Use of extra-financial information by research analysts and by murplelake80

VIEWS: 28 PAGES: 39

									USE OF EXTRA-FINANCIAL INFORMATION
      BY RESEARCH ANALYSTS
     AND INVESTMENT MANAGERS

              MARCH 2007
Contents


Executive summary .................................................................................................................................. 2
Introduction............................................................................................................................................... 3
This study ................................................................................................................................................. 5
Growing interest in SRI ............................................................................................................................. 6
Importance of ESG factors........................................................................................................................ 8
   Identifying the most important ESG factors ........................................................................................... 8
   Sell-side research analysts ................................................................................................................... 9
   Investors ............................................................................................................................................. 12
   Mismatch in expectations?.................................................................................................................. 14
Mainstreaming ESG issues and SRI ....................................................................................................... 16
   Sell-side research analysts ................................................................................................................. 16
   Investors ............................................................................................................................................. 19
Impact of extra-financial information ....................................................................................................... 21
   Impact on valuation and expected returns........................................................................................... 22
Sources of information on ESG issues.................................................................................................... 25
ESG reporting by companies .................................................................................................................. 26
Differences between sectors................................................................................................................... 28
Differences between regions................................................................................................................... 31
                  s
Implications: What’ missing? ................................................................................................................. 32
Appendices............................................................................................................................................. 34




Acknowledgement
We would like to thank all the sell-side research analysts and buy-side fund managers and analysts who
participated in our survey and provided us with valuable comments.




ECCE – European Centre for Corporate Engagement                                                                                                             1
Executive Summary
This report presents the results of a survey conducted among research analysts and investors aiming to
better understand how they incorporate extra-financial information relating to environmental, social and
governance (ESG) issues into their analysis, valuation and investment decisions. With more than 850
respondents from 88 sell-side and 240 buy-side institutions in Europe, this survey is one of the largest
ever conducted in the field of broadly-understood socially responsible investments (SRI), enabling us to
believe that our findings accurately depict the perceptions and beliefs of the whole European investment
community. Key findings include:

•   Evidence suggests a growing interest in SRI. However, investors continue to manage only a small
    percentage of their assets on an SRI basis, while ESG issues remain a niche market and are
    integrated into mainstream investments only to a limited extent.
•   Corporate communication practices relating to ESG issues seem to have improved, but many
    analysts and investors do not perceive that the companies provide enough information to allow
    effective assessment of these factors' impacts.
•   Major differences exist between sectors in the relative importance of various ESG factors.
    Environmental issues are important mainly for companies in environmentally-sensitive sectors such
    as automotive, mining and utilities. Human rights issues play a major role for consumer goods
    makers, and community involvement matters for companies in sectors such as mining, steel and
    metals.
•   Corporate governance criteria are the most important of all ESG factors across all sectors, and are
    seen by many research analysts and investors as forming a separate category.
•   Extra-financial information is believed to have a significantly higher impact on brand and reputation
    than on market value or financial performance. Differences are also noted between short-term and
    long-term impacts.
•   Companies that score high on ESG criteria seem to be rewarded with premium valuation, while
    companies that score low are likely to be penalised with valuation discount. However, a negative bias
    means that low scores have a more pronounced effect on valuation than do high scores.
•   Many sell-side analysts indicate that their institution has not developed an ESG policy, which
    generally hampers the use of extra-financial information in their analysis. Additionally, analysts who
    cover more companies focus less on ESG factors in their analysis.
•   Sell-side analysts use extra-financial information to a lesser extent than investors, and point out that
    the lack of a universally accepted methodology for quantifying ESG data makes it difficult to
    incorporate extra-financial information into their analyses.
•   Investors, in particular, large, long-only institutions, show more awareness of ESG policies and
    products than sell-side analysts do. Fund managers seem to use extra-financial information to a
    lesser extent than buy-side analysts, while hedge fund managers focus less on ESG issues than do
    other investor types.

Our findings indicate a need for academic research on the alpha-generating possibilities of SRI
investments. Our buy-side respondents agreed that the lack of evidence to support the proposition that
investors can be better off (or at least no worse off) by incorporating ESG factors into their analyses and
investment decisions is an issue that will continue to prevent SRI from going mainstream. Unless this
evidence is available, studies of the SRI market run the risk of merely preaching to the choir, instead of
reaching mainstream investors.




ECCE – European Centre for Corporate Engagement                                                           2
Introduction

We gradually have begun to embrace the concept that extra-financial information, i.e., information on
issues that are not directly quantifiable per se, such as good investor relations, training and developing
the workforce or managing atmospheric emissions, may directly impact companies' reputation, value and
performance. However, finance practitioners have been notoriously reluctant to encompass
environmental, social and governance (ESG) factors into their analyses, valuation and decision making.
Research analysts, in particular, have been criticised for their disregard for ESG issues, which also
results in short-term bias in the assessment of future company prospects, and puts too much focus on
next quarter’ figures at the expense of long-term value for the company and its shareholders.1
             s

It is surprising that the people who are expected to perform an in-depth analysis and assess the merits of
a company as a potential investment do not take all aspects into account when making such a
recommendation. It may be that aspects related to environmental, social and governance issues are not
material or financially relevant, and therefore do not strongly impact a company's performance and value.
It may also be that investors simply do not require such an analysis. Both arguments are rather weak and
                                                                   s
do not bear close scrutiny. First of all, a number of the world’ prime institutional investors (including
Universities Superannuation Scheme and Hermes in the UK, and ABP and PGGM in the Netherlands)
have already expressed their dedication to “     responsible investments” a long time ago.2 Second, the
proliferation of investor-sponsored initiatives aiming to popularise extra-financial information, and the
emergence of SRI-focused indices such as the Dow Jones Sustainability Index or the FTSE4Good Index,
suggest that investors are, in fact, actively seeking knowledge of environmental and social issues in the
companies they consider investing in. It is therefore even more surprising that the research community
has not yet caught up with this trend.

On the investor side, socially responsible investments (SRI), which, in a broad sense, means
incorporating ethical, social, governmental and environmental factors into investment decision making,
remains a niche segment of the industry. The standard performance objective of optimising financial
returns on managed assets does not typically extend itself to analysing the societal or environmental
impact of the companies in the portfolio, at least as long as this impact does not directly impact the
company's bottom line or earnings in the coming quarter. Together with the shrinking time horizon of
investment decisions and linking fund managers' compensation to narrowly defined short-term
benchmarks, these issues provide little incentive for investors to focus on the long-term performance of
                                                                          3
                                                              bottom line.” It is no wonder, therefore, that
their investments, or their impact on anything other than the “
SRI is still struggling to move into mainstream investing.

No consensus has yet emerged in the financial community on how to incorporate SRI issues into financial
analysis. Some sell-side brokers employ dedicated SRI research analysts who produce sector or issue-
based notes on SRI topics; others just send out ad-hoc newsletters every now and then. Some buy-side
investment companies have in-house SRI teams working with portfolio managers; others look only at the
bottom line, with no regard for environmental or ethical considerations. Alas, little research has been
done on the use of SRI by investors and sell-side analysts on a pan-European scale, which is exactly
what we have set out to investigate here: we examine the views of sell-side research analysts and buy-
side fund managers and analysts and their use of extra-financial information. We analyse which ESG
factors matter the most to these two groups, how they are incorporated into financial analysis and
valuation, and what impact they have on companies.

