ESG in Sector Strategy: What's Material?
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1 Global Markets Strategy June 23, 2015 Flagship Report ESG in Sector Strategy: What's Material? How Much Does ESG Matter? As equity investors struggle with the extent to which ESG factors are relevant, we examine the issue from a quantitative perspective. An ESG Materiality Matrix For eight of the ten MSCI ACWI GICS we plot the likelihood that a material sustainability issue will occur against the potential financial impact of an ESG event. peterzayda /Bigstock Relative ESG Risks and Opportunities The ESG Materiality Matrix can be used to identify relative ESG risks or opportunities at the sector or industry level. In this report, our focus is on relative ESG risks at the sector level. Sector Overweights that Entail Relatively High ESG Risks Overweights of the Materials, Energy and Health Care sectors create relatively high ESG risks. For Materials and Energy, environmental risks are foremost. In Health Care, the sustainability issue with the greatest likelihood of having a material impact is business model and innovation (e.g., product quality and safety). A Relatively Less Risky Sector Overweight In contrast to Materials, Energy and Health Care, in the Information Technology sector there are a number of ESG issues that could potentially be material, although it s estimated their financial impact would be less significant than in the other three sectors. Figure 1: ESG Materiality Matrix for Eight MSCI GICS Michael Geraghty Global Markets Strategist Source: Cornerstone Capital Group
2 Executive Summary While our prior investigations of the significance of certain ESG factors in sector strategy yielded some interesting insights, they were somewhat limited in scope. In this report, we attempt to more thoroughly identify sustainability issues that are material for sector strategy. The Sustainability Accounting Standards Board (SASB) has been steadily creating sustainability accounting standards on an industry-by-industry basis for the entire U.S. economy. SASB creates unique Materiality Maps for dozens of industries. In these maps, sustainability issues are assigned scores based primarily upon (i) evidence of interest and (ii) evidence of financial impact. Separately, RobecoSAM adopted a two-step approach to help identify the financial materiality of sustainability issues in 59 different industries. In the first step, the most important intangible factors were identified for each industry. In the second step, the factors were prioritized according to (i) their expected magnitude (i.e. degree of impact) and (ii) the likelihood of their impact. Leveraging the approaches of SASB and RobecoSAM, we create a two dimensional materiality matrix for eight of the ten MSCI GICS. While our ESG Materiality Matrix can be used to identify relative ESG risks or opportunities at the sector or industry level, in this report our focus is on relative ESG risks at the sector level. The ESG Materiality Matrix reveals that overweights of the Materials, Energy and Health Care sectors create relatively high ESG risks. For Materials and Energy, environmental risks are foremost. In Health Care, the sustainability issue with the greatest likelihood of having a material impact is business model and innovation (e.g., product quality and safety). In contrast to Materials, Energy and Health Care, in the Information Technology sector there are a number of ESG issues that could potentially be material, although it s estimated their financial impact would be less significant than in the other three sectors. Consequently, an overweight of the Information Technology sector would seem less risky from an ESG perspective than an overweight of the Materials, Energy or Health Care sectors. 2
3 ESG and Sector Strategy: Prior Investigations When we introduced the Cornerstone Capital Sector Strategy Model in the May 2014 edition of The Journal of Sustainable Finance and Banking, we included a number of basic environmental, social and governance (ESG) metrics. We also highlighted the dynamic nature of the model, and emphasized that factors and factor weightings would be reviewed frequently. Subsequently, we examined The Economics of Environmental Issues in Sector Strategy (October 20, 2014). We performed a sensitivity analysis that incorporated assumed prices for greenhouse gases (GHGs), water and waste, and concluded that a rise in specific environmental costs could be more material for some sectors than others: Water prices: A 10% increase in water prices would result in a 9% increase in costs in the Utilities sector. Waste prices: A 10% increase in waste prices would result in a 7% increase in costs in the Telecom sector. GHG prices: A 10% increase in CO2 prices would result in a 4% increase in costs in the Industrials sector. Our next investigation was of S issues: The Social Costs of Business: Implications for Sector Strategy, December 16, Utilizing a number of metrics (i) costs of community support; (ii) costs of cheap labor; (iii) costs of committed and safe employees; (iv) costs of attracting and retaining customers we estimated the social costs of business for the ten sectors in the MSCI ACWI. To be sure, the environmental and social factors we examined in these two prior reports are just some of the potential E and S issues that can play a role in sector strategy. Then, too, governance factors cannot be overlooked. So, for example, following the global financial crisis that began in 2007 Larry Fink, CEO of Blackrock was quoted in 2009 * as saying: I actually don t think risk management failed. I think corporate governance failed While our prior investigations of the significance of certain ESG factors in sector strategy yielded some interesting insights, they were somewhat limited in scope. By contrast, the Sustainability Accounting Standards Board (SASB) has been steadily creating sustainability accounting standards on an industry-by-industry basis for the entire U.S. economy. (Note that, in this report, we use ESG and sustainability interchangeably.) * The Future of Capitalism, Financial Times, May 12,
