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ESG Meets Behavioral Finance – Part 2

Mexican International Sovereign Debt Structure

Mind the Gap: Corporate Carbon Disclosure in EMEA

Exploring the G in ESG: Governance in Greater Detail – Part I

How Did Australian Active Funds Perform in 2017?

ESG Meets Behavioral Finance – Part 2

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Lauren Smart

Managing Director, Global Head Financial Institutions Business

Trucost, part of S&P Global

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Behavioral economics has had a transformational effect on the fortunes of millions of people saving for retirement through the introduction of auto-enrollment, default plans, and “save more tomorrow” schemes. In a series of blogs, I explore how insights from behavioral economics could be used to revolutionize ESG investing and facilitate critical finance flows to a more sustainable economy. In part 1, I explored how we could harness the power of inertia to address the intent-action gap for sustainable investing. In part 2, I explore some of the behavioral biases we exhibit about green investing.

The Big Green Elephant in the Room: Why Do We Assume That “Green” Investing Means Sacrificing Returns?

In an era of information overload, competition for our attention causes us to take mental shortcuts leading to errors and biases. As behavioral economists have pointed out, investors are not immune, which could account for the disconnect between science and investor action on climate change. The World Economic Forum’s 2018 risk report highlights the failure of climate change mitigation and adaptation as one of the most impactful and probable issues facing the global economy[1] and the Financial Stability Board asserts that climate is “the most significant” risk investors face.[2] So why is it that in the 2017 CFA Society ESG survey only 50% of respondents admitted incorporating environmental issues into their investment process, and the main reason cited was immateriality?[3]

The big green elephant in the room is the pervasive belief that investing in a way that considers climate requires financial sacrifice. While this can partially be explained by limited knowledge about climate impacts on asset valuations and how environmental issues can be integrated into portfolio construction, behavioral finance provides insights into additional factors at play. The “no free lunch” heuristic is at the root of our automatic response that “green” or sustainable finance requires a returns sacrifice. To lose weight, you must diet, to pass your CFA, you must sacrifice your social life; there is no reward without risk and “good” things (like “green” products) require sacrifice. Even when there is abundant evidence to the contrary, we are less likely to take it into account because of confirmation bias, which is the tendency to prioritize or interpret new information in a way that confirms our existing beliefs. Confirmation bias is stronger for more emotive and deeply entrenched beliefs, which could explain the slower adoption[4] of sustainable finance in markets where issues like climate change are politically polarized, such as the U.S.[5]

Listening to our reflective systems may lead us to a more logical judgement. We are entering an era of unprecedented population growth, placing huge pressure on the finite resource base for food, water, and energy. At the same time, more volatile weather and increasing pollution is depleting our “natural capital” base and governments globally are working to change the cost-benefit dynamics of polluting industries. Against this macroeconomic backdrop, it is logical that more resource-efficient companies and ones more responsive to changing consumer demand for greener products should do better. Indeed, to make the case more powerfully, try reversing the argument—do we believe more resource-inefficient, polluting companies will outperform going forward? A meta-study by Oxford University seems to confirm the thesis. It found that in 90% of cases, environmentally efficient companies have lower costs of capital and superior stock market performance.[6] This is reinforced by a Stanford University study demonstrating that carbon-efficient companies perform better on traditional financial metrics, such as higher ROI, cash flow, and coverage ratios.[7] This data can feed into portfolio construction for both environmentally themed strategies and the greening of “mainstream” strategies. For example, the S&P 500 Carbon Efficient Index tilts rather than excludes companies and has outperformed the underlying index over the past  five-year period—as have versions that exclude fossil fuels, widely perceived to be the economic “losers” of a low-carbon transition. By addressing our cognitive biases, we can remove a key blocker to the flow of capital to a more sustainable economy.

If you liked this blog, you might also enjoy the blog, “Can ‘Being Green’ Deliver Enhanced Returns?

You can also register to attend the Discover the ESG Advantage event on May 17, 2018, in London.

 

[1] The World Economic Forum (2018), “Global Risk Report 2018

[2] https://www.fsb-tcfd.org/

[3] The CFA Institute (2017), “ESG Survey 2017

[4] Benjamin, Jeff, “Is ESG investing going mainstream?” Feb. 10, 2018.