1
  For a more detailed discussion, see, e.g., “Breaking the short-term cycle. Discussion and recommendations on how corporate
   leaders, asset managers, investors and analysts can refocus on long-term value,”by the CFA Centre for Financial Market
   Integrity and the Business Roundtable Institute for Corporate Ethics [2006].
2
  See, e.g., “European SRI Study,”by Eurosif [2006] for an overview of the trends in the European SRI market.
3
                                      Mainstreaming responsible investment,”by the World Economic Forum and AccountAbility
  For a more detailed discussion, see “
   [2005].


ECCE – European Centre for Corporate Engagement                                                                           3
This study is not the first attempt to analyse the use of extra-financial information and focus on ESG
factors' use by finance professionals. A number of academic investigations have already been conducted
in this field, together with a number of initiatives backed by the investment community itself. Most of these
studies have analysed the content of reports prepared by sell-side research analysts and the explicit use
of extra-financial information therein. An ING study analysed the contents of 23 research reports for the
use of extra-financial information4 and found that, except for “  quality of the management,”social aspects
are almost never mentioned in these reports. A similar, although methodologically more rigorous,
approach is adopted by Hassel and Nilsson, who studied the environmental information contained in 248
research reports on firms in the chemicals and oil & gas sectors.5

The Enhanced Analytics Initiative (EAI) is probably one of the best known initiatives promoting the use of
extra-financial information by research analysts. Created in 2004 as a collaboration of a number of
European institutional investors, EAI has been analyzing and evaluating research reports for their ESG
content and, consequently, using the findings to allocate brokerage commissions to the brokers who
compile better and more detailed analyses of extra-financial information. The most recent report6
highlights gradual improvements in the quality, diversity and coverage of extra-financial issues, although
it admits that integration of extra-financial issues into financial analysis remains disappointing.

The EAI evaluation process has one major weakness, which is that its research reports are submitted
voluntarily by brokerage houses, and therefore are not representative of overall trends in the investment
community. Just as one swallow does not make a summer, one ESG-loaded research report produced by
a dedicated SRI analyst does not mean that extra-financial information is used widely by mainstream
European research analysts. Another problem that is common to all contents analyses is that they do not
reveal which information analysts used in their analysis, merely which is reported.7 This could explain the
findings of Hassel and Nilsson, who observed that 65% of the research reports they analysed contain no
environmental performance information, a rather unusual observation given that the two industries they
analyse are notorious for their environmental impact. Because of this, we believe that a direct line of
communication with research analysts is needed to better understand the type of information they use in
their evaluation process.

This problem was recognised and addressed before by Hummels and his team, who interviewed 22
financial analysts and investment officers in Europe and the US in an attempt to find out whether
mainstream analysts consider extra-financial information when analyzing a company and assessing its
performance. Their study,8 published in association with PricewaterhouseCoopers, is based on the
assumption that “ mainstream analysts may take SEE [social, environmental and ethical] information into
                                                                                         s
account even as they reject the fact that SEE issues have a material impact on a company’ performance
and, as a result, avoid making references to these issues in their reports.” This is also the view we
adopted in our study when we opted for a questionnaire method rather than content analysis. Our
approach is most similar to the one adopted by Hunt and Grinnell, who conducted a survey in 1999 of
315 US-based analysts.9 However, while their survey focused on only environmental factors, ours looks
at a broader scope that includes various ESG factors.



4
  Boleij [2005], “Waar is de menselijke factor? Financiële analyses geanalyseerd.”In VBA Journaal.
5
                                 An
  Hassel and Nilsson [2006], “ empirical study of the actual use of environmental information by financial analysts.”Umeå
   School of Business and Mistra Sustainable Investment program.
6                                               nd
  Enhanced Analytics Initiative [2007], “ EAI 2 anniversary. A retrospective and results of the December 2006 evaluation of
   extra-financial research.”
7
                                                            A
  A flaw identified and discussed by Previts et al. [1994], “ content analysis of sell-side financial analysts company reports.”In
   Accounting Horizons.
8
  Hummels and Wood [2005], “      Knowing the price but also the value? Financial analysts on social, ethical and environmental
   information.”Nyenrode Business Universiteit and Boston College.
9
  Hunt and Grinnell [2004], “ Financial analysts’views of the value of environmental information.”In Freedman and Jaggi (eds.),
   Advances in Environmental Accounting and Management, Oxford.


ECCE – European Centre for Corporate Engagement                                                                                 4
This study

Finance professionals, be they research analysts or fund managers, are not the most receptive audience
to surveys and questionnaires, and many studies targeting them suffer from low response rates. This
often leads to aggregation of the buy-side, the sell-side and sometimes even the corporate world into one
homogeneous group. We believe that any study aggregating responses from such widely different
populations has little chance of generating any meaningful and sensible results. Consequently, our study
makes a very clear distinction between the sell-side research analysts and the buy-side investors (fund
managers and analysts).

Contact details and other information used to select participants for this study were provided by
Bigdough, a database of global finance professionals. We received responses from 330 sell-side analysts
and 724 buy-side investors from the UK and continental Europe (the list of institutions whose employees
participated in the survey can be found in the Appendix). Given that not all respondents completed the
whole survey, only 319 sell-side and 548 buy-side responses were used for the analysis. Nonetheless, to
our best knowledge this study is the largest ever done on the use of ESG information by research
analysts and investors, covering 88 sell-side and 240 buy-side institutions.

The sell-side analysts included in this study predominantly cover equities, typically within a particular
sector or European region, although we also included some strategists and a handful of analysts
representing alternative investment styles. The buy-side investors are mainly fund managers (66%) and
buy-side analysts (19%). People who classify themselves as both fund managers and analysts constitute
9%, with the remaining respondents being mainly CEOs (Chief Executive Officers) or CIOs (Chief
Investment Officers). Long-only asset managers (e.g., pension funds and mutual funds) constitute 60% of
our sample, private wealth management companies 21%, hedge funds 11%, with the remaining 8%
representing other types of investors. Our buy-side respondents cover predominantly equities, although
some are fixed income specialists. A number of buy-side respondents, in particular, from private banking
institutions or hedge funds, indicated that they do not focus on any particular asset class.

In order to avoid the response bias common to other studies of ESG factors and SRI, our invitation to the
questionnaire did not specify the survey's topic or which research institute was conducting it, thereby
ensuring that our responses did not come only from people who were already interested in SRI. We also
made sure that various types of institutions were adequately represented.

Each participant was asked to provide information in response to a number of questions relating to his
use of extra-financial information and his perception of the developments in the SRI arena. Percentages
are based on responses received to each question and, consequently, may not reflect the views of all
participants. In addition, participants were encouraged to write more about their views and to provide
specific comments on how they use extra-financial information. Some of these comments are quoted
later in this report.




