Research Note: Responsible investment strategies: Data sources and usage

Research Note: Responsible investment strategies: Data sources and usage In brief The financial crisis has strengthened calls for the mainstreaming of responsible investment (RI) as an answer to some of the current problems in financial markets, such as short-term focus and inability to price sustainable development effectively. So what is halting RI from becoming more mainstream in today s financial climate? RI can be broadly defined as the consideration of environment, social and governance (ESG) issues with the primary purpose of delivering higher risk-adjusted financial returns. 1 One of the main barriers to growth in this market is the perceived lack of good quality ESG data compared to traditional financial performance data. 2 This research note provides an overview of the main sources of ESG data that currently exist, including the various external data providers that serve the responsible investment market. It maps the way these data sources may be used for three categories of RI strategies: screening, engagement and integration. By mapping ESG data sources against RI strategies we examine where the obstacles in effective use of ESG data lie. Screening involves eliminating companies do not comply with certain standards from the investment universe or alternatively, selecting only those companies that perform well on ESG issues. Engagement involves dialogue established between the investor and company management, whilst integration means integrating ESG factors into fundamental financial analysis The findings show that the data demands of screening and engagement strategies are relatively well served by external data providers of ESG data and through direct company contact. In addition, the study shows that advanced RI strategies such as integration present significant growth opportunities in the RI market, but barriers related to time frames of investment and comparability of ESG data need to be overcome to reap these opportunities. This means that investors with a long-term investment outlook have the most to gain from developing integration strategies. The research note concludes by highlighting some of the current regulatory and market developments that are likely to influence RI strategies and the quality of ESG in the future, including the moves to support active engagement under the UK Stewardship code and the work done on integrated corporate reporting. This means that policy support to standardise ESG reporting by companies will also benefit the development of the RI market as this is likely to improve the comparability of ESG data. 1

Developments in RI The market for responsible investment (RI) has grown rapidly in the last decade: at the end of 2009 the assets under management (AuM) were estimated at 5 trillion in European countries and at $3.07 trillion in US markets. 3 In addition, over 1000 investment institutions have become signatories of the United Nations affiliated Principles for Responsible Investment (PRI), representing AuM of approximately US$ 30 trillion. 4 The developments in the RI market have their roots in ethical investment practices by churches and charities, who avoided investment in so-called sin stocks such as alcohol or tobacco producing companies, a practice labelled negative screening. In the last two decades however the RI market has developed from this activist stance into a commercial project, 5 as institutional investors are increasingly interested in the ESG performance of companies and its relationship with risk and long-term performance. Consequently, common terms used to describe the market have changed; with investor initiatives such as the PRI promoting neutral terms such as responsible investment and ESG instead of terms such as socially responsible investment, or corporate social responsibility. 6 Institutional investors in the RI markets across the globe are increasingly eschewing negative screening practices, and moving towards strategies that favour direct engagement with companies, including shareholder voting and private dialogue with company management on ESG issues. Integration of data on ESG performance of companies into financial investment analysis is also becoming more popular. These strategies increasingly rely on credible and comparable data on the ESG performance of companies. Equity indices with ESG inclusion criteria have been developed by index providers such as FTSE and Dow Jones to aid passive investors interested in responsible investment. These indices set inclusion criteria based on the ESG performance of companies. The data on corporate ESG performance is provided by specialised rating agencies that collect, aggregate and evaluate corporate documentation and reporting on ESG. Research has shown that being included in responsible investment indices, such as the FTSE4Good Index, provides a powerful incentive for companies to improve their practices related to ESG, as they go through the process of providing data to the rating agencies and engage with index providers about the index inclusion criteria. 