4 SASB and Material ESG Factors A mission of SASB is to extend the existing U.S. accounting infrastructure to material ESG factors. According to SASB: * We live in a different world now, one that has greater uncertainty, a broader range of risks and opportunities, and significant resource constraints beyond access to capital. A new, standardized language is needed to articulate the material, non-financial risks and opportunities facing companies today. These non-financial risks and opportunities that affect corporations ability to create long term value are characterized as sustainability issues [italics added]. SASB s five broad categories of sustainability factors form a universe of sustainability issues SASB has identified five broad categories of sustainability factors that, in its opinion, are highly material to investors because they can affect a firm s ability to create long-term value: 1. Environment: Corporate impact on the environment. 2. Social Capital / Dependencies: A corporation s relationships with key outside stakeholders, including customers, local communities, the public and the government. 3. Human Capital: A company s human resources. 4. Business model and innovation: The integration of environmental and social factors in the value creation process, including resource efficiency, as well as the design, use-phase and disposal of products. 5. Leadership and Governance: In addition to corporate governance, this category includes regulatory compliance, lobbying, and political contributions, as well as a company s supply chain management. These five issues create a universe of sustainability issues see Figure 2. Given the goal of identifying material ESG risks and opportunities on an industry-by-industry basis, SASB has acknowledged that the actual determination of materiality is difficult for many non-financial issues. To address this challenge, SASB has designed an evidence-based approach, which involves looking for (i) evidence of investor interest and (ii) evidence of financial impact. * 4
5 Figure 2: SASB Universe of Sustainability Issues Source: Sustainability Accounting Standards Board Evidence of Investor Interest Evidence of investor interest is assessed by examining five issues: (i) financial disclosure; (ii) legal drivers; (iii) industry norms; (iv) stakeholder concerns; (v) innovation opportunity. A keyword search is then performed utilizing tens of thousands of industry-related documents, including Form 10-Ks, legal news, shareholder resolutions and media reports. So, for example, product packaging is within the universe of sustainability issues under Business Model & Innovation in Figure 2. If it is mentioned thousands of times in food retailers source documents, but only a few times in education industry documents, then product packaging is assumed to be more material to food retailers than to education companies. These data-driven tests are complemented by further research during the SASB Industry Working Group (IWG) process. An IWG score indicates the percentage of IWG participants (corporate professionals, investors, analysts, etc.) that found an issue (e.g. product packaging ) to be material for an industry. 5
6 Evidence of Financial Impact Next, SASB assesses the actual or potential impact of sustainability issues (e.g., product packaging ) on the financial performance of companies in an industry. This is done by examining sell side research, investor call transcripts, third party case studies, anecdotal evidence and news articles. IWG feedback is also taken into account. Three areas of actual or potential financial impact (positive or negative) are focused on: Revenues / Costs Assets / Liabilities Cost of Capital Forward-Looking Adjustment In a small number of cases, SASB may allow for a forward-looking adjustment (Figure 3). This is usually associated with issues that have long time horizons such as climate change, resource constraints and / or population growth that might not be captured by a strict analysis of current investor interest or financial impact, but could present significant investment risk over time. Figure 3: SASB s Method of Determining Material Sustainability Issues Source: Sustainability Accounting Standards Board 6
