Sustainability Scrutiny in the Financial Market

0:00 greetings my name is christy bear and i'm the assistant director of the center on finance law and policy 0:05 i am thrilled to welcome you back to our monthly blue bag lunch talk today our speaker is peter adrian's and 0:12 before i tell you about him you know that i am not happy until i have a chance to plug 0:18 other center on finance law and policy activities and so next monday i want to let you 0:24 know that we are sponsoring a panel that's part of um africa week it's called fintech in an 0:32 african context and we have some very cool found the founder of migo money 0:39 the founder of m-pesa the founder of i mean sorry and the former governor of 0:44 the central bank of um nigeria all on the panel 0:49 um so anyway it should be pretty good i hope you'll come the if you click on that link then 0:54 that's where you will register so please join us for that but today we're here to talk about environmental 1:02 finance let me tell you about peter adrian's um peter is the person at the university 1:08 that you reach out to when you want to make something happen and so if you look back through his bio he has 1:16 found he is one of the co-founders of the university's fintech collaboratory he's the founding director of the center 1:23 for smart infrastructure finance he has appointments at ross engineering 1:28 sees like he knows everybody this is the guy that you want to know his research focuses on data driven 1:35 digital business and finance models and specifically he looks at blockchain applications 1:42 smart cities infrastructure and tr how to use technology to advance public 1:50 um public financing for the greater good so this term he's teaching an 1:56 entrepreneurial business fundamentals class and a class on infrastructure finance and 2:01 i also have to plug for a minute the new masters of engineering in infrastructure finance so 2:10 if you understood half of the things that i just talked about you are in for a treat and if you don't then that's okay too 2:17 because the other thing that i like about peter is that he can explain complicated things in a 2:23 straightforward way which is the hallmark of a good teacher so without further delay professor adrian's 2:31 i'll leave it to you well thank you very much christy great introduction and uh great to see 2:36 everyone here on online uh of course it takes about 30 years to 2:42 uh get to know everyone on campus so i would have been around long enough to find the people and in engineering 2:48 and the business school sees and the school for public policy right i mean as christie mentioned uh 2:54 i am co-founder together with uh the center of finance law and policy uh michael christie and and uh adrian 3:02 harris uh public policy as well as um our colleagues at the 3:07 business school the fintech initiative in this whole new collaboratory but that's actually not what i'm gonna be 3:13 talking about today so i i do have a uh 3:18 um a course that i'm teaching in fall also on environmental finance and so this whole you know kind of 3:25 integration between environmental finance and as we'll see in a little bit infrastructure and data 3:32 and how things are moving forward in the current day and age i guess of you know 3:39 new finance sustainability scrutiny in the financial markets is becoming very relevant to the topic of today i should 3:46 mention uh most of the the the topical areas it's going to be a bit of a 3:51 finance talk though promise no equations i'm going to have some some charts but we're going to keep the modeling out 3:58 of it but the the two of the topics that i'm 4:04 going to be referring to uh relate to a collaboration that we currently have with nuveen nuveen is the investment arm 4:13 of tiaa tia of course is the teachers pension fund of which the university of michigan 4:18 is the largest client and so they're also a major driver in in the sustainability space actually 4:25 since 1989 before the modern definition of what sustainability was 4:30 so they've been in the business for a long time and i'm going to be talking a bit about some of the work that we're doing in uh 4:35 one of my uh one of my startups aquarius risk analytics related to this environmental 4:41 or to the sustainability scrutiny so first off what is sustainability scrutiny let me see if i can 4:48 um can everybody see this yet or not yet hang on a sec let me go 4:56 into 5:07 is this forwarding for you or not yes we're good all right yes um so 5:14 let's start with a couple of recent headlines and i'm trying to manage my uh gallery here uh recent headlines that 5:21 many of you may have seen may have read most recently i mean the us was a little 5:27 bit later to the game as a relative to uh to europe but the fed chair powell says central banks must 5:35 help address climate change because of implications on monetary policy 5:40 uh bank regulation financial stability um in sustainable business and finance just 5:46 just a couple days ago a big statement coming up investors are finally waking up to the sdgs the 5:52 sustainable development goals but sort of question is how do we quantify risk how do you quantify risk 5:58 from esg's big elephant in a room and then three out of environmental finance which is a 6:04 blog i use very often not only my classes but also my research that actually 6:09 investors are starting to use in financing are starting to use esg data environmental social and 6:15 governance data as almost a canary in the coal mine for credit rating 6:20 so for you know your your uh standard poor's or moody's credit rating so so the sort of this 6:27 this connection that's being talked about between climate and sustainability and financial 6:33 stability and financial regulation and whatnot and it's still very confusing at this point 6:39 a very confusing topic because financial materiality is not very often sort of linked into 6:46 this whole sustainability discussion a lot of it is still about we gotta do better we gotta 6:52 develop sustainable practices uh it's good for long-term growth it's good for your stability and whatnot 6:58 what i wanted to do is a little bit more scrutiny and go a little bit deeper on how all this sustainability links into 7:05 sustainability conversations link into materiality link into 7:11 issues around not just climate change but sustainability more broadly um so and let me start out with the 7:19 financial stability board um not too many of you may be familiar with the financial stability board 7:25 financial stability board was essentially uh put together in in 2009 after the last financial 7:32 crisis by the g20 at the pittsburgh meeting at that time and so basically the whole idea was well 7:38 let's set up a board