## Chapter 6 — Sustainable Finance: Looking Farther

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### Evolution of ESG associations, standards, and codes
- Major milestones:
  - 2004: Launch of the Who Cares Wins initiative by the UN Global Compact.
  - 2006: Launch of the UN Principles of Responsible Investment.
  - 2007: Issuance of green label bonds by multilateral development organizations catalyzed growth for fixed income.
  - Paris COP21 and the 2015 UN Sustainable Development Goals increased investor and regulatory attention to climate-related risks; most countries committed to emission mitigation.
- Observations:
  - Sustainable investing began in equities and expanded to fixed income through self-declaration and labeling (for example, green bonds).
  - The lack of consistent definitions makes it difficult to pinpoint the global asset size related to ESG, with estimates ranging from $3 trillion to $31 trillion.
  - Labeled bonds—primarily green bonds—are a fast-growing segment, aided by issuance from multilaterals (International Bank for Reconstruction and Development, European Investment Bank) and standards developed by China, the European Commission, the United Nations, and the United Kingdom.

### Climate change: physical and transition risks; implications for financial stability
- Two identified channels of climate-related financial risk:
  - Physical risks: damage to property, land, and infrastructure from catastrophic weather-related events and gradual climate changes.
  - Transition risks: changes in the price of stranded assets and broader economic disruption from evolving climate policy, technology, and market sentiment during adjustment to a lower-carbon economy.
- Financial and economic transmission:
  - Climate-related losses affect the financial system directly (price impairment, reduced collateral values, underwriting losses) and indirectly (lower economic growth and tighter financial conditions).
  - Insurance claims from natural losses have already quadrupled since the 1980s.
  - Risks are large, non-linear, and hard to estimate; catastrophic tail risks are not negligible.
  - In the transition to a cleaner-energy economy, sudden reassessment of valuations in exposed sectors could occur if asset prices do not fully internalize climate risks.
  - Climate change mitigation costs per unit of emission are likely to fall on industrialized economies under “common but different responsibilities” given that most future low-cost mitigation opportunities are in large emerging market economies.
  - Lower- and middle-income countries are very vulnerable, reflecting geography, dependence on agriculture, and lack of resources for adaptation.
- Quantitative and study-based estimates cited:
  - Burke, Hsiang, and Miguel (2015) suggest that average global incomes may be reduced by up to a quarter by 2100.
  - Cambridge Centre for Risk Studies (2015) estimates losses in trillions of dollars.
  - Economist Intelligence Unit (2015) estimates the value of typical equity portfolios could decline by half.
  - A group of large listed companies expects climate change costs to rise to $1 trillion (CDP 2019).
  - For financial losses, the scale and systemic reach imply potentially very large economic and financial costs.

### Transition risks materializing: coal sector example and sovereign risk
- Observations:
  - Transition risks have already materially affected the coal sector through divestment and regulatory actions.
  - Large-scale divestments and commitments by banks and insurers to curtail financing or insuring fossil-fuel sectors can make capital and insurance more difficult and costlier for exposed sectors.
- Sovereign risk implications:
  - Sovereigns are also at risk from ESG noncompliance, as rating agencies and large investors increasingly incorporate ESG considerations into sovereign credit assessments.
- Issuance and asset indicators:
  - The stock of green bonds grew to an estimated $590 billion in August 2019 from $78 billion in 2015.
  - There is little evidence that issuers achieve lower costs through green bonds than conventional bonds, likely reflecting identical credit risk profiles.
  - Secondary market liquidity appears to be slightly worse for green bonds than for comparable conventional bonds, reflecting the large role of buy-and-hold investors.

