The United Nations Sustainable Development Goals (SDGs) can serve as a framework for measuring impact in environmental, social and governance (ESG)-focused investing. Establishing a common approach, and understanding how to measure progress towards meeting the goals, is key to unlocking core fixed income capital for the purpose of positive change.
For a growing number of investors, financial performance is no longer the sole investment objective. Instead, many people are looking to align their financial goals with the ability to influence change – to put their money to work in a way that will have a positive impact on the world.
Yet this is no easy task. For starters, what does “impact” even mean? Many investors have struggled to answer this question, particularly in fixed income. Traditionally, impact investing has focused on project finance or “green” investments, which have clear objectives against which progress can be measured, such as to provide clean water or build a railway. Moving from these types of projects, with well-defined but narrow goals, to establishing objectives for investing in the world’s largest and most complex companies is a challenge. And yet solving it is the key to unlocking the wider pools of capital available for this purpose.
The framework for measuring impact needs to be versatile enough to accommodate the diversity of the global bond universe and clear enough to be measurable. The good news is that a suitable framework already exists.
THE SUSTAINABLE DEVELOPMENT GOALS: A SOLUTION
The Sustainable Development Goals are a set of 17 ambitious goals targeting 169 outcomes in the realms of sustainable development, better environmental outcomes and healthier communities. They were signed by 192 countries in 2015, and range from ending poverty to taking urgent action to combat climate change (see Figure 1). Together they can provide a comprehensive framework for investors seeking to evaluate companies’ positive impact on the world.
WHAT COMPANIES CAN DO TO MEET THESE GOALS
The SDGs are rich in content and offer scope for a wide variety of companies to participate (see Figure 1).
Some goals are precise enough to be addressed by direct business activities, such as those committing to clean water and sanitation (goal #6), and affordable and clean energy (#7). Others can be addressed through a firm’s management of its supply chain and its own governance – for example, a firm can ensure that worker conditions in factories are consistent with the goal of decent work and economic growth (#8).
Other goals are more nuanced and require a creative approach, including no poverty (#1), or peace, justice and strong institutions (#16). These can be best served through non-business activities, such as establishing a charitable foundation, and through collaborative partnerships.
WHY THE GOALS ARE IMPORTANT
Understanding how a firm’s actions align with the SDGs should be important for all investors, not just those seeking to generate a positive social impact with their capital. For the latter, the SDGs provide a framework for evaluation and measurement. For all, SDGs can serve as a guide to understanding fundamental business prospects (something we refer to as “ESG externalities” at PIMCO).
The near collapse of the global banking system in 2008 highlighted these externalities sharply. Taxpayer-funded bailouts raised awareness of banks’ “social license to operate,” and the eight years that followed were marked by increased investor scrutiny, regulatory pressure and heated public debate. The outcome was higher capital requirements, de-leveraging of balance sheets and intense focus on issues of culture and conduct – a critical secular shift that investors needed to recognize.
Another secular shift occurred in energy during the 2000s, as European countries moved towards greater use of renewables – a change accelerated by events in Fukushima in 2011, which triggered a shutdown of nuclear reactors in Germany. German companies that had moved early to address the shift were rewarded with a cheaper cost of debt and healthier margins. Others had to catch up by drastically changing their organizational and legal structures, separating environmentally friendly businesses from their more polluting activities (coal, lignite, nuclear). Decarbonization and enhancing grid capacity – activities aligned with several of the SDGs – are key business objectives for most European utilities, and continue reshaping the competitive landscape.
WHAT CAN INVESTORS DO?
Many companies, large and small, are acknowledging their role within society, because they understand the importance of it to their long-term business prospects. All investors need to understand this too – and the SDGs are a good place to start.
But for those who want to go further, and use their capital to help achieve the goals, there are three main levers to pull:
- Asset Allocation
First, they can decide how and where to deploy capital. Although investing for impact is commonly associated with equities, fixed income can often provide a more direct way to achieve this objective.
For example, an investor seeking to foster economic growth through housing could invest in bank equities (as banks provide credit to the housing sector). However, they will be exposed to many additional risks related to the bank’s broader business, such as a leveraged balance sheet, investment banking exposure and non-residential lending. A more direct way to target housing is to invest in covered bonds, which are secured vehicles backed by residential mortgages. They have strong covenants, a measure of protection from the bank, and also provide a targeted way of directing capital for the purpose of social impact.
Covered bonds, municipals, mortgages, agencies, supranational and local government debt account for around 23% of the Barclays Global Bond Aggregate Index – investing in them offers extensive opportunities to target different SDGs. Investing in green bonds or social bonds provides an even more targeted approach. Allocating capital to any of these bonds can be consistent with promoting access to affordable and clean energy (goal #7), sustainable cities and communities (#11), clean water and sanitation (#6), and industry, innovation and infrastructure (#9), among others.
Investors seeking positive change can also promote engagement with companies. Similar to impact investing as a whole, engagement is most associated with equity investors. But fixed income investors can play just as important a role.
At the heart of engagement is a collaborative relationship between companies and investors. Most companies already report publicly on key ESG indicators, such as gender equality. Investors – both equity and fixed income – can build on what is already publicly available, and engage in a dialogue with firms to deliver greater transparency. Engagement can also serve to raise issues with firms that they may not be currently considering, but which could have a long-term impact on their business.
As part of the investment process, engagement can be very powerful, but it is also a choice. It requires active management, dedicated resources and a long-term commitment. These are the main reasons why the practice is not widespread among asset managers.
- Measuring and reporting
While engagement may be powerful, transparent measurement and reporting are crucial for investors to see the impact of their capital, and for firms to evaluate their own position.
Yet reporting shouldn’t be the sole responsibility of the company. Investors need to provide guidance on information required and work collaboratively with firms to establish key performance indicators (KPIs) given the information available.
South Africa provides a good example of how this can work. Companies there have been mandated to provide integrated reporting since 2011, meaning they must include standardized information on ESG practices alongside financial disclosures. This has allowed ESG-focused investors to set measurable goals for companies and evaluate progress towards meeting them. Adopting this model more broadly, and coalescing behind the SDGs as a means of setting those goals, would be a big step forward in impact investing.
UNLOCKING A MULTI-TRILLION-DOLLAR UNIVERSE
Using the SDGs as a framework for impact investing has the potential to unlock the multi-trillion-dollar universe of core fixed income for the purpose of change. This is a much larger pool of capital than currently exists in the mainly equity-focused impact investment world. For those seeking to align financial goals with an ability to influence change, accessing core fixed income can provide a more holistic approach to impact investing, and better diversification within ESG-focused portfolios.
Learn more about ESG investing at PIMCO