Let me first apologize to my readership. I have been very dilatory in getting this commentary done and this topic is… a bit daunting. In my defense, working for a living can get in the way of thinking and writing. In any event, I have been doing some considerable reading about Environmental, Social and Governance (ESG) issues recently. It had not really been on my screen, in a big way, but has been bubbling along as a thing, important to some, but not so much for us denizens of the commercial real estate finance space.
Now, perhaps with an assist from Uncle Joe’s new administration and broadening engagement across stakeholders and constituencies, it is about to become much more than just chatter. Dechert has a team focusing on ESG issues across multiple business sectors and a lot of work is getting done. Ratings agencies and other purpose-built advisory groups are pressing ahead with advisory services and scoring systems. The NASDAQ is proposing new ESG disclosures from listed companies, the SEC recently announced the hiring of a senior policy advisor on ESG issues and is organizing a “Task Force” to monitor disclosure violations. Yikes! Our principal trade organizations (CREFC, MBA and SFA) are also trying to put a stake in the ground here and sort out what our industry should do, endeavor to be helpful and endeavor to shape the discussion.
Moreover, much of the investor marketplace seems to be pivoting to treat ESG issues seriously. How much of that is a perceived causal link between ESG and credit and how much is about public virtue and, to by cynical, how much is about virtue signaling? Not clear, but for my purposes not relevant either.
The question is, what do we do? And by “we” here, I am speaking very narrowly of the commercial mortgage finance industry. I’m going to get there, but let me start off by sharing some of my undoubtedly impressionistic observation about ESG in the here and now.
- Maybe this is the stuff of “No duh,” but ESG feels as much like a movement, like the “Silent Spring” of the 1960s, as it does a technical reaction to credit risk. It’s harder to get emotionally invested in the analysis of credit risk (even for the truly wonky), but here, lots and lots of people are very It’s personal. There seems to be a growing conviction in the broader polity that business needs to do something about environmental risk, social justice and good or bad governance. I’m not asking the why or whether here, but just focusing on the what.
- Peter Drucker famously said, “You can’t manage what you can’t measure.” Notwithstanding a proliferation of ratings agencies and other vendors with their proprietary methodologies getting into the game, there’s not much evidence out there that any of E, S or G can be measured in a way wide constituencies across stakeholders can agree upon. Transparency, standardization and harmonization are a long way off. Charitably, we are even further off on agreement on the algorithms which might translate agreed upon data points into values or factors that could be applied to adjust credit scores.
- Jargonization in this new field is unsurprisingly breathtaking. It’s not like we’re not already besotted with jargon in the CRE finance space, but do we really need more? And just in case all this jargon is not sufficiently impenetrable, we then acronymize everything to insure complete opacity. Reading the latest S&P piece on the topic, my eyes glazed over after reading such things as
“…the climate scenarios (or Representative Concentration Pathways) RCPs, describe possible pathways of greenhouse gas (GHG) emissions and were produced by the intergovernmental panel on climate change (IPCC) and used in its fifth assessment (AR5)”
- So, what am I supposed to take from the RCPs on the GHGs identified in the IPCCs and most recently used in the AR5? Talking that way is not going to make any of this easier and, believe me, I could show you dozens if not hundreds of other defenestrations of clarity around ESG. One begins to suspect that all this academic babble is deployed in the service of eliding the fundamental nebulosity of the concepts involved here. But, once again, that’s just being too cynical.
- In our space, the relevant credit ratings agencies or agency wannabes are purporting to focus just on ESG’s impact on credit. They disavow any suggestion that they are addressing broader issues that captivate the polity about goodness or virtue. But I’m not sure that’s right. We might be fooling ourselves that we can silo credit away from those broader issues, but for our purposes, whether we can or not is not terribly relevant.
