ESG in Global Markets

[redherring1]

I've been researching and thinking a lot about ESG's impact in finance and wanted to share a few arguments regarding how trading and asset management might evolve based on Environmental, Social, and Governance (ESG) trends and new policies such as Zero Carbon targets which introduce new dynamics to the business world and financial markets.

I expect this article to be a bit unorthodox (as far as trading posts go) and a bit original in a sense that it isn't easy to come across consolidated information on ESG's specific impact on finance and particularly trading. Especially when we include second and third level thinking which is a philosophy American economist Thomas Sowell greatly elaborates in his books. Here are some facts and opinions regarding the transformations that might take place based on ESG trends in the upcoming months, years and decades.

How is ESG going to affect the future of trading?​

I will share some factors needed, and already observed, for global adoption of such new trends including policy trends at government level and consumer trends at public level.

Ingredients for a perfect recipe:​

1. Politics & Macroeconomics​

Almost all countries in the world committed to a Zero Carbon target by 2050. A few significant countries target it even before. For example, Germany and Sweden in 2045 and Iceland in 2040. China, USA, EU, UK and pretty much all the economies will introduce law and regulations to reach that target in the next years.

At first some people may think this is a western sensation but actually even China and Russia are on board and declared their Zero Carbon target dates as 2050 and 2060 respectively. Most people (even Canary Wharf professionals!) fail to realize what these targets will actually entail in the big picture. To be able to accomplish the Zero Carbon economy you need to work towards that goal for decades leading to the deadline year, so, the actual changes will happen long before the target date. And the change mentioned here will occur in top down fashion through law and regulations. In the next paragraph, I will also mention another part of this dynamic which can be considered as the bottom up pair of this equation (generational consumer behaviors).

Here is a list of some of the locomotive global economies and their target Zero Carbon dates.

1. China (2060)
2. USA (2050)
3. EU (2050)
4. UK (2050)
5. South Korea (2050)
6. Brazil (2050)
7. India (2070)
8. Japan (2050)
9. Indonesia (2060)
10. Canada (2050)
11. Russia (2060)
12. Australia (2050)
13. Nigeria (2060)

From this list we can derive the opinion that most open economies with liquid markets will be completely transformed starting from this decade and onward.

2. Generational Wealth Shift: Tendencies of Millennials and Gen Z​

Another part of the equation is the consumer behavior. Do the masses of people, the public, actually care? The answer is yes. Millennials and Gen Z surveys show that millennials are a lot more inclined to care about the investments they are making. 90% of Millennials are interested in pursuing sustainable investments (According to Morgan Stanley survey) Gen Z is known to be a lot more sensitive about the topics of environment and social matters such as inclusiveness.

Considering that millennials will inherit lots of wealth and be in charge of significant amount of wealth in the upcoming years (approximately $70 trillion USD is expected to be passed to next generations from baby boomer parents before 2030), we can conclude that consumer preferences are and will be at least supportive of the top down change occurring from government policies. Baby boomer generation falls in the range of 1944-1964 as birth year who are people roughly between 59 and 79 years old as of 2023.

Now that we seem to have complimentary dynamics for changes to happen at government and public level, let's briefly take a look at statistics and speculate on what changes we can expect in the finance world and particularly trading.

3. Reasons other than generational dynamics that give incentives to ESG investing.​

There are several reasons why investors are increasingly interested in ESG assets that are independent from generational dynamics.

- Long-term financial performance: Companies with strong ESG practices can be more likely to achieve long-term financial success, as they are better equipped to navigate challenges and risks associated with environmental, social, and governance issues.

- Alignment with personal values: Many investors have a growing interest in aligning their investments with their personal values, and ESG investing allows them to do so, by focusing on companies and projects that are aligned with their environmental and social values.

- Risk mitigation: By considering ESG factors in their investment decisions, investors can potentially identify and mitigate environmental, social, and governance risks, which can have a negative impact on financial performance.

- Increased transparency and disclosure: ESG disclosure and reporting standards can result in increased transparency and provide more information and insights into companies' practices and performance.


