By Sandeep Gummadi, Master in Finance Candidate, UMass Boston
Sustainable, responsible, and impact investing (SRI) assets increased 76 percent over the past two years for a total of $6.57 trillion, according to a 2014 industry report. What is driving this trend and the growing importance of environmental, social, and governance (ESG) factors in investment decisions more broadly beyond SRI? How are these factors incorporated into mainstream decision-making? On Dec. 2nd, 2014, the Center for Sustainable Enterprise and Regional Competitiveness (SERC) at UMass Boston hosted a panel presentation and discussion on how investors integrate ESG factors in investment decisions. The event comprised a presentation by Matt Moscardi of MSCI, who introduced ESG research, ratings, and MSCI’s perspective of ESG investing, and Elizabeth Levy of Trillium Assets Management, who elaborated on how they actually use ESG factors and information to make investment decisions. Prof. Lucia Silva-Gao, Associate Professor in Finance at UMass Boston, provided an academic perspective and moderated the event.
Matt Moscardi, who is currently leading the Financials sector ESG research at MSCI, explained what ESG integration is. “Understanding ESG risk in a portfolio is basically about estimating the cost of these externalities and knowing how much they weigh in a portfolio,” explained Matt. Since this creates the need to build metrics and tools which could be used in estimating the costs of externalities, one of the key underlying aspects of ESG integration is rating the companies. “The utility of these ratings is that they help you adjust your position according to the risks they capture and prevent you from paying an extra premium,” said Matt.
Measuring ESG performance has become a barometer of the management quality of a company. Recent research on ‘Activist Investors’ by MSCI brought up an interesting observation where almost all of the companies which were targeted by the activist investors belonged to the poorly performing group of MSCI’s ESG research. The key aspect of ESG integration – is materiality, “despite largely being an outcome of the SRI revolution, ESG factors and their integration in investing is largely driven by materiality, and not just by the virtue of moral obligation,” said Matt while pointing to the evolution of ESG investing from the traditional socially responsible investing. Hence, the process of ESG integration begins with defining materiality, followed by measuring the level of risk in each of the material factors. Finally, by measuring the extent to which the companies are managing these risks. “In a broader context, ESG factors integration is also big-data manipulation. MSCI and several other similar players are trying to pull together a large number of data points together, and create a relative risk framework across companies and industry verticals”. This was further explained using a banking sector example. MSCI started measuring the performance of several banks and researched their individual loan portfolios, their nature, and the inherent risks involved. The findings revealed that the banks were charging 4.5 basis points premium from risky borrowers compared to their peers.
the discussion moved to examine how large customers use such data. Elizabeth Levy, Senior VP and Portfolio Manager at Trillium Asset Management, elaborated further on how they used the ESG research provided by MSCI.
Trillium Asset Management is one of the oldest SRI funds, with $1.7 billion in assets under management. They serve clients with specific ESG focus, both individual and institutional, although the share of institutional clients has seen an increase over the past few years. Trillium has a team of both traditional finance experts and sustainability experts. Like Matt from MSCI, Elizabeth from Trillium also spoke about the evolution of ESG factors from a traditional SRI movement and how Trillium, which originally started with its reactive social screens-based investment criteria, went on to include more proactive ESG investment criteria.
Elizabeth explained, “Trillium takes an integrated approach towards ESG investing right at the fundamental level, where our analysts are responsible for both financial as well as ESG information. Our process begins with a larger list of companies that we are interested in. This list is then split sector-wise among analysts. While the foremost thing to start with is the financial attractiveness of the company in terms of their valuations, we then start looking at factors beyond the financial information”.
“ESG factors and their materiality now start coming into the picture, and that is how MSCI’s research helps us identify the material factors and their weights in defining the overall risk,” explained Elizabeth. Through an example looking at the Capital Goods industry, Elizabeth elaborated on how analysts at Trillium would ideally start looking at companies with high revenue growth rates in energy efficiency exposed products for them to make it to their investing list. The ESG factor integration starts coming into the picture at the revenue estimation level.
Trillium’s other important strategy involves ‘Shareholder Advocacy’, which the company believes is an effective way to bring a positive impact on company policies and performance. Trillium’s advocacy team engages directly with the companies they own to take environmentally and socially positive actions which are in line with the stakeholder’s and company’s interests. Climate change and fracking are two of the areas taken up by the shareholder advocacy team. Elizabeth concluded the discussion with a number of examples of shareholder resolutions filed by Trillium in the best interest of the companies and their stakeholders.
Next, Professor Gao outlined the growing body of academic research which has linked ESG performance and financial performance. Her own research has demonstrated that firms with high levels of chemical emissions in the electric utility industry have a high cost of equity capital (in the electric utility industry. A 2012 award-winning study showed that successful shareholder engagement is associated with higher one-year abnormal returns (also known as the excess or “alpha” return). A 2013 study demonstrated that Global Compact Sustainability Index beat the overall market over the one and two-year periods. In her Environmental Accounting class (MBA AF 631), Prof. Gao introduces students to ESG investing and how they can use the Bloomberg ESG data to construct metrics and track the performance of a sample portfolio.
In the discussion which followed, the audience raised questions about the degree of ESG adoption among the investor community, the process of adjusting cash flow forecast and discount rates based on ESG risks, and the way companies with insufficient disclosure are presently screened. The event concluded with a discussion about the growing career opportunities in the field, as well as the importance of having an analytical mindset and passion for sustainability.