy of the Horizon”, because the impactsof climate change will be felt beyond the
traditional horizons of most actors (investors,
regulators, policymakers) and impose acost on future generations that the current
generation has no direct incentive to fix. He
has therefore argued that ensuring that thefinancial system is resilient to the low carbon
transition and enabling the system to efficiently
finance the transition should be in the financial
policymakers’ clear interest. (Speech 29
September 2015).
3. Global bond markets have a market capitalizationof about $90 trillion, higher than listed equities.
Bonds also constitute a substantial proportionof institutional
investors’ portfolios.
In 2017, pension fundsof the seven largest markets has
an allocation of 27% in fixed income,i.e. about $11 trillion out of $41 trillion total
assets. In Japan, the allocation was twice ashigh (56%) (Willis Towers Watson 2018).
Insurance companies tend to have even moreconservative asset allocations in many places,
not the least for regulatory reasons.
4. For a list of institutions interviewed see
Appendix 1. The intention was not to undertake acomprehensive survey of institutional investors
and their service providers, but to learn fromsome of the stakeholders who are known tobe leading in this area. A more comprehensive
mapping of institutional investor approaches tothe different ESG tools could be an interesting
follow on to this report. Further analysis on the
success of the different approaches in practiceis also warranted.
5. The concept of ‘sustainability’ comes fromenvironmental economics and is rooted in
the idea that ‘human capital’ can substitute‘natural capital’ (“Hartwick’s rule”). The

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 61

‘strong’ interpretation of the term assumes
that “human capital” and “natural capital” arecomplementary, but not interchangeable. The
concepts arose from the work of Robert Solowand John Hartwick in the 1970s. The policy
interpretation of this work came out of theBrundtland Commission (1987) and is the basis
for the idea of ‘sustainable development’.
6. The universal owner hypothesis is based on theidea that there is “no place to hide” as (negative)
externalities of investee companies will affectportfolio returns sooner or later in some form,
e.g. taxes, insurance premiums, inflated input
prices or the physical cost of disasters. The
UNEP use the following definition: “Universal
Owners are large institutional investors
which have highly-diversified and long-term
portfolios that are representative of global
capital markets”.
7. Corporate Social Responsibility (CSR) relates
to companies’ management approaches.
It considers the economic, social andenvironmental impact for all stakeholders. CSR
is again a concept with many definitions andpractices. Double/triple bottom line also add
a social and environmental dimension to thefinancial one.
8. ‘Outcome’ and ‘impact’ can are often used assynonyms in this context. They can also bemeaningfully conceptualized as ‘outcome’referring to a finite, shorter term change, and‘impact’ as broader, longer-term effects that are
more difficult to measure objectively (Harding
2018).
9. According to a survey of investment
professionals by Amel-Zadeh and Serafeim(2017), relevance to investment performance isthe most frequent motivation for use of ESG
data followed by client demand and productstrategy, bringing change in companies, andthen ethical considerations.

62 | ENDNOTES

10. Fiduciary duty is the requirement that those
who manage other people’s money act in theirbeneficiaries’ interests, rather than serving theirown interests.
11. According to the categorization of GSIA (2017),
ESG integration ($7.5 trillion), engagement/
shareholder action ($5.9 trillion), norms-based
screening ($4.4 trillion) and positive screening($0.9 trillion) are the most widespread strategies
across all asset classes. Impact/community
investing and sustainability themed investing
capture only about $100 billion, i.e. 0.5% ofsustainable assets, each.  
12. PRI publishes a series of case studies by fixedincome investors, and on ESG engagement in
fixed income. https://www.unpri.org/about/priteams/investment-practices#FICS
13. Stranded assets are assets that suffer frompremature write-downs or conversion toliabilities. Some experts consider coal and otherfossil fuels as potential for physical, economic
and regulatory reasons.
14. According to Global Impact Investing Network,
the practice of impact investing has four corecharacteristics: (1) investors intend to havea social and/or an environmental impact, (2)investments are expected to generate a financial
return on capital and, at a minimum, a return ofcapital, (3) investments are to generate returns
that range from below market to risk-adjusted
market rate, and (4) investors are committed
to measuring and reporting the social andenvironmental impacts.
15. An example is a combined academic andindustry effort (Vörösmarty et al. 2018) todevelop ‘context-based metrics for investment
decisions that try to capture outputs, outcomes
and impact in the environment and publichealth.

16. For further details see Dr. Bob Eccles
Forbes article March 11, 2018, ‘Measuring
Investors’ Contributions to The Sustainable
Development Goals’, which maps SASB’s  
factors to specific SDGs.

23. UN PRI have an on-going project looking at
this topic in-depth. Further analysis and results
are due out during 2018, which the authors
would encourage readers who are looking for
further detail on this area to follow.

17. Arjales and Bansal (2018) find that bondmanagers are trying to quantify and“financialize” ESG data in their models while
equity managers can live more easily with a‘creative friction’ between financial numbers
and any sort of ESG information.

24. The assessment (GB1-GB5) is distilled from 5
broad factors with a number of sub-factors: useof proceeds, ongoing reporting, organization,
management of proceeds, disclosure on useof proceeds. Proceeds are to be used for cleanwater, sustainable land use, waste and water
management, clean transportation, biodiversity
conservation, renewable energy, climate change
adaptation, or energy efficiency.