A variety of reasons from long-term financial performance to alignment with personal values and risk mitigation to increased transparency additionally support the ESG arguments in the trading and investment world.

ESG Related Financial Securities​

​

ESG Fixed Income​

ESG related fixed income securities are also showing strong performance. We can list some of the ESG fixed income assets as below:

• Sustainability linked bonds
• Sustainability bonds
• Green loans
• Sustainability linked loans
• Social bonds
• Green bonds

Please note some of the debt securities such as green loans may or may not be fixed income securities depending on their repayment structures and whether they have floating rates as fixed income securities, such as bonds and Treasury bills, pay a fixed rate of interest over the life of the security, and the principal is repaid at maturity.

Sustainability bonds are a type of bond that is issued to finance environmental and social projects, and they are becoming increasingly popular as investors look to align their investments with their sustainability values. We can further categorize sustainability bonds as under different niches as below:

• Green bonds: Bonds issued to finance environmentally-friendly projects such as renewable energy, energy efficiency, and sustainable transportation.
• Social bonds: Bonds issued to finance projects that have a positive impact on society, such as affordable housing, healthcare, and education.
• Climate bonds: Bonds issued to finance projects that address climate change and its impacts, such as carbon reduction, adaptation, and resilience.
• Nature bonds: Bonds issued to finance projects that protect and preserve natural ecosystems and biodiversity, such as forest conservation and reforestation.
• Blue bonds: Bonds issued to finance projects that address ocean sustainability and preservation, such as ocean conservation and fishing industry reform.

ESG related fixed income securities are rapidly evolving and these are only a few examples from the fixed income markets.

Global issuance of bonds for environmental, social and governance goals hit $1 trillion record for the first time ever in 2021, expected to grow 5 fold and hit $5 trillion USD by 2025.

ESG Equities​

ESG equities refer to stocks or shares of companies that are considered to have strong Environmental, Social, and Governance (ESG) practices. ESG equities are selected based on a range of ESG factors, such as a company's carbon footprint, labor practices, diversity and inclusion policies, and governance structure, among others.

Quite a few finance institutions already provide rankings on company stocks based on their ESG performances. Some global examples to such ranking providers are: MSCI, JPMorgan, BlackRock, Sustainalytics, Morningstar, Bloomberg, FTSE Russell and RobecoSAM.

In the UK, Schroders, UBS Asset Management, Impax Asset Management, Legal & General Investment Management (LGIM), Aviva Investors, Aberdeen Standard Investments and BMO Global Asset Management provide ESG rankings on various equities.

Investors who are interested in ESG investing often look for ESG equities as a way to align their investments with their personal values and support companies that are committed to sustainable and responsible business practices. By investing in ESG equities, investors can potentially achieve a positive financial return and improve risk management practices while also making a positive impact on the environment and society.

Multinational global companies are also following the trend. Amazon has a Climate Pledge for Carbon Neutrality in 2040. Apple and Facebook have similar programs for 2030 (end of this decade!) and Google already claims to be carbon neutral since 2007. Nestle and Coca Cola are following from a bit behind as they target 2050. Additionally 100s of global companies have pledged and are taking steps to achieve their goals.

As the ESG momentum continues at private and public companies, this will mean more ESG-savvy roles at companies and investment firms to execute ESG related tasks and carry out ESG related analyses. In the early millennia, companies used to employ a single person who would be the go to person for trivial ESG tasks and questions. I think it's clearly visible that we are way passed that era where companies are actually transforming their organizations to blend ESG practices to their core operation. This means

For example, PWC has some 300K+ employees globally and they are planning to have 100K employees in ESG positions by 2026, a mind blowing figure considering it's coming from a single entity and consists of the consulting giant's one third of employee base.

Similarly, trading and asset management firms will increasingly need ESG related equity research analysts, quantitative analyst and specialized traders to answer the demands that are happening already and/or will be happening at an increasing pace.