ECCE – European Centre for Corporate Engagement                                                        5
Growing interest in SRI
A CSR Europe study done in association with Deloitte and Euronext                     FIGURE 1: Expected change in the
in 200310 found that 69% of fund managers and analysts believe                        investment community's level of
that interest in SRI would rise over the next two years. A more                       interest in ESG issues over the
recent Mercer study11 also found expectations of increasing interest                  next 3 years
in corporate governance and sustainability over the coming years.
                                                                                                     Sell-side
This is hardly surprising given the number of new global and pan-
European initiatives, in particular, those related to global climate                                   0% 1%
                                                                                               17%                 18%
change (such as the Carbon Disclosure Project or The Institutional
Investor Group on Climate Change), and the increase in funds
managed under SRI mandates.12

Our respondents also share the view that environmental, social and
governance issues are no longer below investors' radar screen.
81% of sell-side research analysts reported an increase in the
investment community's level of interest in ESG matters over the
                                                                                                       64%
past two years, while only 2% reported a decrease over this period.
More importantly, roughly the same percentage of analysts expect                                 Significantly decrease
                                                                                                 Slightly decrease
an increase in this interest over the coming three years.
                                                                                                 Remain unchanged
                                                                                                 Slightly increase
The information needs of the investment community seem to have                                   Significantly increase
expanded proportionally to the increase in the level of interest in
ESG issues. Our sell-side respondents indicated that investors now
seem to require more information than before about environmental,
social and governance issues. This is also one of the key findings of                 FIGURE 2: The extent to which the
the recent Extel survey,13 which notes that SRI and SRI research                      investment community wants to
continue to grow, and of the aforementioned Mercer study, which                       know more about ESG issues
found growing demand for integration of ESG factors into                                             Sell-side
investment processes.
                                                                                                 13%         10%
One particular observation from the Deloitte and Mercer studies is
that most investors believe that products with SRI characteristics
are likely to remain a niche market, with only a minority of
respondents expecting social and environmental considerations to                                                       28%
become a significant aspect of mainstream investment decisions in
the coming years. This is also one of the observations presented in
the Extel survey: investors are “ frustrated that analysts and brokers                        49%
continue [… ] to treat SRI as a separate discipline.” Instead of                                     Not at all
integrating extra-financial information into all research and analysis                               Slight extent
to make it an integral part of such analysis, SRI is still seen as a                                 Moderate extent
stand-alone research product and is operated independently from                                      Great extent
other mainstream research.




10
   Deloitte, Euronext, CSR Europe [2003], “     Investing in responsible business – the 2003 survey of European fund managers,
   financial analysts and investor relations officers.”
11
   Mercer IC [2006], “ 2006 fearless forecast. What do investment managers think about responsible investment?”
12
   See, e.g., “European SRI Study”by Eurosif [2006].
13
   Thomson Extel and UKSIF [2006], “     SRI & extra-financial survey 2006.”


ECCE – European Centre for Corporate Engagement                                                                              6
The recent Extel survey14 found that almost 50% of the buy-side          FIGURE 3: What percentage of the
European institutions surveyed manage more than 10% of their             total assets managed by your
assets upon an SRI basis, a percentage that has barely changed           institution is managed upon an SRI
each of the past four years the survey has been conducted.               basis?
However, our respondents report a significantly different set of                        Buy-side
numbers: 33% claim that their institution does not manage any
funds at all upon an SRI basis, and only 13% reported a 10% or                      13%
                                                            s
higher share of SRI-based assets in their institution’ portfolio.
This can be caused by several factors:                                          8%                  33%
  • We do not know the Extel sample's methodology, other than
    that it surveyed 124 buy-side European firms. Perhaps the
    survey included only the largest European long-only asset
    managers and pension funds, i.e., investors who are
    traditionally SRI-focused. Our sample, on the other hand, also
                                                                                    46%
    covers many hedge funds and private wealth management
    companies, who do not typically rate SRI high on their agenda.                    None at all
  • Our respondents might not have a clear picture of their                           Less than 5%
    institution's total asset portfolio and, therefore, their estimates               Between 5% and 10%
    might be based only on their own perception of their institution,                 More than 10%
    which does not necessarily reflect its true state.
  • No clear industry standard exists to determine the amount of assets managed upon an SRI basis.
    The main problem is that SRI is often a catch-all, umbrella term that encompasses a whole range of
    strategies, from integrating extra-financial information into the analysis and investment decision
    making, to investing only in companies that are known to be ethical and to focus on sustainable
    development, to implementing negative screening for ethical exclusions (e.g., for gambling or
    armament companies), to merely excluding tobacco companies from the portfolio. Because of this,
                                                                        SRI-based management.”
    different respondents might consider different things to constitute “

This last problem is particularly common in studies of the aggregate SRI market, especially those that
                                                                               s
attempt to report the total amount of SRI investments. Changes in Eurosif’ survey methodology to
include negative screening, regarded as common practice among institutional asset managers, and to
constitute a class of SRI-based asset management, have resulted in over a 10-fold increase in reported
SRI-based assets under management in many European countries. This lack of uniform understanding of
the SRI terminology has been flagged by many of our respondents. Some of them even chose to send us
their SRI investment process guidelines, to clarify what they actually mean by SRI. In particular, some of
them pointed out that what might be seen as SRI-based exclusion can also be simply legal protection:

"We do have restrictions in our investment guidelines with respect to some companies, but these mostly result
from the legal framework (e.g., companies investing in anti-personnel mines, cluster bombs, etc.)."




14
                                     SRI & extra-financial survey 2006.”
     Thomson Extel and UKSIF [2006], “


ECCE – European Centre for Corporate Engagement                                                            7
Importance of ESG factors
Identifying the most important ESG factors
A number of rating agencies take many different ESG factors into account in order to rank companies on
a certain responsibility scale.15 Even though these agencies have identified and combined several
hundred different factors to ultimately yield a single aggregate rating, only a handful of these factors are
actually meaningful in practical terms. After all, it is questionable whether analysts and investors wander
around placing a tick or cross by each of the possible criteria for each company they cover; consequently,
most practice-oriented research in this area uses only the dozen or so key ESG factors that are deemed
to have the most impact on the companies. In this study we did not want to reinvent the wheel, so we
built upon a number of previous studies that had set out to identify these most relevant factors. The
following have been particularly instrumental in establishing the most relevant ESG factors:
- Enhanced Analytics Initiative, whose June 2006 report16 presents the results of the evaluation of
     extra-financial research prepared by sell-side analysts
- Gribben and Gitsham from Just Pensions,17 who surveyed trustees of UK pension funds
- Hesse, in association with Deloitte,18 who established the most important non-financial sustainability
     performance indicators for DAX 30 companies
- Hummels and Timmer from the Universiteit Nyenrode,19 who surveyed the state of SRI investments
     among the largest pension funds in the Netherlands
- Pasheva and the team led by Bassen from Hamburg University,20 who attempted to identify the most
     important corporate responsibility criteria for analysts and investors in the utilities sector

The following 25 ESG factors grouped into five broad categories were used in our study:

            Environmental Responsibility                          Community Involvement
            Management of atmospheric emissions                                                s
                                                                  Societal impact of company’ products and services
            Waste management                                      Promotion of social and economic development
            Development of “  Green”products and services         Contribution to general interest causes
            Existence of environmental policy                     Details about community involvement
            Protection of water resources
            Fixed quantitative environmental targets              Corporate Governance
            Certified environmental management systems            Good investor relations
                                                                  Shareholders rights
            Human Rights                                          Audit and internal controls
                                                                  Remuneration of directors and key executives
            Respect for human rights
                                                                  Board composition
            Elimination of child / forced labour
                                                                  Compliance with the local corporate governance code
            Employment Practices
            Training and development
            Encouraging employee participation
            Integration of HR resources into corporate strategy
            Improvements of health and safety conditions
            Diversity management and equal opportunities
            Management of working hours




15
   Examples include Core Ratings, Deminor, Innovest, Oekom and Vigeo, among others. For an overview see SustainAbility and
                  Values for money. Reviewing the quality of SRI research.”
   Mistra [2004], “
16
                                         Strengthening institutional commitment.”
   Enhanced Analytics Initiative [2006]. “
17
                                   Will
   Gribben and Gitsham [2006]. “ UK pension funds become more responsible? A survey of trustees.”Just Pensions and UK
   Social Investment Forum.
18
    Hesse [2006]. “ Added value, long term. Non-financial sustainability key performance indicators on their way into financial
   reports of German companies.”Deloitte and German Federal Ministry of the Environment.
19
   Hummels and Timmer [2003]. “     Money and morals. The development of socially responsible investing among Dutch pension
   funds.”Universiteit Nyenrode and Dutch Association of Investment Analysts.
20
    Pasheva and Bassen [2006]. “     The influence of corporate responsibility on the cost of capital. An empirical analysis.”
   Universitaet Hamburg, Schlange & Co. and Deutsche Bank.


ECCE – European Centre for Corporate Engagement                                                                             8
Sell-side research analysts
The backbone of our study is determining which ESG factors the finance professionals actually use. We
intuitively expect some factors to be more important than others, so our first task is to establish the
weights assigned to these factors and to determine how they are used. The chart below depicts the
relative importance of the 25 key ESG factors we use throughout this study for the analysis, valuation
and recommendation by the sell-side research analysts. Respondents had to assign a degree of
                                                        not                   very important.”
importance based on a 1-5 Likert scale that ranges from “ important at all”to “

  FIGURE 4: Relative importance of ESG issues for the analysis, valuation and recommendation of sell-side
  analysts

                                        Good investor relations
                                           Shareholders rights
                                     Audit and internal controls
               Remuneration of directors and key executives
                                            Board composition
        Compliance w ith the local corporate governance code
                                     Training and development
                            Encouraging employee participation
               Integration of HR issues into corporate strategy
                                     Respect f or human rights
                             Elimination of child / forced labour
                Improvements of health and safety conditions
          Societal impact of company's products and services
                Diversity management and equal opportunities
                                 Management of w orking hours
                Promotion of social and economic development
                       Management of atmospheric emissions
                                           Waste management
               Development of "green" products and services
                             Existence of environmental policy
                                Protection of w ater resources
                        Contribution to general interest causes
                         Details about community involvement
                       Fixed quantitative environmental targets
                Certified environmental management systems

                                                                1.0       1.5     2.0      2.5   3.0    3.5   4.0    4.5   5.0
                                                                    Not important at all                         Very important
              Corporate Governance                  Human Rights                            Environmental Responsibility
              Employment Practices                  Community Involvement


It is striking that these factors encompass the whole spectrum of importance – from ones that do not
seem to matter much, such as certified quantitative environmental targets, to ones that are very important
to research analysts, such as audit and internal controls. A very pronounced difference was also seen
between the importance of the five major categories we used. Corporate governance undoubtedly
matters the most – the six corporate governance criteria used in our study are also the six most important
ESG factors altogether. This special impact of corporate governance provisions was also mentioned in
the open-ended responses, where our respondents indicated that corporate governance should not be
bundled together with other ESG factors. They claim that corporate governance has a much more direct
effect than any of the other factors on the company's bottom line and performance; in particular, its ability
to promote effective managerial decision making and to prevent opportunistic behaviour that decreases

ECCE – European Centre for Corporate Engagement                                                                                   9
firms' value. In this respect, the respondents indicated that corporate governance analysis is a must-have
for any decision making, and is not considered to be “          extra-financial” in nature. As one of our
respondents mentioned:

                                                                                                       s
"All investors are highly concerned with corporate governance issues. Investigating a company’ corporate
governance practices, such as the risk of expropriating minority shareholders, is a necessary part of our analysis.
We cannot possibly recommend a company to an investor without first making sure that its management team
will not flee with pockets full of cash several months down the road."

Some of the factors relating to employment practices, such as training and development and employee
participation, also score above average on the importance scale. However, the less “      tangible”aspects of
employment practices, such as diversity and equal opportunity, rank visibly lower on the importance
scale. It is also particularly interesting to note that all factors related to environmental responsibility and
community involvement are lingering on the left half of the scale, among the least important factors. This
contrasts with previous studies, in particular, the recent study by Pasheva and Bassen,21 who found
environmental issues to be of utmost importance to analysts. This difference could be attributed to the
fact that their study was limited to the utilities sector, where environmental factors most likely play a
disproportionately important role relative to other sectors. In fact, when we look at the importance of ESG
factors across different sectors, research analysts covering environmentally-sensitive sectors (such as
utilities, chemicals or mining) assign far greater weight to environmental factors than analysts covering
retailers or gaming companies. We discuss these differences between sectors in later sections.

We also observed with interest that research analysts covering small-cap companies assign significantly
less importance to environmental factors than do analysts covering mid- and large-caps. This might be
caused by the fact that companies in environmentally-sensitive sectors, such as oil, gas and mining, tend
to be large in terms of market capitalisation, while small-cap analysts focus on companies in sectors such
as technology, business services and leisure, so we abstain from making any hasty conclusions.

Our findings so far seem to indicate limited use of extra-financial information by research analysts. Does
all this mean that research analysts are completely indifferent to environmental, ethical and social issues,
or that they do not care about pollution, atmospheric emissions, abuse of the workforce and the negative
impact of companies’operations on their local communities? This is most certainly not the case, given
that many non-financial issues affect valuations directly and significantly, and so cannot be ignored by
analysts. However, in a “ negative”way, these factors seem to come into play only when there is concern
about a lack of certain measures. As one of our respondents put it:

"The issues are very important - but in a negative way, i.e., no one pays any attention to
environmental/labour/safety issues until there is a problem - then if there is a problem, we attempt to value it."

On a day-to-day basis, these factors do not seem to play a major role in financial analysis. This should
not necessarily come as a surprise – research analysts should not be expected to be experts in all types
of environmental and labour issues across various countries and legislations. In most cases they expect
the companies' management to deal with these issues on their behalf. In the words of one of our
respondents:

"I don't think it's my job to - indeed, I think it would be counter-productive if I did - have an opinion on the
environmental practices of a facility I've never visited, in a country which quite possibly I've never visited,
either, whose laws and legal practices are obscure, whose language I don't speak, and on which, consequently, I
have no qualification to comment."
21
     Pasheva and Bassen [2006]. “   The influence of corporate responsibility on the cost of capital. An empirical analysis.”
     Universitaet Hamburg, Schlange & Co. and Deutsche Bank.