7 Yet little is known about the use of ESG data and metrics by investors. ESG data Reflecting the fact that current interest in RI is relatively recent, there is limited academic research on the use of ESG data by investors. Studies that have examined the role of mainstream financial analysts in providing ESG information found that this information features in their recommendations only to a limited extent, albeit interest from investors in ESG metrics is growing. 8 Industry reports point towards a mismatch between sell-side research and buy-side information needs on ESG, as sell-side analysts appear more sceptical about the materiality of ESG issues and its potential to become a significant aspect of mainstream investment decision making. 9 So where do investors active in the RI market get their information from? A 2007 survey of European investment institutions found that the two most common methods of collecting ESG information were through in-house research and direct contact with companies. 10 In addition, a 2010 survey of European asset owners found that 51% of those surveyed relied on specialised ESG data providers. 11 The number of specialist ESG data sources has increased rapidly in the last decade, as many external data providers have seized the opportunity provided by the growing responsible investment markets and the increase in corporate reporting on ESG. A survey by consultancy SustainAbility in 2010 counted more than 80 rankings and ratings that have been developed in the last decade alone. 12 Table 1 provides an overview of the different types of specialist ESG data sources that currently exist in the responsible investment market. We distinguish between provider of indices (broad or thematic), ratings and databases even though these types may overlap to some degree (i.e. a database provider may also offer ratings), because the extent of analysis and interpretation of the data undertaken by the providers differs for each type. 13 2

Table 1. Specialised ESG data sources Type Example (launch date) Coverage Screens Indicators/inclusion criteria Broad indices Thematic indices Ratings Databases ASPI Eurozone (2001) Dow Jones Sustainability Indexes (1999) ECPI Ethical /ESG Indices (from 2001) Ethibel Sustainability Index (2002) FTSE4Good Index Series (2001) MSCI ESG Indices / MSCI Global Socially Responsible Indices (2010)* NASDAQ OMX CRD Global Sustainability Index (2009) Stoxx Global ESG Leaders Index (2011) / Stoxx Sustainability Indices (2001) Calvert Social Index (2000) Corporate Sustainability Index (ISE) (2005) Jantzi Social Index (2000) JSE SRI index (2004) MSCI KLD 400 Social Index (1990)* FTSE4Good Environmental Markets (2008) Global Challenges Index (2007) S&P Global Green Energy (2007) FTSE ESG Ratings(2010) Eiris Sustainability ratings (2012) GMI Ratings (2010)** Asset4 Carbon Disclosure Project (CDP) EIRIS IW Financial MSCI Trucost Vigeo The broad indices cover E, S, and G. They also cover multiple countries, regions and industry sectors E, S and G; one country Environment only; multiple countries or regions Most broad indices (provide the possibility to) screen out companies in industries such as alcohol, tobacco, gambling, weapons, adult entertainment As the broad indices above Companies are selected into the index, rather than screened out Common criteria covers information on how a company responds to or manages issues such as: -climate change -community involvement -corporate governance -employee relations -environmental management -human rights -supply chain management -stakeholder relations As the broad indices above Environmental indices serve to identify clean tech / environmental technology companies E, S and G No As the broad indices above E, S and G or E/G only Databases provide information on company activities which can form the basis for screens on e.g. tobacco As the broad indices above. The number of indicators covered may vary from 300 (EIRIS) to 750+ (Asset4). Some cover only environmental data (CDP, Trucost). * The MSCI Indices are broadly based on various indices developed by former data provider KLD, the first one of which, the Domini Social Index, was developed in 1990 ** GMI Ratings based on research by GovernanceMetrics International, The Corporate Library and Audit Integrity, which all merged in December 2010 3

Broad ESG indices include companies from multiple geographic regions and usually cover all three areas of ESG, setting inclusion criteria for companies based on their performance against environmental, social and governance criteria. Differences in the definition and scope of ESG as analysed by the data providers means some companies score better in some indices than in others. Whilst some companies that are well known for their ESG performance are included in the majority of broad ESG indices, differences in company inclusion in the various indices may also be due to: Differences in the underlying universe of companies from which inclusion is selected (i.e. the ASPI Eurozone selects from the EURO STOXX index, the FTSE4Good from the FTSE All World etc) Differences in absolute vs. relative benchmarks for