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TBLI 2013: Application of ESG Signals in Portfolio Construction
June 18, 2013Olga EmelianovaMSCI ESG IVA Rating Research
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Current trends in ESG investment• Do we see any growth in SRI or ESG integration?• What drives investment strategies?• What tools are available?
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Increased Focus on ESG Integration by Investors Asset Owners are increasingly interested in incorporating long term
sustainability issues and scrutinizing the ESG performance of asset managers 7% of the total global investable market is subject to PRI ESG integration Asset owners and managers increasingly finding ESG to be a material topic for
engagement: tripling of ‘FOR’ votes on E&S proxy proposals since 1999
3
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 20110%
5%
10%
15%
20%
25%
7.4% 7.6% 8.7%9.4%
12.0%12.1%
9.8%
12.5%
15.0%14.0%
16.3%
18.3%20.6%
Source: ISS Checklist
Average Vote Results for All E&S Proxy Propos-als
Source: UNPRI 2011 Report on Progress
UN PRI Signatories & AUM
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The Evolution of ESG Investment Mandates
Socially Responsible Screening• Supports screening on religious, ethical, and divestment criteria (e.g.
weapons, tobacco, Sudan, etc.)
ESG Ethical Evaluation• Analyzes & monitors ‘ESG controversies’ and violations of global norms such
as the UN Global Compact
ESG Integration• Identifies ESG related investment risks and opportunities not often captured
by conventional analysis
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Identifying Systemic Risks through Macro Trends
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Resource Scarcity
Water Stress Operational disruption; License to operate; Cost Increases from rationing, pricing
Limited Arable Land
Commodity price volatility; License to operate
Finite Resources Increased operational costs to uncover ‘unconventional’ sources (waste, H&S)
Demographic Shifts
Geographic distribution of labor
Rising wages, Labor standards
Changing diet and lifestyle
Increased healthcare burden (for all sectors); Changing disease burden (opportunity for healthcare sector)
Climate Change
Changing Weather Patterns
Rising insurance costs; Volatile commodity prices; Security of physical assets; Opportunities in cleantech
Regulations Increased energy costs; Increased compliance costs
Information Revolution
Data Security Increased operational costs; Litigation; Regulatory compliance
Loss of Privacy Litigation; License to operate; Regulatory compliance
Population, economic growth outstrips natural capacity
Richer EM, Aging DM
Rising temperatures, sea level
Digitalization of all assets
Macro Trends Systemic Risks Cost to Companies
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ESG assessment: company level• Are there implications of ESG performance on
companies’ capacity for long-term growth?• Can we anticipate ESG-related events or assess long-
term performance risks?
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Examples: ESG Events and Performance
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Aug-11 Feb-12 Aug-120
1
2
3
4
5
6 Aquarius Platinum Limited
May 2012: work stoppages ordered by Government
March 2012: Rated ‘CCC’Bottom quartile ranking on ‘Health & Safety’
Oct-10 Feb-11 Jun-11 Oct-11 Feb-12 Jun-12 Oct-120
20
40
60
80
100
120 Monster Beverage
Oct 23rd FDA probe of five reported death linked to Monster Energy Drink
2011
B
2012
CCC
June, 2012: Downgrade to ‘CCC’Bottom quartile ranking on ‘Nutrition & Health’
Other examples: Massey Energy, Sun Hung Kai Properties, Carnival, Zijin Mining, FoxconnDisclaimer: Examples only. Past performance is not indicative of future performance
2010
BB
2011
CCC
2012
CCC
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Examples: ESG Factors and Financial Performance
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2013 Q1 Results
Same Store Sales
Operating Profit
-50%
-40%
-30%
-20%
-10%
0%
10%
China
US
-41%
-20%
Yum! Brands2011 IVA Profile: ”the company's high exposure (to food
safety problems) compared to peers does not appear to be adequately countered by strategies to reduce food safety incidents”
Source: Data from Yum! Brands Investor Presentation May 8, 2013
2010
B
2011
CCC20
12CCC
0
10
20
30
40
50
60
Corrupt Officials
Gap between Rich & Poor
Food Safety
% R
espo
nden
ts2008
2012
Top Three Issues Cited by Chinese Respondents as a ‘Very Big Problem’
Source: Pew Research Project, Global Attitudes Survey China 2012
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Level of Exposure
Management Capacity
Type of operations
Location of operations
Size of operation, etc.
Unlike traditional SRI ratings, MSCI ESG IVA ratings examine companies’ exposure to ESG-related risks and the management capacity to mitigate such risks
Companies with higher risk profiles are expected to demonstrate stronger mitigation systems
MSCI ESG IVA Rating Model
Policies & commitments
Programs & initiatives
Performance indicators
Controversies
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Example: Assessment of Health & Safety in Mining
1. Geographic Location
2. Mine Production Type
1. H&S Strategy and Targets Reduction Targets
2. H&S Management Systems OHSAS 18001 certification
3. H&S Performance Metrics Injury Frequency Rates and Fatalities Y-o-Y Improvement Trends
4. Management of H&S Incidents Impact Size, Pattern of Events,
Company’s Response, etc.
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Risk Management & PerformanceRisk Exposure
CountryFatalities per
100,000 miners
Australia 11.16India 31.33Indonesia 23.50
Mine CharacteristicAverage
Death per 100,000
Average Injury per 100,000
Underground Coal 42.91 7,253.03Underground Metallic 28.18 5,393.02Surface Metal, Stripping 7.04 3,265.51Surface metal 6.89 3,193.01Surface Coal, Stripping 14.32 2,263.64Surface Coal 13.73 2,249.95
Underground Coal 42.91 7,253.03Underground Metallic 28.18 5,393.02Surface Metal, Stripping 7.04 3,265.51Surface metal 6.89 3,193.01Surface Coal, Stripping 14.32 2,263.64Surface Coal 13.73 2,249.95
Risk levels are tied to mining operation characteristics
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Calculating Key Issue Scores (0-10): RisksHow Well Is the Company Managing the Issue, Given Its Specific Risk Level?