and figure out because how we can standardize not yet climate but in general other 7:46 risk disclosures that are currently not being disclosed by either corporates or other players in the market 7:53 by 2005 the the financial stability board launched the task force on 7:59 climate-related financial disclosures because as you see here on the left the 8:04 argument is that climate-related risks are a source of financial risk and it's being talked about as you just saw in the 8:11 headlines over and over again and the argument is if it is a source of 8:16 financial risk and occur in a source of market risk it falls quickly in the mandates of central banks of supervisors 8:22 to ensure that the financial system is resilient to these risks now the big question is that might be true as a statement the 8:29 big question is how do you actually then quantify that or how much of an impact does climate 8:35 change and all these esg and sustainability disclosures that that corporations as 8:40 well as public governments are issuing how well are they related 8:45 to financial risk and how do we quantify how do we look at so the perturbations of these financial risks in the market 8:52 on the right i i mentioned that you know i mean climate with at least is non-diversifiable so it's not easy 8:58 for a corporation global corporations that are currently operating uh in the market 9:03 to diversify away from climate risk because one way or another whether it's through water whether it's through temperature whether 9:09 it's through uh droughts or storms or whatever you are exposed and therefore there is a financial impact 9:15 now there just to be sure there are currently no mandatory disclosures so even the the 9:22 task force and climate-related disclosures is not a mandatory disclosure it is a 9:27 it is a suggested disclosure on how uh how corporations should keep track 9:34 of how their operations and performance are being impacted by climate change and 9:40 so we're looking at issues such as revenues by of the company i mean how stable are those expenditures 9:47 assets and liabilities and of course in assets and liabilities in the context of carbon we talk a lot about stranded assets it's 9:55 a lot a lot about facilities of corporations that cannot 10:01 maintain or continue uh productivity under uh current either carbon guidance 10:08 but also cannot maintain productivity as a result of of water impacts as a result of 10:13 climate i'm going to talk a little bit about that as well and then of course there is the whole question regarding you know is climate 10:19 impacting you know how uh how corporations as well as as banks actually finance 10:27 finance new projects and new programs so so there's a guidance structure here 10:34 and this kind of gives you a very high level 30 000 foot overview right so we're basically we're looking 10:40 at on the one hand all the risks i guess that corporations and i'm going to be extending it also to 10:45 local governments later on in my talk but are impacted by policy and legal 10:50 technology uh technology deployment or or technology non-deployment market 10:57 risks right market risks the whole perception around climate change and how that's impacting 11:02 customer base and then of course the whole uh i mean reputational and and other risks on the 11:08 other hand we have the the new opportunities right the opportunities of resource efficiency 11:14 a lot of talk about resource efficiency i'm going to talk a little bit about resource water usage 11:20 and consumption but also energy sources that are being procured most recently even though it didn't help 11:26 them right the keystone pipeline some of you heard about that that of course he was allowed under to 11:31 proceed under the trump administration as soon as biden came in office on day one he killed off the keystone pipeline 11:38 keystone responded right away and said wait wait we're going to be pumping all our oil through this pipeline using 11:43 renewable energy well it wasn't enough to to actually make a difference i mean the project is 11:48 still not not moving forward but so the use of of of you know how how new energy sources are being used in 11:55 corporations and in projects are all sort of new opportunities for corporations to actually respond to the 12:02 risks on the left right but of course all of these have financial impact from an income perspective from a cash flow perspective 12:09 and from a balance sheet perspective and that in turn has an impact on the capital 12:15 markets and on how one discloses one's one's risks 12:20 so the what i'm going to be probing here a little bit is well we don't really have 12:28 standardized or benchmarked ways to disclose this information and if 12:35 there is no benchmark or no standard neither the securities and exchange commission nor 12:40 any other organization is going to mandate that corporations uh are going to be 12:47 disclosing these kind of risks because as i said there is really no common standard at this point so still very 12:54 much in the exploratory stage the good thing is that information is starting to 12:59 pop up right and so so let's talk talk about esg because whereas some of you may have heard about tc at 13:06 tcfd i don't know dcdf i guess i got dyslexic here for a little bit so 13:11 task force and climate related disclosures actually has a relationship to esg and 13:16 many more of you may be familiar with esg which isn't an equally confusing concept 13:23 that is sort of all the aspirations i guess that that corporations and different 13:28 aspirations by industry sectors have on how they will either disclose 13:33 the risks or manage the risks but again there is no benchmark i mean you look at them in thomson reuters you look at msci 13:40 you look at sustain analytics you look at all these different you know ratings providers and they're all going to look at 13:46 esg ratings which are in many ways tied to you know to to climate and to social 13:52 and to risk management into governance of the operation it's not again not standardized right so 13:57 if if neither tcdf is required or standardized nor esg being standardized 14:04 or required then how on earth are we going to bring the two of them together and say we have to disclose our 14:11 our material risks well what is the what is then the baseline right i mean both 14:16 of them are related but both are equally poorly specified to mean despite the fact that now we have 14:23 a sustainable um 14:28 the standards board in in california it's trying to standardize how we disclose esg risks and and despite the guidance that 14:36 comes from the financial stability board through the tcfd on how we disclose metrics and targets 14:42 risk management strategy