[5] Dunlap, Riley E., McCright, Aaron M., and Yarosh, Jerry H., (September 2016) “The Political Divide on Climate Change: Partisan Polarization Widens in the U.S.” Environment Science and Policy for Sustainable Development, 58(5): 4-23.

[6]   Clark, Gordon L., Feiner, Andreas, and Viehs, Michael, “From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance,” University of Oxford, September 2014.

[7]   In, S., Young, Park, K., Young, and Monk, A., “Is ‘Being Green’ Rewarded in the Market? An Empirical Investigation of Decarbonization Risk and Stock Returns,” 2017.

If you enjoyed this content, join us for our Seminar Discover the ESG Advantage in
London on May 17, 2018.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Mexican International Sovereign Debt Structure

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Jaime Merino

Director, Asset Owners Channel

S&P Dow Jones Indices

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To continue my last post about the Mexican sovereign debt structure, I will talk about the international debt issued by Mexico. The issuance of government securities in international markets is critical to achieve the Mexican federal government’s funding objectives. The process of the federal government’s securities allocation in international markets is as follows.

  1. The federal government agrees with investment banks to issue securities in the market.
  2. The investment banks announce the transaction and promote it to investors.
  3. Investors purchase, through the investment banks, securities issued by the federal government.
  4. Investment banks deliver proceeds from the transaction to the federal government. Simultaneously, the federal government instructs the fiscal agent to deliver the securities to investors.

According to the Mexican Ministry of Finance, unlike domestic debt, there is no timetable for the issuance of securities denominated in foreign currency, since the decision to issue external debt is linked to the public debt strategy as well as to market conditions. Currently, the federal government has debt in U.S. dollars (USD), euros (EUR), British pound sterling (GBP), and Japanese yen (JPY) with 20, 2, 11, and 11 bonds by currency, respectively.

Of note, Mexico has issued three bonds with maturities of 100 years (perpetual bonds). The latest was issued in April 2015 in euros and will mature in 2115; the one issued in USD matures in 2110 and the one issued in GBP matures in 2114. This last bond was actually the first sovereign bond issued by any country in GBP with that maturity, and it had a bid-to-cover ratio of 2.5, which indicates the acceptance of Mexican issuances in global markets.

With USD 68,500 million of outstanding debt in the four currencies, Exhibit 1 shows the structure for these bonds, and we can see that 65% of the total amount is issued in USD. Almost 40% of the total debt has a maturity of more than 20 years and 30% between 5 and 10 years (see Exhibit 2).

The 10 different indices in the S&P/BMV Fixed Income Index series are designed to track the performance of bonds issued in U.S. dollars. Exhibit 3 shows the returns of the S&P/BMV Sovereign International UMS Bond Index and the S&P/BMV Sovereign International UMS Bond Index (USD), with the returns of the former expressed in Mexican pesos and the latter in U.S. dollars.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Mind the Gap: Corporate Carbon Disclosure in EMEA

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Soren Stober

Director of Business Development ESG & Sustainability

Trucost, part of S&P Global

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Many companies in the Europe, Middle East, and Africa (EMEA) region appear not to be fully disclosing their carbon emissions—especially from their supply chain and use of products. For many sectors, this is often where most risks lie. Nevertheless, across EMEA there are encouraging signs that companies are investigating these gaps and taking action to prepare for the low-carbon transition and compliance with emerging voluntary disclosure requirements or potential legislated disclosure requirements.

The findings come from Trucost’s analysis of the latest data on carbon disclosure gathered by the investor-led CDP environmental data disclosure initiative from companies in 2017. Some 1,900 companies worldwide responded to the CDP’s data request, of which over 40% are headquartered in the EMEA region.

Trucost’s analysis suggests significant gaps in emissions disclosure among EMEA companies. Across all sectors, companies tend to underreport their carbon emissions by 7%, on average. To dig deeper, Trucost sampled emissions data from firms in two sectors—health care and financials—comparing their actual disclosed emissions with expected emissions, given their business activities. The results show a significant shortfall (see Exhibit 1).