- A lot of the things in the E of ESG are things which we already pay some considerable attention to in the CRE finance marketplace. Do we notice and care whether an asset is in a flood plain, or in Tornado Alley or nestled among the golden (read “burnt”) hills of California? Yes, we do. There’s even some G in our diligence. Do we take into account governance related issues such as the difficulty of enforcing loans in Italy or the Caribbean? How about instability? Do we worry about bad actors, assessing them through our increasingly robust KYC processes? Yep. So far so good, on the E and G axes. With respect to the S? Not so much.
- Relatedness is the central analytic problem here. John Muir said, “When we try to pick out anything by itself, we find it hitched to everything else in the Universe.” Pick your quote on interconnectivity, but if the analysis devolves into seeing everything connected to everything, we have a problem. Let’s just try this for fun. Think about inequality. Assuming inequality is a data field, does it connect to social unrest? If so, does that result in higher insurance costs resulting from the risk of urban tumult? Maybe retail sales are depressed. Will urban versus ex-urban property values fall? Will government support for infrastructure spending be diminished as dollars are realigned to redistributive goals result in higher taxes? All that might be true… maybe. The hard part, of course, is to cull the more powerful causal drivers from the coincident and the weaker relationships and establish transparent and replicable connectivities between observable conditions and credit outputs.
- Said another way, it’s easy to see the inputs; it’s much harder to see the outputs. When outputs are not largely observable, inputs are all we’ve got. Because of our inability in the here and now to agree upon relationships between data and outputs, we’re likely to simply count data point inputs in terms of scaling. Remember the old lawyer’s saying, if you have the law on your side, bang on the law. If you have the facts on your side, bang on the facts. Otherwise, just bang on the table. Inputs might be the table.
- When the math is complex, when the assumptions are numerous and the means, methods and modalities of deriving conclusions from data are not easy to understand, ESG ratings are likely to become functions. We rely on functions a lot, every day. It’s shorthand for understanding the underlying complexity of the world. It’s not a bad thing, but it’s a thing. We don’t ask about what’s behind the math, what’s behind the algorithms, what are the methods and modalities creating the function, we simply deal with the function as a thing, a fact, not a conclusion or an output from a complicated analysis. Maybe I didn’t say that too clearly, but think about LIBOR; very few who use LIBOR have much of a clue or even an interest in how LIBOR is set on a daily basis. Yes, we hear it’s about interbank quotes, but that’s about it, isn’t it? LIBOR became a function. I could not replicate how it is derived. At least until recently, we used it without any concern whatsoever to whether it truly represented observable inputs from interbank lending.
- So not just to pick on S&P, the perpetrator of my death-by-acronym above, a recent Fitch paper entitled ESG and Credit endeavors to explain its five-point scoring process along each of the environmental, social and governance axes. Fitch has identified five E, five S and five G issues in its CMBS template. This process appears on its face to be highly numeric, and the emphasis here is on “appears to be highly numeric” because before the math, there’s a lot of judgment which inevitably remains highly idiosyncratic.
- In a delightful color-coded guide to ESG, we can graphically see how a particular issuer or a particular data set stands up in the Fitch model. Now I’m not belittling this exercise or dismissing the significance of the hard work that went into building it, but it’s effectively a fancy opinion with a bunch of numbers. It’s can’t be reverse engineered from the data, because first, we can’t decide on the data and then the judgment tying the data to the sale is simply not replicable. In other words, while it may be entirely valid, it’s also entirely idiosyncratic. Does it deliver information to the reader? Is it aligned with achieving the goals of the ESG polity? Certainly. The inability to replicate and the lack of transparency and standardization might be viewed as very close to fatal flaws, but only if you think that. If we can all agree that these ratings provide relevant information and embrace their function status and move on, then that’s what we will do.
- If you want a preview of ESG in the financial sector and even debt markets, go to Europe. Take a look at the Sustainable Financial Disclosure Regulations (SFDR) which go into effect in October. The near term likelihood that ESG will be fully imported into debt markets and the recent announcements (once again, I love the jargon) from the EU directing the EBA to publish a report later this year on developing “a specific sustainable securitization framework for the purposes of integrating sustainability related transparency requirements into the EU securitization regulation. It’s coming.
