Components of Sustainability
Gail Doolin, CFA
Dec. 8, 2010
Agenda
• Overview of Sustainability
• ASSET4 ESG Data at Thomson Reuters
• Correlation of ESG scores with CDS spreads &
Earnings Surprises
• ESG scores as Predictor of Future Returns
• Combining ESG with Earnings Quality Model
• Q&A
Sustainability - Finally Moving Mainstream?
“Are all Components of ESG Scores
Equally Important?”
The Financial Professionals Post, July 14, 2010
“A Quant’s Take on ESG”
responsible-investor.com, September 17, 2009
“Asset Managers Find New
Sources Of Alpha –
Responsible Investing”
Institutional Investor, November 2010
“Quants and Do-Gooders Unite”
The Wall Street Journal, November 2, 2010
Concept of Sustainability
Sustainable development “meets the needs of the
present without compromising the ability of future
generations to meet their own needs”
(The Brundlant Commission, 1987)
ESG: The Corporate View
• According to an Issue of The McKinsey Quarterly:
80% of CFOs and CIOs believe that ESG information
can serve as a proxy for the quality of a company’s
management.
• An 2009 IBM Survey of business leaders revealed:
More than 2/3 of organizations surveyed “focus on
CSR as part of an integrated business strategy to
grow new revenue streams and control costs.”
Source: The McKinsey Quarterly, Feb. 2009
5
Key Sustainability Concerns
Environmental
• New environmental regulations
• Reputation damage from waste, pollution, spills,
• Continued access to natural resources
•Physical property damage from climate change
Social
• Ability to hire & retain talent
•Labor related controversies
• Product related complaints
• Human rights
Governance
• Reputation damage & legal costs
• Shareholder controversies
Economic
• Supply Chain risk
• Customer loyalty
Financial Impact
• Higher raw material costs
• Increased legal costs
• Fines and legal judgments
• Supply chain interruption
• Higher insurance costs
• Revenue impact due to
consumer backlash
• Higher costs to attract talent
• Increased cost of capital
Corporate Reporting Continues to Grow
Source: CorporateRegister.com
What are the Characteristics of ESG Content?
• Reporting is largely voluntary so it is heavily
skewed to large, publicly traded companies
• Despite the GRI’s efforts, what is reported and how
it is reported still lacks standardization from firm to
firm even within the same country/industry.
• Trend is toward more industry specific measures
• Europe has highest concentration of reporting
companies, followed by U.S. In Asia, Australia has
greatest interest.
• CSR reports are updated annually
• There is a limited amount of history
Asset4’s Content Attributes
• Content collection practices
– Rely on publicly available sources
– Link back to source document for verification
• Standardization methodology
– Calculate KPIs from raw data points
– Multiple levels of ratings
• Coverage
– Cover >3,000 companies globally including coverage for MSCI World,
MSCI Europe, DJ Stoxx 600, Russell 1000 and FTSE 350
• History
–
History back to 2002 (approx 950 companies)
–
Minimum of 3 years of history
• Dynamic ratings
–
Factor in the impact of news controversies
ASSET4 ESG Data Sources and Products
Annual
Reports
Company
Websites
NGO
Websites
Stock Exchange
Filings
CSR
Reports
News
Sources
Data Collection
Objective
ESG Database
Data Analysis
Negative Screening
Excel Add-in
Data Feeds
News Monitoring
10
ESG Data and Framework
Overall performance
Company overview
Pillars
Economic
Performance
Social
Performance
Environmental
Performance
Corporate Governance
Performance
 Client Loyalty
 Resource Reduction
 Employment Quality
 Board Structure
 Performance
 Emission Reduction
 Health & Safety
 Compensation Policy
 Shareholders Loyalty
 Product Innovation
 Training & Develop.
 Board Functions
 Diversity
 Shareholders Rights
 Human Rights
 Vision and Strategy
Categories
 Community
 Product Responsibility
Indicators
Data
Points
More than 250 indicators (calculated from data point values)
More than 750 data points
Link to public data sources (Raw Data)
11
Data Roll-up Example
Standardization Allows for Peer Comparison
Asset4 Coverage Growth by Region
1600
4000
3414
1400
3500
3111
Number of Companies per Region
1200
3000
2552
1000
2245
800
2500
2282
2000
1823
600
400
1500
959
970
1000
200
500
0
0
2002
2003
Emerging Market
2004
2005
2006
Fiscal Year
Developing asia excl Japan
2007
Developed Europe
2008
North America
2009
Grand Total
Access to ESG Related News Stories
Dynamic Ratings
News stories pertaining to specific types of controversies impact
KPIs so ratings can change due to events throughout the year.