strategy and governance the big question is are these ratings 14:48 even if they're connected these ratings that might relate to your tcfd a good measure 14:55 of material risk or returns right so that's ultimately what we want to probe right it's that 15:00 that that scrutiny in the markets has to at some point boil down not to 15:06 what we call metrics creep um you know again talking about this year esg 15:11 ratings you see i mean a lot pizza that sliced up in many different ways 15:16 so we have ratings providers that come up with more and more metrics the question is 15:22 are they materially relevant and if they're not then we're running into problems in how 15:27 we're going to be disclosing information that we need to disclose so what's this financial scrutiny that i'm talking about here two things 15:35 and two things that are very related right so one do risk disclosures 15:40 condition capital for sustainable investment and conditioning capital for sustainable 15:45 investment really means is capital that gets used to invest in companies in projects 15:52 in different sectors whether it's agriculture or mining or whatever it might be does does that take 15:59 into account these esg or sustainability risk disclosures 16:04 or do these sustainability risk disclosures provide a financial incentive for corporate 16:09 sustainability corporations disclose a lot too but how material is it to the company so 16:14 how material is it to investment to the investment side and how material is it to to to the corporation so i want to sort 16:22 of go beyond saying we need to disclose everything uh to saying well 16:27 it's important that we understand what the materiality is what the impact is of these of these 16:33 disclosures so connecting the two dots that the capital side and the corporate side 16:38 and for those that i didn't put the link in here but this sort of evolved out of a conversation 16:44 that i uh i had for for a long time with john allen at the school of environment sustainability 16:51 ravian appendi at the at the ross school of business um and and that we essentially uh um 16:57 structured as a talk uh for uh earth day at 50 last march so almost a year ago with a 17:03 talk about conditioning sustainable conditioning of capital and that the talk is actually available 17:08 online so let's talk a little bit about this and we're going to start sort of at a at a top level here right so does esg 17:16 scoring have financial materiality and the indicators and these are 17:21 indicated this this is 2016 through 2019 these are not my data this is from 17:26 msci msci is a is a um an index provider 17:33 but msci spun out of morgan stanley that's what the ms stands for 17:39 spun out i mean almost 20 years more than 20 years ago and they look at risk right but they 17:44 also have a group called the uh the esg research group within msci so they set up sustainable 17:50 indexing and they've been looking at sort of sustainability for a very long time for about 20 years 17:56 in from a financial side so not from an environmental disclosure side 18:01 not from a total tons of carbon or total acre feed or square or cubic kilometers 18:08 of water or from biodiversity but really looking at this through a financial lens 18:14 right and what we see here are sort of three pieces of information on cost of cost of capital and that's 18:21 this this is the the cost at which the the cost to a corporation 18:26 to get debt i guess acquire debt from banks 18:32 or or to sell their shares in the market and get the returns from that 18:38 and what it lists here what it compares here companies that have a low esg rating and companies that have a high 18:45 esg rating and then you got the other quartiles in between right so this is the bottom uh actually bottom quintile 18:51 right the top quintile and you got the other ones in between here right and this is for the usa for europe japan so total cost of 18:58 capital cost of equity and cost of debt so so the debt is probably easier to 19:04 easiest to understand for most of the audience that is if a corporation wants to expand might 19:10 build a new facility expand its operations and whatnot and it goes to the debt markets to actually get 19:15 a loan the the the the debt market to whomever the bank is the investment bank is looks 19:21 at the corporation looks at where they're going to be putting that that facility but also looks at how that 19:27 company manages it manages its risk and what we're seeing for example just here on the 19:33 right right between dark blue and orange that there is a significant impact of whether a company is 19:42 is i guess completely transparent in disclosing its esg risks 19:47 or not disclosing or very poor if poor or not disclosing its ex esg risks 19:54 i.e the cost of debt is lower for a higher esg rated company for a 20:00 lower esg rated company as i said these are data from uh that were currently available 2016 20:06 through 2019 we're going to keep 2020 for now out of any kind of financial analysis 20:13 because uh as we have learned i mean it's going to be quite an anomaly in ever every uh uh every forthcoming 20:19 analysis so and the reason for that is that that high esg rating rated companies i mean 20:28 companies that disclose and understand a lot of their factors that they are 20:33 exposed to that expose their their future growth their future revenue 20:39 uh their future operational capacity of facilities their future uh um maintenance of their 20:45 assets and whatnot actually have more resiliency there more resiliency to 20:51 do future i mean climate and social and other types of um 20:58 impacts on their operations right so higher esg rate companies tend to be less exposed 21:04 to systematic risks than low esg rated companies this isn't just climate this is right now just 21:10 this is esg and esg has e s g in it so e the climate technically 21:16 would fit in e right under the environmental uh however climate means more than carbon we very 21:23 often tend to take a very reductionist approach and look at climate as being carbon climate is much more than carbon 21:31 because it looks also about where you operate how you operate how you engage with the 21:36 community where you operate et cetera et cetera but what we're seeing is that these highest g-rated companies are less exposed and therefore 21:43 they're rewarded by the market in actually having to pay less for their debt right so that's a 21:49 great sort of initial step so there is actually some materiality in disclosing that information to the 21:55 market so so let's look at let's drill this down because esg is sort of everything 22:01 but the kitchen sink as you just saw before right it has all the factors when you got