### Is there a case for ESG-linked portfolio investment?
- Evolution of ESG investment strategies:
  - Initial phase: negative/exclusionary screening (excluding sectors such as tobacco, munitions).
  - Later strategies: positive/best-in-class screening, norm-based screening, sustainability-themed investments, corporate engagement, impact/community investing.
  - Increasing integration: ESG information is being explicitly and systematically integrated into investment analysis and decisions across asset classes.
- Asset-class application examples:
  - Equities: long-standing ESG application with active engagement rights.
  - Fixed income: growing ESG integration, labeled bonds (green, social, sustainability), green mortgage-backed securities, green loans, sustainability-linked loans, and ESG incorporation into sovereign and corporate credit analysis.
  - Alternative investments and private markets: aided by longer time horizons and scope for investor activism.
- Performance considerations:
  - No conclusive evidence that sustainable funds consistently out- or underperform conventional funds.
  - Restricted investment can reduce diversification and increase volatility.
  - IMF staff analysis suggests performance of sustainable and conventional funds is comparable.
  - Investors justify allocation to ESG funds given similar fees between ESG and regular funds, though anecdotal evidence shows sustainable active management fees are often higher, which may hinder wider adoption—especially by public pension funds.

### Challenges faced by ESG investors and issuers
- Data, disclosure, and methodological issues:
  - Lack of consistent methodologies and reporting standards; corporate reporting is largely voluntary, inconsistent, and particularly sparse on environmental and social dimensions, though disclosure has been improving.
  - Investor surveys show concerns about data comparability across firms and time, data quality, and timeliness.
  - Third-party ESG score providers face concerns about opaqueness of methodologies and informational materiality; ESG scores across providers are often inconsistent.
  - There appears to be little correlation between ESG score informational content and investor perception of a firm’s enterprise value.
- Greenwashing and reputational risk:
  - False claims of ESG compliance (greenwashing) may give rise to reputational risk.
  - Investment fund classifications can be inconsistent: only 37 percent of Lipper ethical funds also carry a “sustainable” designation by Bloomberg.
- Legal and liability risks:
  - Legal risks arise from parties seeking compensation for climate-related losses.
  - Failure to disclose risks posed to business models and portfolios by climate change and other ESG risks can be a liability for investors and issuers.
- Market-structure implications:
  - As ESG investment strategies are more widely adopted, issuers will be exposed to investor decisions on ESG guidelines, which can amplify impacts on sectors (for example, fossil fuels) through divestment and reduced access to capital.

### Funds with an ESG mandate by asset class; growth and scale
- Key figures:
  - ESG funds control some $850 billion in assets (less than 2 percent of the total investment fund universe).
  - ESG equity funds have reached $560 billion in 2019.
  - 2019 data are as of September 2019 for panels referenced.

### Developments in global sustainable debt markets
- Market scale and timing:
  - Green bond issuance globally reached $168.4 billion in 2018.
  - 2019 year-to-date (YTD) data cited are until August 2019.
- Regional issuance:
  - Green bond issuance by Africa and the Middle East was $97 million in 2018.
  - Green bond issuance by Africa and the Middle East was $600 million for the first eight months of 2019.
- Credit quality and market microstructure:
  - AAA rated bonds accounted for an average of 30 percent of overall issuance from 2015 to 2018.
  - There is no consistent premium or discount at issuance between green and non-green bonds by the same issuer.
  - Secondary market liquidity is slightly worse for green bonds, possibly driven by the nature of the buy-and-hold investor base.
- Issuer and sector concentration:
  - Europe has driven global green bond issuance, with the Asia-Pacific region catching up rapidly because of China.
  - Issuers of green bonds tend to be concentrated in a few sectors.
  - Credit quality of green bonds has become more diverse, but most green bonds are highly rated, with a small fraction below investment grade.

### Fund performance, risk, fees, and passive investing implications
- Performance and risk:
  - There is no consistent evidence that sustainable funds regularly over- or underperform comparator global equity funds.
  - Simple exclusion rules can increase the volatility of equity portfolios (higher volatility of the exclusion portfolio is observed).
- Fees:
  - Fees of sustainable funds are comparable to those of their conventional peers for some retail funds.
  - Retail sustainable fund expense ratios are presented in the source figures (markers: minimum, mean, maximum).
- Passive investing:
  - Indices that track assets based on ESG criteria have opened the market to passive investors, but further fund and asset standardization may be needed to match investor expectations regarding ESG compliance.
  - Passive investing is prima facie not conducive to sustainable investing given the need for greater engagement with issuers and higher analytical burden and cost, and may prove less effective in generating impact.

