How do you measure the ‘sustainability’ of an investment?

More than a quarter of assets under management globally are now being invested with the environment, social and governance factors in mind

(FILES) In this file photo taken on November 17, 2008 wind turbines are pictured near Kisielice, Poland.  After a few years of crisis, due to prohibitive legislation, the Polish wind energy sector is facing new development prospects. / AFP / Janek SKARZYNSKI / TO GO WITH AFP STORY by Michel VIATTEAU

Sustainable investing has come a long way, with more than a quarter of assets under management globally now being invested with consideration of environmental, social and governance (ESG) factors. While sustainable investing was long considered a niche in equity investing, the launch of the United Nations-supported Principles for Responsible Investment (PRI) in 2006 was a catalyst for the concept to spread into mainstream investing, accelerating investor demand.

Climate change and resource scarcity, workplace productivity and product safety, along with technological advances and changing consumer preferences, are significant ESG-related risk factors that have real credit implications for a business.

Regulators, intent on meeting global climate and sustainable development commitments, are working to better integrate ESG concepts into the financial system. Concurrently, investors are not only taking greater interest in how companies address these challenges, but are also avoiding certain investments based on their ESG preferences. In turn, new fixed-income products have been developed and are expanding rapidly to meet growing investor demand. As mainstream capital markets increasingly find ways to address ESG-related risks and opportunities, many of which are not easily discernible on financial statements, we expect these trends to continue.

Led by the UAE, the GCC over the past few years has been investing in renewables, particularly solar power, and already hosts an active and growing green energy market. The International Renewable Energy Agency (Irena) in its 2019 report expects that nearly 7 GW of new renewable power generation capacity is expected to come online by the early 2020s. These are all transactions that could be funded via green finance.

The first green bond in the region was issued by the National Bank of Abu Dhabi (now First Abu Dhabi Bank, after its merger with First Gulf Bank) in March 2017, for a total of $587 million (Dh2.8 billion). In green loans, we have seen Masdar in Abu Dhabi tap the market with a green $75m revolving credit facility (RCF) in September 2018 to fund its sustainability projects.

But how does an investor measure the ‘sustainability’ of an investment?

On the back of market demand for rankings that consistently measure risk and environmental impact, S&P Global Ratings also created a tool to specifically measure the ‘green-ness’ of a financing. Launched in 2017, the Green Evaluation is an asset-level environmental credential, which aims to provide investors with a more comprehensive picture of the green impact and climate risk attributes of their portfolios. It can be used for any type of financing and sets a new standard in the green finance market.

The Green Evaluation works by compiling an aggregated score for any project based on analysis of three factors: the transparency, governance, and either the mitigation or the adaptive impact of a project, with a final score out of 100 delivered to investors.

ESG factors have the potential to affect creditworthiness, but S&P Global Ratings has also developed some tools to help investors make sustainable decisions beyond credit quality with conviction; our ESG Evaluation and Green Evaluation.

The ESG Evaluation takes a broad view of the impact of a company's ESG exposures on its future sustainability. It is grounded in how ESG factors could affect its stakeholders and potentially lead to a material financial impact. To assess an entity, firstly, we establish its ESG profile, which captures the exposure of an entity’s operations to observable ESG risks and opportunities, accounting for the governance structure in mitigating risks and capitalising on opportunities.

To help form an ESG Evaluation, S&P Global Ratings has also created a Risk Atlas, which comprises both a sector risk and country risk, in an interactive, publicly accessible online infographic. The sector risk component of the Risk Atlas combines our analysis of a sector's exposure to environmental and social risk, including factors such as inherent exposure to land and water use, manufacturing footprint, and packaging, as well as social risk such as human capital and safety management. We have deemed the oil and gas and metals and mining sectors as the most highly exposed sectors, while asset managers and business services are considered among the least exposed sectors.

The country component highlights our view about the relative risk exposure of countries and regions to both natural disasters and the relative quality of corporate governance and ESG standards. For example, most countries in the Middle East region are considered to have low natural disaster risk (flooding, seismic activity), while there are distinct variations of corporate governance in the region.

Of course, industry and country risk factors are not static: they are in continual flux, presenting ever-shifting risks and opportunities for businesses and institutions. This is why the Risk Atlas is intended to be a dynamic form of commentary that will be revised periodically in line with S&P Global Rating’s views. The Profile score combines the sectoral and geographic risk exposures from the Risk Atlas with the entities performance compared to sector peers and industry standards on twelve ESG factors.

After determining an entity’s ESG Profile, we then assess the entity’s long-term preparedness, namely its capacity to anticipate and adapt to a variety of long-term plausible disruptions. These could involve ESG issues such as climate change and demographic shifts, as well other disruptive trends such as technological or regulatory developments where relevant, among other factors. This is because, in our opinion, high-quality corporate governance includes the full spectrum of current and potential risks and opportunities an entity faces beyond typical financial planning horizons.

The ESG Evaluation is not a credit rating, a measure of credit risk or a component of our credit rating methodology, but the information we gather from the evaluation can inform our credit analysis of rated entities.

While markets still have much to do in the ESG sphere, S&P is preparing for the challenges ahead and hopes that by providing investors with data-driven, up to date information in easy-to-use formats such as the ESG Evaluation and Green Evaluation tools, we can support greater transparency in sustainable finance.

Hadi Melki is a managing director at S&P Global Ratings