The types of controversies that can change ratings include:
Accounting
Anti-Competition
Biodiversity
Business Ethics
Child Labor
Consumer
Critical Countries
Diversity and Opportunity
Employee Health & Safety
Freedom of Association
FDA Warning Letters
General Shareholder Rights
Human Rights
Indigenous People
Insider Dealings
Intellectual Property
Management Compensation
Product Impact Media
Product Quality and Responsibility
Public Health
Social Exclusion
Spills and Pollution
Tax Fraud
Wages or Working Conditions (Company)
Wages or Working Conditions (Contractor)
TR Studies Related to ESG Data
Examination of ESG Performance & CDS Spreads
• CDS Spreads measure the cost of ensuring against
default and the riskiness of a bond
• Examined the relationship between CDS spreads
and ESG scores
– Segregated ESG performers into 4 quartile groupings
– 2005-2007
– 2008-present
• Hypothesis: Higher ESG performers should have
lower CDS spreads
CDS Spreads vs. ESG Performance
2005-2007
80
70
60
50
CDS
40
BPS
30
20
10
0
0-25%
25-50%
50-75%
ESG Scores
75-100%
CDS Spreads and ESG Scores
2008-present
450
400
350
300
CDS
BPS
250
200
150
100
50
0
0-25%
25-50%
50-75%
ESG Scores
75-100%
Examination of Reported Earnings vs. Estimates
and ASSET4 ESG scores
• ESG as proxy of management quality
– Greater awareness of business performance
– Transparency with investors on information
– Should be reflected in better earnings results
• Examination of I/B/E/S estimates vs. actuals
• Companies with higher ESG scores should outperform those with lower scores
Methodology of Study
• Actual earnings announcements compared to
I/B/E/S estimates for companies in the ASSET4
Universe
– Placed into quartile groupings corresponding to the
ASSET4 scores at the time
• Percentage of announcements above or below the
estimates within each ASSET4 scoring group
compared
• Annual announcements examined 2005-present
• Quarterly announcements examined 2008-present
Frequency of US Annual Earnings Above Estimates
75.0%
69.6%
70.0%
70.3%
70.8%
66.9%
65.0%
61.5%
60.0%
55.0%
0-25%
25-50%
50-75%
75-100%
Company ESG Scores
90-100%
Frequency of US Annual Earnings Below Estimates
40.0%
38.5%
35.0%
33.1%
30.4%
29.7%
30.0%
29.2%
25.0%
0-25%
25-50%
50-75%
75-100%
Company ESG Scores
90-100%
Gap between ESG leaders and laggards –
Annual earnings above estimates
90.0%
80.0%
77.2%
75.7%
73.0%
70.6%
70.0%
66.4%
60.0%
64.5%
63.9%
61.0%
56.7%
55.2%
50.0%
40.0%
2005
2006
2007
2008
2009
ESG 0-25%
ESG 90-100%
Gap Between ESG Leaders and Laggards –
Annual Earnings Below Estimates
50.0%
45.0%
44.8%
43.3%
40.0%
39.0%
35.5%
35.0%
36.1%
33.6%
30.0%
ESG 0-25%
ESG 90-100%
29.4%
27.0%
25.0%
24.3%
22.8%
20.0%
15.0%
2005
2006
2007
2008
2009
Information Coefficient of ESG Factors
ESG factor
Global IC's of ESG Factors
with Future Returns
Integrated
Rating
Corporate
Governance
12 month
Economic
6 month
Environmental
3 month
1 month
Social
-0.01 0.00 0.01 0.02 0.03 0.04 0.05 0.06
Information coefficient
Combining ESG with Earnings Quality Model
Information coefficient
Linear Combos of
ASSET4 Overall Score with EQ
0.07
0.06
0.05
0.04
0.03
12 month
0.02
6 month
0.01
3 month
0.00
1 month
0%
20%
40%
60%
All ESG
80%
100%
All EQ
Weight on EQ
Filtering with ESG Improves Risk-Adjusted Returns
Number of
50
stocks in long 100
and short sides 200
Number of
50
stocks in long 100
and short sides 200
0%
0.669
0.772
0.957
Percent of universe eliminated by ESG score
5%
10%
15%
20%
25%
0.787
0.919
0.830
0.754
0.749
0.919
0.972
0.998
1.042
0.988
1.054
1.079
1.115
1.182
1.292
Risk-adjusted returns of long-short portfolio
30%
0.746
1.053
1.156
0%
0.0%
0.0%
0.0%
Percent of universe eliminated by ESG score
5%
10%
15%
20%
25%
17.6%
37.4%
24.1%
12.7%
12.0%
19.1%
25.9%
29.3%
35.0%
28.0%
10.2%
12.8%
16.6%
23.5%
35.0%
Percent improvements in risk-adjusted returns
30%
11.6%
36.5%
20.8%
Observations & Conclusions
• Like KPIs, interest in industry specific ESG measures
will continue to grow
• Events will become more embedded in sustainability
ratings, allowing them to evolve more quickly
• As more companies report, large cap bias will weaken
• As expected, ESG scores are positively correlated with
earnings surprises and negatively with CDS spreads
• Starmine’s research shows that ESG scores add value
on an absolute and risk-adjusted basis