SUSTAINABLE, GREENER FUTURES.

Serafino Tavoletti, Market Hub Brokerage & Execution, Banca IMI

Incorporating environmental, social and corporate governance (ESG) factors in investment strategies has become a distinct service for many providers of investment products. ESG investing is an approach that focuses on several non-financial dimensions of a stock’s performance, including the impact of the company on the environment, a social dimension and governance. This investment philosophy has been gaining momentum, not only in Europe, but across the globe, becoming the most widely used strategy by SRI investors and there is rising interest by “millennials funds”. Let’s have a look at these 3 factors.

Environmental criteria look at a company’s energy use, waste, pollution, natural resource conservation and animal treatment. They also evaluate which environmental risks might affect a company’s income and how the company is managing those risks.

Social criteria look at the company’s business relationships. In other words, it is about the impact that a company can have on their employees and on society: diversity and inclusion policies, safe and healthy working conditions, labour standards across supply chains, and good relationships with local communities.

Governance factors focus on corporate policies and how companies are governed. Responsibilities, rights, and expectations of stakeholders are considered, so that interests are met and a consensus on a company’s long-term strategy is achieved. Illegal behaviour or the use of political contributions to obtain favourable treatment are among the screening criteria.

For each of these dimensions, a lot of information on the firm’s practices is being collected and analysed. ESG investing relies on the belief that both investors and society benefit by including ESG information. This means that capital is being invested to ensure that today’s investment needs are met without endangering future generations.

It’s still early days and challenges remain over the different definitions, lack of standards and varying market structures, but the adoption of this approach is spreading rapidly and increasing amounts of money are flowing into funds that consider ESG factors in their investment process. Morningstar estimates that Ä34.4 billion flowed into European ESG funds in 2018, bringing the total assets under management to Ä684 billion at year-end.

It was just a matter of time before the ESG movement moved from the equities sphere across fixed income and listed derivatives. This is well reflected in the product range of index providers and derivatives exchanges. The most recent examples are in Europe, where two leading exchanges have launched futures on stock market indices that meet ESG standards. Nasdaq was the first exchange to move into this new sector in October 2018; the exchange launched futures on a version of the OMX Stockholm 30, the main benchmark for Swedish stocks, that excludes companies that fail to meet ESG standards. Plans are also underway for a corresponding ESG index of the OMXC25 in Denmark and the OMXH25 in Finland.

In February, Eurex introduced the Stoxx Europe 600 ESG-X Index, a version of the large-cap Stoxx Europe 600 that screens out companies with low ESG rankings and the Euro Stoxx 50 Low Carbon Index based on the Euro Stoxx 50. It also launched the Stoxx Europe Climate Impact Index, a group of roughly 260 European corporations that disclose the environmental impact of their businesses and excludes companies in industries such as coal, aiming to help market participants address the challenges and opportunities of sustainable investing. Eurex also gained CFTC approval to make these products available to US investor and is working to expand the product range to cover more regions together with the introduction of options to support market participants with efficient derivatives instruments and meet the requirement to incorporate ESG into their investment strategies.

Open interest in the Nordic exchange has been relatively stable with an average of 27,500 contracts, the equivalent of Ä415 million. Eurex on the other hand has seen a growth since its birth, showing in 7 months an average open interest of 40,000 contracts, around Ä570 million. However, it’s still too early to see consistent volumes and regular activity. Despite this variability, the books are liquid, showing decent bid /offer spread thanks to liquidity providers.

The introduction of listed derivatives has been crucial because it gives asset managers more flexibility to hedge their portfolios, create synthetic positions, manage unwanted sustainability risks and meet investment mandates in a cost-effective way, compared to capital intensive products like ETFs or structured products.

One aspect to consider though is the fact that ESG can be confusing for investors who are familiar with the classic socially responsible investing (SRI) methodology. ESG investors choose companies because of impressive environmental, social and governance attributes; conversely, a traditional SRI investor focuses on excluding certain industries (tobacco, alcohol, weapons, gambling). ESG offers more flexibility and depth of research to define a comprehensive corporate initiative and management’s patterns. Moreover, ESG is also a stakeholder-centric theory, which means how companies treat all their stakeholders will impact their long-term success or failure.

Despite the proliferation of sustainability indices and ESG agencies, there is no standard methodology for the evaluation of companies. Recent work done by the European Commission to develop a ‘taxonomy’ aims to develop a ‘universal understanding’ of what is environmentally sustainable, shared by scientists, governments and industrialists. A proposal for a regulation has been brought forward to introduce disclosure obligations on how institutional investors and asset managers integrate environmental, social and governance factors in their risk processes. We expect this to become mainstream in the coming years, with positions slowly shifting from traditional benchmarks to more sustainable alternatives.

Through its 2018-2021 business plan, Intesa Sanpaolo, which is already a leading bank in corporate social responsibility, aspires to become a world-class reference model on social and cultural responsibility. Furthermore, Market Hub, the brokerage & execution team of Banca IMI, provides to its clients full access to trade ESG-related financial products, giving the opportunity to exploit these increasingly relevant products.

©Best Execution 2019
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