Introduction to Sustainability

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Sustainability

Tax Avoidance Labor Rights

Data Privacy Business Ethics

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Outline

gWhat is Sustainability
gWhy Sustainability Matters
gDefinition of Materiality
gESG Ratings of Companies
gApplications
/Approaches to Sustainable Investing
/ESG Integration into Equity Research
/Sustainability Ratings for Funds

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 What is the Role of Business In Society

gMilton Friedman, the great economist propounded the shareholder view of the firm
/“The social responsibility of business is to increase profits, as long as it stays within the
rules of the game, i.e. engages in open and free competition without deception or fraud”
(1971)

gMichael Porter (1979) exemplified the competitive forces faced by the company through
his five forces model – in his model, the business is engaged in competition with its
stakeholders (suppliers, customers, other competitors) for its share of profits

gBut the thinking changed in the 2000s – Michael Porter propounded the shared value
theory; the central premise is that the competitiveness of the company and the health of
the communities are mutually dependent

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Sustainability

Sustainability focuses on meeting the needs of the present without compromising the
ability of future generations to meet their needs.
Sustainable Investing is a long-term investment approach that incorporates environmental,
social, and governance factors in the investment process

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Why Sustainability Matters

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Why Sustainability Matters

Market Valuations Don’t

Sustainability Issues Impact
Reflect Financial
Performance
Statements

Investor Pressure for More

Increasing Investor Interest
Disclosure

Sustainability a Response Sustainability is not in

to Short-termism Conflict with Fiduciary Duty

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 Market Valuations Don’t Reflect Financial Statements

Traditional financial statements explain a very small part of a company’s value

gIn 1975, only 17% of assets were

intangible; in 2015, the proportion was
84%

gConventional accounting does not treat

nonfinancial resources—human,
social, and natural capital—as assets,
even though they undeniably represent
sources of future value

gIn the absence of accounting metrics,

they’re sensitive to impairment by
management

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Sustainability Issues are Business Issues

A 2015 review of more than 2,000 empirical studies found that approximately 90%
showed a non-negative relation between sustainability criteria and corporate financial
performance.

Research further suggests that firms focusing their sustainability investments on

material factors enjoyed significantly higher accounting and risk-adjusted market
returns.

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Increasing Investor Interest

Half of global institutional assets—about $70 trillion—are managed by signatories to

the Principles for Responsible Investment (PRI), which promotes the incorporation of ESG
factors into investment decisions.

According to U.S. Forum for Sustainable and Responsible Investment (U.S. SIF), such
investments represent $8.72 trillion—more than 20 percent of the AUM in the U.S.

80 1800
70 1600

60 1400
1200
50
1000
40
800
30
600
20 400
10 200
0 0
Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12 Apr-13 Apr-14 Apr-15 Apr-16 Apr-17
Assets under management (US$ trillion) Number of AOs

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 Investor Pressure For More Disclosure

gA group of investors representing nearly $2 trillion in AUM sent a letter to the SEC in 2015
calling for improved disclosure by oil and gas companies of “critical climate change-
related business risks that will ‘profoundly affect the economics of the industry.’”

gIn a June 2016 letter to S&P 500 CEOs, the chief executive of BlackRock, the world’s
largest asset manager, urged them to focus on long-term sustainability, saying, “Over the
long-term, environmental, social and governance issues—ranging from climate
change to diversity to board effectiveness—have real and quantifiable financial
impacts.”

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Focus on Sustainability Partly a Response to Short-Termism

gEarnings Guidance, a questionable practice

/“Guidance can lead to a lot of malpractice,” Warren Buffett said.
“If the CEO says, ‘We’re going to earn $1.06 next quarter,’ I think
that if they’re going to come in at $1.04, there’s a lot of attempts
to find a couple extra pennies someplace.”
/In a survey, 80 percent of executives said they would decrease
discretionary spending (such as R&D or advertising), while 39
percent have said they would incentivize customers (i.e. offer
them discounts) to make early purchases

gCapex and R&D expenditures have decreased significantly in recent

years as an increasing portion of corporate earnings is being
distributed to shareholders as buybacks. In other words, investors
are getting returns today, but they may be coming at a long term
cost

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Sustainability Not in Conflict with Fiduciary Duty

gA common misconception is that fiduciary duty legally

compels asset managers to solely maximize financial
returns

gLargest institutional investors own such significant

amounts of assets that many have adopted a “universal
owner” approach
/The trustees consider not only returns, but also the
opportunity to stimulate wider economic growth,
which is also in the best interests of their
beneficiaries (citizens).
/The fiduciary’s duty of loyalty calls for impartial
treatment of different types of beneficiaries,
including different generations.