inclusion (i.e. the DJSI includes only the highest scoring companies relative to industry sector, the FTSE4Good index includes all companies that pass the ESG criteria etc) Most indices no longer automatically exclude companies that are involved in potentially controversial activities, such as tobacco, but some (e.g. DJSI) do provide the possibility for clients to screen these companies out. Reflecting the changing attitude towards negative screening (see below), the FTSE4Good Index has allowed companies from some industry sectors it previously barred from entry, such as uranium mining and nuclear energy, to gain inclusion provided stringent industry specific criteria are met. Thematic ESG indices cover either companies from one country or only one aspect of ESG; at the moment most thematic indices focus on environmental performance. Whilst the selection process of the country specific ESG indices does not differ much from the broad ESG indices, the environmental indices generally aimed at selecting top performing companies only. The Global Challenges Index, for example, was created to identify companies which substantial contribution to surmounting global challenges such as climate change, provision of drinking water or combating poverty. 14 ESG ratings represent a relatively recent phenomenon that departs further from the traditional index based ESG metrics. Most ratings provide company scores that are calculated relative to the performance of peers in similar industry sectors. Scoring can be relatively qualitative (e.g. EIRIS Sustainability Ratings score companies on a scale of A-E) or more quantitative (e.g. FTSE ESG Ratings include a sector relative score out of 100). Most ratings also factor the relative ESG risks of different industry sectors into their scores. Through a number of mergers and acquisitions in recent years a few large ESG database providers have emerged that have global coverage, including MSCI, Asset4 and EIRIS. The raw data on corporate ESG performance is collected by these agencies and used to create indices and ratings. It can also be offered to investors in raw form; some databases are available through platforms such as Thomson Reuter s Datastream, Bloomberg etc (e.g. Asset4). Some data providers, such as Asset4, collect publicly available information only; others, including CDP and EIRIS, solicit additional company information through questionnaires. Use of ESG data in RI strategies Despite the developments in the provision of ESG data described above, it seems barriers to their effective use still remain. Common barriers often cited in surveys and research reports 15 include: The materiality of collected information for financial performance is not always clear, for example due to a lack of industry sector specific indicators and criteria. There is limited independent verification of the research process and its results. Due to a lack of standardised corporate reporting on ESG, the comparability of ESG data across companies is limited. In addition, comparing ESG data from different ESG providers is hampered by differences in research methodologies. In addition to the point above, not all ESG data are easily quantifiable into ratios or other measures that can be used straightforwardly in investment analysis. In table 2 we summarise often cited barriers to the effective use of ESG data. 16 In the following sections we focus on each of the strategies commonly used in the RI market in the UK screening, 4

engagement and integration in order to examine the extent to which such barriers may be overcome. Table 2. Overview of barriers to effective use of ESG data Commonly cited barriers RI strategies Screening Engagement Integration ESG data is not in-depth or specific enough for client X X X demands External ESG providers hold no shares therefore have X less influence in requests for information ESG data is not always up to date with company X X X improvements ESG data is not material for financial performance or X only material for long-term investments It is difficult to use ESG data comparatively across companies or over time X Screening Screening strategies consist of positive and negative screening. Negative screening involves eliminating from the investment universe companies or countries that do not comply with certain standards or international treaties, such as the Fundamental Conventions of the International Labour Organization (ILO). Sector-based exclusions consist in eliminating from the investment universe sectors that are not deemed to be in line with values (tobacco, alcohol, weapons, etc.). Positive screening or the best-in-class approach means selecting the equity issuers in each sector with the best extra-financial ratings. 17 According to RI industry organisation Eurosif, 87 billion was invested in 2009 in the UK market in accordance with screening approaches. 