7 SASB Materiality Maps Ultimately, SASB creates unique Materiality Maps for dozens of industries. In the Materiality Maps sustainability issues are assigned scores based upon (i) evidence of interest, (ii) evidence of financial impact and (iii) forward-looking adjustment. Scores range from 0.5 (for the least material issues) to 5.0 (for the most material issues). Any issue with a score of at least 2.25 is considered to be material to an industry. By way of example of a materiality map, an article * by two SASB members Robert G. Eccles (SASB Board of Directors) and George Serafeim (member of SASB Standards Council) contained a materiality map for industries in the Health Care sector (Figure 4). Not surprisingly then, in the Biotechnology industry product quality and safety is paramount (score of 5.0). Conversely, fuel management is hardly material at all (score of 0.5), although it is quite material in Health Care Distribution (score of 2.25). Similarly, supply chain standards are much less important in Health Care distribution (0.75) than in Biotechnology (2.50). RobecoSAM s Materiality Matrices In a joint report with the Global Reporting Initiative, RobecoSAM moved beyond a one-dimensional materiality map to a two-dimensional materiality matrix. Specifically, RobecoSAM adopted a two-step approach to help identify the financial materiality of sustainability issues in 59 different industries. In the first step, the most important intangible factors were identified for each industry (which is analogous to SASB s universe of sustainability issues outlined above). In the second step, the factors were prioritized according to (i) their expected magnitude (i.e. degree of impact) and (ii) the likelihood of their impact: The expected magnitude, or degree of impact, was defined by the potential impact of the sustainability issue on business value creation drivers. The likelihood reflected the probability that the financial impact of a particular sustainability issue would materialize. Among other things, likelihood can be determined by changes in regulation, changes in public perception (e.g., reputational risk) or evolving industry trends. * The Performance Frontier, Harvard Business Review, Robert G. Eccles and George Serafeim, May 2013 Defining Materiality: What Matters to Reporters and Investors, Global Reporting Initiative and RobecoSAM,
8 Figure 4: Materiality Map for Health Care Sector Source: Eccles and Serafeim 8
9 This framework produced a two-dimensional materiality matrix for each industry, and illustrated the potential impact of the sustainability issue on the industry (x-axis) in relation to the likelihood it would occur (y-axis). So, for example, Figure 5 displays a materiality matrix for the Technology Hardware & Equipment industry and illustrates that, based on RobecoSAM s approach, the most material factors (top right quadrant) include (i) innovation management; (ii) supply chain management and (iii) corporate governance. RobecoSAM shaded the six most important financially material sustainability issues in blue, and the other issues in green Figure 5: Materiality Matrix for the Technology Hardware & Equipment Industry Source: RobecoSAM As noted, the key difference between RobecoSAM s two-dimensional materiality matrices and SASB s one-dimensional Materiality Maps is that the former incorporate (on the y-axis) the likelihood of sustainability issues having a financial impact. 9
10 Determining ESG Materiality for Sector Strategy Our materiality matrix focuses on the MSCI GICS the industry taxonomy used by many sector strategists Leveraging the approaches of SASB and RobecoSAM, we create a two-dimensional materiality matrix for eight of the ten MSCI GICS Figure 6. (For the reasons outlined below, two GICS are omitted: Consumer Staples and Utilities.) Importantly, our focus in this report is solely on ESG risks we will address ESG opportunities in a subsequent analysis. Figure 6: ESG Materiality Matrix for Eight MSCI GICS *Only 48% of the Consumer Discretionary Sector is represented Source: Cornerstone Capital Group Our approach is as follows: We take each of the ten GICs in the MSCI ACWI and break them down by major industry. In the case of Health Care, the four largest industries are: Pharmaceuticals, Biotechnology, Health Care Equipment and Managed Health Care. We map these MSCI industries to the comparable SASB industries (Figure 7). Figure 7: Mapping MSCI Industries to SASB Industries in the Health Care Sector MSCI Industry Pharmaceuticals Biotechnology Health Care Equipment & Supplies Managed Health Care SASB Industry Pharmaceuticals Biotechnology Medical Equipment & Supplies Managed Care Source: Cornerstone Capital Group 10
11 Utilizing the SASB scoring methodology outlined in the section associated with Figure 4, we rank sustainability issues for each industry from least material (e.g., 0.5 for fuel management in Biotechnology) to most material (e.g., 5.0 for product quality and safety in Biotech). We aggregate the scores to derive a single materiality impact score for each industry. So, for example, in Figure 4 the sum of the scores for the Biotechnology industry is 84.25; by contrast, the sum of the scores for the Health Care Distribution industry is just This suggests that sustainability issues can potentially have a greater impact on the Biotechnology industry than on the Health Care Distribution industry. (So, if we plotted just these two industries in Figure 6, Biotechnology would be much further to the right on the x-axis than Health Care Distribution.) We create an aggregate industry score, then weight that score by the weight of the industry in its MSCI GIC We weight the materiality impact scores by the weight of the industry in the relevant MSCI ACWI GIC. So, for example, the Biotech score of is assigned a weight of 15% (based on the weight of Biotechnology in the MSCI ACWI Health Care GIC). Similarly, the Health Care Distribution score of 60.5 is assigned a weight of 3%. We sum the weighted scores of the industries in the relevant sector in order to derive that sector s potential ESG impact. Figure 6 illustrates that, based on this methodology, the potential degree of ESG impact in the Health Care sector is relatively high, with only Energy having a higher potential ESG impact (i.e., Energy is to the right of