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September 27, 2021

Smith's Research & Gradings

ESG is Here to Stay (Part Two)

ESG is Here to Stay (Part Two)

Smith's Municipal Bond Conference featured a panel on ESG. Whether it is referred to as sustainable investing, socially responsible investing, or impact investing, ESG has become more than a niche sector. Investors are committed to sustainability, but questions remain: How to incorporate ESG into muni bond portfolios? Are bonds designated as Green really Green? What parameters should be used when evaluating Green bonds?

The participants included: Zachary Solomon, Executive Director, Morgan Stanley; Sammi Chhea, Senior Vice President, Jefferies LLC; Leonard Jones, Managing Director, Moody's Investors Service; Ariel Cuschnir, Executive Advisor, GHD.

Dr. Ariel Cuschnir, GHD

Ariel Cuschnir, Ph.D. is an Executive Advisor for ESG and Sustainability at GHD. GHD is one of the world's largest global professional services company. The organization is positioned at the intersection of strategic  planning, investment, enterprise and asset  level advisory as well as implementation and their comprehensive offering is an aggregate  of technical, digital and management  consulting services.

Starting in the international arena, Dr. Cuschnir has been practicing "ESG" for three decades. "The first project I was involved in ESG and project financing was a world bank project that they sent me to Pakistan in 1991," he explained.

Although Dr. Cuschnir is involved in project financing, his focus has been on the environmental and social side, now primarily in North America.

Offering up his experience with ESG from a different perspective, Dr. Cuschnir explained GHD works to support the data seen in the U.S. Municipal Bond Market.

"The Biden administration is putting a lot of effort into ESG in this country. Bottom line is, the experience that I have and information that we have in our group can help you in terms of investment risk reduction, by incorporating environmental performance and governance  standards as risk reduction tools into the investment  decision process and in monitoring bond performance.

"We talk a lot about the G in ESG and the data, but I have a feeling that we are skimming the surface of the data and I believe that it's high risk for all of the investors."

Importance of Data

Dr. Cuschnir emphasized the importance of focusing more on hard data. "I think assessing environmental and social risks goes beyond the financials, disclosure or ratings. In my opinion, ESG is managing risk from the governance perspective, from the management systems," he said.

When evaluating a project, using ratings cannot be the only approach.

"I've managed investments for small projects like a small wind farm project in California of $70 million, to the expansion of the Panama Canal, $2 billion by many international lenders. Governance is the key. If the governance part of a framework is sustained also by a framework that contains standards and metrics, you have a package for all your needs."

It is important to understand the type of municipal green bonds being evaluated. Municipalities are involved in a variety of  areas including renewable energy, clean transportation, clean water and flood management.

"The main issue that I have seen in my evaluations," Dr. Cuschnir said, "is that we have to sift through sustainability reporting and transparency to understand what they intend to do and what they're really doing. That's a big deal, because we are lagging behind by having no procedures, by not applying hard data to standardizations and metrics. We're ignoring the actual risks which investors are exposed to. Typical standards and requirements for performance include the European Union taxonomy but there are others."

Understanding CAPEX expenditures is important. Dr. Cuschnir explained, "You provide the financing for a bond or for a project, and we need to understand what's happening after the recipient of the bond funds get their money. We need to monitor their performance. Otherwise, risk will resurface."

GHD monitors material risk as a part of their evaluations. They often see medium and long term risk levels resurface because they were not properly managed through a management system and then get upgraded to a material risk two years after investment.

"Once again, I want to emphasize an environmental social management system as a key to succeed in reducing investment risks for municipal bonds or for any type of investment that you want to address," he stated.

Core Principles

Core Principles were basically designed to protect investments. It started in the year 2000 when Citigroup had problems in Indonesia. The Core Principal Association was created, which eventually led in 2006, to the development of the first Core Principles and the IFC Performance Standards.

Dr. Cuschnir explained, "Originally they divided their analysis into countries— designated and non-designated. Countries like the US that have a strong regulatory framework didn't need these standards. Last September, the Core Principal Association, which includes 80% banks that finance 80% of the infrastructure around the world, including the United States, put out the Core Principal Number Four.

"Under Core Principal Number Four, the line between designated and non-designated countries becomes more blurry. Now suddenly, the Core Principles and the IFC Performance Standards became an important tool for the risk reduction management procedures. Suddenly, these standards can be used as a risk reduction tool for any investment."

Zachary Solomon, Morgan Stanley

Zach Solomon is an Executive Director in Morgan Stanley's Public Finance group, where he serves as the Head of Tax-Exempt Project Finance and Sustainable Infrastructure Groups. Under Zach's leadership, Morgan Stanley's Municipal Sustainable Infrastructure practice ranks #1 in Green, Social and Sustainability Bonds underwritten for municipal and not-for-profit issuers.

Describing ESG to Morgan Stanley's issuer clients, Mr. Solomon emphasizes what they should be thinking about from a disclosure perspective is being defensive versus being on the offensive. He explained, "What I think that means for an issuer is to say, to be on the defensive means that every issuer should be considering ESG and how it affects them, their communities, their organizations, and they should be disclosing how they believe they are addressing those ESG considerations."

An example he uses is cybersecurity. "Five years ago," he said, "you couldn't find the word cybersecurity in an offering document. Now, because the rating agencies say, 'What are you doing on cybersecurity?' Every single offering document has it. That's what I think it means to be defensive in one of these regards.

"Every document should have an ESG paragraph. It should have a sustainability paragraph. Being able to identify the challenges of that community is a step towards addressing it. I think investors want to see that kind of disclosure.

"Being offensive is where you use the labels. Just because there are ESG considerations doesn't mean you are a good candidate. Just because you're a Muni issuer, doesn't mean you are a good candidate to label your bonds as green, social, or sustainability."

With a green ,social or sustainability bond in the market one per week or every week and a half, even small issuers can gain a level of visibility within the investor complex that they normally wouldn't have for a regular project.

"It's a great way to enhance visibility, but if you don't do it with some credibility, you've really just incurred reputational risk more than anything, because you've enhanced your visibility on something that people actually don't want," Mr. Solomon said.

Need for Standardization

On the investor side, many firms are developing their own portfolios and their own mandates about what ESG means. The market will not ever agree on what exactly should go into an ESG portfolio.

Mr. Solomon agrees that there may be, as in Europe, a push towards regulation around what can be called an ESG fund or not.

He said, "What we're seeing is a continued growth of ESG investment globally. And, the most acute interesting development, is the growth of ESG portfolios within the Muni market specifically, and specifically to address tax-exempt bonds. The investor market for labeled bonds globally is dramatic, and for ESG assets is dramatic, but many portfolios, don't invest in tax-exempt Muni bonds. There may be huge numbers of assets being dedicated to ESG portfolios, but the vast majority of them just don't invest in our market."

Mr. Solomon believes institutional investors in market retail and professional retail are "doing great on this round." But the question remains, how do the institutional investors create funds and accumulate assets such that it reflects itself in the actual market? And, how can it be done in a way that is both credible and creates outsized outcomes particularly for issuers?

"I think it's twofold, one is a disclosure on an upfront basis. Having good, credible disclosure that represents best practices and is transparent, is the way to attract these ESG portfolios, particularly highlighting projects that impact their communities and have a really great E S or G or all the above frameworks.

'The other way to create outsized outcomes and the next frontier of the market is through metrics and data. For example, Moody's recently bought a number of data providers. I think we'll continue to see integration of that data, not only in ratings and investment portfolios but in how issuers are able to tell their story about the impacts of their projects. Project impact could potentially be linked to performance outcomes in the bonds themselves, including financial metrics."

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