Bond issuance in the Gulf has increased significantly since 2000. The GCC fixed rate US dollar-denominated bond and sukuk universe grew by 17 percent from 2017 to 2018.
Issuers in the Gulf should look beyond financials to stand out, as bondholders around the world increasingly analyse environmental, social and governance (ESG) indicators to spot opportunities from a broad and deep pool of corporate credits.
This is in part thanks to a growing body of academic research which shows a positive correlation between how well a company rates on ESG metrics and its cost of capital — meaning that the non-financial aspects of a business’s performance can have a lasting effect on its creditworthiness and investibility.
ESG rating isn’t yet a hard science. But the choice of ESG indicators available is limited. There are still inconsistencies around what ESG-relevant information companies report and how.
Asset managers often cling to rankings offered up by agencies when it comes to building corporate bond portfolios. The two major agencies that dominate the ESG ratings industry — MSCI and Sustainalytics — aren’t always strictly comparable, due to differing methodologies. For instance, there is essentially no correlation between governance scores in the banking and brokerage sectors. And ratings often act as proxies for balance sheet strength — in other words, they add no relevant information to existing financial metrics.
Some asset managers look to socially responsible investing, which takes a rigid, exclusionary approach to investing based solely on moral or ethical considerations. This often has a negative effect on performance in part because most sectors are critical to the wider functioning of the economy. We may not like the environmental side effects of the oil industry, but for now, without it, most people in the world would be much worse off. And it’s important to note that some oil producers take ESG very seriously, engaging with their critics and making significant improvements in their carbon footprints.
It’s unsurprising that 79 per cent of surveyed asset managers considered governance to be the most important ESG factor. Strong governance is associated with better management and a lower incidence of credit rating downgrades. And governance issues can come to the fore much quicker — which is important for asset managers who are frequently measured on quarterly performance.
Environmental and social factors tend to be harder to quantify and to time, and easier to ignore from a purely financial perspective. And yet they offer a much deeper insight into corporate body language than balance sheets alone can offer. Many individuals, pension funds and institutions — the ultimate beneficiaries for whom asset managers invest — consider E and S to matter even more than G, in part due to their longer time horizons.
A more flexible and nuanced approach focused on non-financial factors that had previously been overlooked because they couldn’t be measured, but which pose material risk, is likely to reap bigger rewards. This is because ESG factors come into play from various directions. Government regulation is taking on ever more environmental and social dimensions. Consumers are becoming increasingly reluctant to buy goods and services from companies that are unethical or polluting. And investors are becoming more sensitive to the risk of lending to unethical or badly run companies.
For instance, serious environmental problems are often flagged up by a corporate culture that suggests a willingness to accept more minor infractions. BP’s Deepwater Horizon catastrophe was anticipated by the company’s poor environmental record elsewhere over a number of years. Environmental costs can also disrupt supply chains. For example, some polluting motors are no longer produced. Companies that still use older versions and that fail to factor in these changes can end up with substantial development and maintenance costs.
Regulation for environmental issues offers a framework of rules for companies as well as a schedule that investors can track closely. Take the new rules being imposed on global shipping by the International Maritime Organisation (IMO). From 2020, the IMO is cutting allowable ship fuel sulphur content to 0.5 per cent from 3.5 per cent by mass. How businesses are reacting offers an insight not only into their ESG credentials but also the quality of their management.
Shipowners who frequent the Middle East face further challenges since all fuel oil supplied from the region’s major refineries is high sulphur. Some shipping companies in the Gulf have already started to prepare; others haven’t, leaving themselves open to significant costs down the road.
Social factors, such as the pressure on companies to close gender pay gaps provide an even clearer appraisal of corporate body language. For firms with thin margins, this shift could ultimately have a significant impact on earnings. Companies with poor employee relations or ones that fail to tackle issues like discrimination not only face potentially expensive workforce problems but risk damage to their brand value and reputation. Others face opprobrium from how they’re perceived to treat users, like Facebook.
By using ESG factors to identify corporate body language, investors can gain a clear edge in surfacing the gems and identifying which sectors to move away from over the long-term. This provides a more holistic perspective than the financial metrics provided by ratings systems and a more flexible and less exclusionary approach than stricter socially responsible investing.
Frédéric Salmon is head of credit at Pictet Asset Management