ECCE – European Centre for Corporate Engagement                                                                          10
One major obstacle to incorporating extra-financial information into a company's valuation is analysts'
limited ability to factor in the costs of issues such as atmospheric emissions or the societal impact of the
          s
company’ products. Given that no generally accepted criteria exist for quantifying ESG data, analysts
have to make judgement calls on how they incorporate this information. A number of our respondents
indicated that they are able to give only a very superficial treatment to this kind of information, e.g., by
recommending a valuation discount to more environmentally-friendly peers of a company with a known
and non-remedied problem with atmospheric emissions, in the example of one of our respondents:

"They [a named company] are probably the world's single largest point source of atmospheric sulphur. They have
very high sulphur dioxide emissions, due to antiquated technology and limited inclination to invest in any form
of remediation. The existence of this problem, and the company's dilatory efforts to deal with it, are something
that I effectively factor into valuation - but only in the most general sense. There are very basic issues I have no
real idea about, for instance, how much the current sulphur emission position costs."




ECCE – European Centre for Corporate Engagement                                                                  11
Investors
Buy-side respondents' view of the importance of ESG factors is similar to that of sell-side analysts. The
table below depicts the importance weights attached to each of our 25 key factors on a 1-5 Likert scale
             not
ranging from “ important at all”to “very important."

  FIGURE 5: Relative importance of ESG issues to investors' investment decisions and recommendations


                                        Shareholders rights
                                  Audit and internal controls
                                    Good investor relations
      Compliance w ith the local corporate governance code
             Remuneration of directors and key executives
                                           Board composition
                          Elimination of child / forced labour
                                   Respect for human rights
                                  Training and development
                         Encouraging employee participation
            Integration of HR issues into corporate strategy
              Improvements of health and safety conditions
       Societal impact of company's products and services
              Diversity management and equal opportunities
                          Existence of environmental policy
                                        Waste management
             Promotion of social and economic development
                             Protection of w ater resources
                            Management of w orking hours
                    Management of atmospheric emissions
            Development of "Green" products and services
                     Details about community involvement
                    Contribution to general interest causes
              Certified environmental management systems
                     Fixed quantitative environmental targets

                                                             1.0        1.5     2.0     2.5   3.0   3.5    4.0      4.5      5.0
                                                                 Not important at all                            Very important


                       Corporate Governance                  Human Rights                     Environmental Responsibility
                       Employment Practices                  Community Involvement




These results are quite similar to the perceptions of the sell-side analysts, both in terms of the relative
importance of the ESG factors and the difference between various types of factors, with environmental
responsibility and community involvement lagging at the low end of the spectrum. Again, corporate
governance indicators are the most important ESG factors in the eyes of the buy-side community, and
again our respondents indicated that corporate governance and SRI are two very distinct concepts:

"I do not believe that corporate governance issues can or should be 'bundled' with SRI issues. The former are
about improving returns to investors, the latter are not."
"Corporate governance is of utmost importance, as the guys running the company do not, in most cases, have the
same interest as their shareholders."



ECCE – European Centre for Corporate Engagement                                                                                    12
Our results again contrast with the findings of the Extel 2006 survey, which asked European investors to
rank the importance of SRI data related to corporate governance, environmental performance, ethical
responsibility and social responsibility. These four factors roughly correspond to our five key ESG groups,
and we thus would expect the magnitude and relative importance of each of these groups to be similar
between these two studies. However, the Extel survey found little difference between these factors, three
out of four of which scored notably above four on the 1-5 scale, with environmental performance (4.47)
coming just a whisker ahead of corporate governance (4.45) and social responsibility (4.37). This
difference in results between the two studies may be attributed to their different methodologies or to a
potential selection bias. However, it may also be that the respondents of the well-known Extel survey
wanted to show themselves in a better light than our respondents, and therefore overestimated the
importance of SRI to their analysis.

In our survey, buy-side analysts seem to focus more on extra-financial issues than fund managers for
information related to environmental responsibility, human rights, employment practices and community
involvement. However, there is no difference between these two groups when it comes to corporate
governance issues, which again reinforces the view that corporate governance information is used
differently from information on other ESG issues.

Investors who work predominantly with equities focus more on environmental and human rights than
fixed income-oriented analysts do; however, no meaningful difference distinguishes these two groups in
factors related to employment practices and community involvement. From the corporate governance
factors, compliance with the local corporate governance code is much more important for fixed income
investors, while shareholder rights matter much more for those focusing on equities. In line with
expectations, hedge fund managers and investors managing "alternative" portfolios and asset classes
demonstrated less focus than other investor types on all ESG factors except those relating to corporate
governance issues, while long-only investors, such as pension funds or mutual funds, focus the most on
ESG factors. Interestingly, private bankers seem to focus less on ESG factors, especially the ones
related to corporate governance, than long-only investors, which is remarkable given that we would
expect their products to be more tailored to the investment needs of the individual investors, who are
generally believed to be more sensitive than institutional investors to ethical or environmental issues.

Not surprisingly, investors with "passive" index-tracking portfolios do not attach high importance to extra-
financial information. A number of fund managers who manage their portfolios only passively indicated
that this study is not really relevant for them, or simply declined to participate in our study:
"I am an indexed fund manager, this [questionnaire] is not really applicable for me."
"We are managing our funds only passively, this [survey] is not relevant to us."
This observation suggests that future studies on the use of extra-financial information should not treat
index-oriented managers in the same way as active investment managers. As their portfolio essentially
mirrors the underlying index, these managers may have little need for their own judgement, and instead
need to hold only the stocks that constitute the index, whether or not those stocks are environmentally or
socially responsible. However, given that indices are often tracked with restricted investment universes
anyway, an SRI-based universe might be very well suitable for regular index tracking. It may be that one
day a range of new enhanced index-tracking products that also incorporate extra-financial information will
emerge.




ECCE – European Centre for Corporate Engagement                                                          13
Mismatch in expectations?
We intuitively expect sell-side research analysts to produce analyses and output that meet the needs of
buy-side investors. After all, there would be little point in producing research reports that do not feature
the issues and analyses that investors want to see. Applying this fundamental assumption to the use of
extra-financial information, we would expect to see little difference in the importance of ESG factors in the
analyses, valuation and recommendation done by the research analysts, or in their importance to the
buy-side community.

In our survey we compared the weights that research analysts and investors attach to the ESG factors. In
addition, we also asked research analysts to state the factors' perceived importance to investors' decision
making. The findings are reported in the table below.