### Data, disclosure, and measurement gaps
- Observations:
  - Corporate reporting on ESG factors is limited and lacks standardization despite improved disclosures in recent years.
  - ESG scoring methodologies vary, partially reflecting the lack of a generally accepted ESG taxonomy.
  - There is little apparent correlation between ESG scores and corporate valuations in the presented evidence.
- Potential actions:
  - Consistent corporate ESG reporting would incentivize acquisition of ESG data and assessment of financial materiality by investors.
  - Consideration could be given to mandatory minimum ESG disclosure requirements, especially of financially material information, taking into account costs and complexities of new regulations and reporting requirements.
  - ESG disclosure and reporting requirements for asset managers could help investors better assess ESG risk exposures and aid regulators in financial stability analysis.

### Policy recommendations and market-supporting actions
- Standardization:
  - Standardization of ESG investment terminology, product definitions, and clarification of what constitutes E, S, and G could support market development, address greenwashing concerns, and reduce reputational risk.
  - Work is underway to develop an ESG taxonomy in the European Union by the European Commission (on a recommendation by the EU Technical Expert Group on Sustainable Finance 2019b); various jurisdictions have either published or are developing green bond standards.
- Regulatory guidance:
  - Clarification of the role of ESG factors in prudent investment governance by regulators would help reduce uncertainty regarding fiduciary duties among some investors.
  - Reconciling fiduciary responsibility with long-term goals through clear metrics can provide clearer objectives to asset managers, institutional investors, and service providers.
- Supervisory and central bank action:
  - Regulators and central banks can support development of ESG-related markets by fostering awareness and offering intellectual leadership in assessing ESG risks.
  - Policymakers should incorporate ESG principles, and climate-related financial risks in particular, into financial stability monitoring and assessment and into microsupervision (such as stress testing).
  - Consider incentives to jump-start green finance markets (examples noted include a sustainable bond grant program and expansion of collateral to include green bonds).
- Market infrastructure and third-party roles:
  - Credit rating agencies and ESG data providers can further integrate material ESG information into credit ratings and other scores, aggregate relevant information, and design reliable metrics for ESG benchmarks.
  - Regulators should consider developing standards and accountability for third-party verifiers and auditors certifying sustainable investment products.
- Fiscal and structural policy:
  - Finance can help mobilize funding to achieve sustainability goals, but policies and regulations are needed to set price signals for markets.
  - Fiscal measures, including pricing of externalities such as carbon emissions and phasing out fuel subsidies, and structural policies supporting investment in climate infrastructure are particularly important to encourage more sustainable approaches by consumers and businesses.

### IMF role and multilateral cooperation
- IMF actions and plans:
  - The IMF will continue to incorporate ESG-related considerations, in particular related to climate change, when critical to the macroeconomy.
  - The IMF is incorporating climate change into multilateral (October 2019 Fiscal Monitor) and bilateral surveillance (through analysis in Article IV consultations and in Financial Sector Assessment Programs, including in stress tests).
  - Additional research on long-term consequences of ESG-related risk factors, including but not limited to climate change, is planned in the April 2020 GFSR.
- Multilateral cooperation:
  - Multilateral cooperation can help bridge gaps in supervisory capacity on ESG issues and avoid fragmentation of sustainable asset markets.
  - Where data gaps are identified at the national level, countries should seek to remediate them.

