ESG Default Insurance is a solution that forces a company to focus on specific stakeholders, helps serious ESG companies separate themselves from companies that are lip service, gives socially active investors the game By making it financially lucrative to sue a company if it gives up on its ESG promises and empowers the insurance company to serve as an effective ESG insurance service.
COP26 is in full swing, but questions persist as to whether a top-down carbon budget management process is effective or a micro-bottom-up approach is better. Inspired by older concepts such as financial statement insurance, credit default swaps, and director and officer insurance, I explored a mechanism that takes a bottom-up idea: ESG default insurance.
A company could take out ESG default insurance with a counterparty such as an insurance company or an investment bank or even an ESG rating agency by paying a premium. The hedge provides protection to investors against losses incurred due to broken ESG promises. Suppose socially active investors believe that a company has broken its ESG promises or has engaged in greenwashing. The insurance company settles with these investors in this case of ESG default. The act of an ESG default may also involve legal action filed by socially active investors or an NGO.
No market observer should assume that a company that defines ESG will achieve these goals in total. In fact, many of my articles document that companies are breaking their promises. The very disclosure of whether the company has insurance and the amount of coverage sought helps serious ESG companies credibly separate themselves from companies less serious about delivering on their ESG promises. The insurance company is obviously interested in minimizing payments in such an arrangement. Thus, the insurance company appoints and pays a auditor who annually certifies the accuracy of the ESG statements made by the company.
The figure below illustrates the ESG default insurance process in pictorial form:
A nascent version of this idea is already seen in green bonds where the interest rate paid on the bond is contracted to rise if a company forgoes an ESG commitment. Let us take a concrete example. Black Rock recently issued a $ 4.4 billion loan that will increase the interest rate on the loan by 0.05% if a company does not increase the share of Blacks and Latinos in its workforce. American to 30% by 2024 and the proportion of women among its seniors. leadership ranks 3% each year.
I read this as an important development for two reasons. First, transactions like this open the door to my idea of ââESG default insurance and the actual outcome around which default can be defined – BlackRock’s promise of diversity. One of the problems with ESG finance is the clutter associated with the hundreds of data points associated with E, S, and G. This transaction takes the clutter out of the way and tells investors that a company cares deeply about one stakeholder: a diverse workforce. This is obviously not perfect, as the definition of “higher rank” or who exactly is considered “Black or Latino” remains vague. But the focus is certainly better than looking at hundreds of different data points in BlackRock’s ESG report.
At this point, you may be wondering how ESG default insurance is different from green bonds or sustainability bonds more broadly? Could we just execute sustainability bonds with punitive increases rather than cuts to achieve the same result? I think ESG default insurance is better for the following reasons.
Â· More important issues: Sustainability bonds are only a tiny fraction of a company’s capital structure today. Therefore, the penalty for breaking the ESG promise rarely bites. The penalty for breaching an ESG promise is minimal in financial terms for BlackRock’s sustainability obligation at $ 220,000 per year (0.05% * $ 4.4 billion). ESG default insurance will involve larger commitments in the form of premiums from serious companies.
Â· ESG Default Probability Market Signal: Involving a profit-maximizing intermediary such as an insurance company ensures that the pricing of a company’s greenwashing risk, via publicized premiums, is as accurate as possible, based on the information available. Durable bond âdefaultâ thresholds are set unilaterally by the company, not by the market or a neutral intermediary such as an insurance company.
Â· Independent ESG auditor: ESG default insurance eliminates conflicts of interest for ESG auditors because they are appointed by the insurer and not by the firm. The ESG auditors I have seen are, by and large, anonymous auditors with barely enough capital to survive a single lawsuit. Will these auditors really be able to resist pressure from firms? Additionally, a few ESG rating agencies are entering the insurance industry with the usual conflicts of serving as both judge and consultant. The insurance company has an incentive to minimize payments and will either find the best auditor or perform the due diligence itself.
Â· The insurer cares financially about the ESG default: The insurer has the skin in the game to ensure that it does not under-price the premiums of a company that is unlikely to achieve its ESG objectives. The proceeds of settlement in the event of default are paid by the insurance company, not by the company. Therefore, the insurance company has its skin in the game to ensure that the likelihood of an ESG default is either publicized or prevented.
Â· Who applies the ESG default with sustainability obligations? The legal definition of an ESG âdefaultâ in the world of sustainability bonds is unclear. Will an equivalent of the ISDA determination committee determine how the ESG default is determined? I do not think so. My intuition is that it is difficult to prove the failure of an ESG commitment on an obligation linked to sustainable development. ESG default insurance makes it relatively easier for an NGO or socially activist investor to sue a business. Insurance can let a court, as opposed to a company-affiliated bond trustee, decide what the breach of a social or environmental promise entails.
Â· Social investors have teeth with ESG default insurance: ESG default insurance empowers socially responsible investors. The best they can do now to uphold ESG promises is to introduce proxy resolutions in the hope of forcing companies to align. The existence of ESG default insurance will make it financially lucrative to sue a company for failing to keep its ESG promises.
The insurer could even be an ESG rating agency or an investment bank or any other well-capitalized entity. Competition between these insurers will ensure that collusion between a company and the insurer is less likely. More importantly, public disclosure of the default ESG insurance premium will allow stakeholders to decide whether this premium is indeed too low to be true.
ESG default insurance is a solution that forces a company to focus on specific stakeholders, helps serious ESG companies separate themselves from those who pay lip service, gives skin to socially active investors in the industry. skin socially active investors in the game by making it financially lucrative to sue a company if it gives up on its ESG promises, and empowers the insurance company to serve as an effective ESG insurance service. I hope we will see the widespread adoption of the idea.
I’m sure I overlooked the issues with the idea. Please feel free to comment on my Linked In page. All critical comments are welcome.