Does your ESG integration program have an edge? If not, read on. Everyone knows that it’s difficult to produce alpha—an abnormal excess return over the market—due to skill rather than luck. And yet, by looking deeply, and at the right factors, one can find investment opportunities (and market inefficiencies) that are overlooked by others.
Howard Marks, Co-Chairman of Oaktree Capital Management, refers to this process as “second-level thinking” in his incredible book The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor (46). Marks goes on to explain:
Second-level thinkers know that, to achieve superior results, they have to have an edge in either information or analysis, or both” (78).
Sustainable investing is all about second-level thinking. First, we need to gain an informational advantage by identifying material environmental, social and governance (ESG) factors. Then, we need to understand how that information drives intrinsic value, and cash flow, to design investment strategies that appropriately meet the client’s risk and return objectives over an appropriate time horizon.
Corporate Sustainability: First Evidence on Materiality
The good news is that Harvard researchers have found new evidence linking performance on sustainability issues to financial performance. Importantly, the research differentiates between material and immaterial sustainability factors—addressing a significant gap in prior research.
Authors Mozaffar Khan, George Serafeim and Aaron Yoon from Harvard Business School present their findings in Corporate Sustainability: First Evidence on Materiality (Working Paper 15-0703). A major finding is that firms with high performance on material sustainability issues and concurrently low immateriality scores have the best future stock performance—generating an annualized alpha of 6.01%.
Using calendar-time portfolio stock return regressions we find that firms with good performance on material sustainability issues significantly outperform firms with poor performance on these issues, suggesting that investments in sustainability issues are shareholder-value enhancing” (1).
In addition, firms with good performance on material sustainability factors also outperformed those with good performance on immaterial sustainability factors by an annualized alpha of 1.96%. So, again good performance on the right (material) ESG factors adds value. The results are summarized below.
Source: Sustainability Accounting Standards Board (SASB) Industry-based Standards to Guide Disclosure and Action on Material Sustainability Information Slide 22 (2015).
Even good performance on immaterial sustainability factors added .6% annualized alpha. At a minimum, this means that sustainability investments are not shareholder value-destroying (3). However, firms with poor performance on sustainability factors (both material and immaterial) underperformed by an annualized alpha of -2.90%.
What’s the big idea? Access to material sustainability information can give your ESG integration program an edge.
Material ESG Information Access
In the Harvard study cited above, the data collection process was driven based on materiality guidance on sustainability issues from SASB. The SASB website provides a sector-level materiality map that identifies sustainability issues by level of materiality at http://materiality.sasb.org. In short, this map is a great starting point for identifying which issues are likely to be material for more than 50% of the industries in the sector. Then, the Harvard researchers used MSCI KLD as the source of their sustainability data—which is the most widely used dataset by past studies (7).
SASB sustainability issues are organized under the following five categories: Environmental, Social Capital, Human Capital, Business Model and Innovation and Leadership and Governance. For example, the environmental category contains issues like greenhouse gas (GHG) emissions, air quality, energy management, fuel management, water and wastewater management, waste and hazardous materials management and biodiversity impact.
After identifying the material issues, the SASB Standards Navigatorhttps://navigator.sasb.org/ can be used to research specific “evidence-based metrics” that are known to impact business value in the areas of revenues, costs, assets, liabilities and cost of capital. Bottom line, it’s all about analyzing the right non-financial ESG metrics that can have a material impact on financial performance.
For illustrative purposes, a few SASB environmental accounting metrics applicable to the Oil and Gas Exploration and Production industry are shown below. As you can see, each metric in the SASB Standards has a unique reference number, description and a clearly defined unit of measurement.
Sector: Non-renewable Resources, Industry: Oil & Gas Exploration and Production
- Greenhouse Gas Emissions – Accounting Metric NR0101-01 – Gross global Scope 1 emissions, percentage covered under a regulatory program, percentage by hydrocarbon resource. Unit = Metric tons (t) CO2-e, Percentage (%). The registrant shall disclose gross global Scope 1 greenhouse gas (GHG) emissions to the atmosphere of the six greenhouse gases covered under the Kyoto Protocol: carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride
- Air Quality – Accounting Metric NR0101-04 – Air emissions for the following pollutants: NOx (excluding N2O ), SOx, volatile organic compounds (VOCs), and particulate matter (PM) Unit = Metric Tons (t)
- Water Management – Accounting Metric NR0101-06 – Volume of produced water and blowback generated; percentage (1) discharged, (2) injected, (3) recycled; hydrocarbon content in discharged water. Unit = Cubic meters (m3), Percentage (%), Metric tons (t)
- Reserves Valuation & Capital Expenditures – Accounting Metric NR0101-22 – Sensitivity of hydrocarbon reserve levels to future price projection scenarios that account for a price on carbon emissions. Unit = Million barrels (MMbbls), Million standard cubic feet (MMscf).
Importantly, SASB standards are drawing wide interest across the globe and have been downloaded over 27,392 times by more than 4,640 users in over 65 countries in top capital markets including the U.S. ($25.9B), E.U. ($10.4B), Japan ($4.6B), China (3.9B) and Hong Kong ($3.1 B) (Slide 24).
SASB standards can be downloaded, at no charge, for a variety of sectors and industries at: http://www.sasb.org/standards/download/. Additionally, MSCI ESG Research sells a comprehensive suite of ESG data, ratings and research products. See https://www.msci.com/resources/factsheets/MSCI_ESG_Research.pdf
A Vision of the Future
As noted at the outset, after gaining an informational advantage one must then be able to efficiently analyze the data in order to design investment strategies that appropriately meet the client’s risk and return objectives. Given the wealth of new ESG information that will be coming down the pike through the SASB Standards, there will be exciting opportunities to develop new investment strategies and analysis.
For example, financial analysts will enjoy creating new multi-factor regression models that incorporate material ESG factors in an attempt to forecast sources of performance and risk. And there will be even more ways to conduct peer comparisons with a complete data set—using consistent ESG units—while benchmarking against the industry average.
SASB provides a vision of this future in the illustration below. It shows a hypothetical peer comparison using sustainability fundamentals in the pharmaceutical industry.
Source: SASB: Industry-based Standards to Guide Disclosure and Action on Material Sustainability Information Slide 19 (2015).
It’s my hope that more access to high-quality, material ESG information will improve the investment decision making-process, increase business competition and lead us to a more sustainable future.