FIGURE 6: Relative importance of ESG issues to analysts, investors and investors as perceived by analysts.
Shaded factors show a difference between analysts and investors that is significant at the 0.01 level.
                                                                                  Investors
                                                                Analysts in                         Investors in
                                                                                perceived by
                                                              their research                      their decisions
                                                                                   analysts
                 Existence of environmental policy                    2.57           3.05               3.10
Environmental
Responsibility   Certified environmental management systems           2.24           2.71               2.75
                 Fixed quantitative environmental targets             2.36           2.83               2.74
                 Development of "green" products and services         2.59           3.04               2.92
                 Management of atmospheric emissions                  2.72           3.18               2.99
                 Protection of water resources                        2.57           3.01               3.02
                 Waste management                                     2.67           3.05               3.04

                 Respect for human rights                             3.15           3.45               3.69
 Human Rights
                 Elimination of child / forced labour                 3.14           3.50               3.76

                 Integration of HR issues into corporate strategy     3.23           3.33               3.41
 Employment
  Practices      Diversity management and equal opportunities         2.89           2.97               3.15
                 Improvements of health and safety conditions         3.02           3.11               3.36
                 Encouraging employee participation                   3.32           3.32               3.42
                 Management of working hours                          2.83           2.99               3.00
                 Training and development                             3.62           3.60               3.57

                 Promotion of social and economic development         2.81           2.83               3.03
   Community
  Involvement    Details about community involvement                  2.46           2.61               2.86
                 Contribution to general interest causes              2.47           2.63               2.81
                 Societal impact of company's products and services   2.92           3.02               3.18

                 Compliance with corporate governance code            4.11           4.24               4.29
   Corporate
  Governance     Good investor relations                              4.73           4.67               4.50
                 Audit and internal controls                          4.51           4.51               4.51
                 Shareholders' rights                                 4.51           4.67               4.54
                 Remuneration of directors and key executives         4.12           4.31               4.21
                 Board composition                                    4.12           4.28               4.16




Many of these factors appear to be more important to the buy-side than the sell-side. In particular, all
factors related to environmental responsibility and human rights score higher on the importance scale for
investors than for the research analysts, together with some factors related to community involvement.




ECCE – European Centre for Corporate Engagement                                                                14
Our findings corroborate the results of the Deloitte and CSR Europe study,22 which observed that sell-
side analysts are more sceptical than investors about non-financial risks' impact on shareholder value or
growth, and about SRI's potential to become a significant aspect of mainstream investment decision
making. Sell-side analysts were also found to be less likely than fund managers and buy-side analysts to
use information on companies’  social and environmental performance.

Our findings might suggest that investors' needs and wants with regard to environmental, social and
governance issues are not necessarily met by the research analysts and their reporting. Interestingly,
however, research analysts seem to be aware of this discrepancy. When asked to give their view of these
issues' perceived importance to investors, their ranking was very close to, and in many cases spot-on
with, the actual ranking by investors. This could imply that research analysts are very well aware of this
difference, but just do not act to fill this gap. We find no obvious explanation for this difference other than
speculating that sell-side analysts and institutions might not have an incentive to spend resources on
analysing extra-financial information. Given that written research is gradually declining in importance
relative to more service-oriented factors,23 focusing on enhancing the analysis simply might not be worth
the effort from the perspective of the sell-side community.

As there seems to be a discrepancy between the importance                           FIGURE 7: To what extent do you
attached to ESG issues by investors and research analysts, we                       discuss ESG practices with the sell-
were interested to see the level of communication between these                     side research analysts covering the
two groups. We asked our buy-side respondents about the extent                      companies you invest in?
to which they discuss ESG practices with the sell-side analysts,                                  Buy-side
and found that there is, indeed, only limited dialogue. 22% of our
                                                                                                   4%
respondents indicated that they do not discuss these issues at all,
                                                                                                              22%
while only a third indicated that they discuss them to a moderate
or great extent.                                                                        28%

This finding is contrary to our expectations. After all, if it is
investors who want more information on ESG issues, they should
be responsible for leading the dialogue with sell-side analysts.                                   26%
However, one of the later sections of this report presents the
                                                                                20%
findings on the various sources of extra-financial information used
by investors. Given that sell-side research comes significantly                   Not at all
behind in-house research and direct data from the companies, it                   Only slight extent
                                                                                  Neutral
may be that investors simply prefer other sources of extra-
                                                                                  Moderate extent
financial information to that made available by sell-side analysts.               Great extent
However, the true reason might be simply related to the fact that
sell-side research analysts do not include extra-financial information to a degree that the buy-side would
see as satisfactory and, consequently, investors choose not to engage in a dialogue to the extent that
they would do otherwise.

Buy-side analysts seem to discuss extra-financial issues with sell-side analysts to a larger extent than
fund managers do. At the same time, hedge fund representatives talk the least with the sell-side about
ESG factors, but are generally the most satisfied with the quality of sell-side research. At the same time,
however, they also pay the least attention to these factors in their decision making. As far as information
on corporate governance factors is concerned, however, hedge funds are the least satisfied group, which
also highlights the relative importance of corporate governance information to hedge funds.




22
   Deloitte, Euronext, CSR Europe [2003], “     Investing in responsible business – the 2003 survey of European fund managers,
   financial analysts and investor relations officers.”
23
   See “Mainstreaming responsible investment”by World Economic Forum and AccountAbility [2005].


ECCE – European Centre for Corporate Engagement                                                                            15
Mainstreaming ESG issues and SRI
Sell-side research analysts
Despite SRI's growing importance, the winds of change have not managed to reach the whole investment
community just yet. It may be that many such initiatives are targeting only a handful of dedicated SRI
specialists, leaving the general financial community behind. In order to find out whether this is indeed the
case, we asked our sell-side respondents several questions seeking to understand whether the company
they work for – a sell-side broker – has dedicated policies, research products and personnel in place to
deal with environmental, social and governance issues.

  FIGURE      8:   Does    your       FIGURE      9:    Does    your      FIGURE      10:   Does    your
  institution have a developed        institution   offer  dedicated      institution   have   dedicated
  policy regarding ESG issues in      research products focusing on       research personnel focusing on
  research?                           ESG issues?                         ESG issues?

                Sell-side                           Sell-side                       Sell-side

        Don’t                               Don’t                               Don’t
        know                                know                                know
        19%                                 14%                                 12%
                            Yes                                 Yes                             Yes
                            38%                                 38%                             37%




         No                                No                                  No
        43%                               48%                                 51%



Only 37-38% of our respondents indicated that their companies are indeed addressing these issues,
while between 43% and 51% of respondents stated that their institution has no such initiatives. What we
found particularly surprising is the large number of respondents who stated that they simply did not know
whether their companies have such policies, products and personnel in place. This suggests that
research analysts are kept out of the loop with regard to ESG initiatives introduced in their companies.

This lack of a developed policy regarding environmental, social and governance issues in research
impacts very profoundly the actual use of extra-financial information. Putting it very simply, having a
developed ESG policy encourages using extra-financial information and incorporating it into the analysis
and valuation performed by the research analysts. The table below compares the responses of analysts
who indicated that their institution has a developed policy toward ESG issues in research to those who
stated that their institution has no such policy. The scale goes from 1 (not important at all) to 5 (very
important). The significant results indicate that the existence of such a policy makes analysts incorporate
more extra-financial information into their research. Corporate governance is not very significant here,
which again confirms our findings that research analysts treat governance criteria differently from
environmental or social factors, almost all of which are used more by analysts from brokerage houses
that have a developed ESG policy than by those from brokerage houses that don't.




ECCE – European Centre for Corporate Engagement                                                            16
FIGURE 11: Impact of existence of ESG policy on the relative importance of ESG issues for sell-side research
analysts. Shaded factors show a difference that is significant at the 0.1 level.