Health Care on the x-axis in Figure 6). We referenced above that, as per RobecoSAM s methodology, the likelihood that sustainability issues have a material financial impact is dependent on a number of factors including, among other things, changes in regulation, changes in public perception (e.g., reputational risk) or evolving industry trends. So, taking the Technology Hardware and Equipment industry as an example, Figure 5 illustrates that three sustainability factors in particular have a very high likelihood of causing a material financial impact in this industry (i.e. they are all at the very top of the y-axis): (i) innovation management; (ii) supply chain management; (iii) corporate governance. Our approach here is, once again, to aggregate from the industry to the sector level. Industry likelihoods of material ESG impact are based on Cornerstone Capital analysis of the SASB and RobecoSAM frameworks. Accordingly, Figure 6 illustrates that the likelihood of a material ESG impact is higher in the Information Technology sector than in the Health Care sector, but is lower than the estimated impact in the Energy sector (i.e. given the relative positions of the three sectors on the y axis). 11
12 Finally, as has been alluded to above, our analysis does not extend to the entire ten MSCI GICS: Only 48% of the MSCI ACWI Consumer Discretionary Index is included in Figure 6. The reason for this is that, as Figure 8 illustrates, SASB has yet to cover some major industry sectors in that GIC. *Note that MSCI classifies 29% of the industries in the MSCWI ACWI Consumer Discretionary Index as Other Figure 8: Mapping MSCI Industries to SASB Industries in Consumer Discretionary Sector* MSCI Industry (% Weight) SASB Industry SASB Sector Auto Manufacturers (17%) Automobiles Transportation Cable & Satellite (9%) Cable & Satellite Services Movies & Entertainment (8%) Media Production & Distribution Services Apparel (7%) Restaurants (6%) Restaurants Services Internet Retail (6%) Auto Parts (5%) Auto Parts Transportation Home Improvement (5%) Apparel Retail (5%) Hotels, Resorts & Cruise Lines (3%) Hotels & Lodging Services Source: Cornerstone Capital Group The two MSCI GICs that are not included in Figure 6 are Consumer Staples and Utilities. Figure 9 illustrates that SASB plans to fully complete its analysis of all the industries in these two sectors by March Figure 9: Consumer Sectors and Utilities: Planned SASB Release Dates Consumer Sectors MSCI Industry (% Weight) SASB Sector SASB Release Date Utilities MSCI Industry (% Weight) SASB Sector SASB Release Date Packaged Foods (25%) Consumption I June 2015 Electric Utilities (50%) Infrastructure March 2016 Tobacco (14%) Consumption I June 2015 Multi-Utilities (33%) Infrastructure March 2016 Household Products (13%) Consumption I June 2015 Gas Utilities (8%) Infrastructure March 2016 Soft Drinks (11%) Consumption I June 2015 Ind. Power Producers (5%) Infrastructure March 2016 Hypermarkets (8%) Consumption II Sept 2015 Water Utilities (3%) Infrastructure March 2016 Food Retail (8%) Consumption II Sept 2015 Renewable Energy (1%) Renewable Resources December 2015 Brewers (7%) Consumption I June 2015 Drug Retail (5%) Consumption II Sept 2015 Personal Products (4%) Consumption I June 2015 Distillers (4%) Consumption I June 2015 Source: Cornerstone Capital Group 12
13 ESG Materiality and Sector Strategy: Four Conclusions Our conclusions pertain solely to ESG risks; we will look at opportunities in a future report Based on the analysis above, we draw four broad conclusions for sector strategy. (Bear in mind that the focus of this report is solely on ESG risks we will address ESG opportunities in a subsequent analysis.) An overweight in either the Materials or Energy sectors creates relatively high ESG risk. The likelihood that a significant sustainability event could arise in the Materials and Energy sectors is relatively high and, should it occur, it s estimated the potential financial impact would be large (Figure 6). Not surprisingly, of the five sustainability categories that SASB has identified (Environment, Social Capital, Human Capital, Business Model and Innovation, Leadership and Governance), the Environment factor dominates in the Materials and Energy sectors. An overweight in the Health Care sector also creates relatively high ESG risk, albeit for different reasons. In contrast to Materials and Energy (where the Environment factor dominates), the sustainability issue with the greatest likelihood of having a material impact in the Health Care sector is Business Model and Innovation. In the Pharmaceuticals (57% MSCI weight) and Biotechnology (15% MSCI weight) industries, product quality and product safety are, not surprisingly, key categories under Business Model and Innovation. An overweight in the Information Technology sector creates relatively less risk than an overweight in the Materials, Energy or Health Care sectors. Figure 6 illustrates that, while the likelihood that a material sustainability issue could arise in the Information Technology sector is higher than in the Health Care Sector (y-axis), it s estimated the potential financial impact would not nearly be as large (x-axis). Obviously, Business Model and Innovation issues pertaining to product quality and product safety can never be ruled out in the Health Care sector and could, potentially, be catastrophic. In the Information Technology sector, by contrast, potential sustainability issues are fairly evenly distributed: Leadership and Governance (27%), Social Capital (25%), Human Capital (20%), Environment (16%), Business Model and Innovation (12%). The implication would seem to be that, in contrast to Materials, Energy and Health Care, there are a number of ESG issues that could potentially be material in the Information Technology sector, although it s estimated their financial impact would be less significant than in the other three sectors. 13