18 Screening is often part of the offer for more traditional RI clients, such as churches and charities, and the relevant screens are often determined by demand from this part of the market. Negative screening, being the traditional and most established approach to RI, is relatively well served by existing external data providers and data sources. As can be seen in table 1, most specialist ESG data sources provide the possibility to screen out particular companies or sectors. Passive investors can use ESG indices with exclusions such as FTSE4Good, the DJSI or custom made indices. Active investors frequently use the ESG databases such as the one provided by EIRIS or MSCI for information on company involvement in controversial activities. A recent case study by the PRI shows that even relatively small asset owners are able to purchase ESG data specific to their needs. 19 Asset managers with large internal research teams sometimes collect this type of information autonomously as part of the investment selection process and/or the engagement process (see below). Best-in-class screening requires more detailed ESG information, as it is based on comparing ESG performance of companies within sectors on potentially a wide range of issues. Best-in-class indices may be used by passive investors, and the newly developed ESG ratings also provide a source of comparative ESG scores that may be used for best-in-class screening by active investors. For example, when using a rating, asset managers may decide to delineate the investible universe based on a minimum scoring level achieved in the ESG rating. It seems as though there are relatively few barriers to using ESG data for negative screening effectively, but more sophisticated screening approaches, such as best-in-class, potentially face more hurdles related to ESG data. For example, when using data to create relative ESG scores and ratings, the timeframes of data collection become more important. An often heard complaint related to ESG databases of external specialist providers is that these are not updated frequently enough to capture the most recent information on company improvements in the area of ESG. This may skew ESG rating scores, creating the need for additional research by in-house research teams, which may not always be possible for asset managers with limited resources allocated to ESG. 5

Engagement Engagement is a term used for dialogue established between a shareholder and a company with a view to improving the company s value in the medium and long term, through the greater incorporation of environmental and socially responsible risk factors. 20 The Eurosif survey describes this strategy as responsible ownership, where asset managers engage with companies about their ESG performance voting shares, monitoring corporate behaviour and intervening where necessary. According to Eurosif, 830 billion in AuM in the UK are managed under an engagement policy at the end of 2009. 21 The marked difference between screening and engagement strategies lies in the fact that in pure engagement strategies companies are not automatically excluded from the eligible universe or portfolio if their ESG performance is problematic. Instead asset managers engage in a private dialogue with corporate managers with a view to improve ESG performance. If company improvements are lacking, investors may choose to make the issue public through shareholder resolutions or decide to divest. The PRI has set up the Engagement Clearinghouse to encourage investors to collaborate on engagement activities. 22 Engagement is a more time-consuming RI strategy that requires more in-depth data than (negative) screening. Up to date information is required firstly to select target companies for engagement based on their lack of ESG performance, and secondly to prepare the engagement dialogue with the company. This means data from specialist ESG providers is often supplemented with in-house research. ESG ratings may also be used to select companies or themes for engagement or even to track improvement in ESG scores as a result of dialogue with company management. The engagement process itself can be used to gather more up to date or in-depth information through direct dialogue with company management. One of the downsides to using data provided by external ESG providers may be related to the fact that they are not shareholders in the company, and therefore company management may be less inclined to provide information to them. This barrier is overcome through engagement strategies. Voting on shareholder resolutions related to ESG is also considered to be part of engagement strategies for some investors. Mainstream proxy voting agencies such as ISS have started to offer proxy voting services for ESG related shareholder resolutions. However because most asset managers have mandates for ESG engagement on specific themes or companies, it is sometimes difficult to translate these into general voting advice that is relevant for a larger group of investors or into a voting policy that can consistently be applied across companies. Integration The term integration relates to integrating ESG factors into fundamental financial analysis. Out of the three categories of RI strategies, integration is the newest and most varied approach. According to Eurosif, integration is performed for investors looking purely for improved risk management or greater alpha. 