UN Links Environment To Performance
By: Ian Ihnatowycz & Martin Grosskopf
There is increasing evidence to suggest that environmental and social factors can have a material impact on security valuation levels and, by inference, on investment performance. A recent study conducted by a group of asset managers, under the auspices of the United Nations1, shows a clear link between these complex issues and equity valuations within a number of sectors.
For Canadian institutional investors, the results provide clear evidence of the need to apply the same level of diligence on material social and environmental factors as to other financial concerns within their analysis and portfolio management processes.
In early 2003, the United Nations Financial Initiative formed an asset management working group (AMWG) tasked with determining whether there was adequate evidence to suggest a link between social and environmental factors and equity valuations. Acuity Investment Management and 11 others managers from North America, Europe, Asia, Africa, and Latin America with considerable experience in managing portfolios using environmental and social criteria were asked to develop a work plan to address this issue.
The AMWG focused its efforts on providing base-line research on the merits of applying environmental and social criteria within the investment decision process. The research was to be completely divorced from any ethical imperative. To accomplish this, the AMWG contacted 50 sell-side research firms who employed leading analysts within a number of target sectors which faced particularly challenging social issues. The response was strong, with 11 reports from nine brokerage houses, representing most regions in the world with the exception of North America. The sectors covered included oil and gas, chemicals, apparel, electronics, insurance, utilities, and aviation.
The results found that:
- “Environmental, social and corporate governance issues affect long-term shareholder value. In some cases those effects may be profound.” Importantly, the impact could be either positive or negative depending on the issue. For example:
- A report by Dresdner Kleinwort Wasserstein on European energy utilities found a significant positive impact for most companies due to creation of a European carbon emissions trading market. However, the relative impact varied from under five per cent to as high as 20 per cent depending on the company’s technology positioning and ability to pass through costs (see Figure 1).
- Goldman Sach’s European oil and gas team found that poor positioning on key environmental and social issues could significantly limit major producers’ opportunities for value creation. Goldman developed a social ranking system (the GSEES) and concluded that “The companies with the best social and environmental track record, as measured by the GSEES Index, dominate the next generation legacy assets. In an increasingly complex world, we believe such issues are part of the relative quality of overall management performance needed to compete successfully. In this respect, social and environmental issues already appear to be playing a role in determining the relative winners within the industry.” (See Figure 2 with BP ranking highest)
- Financial research was greatly aided by clear government positions with respect to environmental and social issues. In some cases, analysts were not able to provide in-depth reports due to a lack of certainty regarding environmental policy.” This reflected the lack of response from North America where analysts were reluctant to commit resources to the study without clarity on regulatory thrusts within their sectors.
- “The majority of analysts noted difficulties in comparative analysis due to the range of reporting practices.” This is not surprising given differing standards and guidance even for common financial data.
The Canadian Context
Given the tendency in Canada for environmental and social issues to be framed in an ethical or political context, it is not surprising that there has been relatively little emphasis on these issues within the pension community. Indeed, when faced with stakeholder pressure to apply ethical screens to plan investment portfolios, most trustees are advised by their legal counsel and/or consultants to avoid applying any non-financial criteria that would limit the investable universe, given that their primary responsibilities are to preserve capital or maximize returns within acceptable risk/return parametres. Unlike in the European or U.S. context where some high profile pension plans – such as ABP (Netherlands), CalPERs (California), and the City of New York – have interpreted fiduciary responsibility to include consideration of social objectives, very few Canadian pension investors have adopted this approach. Those that have tend to be mission based investors with very definable social objectives.
Most pension plans would generally agree that their investment managers should take social and environmental issues into consideration where they may have a material financial impact. However, unlike governance issues that are examined proactively and explicitly, environmental and social factors are generally only considered after the issues have already had a material impact. This tendency to be reactive is evident from a number of sources:
- A recent study by Yale University3 on the Canadian and U.S. mining industry noted serious flaws in corporate disclosure of environmental information prior to and during events which resulted in significant share price deterioration. Disclosures of environmental and social risks appear to be below the level of diligence that is attributed to other factors.
- An ongoing study by Environment Canada, involving interviews with analysts in Canada, the U.S., and Mexico indicates that analysts appear to place little weight on environmental factors unless asked by buy-side clients or unless the regulatory context is clear. Corporate expenditures on “sustainability” or “corporate social responsibility,” which are often more strategic in nature, appear to be of little interest at this point.
There are some exceptions where analysts have addressed both short- and long-term environmental impacts. A recent Lehman Brothers report on the Power and Utilities sector, although focused on U.S. utilities, found a significant deficiency within most companies in the sector in reporting capital expenditure requirements for pending air emissions legislation4. Unfortunately, this in-depth analysis is rare and continues to be issue specific, largely ignoring the financial impacts of other regulatory initiatives on waste disposal or water use, for instance. Clearly, client interest and requests will serve to increase the resources devoted to these issues and improve the quality of analysis within sell-side brokerages and independent research firms.
The work of the AMWG provides clear evidence that incorporation of social and environmental criteria within a variety of valuation methodologies is both possible and prudent within a fiduciary context. While a sophisticated approach on these issues begins with tasking investment managers with developing and applying appropriate sector specific criteria5, other areas that institutional investors should consider include:
- The impact of investment style: what social and environmental issues are relevant for momentum, growth, value, or hedge strategies?
- The impact of market capitalization: should the same criteria be used for small and large cap companies?
- Internal vs. external research: to what extent should these issues be delegated to third party research firms? What level of expertise should reside with the investment manager?
The AMWG research is ground breaking in being the first global attempt to evaluate social and environmental issues systematically within the context of fundamental security selection. The results indicate that the issues have material impact on equity valuation levels and, by inference, on investment performance. Furthermore, their inclusion is not dependent on adoption of an explicitly ‘ethical’ investment policy. As a result, institutional investors should ensure that their investment decision-making and portfolio management process incorporates an appropriate emphasis on these increasingly important issues.
Martin Grosskopf is investment analyst and manager of sustainability research and Ian Ihnatowycz is president and chief investment officer at Acuity Investment Management.
1. UNEP Finance Initiative, The Materiality of Social, Environmental and Corporate Governance Issues to Equity Pricing, June 2004.
2. Dresdner Kleinwort Wasserstein, European Utilities: Carbon Derby, October 2003.
3. Robert Repetto, Silence is Golden, Leaden, and Copper. Disclosure of Material Environmental Information in the Hard Rock Mining Industry, Yale University, July 2004.
4. Lehman Brothers, On the Regulatory Horizon, Dark Clouds with a Silver Lining, September 2004.
5. Please refer to Goldman Sachs report noted above for a general introduction to environmental, social and governance criteria.
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