So, with all that said, what do we do? Short answer, we need to embrace ESG sensitivities in credit ratings and investment decision making.
So, first step; don’t fight the tape. Yes, we can be aware of all the intellectual vulnerabilities, elisions, assumptions and basic guessing in the structure of the ESG ratings process. Work with it. Engage, don’t carp. Having an ESG score on your deal will not be an option. Some of the agencies now, and certainly all of them shortly, will simply provide ESG information in connection with every rating they do, and they will present it in a more unambiguous and unhighlighted manner. Already we can see this in the presales. The other agencies don’t have Fitch’s cute color-coded system superficially suggesting certainty, but the information is there. The analysis will get sharpened and at some point, I would expect to see subtext attached to credit ratings indicating relevant ESG compliance.
The industry should engage, through our trade organizations and otherwise, with the ratings agencies, investors, the freestanding ESG rating institutions and organizations and other constituencies to try to reduce the chaos here. We need to get to an agreed upon taxonomy, much like the IRP as soon as possible and agree on what data needs to be harvested and how it should be presented and delivered. We’ve seen this movie before. To the extent we don’t make this happen, we leave it to others who don’t understand our industry to make it up and do it to us. That can’t be a good thing.
Moreover, let’s not wait upon a completely agreed upon ESG taxonomy, it’s time to begin engagement on disclosure and structure in our transactions now. Note that ESG is both a shield and a sword; demonstrating alignment can be economically positive. As no one is sure what inputs are critical and no one has real visibility into the relationship between inputs and outputs, industry participants are free to develop their own views here.
Should risk factors be enhanced along ESG axes? Certainly. Given that in the typical CRE securitization offering document we solemnly tell investors that there’s risks associated with investing in real estate, we surely can find space in our 80 or 90 single spaced, turgid pages of risk factors, a place for a robust discussion of ESG.
Inoculate yourself against risk by disclosing in the risk factors any identified issues. To the extent there is inadequate information to make an assessment of ESG, perhaps we should say that. Perhaps we should highlight questions asked but not answered. We can and certainly should indicate that while the sponsor attempted to identify positive ESG inputs, we can provide no assurances as to whether value along the various ESG axes will be delivered from those inputs.
On the flipside, let’s tell investors where alignment is good. To the extent investors and other stakeholders are looking for ESG alignment, and an alignment is largely assumed based on a compilation of ESG inputs, the path forward is clear: Invest in diligence, up the input count and disclose. Develop an ESG profile for your transaction.
Can we highlight or establish how certain assets have positive (or negative) externalities regarding local communities, particularly economically disadvantaged communities? Can we identify governance issues in our deal sponsor? Is there diversity in deal sponsor management and perhaps even major tenant management? Look, there is a remarkably large amount of literature out there suggesting connectivity between the characteristics of the transaction and social justice issues that can be mined for inputs and potential relationships. Can we map transactions to applicable scoring methodologies? Certainly, that can be reverse engineered.
Look, right now, this is largely about accumulating good inputs. The more the better. The more the higher the score. Many of these things don’t actually cost money. The fact that we can’t replicate outputs or even agree on what the outputs are from the inputs, doesn’t matter; it’s a function, and as long as we can have visibility into the inputs, we can create value here.
And finally, let’s go all in with deals that are specifically designed around ESG goals and therefore can be branded as deals designed around ESG goals. This, of course, is already happening, so get on the board and get a green deal done. Green is perhaps the easiest thing to engineer within this ESG framework.
It’s still early days. This is a thing and the governments’ regulators and investors will increasingly care about ESG and increasingly care about documentable evidence of ESG compliance. Might we get a premium for really good ESG scores? Maybe, but more certain is that negative scores won’t be helpful in selling securities.
Not to be cynical, but like any complicated set of rules, protocols and procedures, there will be opportunities to create value from clients where the value of compliance demonstrably exceeds the costs of compliance. That’s a math we can solve.