23 Integration may also be combined with other RI strategies. The Eurosif survey found that in the UK 410 billion in AuM were considered subject to integration at the end of 2009. Despite the growing market share of integration RI strategies, it seems investors are still struggling to integrate ESG data into fundamental analysis in a systematic way. Out of the three issue areas, integration of governance factors seems most established. However, often integration occurs on a case-by-case basis where ESG information may be taken into account in the stock selection process, especially for high risk companies. Most of the problems related to the effective use of ESG data referred to at the beginning of this section, such as issues with comparability, materiality and lack of historical data, make integration into fundamental analysis more difficult. For example, research on the materiality of ESG factors may show that these mainly affect long-term performance, which means that they are difficult to take into account for investors with a shorter term outlook. 24 Effective integration strategies also rely on comparable data within and across industry sectors and regions. 6

In summary, most screening approaches to RI are relatively well served by external ESG providers, though best-in-class approaches could benefit from more up to date corporate ESG information. Engagement and voting are less well served because these approaches need in-depth, specific information, but for engagement a lot of that information can be obtained through the dialogue with corporate management. Integration approaches still face the most barriers to effective use of ESG data. Future outlook Despite the barriers to effective use of ESG data that exist for the more advanced RI strategies, it is likely that the demand for ESG data will continue to grow in the future. The latest figures of market size relate to end 2009 and show continuing grow in AuM, despite the financial crisis. More recent figures related to PRI signatory numbers show growth. Several regulatory and market developments may aid investors to overcome the identified barriers to the use of ESG data: Many of the barriers identified in this research note relate directly to the quality of corporate reporting on ESG issues. Standards for ESG reporting have improved in recent years and continue to develop. The move towards integrated reporting, defined by the International Integrated Reporting Council as a new approach to corporate reporting that demonstrates the linkages between an organisation s strategy, governance and financial performance and the social, environmental and economic context within which it operates, is building up steam. 25 Several other organisations are looking towards improving corporate ESG disclosure standards, including the World Federation of Stock Exchanges and the Sustainability Accounting Standards Board, which is looking to standardise ESG disclosure in 10K filings 26. The European Commission has announced its intention to put forward a legislative proposal on corporate reporting of social and environmental issues. 27 The 2010 Stewardship Code in the UK aims to enhance the quality of engagement between institutional investors and companies. Although not specifically focused on engagement related to ESG, the FSA's Conduct of Business Rules require asset managers to produce a statement of commitment to the Stewardship Code or explain why it is not appropriate to their business model. The Financial Reporting Council lists all investors that have published such a statement; currently 185 UK asset managers have published their policies on the FRC s website. 28 It is hoped the disclosure requirements to the Code will assist asset owners and pension fund trustees to select asset managers with high quality engagement practices. It seems some shareholder activist groups in the US also increasingly favour an engagement approach above the more antagonistic approaches of filing shareholder resolutions. 29 Other market developments also aid asset owners in incorporating ESG requirements in selection and monitoring criteria for asset managers. For example, the investment consultant group Mercer has rated over 5000 ESG strategies across all asset classes. 30 The market for ESG data therefore continues to change and adapt to new regulatory, market and ESG developments. It seems some providers have responded to the call to provide more ESG analysis rather than just collecting and aggregating ESG data 31 for example by providing relative ESG scores and ratings. In addition, through mergers and acquisitions many specialist ESG providers and research teams have moved into larger mainstream financial providers, a trend that is also visible at the sell-side of the market 32 (Hutchinson, 2008). This may mean that ESG research can benefit from the available expertise in these organisations to overcome the barriers highlighted in this research note, especially those related to the integration approach. In summary, it is clear that the RI market has developed substantially from its traditional roots in the last two decades. The ongoing regulatory and market developments highlighted in this report provide substantial momentum for investors to use ESG data. As ESG reporting by companies continues to develop, data issues such as those related comparability, materiality and timeframes may be reduced. Vice versa, increased demand for ESG data from investors is likely to help overcome some of the other barriers identified, such as those related to resource and power constraints by ESG data providers. This would accommodate the development of more advanced RI strategies and novel ways of integration of ESG into fundamental analysis and is likely to benefit continued growth in the RI market overall. 7

