Implementing ESG – the sustainable bank’s way
Some 75% of the core portfolios of KfW, Germany’s development bank, is managed sustainably, as Nina Röhrbein finds
While Germany has an image that is clean and green, Europe’s biggest economy is lagging behind several of its European counterparts when it comes to sustainable investment.
“The countries leading sustainable or environmental, social and corporate governance (ESG) investments tend to be the ones that are host to large pension funds, such as the Nordic countries, the Netherlands and the UK,” says Solveig Pape-Hamich, who is in charge of implementing the UN Principles for Responsible Investment (UN PRI) in the liquidity portfolio at the German state-owned development bank KfW.
“Germany’s pension system is still largely based on the pay-as-you-go system and capital has only relatively recently been accumulated. This different background and mentality creates doubt among German investors about whether they can become a signatory to the UN PRI and fulfil their obligations,” Pape-Hamich says.
Nevertheless, KfW became a PRI signatory in 2006.
The bank has for a long time paid attention to sustainability, in particular when it concerns the environment. In 2009, for example, through its loan programmes close to a third - around €20bn - of KfW’s credit business was invested in environmental projects. In the first six months of 2010, €11bn went into environmental and energy-related projects.
With the German government owning 80% and the federal states 20% of KfW, becoming a PRI signatory matched its overall strategy to set a positive example to other German investors.
However, due to capital market activities, which it performs on behalf of the federal government, such as support in privatisation transactions, KfW applies its ESG criteria mainly to its core portfolio. Pape-Hamich estimates that around 75-80% of KfW’s business is currently managed sustainably.
With regard to the implementation of ESG into portfolio management, KfW has developed its own approach.
“The PRI are currently applied to KfW’s core bond portfolio, the so-called liquidity portfolio,” says Pape-Hamich. “This portfolio contains medium-term financial assets used as reserves to maintain an adequate liquidity level at all times.”
The liquidity portfolio contains around €20bn of fixed income assets. It is made up of government bonds, Pfandbriefe, financials and bonds from other government-linked agencies. KfW does not buy non-financials.
“We run a buy-and-hold strategy, in other words we hold positions until maturity, with few exceptions,” says Pape-Hamich. “The bank has a central risk management unit, which sets maximum investment limits per issuer or loan.”
Having signed up to PRI, the bank decided how it would integrate ESG criteria into its decision-making process without having to completely restructure the portfolio.
“First we had to define sustainability,” says Pape-Hamich. “As a development bank especially committed to environmental and climate-related issues, our focus is on the financing of environmental projects. That is why we have weighted environmental with 60%, social with 20% and governance criteria with 20%. All these will be made up in total of 60 individual factors.”
Due to a limited in-house research capacity, the bank had to find a rating agency to define those 60 criteria and undertake the rating of companies in the portfolio.
“While there is plenty of research available on sustainability in equities, it was more difficult to find any analysis on fixed income issuers,” says Pape-Hamich. “It was particularly challenging to rate some of the smaller issuers. Because our portfolio has a large regional diversification it was important for us to find an international partner, and so we started to work with ESG research provider Sustainalytics.”
Both mainstream approaches, negative screening or exclusions and positive screenings, also known as best-in-class, were discussed when KfW entered the sustainability market in 2007.
“Back then we came to the conclusion that negative screening is only of use for real corporate paper, which we do not have in our portfolio,” says Pape-Hamich. “We found it difficult to apply an exclusionary screen to the financial titles and government bonds in our portfolio. In a highly diversified fixed income portfolio such as ours, however, the best-in-class approach also fails to work. If we only invest, for example, in the top 30% of the assets, we would have conflicting goals and not be able to reach a similar standard of diversification, which is one of our fundamental portfolio objectives. In the end we developed our own strategy.”
KfW implemented its sustainability strategy via a new process in addition to the old one, which was entirely based on creditworthiness. Now the investment decisions are taken in a two-tier process. First the portfolio manager selects the issuer in which he would like to invest, with the risk unit setting the investment ceiling for the issuer. Second, the ESG criteria come into play, with external providers undertaking the rating. “The top 20% of issuers with a good rating will keep their maximum investment limit, 60% of issuers with a slightly lower rating will incur a deduction of 10%, while the worst 20% of issuers receive a deduction of 30% of their maximum investment limit,” says Pape-Hamich. “Some people may assume a deduction of 30% is not a problem but several portfolio managers have not welcomed the 30% restriction on their business. For us it meant that by introducing this process we cancelled €2bn of available limits simply because we do not view certain issuers as sustainable enough and do not want to invest in them to the same extent we invest in more sustainable issuers.”
The 20/60/20 ratio is relative and KfW updates ratings every month. If one issuer improves and consequently moves from the average to the best-ranked group, automatically one of the previously best issuers deteriorates, falls into the average group and has its limits cut by 10%. The idea is to create competition between issuers.
“But we can only create competition if we communicate this to the issuers,” says Pape-Hamich. “As we are not a shareholder we cannot simply go to an annual general meeting but have to approach the issuers directly and try to establish permanent contact with them. Therefore, in 2010 we focused on establishing communication with issuers.”
Last year, KfW also came to the conclusion that it would, after all, like to have some exclusionary criteria.
“Unlike with the projects KfW finances directly, we have no influence on what kind of project we will finance with our money as an external lender of capital,” says Pape-Hamich. “Therefore, we want to be able to exclude certain issuers right from the start. We initially said exclusions would only work for corporates, hence we have tried to undertake exclusions via the corporate stakes of financials. In other words, an issuer that holds a large share of corporates in a sector that we do not agree with, for example, chemical weapons, will not be supported with our capital.”
In other branches of KfW - such as in its subsidiary Deutsche Investitions- und Entwicklungsgesellschaft - exclusions have already been applied during lending procedures based on the exclusion list of the International Finance Corporation. While KfW did not adopt those fully, it has tried to remain consistent with the exclusionary screen in the wider context. As a result, KfW’s exclusion criteria, which are expected to be introduced in the first quarter of 2011, are to 95% based on the IFC exclusion list.