MSCI boss warns of climate risks

He thinks that the same logic explains attitudes towards the climate crisis. “The benefit of the Paris Agreement is that we set a date — 2050. The curse of the Paris Agreement is that we set a date — 2050.”

The legally binding climate change treaty was adopted in 2015 by 196 parties at the UN Climate Change Conference (COP21) in Paris. The long-term goals to reduce emissions and keep global temperature rise below 1.5°C were widely considered a breakthrough, but the latest science shows the world’s current trajectory is inconsistent with this goal.

“Imagine getting 200 countries to agree to a date; you had to put the furthest date possible,” says Fernandez. “Many people think this problem will start happening in 2050. This is probably happening already.”

See also: MSCI's new Sustainability Institute aims to create real-world influence and action

Eight years later, COP28 is currently underway in Dubai. The convention runs from Nov 30 to Dec 12 and global leaders are expected to tackle their first-ever global stocktake, a process for them to measure their progress towards the Paris Agreement and identify gaps. The discussions will help governments prepare more ambitious national climate action plans — known as nationally determined contributions (NDCs) — due in 2025.

While Fernandez is not involved in the negotiations, he sees a role in catalysing providers and users of capital in the private sector to act now. “We need to move faster … in understanding the risk and the return on securities and assets in their portfolios related to climate risk.”

His other objective at COP28 is to convince leaders that the voluntary carbon market is a “big solution” to the climate crisis. “Some people don’t want the voluntary carbon market to exist because they feel that if companies buy carbon credits, they’re going to take an easy road out and they’re not going to decarbonise their operations.”

See also: Sembcorp and NYSE-listed Bloom Energy to bring low-carbon solutions to Singapore

Fernandez cites findings from voluntary carbon market intelligence firm Trove Research, which MSCI acquired in October. “They have concluded that companies in the world that buy carbon credits decarbonise at a rate twice as fast as companies that don’t use carbon credits. That flies against the thesis of people who say they shouldn’t do carbon credits.”

However, the carbon credit market has faced multiple controversies this year over misstated or exaggerated impact. “The evolution of almost every market in the world starts difficult … That doesn’t mean we like or accept it; we must work hard to create information, standards and everything to develop the market.”

He admits the carbon credit markets need “a lot more standards, more information [and] more understanding” of what is being traded.

He adds that subjecting carbon credits to a standard helps illuminate this opaque field. “The same way you sell a triple-A bond [or] a triple-C bond, you know, there is a market for everything in life. But you need to know what is triple-A or triple-C and what is high-quality and low-quality.”

Assessing sustainability since 1998

Fernandez was in Singapore to attend the Bloomberg New Economy Forum in early November. In an exclusive interview with The Edge Singapore, MSCI’s head honcho speaks of a long history of convincing the financial industry of the coming risks to their portfolios, a journey that he claims began in 1998.

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Two years after assuming the top job at the major index provider, Fernandez found himself in Geneva facing MSCI’s Scandinavian clients, who were asking for indices on what was then called SRI, or socially responsible investing.

“They would call us and say: ‘I need to understand how my portfolio is doing against the benchmark of SRI indices’ and we would tell them we didn’t know anything about that. After a few of those calls, I eventually said, ‘Look, we better listen. We better have what they’re looking for.’”

Fernandez spent a day with an investment head from a Norwegian company and emerged fully convinced of the importance of SRI. With a background in economics, Fernandez says he recognised the externalities that were not captured in the prices of securities.

“The system is predicated on us being able to price assets properly to allocate capital properly. I discovered that many of these environmental, social [and] governance issues needed to be incorporated into the valuation of bonds, equities and stocks.”

At that time, however, MSCI was owned by Morgan Stanley, which feared angering its corporate clients should they be assigned a poor SRI rating. “So, we created SRI indices that are more on-demand for clients.”

Fernandez is no stranger to the former parent company. Before joining MSCI, he had been at Morgan Stanley since the 1980s, working on emerging markets business strategy, equity derivatives sales and trading, mergers and acquisitions, mortgage-backed securities and corporate finance.

In mid-2007, Morgan Stanley decided to divest MSCI, leading to the company going public on the New York Stock Exchange in November. After the divestment was completed in 2009, Fernandez “immediately” started developing environmental, social and corporate governance (ESG) ratings — the nomenclature had shifted over nearly a decade.

“We made a few acquisitions that created the foundation and we grew it and grew it. Today, we’re the largest ESG rating agency in the world.”

Confusion over ESG ratings

There is still confusion over ESG ratings today, says Fernandez, and people ask why ratings differ across agencies. But these ratings are very different from the traditional credit ratings, he adds, which are “highly unidimensional”.

“They only measure the cash flows of a company and how stable those cash flows are against the debt of a company. Three of us can look at a balance sheet and an income statement and say: ‘Well, this is a fact.’”

On ESG, however, he adds that each agency may focus on different pillars and assign different weights to them. “Those are going to lead to diametrically different ratings. So, there is a lot of confusion in the world.”

MSCI says it rates 8,500 companies — 14,000 issuers including subsidiaries — and more than 680,000 equity and fixed-income securities globally. Companies are assessed on 33 “key ESG issues”, such as biodiversity and land use, employees’ access to healthcare and executive pay.

Some companies have complained about the ratings they have received, says Fernandez. “There’ll be people who look at their ESG rating and say: ‘I cannot believe this! My ESG rating is very low. I am the company that is the best at helping the climate of the world.’ We say: ‘Great, but your social environment and governance are very poor.’ They think their ESG rating must be triple-A only because of their environmental or climate change [initiatives]. What about social? What about governance?”