Authors: Dr Rieneke Slager and Professor Jeremy Moon International Centre for Corporate Social Responsibility Nottingham University Business School Jubilee Campus Wollaton Road Nottingham NG8 1BB E: Rieneke.Slager@nottingham.ac.uk Oct 2012 1 Eccles, N. and S. Viviers. 2011. The Origins and Meanings of Names Describing Investment Practices that Integrate a Consideration of ESG Issues in the Academic Literature. Journal of Business Ethics 104(3): 389-402 2 Amaeshi, K., Grayson, D. 2009. The Challenges of mainstreaming Environmental, Social and Governance (ESG) issues in Investment Decisions. Cranfield University, SDA Bocconi School of Management, Vlerick Leuven Gent Management School on behalf of EABIS. 3 Eurosif, 2010. European SRI study 2010. http://www.eurosif.org/research/eurosif-sri-study 4 As of April 2012. http://www.unpri.org/about/ 5 Louche, C. 2004. Ethical Investment: processes and mechanisms of institutionalisation in the Netherlands, 1990-2002, PhD dissertation, Erasmus University Rotterdam. 6 DBCCA, 2012. Sustainable Investing. Establishing Long-Term Value and Performance. DB Climate Change Advisors, Deutsche Bank Group www.dcbba.com/research 7 Slager, R., Gond, J-P., Moon, J.2012. Institutional work for standardization: The regulatory power of a responsible investment standard. Organization Studies, 33: 763-790. 8 Nilsson, H., Cunningham, G.C., Hassel, L. 2008 A Study of the Provision of Environmental Information in Financial Analysts Research Reports. Sustainable Development, 16: 180-194; Eccles, R. G., G. Serafeim, M.P. Krzus 2011. Market Interest in Nonfinancial Information.Journal of Applied Corporate Finance, 23(4): 113-127. 9 Jaworski, W. 2007. Use of extra-financial information by research analysts and investment managers. European Centre for Corporate Engagement. 10 Jaworski, 2007. 11 Novethic, 2010. European asset owners: ESG perception and integration practices. http://www.novethic.com/novethic/v3_uk/upload/esg_survey_2010.pdf 12 SustainAbility 2010. Rate the Raters Phase Two. Taking Inventory of the Ratings Universe. http://www.sustainability.com/library/rate-the-raters-phase-two 13 Whilst RI strategies are increasingly common in a wide range of asset classes (Eurosif 2010), we focus here on ESG data and RI strategies related to listed equity, which still represents the asset class in which RI strategies are most advanced. 14 See for further information: http://www.gcindex.com/en/ 15 For an overview see Amaeshi and Grayson (2009). Also see Beloe, S., Scherer, J., Knoepfel, I. 2004. Values for Money: Reviewing the Quality of SRI Research. SustainAbility, 2004. http://www.sustainability.com/library/values-for-money 16 We base our overview on a review of relevant literature, including various industry reports (see references), as well as conversations with RI specialists at Aberdeen Asset Management, Allianz Global Investors, CCLA, and Sarasin & Partners. 17 Definition from Novethic (2010). 18 Eurosif (2010). 19 PRI, 2011. Implementation of the PRI by small and resource constrained investors. www.unpri.org 20 Definition from Novethic (2010). 21 Eurosif (2010). 22 See http://www.unpri.org/collaborations/ 23 Eurosif (2010). 24 Conversely, this may also affect the offering of ESG research by sell side analysts. As there is less trade flow emanating from long-term RI investors, there is less of a business case for sell side 8

analysts to provide this type of research, according to Integrity Research Associates (http://www.integrity-research.com/cms/2008/12/10/jp-morgan-citi-move-away-from-esgprovision/ 25 See www.theiirc.org 26 For further information on the activities of these organisations see: http://www.worldexchanges.org/sustainability/m-2-0.php and http://www.sasb.org/ 27 European Commission, COM(2011) 681 http://eurlex.europa.eu/lexuriserv/lexuriserv.do?uri=com:2011:0681:fin:en:pdf 28 As of August 2012. See http://www.frc.org.uk/our-work/codes-standards/corporategovernance/uk-stewardship-code.aspx 29 Mathiasen, C., Mell, E. 2012. 2012 U.S. Proxy Season Preview Environmental & Social Issues. Institutional Shareholder Services Inc. http://www.issgovernance.com/2012proxyseasonpreviewes 30 See http://www.mercer.com/articles/esg-ratings-update 31 Beloe et al (2004) 32 Hutchinson, T. 2008. JP Morgan, Citi Move Away From ESG Provision. http://www.integrityresearch.com/cms/2008/12/10/jp-morgan-citi-move-away-from-esg-provision/ 9