18. For an investor-related literature overview on
ESG in equities, and more general, see, e.g.
Dimson et al. (2013).
19. The result for portfolio studies is commented
by the authors: “It is important to be awarethat the results of these (to date about 150
studies) are overlaid by various systematic andidiosyncratic risks in portfolios and, in the caseof mutual funds, by implementation costs.”
20. These findings relate to the work of Khan et al.
(2015), which finds that firms with good ratings
on material sustainability issues significantly
outperform firms with poor ratings on theseissues. In contrast, firms with good ratings
on immaterial sustainability issues do notsignificantly outperform firms with poor ratings
on the same issues. The authors note that theresults “have implications for asset managers
who have committed to the integration ofsustainability factors in their capital allocation
decisions.” (p. 1)
21. Summit (2017), Douglas et al. (2017), e.g.,give an overview for equities. Mooji (2017a)
found 218 ESG initiatives, of which 57 for
ESG ratings, 38 for ESG rankings, 57 for ESG
indexes. Most of them concentrate on equities.
22. Some providers use the term “ESG ratings” but theterm “ESG score” is preferred to avoid confusion
with traditional credit ratings. ESG rankings are
typically based on an ESG scoring system.

25. MSCI took over KLD Research and Analytics
in 2010 and Governance Holdings (GMI
Ratings) in 2014.
26. Such findings have been supported by otherparties though their own in-house research.
27. The country sustainability score does not takethe annual change into account, it is based on thecurrent level. The change vs the previous scoreis only taken into account for the calculation of
the country grades used in the ESG sovereign
bond index.
28. Labelled green bonds are labelled as ‘green’ by
the issuer and are financing green assets andprojects. Unlabelled but still ‘climate-aligned’bonds are issued by entities enabling a low
carbon economy but are not labelled ‘green’.
29. The Green Bond Principles (GBP) arevoluntary process guidelines that recommend
transparency and disclosure and promote
integrity in the development of the Green
Bond market by clarifying the approach
for issuance of a green bond. The GBP havefour core components: 1. Use of Proceeds, 2.
Process for Project Evaluation and Selection, 3.
Management of Proceeds, 4. Reporting.

INCORPORATING ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS INTO FIXED INCOME INVESTMENT| 63

30. The bonds directly link returns to the stock
market performance of companies in the
Solactive Sustainable Development Goals(SDGs) World Index. The index includes 50
companies that are recognized industry leaders
on environmentally and socially sustainableissues, or that dedicate at least 20% of theiractivities to sustainable products.
31. The proceeds of each HSBC SDG Bond will be
used to finance in whole or in part, businesses
and projects that promote any of the selected
seven SDGs.
32. Since 2007, the World Bank Treasury hasdelivered $3.9 billion in catastrophe risk
transactions—including more than $2 billion
since July 2017. IBRD cat bonds have beenrecognized as sustainable investments forinvestors active in the insurance-linked
securities (ILS) market.
33. BlackRock CEO Larry Finks’s 2017 Annual
Letter to CEOs outlining a new approach tocorporate engagement has been much quoted.
https://www.blackrock.com/corporate/en-no/
investor-relations/larry-fink-ceo-letter
34. As the Economist (2017) article lays out:
“Money managers’ deepening love affair withsustainable investment stems not from warm,
fuzzy ideas about doing good. For most it is
a commercial choice. That worries some SRI
purists, who fear that “mainstreaming” willlead some fund managers to put an ethical gloss
on conventional investments.”
35. See, e.g., Khan (2017). In terms of consistency,
in describing their ESG investment approach,
QIC (2017), for example note that: “Inpractice, MSCI and Sustainalytics ratings often
disagree with each other. When measuring the

64 | ENDNOTES

relationship between ESG ratings of the two
providers, we found positive but low correlations
across all three dimensions as well as for thecomposite rating. This is not surprising, given
the differences in methodology. To sum up: Like
corporate bond ratings, ESG ratings should
not be considered as a simple commodity.
Ratings from different providers carry different
information and can potentially suggest
different portfolio management decisions. At
the end of the day, investors and asset owners
need to do their own work to reach their own
conclusions rather than reflexively following
the analysis of providers.” (p. 5)
36. A lack of robustness and consistency behindmuch of the data lies behind these concerns.
For example, some of the data used to assessclimate risk use assumptions based on what are
random events. This means that the portfolios
created based on that data are not less affectedby climate risk.
37. See, e.g., BlackRock (2016) that mentions“survey fatigue”. Mooji (2018) reports
widespread “reporting fatigue”, poor qualityof information and lack of transparency in the
ESG industry that is counterproductive.
38. Arabesque, a “quant” asset manager that uses
ESG data, examines the sustainability of over
7,000 of the world’s largest listed companies. Its
technology combines over 200 ESG measureswith other data points (such as news stories
from 50,000 sources) to rank companies.
39. See Financial Times January 2016, ‘Quants are
the new ethical investors’.
40. In 2018, APG took over the data analytics
team for sustainable investing from Deloitte
Nederland.