14 14 An overweight in Financials appears relatively low-risk. The likelihood that a material sustainability issue could arise in the Financials sector is medium and, should it occur, the potential financial impact is estimated to be relatively modest. This conclusion may seem counterintuitive following the financial crisis of However, it s important to bear in mind a few points. First, the Investment Banking & Brokerage industry has just a 3% weight in the MSCI ACWI Financials Index. Furthermore, the sustainability issue with the greatest likelihood of having a material impact in the Financials sector is Business Model and Innovation, much more so than Leadership and Governance, reflecting, perhaps, heightened regulatory scrutiny of the Financials sector globally.
15 Michael Geraghty is the Global Markets Strategist for Cornerstone Capital Group. He has over three decades of experience in the financial services industry including working as an investment strategist at UBS and Citi. 15
16 Important Disclosures: Erika Karp, CEO of Cornerstone Capital Inc., is a member of the Board of Directors of the Sustainability Accounting Standards Board. Michael Baldinger, CEO of RobecoSAM, is a member of the Board of Directors of Cornerstone Capital Inc. Cornerstone Capital Inc. doing business as Cornerstone Capital Group ( Cornerstone ) is a Delaware corporation with headquarters in New York, NY. The Cornerstone Flagship Report ( Report ) is a service mark of Cornerstone Capital Inc. All other marks referenced are the property of their respective owners. The Report is licensed for use by named individual Authorized Users, and may not be reproduced, distributed, forwarded, posted, published, transmitted, uploaded or otherwise made available to others for commercial purposes, including to individuals within an Institutional Subscriber without written authorization from Cornerstone. The views expressed herein are the views of the individual authors and may not reflect the views of Cornerstone or any institution with which an author is affiliated. Such authors do not have any actual, implied or apparent authority to act on behalf of any issuer mentioned in this publication. This publication does not take into account the investment objectives, financial situation, restrictions, particular needs or financial, legal or tax situation of any particular person and should not be viewed as addressing the recipients particular investment needs. Recipients should consider the information contained in this publication as only a single factor in making an investment decision and should not rely solely on investment recommendations contained herein, if any, as a substitution for the exercise of independent judgment of the merits and risks of investments. This is not an offer or solicitation for the purchase or sale of any security, investment, or other product and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities. Investing in securities and other financial products entails certain risks, including the possible loss of the entire principal amount invested. You should obtain advice from your tax, financial, legal, and other advisors and only make investment decisions on the basis of your own objectives, experience, and resources. Information contained herein is current as of the date appearing herein and has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed and should not be relied upon as such. Cornerstone has no duty to update the information contained herein, and the opinions, estimates, projections, assessments and other views expressed in this publication (collectively Statements ) may change without notice due to many factors including but not limited to fluctuating market conditions and economic factors. The Statements contained herein are based on a number of assumptions. Cornerstone makes no representations as to the reasonableness of such assumptions or the likelihood that such assumptions will coincide with actual events and this information should not be relied upon for that purpose. Changes in such assumptions could produce materially different results. Past performance is not a guarantee or indication of future results, and no representation or warranty, express or implied, is made regarding future performance of any security mentioned in this publication. Cornerstone accepts no liability for any loss (whether direct, indirect or consequential) occasioned to any person acting or refraining from action as a result of any material contained in or derived from this publication, except to the extent (but only to the extent) that such liability may not be waived, modified or limited under applicable law. This publication may provide addresses of, or contain hyperlinks to, Internet websites. Cornerstone has not reviewed the linked Internet website of any third party and takes no responsibility for the contents thereof. Each such address or hyperlink is provided for your convenience and information, and the content of linked third party websites is not in any way incorporated herein. Recipients who choose to access such third-party websites or follow such hyperlinks do so at their own risk. 16
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