© Forum for the Future 2002 Investing in Sustainability A new mainstream investment style or values-based investing? Presentation to the TBLI conference by Brian Pearce 18 October 2001 C entre for S ustainable I nvestment

© Forum for the Future 2002 The UK SRI revolution? Yesterday SRI was mostly –about applying criteria to the screening of stocks –something that a small minority of ethically - driven retail investors did Tomorrow SRI could be mostly –about integrating environmental/social factors into core investment and corporate governance processes –something that most large institutional investors do across their assets C entre for S ustainable I nvestment

© Forum for the Future 2002 Rating and Indices Changing the world or a new mainstream investment style Confusion of sustainability with social/green investing Two distinct investment styles require distinct rating tools and indices –Not negative screening vs positive selection/shareholder activism –But tools to measure social/env. impact vs investment potential Recent boost for social investment but setback for sustainability investment –FTSE4Good and linked tracker fund and derivative products –Hiring of leading social and engagement experts by UK SRI teams Sustainability investors need further advances in rating tools and indices if progress is to be made C entre for S ustainable I nvestment

© Forum for the Future 2002 Confusion of sustainability with social/green investing A recent major investment study illustrates this confusion: –‘Sustainability investing encompasses any investment that apply ethical, environmental and social criteria…because the concept of social responsibility is a reflection of individual values and social concerns, much subjective judgement is involved’ UBS Warburg study, August 2001 However this is confusing two investment styles: –‘Integrating personal values and societal concerns with investment decisions is called SRI [Social Investment]. With SRI you can put your money to work to build a better tomorrow...’ US Social Investment Forum C entre for S ustainable I nvestment

© Forum for the Future 2002 Sustainability investing is distinct from social/green investing ‘Companies most likely to be growing consistently over the next few decades are those promoting or benefiting from sustainable development…. ….this approach is radically different from traditional ethical investment…. ….instead of focusing on negative criteria and then applying financial analysis to a restricted universe, the focus is on making a direct link between sustainable development and long-term returns….’ Morley Fund Management C entre for S ustainable I nvestment

© Forum for the Future 2002 Two very distinct investment styles C entre for S ustainable I nvestment SUSTAINABILITY INVESTORS SOCIAL INVESTORS Environment Community Employees Fixed capital Add value to stakeholders Add value to enterprise

© Forum for the Future 2002 Why has this not been done before? Is it material? –Shareholders want to know how this creates business success Is the information there? –Vast majority of environmental/social reports do not address this at all Do we have the tools to analyse the data? –Some being developed but limited capacity to use them C entre for S ustainable I nvestment

The impact pathways to shareholder value Creating value from globalisation and sustainability challenges

© Forum for the Future 2002 Why - Evolution or Regulation? Evolutionary response: –CSR increases profit/shareholder value; –Managers maximising stakeholder value; –Response to external social pressures; Regulatory response. C entre for S ustainable I nvestment

© Forum for the Future 2002 C entre for S ustainable I nvestment Profit MAX Compliance cost Regulation Tax Social good MAX Market pressure Stakeholder pressure Government objective function X0X0 X1X1 X2X2 X3X3 SRI Ethical investment

Sustainable development Bill Gates on how to value a company ‘Assets are just dead objects. They have nothing to do with the innate spirit that moves and propels a company’

Sustainable development How is the shareholder value of a company estimated? Shareholder value =  (free cash flow)/(1+cost of capital) n - debt capital free cash flow = profits - net depreciation of manufactured capital

Sustainable development The link between triple bottom line and the capitals model Depreciation Manufactured capital stock Investment in buildings, vehicles and machinery Flow of accomodation, transport and production services Natural capital stock Investment in restoration or mitigation Degradation due to pollution or waste inflows in excess of natural absorption Flow of energy, raw materials, waste sink and environmental services for production OUTPUT OF GOOD OR SERVICE Payments for inputs EBIT Sustainable free cash flow if…

Sustainable development What is sustainable shareholder value?  (Cash flow - depreciation Km - depreciation Kh - depreciation Ks - depreciation Kn)/(1+cost of capital) n - debt capital depreciation Km = worn out planes - investment in new planes and contribution to other sectors’ productivity and inward investment depreciation Kh = obsolete skills in workforce - training depreciation Ks = community damage from tourism - community investments depreciation Kn = noise, local air quality and climate change damage

© Forum for the Future 2002 What is needed from raters and index providers Social investors –Ratings of companies that add value to stakeholders –Indices to encourage the adoption of CSR Sustainability investors –Ratings of companies that maximise their enterprise value from all their asset stocks e.g. what type of environmental management creates enterprise and shareholder value? –Indices for benchmarking and linked tracker funds and derivative products C entre for S ustainable I nvestment

© Forum for the Future 2002 What rating tools and indices are available? C entre for S ustainable I nvestment

© Forum for the Future 2002 How well do the raters serve sustainable investors? C entre for S ustainable I nvestment

© Forum for the Future 2002 How well do the index providers serve sustainability investors? Sustainability investing is a thematic, performance-based, approach like growth or value investing –No globally accepted benchmark index for benchmarking or linking tracker funds and deriviative products UBS Warburg study disputes outperformance claims –FTSE4Good underperforms once selection and survivorship bias removed; –In addition FTSE4Good and DJSGI performance attributed not to social performance but to country, sector or style tilts and factors bets –Invalid criticism of DJSGI as expect country/sector tilts from issues like policy response to climate change C entre for S ustainable I nvestment

© Forum for the Future 2002 The Challenge Social investors are well provided for. Sustainability investors are not. If sustainability investing is to become a mainstream investment style to challenge growth and value investing: –Rating and index providers must clarify tool objectives ‘Changing the world’ or ‘improving investment performance’ –Raters need to show how enterprise value is created by corporate management of their environmental and social performance –Rating tools need to add value to existing valuation methods, be forward-looking, comprehensive, based on industry value drivers, capable of comparing companies across industries, transparent and easily understood (not an easy task!). C entre for S ustainable I nvestment