*Source: Chapter 6, "Sustainable Finance: Looking Farther," Global Financial Stability Report: Lower for Longer, International Monetary Fund | October 2019.*

### 1. Selected ESG Issues

### 1. Selected ESG Issues

### Evolution of ESG associations, standards, and codes
- Major milestones:
  - 2004: Launch of the Who Cares Wins initiative by the UN Global Compact.
  - 2006: Launch of the UN Principles of Responsible Investment.
  - 2007: Issuance of green label bonds by multilateral development organizations catalyzed growth for fixed income.
  - Paris COP21 and the 2015 UN Sustainable Development Goals increased investor and regulatory attention to climate-related risks; most countries committed to emission mitigation.
- Observations:
  - Sustainable investing began in equities and expanded to fixed income through self-declaration and labeling (for example, green bonds).
  - The lack of consistent definitions makes it difficult to pinpoint the global asset size related to ESG, with estimates ranging from $3 trillion to $31 trillion.
  - Labeled bonds—primarily green bonds—are a fast-growing segment, aided by issuance from multilaterals (International Bank for Reconstruction and Development, European Investment Bank) and standards developed by China, the European Commission, the United Nations, and the United Kingdom.

### Climate change: physical and transition risks; implications for financial stability
- Two identified channels of climate-related financial risk:
  - Physical risks: damage to property, land, and infrastructure from catastrophic weather-related events and gradual climate changes.
  - Transition risks: changes in the price of stranded assets and broader economic disruption from evolving climate policy, technology, and market sentiment during adjustment to a lower-carbon economy.
- Financial and economic transmission:
  - Climate-related losses affect the financial system directly (price impairment, reduced collateral values, underwriting losses) and indirectly (lower economic growth and tighter financial conditions).
  - Insurance claims from natural losses have already quadrupled since the 1980s.
  - Risks are large, non-linear, and hard to estimate; catastrophic tail risks are not negligible.
  - In the transition to a cleaner-energy economy, sudden reassessment of valuations in exposed sectors could occur if asset prices do not fully internalize climate risks.
  - Climate change mitigation costs per unit of emission are likely to fall on industrialized economies under “common but different responsibilities” given that most future low-cost mitigation opportunities are in large emerging market economies.
  - Lower- and middle-income countries are very vulnerable, reflecting geography, dependence on agriculture, and lack of resources for adaptation.
- Quantitative and study-based estimates cited:
  - Burke, Hsiang, and Miguel (2015) suggest that average global incomes may be reduced by up to a quarter by 2100.
  - Cambridge Centre for Risk Studies (2015) estimates losses in trillions of dollars.
  - Economist Intelligence Unit (2015) estimates the value of typical equity portfolios could decline by half.
  - A group of large listed companies expects climate change costs to rise to $1 trillion (CDP 2019).
  - For financial losses, the scale and systemic reach imply potentially very large economic and financial costs.

### Transition risks materializing: coal sector example and sovereign risk
- Transition risks have already materially affected the coal sector through divestment and regulatory actions.
- Large-scale divestments and commitments by banks and insurers to curtail financing or insuring fossil-fuel sectors can make capital and insurance more difficult and costlier for exposed sectors.
- Sovereign risk implications:
  - Sovereigns are also at risk from ESG noncompliance, as rating agencies and large investors increasingly incorporate ESG considerations into sovereign credit assessments.
- Illustrative issuance and asset indicators:
  - The stock of green bonds grew to an estimated $590 billion in August 2019 from $78 billion in 2015.
  - There is little evidence that issuers achieve lower costs through green bonds than conventional bonds, likely reflecting identical credit risk profiles.
  - Secondary market liquidity appears to be slightly worse for green bonds than for comparable conventional bonds, reflecting the large role of buy-and-hold investors.