                                                                      ESG policy   No ESG                     Sig.
                                                                                             df    t-stat
                                                                        exists      policy                  2-tailed
                 Existence of environmental policy                       2.89       2.26     165   3.15      0.002
Environmental
Responsibility   Certified environmental management systems              2.56       1.93     161   3.40      0.001
                 Fixed quantitative environmental targets                2.71       2.05     163   3.47      0.001
                 Development of "green" products and services            2.82       2.40     161   2.01      0.047
                 Management of atmospheric emissions                     2.93       2.45     156   2.24      0.027
                 Protection of water resources                           2.80       2.23     156   2.79      0.006
                 Waste management                                        2.91       2.42     158   2.30      0.023

                 Respect for human rights                                3.44       2.92     158   2.47      0.014
 Human Rights
                 Elimination of child / forced labour                    3.51       2.86     147   2.74      0.007

                 Integration of HR issues into corporate strategy        3.43       3.09     173   1.89      0.061
 Employment
  Practices      Diversity management and equal opportunities            3.12       2.76     172   2.01      0.046
                 Improvements of health and safety conditions            3.22       2.83     171   2.25      0.026
                 Encouraging employee participation                      3.39       3.21     174   1.08      0.283
                 Management of working hours                             3.09       2.59     172   2.92      0.004
                 Training and development                                3.85       3.50     175   2.14      0.034

                 Promotion of social and economic development            3.02       2.55     172   2.70      0.008
   Community
  Involvement    Details about community involvement                     2.63       2.26     172   2.21      0.029
                 Contribution to general interest causes                 2.70       2.30     170   2.28      0.024
                 Societal impact of company's products and services      3.22       2.78     169   2.25      0.026

                 Compliance with corporate governance code               4.24       3.90     183   2.56      0.011
   Corporate
  Governance     Good investor relations                                 4.82       4.68     182   1.48      0.141
                 Audit and internal controls                             4.51       4.52     183   -0.04     0.970
                 Shareholders’rights                                     4.63       4.47     183   1.38      0.169
                 Remuneration of directors and key executives            4.33       4.06     183   2.36      0.020
                 Board composition                                       4.22       4.11     183   0.83      0.407


Even if sell-side brokers have developed policies and checks in place to ensure that extra-financial
information is incorporated into research, it is up to individual analysts to incorporate these factors. Given
                                                                                    s
that it takes time and effort to conduct a thorough investigation of a company’ environmental or ethical
impacts, the analyst, typically seriously constrained in time and covering a handful of companies, might
not be able to devote the time and effort necessary to conduct such an investigation. We therefore expect
analysts who cover many companies to focus less on extra-financial information in their research than
analysts who cover only a few companies.

We test this hypothesis in our study by comparing the mean assigned to the ESG factors for analysts
who cover less than 10 companies, and 10 or more companies. The table below reports the results of an
independent samples t-test using a scale from 1 (not important at all) to 5 (very important). It is not
surprising that analysts who cover fewer companies have more time to spend on thorough analysis and
are therefore more able to incorporate environmental, social and governance issues into their analysis,
than analysts who cover a large number of companies.




ECCE – European Centre for Corporate Engagement                                                                   17
FIGURE 12: Impact of the number of companies covered on the relative importance of ESG issues for sell-side
research analysts. Shaded factors show a difference that is significant at the 0.1 level.
                                                                       Covering    Covering
                                                                                                                Sig.
                                                                        1 to 9    10 or more   df    t-stat
                                                                                                              2-tailed
                                                                      companies   companies
                 Existence of environmental policy                       2.72        2.37      218   1.96      0.051
Environmental
Responsibility   Certified environmental management systems              2.36        2.12      214   1.45      0.148
                 Fixed quantitative environmental targets                2.50        2.20      215   1.78      0.076
                 Development of "green" products and services            2.71        2.43      213   1.52      0.130
                 Management of atmospheric emissions                     2.91        2.43      208   2.54      0.012
                 Protection of water resources                           2.72        2.34      205   2.10      0.037
                 Waste management                                        2.84        2.46      209   2.04      0.043

                 Respect for human rights                                3.35        2.96      206   2.05      0.041
 Human Rights
                 Elimination of child / forced labour                    3.33        2.97      190   1.71      0.090

                 Integration of HR issues into corporate strategy        3.47        2.98      231   3.16      0.002
 Employment
  Practices      Diversity management and equal opportunities            3.04        2.73      229   1.99      0.048
                 Improvements of health and safety conditions            3.16        2.90      227   1.67      0.097
                 Encouraging employee participation                      3.52        3.15      231   2.51      0.013
                 Management of working hours                             2.94        2.69      228   1.63      0.104
                 Training and development                                3.80        3.43      232   2.66      0.008

                 Promotion of social and economic development            2.95        2.58      226   2.34      0.020
   Community
  Involvement    Details about community involvement                     2.61        2.29      227   2.12      0.035
                 Contribution to general interest causes                 2.63        2.29      227   2.25      0.026
                 Societal impact of company's products and services      3.10        2.67      225   2.68      0.008

                 Compliance with corporate governance code               4.21        4.07      245   1.25      0.214
   Corporate
  Governance     Good investor relations                                 4.87        4.66      246   2.93      0.004
                 Audit and internal controls                             4.61        4.46      245   1.57      0.119
                 Shareholders’rights                                     4.62        4.45      246   1.76      0.080
                 Remuneration of directors and key executives            4.23        4.05      246   1.80      0.073
                 Board composition                                       4.19        4.11      246   0.76      0.450


When analysing the impact of the number of companies covered on the use of extra-financial information,
we must note that this impact is very closely linked to the research analyst's experience. To put it simply,
a rookie analyst would be given only a handful of companies to cover, but a more experienced analyst
could cover even the whole sector on his own. Because of this, the effect of the breadth of coverage can
be twofold:
• Analysts covering more companies can spend less time analysing each individual company and are
    therefore forced to cut corners and focus less on extra-financial information.
• Analysts covering more companies are more experienced, and therefore possibly also older, which
    could imply that they are so set in their own ways of performing analyses that they have not
    embraced the recent trend of using extra-financial information.
Given that analysts who cover fewer companies or are less experienced indicate that they discuss ESG
issues with the companies they cover to a larger extent than do other analysts, we believe that there
might be at least a grain of truth in our speculation.




ECCE – European Centre for Corporate Engagement                                                                     18
Investors
In contrast to our sell-side respondents, almost half of investors indicated that their companies are
addressing ESG issues. In addition, a much lower percentage of buy-side respondents indicated that
they do not know whether their company has ESG policies, products and personnel in place, suggesting
that the buy-side is more aware of the general topic of SRI than is the sell-side.

  FIGURE      13:   Does   your            FIGURE      14:    Does   your          FIGURE      15:   Does    your
  institution have a developed             institution   offer  dedicated          institution   have   dedicated
  policy regarding ESG issues in           investment products focusing            investment personnel focusing
  investing?                               on ESG issues?                          on ESG issues?