Scope 3 emissions are of notable concern and complete reporting in this area remains a challenge. Scope 3 emissions include business travel, and companies may be most likely to report emissions in this scope because they are easier to measure. Emissions from supplies of goods and services and use of products tend to be harder to measure but are often of greater importance—in some sectors, they could account for 80% of a company’s emissions. This blind spot is a risk to companies, as costs from carbon pricing measures such as carbon taxes, fuel duties, and emissions trading schemes could be passed up the supply chain or make carbon-intensive products more costly to own and hence less attractive to buy.

The good news is that businesses are increasingly trying to understand scope 3 risks, and our analysis of CDP data found that companies were using techniques such as input-output modeling to calculate their supply chain emissions. Two-thirds of EMEA respondents were also engaging their suppliers to implement measurement and reduction initiatives.

In further good news, Trucost’s analysis found that about 80% of EMEA companies responding to the CDP set an internal price on carbon in 2017, and 50% are adopting science-based targets that are aligned with the Paris Agreement to limit global warming to 2 degrees Celsius.

Although progress is being made, EMEA companies need to continue improving their reporting. Carbon disclosure is evolving due to demand from investors for financially relevant carbon data and forward-looking metrics that assess exposure to carbon risks. The disclosure of such data is being encouraged by the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD), whose membership includes EMEA financial policymakers and regulators. From 2018 onwards, the CDP is set to align its annual climate change information request with the TCFD recommendations.

In addition, the EU High-Level Expert Group on Sustainable Finance’s report, “Financing a Sustainable European Economy,” makes wide-ranging recommendations that could affect how EU companies will be required to disclose environmental as well as social and governance information. Although the initial focus of the report is on how financial institutions and regulators should support the transition to a more sustainable economic model, recommendations made in the report could inform how companies are expected (or required) to disclose their carbon emissions to the financial market in future.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Exploring the G in ESG: Governance in Greater Detail – Part I

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Kelly Tang

Director

Global Research & Design

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There is increasing evidence of the link between ESG and financial outperformance as better data quality, standardized data, longer data history, and heightened interest in assessing the materiality of ESG drives continued research. However, there is already substantial empirical evidence to suggest that the “G” aspect of ESG ultimately yields better corporate returns.

Governance data, unlike environmental or social data, has been compiled for a longer period of time and the criteria for what comprises good governance and its classification has been more widely discussed and accepted. Harvard researchers Gompers, Ishii, and Metrick (2003)[1] constructed a Governance Index (G-Index) consisting of 24 governance provisions that weaken shareholder rights and ranked companies based on their scores.

Subsequent research from Bebchuk, Cohen, and Ferrell (2009)[2] identified six corporate governance provisions that are associated with what is considered poor governance and that negatively affect valuation. These six provisions are called the “E-Index” (E for entrenchment), and while they (Bebchuk, Cohen, and Wang, 2012)[3] found that both the G-Index and E-Index would have resulted in abnormal returns in the 1990s, the premium dissipated in the 2000s as the markets learned to distinguish between firms with good governance and those with poor governance and price these discrepancies accordingly.

Through a blog series on governance, we will be detailing what the categories and criteria are that define good governance. For sustainability research, S&P Dow Jones Indices partners with RobecoSAM, an asset manager known for its Corporate Sustainability Assessment (CSA), resulting in an overall sustainability score for companies in addition to the three underlying dimension scores that measure their environmental, social, and governance performance.

Economic Dimension Score

Based on RobecoSAM’s definition, the governance score is referred to as the economic dimension score (EDS), as it evaluates the corporate governance performance of companies but includes additional key measurements that evaluate the quality of a company’s management systems as well as its ability to manage long-term risks and opportunities. In order to understand the G component of ESG and how it affects stock performance, it is helpful to delve deeper into what constitutes good governance.

There are eight specific EDS criteria as outlined in Exhibit 1. The first is corporate governance, which evaluates the systems that ensure a company is managed in the interests of its shareholders (including minority shareholders).