the three pillars you got the e the 22:07 s and the g and then the under e under s and under g got multiple different factors 22:13 that are measured in many different ways so so there's sort of a lot of uncertainty in looking at that bucket 22:19 bucket of data so let's look at one specific one for example just water risk and frankly i mean i i'm very involved 22:26 in water risk and when i go to climate conference or investor conferences many investors now 22:31 will look at climate through a water risk lens because they say water risk is local you 22:37 can say a corporation has a certain exposure a carbon exposure but its water exposure is very local 22:43 based on is the facility in the us exposed the facility the northeast south south uh the southwest uh in 22:51 central america europe south africa where are its operations right sort of going to these 22:56 very specific localities gives you and looking at the weather impacts and the climate impacts both of 23:02 them in these regions sort of gives you a reading on potentially where the water risk exposures are and here's some data 23:09 so cdp uh which is uh a non-profit out of in london actually also in new york uh 23:16 cdp stands for carbon disclosure project it started as a carbon disclosure project but they have actually a water 23:22 disclosure group within cdp uh so they look at the water report and so 23:28 some some ideas here 75 percent of the largest reporting companies identify higher water risks year and 23:34 year and high water risk is more both a risk from the perspective how much you use 23:39 the quality that you use the access that you have to it the competition that you have with other water users et cetera et cetera et 23:45 cetera right and so you have you see some numbers here on financial impact right but the question is i mean 23:52 this financial impact is sort of calculated by others right that is not really a disclosure 23:57 necessarily by the company as in you know we have this much less that we could be 24:02 producing it's sort of more an analysis by the financial markets of for example mining companies or power 24:08 companies or biotech and other companies um how water is 24:14 impacting for us different operations the question is would it be rewarded would the company 24:20 be rewarded if it makes an investment in water risk as part of esg and as part of tcfd 24:28 right is is it rewarded when it makes that that investment and so one of the things that 24:34 we've been looking at is something called a water beta because again when i talk about the capital 24:40 markets i mean initially we're going to be talking about it from the perspective of of the investment community that looks 24:46 at these companies and then engages with these companies and say hey you got a problem in this locality that 24:52 locality with that particular plant and whatnot and so we formulated something called water beta this is done with a 24:59 a lot of partners including msci uh including uh morgan stanley including uh 25:04 more recently nasdaq and other types of of organizations we will look at how much 25:10 volatility in share price and how much premium in share price could be realized by a 25:17 corporation if it manages the volatility that is caused by 25:22 water i.e indirectly through climate change climate change impacts and beyond 25:31 so water beta is something that we kind of map as a as a risk here right 25:37 relative to financial data and by the way beta what when you say beta in the financial 25:44 markets it automatically means volatility it automatically means risk so financial beta 25:49 is really about this is the systematic risk so risk that every company is exposed to 25:55 relative to the global market and water beta is a specific company's risk relative 26:01 related to water relative to its index right now we can start seeing that different kinds of companies 26:08 but so basically above one means you're more more uh volatile than the market below 26:14 when you're less volatile than the market and then here you have a range too so now here it depends on what industry 26:19 you belong to whether you're you have high water risk you've got low water risk and it impacts your performance on the capital markets 26:28 so health care you know has a different impact impacts impacted by a lot of water risk 26:33 oil and gas food and beverage more so than system than systematic risk financials 26:40 impacted more by systematic risk you're looking at companies like mining companies and energy companies 26:45 a lot of global market risk and and um and water risk right so it becomes 26:52 kind of a way to triage your companies in the capital markets and here's something i forgot to say 26:58 because most in the audience probably come from or think about uh you know we need 27:06 better policy to regulate and govern our corporations and i don't disagree with 27:11 that however the the the tact that we have taken sort of following tcfd 27:17 is no no no let's look at where the market signal is is there a market signal that would 27:23 prompt a company to become more sustainable as opposed to a policy signal that 27:28 forces a company to become more sustainable it's kind of like you know the stick in the character we're trying to bring together so if you look 27:34 historically at before at the performance of companies in these different spaces if we look at an 27:40 index so we benchmark for example uh the uh um this is a 27:47 this is an index of companies where we incorporate water risk in how you 27:54 allocate companies in a bucket of companies that that banks invest in a pension 28:00 fund's investing so basically companies with high water risk we allocate less off in 28:05 companies with low body risk we allocate more of and of course this changes every quarter this changes every 28:11 year what we see is we have a constant outperformance when we take into account water risk 28:19 relative to the benchmark and it started breaking out around i mean the data's not on here because it's kind of a 28:25 cartoonish version of the real data around about 2013 or so 2013 is when we started seeing a 28:32 separation of water really becoming an additional risk factor 28:38 that the market started looking at relative to the benchmark in the benchmark in this 28:44 case is an is an index that is not adjusted for water risk so water risk actually 28:51 commands a risk premium right over and above all the other risks 28:57 that corporate companies are exposed to and so the water beta that volatility risk is essentially kind 29:05 of that difference between the benchmark and the uh and the uh 29:11 uh the the water risk adjusted uh water is the new water is could just the benchmark so the question you're