### Is there a case for ESG-linked portfolio investment?
- Evolution of ESG investment strategies:
  - Initial phase: negative/exclusionary screening (excluding sectors such as tobacco, munitions).
  - Later strategies: positive/best-in-class screening, norm-based screening, sustainability-themed investments, corporate engagement, impact/community investing.
  - Increasing integration: ESG information is being explicitly and systematically integrated into investment analysis and decisions across asset classes.
- Asset-class application examples:
  - Equities: long-standing ESG application with active engagement rights.
  - Fixed income: growing ESG integration, labeled bonds (green, social, sustainability), green mortgage-backed securities, green loans, sustainability-linked loans, and ESG incorporation into sovereign and corporate credit analysis.
  - Alternative investments and private markets: aided by longer time horizons and scope for investor activism.
- Performance considerations:
  - No conclusive evidence that sustainable funds consistently out- or underperform conventional funds.
  - Restricted investment can reduce diversification and increase volatility.
  - IMF staff analysis suggests performance of sustainable and conventional funds is comparable.
  - Investors justify allocation to ESG funds given similar fees between ESG and regular funds, though anecdotal evidence shows sustainable active management fees are often higher, which may hinder wider adoption—especially by public pension funds.

### Challenges faced by ESG investors and issuers
- Data, disclosure, and methodological issues:
  - Lack of consistent methodologies and reporting standards; corporate reporting is largely voluntary, inconsistent, and particularly sparse on environmental and social dimensions, though disclosure has been improving.
  - Investor surveys show concerns about data comparability across firms and time, data quality, and timeliness.
  - Third-party ESG score providers face concerns about opaqueness of methodologies and informational materiality; ESG scores across providers are often inconsistent.
  - There appears to be little correlation between ESG score informational content and investor perception of a firm’s enterprise value.
- Greenwashing and reputational risk:
  - False claims of ESG compliance (greenwashing) may give rise to reputational risk.
  - Investment fund classifications can be inconsistent: only 37 percent of Lipper ethical funds also carry a “sustainable” designation by Bloomberg.
- Legal and liability risks:
  - Legal risks arise from parties seeking compensation for climate-related losses.
  - Failure to disclose risks posed to business models and portfolios by climate change and other ESG risks can be a liability for investors and issuers.
- Market-structure implications:
  - As ESG investment strategies are more widely adopted, issuers will be exposed to investor decisions on ESG guidelines, which can amplify impacts on sectors (for example, fossil fuels) through divestment and reduced access to capital.

*International Monetary Fund | October 2019*

### 1. Funds with an ESG Mandate by Asset Class

### 1. Funds with an ESG Mandate by Asset Class

### Growth and scale of ESG-dedicated funds
- ESG funds control some $850 billion in assets (less than 2 percent of the total investment fund universe).
- ESG equity funds have reached $560 billion in 2019.
- 2019 data are as of September 2019 for panels 1 and 2 referenced.

### Developments in global sustainable debt markets
- Global sustainability-linked bond issuance has been led by green bonds.
- Green bond issuance globally reached $168.4 billion in 2018.
- Regional issuance notes:
  - Green bond issuance by Africa and the Middle East was $97 million in 2018.
  - Green bond issuance by Africa and the Middle East was $600 million for the first eight months of 2019.
- Credit quality:
  - AAA rated bonds accounted for an average of 30 percent of overall issuance from 2015 to 2018.
- Market microstructure observations:
  - There is no consistent premium or discount at issuance between green and non-green bonds by the same issuer.
  - Secondary market liquidity is slightly worse for green bonds, possibly driven by the nature of the buy-and-hold investor base.
- Notes on data timing:
  - 2019 year-to-date (YTD) data in cited panels are until August 2019.

### Issuer and sector concentration
- Europe has driven global green bond issuance, with the Asia-Pacific region catching up rapidly because of China.
- Issuers of green bonds tend to be concentrated in a few sectors.
- Credit quality of green bonds has become more diverse, but most green bonds are highly rated, with a small fraction below investment grade.

### Fund performance, risk, and fees
- There is no consistent evidence that sustainable funds regularly over- or underperform comparator global equity funds.
- Simple exclusion rules can increase the volatility of equity portfolios (higher volatility of the exclusion portfolio is observed).
- Fees:
  - Fees of sustainable funds are comparable to those of their conventional peers for some retail funds.
  - Retail sustainable fund expense ratios are presented (markers: minimum, mean, maximum) in the source figures.