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When risk exposure=0 and risk management=0, the KI score=5
When risk exposure=10, the highest KI score is capped at 7 (because there are risks that can’t be fully managed even if company is doing everything possible)
When risk management<5, it is not possible to get KI score=10 even if exposure is very low (we set a minimum for ‘management’ attention)
0
1
2
3
4
5
6
7
8
9
10
0 1 2 3 4 5 6 7 8 9 10
Risk
Man
agem
ent
Risk Exposure
Key Issue Score = 10
Key Issue Scores = 0
Key Issue Score = 2
Key Issue Score = 10
Source: MSCI ESG Research
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Example: Company Performance on H&S Key Issue
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= 10,000 employees
Alcoa
BHP Billiton
Norsk Hydro
Boliden
Cameco
Anglo AmericanRio Tinto
Xstrata
Freeport-McMoRan
Sumitomo MetalPeabody Energy
Inmet
ENRCGlencore
KGHMGrupo Mexico
CONSOL Energy
Arch Coal
Ivanhoe Mines
Lynas Corp
Coal India
MMC Norilsk
China Shenhua Energy
Kazakhmys
Vedanta Res.
Sterlite (India)South. Copper
First Quantum
Alpha Natural
0
5
10
4 5 6 7 8 9 10
Top Quartile Second Quartile Third Quartile Bottom Quartile
Risk
Man
agem
ent
Risk Exposure
Moderate Management
(Safety management structure average for
industry, some improvement, average
performance)
Strong Management of Key Issue
(Regular audits, strong improvements, leading
performance)
Poor Management (Average to poor safety
metrics, lack of stringent management systems
and programs)
Moderate Risk (Regions with higher safety standards and metrics such as Australia, lower risk operations such as surface mining)
High Risk(High risk countries such as China and high risk operations such as
primary processing or underground coal mining)
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Darden
Domino's
McDonalds Corp
Chipotle Mexican Grill
Starbucks Corp
Yum! Brands
0
1
2
3
4
5
6
7
8
9
10
0 1 2 3 4 5 6 7 8 9 10
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Finding Value in ESG Analysis:Benchmarking Exposure and Management of Food Safety Risks
High Risk Exposure, Poor Risk Management
• higher % revenues from products prone to recalls, high health impact
• Larger, more complex operations
Low Risk Exposure,Strong Risk Management
• Traceability• Testing• Employee Training• Franchisee Training• Certification• Etc.
Risk Management
Risk Exposure
Source: MSCI ESG Research IVA Industry Report; Restaurants, 2012
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ESG assessment: portfolio level• Can ESG factors be integrated in portfolios?• Z. Nagy, D. Cogan, and D. Sinnreich “Optimizing ESG
Factors in Portfolio Construction” (December 2012)
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“ESG Factors in Portfolio Construction”: Three ESG-tilt Strategies Approach
Use case: Asset owner seeks to raise ESG profile of global portfolio without incurring large tracking errorCombine MSCI ESG IVA Ratings with Barra Global Equity Model to build optimized portfolios
with higher ESG scoresKeep risk, performance and structural characteristics equivalent to benchmarks like the MSCI
World Index (risk reducing or index enhancing, rather than alpha seeking)
Strategy 1: ESG exclusion Worst-in-class approach excludes low-rated (‘CCC’) companies
Strategy 2: ESG tilt Best-in-class approach overweights higher-rated ESG companies, underweights lower-rated ones
Strategy 3: ESG momentum
‘Best-effort’ approach overweights companies with ESG ratings upgrades over the preceding 12-month period and underweights companies with ratings downgrades
Time series: Feb. 2007 – Dec. 2012 for ESG Exclusion & ESG Tilt; Feb. 2008 – Dec. 2012 for ESG Momentum
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Performance Analysis: Comparing the Three ESG Tilt Strategies
During the sample period all three strategies showed potential to improved ESG characteristics of a portfolio while limiting tracking error, impact on risk-adjusted returns
The best active returns and highest information ratio during the sample period came with companies showing ESG momentum – i.e. their IVA ratings improved over a recent time period
Comparison of ESG Strategies, February 2008 – December 2012
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ESG strategy ESG Exclusion ESG Tilt ESG
Momentum
Active return (annual, %) 0.10 0.05 0.35
Common factor contribution (annual, %) 0.06 0.03 0.08
Asset specific contribution (annual, %) 0.05 0.01 0.27
Tracking error (ex-post, annual %) 0.45 0.46 0.36
Information ratio 0.23 0.10 0.97
Average improvement in ESG score 1.27 1.21 0.46
Average relative improvement in ESG score (%) 23 22 8 Disclaimer: Past performance is
not a predictor of future results
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About MSCI ESG Research The leading provider of tools to measure and manage ESG Risk for asset owners, investment managers,
and consultants Over 60 asset owners with $2.3 trillion in assets depend on MSCI ESG Research Over 500 clients with $15 trillion in assets globally
ESG ratings and research expertise produced 100% in-house Signatory to the Principles for Responsible Investment (www.unpri.org)
Direct successor to IRRC (1972), KLD (1988) and Innovest (1998)
Staff of 140+, including more than 90 in ESG research
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EMEA: Paris, London, Geneva
APAC: Tokyo, Sydney, Manila, Mumbai, Hong Kong, Beijing
Products and services: ESG research and ratings Screening data Custom research Indices
17
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Americas + 1.212.804.5299
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www.msci.com/esg
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