asking 29:17 probably is now why is this line higher than that line because this is performance right this is returned so why is the high water 29:23 risk index better performing aha because we discounted the companies that had high water risk 29:29 and we essentially put a premium on the companies that have a low water risk and that's why you get an out performance 29:36 when in fact we can start seeing that depending on the company and i'm just going to disclose one here 29:41 because we started to work a lot with the japanese so japan and europe the japanese market and the 29:47 european market are very bought into disclosing their risks to 29:52 the tcfd american companies are not that much bought into that yet i mean it's coming 29:57 but they're not quite there yet so it's mainly the japanese and the and the european markets and so when you look at it this is asahi 30:05 some of you might know aside from asahi beer so they command a an additional premium 30:12 share price premium of about three percent over the benchmark by managing their 30:17 water risk right so you can start seeing financial materiality 30:22 so far not just in borrowing money from the market but also a share price premium that you 30:29 can command in the market and so a lot of that so esg is nice but esg and and and tcfd related to 30:37 financial metrics really drive uh market forces right let's move forward 30:43 um so let's look at uh let me move forward to 30:50 to green bonds so let's look at actually this title here carried over i apologize for that so what about the 30:57 fixed income market so let's move from this the stock market to the fixed 31:02 income market because many corporations they issue bonds right sometimes they 31:07 just issue plain vanilla bonds and sometimes they issue 31:14 green bonds right we've seen a lot more green bonds including from microsoft and amazon and other companies 31:19 the big question is is there a benefit in doing that aside from having a green bond i mean does it ever 31:25 carry a market premium all i'm showing here is so what this should say is what is the impact on the 31:30 on the the fixed income market so agree uh let's first look at at the green bonds 31:35 so green bonds are issued both by government governments and by corporations and right now we're just going to worry 31:41 about the corporations when we look at the corporations what is a lot of that invested in 31:46 now you can look at well sort of the percentages of where the green bonds are actually invested in and this looks great i mean 31:52 we have investment of green bonds and transportation in buildings uh buildings and energy and in water 31:59 transportation all of that so i mean this is fantastic the problem is the green bond market is still only a couple of percent of the 32:06 total bond market so part of the problem that we do not have more green bonds than we should 32:12 have i mean it's 400 billion right about 400 billion but there is close to you know 80 32:19 trillion in in uh in bonds overall right so it's still a very small percent 32:25 so one of the challenges is that perception of higher cost for issuers so this is an interesting thing too on 32:32 materiality so if one can demonstrate that a green bond not only looks great 32:37 for a company to issue because you're investing in green technology and everything else that's sustainability if 32:44 there is actually a market signal that tells you that you know what it's not only good for you from a you know from a 32:50 marketing perspective it's also good for you from from an issuance perspective from a cost 32:56 perspective now we're looking again at financial materiality and we're starting to see some of that these are early data and 33:02 this is just data over over almost about a year these are not ours so the materiality in the green 33:08 bond yields so one of the ways of looking at green bound performance and cost is by looking at the yield to 33:15 the yield spread so basically the more volatile the more 33:20 volatile a bond or riskier the more risky a bond the higher the yield would be right and what we're 33:26 starting to see is over time that the spread of conventional bond yields 33:34 over over green bond yields is starting to starting to decrease so the basis points 33:41 are starting to decrease so so what happens is that that essentially over time we're starting to see that 33:48 green bonds are becoming cheaper than vanilla bonds than 33:54 non-green bonds even though the underlying risk is the same i mean if i'm a corporation 34:00 and i want to issue a green bond versus a regular bond the risk of the bond is essentially 34:08 the the price of the bond the the credit rating i'm getting for the bond is going to be the same 34:13 because the credit rating is based on the credit of the credit rating of the company so if 34:19 i'm apple and i issue a regular bond or issue a green bond it's all based that interest rate that 34:24 you pay is all based on the on the risk of of the company itself so it doesn't really matter it's green or 34:30 not where it does become important is what the demand is for these bonds right so 34:36 the demand for the bonds um is going to sort of drive canada 34:41 that risk premium and hopefully drive the risk premium lower so what we want to see is that the yield 34:47 goes down that we get a lot more demand for green bonds and that basically investors perceive 34:53 green bonds to be less risky than other bonds so here here we see the difference so 34:59 this corporate esg score matters so now we'll look at green bonds where we layer on top of that 35:06 whether or not the company is a high esg scoring company or a low esg scoring company so when you're a low esg 35:14 let's first do the highest g scoring company when you're high esg scoring company what we see over here is that the yield 35:22 um of the uh 35:28 right we see a um oops a lower yield of of the 35:35 uh of a green bond for high uh esg scoring companies than what we see 35:40 for low esg scoring companies so basically if you're a company that does not disclose any of its esg risk 35:47 and you're issuing a bond you're not going to have as much demand for your bond whereas if you're a 35:53 company that is a high scorer of esg risks and you issue a green bond 35:59 is going to be much more demand for your bond when there is much more demand for the bond what's going to happen is that 36:05 the yield of the bond the yield is inverse to the demand right so when 36:11 there's a lot of demand for a bond the yield will go down and actually the bond becomes cheaper over time and less risky over 36:19 time which is a great market signal because it tells you look disclose your esg risks issue green 36:25 bonds and over