ESG Derivatives​

ESG derivatives are financial instruments that are linked to the environmental, social, and governance (ESG) performance of indices or assets.
Examples of financial derivatives which have ESG securities as underlying assets include:

- ESG swaps: Swaps that pay or receive a predetermined amount based on the ESG performance of a bond, company or index.
- ESG options and warrants: Publicly listed or OTC (over-the-counter) financial securities that give investors the right, but not the obligation, to buy or sell ESG securities based on a pre-determined price.
- ESG futures: Futures contracts that obligate the buyer to purchase or the seller to deliver a specific ESG security at a predetermined price and date.

The use of ESG derivatives is only expected to grow as the ESG assets' popularity grow as the underlying assets and more investors seek to incorporate ESG considerations into their investment strategies, and as countries, companies and markets increasingly adopt ESG practices.

ESG-related ETFs & Indices​

ESG ETFs are exchange-traded funds that track the performance of ESG-focused indices or companies and provide investors with exposure to ESG-friendly investments.

Here are some of the big ESG ETFs in demand:

- MSCI ESG Indices: These are a series of indices developed by MSCI that meet certain ESG criteria.
- S&P ESG Indices: A subsidiary of S&P Global, and track the performance of companies that meet certain ESG criteria.
- FTSE4Good Indices: A subsidiary of the London Stock Exchange, tracking the performance of companies that meet certain ESG criteria.
- DJSI Indices: These indices are developed by S&P Dow Jones Indices and RobecoSAM and track the performance of companies that meet certain ESG criteria.
- STOXX ESG Indices: A subsidiary of Deutsche Boerse AG tracking the performance of companies that meet certain ESG criteria.
- MSCI ESG Indices: MSCI's ETF offering investors a range of ESG-focused indices and funds.
- BlackRock's iShares ESG ETFs: BlackRock is a leading investment management firm that offers a range of ESG ETFs, including the iShares MSCI KLD 400 Social ETF and the iShares MSCI ACWI Low Carbon Target ETF.
- State Street Global Advisors' SPDR S&P Kensho Intelligent Structures ETF: State Street Global Advisors offers the SPDR S&P Kensho Intelligent Structures ETF, which invests in companies that are developing technologies to improve the energy efficiency and sustainability of buildings.
- Invesco's PowerShares Cleantech Portfolio ETF: Invesco offers the PowerShares Cleantech Portfolio ETF, which invests in companies involved in the development and commercialization of clean technology solutions.
- Robeco Sustainable Equity Fund: Robeco is a leading sustainable investment firm that offers the Robeco Sustainable Equity Fund, which invests in companies that are considered to have strong ESG practices.
- BNP Paribas Easy ESG ETFs: BNP Paribas offers a range of ESG ETFs, including the BNP Paribas Easy MSCI World ESG Leaders UCITS ETF and the BNP Paribas Easy MSCI Europe ESG Leaders UCITS ETF.

There are quite a few others but this is a good list representing various issuers with significance in the financial world.

According to a NASDAQ article ESG ETFs grew nearly 10X in 3 years between 2018 and 2021 reaching approximately $400bln USD from $40bln USD. Some forecast estimate ESG ETFs to pass $1 trillion USD mark by 2026 or sooner.

Trading Technologies & Fintech​

The Environmental, Social, and Governance (ESG) trend is likely to have a significant impact on trading solutions and the fintech industry as well.

Increased demand for ESG-focused financial products and services necessitates fintech companies who offer innovative solutions, such as ESG-focused investment apps and ESG-centred digital banking services that incorporate ESG metrics into their product offerings. Changes in laws, regulations and standards further dictate proactive regtech solutions in addressing ESG compliance issues, and as a result, fintech/regtech companies will have opportunities to provide solutions to evolving regulations and standards.

Fintech companies are also likely to help financial institutions integrate ESG metrics into their risk management systems, to better understand and manage the environmental, social, and governance risks associated with financial products and services. Considering the impacts we can expect seeing more and more investment inflow to ESG related fintech companies.

Furthermore, increased demand for ESG data and analytics, ESG-focused trading products, trading algorithms that include ESG parameters and ESG-oriented risk management are just a few major topic directly related to ESG and trading. Following fintech companies already came to my attention through the previous years in the ESG space.

