Making sure ESG works is next step in its evolution

Money managers and institutional investors are pushing their way to the edge of the next step for ESG investing: making sure it works.

Even as more managers and investors have busied themselves in recent years with integrating environmental, social and governance factors into their investment decision-making processes, a clear approach to measuring whether that integration adds financial — or extra-financial — value to portfolios has yet to develop.

“There is still a lack of evidence around how these processes work, and if they work,” said one ESG expert speaking anonymously. “I'm worried we are patting ourselves on the back too soon.”

Therese Niklasson, head of ESG research at Investec Asset Management Ltd. in London, said: “The industry has been eager to tell the world and its clients that we have this all figured out; (however) we are yet some way from having measurable processes which continuously demonstrate added value.”

Part of the problem is that it's just too soon. Many managers have created their integration programs (Pensions & Investments, April 5, 2010), or, like Investec, are in the process of doing so.

However, efforts are under way to address the issue of measurement. As far back as May 2008, Pictet Asset Management showed in a white paper that a portfolio composed of best-in-class greenhouse-gas-emitting companies produced nearly 35% less carbon dioxide than companies in a traditional benchmark portfolio.

Money managers such as RCM Capital Management LLC, AXA Investment Managers SA and Schroder Investment Management Ltd. are working on ways to measure how ESG integration affects either investment returns or the sustainability of portfolios.

At the heart of the measurement problem is the lack of corporate disclosure on environmental and social metrics, such as water usage.

For instance, while 91 of the largest 100 U.K. companies tout high standards of business ethics and integrity in their annual reports, just eight provide a specific metric of the company's ethical performance, according to a December study by the Chartered Institute of Internal Auditors.

“By providing specific measurements of their ethical performance, companies enable investors to monitor changes in performance, and potentially also to compare an organization with its peers,” according to the study.

In May, sports clothing retailer PUMA AG emerged as a leader in this area when it disclosed its first environmental profit-and-loss statement based on 2010 business results. The company found its operations and suppliers produced greenhouse gas emissions and water consumption with a “direct ecological impact” worth e94.4 million ($120 million).

“By putting a monetary value on the environmental impacts, PUMA is preparing for potential future legislation such as disclosure requirements,” according to a company statement at the time. “These costs will serve as a metric for the company when aiming to mitigate the footprint of PUMA's operations and all supply chain levels and will not affect PUMA's net earnings.”

In November, Bloomberg LP updated its portfolio analytics tools used by money managers to now allow users to incorporate 130 ESG indicators into the analysis of a company. However, that tool captures only data that companies disclose. Later this year, the information provider plans to add estimates on environmental data for companies that fail to disclose, something competitor Style Research has offered through a partnership with environmental data provider Trucost PLC for a few years.

“If a portfolio company discloses absolutely nothing, the results of that (portfolio analysis) won't be as meaningful. To get a true picture, you need to plug those gaps,” said Barbara Evans, London-based ESG analyst at Bloomberg.

“This is the beginning of something that will become a much bigger conversation,” Ms. Evans said. ESG investment professionals will eventually “have to show in hard numbers what value (they're) adding. They need to prove they're adding value.”

At RCM, there's little doubt that ESG integration boosts investment returns. In August, a company report showed that investing in companies with above-average ESG ratings can add as much as 160 basis points to annual global equity returns and 200 basis points to U.S. equity returns.

“We are always looking for ways to measure whether ESG is making a positive impact or a negative impact on performance,” said Bozena Jankowska, director and global head of sustainability research at RCM, London.

Now, RCM is working on a framework to measure the correlation between the sustainability ratings it produces and relative stock performance.

“That's very early days; it's a work in progress,” Ms. Jankowska said. She hopes the framework will be in place by the end of the year.

The key is to apply metrics appropriately for each sector. That is, it's not helpful to screen an entire portfolio for health and safety practices, which is a key issue for the oil and gas sector but “not such a relevant thing for the insurance industry, for example,” she said.

AXA Investment Managers has also studied how its “good,” “bad” and “neutral” ESG ratings relate to investment returns. Matt Christensen, global head of responsible investment at AXA IM in Paris, said companies rated “good” outperform “bad” picks by more than 100 basis points each year.

“There is no doubt whatsoever that (ESG integration) adds value,” Mr. Christensen said.

Now Mr. Christensen is working to develop three or four environmental and social metrics to measure how ESG integration has affected portfolios. A carbon footprint measure is already in use; he hopes to have the rest in place by the end of the year.

“With these metrics in place, we will be able to talk about returns in a more holistic sense,” Mr. Christensen said.

Other metrics might include water consumption, as well as social and governance metrics yet to be determined.

Similarly, Schroders is considering making carbon footprint data available on all of its investment portfolios.

“We need to start thinking about this much more in terms of demonstrating an impact,” said Richard Stathers, equity analyst and head of responsible investment at Schroders in London. “It has to go that way. I can't see any other directions for ESG.”

Asset classes aren't created equally in terms of ESG integration. While integration got an earlier start in some asset classes, such as public equity, and others (such as fixed income) have trailed, real estate is perhaps the asset class best-suited to measurement.

“In terms of putting numbers on it, real estate is much easier (than other asset classes) as they are our buildings, and we can directly measure change,” said David Russell, London-based co-head of responsible investments at the �33 billion ($51 billion) Universities Superannuation Scheme, Liverpool, England.

For TIAA-CREF, real estate is one of the manager's biggest greenhouse gas emitters, so tackling it in terms of sustainability “shows we're being as responsive to our ESG responsibilities as possible,” said Nicholas E. Stolatis, director, global real estate sustainability and enterprise initiatives, at TIAA-CREF, New York.

The manager has cut $15 million off its aggregate utilities bill across its $17 billion portfolio. But it's not so simple to calculate how environmental savings efforts have boosted investment returns.

“The benefits are not simply limited to the dollars involved” in utilities, Mr. Stolatis said. “If we can decrease the downtime of vacancies and increase the rate of renewals, all of that has an impact on our bottom line.”

The portfolio has produced measurable environmental savings, though. In the year ended Sept. 30, the portfolio cut 90,000 tons of carbon emissions (which Mr. Stolatis said is akin to removing 17,700 cars from the roads for a year). TIAA-CREF has also cut its electricity consumption by 150 million kilowatt hours, and reduced its energy intensity (energy use per square foot) by 15% since 2007.

Meanwhile, private equity was one of the ESG laggards — until recently. Now more than 60% of private equity and venture capital firms in the U.K. have ESG policies and/or principles, up from 24% in 2009, according to a recent survey — “Evolving views of sustainability in private equity and venture capital” — by industry group British Private Equity and Venture Capital Association.

“Private equity should be easier (to integrate ESG into) than public equity because there's a much better link to the (investment) processes,” said Helen Steers, London-based partner and head of European primary investment at private equity fund-of-funds manager Pantheon Ventures Inc. “The fact that the company managers are owners of the business ... you get that direct linkage.”

Ms. Steers said many private equity managers were slow to warm to ESG integration because they didn't recognize the financial benefits.

Similarly, Bloomberg's Ms. Evans said she hasn't heard great demand from managers in all asset classes for ESG measurement tools. “I don't think that's because they don't want (them); I think it's because they don't even know it's a possibility.”

However, others say measurement tools have a long way to go before they are able to truly help investors understand the impact of ESG integration.

“It's a logical question to ask. But it will be awhile before we know how to do it,” said Rob Lake, London-based director of strategic development at the United Nations' Principles for Responsible Investment.

Investec's Ms. Niklasson added: “People are trying to come up with more clever machines. The problem is we still have a lot of assumptions.”