time your bond will become more attractive to become attractive to 36:32 investors there's a lot of demand from investors and becomes cheaper to the to the payer 36:38 so we wanted to go beyond that and say you know what the green bonds are only two percent of 36:44 the total bond market there is a lot more bonds out there right that are vanilla bonds 36:50 and so this is work that one of my students is doing one of my students don lee is doing and she's looking at 36:56 at um the the uh plain vanilla bonds so 37:03 mainstreaming green bonds so we're going to go to the vanilla bond so we went beyond green bonds 37:08 only the ones that are uh triple b rated or higher right um and we wanted to see 37:14 if you just issue any kind of bond and you have you just did you disclose your esg 37:21 risk or you do not disclose your esg risk so we actually set the bar lower than before remember before we had 37:27 a green bond and we had high and low esg rating so now we have a none none green bond or 37:35 plain vanilla bond and we're looking at do you disclose your esg risks or do you not disclose 37:40 your esg risks and what we're starting to see so we looked at all bonds that were issued over the past 15 37:46 20 years across all these different sectors of the economy and one of the things that we started to 37:51 see is a is a change again 37:57 in how the bonds are being perceived just by companies that are disclosing 38:03 their esg risk so basically telling the market that you understand what your 38:09 environmental social and government risks are actually gives you a 10 basis point 38:17 decrease on the spread or on the risk of your bond which is great right because it's again 38:23 a market signal where you disclose your esg risk 38:29 the market response you have a lot of buyers and investors that want your bond because of a lot of high demand for that 38:35 bond the yield spread goes down the risk goes down right and so therefore the cost of that 38:40 bond goes down so and there is a bit of a difference at 38:45 the time of issue at the time of issue you have plus numbers and after we have negative numbers why is that 38:50 well it's kind of like you know issuing all your risks to the tax man right the more you disclose the the 38:56 riskier you appear right to finish at the time of issue of the the bond you know the bond is viewed 39:04 to be more risky but then after you start trading when people understand i guess 39:11 and the liquidity of that bond over time people start understanding how a corporation is managing its risk 39:17 the the risk of the yield goes down so basically what it says is 39:22 esg disclosure results in a lower risk bond after trading so again we have a 39:27 positive signal we have a positive signal from esg disclosure on on on 39:33 on your performance in the in in in the uh your share price performance in the market on the borrowing costs for debt 39:42 on the bonds that you're issuing so so far it's all positive that's part of your materiality so now i want to just 39:50 go to something that goes beyond the corporates and the corporate the the the municipal the public sector 39:56 doesn't fit within tcfd i just have one two more slides here so these are the municipal bonds 40:03 so these are a whole different set right so for those not familiar with the municipal bonds this is sort of our 40:08 universe in which municipal bonds have invested in over time right municipal bonds are 40:14 are a very significant fraction of the total bond market and that's sort of a lot of the work that we're doing with nuveen which is 40:21 that tiaa investor and third largest holder of muni bonds so basically they said 40:26 you know why should companies even disclose why should governments or cities meet counties 40:34 municipalities disclose their esg risk we're just gonna rate externally we live 40:40 in the in the era of big data we're gonna gather all data we can find about a city 40:46 about a county about a state and all the bonds that they issued all this stuff we're just going to rate 40:52 it we're going to rate it using esg models and now we want to find out i guess whether 40:58 you know the underlying should i say the underlying 41:05 esg metrics intentional or not of any municipality actually start 41:11 making a difference in in in the bond market so we're rating 41:16 all these models we've been looking at models across water and hospitals and electric and city and schools and higher education 41:23 and now we're looking at them in transportation and everything else we look at sort of different ways and 41:29 how we could start looking at all these municipal bonds and i said the third largest holder of community bonds the current market of muni bonds 41:35 is about 3.8 trillion dollars outstanding right so essentially screen all these 40 41:41 000 issues for this particular this particular owner right and look at sort of how 41:47 different bonds spread out now what what nuveen would do with that once they have that information they will bundle 41:53 the top quintile and the bottom quintile and they sell it to you and me for those of you that are taiaa right so you can actually go into 42:00 your pension fund and select you know your bond fund and you will get a different kind of performance but now think about it that 42:07 some of the underlying metrics that are part of your sustainable bond fund 42:12 may actually have been generated by the university of michigan which is i think pretty pretty cool so we're not there yet we 42:19 don't know yet i guess how a high esg a low esg rated bond municipal bond fund is going to perform 42:25 we don't yet know what the market signal is going to be however there is some hope and the hope is this 42:35 municipalities as i mentioned earlier also issue green bonds 42:42 a fraction right just like corporates issue green bonds but it's only two percent of the 80 trillion dollars 42:49 in in the bond market the corporate bond market municipalities also issue green bonds 42:55 but it's a very small fraction of the total municipal bond market so when you look at the green municipal 43:02 bond market since about 2016 and this is not our work this is work 43:08 that was just published last year we're starting to see a premium there as well of eight basis points so 43:15 if there's anything that municipalities want more than anything else particularly post covet is let's source 43:22 our capital for our infrastructure for all the stuff you want to build as cheaply as possible right and so 43:29 the less you have to pay for your bond the better right over time and so what we're 43:34 starting to see is that the yield spread and this is secondary that's once a 43:40 green municipal bonds start trading that we're starting