© Forum for the Future 2002

© Forum for the Future 2002

Investing in SustainabilityA new mainstream investment style

or values-based investing?

Presentation to the TBLI conference by Brian Pearce

18 October [email protected]

.uk

Centre for Sustainable

Investment


The UK SRI revolution?• Yesterday SRI was mostly

– about applying criteria to the screening of stocks– something that a small minority of ethically - driven

retail investors did

• Tomorrow SRI could be mostly– about integrating environmental/social factors into

core investment and corporate governance processes– something that most large institutional investors do

across their assets


Investment


Rating and IndicesChanging the world or

a new mainstream investment style

• Confusion of sustainability with social/green investing

• Two distinct investment styles require distinct rating tools and indices– Not negative screening vs positive selection/shareholder activism

– But tools to measure social/env. impact vs investment potential

• Recent boost for social investment but setback for sustainability investment– FTSE4Good and linked tracker fund and derivative products

– Hiring of leading social and engagement experts by UK SRI teams

• Sustainability investors need further advances in rating tools and indices if progress is to be made

Centre for Sustainable Investment


Confusion of sustainability with social/green investing

• A recent major investment study illustrates this confusion:– ‘Sustainability investing encompasses any investment that apply

ethical, environmental and social criteria…because the concept of social responsibility is a reflection of individual values and social concerns, much subjective judgement is involved’ UBS Warburg study, August 2001

• However this is confusing two investment styles:– ‘Integrating personal values and societal concerns with investment

decisions is called SRI [Social Investment]. With SRI you can put your money to work to build a better tomorrow...’ US Social Investment Forum



Sustainability investing is distinct from social/green investing

• ‘Companies most likely to be growing consistently over the next few decades are those promoting or benefiting from sustainable development….

• ….this approach is radically different from traditional ethical investment….

• ….instead of focusing on negative criteria and then applying financial analysis to a restricted universe, the focus is on making a direct link between sustainable development and long-term returns….’ Morley Fund Management



Two very distinct investment styles


SUSTAINABILITYINVESTORS

SOCIALINVESTORS

Environment

Community

Employees

Fixed capital

Add value to stakeholdersAdd value to enterprise


Why has this not been done before?• Is it material?

– Shareholders want to know how this creates business success

• Is the information there?– Vast majority of environmental/social reports do not

address this at all

• Do we have the tools to analyse the data?– Some being developed but limited capacity to use them


Investment

The impact pathways to shareholder valueCreating value from globalisation and sustainability challenges

FranchiseProtection

ProcessChanges

ProductChanges

New MarketDevelopment

Business value Right to operate Cost & liabilityreduction

Market share &pricing powerthroughcustomerloyalty andreputation

New marketsMarketredefinition

Focus Compliance Efficiency InnovationValue chain

Innovation

Financialimpact

ReducesearningsReduces risksCan open newmarkets

IncreasesmarginsReduces risksOften uses lesscapital &increases returnon equity

Increasescompetitiveadvantage

IncreasesrevenuesIncreasescompetitiveadvantageDiversification


Why - Evolution or Regulation?• Evolutionary response:

– CSR increases profit/shareholder value;– Managers maximising stakeholder

value;– Response to external social pressures;

• Regulatory response.


Investment



Investment

ProfitMAX

Compliancecost

RegulationTax

Social goodMAX

Market pressure

Stakeholder pressure

Government objective function

X0

X1

X2

X3

SRI

Ethical investment

Sustainable development

Bill Gates on how to value a company

‘Assets are just dead objects. They have nothing to do with the innate spirit that moves and propels a company’

Sustainable developmentHow is the shareholder value of a company estimated?

Shareholder value =

(free cash flow)/(1+cost of capital)n - debt capital

free cash flow = profits - net depreciation of manufactured capital

Sustainable developmentThe link between triple bottom line and the capitals model

Depreciation

Manufactured capital stock

Investment in buildings, vehicles and machinery

Flow of accomodation, transport and production services

Natural capital stock

Investment in restoration or mitigation

Degradation due to pollution or waste inflows in excess of natural absorption

Flow of energy, raw materials, waste sink and environmental services for production

OUTPUT OF GOOD OR SERVICE

Payments for inputs

EBIT

Sustainable free cash flow if…

Sustainable developmentWhat is sustainable shareholder value?

(Cash flow - depreciation Km - depreciation Kh - depreciation Ks - depreciation Kn)/(1+cost of capital)n - debt capital

depreciation Km = worn out planes - investment in new planes and contribution to other sectors’ productivity and inward investment

depreciation Kh = obsolete skills in workforce - training

depreciation Ks = community damage from tourism - community investments

depreciation Kn = noise, local air quality and climate change damage


What is needed from raters and index providers

• Social investors– Ratings of companies that add value to stakeholders

– Indices to encourage the adoption of CSR

• Sustainability investors– Ratings of companies that maximise their enterprise value from

all their asset stocks e.g. what type of environmental management creates enterprise and shareholder value?

– Indices for benchmarking and linked tracker funds and derivative products



What rating tools and indices are available?

Ratings Indices

Social investors KLD, IRRC

EIRIS, BiEOkom…

Domini 400 Social,Citizens, Calvert Social

FTSE4Good

Sustainability investors SAMInnovestSERMSarasin, Morley

DJSGI



How well do the raters serve sustainable investors?

Advantages Disadvantages

Innovest Model financial risksand opportunities

Only coversenvironment

SERM Model financial risks Only coversenvironmental hazards

SAM Covers environment,social and 'fixed capital'

Weighting arbitrary'Best in class'

Bank Sarasin/Morley Beyond 'Best in class' 'Box ticking' rather thanintegrated model



How well do the index providers serve sustainability investors?

• Sustainability investing is a thematic, performance-based, approach like growth or value investing– No globally accepted benchmark index for benchmarking or

linking tracker funds and deriviative products

• UBS Warburg study disputes outperformance claims– FTSE4Good underperforms once selection and survivorship bias

removed;

– In addition FTSE4Good and DJSGI performance attributed not to social performance but to country, sector or style tilts and factors bets

– Invalid criticism of DJSGI as expect country/sector tilts from issues like policy response to climate change



The Challenge

• Social investors are well provided for. Sustainability investors are not.

• If sustainability investing is to become a mainstream investment style to challenge growth and value investing:– Rating and index providers must clarify tool objectives ‘Changing

the world’ or ‘improving investment performance’

– Raters need to show how enterprise value is created by corporate management of their environmental and social performance

– Rating tools need to add value to existing valuation methods, be forward-looking, comprehensive, based on industry value drivers, capable of comparing companies across industries, transparent and easily understood (not an easy task!).


Economy & Finance

© Forum for the Future 2002