Olga emelianova room b, 19th floor-workshop 13

TBLI 2013: Application of ESG Signals in Portfolio Construction

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Portfolio Construction

June 18, 2013

Olga Emelianova

MSCI ESG IVA Rating Research

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

20.6%

25%

Average Vote Results for All E&S Proxy ProposalsUN PRI Signatories & AUM

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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%

0%

5%

10%

15%

20%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Source: ISS Checklist

Source: UNPRI 2011 Report on Progress

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

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• 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

4

Identifying Systemic Risks through Macro Trends

Resource

Scarcity

Water StressOperational disruption; License to operate; Cost Increases

from rationing, pricing

Limited

Arable LandCommodity price volatility; License to operate

Finite Resources Increased operational costs to uncover ‘unconventional’

sources (waste, H&S)

Geographic Rising wages,

Population, economic growth outstrips natural capacity

Macro Trends Systemic Risks Cost to Companies

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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 SecurityIncreased operational costs; Litigation; Regulatory

compliance

Loss of Privacy Litigation; License to operate; Regulatory compliance

Richer EM, Aging DM

Rising temperatures, sea level

Digitalization of all assets

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

0

1

2

3

4

5

6

Aug-11 Feb-12 Aug-12

Aquarius Platinum Limited

May 2012: work stoppages ordered by Government

March 2012: Rated ‘CCC’

Bottom quartile ranking on

‘Health & Safety’

BB

20

11

CCC

20

12

CCC

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0

20

40

60

80

100

120

Oct-10 Feb-11 Jun-11 Oct-11 Feb-12 Jun-12 Oct-12

Monster Beverage

Oct 23rd FDA probe of five reported death linked to Monster Energy Drink

20

11

B

20

12

CCC

June, 2012: Downgrade to ‘CCC’

Bottom quartile ranking on

‘Nutrition & Health’

Other examples: Massey Energy, Sun Hung Kai Properties, Carnival, Zijin Mining, Foxconn

Disclaimer: Examples only. Past performance is not indicative of future performance

Examples: ESG Factors and Financial Performance

2013 Q1 Results

0%

10%

Yum! Brands

2011 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”

20

10

B

20

11

CCC2

01

2CCC

50

60

Top Three Issues Cited by Chinese

Respondents as a ‘Very Big Problem’

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Same Store

Sales

Operating

Profit

-50%

-40%

-30%

-20%

-10%

0%

China

US

-41%

-20%

Source: Data from Yum! Brands Investor Presentation May 8, 2013

0

10

20

30

40

50

Corrupt

Officials

Gap

between

Rich &

Poor

Food

Safety

% R

esp

on

de

nts

2008

2012

Source: Pew Research Project, Global Attitudes Survey China 2012

Management

� 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

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Level of

Exposure

Management

Capacity

� Type of operations

� Location of operations

� Size of operation, etc.

� Policies & commitments

� Programs & initiatives

� Performance indicators

� Controversies

Example: Assessment of Health & Safety in Mining

1. Geographic Location 1. H&S Strategy and Targets� Reduction Targets

2. H&S Management Systems� OHSAS 18001 certification

Risk Management

& PerformanceRisk Exposure

Country

Fatalities per

100,000

miners

Australia 11.16

Risk levels are tied to mining operation characteristics

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2. Mine Production Type

� 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.

10

Australia 11.16

India 31.33

Indonesia 23.50

Mine Characteristic

Average

Death per

100,000

Average

Injury per

100,000

Underground Coal 42.91 7,253.03

Underground Metallic 28.18 5,393.02

Surface Metal, Stripping 7.04 3,265.51

Surface metal 6.89 3,193.01

Surface Coal, Stripping 14.32 2,263.64

Surface Coal 13.73 2,249.95

Surface Metal, Stripping

Calculating Key Issue Scores (0-10): RisksHow Well Is the Company Managing the Issue, Given Its Specific Risk Level?

4

5

6

7

8

9

10

Ris

k M

an

ag

em

en

t

Key Issue Score = 10

Key Issue

Score = 2

Key Issue

Score = 10

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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

0 1 2 3 4 5 6 7 8 9 10

Risk Exposure

Key Issue

Scores = 0

Source: MSCI ESG Research

Example: Company Performance on H&S Key Issue

= 10,000 employees

Alcoa

BHP Billiton

Norsk Hydro

Boliden

Cameco

Anglo AmericanRio Tinto

Xstrata

Freeport-McMoRan

Inmet

5

10

Top Quartile Second Quartile Third Quartile Bottom Quartile

Risk Management

Moderate Management

(Safety management structure average for

industry, some

Strong Management of Key Issue

(Regular audits, strong improvements, leading

performance)

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Sumitomo Metal

Peabody Energy

Inmet

ENRC

Glencore

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

4 5 6 7 8 9 10

Risk Exposure

industry, some improvement, average

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)

Darden

McDonalds Corp

5

6

7

8

9

10

Finding Value in ESG Analysis:Benchmarking Exposure and Management of Food Safety Risks

Low Risk Exposure,Strong Risk Management

•Traceability

•Testing

•Employee Training

•Franchisee Training

•Certification

•Etc.

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Domino's

McDonalds Corp

Chipotle Mexican

Grill

Starbucks Corp

Yum! Brands

0

1

2

3

4

0 1 2 3 4 5 6 7 8 9 10

13

High Risk Exposure,

Poor Risk Management

•higher % revenues from products prone to

recalls, high health impact

•Larger, more complex operations

Risk Management

Risk Exposure

Source: MSCI ESG Research IVA Industry Report; Restaurants, 2012

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 error

�Combine MSCI ESG IVA Ratings with Barra Global Equity Model to build optimizedportfolios with higher ESG scores

�Keep 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

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� 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

ESG strategyESG

ESG TiltESG

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ESG strategyESG

ExclusionESG 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

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)

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� 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

� Americas: New York, Boston, San Francisco, Toronto, Ann Arbor, Rockville

� EMEA: Paris, London, Geneva

� APAC: Tokyo, Sydney, Manila, Mumbai, Hong Kong, Beijing

� Products and services:� ESG research and ratings

� Screening data

� Custom research

� Indices

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Americas + 1.212.804.5299

Asia Pacific + 612.9033.9339

Europe, Middle East and Africa + +44.207.618.2510

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