to see a spread between between a vanilla bond 43:47 and a and a green bond a green municipal bond so the green municipal bond becomes 43:52 a more trusted more in demand less risky bond 43:58 over time just like the corporate bonds corporate green bonds or corporate bonds 44:04 that are disclosed by that are issued by esg disclosing corporates also become more um attractive 44:12 so just a couple of take-home messages here because there's sort of a lot of data i went through but the the the basic point was does this 44:20 closing your risk or does even managing your risk or does understanding your esg and climate risk 44:27 actually matter in the capital markets are the markets starting to respond is there a market signal as well as the 44:36 the the the typical policy signals or the pulse signals that most of us that many of us look at is there a capital market signal and 44:42 there is so the sustainability scrutiny as i argued is going to be a necessary condition 44:48 for disclosure and materiality pricing right and materiality pricing ultimately will really help scaling 44:57 all this sustainability work that is i mean to be honest still fairly fringe it's sort of it's not it's 45:02 a fraction of the market is this if we can make sustainability material and we have a material signal 45:10 can we can sustainability become a mainstream financial signal 45:15 that essentially will drive the way how we invest in infrastructure in corporate infrastructure or in municipal 45:20 infrastructure so esg disclosures are becoming increasingly material in terms of cost of capital uh so both 45:27 debt and equity in terms of bond yield spread tcdf disclosures which are very closely 45:34 related to esg factors and metrics they have to be financially material right because otherwise the market won't respond i mean that was 45:40 the premise of tc tcfd i don't know why i will see tcdf i must be dyslexic 45:46 so it is tcfd scalability will be improved when actual 45:53 price signals emerge and become stable or can be benchmarked across sectors and 45:59 geographies right and that's something that everybody has been looking at there's actually even still papers out there that right now say we're all 46:05 hoodwinked by esg because esg right now is a lot driven by 46:11 metrics in the physical world that are not well translated in the financial world and if you can translate in the 46:16 financial world it's very hard to know how to respond to them corporate engagement and disclosing 46:22 esg risk under tcfd guidance is likely to be become more facilitated when these 46:29 financially material risks can be measured and verified and this is actually something that we are doing 46:35 with uh the japanese a japanese company that is working with pr practically all holdings of the nikkei 46:41 225 is to actually start giving them a financially material metric to disclose 46:48 their water risk for their tcfd disclosures such that their share price can sort of 46:54 improve or capture a premium this is the last thing i wanted to say it's a lot of 47:00 information uh and as i said it's really sort of taking the the capital markets ankle instead of the 47:06 policy angle to sort of figure out where we meet in the middle 47:11 thank you awesome thank you before we let's go 47:17 ahead and just jump into questions and so we'll go caitlyn and then daniel 47:22 caitlin do you want to unmute yourself and then just ask yeah that'd be great thank you so much 47:27 and thank you for joining us professor adrians absolutely my question is in regards to 47:33 the different elements of esg investing right they're an inclination for 47:40 the more um i guess tangible elements of esg ratings to be 47:47 moving towards carbon measurements i feel like that is probably the most quantitative measurement but i guess 47:54 going along with that how will more qualitative factors such as social implications be brought into 48:00 these ratings or do you think that they need to be ratings in and of themselves separately 48:08 um that's a very good question so sort of i mean your question in part is an aggregate metric 48:14 right the whole question of aggregate versus versus sort of more specific metric all the indicators in 48:21 the market right now are that people are probably going to be moving away as far as materiality is 48:27 concerned from esg the value is going to be in the pillars and the factors so esg 48:34 becomes part of factor investing but an aggregate esg value in the financial markets is 48:41 probably slowly going to sort of become more granular to figure 48:46 out what can you actually measure having an impact on future growth and what are 48:52 more intangible factors that are going to be um part of part of uh sediment sediment 48:59 factors right so this sort of sentiment factors and and the the real operational kind of 49:06 risk factors and i think that's that's the direction things are going in fact when i talk to to msci 49:13 and and to many of the other providers in the industry i just recently had a call with refinitive and and with nasdaq they now get calls from 49:20 specific pension funds from wherever they are is to actually develop a very specific index 49:26 specifically on one metric out of the entire esg universe to try to figure out i 49:32 guess how to improve just on that so i hope that that answers your question 49:38 if not directly in a roundabout way absolutely thank you so much really interesting um daniel and then 49:45 allegra uh hi oh thank you thank you professor for your uh presentation 49:50 daniel i guess the question that came to mind as we're presenting um is how much do the esg ratings 49:58 correlates with um with a uh firm performance right historical performance 50:04 right to sort of try and tease out of the causality versus correlation right because maybe 50:10 investors just look at other metrics that also correlate with psg 50:16 there's a paper that just came out of the financial literature and the title is aptly uh 50:23 there's the up title is aggregate confusion and that it does not well so there's 50:30 sort of two things one esg ratings are a very poor characteristic 50:36 of esg risk because there's so many different ways 50:42 and poor benchmarks on which they are being measured there is some degree of 50:47 agreement in some sectors and there is a lot of disagreement in other sectors so and a lot of it has 50:54 to do with i mean this actually your question reminds me of um when i started going with this whole 51:01 water beta and aquarius to the capital markets and i went to many for about a year so i went between 51:06 london and frankfurt and singapore and new york and whatnot and a couple of times i made it onto the trading floor 51:12 and i