• Truvalue Labs uses artificial intelligence to analyze ESG data and provide investment insights to asset managers and other financial professionals.
• Sustainalytics is a leading ESG research and analysis firm that provides data and insights to help investors integrate ESG considerations into their investment processes.
• Just Capital is a nonprofit organization that uses data to rank companies on various ESG metrics.
• Arabesque S-Ray is a data analytics firm that provides ESG insights and analysis to investors and
• ImpactMgmt is a platform that provides data and insights to help investors make more informed investment decisions based on ESG criteria.
• Clarity AI is a data analytics firm that uses artificial intelligence to provide ESG data and insights to investors.

I think fintech solutions with ESG components are incredibly exciting both from entrepreneurial perspective and trader perspective if you want to be on top of recent trends and smart solutions which can help increase AUM figures as well as trading profitability.

Summary​

In summary, there are quite a few supporting arguments that ESG will transform trading and, in a broader context, the finance industry.

ETFs and Fixed Income activity clearly show strong growth in ESG related assets. There are solid reasons why it might be beneficial and rewarding to have some level of preparation to build a future-proof career/startup by proactively staying up-to-date with ESG trends. Statistics, consumer surveys and government policies collectively show us the significant impact and opportunities that will occur around ESG-savvy business solutions, trading strategies, investment practices and data solutions. I wish all of you fruitful careers full of exciting opportunities that also benefit our world.


References:
[1] https://www.cityindex.com/en-uk/news-and-analysis/a-guide-to-esg-investing/
[2] https://www.nnip.com/en-INT/profess...ed-bonds-a-viable-alternative-for-green-bonds
[3] https://www.eurex.com/ex-en/markets/idx/Equity-Index-ESG
[4] https://www.climatebonds.net/resour...ebt-topped-1trillion-2021-huge-volume-climate
[5] https://www.nasdaq.com/articles/etfgi-reports-etfs-focused-on-esg-strategies-listed-globally-gathered-net-inflows-of-$7.55
[6] https://www.morganstanley.com/pub/c...ignals/pdf/Sustainable_Signals_Whitepaper.pdf

 

[JustAnotherHuman1]

Cheers for this insightful piece, as always.

Would you agree that ESG as an industry was really nowhere compared to 7/8 years ago vs today? I mean, I don’t remember a lot of news coverage on it, of course green technology was around then but not as much as today which I think also has to do with the fact that really there was no tangible proof of global warming until last years heatwaves and drought around the world. Now that we experience the consequences on our own skin, it’s a different story. It’s only nowadays that we see headlines such as “it’s code red for humanity” etc.

What do you think about the huge US green package announced recently? There was a lot of debate around it saying it makes the EU less competitive as there is no such package there. IMO the US is taking action and is right for it while the EU is considering options for years before taking any real action.

Have you heard of https://permutable.ai/? Some free advertisement for them I guess but I did a short gig for them recently and thought their product is quite interesting and ever so current.

 

[curious_finance1]

Very detailed article, nicely done @redherring !
I have some experience in fixed income ESG, have researched quite a bit to create a product that would measure ESG portfolios, helping investors choose their portfolio structure based on market data and potential return. I strongly agree that the ESG is one of the hot topic in finance now-a-days , gaining the attention of the largest asset managers in the world. (even Blackrock has acted as representative for the market overall based on the impact their assets under management have on a global scale article for reference)

I personally see a value beyond economic return in ESG and what its principles stand for, and am totally in favor for it. However, even though the discussions are being had, the public focus is around ESG and countries and biggest companies have pledged zero emissions and strongly focusing on ESG investments for the future, there are still main issues with it generally speaking. A lack of standardized criteria for what makes an investment sustainable, or what the clear impact of an ESG investing is, how to measure the impact accurately, the performance in time of the ESG investment that would generate the desired return for investors - all these seem to not be very well structured or verified in a sense. What do you think of the problems with ESG? Do they make sense in the current situation?