Following accusations of corporate mismanagement at Indian multinational conglomerate Adani Group earlier this year, a Bloomberg story in February claimed MSCI would review holdings in its ESG indices monthly instead of quarterly. An MSCI spokesperson tells The Edge Singapore this “was not an accurate reflection” of its index methodologies and “only certain” MSCI ESG and Climate indexes apply screens on MSCI ESG controversies “every month”.

“MSCI ESG and Climate indexes apply screens on MSCI ESG controversies every quarter,” says MSCI. “Therefore, for such indices, any changes to ESG controversies published by MSCI ESG Research are considered at the next regularly scheduled quarterly index review.”

In the November edition of the MSCI ESG Controversies and Global Norms Methodology, an ESG controversy case is defined as an event or an ongoing situation where company operations or products allegedly have a negative ESG impact.

Cases include allegations that a company has violated existing laws, suffered accidents or incurred health and safety fines.

Transition, war and ESG

In Fernandez’s view, the Industrial Revolution lasted 150 years, but the transition to renewable energy must be completed in 15 years. “Now, because of that transition, there is going to be a total repricing of assets and reallocation of capital.”

He adds that sovereign wealth and pension funds will not hold high-climate risk assets for 20 to 30 years. “Your assets will get cheaper and cheaper and you’ll get stuck with stranded assets. You’re going to start moving that money from high-climate risk assets to low-climate risk assets.”

Fernandez says some companies will be winners from climate change and some will be losers. “The only problem is, you don’t know which one is which. So, the function of MSCI is to help you differentiate which one is going to be higher-risk and therefore lower-priced, and which one is going to be lower-risk and higher-priced.”

The momentum for this transition lost some steam when Russia invaded Ukraine, says Fernandez, because the governments and central banks of the world began to get worried about the transition from Russian gas to American, Norwegian or Qatari gas.

Recent global events have also forced asset managers to reconsider the tenets of ESG investing. At the end of the third quarter, 1,238 funds claiming to “promote” ESG held stocks in the industry classification code “Aerospace and defence”, according to Morningstar data. That is roughly 25% higher than in March 2022, right after Russia invaded Ukraine.

Traditionally, fund managers claiming to be socially responsible would immediately screen defence stocks from their holdings. Alexander Stafford, chair of the UK All-Party Parliamentary Group on ESG, told Bloomberg that “the violence” following the “invasion of Ukraine has cemented to me the ESG case for defence-related investment”.

Fernandez says there are two ways to look at defence. “One way is that it keeps the peace in the world and another is that it creates war in the world, the same way that a pharmaceutical product — a drug — will kill you if you abuse it. But if you use it properly, it will help you.”

The same can be said of derivatives and wine, he adds. “Derivatives are good to hedge risk, but if you misuse them, you will increase your risk. A lot of times, the good things in life come with both sides. One and two glasses of wine is a phenomenal enjoyment; drinking a bottle or two bottles daily may kill you.”

Striking that balance is essential. “Defence stocks help us keep peace in the world. If you say we’re going to kill all the defence companies in the world, then I think we’re going to have a lot more war than peace.”

‘Bullish’ on Asia Pacific

While Fernandez is based in New York, he regularly visits Asia. His previous trip in May saw him stop by Singapore, Malaysia, the Philippines, Hong Kong and Taiwan.

“I am very bullish on [the] Asia Pacific,” he adds. “First, it’s not at war, compared to the Middle East and Europe. It’s very dynamic; people [here] want to move forward and improve their lives.”

Born in Mexico City, Fernandez grew up in Nicaragua. He earned a bachelor’s degree in economics at Georgetown University in 1979. While attending Georgetown, he worked as a diplomat in the Nicaraguan Embassy in Washington. He later pursued doctoral studies in economics at Princeton University for two years before enrolling in the MBA programme at Stanford University.

Calling Asia Pacific “the most dynamic region in the world”, Fernandez thinks the greatest economic growth will come from China and India for a few reasons. “The developed North is shrinking demographically. So, economic growth will have to slow down and China is beginning to shrink demographically, but India is growing [and] Southeast Asia is growing. That will tell you that more capital must come to this region because of higher economic growth.”

However, he adds that the “flip side” is heightened geopolitical risk. “Because of the geopolitical risks between the US and China, people are going to be very cautious about putting a lot of capital into China and countries that are dependent on the growth of China.”

With China and India using coal to power their industries, Asia is also the highest-polluting region in the world, says Fernandez. This puts Asian companies at risk, too, along with the greater threat of climate-related natural disasters in the tropics.

“If the biggest impact on assets by physical risk — typhoons, droughts, floods and rising temperatures — are going to be in the tropics, but the biggest value of assets is in Asia, then the biggest effect on valuations are going to be in Asia,” he adds. “So, that will be another factor for investment and finance.”

Fernandez says MSCI needs to be closest to where climate risks pose the greatest threat. He adds: “We’re going to put more and more people on climate risk research and analysis in Asia.”

Singapore is a big hub for MSCI “for sure”, he adds. “That is going to grow significantly; our climate risk research and analysts — a lot of them will be located here. Some will be in Manila, some in Greater China, but Singapore will benefit greatly.” 

Photos: Samuel Isaac Chua/The Edge Singapore

Follow The Edge Singapore’s coverage of COP28 here.