Codes of business conduct addresses business ethics and whether the company’s code of conduct and compliance practices are designed to prevent bribery and corruption in the organization. Companies active in countries with weak anti-corruption laws are exposed to additional reputational and legal risks.

Risk and crisis management examines the effectiveness of the company’s risk management organization and practices, including the independence of risk management from business lines as well as the identification of long-term risks, their potential impact, and the company’s mitigation efforts.

Supply chain management is becoming increasingly important as companies expand to operate on a global level. When a company outsources its production, services, or business processes, it also outsources its own corporate responsibilities and its reputation. Companies need to have strategies in place to manage the associated risks and opportunities posed by their supply chain.

The tax strategy criteria examines the degree to which the company has a clear policy on its approach to taxation issues and an awareness of the extra-financial risks associated with the company’s tax practices.

The materiality score aims to assess the company’s ability to identify the sources of long-term value creation, understand the link between long-term issues and the business case, develop long-term metrics, and transparently report these items publicly.

In the policy influence criteria, RobecoSAM evaluates the amount of money companies are allocating to organizations whose primary role is to create or influence public policy, legislation, and regulations. Companies are also asked to disclose the largest contributions to such groups.

Impact measurement and valuation strives to assess whether companies have business programs for social needs, such as strategic social investments, and if they are measuring and valuing their broader societal impacts with metrics. Companies need to analyze the impacts of externalities that are not currently reflected in financial accounting, but which, over time, may have the potential of becoming priced in.

As discussed and laid out in this blog, the EDS comprises more than a traditional governance score. The inclusion of risk and crisis management, supply chain management, and tax strategy criteria differentiates the RobecoSAM EDS from a traditional governance score that relies heavily on more standard corporate governance metrics. In the next blog in this series, we will examine whether the EDS contains risk/return information and how it may impact future stock performance.

[1]   https://papers.ssrn.com/sol3/papers.cfm?abstract_id=278920

[2]   https://papers.ssrn.com/sol3/papers.cfm?abstract_id=593423

[3]   https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1589731

If you enjoyed this content, join us for our Seminar Discover the ESG Advantage in
London on May 17, 2018.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

How Did Australian Active Funds Perform in 2017?

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Priscilla Luk

Managing Director, Global Research & Design, APAC

S&P Dow Jones Indices

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The SPIVA® Australia Scorecard reports on the performance of actively managed Australian mutual funds against their respective benchmark indices over various investment horizons. In the year-end 2017 report, we extended the analysis to 15 years.

In 2017, the majority of Australian funds in most categories underperformed their respective benchmarks, apart from the Australian A-REIT category. There were 74%, 69%, and 59% of funds in the Australian Equity Mid- and Small-Cap, Australian Bonds, and Australian Equity General categories, respectively, that underperformed their respective benchmarks. Over the 10- and 15-year periods ending Dec. 31, 2017, a minority of funds in most categories delivered higher returns than their respective benchmarks. Less than 15% of International Equity General and Australian Bonds funds and less than 30% of Australian Equity General and Australian Equity A-REIT funds managed to outperform their respective benchmarks on an absolute basis.

Apart from comparing active funds against their respective benchmarks to evaluate their performance, persistence is an additional test that reveals fund managers’ skills in different market environments. Results from the latest Persistence of Australian Active Funds report show that a minority of high-performing funds in Australia persisted in outperforming their respective benchmarks or consistently stayed in their respective top quartiles for three consecutive years, and even fewer maintained these traits consistently for five consecutive years.

Out of the 177 top-quartile Australian active funds in 2013, only two of them (1.1%) remained in the same quartile for the next four consecutive years (2014-2017). Among the 382 Australian active funds that beat their respective benchmark in 2013, only four of them (1.0%) managed to continue their outperformance over the following four consecutive years (2014-2017).

Overall, identifying outperforming active funds is challenging, because the majority of funds delivered lower returns than their respective benchmarks in most categories, as shown in the SPIVA Australia Scorecard. Considered together with the observed weak performance persistence for top-performing funds in Australia across three- and five-year periods, finding funds that beat the benchmark for several consecutive years may appear an inconceivable mission.

The posts on this blog are opinions, not advice. Please read our Disclaimers.