started talking to some of the folks that were you know actually doing the real-time analysis and and i said 51:18 okay how do you incorporate water risk is there so we don't how do you incorporate esg risk you said well we don't really 51:23 there's so much else to keep track of um so then the question was about how would you incorporate it so well i mean 51:30 if you have something within what you're measuring that is sort of a 51:36 a a regular risk for a certain type of company or for a certain type of sector we can actually incorporate it and know 51:44 what to do with it i guess in our in our risk assessment and i said wait a minute i mean so 51:49 if you have two companies that are exactly the same say two mining companies to semiconductor companies 51:54 whatever it is and one is a higher water risk user a high carbon emitter and the other one is a low water risk user 52:00 and the low carbon emitter the low one is a better one right and he said well to you it is but these 52:07 these numbers in terms of carbon and the numbers in terms of water as in tons of carbon or square 52:14 or cubic kilometers of water are no financial risk metrics i have no idea what these companies even 52:22 the high water risk in the high carburetors company is actually doing to mitigate its risk 52:27 such that it affects its price performance it's credit risk it's everything else right so it's the 52:34 the the devil is in the translation between the esg 52:40 risk and the financial risk and that's why i said look we need to have more 52:45 research that goes on and starts looking from the capital through the capital markets lens 52:51 right to these things out now that said there are many different groups including at harvard and elsewhere 52:57 that are building all sorts of statistical models as well as machine learning models to 53:02 try to tease out which factors make sense it was a recent study was done by deutsche bank and i 53:08 know it's not the best example because it is in the news for various bad reasons but they did one on esg and sort of 53:15 corporate performance and the only factor that statistically stood out was retention programs of 53:22 companies and it was not in 2020 by the way this was before covet retention programs and pension 53:28 programs of companies those were the two esg factors out of everything else that really explained the difference i 53:34 guess of high esd low esg so so this you know it's a very tough place to be in and so that's why 53:41 we start looking for these market signals and that's also back to the earlier question that was asked 53:48 why aggregate esg is going to be a continue to be a very tough sell and 53:54 people are going to start going more towards discrete and more granular factors 54:00 within esg and looking at either sentiment side things or operational side 54:07 thank you very much all right allegra and then i have one more question to ask 54:12 and we'll wrap up go ahead great thank you so much professor for this um 54:18 non-boring talk about green bonds i i've been to a lot of talks about green bonds and this one was 54:24 not boring and so congratulations um that was great um my question is about 54:30 disclosure and reporting standards um you know and different stock markets 54:36 what you see is the value or leverage um of having different stock markets create their own mandatory 54:41 reporting frameworks i'm thinking here of the johannesburg stock exchange with their mandatory integrated reporting from assist now 54:49 almost a decade ago to something like the nasdaq that doesn't have any of these so do you think 54:54 requiring esg very granular esg reporting at the level of stock markets 54:59 uh makes sense as a point of leverage or is it really at the national you know like the sec and you 55:05 know the hong kong reporting commission level that would make the most uh difference in your mind thanks 55:12 that is and well first uh first off thanks for uh your comment regarding the green bonds uh i 55:17 think this whole yield spread is a very a very cool thing and then relating it to esg disclosure your other question 55:24 is is very dear to my heart because it does it did become a very recent problem even in our own analysis that 55:32 yes it will to a large degree become also stock market specific so not only is there not 55:39 a benchmark on esg it is also another benchmark on what different 55:44 markets actually require right i mean i used to spend a lot of time in finland the finns do it again very different the 55:49 nordics in general right to do it again very different and so johannesburg and whatnot so we we 55:55 just mainly looked at because of our recent work between the u.s and for example look at 56:01 nasdaq versus or smp versus um uh say say the nikkei 225 56:08 and basically there is almost no comparison you cannot say look at all these are all the 56:14 equities and this is how we're going to be treating them and this is a disclosure no matter where they are traded or whatever the primary trading uh trade 56:21 trading market is it will not work and we know by now that that will not work because of 56:27 the different requirements i guess that already are in existence in these different uh platforms and so 56:35 therefore things that you're calling out as an opportunity for example for dsmp already were incorporated 56:42 as a disclosure is a risk that's really taken into account for example in the nikkei market 56:49 right there's already taken to account in johannesburg and so those are going to be very interesting things to 56:54 tease out we're actually now starting to look at these correlations between stock markets which sorry daniel but that makes even 57:00 the esg more confusing because now now you have to start worrying about where you're trading 57:08 oh and with that we're at time and so i am sorry the last question just doesn't 57:13 get asked oh so painful so painful um 57:21 oh can i hear you whoops sorry um i have a fast mute because if i have 57:27 a little kid um so thanks for joining us today if you missed any of our previous talks 57:33 then you can view those on our website and if you didn't get a chance to ask professor adrian's a question i'm 57:39 putting his email address right now in the chat and you are welcome to 57:45 email him directly absolutely and happy to uh happy to respond and engage um can we 57:52 all just have a a moment to uh verb to acknowledge professor adrian's 57:59 thank you thanks again hopefully next time live yes we can all hope so please come back 58:07 next month where our topic will again center on fintech and financial inclusion with professor terry 58:14 friedlein from the school of social work thanks everybody awesome thank you thanks christy