Understanding sustainability

We all know finance has a powerful influence on the world. At UBS, we reimagine the power of people and capital, to create a better world for everyone: a fairer society, a more prosperous economy and a healthier environment. That’s  why we partner with our clients to help them mobilize their capital towards a more sustainable world. And its why we’ve put sustainability at the heart of our own business too.

 

What is ESG?

ESG stands for environmental, social and governance, which deals with a wide range of issues. These include how corporations respond to climate change, treat their workers, manage their supply chains and how they build trust and drive innovation.

Some companies and organizations have sustainability at the core of what they do, for example, bio energy or sustainable agriculture companies. Other companies focus on how they do things. This includes building sustainability considerations into their business practices, such as how they manage their supply chains, treat their staff and other stakeholders, and govern their risks and processes.

From consumers to corporates to investors, decision making now often includes social and environmental considerations. These, and other non-financial factors, are expected to become more important in investment decisions and valuations.

It may or may not be possible to measure their impact, but this is not a new challenge in the context of active investment approaches in general.

Want to know about UBS’s commitment to sustainability?

 

Approaches to Sustainable Investing

Investors put money into financial markets to protect and grow their wealth. Sustainable investing supports these objectives, while also typically seeking to generate benefits for the wider society.

Generally speaking, sustainable investing offers distinct approaches.

The first approach is usually known as impact investing, which means investing with the intention to generate measurable and verifiable environmental and social impact alongside a financial return. Minimum investments in this area tend to be higher than with other approaches. Additionally, these are often private equity investments with higher associated risk.

At UBS, we have recently evolved our own definitions of sustainable investing, which now includes the first approach, that is impact investing, as well as another category that we call sustainability focus. This includes strategies that have explicit sustainable intentions or objectives that drive the strategy. Underlying investments may contribute to positive sustainability outcomes through products, services or use of proceeds.

We further identify two approaches that consider ESG factors in the investment process to varying degrees, notably also in investment strategies and products not explicitly labelled as sustainable investment: ESG integration and exclusion.

ESG integration means taking environmental, social, and corporate governance, or ESG factors, into traditional investment processes to improve portfolio risk and/or returns. Building ESG considerations into business practices is an effective way to meet sustainability targets whilst supporting returns. But because the focus is more on how a company does things rather than what it does, certain industries might remain in your portfolio.

The last approach, exclusion, involves excluding companies or industries from portfolios where they are not aligned with an investor’s values. On the positive side, this allows for the strictest application of aligning values with investments, however it limits the options to invest. Also with this approach, there isn't an opportunity to influence how companies are run.

Regardless of what approach an investor chooses, engagement in sustainable investing is growing.

 

ESG related financial products

When it comes to financial products available across traditional asset classes, there are various options at hand in the ESG space.

There are growing efforts to ensure transparency around the sustainability objectives, impact, and verification of various investment products and sustainable investments. The European Union’s Sustainable Finance Disclosure Regulation (SFDR) legislative framework is an important marker. In the future, ESG-related financial products may not be marketed as "sustainable" or "green”; some approaches to sustainable investing will become the norm, while others may not meet the standards set for what is considered sustainable.

Green bonds are fixed income instruments in which proceeds are earmarked for projects with environmental value and typically trade at comparable spreads to similarly ranked bonds of the same issuer. Independent auditing and verification remains voluntary, so understanding the actual impact depends on transparency, reporting, and second party verification.

Sustainability-linked bonds are defined as any type of bond instrument for which the characteristics can vary depending on whether the issuer achieves predefined sustainability or ESG objectives. In other words, the issuing company commits to future sustainability improvements within a set time frame.

There are also transition bonds, as well as sustainability and socially responsible bonds and loans. One such example is social impact bonds, linked to a specific objective (education for instance) and measured against a pre-defined target.

Within the equity space, products include ESG exchange traded equity funds. That is, funds that consider ESG criteria to generate returns and positive impact.

Positively screened or improving ESG equities include equity shares in companies that manage, or are getting better at managing, ESG issues and seize ESG opportunities better than their competitors, according to ESG ratings.

Similarly, ESG thematic equities strategies focus on companies that sell products and services that tackle a particular environmental or social challenge, and/or whose businesses are particularly good at managing a single ESG factor, such as gender equality.

There are also many private market investment products, such as positively screened and thematic funds or private debt fund lending to businesses that have positive outcomes for underserved people and the planet.

 

1 2 3 – as easy as A B C?

It has become increasingly clear that we need to accelerate the transition to a low-carbon economy in order to limit the global rise in temperature to 1.5% from pre-industrial levels and mitigate the effects of climate change. To achieve that, emissions from greenhouse gases which trap heat in the atmosphere need to be reduced.

According to the United States Environmental Protection Agency, carbon emissions are responsible for 81% of overall greenhouse gas emissions, of which businesses are responsible for a lot of it. The rest of GHG emissions are methane (10%), nitrous oxide (7%) and fluorinated gases (3%).¹ The major contributors of carbon dioxide emissions are transportation, industrial processes and the combustion of fossil fuels to generate electricity.

As a first step to reducing emissions, many companies classify and report their carbon footprint according to the three scopes set out in the Greenhouse Gas Protocol Corporate Standard, a widely used international accounting tool.²

Scope 1 and 2 are mandatory to report in numerous countries. Scope 1 includes direct emissions from owned or company-controlled sources and activities, such as fleet vehicles. Scope 2 covers indirect emissions created during the production of the purchased energy, heating or cooling and used by the company.

Scope 3 are all indirect emissions that occur in the value chain of the reporting company. These typically account for the largest share of the company’s footprint. Reporting on Scope 3 emissions is (still) voluntary. These indirect emissions include both upstream emissions such as transport and distribution, and business travel, as well as downstream emissions such as waste disposal or end use of goods and services.

Why is it important for companies to report emissions? In short, it’s difficult to manage what can’t be measured.

UBS plans to achieve net zero greenhouse gas emissions by 2050.

Sources:

¹https://www.epa.gov/ghgemissions/overview-greenhouse-gases

²https://ghgprotocol.org/

 

ESG data and disclosures

Sustainability disclosures and reporting can help companies set goals, measure performance and manage change around Environmental, Social and Governance (ESG) impacts. Most public, and many private, companies are now being evaluated and rated on their ESG performance by various third-party providers of reports and ratings.

As ESG factors become more important in investment decisions and valuation, investors and other stakeholders increasingly rely on these reports to measure ESG performance.

There are, however, challenges and considerations to take into account when it comes to ESG data, metrics and ratings:

  1. Materiality is crucial when analyzing ESG data: issues that are relevant to a company's operating performance should be the focus as they have an impact on financial performance over the longer term.
  2. There are still no industry-wide definitions and benchmarks on sustainable investing and impact investing.
  3. A lack of a single standard for disclosure means that reporting remains inconsistent across companies.
  4. There is no protection from green-washing or misuse, which undermines credibility and investor confidence.
  5. ESG data is typically reported annually, which means there is a significant lag time compared to financial information.
  6. Data primarily covers a company's own operations, with little information on the external impacts of a company's products and the reputation of the company.
  7. Sustainability disclosures might be influenced by marketing concerns and fail to provide an objective view of company performance.
  8. Controversial information is already known in the public domain and therefore already reflected in valuations.

To stay attractive for clients, investors, employees and other stakeholders, sustainability needs to become a cornerstone of business.

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* UBS Internal Data, 2019

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