KfW: Sustainability Policies in Portfolio Management

KfW Bankengruppe (KfW) is Germany’s biggest promoter of climate protection and renewable energy technologies and, with a balance sheet total of around €500bn (US$616bn), one of the country’s three largest banks. Owned by the German Federal Government and the federal states, KfW’s mission is to support the sustainable improvement of economic, social and ecological living conditions in a national and international context. The bank regards securing the natural bases of life as one of several global challenges. A large part of its business activities is dedicated to this challenge and KfW’s goal is to commit at least one third of its loans towards this purpose; amounting to around €23bn in 2011. A current example is financial support for Germany’s energy turnaround away from nuclear power, for instance by financing offshore wind parks, the energy-efficient refurbishments of buildings and new builds. As a bank with no branch network or customer deposits, KfW refinances its lending business almost exclusively in the international capital markets, which in 2011 amounted to about €80bn.

In regard to KfW’s own carbon footprint, the bank achieved the goal of becoming carbon neutral in 2006 and has used ‘green’ electricity only since 2008. All new buildings and refurbishments of its existing properties are energy efficient, with very low primary energy consumption amounting to less than 100 kilowatt hours (kWh) for its newest buildings. Many corporates could learn from its green path.

Adding ESG Criteria to the Liquidity Portfolio

In addition to promoting sustainability through its lending business and in-house environmental protection activities, KfW aims to act as a responsible investor in the capital markets and to also account for sustainability in its investment decisions. The bank was a signatory to the United Nation’s (UN) Principles for Responsible Investment (PRI) in 2006 and decided to develop and implement a sustainable investment approach for its liquidity portfolio. For these asset management activities, the PRI constitute the global guiding principles.

The liquidity portfolio, with a volume of around €20bn, is managed within KfW’s treasury department in order to control liquidity across the group. The key investment objective of the portfolio is to secure liquidity. This portfolio is a pure fixed-income portfolio, entirely consisting of debt securities issued by sovereigns, supranational organisations or banks and of covered bonds.

KfW pursues a buy-and-hold strategy, meaning that the bonds are held to maturity. Risk is managed on the one hand through strict minimum credit requirements for issuers, a broad regional distribution of issuers and bond duration targets. Furthermore, the maximum investment amount for each bond issuer (i.e. the limit) is set according to the bank-wide single borrower limit framework.

In response to the characteristics of the liquidity portfolio and its investment guidelines, in 2008 KfW started to integrate environmental, social and governance (ESG) criteria within its investment approach. This implies that in addition to the credit assessment of the issuers, their sustainability rating is also included in the limit assessment.

A Sustainable Investment Approach

To develop a sustainable investment approach, KfW initially had to operationalise the concept of sustainability. The sustainability strategy of the Federal Government, combined with the bank’s own internal environmental and social guidelines, mission statement and core activities served as the basis to accomplish this. In particular KfW specified the three main criteria – ESG – by using a variety of individual and specific parameters.

As KfW defines itself as an ‘environmental bank’, it allocates 60% to the environment in its overall sustainability rating for non-governmental issuers and the two other criteria are weighted at 20% each. There is one exception: the three ESG criteria are equally weighted for sovereign issuers as overweighting the criterion of environment is considered inappropriate.

Portfolio Optimisation and Sustainability Incentives for Issuers

Based on the bank’s sustainability criteria, a sustainability rating agency was contracted to generate sustainability scores for all issuers in the liquidity portfolio. These are not produced in the form of absolute ratings, as in conventional credit ratings, but in the form of rankings. In other words, a rating always has to be interpreted relative to the rest of that specific industry. Using this methodology, KfW obtains a respective ranking for all sovereign and non-governmental issuers in its portfolio universe, sorted by their level of sustainability. Based on these scores, the portfolio universe is separated into sovereign and non-governmental issuers and then broken down into three groups: issuers with a good sustainability rating, those with an average sustainability rating and issuers with a relatively poor sustainability rating. The sustainability scores and ratings are updated on a monthly basis.

Based on these ratings, KfW determines whether to maintain or to reduce the maximum limit volume for an issuer. The 20-60-20 rule determines the breakdown of the liquidity portfolio universe into the 20% of top issuers, the 60% of issuers with an average rating and the 20% of issuers with a relatively poor rating. For the top 20%, the pre-determined limit volume remains in place. The limit volume of the 60% of issuers with an average rating is reduced by 10%, while that of the 20% issuers having a relatively poor rating is reduced by 30%.

This approach increases the sustainability rating of the bank’s portfolio overall and reduces the amount of investments that are less sustainable. In addition, it promotes competition among issuers and encourages them to improve their sustainability rating in order to prevent limit reductions, or to regain a limit increase in the event this has been reduced.

This competition is deliberately addressed by KfW’s engagement activities, which the bank has increased since 2011. This means that each non-governmental issuer is kept informed of its individual sustainability rating in comparison to the relevant peer group, as well about the implications concerning the maximum limit volume. In order to promote a better understanding of this sustainable investment approach and to improve future collaboration, KfW also offers to discuss the process on a bilateral basis.

In addition to integrating ESG criteria in its responsible investment approach, the bank began to consider exclusion criteria in its investment decisions at the start of 2011. The objective is to prevent possible negative ESG impacts that may be generated by the use of the debt capital provided by KfW.



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