COP 26 Launch
"Returns - identifying the opportunity in the transition to net zero"
Panel discussion by Ignazio Visco
Governor of the Bank of Italy
London, 27 February 2020
Let me thank Governor Carney and the conference organisers for their kind invitation.
As you know, the growing use of fossil fuels is pushing greenhouse gas concentrations
to levels such that, unless forceful measures are taken, will lead to an increase in the
temperature of the planet ranging from 3 to 5 degrees Celsius by the end of this century.
These are well beyond the threshold of 1.5 degrees that, if surpassed, would bring
potentially catastrophic consequences for the world.
Stopping climate change is first and foremost a responsibility of national
governments, the only institutions that can provide the right incentives to allocate capital
to "green" investments, levy taxes on carbon emissions, and introduce regulations limiting
the amount of permissible emissions. But the challenge is enormous. Overcoming it will
require strong efforts by all institutions and individuals.
Given its central role in the allocation of resources, the financial sector can be key
in influencing the transition to a zero-emissions economy. Central banks may play their
part. First, they can help to raise awareness of the risks related to the sustainability factors
and the channels through which they are transmitted from the real economy to the
financial system. Second, they can promote the dissemination of more information on
environmental risks and favour a better management of climate-related risks by financial
intermediaries. Third, they can lead private investors by example, by adopting suitable
policies in the management of their own financial resources.
In this perspective, this panel discussion gives me the opportunity to describe the
main changes that we have recently made to the Bank of Italy's investment strategy
in our capacity as portfolio managers. Specifically, last year we decided to integrate
Environmental, Social and Governance (ESG) factors into the management of our equity
portfolio. We have also completed background studies to launch, this year, an analogous
initiative for our corporate bond portfolio.
With regard to the equity portfolio, we have added two criteria to our previous
strategy:
- the first discards the companies that belong to the sectors excluded by the
United Nations Global Compact (controversial weapons and tobacco);
- the second gives preference to the companies with the best ESG scores.
Here I would like to make three brief points that deserve special attention. They
concern the returns of sustainable investment, the problems in using ESG scores, and
the principle of market neutrality that, as a central bank, guides our investment strategy.
The decision to account for ESG factors has been taken to fulfil our duties in terms
of social responsibility and to lead investors by example without hampering our price
stability mandate. This change has not undermined the financial performance of our
portfolio. A backward test over a ten-year horizon run before we implemented the new
strategy showed that the new portfolio would have beaten the previous portfolio and
the market benchmark in terms of both higher return and lower volatility. Since we have
implemented it, the new portfolio has continued to perform better than the old one both
in return and volatility.
The fact that constraining the portfolio to fulfil ESG criteria does not penalise its
financial performance is not necessarily surprising. Several studies confirm that sustainable
investment leads to risk-adjusted returns that are often higher than those achieved using
traditional financial models. These findings may be due to a number of reasons.
- First, investors may have underestimated environmental and social risks in the
past and may not have anticipated the higher returns due to the
faster-thanaverage growth of the green sector.
- Second, in its practical implementation, the traditional risk-return approach
uses historical time series, which make it backward-looking. The sustainability
assessment, instead, implies a forward-looking long-term view, which could
help to mitigate the "short-termism" that often drives financial investments.
- Third, good ESG practices seem to provide firms with a competitive advantage
stemming from innovation. They also contribute to reducing operational,
legal and reputational risks and lead to a more efficient resource allocation, as
resources can be shifted from risk management to productive activities. This
lowers the cost of capital and improves market performance.
The second issue concerns the problems related to ESG scores. Today, there are
neither globally accepted rules for ESG data disclosure by individual firms, nor agreed
auditing standards to verify the reported data. Moreover, there are intrinsic difficulties in
deciding which indicators are relevant in assigning an ESG score (how we should evaluate,
for example, the "social" component of the score), especially when compared to financial
aggregates, where the most important indicators, such as revenues, costs, earnings and
cash flows, are all widely available auditable items.
ESG-score providers rely heavily on voluntary disclosure by firms and on subjective
methodologies to select, assess and weight single indicators. This adds to the arbitrary
nature of the scores. As a result, ESG scores of individual firms differ greatly across rating
agencies if compared, for example, with credit ratings. Our studies find, in line with
existing literature, that the correlation between the ESG scores assigned to the euro-area
listed companies by three of the main providers ranges from 40 to 60 per cent, compared
with a correlation between credit ratings that is over 90 per cent. There is also evidence
of biases in ESG scores, which tend to overrate companies that are larger and belong to
specific industrial sectors and geographic regions.
In building our portfolio, we have carefully selected the ESG provider and we
have performed our own calculations, which show a significant improvement in the
environmental footprint of the new portfolio. In particular, compared with the composition
of the old one, the shareholdings included in the new portfolio are characterised by
much lower greenhouse gas emissions (down by 23 per cent) as well as by lower energy
and water consumption (by 30 and 17 per cent respectively).
The lack of disclosed data and the lack of disclosure standards prevent ESG-score
providers from correctly assessing the sustainability of business practices. In Europe, a
directive requires large companies to provide information on the way they operate and
manage environmental and social challenges; this directive applies to approximately
6,000 companies with more than 500 employees. The importance of this issue, however,
warrants further public action for small and medium enterprises and, especially, for
enhancing the standardisation of data for all firms.
The last issue that I would like to discuss concerns market neutrality. As a central
bank, our investment strategy has always been careful in avoiding being a source of
market distortion. And this principle of market neutrality has been preserved in the new
portfolio: among the companies with a high ESG score, we have selected those that have
kept the distance between the new portfolio and the market benchmark below a specific
threshold. As a result, we have improved the ESG score of our portfolio at the expense
of only a slight increase in the ex ante tracking error vis-à-vis the benchmark (which
comprises all the listed non-financial corporations in the euro area).
We could question, however, whether this principle should be fully preserved or
rather be revised in a context in which, in the absence of further regulation, market forces
are pushing greenhouse gas concentrations to levels that will soon be dangerous for the
wellbeing of people, not to speak of the stability of the financial system. I believe that
this is an important topic, which I leave as an open issue and which certainly warrants
further research.
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