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Materiality

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 History – 1929 Crash, Securities Act, and Disclosure

gIn September 1929, the frantic

selling of securities on the New York
Stock Exchange (NYSE) led the
market to lose about 80 percent of its
value by the end of June 1932.
/The Senate Committee’s Report
describes many examples of
securities being sold using false or
misleading information

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History – 1929 Crash, Securities Act, and Disclosure

gCongress passed the Securities Act of 1933 and the Exchange Act of 1934.

gSecurities Act requires companies to fully and truthfully disclose information about
the company in a registration statement filed with the SEC.
/To meet the SEC’s disclosure requirements, a company issuing securities must make
available all information, whether it is positive or negative, that might be relevant
to an investor’s decision to buy, sell, or hold the security.

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 Definition of Materiality

gSupreme courts have defined materiality over the course of several landmark cases

gFor a fact to be material

/You don’t need to prove that its omission would change your decision. The standard only
requires that the omitted fact would have assumed significance in your deliberations.
/A common practice of companies denying merger rumors, might be afoul of law

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Interpreting Materiality: GM on Civil Rights and Environment

gDuring the 1970s, campaigners asked

GM to disclose its environmental and
civil rights performance

gThe SEC and the courts concluded the

requested disclosures were not
needed

gThe disclosures were deemed

immaterial because investor interest
in terms of ethical investing, a well
as shareholder resolutions were
minuscule in the 1970s

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 Interpreting Materiality: BP Oil Spill

gShareholders brought suit against BP, alleging

false and misleading statements about their
knowledge of corrosion in an oil pipeline.

gPlaintiffs focused on press statements by BP’s

senior executive about a possible spill, and
statements in BP’s annual reports about
compliance with applicable environmental
laws

gThe courts concluded that “facts

demonstrating public interest in the
withheld information demonstrate its
materiality.”

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 Sustainalytics Materiality Assessment (Automobiles)

gThe Materiality Matrix presents, from the perspective of the industry, the most material
ESG issues from a business impact and/or environmental/social impact perspective.
gThe location on the matrix indicates the relative importance of the ESG issue, with those
located in the top right corners being the most material for the industry as a whole.

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 SASB Disclosure Topics (Pharma)

gSustainability Accounting Standards Board (SASB), a non-profit, also lists the material
issues per industry according to different dimensions
gThe key issues for the pharmaceutical companies are shown below, and include energy
and water efficiency, access to medicines, ethical marketing, employee health and safety,
and Corruption and Bribery

Biotechnology and Pharmaceuticals

Environment Social Capital Human capital Business model Leadership and
and innovation Governance
Energy, water • Access to • Employee • Affordability • Corruption
and waste medicines recruitment and fair and bribery
efficiency • Counterfeit and pricing • Supply chain
drugs retention • Drug safety quality
• Employee and side management
health and effects
safety

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ESG Ratings of Companies

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Sustainability Ratings

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Case Study I - Facebook

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 Case Study II – Novo Nordisk

gNovo Nordisk, the Danish pharmaceutical company (market cap $120 bn) which produces
insulin is regularly rated as the most sustainable company on earth.

ESG Environment Social Governance

82 85 82 81

Key Issues Comments

Product Governance Increased Adverse Reporting of Side Effects even in

Access to Basic Services
Business Ethics
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emerging markets where standards are lower
Novo Nordisk has committed to raising no more than 10%
every year in the US, where high prices are an issue.
It has also committed to keep insulin prices 20% lower in
poor countries vis-à-vis developed markets
The company has strong clinical trials program. The trials are
conducted only where the drugs are marketed.
 QUIZ TIME

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Applications

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Application I - Sustainable Investing

• Sustainable investing follow different approaches, from basic approaches (exclusionary

screening, divestment) to more investor directed approaches

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Application II – ESG Integration In Equity Research

gESG considerations impact valuations and Moat ratings of a company.

gFor example, ESG is an important consideration for Utilities because-
/Today, electricity use is 13 times greater than it was in 1950.
/Electric utilities produce more than 30% of total U.S. greenhouse gas emissions,
primarily carbon dioxide, but have cut total emissions 25% since their 2007 peak.
/Utilities are heavily regulated, and ESG factors have become important inputs in
predicting how constructive a regulatory framework will be for investors in the
future.

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Case Study: ESG Integration in Equity Research

gDominion Resources (Wide Moat)

/This once coal-reliant utility now produces only about 20% of its generation from coal,
down from almost 50% 10 years ago.
/It has four small power plants that use 100% wood waste, three of which were
converted from existing coal-fired plants.
/As it converted it’s existing coal plants into more sustainable biomass plants, regulators
allowed the utility to charge a premium to cover its investments.
/Its plant in Virginia received a 200-basis-point premium over its base ROE for the
biomass conversions, providing returns on invested capital well above cost of capital.

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Application III - Morningstar Sustainability Rating

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 Application III - Illustration

Every fund in our coverage universe gets a Sustainability (Globe) rating, indicating its
degree of sustainability relative to its peers

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Application III (b) – Low Carbon Designation

Morningstar recently augmented its Sustainability Ratings for funds, with the launch of
the Low Carbon designation, which reflects the carbon risk of the underlying holdings

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