 

[redherring1]

Very detailed article, nicely done @redherring !
I have some experience in fixed income ESG, have researched quite a bit to create a product that would measure ESG portfolios, helping investors choose their portfolio structure based on market data and potential return. I strongly agree that the ESG is one of the hot topic in finance now-a-days , gaining the attention of the largest asset managers in the world. (even Blackrock has acted as representative for the market overall based on the impact their assets under management have on a global scale article for reference)

I personally see a value beyond economic return in ESG and what its principles stand for, and am totally in favor for it. However, even though the discussions are being had, the public focus is around ESG and countries and biggest companies have pledged zero emissions and strongly focusing on ESG investments for the future, there are still main issues with it generally speaking. A lack of standardized criteria for what makes an investment sustainable, or what the clear impact of an ESG investing is, how to measure the impact accurately, the performance in time of the ESG investment that would generate the desired return for investors - all these seem to not be very well structured or verified in a sense. What do you think of the problems with ESG? Do they make sense in the current situation?

Thank you! I appreciate your comment.
I have to agree with you about the current momentum and backing ESG has. And also nice to hear that you see value in ESG practices as well.

You've mentioned a very critical and strategic point related to ESG which I think is an opportunity for me to elaborate a bit on the standards and frameworks that currently exist in the space, they usually go unnoticed at this stage but most large companies are already familiar with them.

I think the verification, measurement and standardization aspects of ESG are all tangible problems that can and will be solved. Governance is a hybrid problem with soft and hard components but again it's not too difficult to build on the existing frameworks there.

In my opinion, the biggest problems about ESG are related to the social aspects of the movement. Coming up with metrics to quantify complex social performance for companies and countries will remain to be a difficult task in the foreseeable future. Having said that I think organizations are getting better at promoting diversity without hurting a specific group, leveling the playing field for different genders in terms of compensation, increasing accessibility at workplace, allocating resources to preferred causes, helping local communities and taking responsibility for second and third tiers in the supply chain are a few of them. So even the social aspect can be placed on a standardized framework to a degree it's just more challenging to measure.

Another big problem is the delegation of responsibility in the supply chain across multiple tiers all the way from to source to the end client. I think this too can be solved with sensible algorithms which all stakeholders agree on. It might take some discussing, but it's not impossible to tie it all to parameters. Needless to say, the big fish needs to take bigger responsibility than the small fish and everyone should be incentivized accordingly when they do the right thing.

So, re standardization:
As far as frameworks go, we already have a mandatory reporting framework in the UK for big companies called SECR (Streamlined Energy and Carbon Reporting). SECR mandates publicly listed companies, large LLPs or unquoted companies above certain size that have consumed 40.000 kWh energy fall under SECR reporting obligations.

Regarding large unquoted companies, definition according to UK Gov guidance is as following (as accessed on 12/2/2023): The 2018 Regulations require large unquoted companies that have consumed (in the UK), more than 40,000 kilowatt-hours (kWh) of energy in the reporting period to include energy and carbon information within their directors' (trustees') report, for any period beginning on or after 1 April 2019....
Large companies, as defined in sections 465 and 466 of the Companies Act 2006, are companies that meet two or more of the following criteria:

• turnover (or gross income) of £36 million or more,
• balance sheet assets of £18 million or more,
• 250 employees or more.

I don't think mandatory framework equivalents exist at federal level in the US or even in the EU but they have their own voluntary systems. It's still very early years of ESG reporting but I think we will see more international standardization after some experience.

Additionally we have international frameworks: CDP (Carbon Disclosure Project) and TCFD (Task Force on Climate-related Financial Disclosures). CDP is a global disclosure system for cities and countries as well as companies. TCFD is also a global standard for companies based on their financial metrics related to climate and governance topics.

While CDP focuses on measuring and managing a company's environmental impact, TCFD focuses on the financial implications of climate-related issues for a company. They compliment each other nicely and I think are great starting points. As data is collected and experience with regards to measurements and reporting acquired, I think eventually some of these frameworks will likely be mandatory somewhere down the road to reach the carbon-zero objectives of governments.

Not to say challenges don't exist but as the old saying goes when there is a will there's a way.

Thanks again and have a great week ahead!

 

[redherring1]

Cheers for this insightful piece, as always.

