A Patchwork of Standards Raises Risks of ESG Fixed Income Funds

Environmental, social, and governance frameworks are better suited for stocks than to fixed income.

Illustration by II

Illustration by II

Managers that want to run fixed-income funds with a focus on environmental, social, and governance factors face larger research challenges than those in stocks. But the massive opportunity in bonds may make the uphill battle worth it.

According to a new report from CRISIL, a global analytics company that is part of S&P Global, ESG-labeled fixed-income funds accounted for about 3 percent of total assets in the category last year, while equity funds with the same objective accounted for roughly 5 percent of the total. This is largely because ESG ratings and frameworks were built around stocks.

“The ecosystem caters to equity way more than it does to credit,” Abhik Pal, CRISIL’s senior director and global practice head of fundamental research, told Institutional Investor. “For example, if you look at the data providers and the framework providers, the larger ecosystem is [generally] a little more equity-focused.”

Pal said credit providers therefore have to do more due diligence to integrate available ESG products into their funds. According to the report, this is because most ESG frameworks include both risks and opportunities, even though fixed-income investors are mostly interested in detailed analyses of the risks.

“They’re looking [more] at a longer landscape or time horizon,” Pal said.

Negative corporate governance issues impact stock investors far more than those in fixed-income, but generic ESG frameworks place a large emphasis on this aspect, the report said.

Another challenge for fixed-income managers is that external ratings vary greatly. According to CRISIL’s analysis of over 400 companies, the average correlation of ESG scores was 0.34 percent. The report attributes the low correlation to the lack of standardized definitions of ESG measures, differences in rating methodologies, and different factor weightings included in the overall score. For this reason, Kroll Bond Rating Agency decided to stay away from developing a simple score when it entered the market.

“A lot of the [ratings are] based on data available and not really on what is needed,” Pal said.

For example, Pal said, if a rating agency looks at Tesla and ignores ESG data that is not provided — and does not penalize the company for the missing information — the ESG score will be high. If another agency or index provider takes a deeper dive into Tesla’s practices and penalizes it for the missing data, Tesla would end up with a lower score.

“I don’t think the frameworks are vastly different, but the way people apply the frameworks — what kind of data they get, the quality [of that data] — [makes] a huge difference in the way the ESG ratings are disparate, and that’s a big problem in the market,” Pal said.

Based on the same analysis, CRISIL founds “significant gaps” in disclosure of the key metrics used to calculate ESG scores. For example, only 75 percent of non-rated firms reported their scope 1 and 2 emissions, while 95 percent of investment-grade firms reported theirs.

Greenwashing is also a larger issue in fixed income. This is because global standards for green bonds lack consensus, KPI targets are “not ambitious,” financial penalties for greenwashing are lax, and post-issuance reporting is inadequate, the report said.

CRISIL argues that despite challenges, there is room and demand for greater ESG integration in fixed income. The report suggests that fixed-income funds use alternative data to enhance scoring, use proxies to boost product credibility, and conduct independent assessments on their products.