### Challenges in ESG investing and issuer constraints
- Measuring ESG effects remains challenging.
- Indices that track assets based on ESG criteria have opened the market to passive investors, but further fund and asset standardization may be needed to match investor expectations regarding ESG compliance.
- Passive investing is prima facie not conducive to sustainable investing given the need for greater engagement with issuers and higher analytical burden and cost, and may prove less effective in generating impact.
- Issuers of ESG-compliant assets face:
  - Difficulty realizing immediate gains due to the long-term nature of positive externalities.
  - High cost of ESG reporting.
  - Expensive and complicated external review procedures.
  - A lack of eligible assets.
  - Complexity and unclear definitions of the E, the S, and the G, leading to reputational risk.

### Data, disclosure, and measurement gaps
- Corporate reporting on ESG factors is limited and lacks standardization despite improved disclosures in recent years.
- ESG scoring methodologies vary, partially reflecting the lack of a generally accepted ESG taxonomy.
- There is little apparent correlation between ESG scores and corporate valuations in the presented evidence.
- Consistent corporate ESG reporting would incentivize acquisition of ESG data and assessment of financial materiality by investors.
- Consideration could be given to mandatory minimum ESG disclosure requirements, especially of financially material information, taking into account costs and complexities of new regulations and reporting requirements.
- ESG disclosure and reporting requirements for asset managers could help investors better assess ESG risk exposures and aid regulators in financial stability analysis.

### Policy recommendations and market-supporting actions
- Standardization:
  - Standardization of ESG investment terminology, product definitions, and clarification of what constitutes E, S, and G could support market development, address greenwashing concerns, and reduce reputational risk.
  - Work is underway to develop an ESG taxonomy in the European Union by the European Commission (on a recommendation by the EU Technical Expert Group on Sustainable Finance 2019b); various jurisdictions have either published or are developing green bond standards.
- Regulatory guidance:
  - Clarification of the role of ESG factors in prudent investment governance by regulators would help reduce uncertainty regarding fiduciary duties among some investors.
  - Reconciling fiduciary responsibility with long-term goals through clear metrics can provide clearer objectives to asset managers, institutional investors, and service providers.
- Supervisory and central bank action:
  - Regulators and central banks can support development of ESG-related markets by fostering awareness and offering intellectual leadership in assessing ESG risks.
  - Policymakers should incorporate ESG principles, and climate-related financial risks in particular, into financial stability monitoring and assessment and into microsupervision (such as stress testing).
  - Consider incentives to jump-start green finance markets (examples noted include a sustainable bond grant program and expansion of collateral to include green bonds).
- Market infrastructure and third-party roles:
  - Credit rating agencies and ESG data providers can further integrate material ESG information into credit ratings and other scores, aggregate relevant information, and design reliable metrics for ESG benchmarks.
  - Regulators should consider developing standards and accountability for third-party verifiers and auditors certifying sustainable investment products.
- Fiscal and structural policy:
  - Finance can help mobilize funding to achieve sustainability goals, but policies and regulations are needed to set price signals for markets.
  - Fiscal measures, including pricing of externalities such as carbon emissions and phasing out fuel subsidies, and structural policies supporting investment in climate infrastructure are particularly important to encourage more sustainable approaches by consumers and businesses.

### IMF role and multilateral cooperation
- The IMF will continue to incorporate ESG-related considerations, in particular related to climate change, when critical to the macroeconomy.
- The IMF is incorporating climate change into multilateral (October 2019 Fiscal Monitor) and bilateral surveillance (through analysis in Article IV consultations and in Financial Sector Assessment Programs, including in stress tests).
- Additional research on long-term consequences of ESG-related risk factors, including but not limited to climate change, is planned in the April 2020 GFSR.
- Multilateral cooperation can help bridge gaps in supervisory capacity on ESG issues and avoid fragmentation of sustainable asset markets.
- Where data gaps are identified at the national level, countries should seek to remediate them.

*Source: Chapter 6, "Sustainable Finance: Looking Farther," Global Financial Stability Report: Lower for Longer, International Monetary Fund | October 2019.*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2019/october/english/ch6.pdf_