Would you agree that ESG as an industry was really nowhere compared to 7/8 years ago vs today? I mean, I don’t remember a lot of news coverage on it, of course green technology was around then but not as much as today which I think also has to do with the fact that really there was no tangible proof of global warming until last years heatwaves and drought around the world. Now that we experience the consequences on our own skin, it’s a different story. It’s only nowadays that we see headlines such as “it’s code red for humanity” etc.

What do you think about the huge US green package announced recently? There was a lot of debate around it saying it makes the EU less competitive as there is no such package there. IMO the US is taking action and is right for it while the EU is considering options for years before taking any real action.

Have you heard of https://permutable.ai/? Some free advertisement for them I guess but I did a short gig for them recently and thought their product is quite interesting and ever so current.

Cheers, thank you so much for chiming in. I have replied to your comment shortly after you posted it but something must have happened during the submission process. I should have checked, my bad!

I certainly agree with the recognition and traction ESG gained since 2015. Paris Agreement was a major milestone and an accomplishment of the United Nations Framework Convention on Climate Change (UNFCCC) which accelerated the ESG movement globally. It's hard to comment on the cause and effect but 2010s saw a huge increase in socio-environmental awareness overall. I think in the preceding years there have been lots of news coverage about negative matters such as excess plastic use, microplastics epidemic, land-sea-air pollution (especially in India & China and other emerging economies), climate crisis, deforestation, mass migration cycles of animals, decreasing bee and flying insect populations and many more alarming phenomenon. Increased demand for ESG might have been a reaction from our mutually evolving human psyche after years of negative coverage and lack of serious action at institutional and individual levels but we seem to have steered towards the right direction after all.

I think the bill which passed the US Senate and then the US House of Representatives in last August is impressive to say the least. The new federal law (IRA or Inflation Reduction Act) will allocate $700+ billion government revenue to climate, healthcare and tax over the 10+ years from which $369 billion is expected to be allocated to countering climate change. It has been announced as "the most significant climate legislation in U.S. history" and it's expected to lower US carbon footprint by 40% before 2030. This is great news but let's remember something about the United States; it is one of the biggest carbon emitter on both per capita and nominal bases:

- carbon emission per capita in the US came after Qatar, Kuwait, UAE and Bahrain with approximately 16 metric tons in 2021.
- On nominal basis, US comes second in the world with approx. 5 billion metric tons. China is first with approx. 10 billion mt tons but has only 7 mt tons per capita.


In addition to US' existing ultra large carbon footprint and lack of green energy in its electricity generation stack, US is known to have an efficiency and supervision problem when it comes to spending government budget. I still agree that it's a very bold and impressive bill but both sides have their strengths and shortcomings. EU is known to conceptualize great frameworks and legal systems and put them in practice with great supervision and efficiency although usually at slower rates than the US government. I think EU will follow the steps of USA in terms of matching government efforts but understandably there is less pressure as EU already has a big head start with green energy and less aggressive consumerism. I appreciate this opportunity to exchange our views on this. Thanks again for your great insight and comments!

I hadn't heard of permutable.ai, I checked their API and it looks quite promising. I need to make a few more tests , I think by elaborating their solutions a bit and using the existing momentum they can reach much higher operational activity levels. I think we will see plenty of M&A activity and some consolidation in climate tech in the next years, there is bread to be made for finance professionals as well as tech people.

Thanks again!
Have a great week ahead.

 

[TheCanaryConsultant1]

Thank you, incredibly well written and insightful piece. Regarding pollution, when looking at CO2 emissions on Statista (https://www.statista.com/statistics... biggest emitter,global CO₂ emissions in 2021.) it seems that together China, USA, India and Russia account for more than 55% of CO2 emssions worldwide (China being 30.9%). All the rest is below 3%. Would a drastic change in these countries not be the real game changer in terms of pollution ? I agree that we are observing a shift in investment strategies towards ESG but regarding the "E", the real change needs to happen there, no?

Also, I have noticed we start seeing quite a few articles coming up where investment companies are actually not up to the ESG standards they claim to be at, and that the ESG is more a marketing tool?