             Buy-side                                  Buy-side                                    Buy-side
          Don’t                                       Don’t                                    Don’t
          know                                        know                                     know
          10%                                          5%                                       9%


                            Yes
                                                                                                                 Yes
                            44%              No
                                                                    Yes                                          47%
                                            40%
                                                                    55%                   No
     No
                                                                                         44%
    46%




Given that our respondents come from a variety of backgrounds, we wanted to investigate whether the
institution's size and type are somehow linked to the extent to which it implements ESG measures in the
investment process. Intuitively, we expected to see a positive relationship between the institution's size
and its implementation of ESG measures, because a large investor has more manpower and more
resources than a small one to support a dedicated SRI team. We also expected long-only investors
(especially pension funds) to be more associated with ESG practices than hedge funds or private wealth
management companies, which would be in line with our finding that these investors place less
importance on ESG factors than long-only investors do. In the chart below we show the percentage of
respondents who indicated that their institution has a developed ESG policy, or dedicated investment
products or personnel, for four size categories and the three most represented investor types.


  FIGURES 16 and 17: Existence of ESG policies, investment products and investment personnel

              By Total Assets under Management                                          By Investor Type
  100%                                                            100%

   80%                                                            80%

   60%                                                            60%

   40%                                                            40%

   20%                                                            20%

    0%                                                             0%
            <€1bn       €1bn-10bn   €10bn-50bn     >€50bn                  Hedge Fund     Private Banking   Long-only

                    Developed ESG policy         ESG investment products      ESG research personnel




ECCE – European Centre for Corporate Engagement                                                                         19
Larger institutions show more ESG awareness than small institutions, with between 60% and 80% of our
respondents from institutions managing over €    50bn in assets saying that they have dedicated ESG
policies, products or an expert research team, compared to only 20% of respondents from institutions
managing less than €1bn in assets. Similarly, long-only investors are at the forefront of ESG awareness,
with almost 60% of the “  Yes”respondents, while hedge funds are the least likely investor type to tackle
ESG issues. Interestingly, private banking investors seldom have developed ESG policies or dedicated
SRI personnel, but they often have dedicated investment products, which might reflect pressure for
ethical or environmental investments coming from individual investors.

While interpreting these results we must give a word of caution. The size and type of investor are two
measures that are highly correlated. In particular, long-only investors (pension funds and mutual funds)
also tend to be the largest institutional investors by assets under management. However, our results
indicate that large hedge funds and private banking companies are much more likely to have ESG
policies, products and personnel in place than are small hedge funds and private banking companies.

A major consideration on the buy-side is that it is one thing to have a team of specialist SRI analysts who
assist the core investment team with investment decisions by providing input on extra-financial issues
when required, but quite another thing to expect all portfolio managers and buy-side analysts to include
                                                                                                    s
these issues in their decision making on a daily basis. In a recent study prepared for the UK’ Marathon
Club,24 a majority of buy-side respondents indicated that a team of specialist analysts should be
employed to research, vote and engage with companies on relevant corporate governance and corporate
responsibility issues. However, the study's authors acknowledged that integrating the two teams (i.e., the
core investment team and the SRI team) may not always result in the full integration of corporate
governance and/or responsibility into buy/sell decisions. It is also not certain whether this continued
separation of the SRI team from mainstream investments is the best policy in the long run, as it might
continue to restrict the analysis of extra-financial information to a handful of SRI specialists, thus keeping
SRI investing as a niche strategy. Several of our buy-side respondents indicated that they are not
concerned with ESG issues at all, and leave the analysis of extra-financial information to their SRI team:

"The inclusion of non-financial information (environment, human rights, etc.) is not part of my job, but belongs
to the SRI team."
"Because I am not part of the team working on SRI issues, this [study] is mostly irrelevant to me."

In general, our buy-side respondents indicated that they mainly integrate ESG issues into their analysis
of equities. Integration of extra-financial information into the analysis of fixed income securities, real
estate or private equity is done to a much lesser extent, although a number of our respondents
mentioned that they have started developing a framework for these asset classes as well. However, a
handful of investors use an integrated framework for analysis that covers various asset classes:

"[Extra-financial information is] usually allocated to a specific company that may be present in one or more asset
classes"




24
                    Investment beliefs relating to corporate governance and social responsibility,”University of Bath.
     Guyatt [2005], “


ECCE – European Centre for Corporate Engagement                                                                          20
Impact of extra-financial information

It is becoming generally accepted that extra-financial information might help to explain companies'
performance. When asked to explain what extra-financial information's impact is, however, many finance
professionals are unable to clearly state what it actually affects: revenues, profitability, market value,
share price performance or some other measure.

A number of previous studies suggest that ESG factors might influence the reputation of a company and
its brand.25 However, while the widely publicised examples of corporate failures, such as child labour at
                                                                  s
Nike, the Ogoni struggle against Shell in Nigeria or Wal-Mart’ discriminatory labour practices, clearly
                                                                            s
demonstrate that the impact of extra-financial information on the company’ reputation can be immense,
links with market value and financial performance do not yet seem to have been established beyond
reasonable doubt. Nonetheless, the UK’ Just Pensions 2006 study26 found that almost all of the ESG
                                          s
issues included in the survey are believed to have either “some”or a “  substantial”impact on the value of
FTSE companies, especially in the long term. A CSR Europe study, done in association with Deloitte and
Euronext in 2003,27 found that 79% of fund managers and analysts believe that good management of
                                                               s
social and environmental risks positively impacts a company’ market value in the long term, but has little
impact in the short term. This also confirms the findings of a previous survey commissioned by CSR and
Euronext in 2001,28 which reported that 86% of European fund managers and financial analysts believe
                                                                       s
that social and environmental risk management improves a company’ market value in the long term, but
only 30% believe in such management's short-term effects.

In our study we wanted to assess the           FIGURE 18: Impact of ESG factors on brand and reputation,
expected impact of environmental, social       market value and financial performance of companies in the
and governance factors on the brand and        short and long term
reputation, market value and financial
                                                                               Sell-side
performance of companies in the eyes of
our respondents. Here we defined short
                                                  Brand and
term as the next 1-2 years and long term
                                                  reputation
as the next 5-10 years.        Brand and
reputation appear to be affected the most,
both in the short and long terms. On the        Market value

other hand, ESG factors do not seem to
dramatically impact either the market             Financial
value (average of 3.2 on a scale ranging        performance

from 1 - not important at all to 5 – very
                                                             1.0            2.0          3.0         4.0           5.0
important) or financial performance of the
                                                              Not important at all                     Very important
companies (average of 3.0). However, the
impact on both market value and financial                                Short term          Long term
performance is higher in the long term
than in the short term,29 which corroborates the belief that extra-financial factors, in particular, those
related to environmental issues, have a long-term impact.




25
   See, in particular, studies by Charles Fombrun and publications by the Reputation Institute.
26
                                   Will
   Gribben and Gitsham [2006], “ UK pension funds become more responsible? A survey of trustees,”Just Pensions and UK
   Social Investment Forum.
27
   Deloitte, Euronext, CSR Europe [2003], “     Investing in responsible business – the 2003 survey of European fund managers,
   financial analysts and investor relations officers.”
28
   Taylor Nelson [2001], “  The European Survey on SRI and the Financial Community.”
29
   Results (not reported here) of a paired samples t-test are significant at the 0.01 level for both measures.


ECCE – European Centre for Corporate Engagement                                                                            21
Impact on valuation and expected returns

In the previous sections we observed that many ESG factors seem                     FIGURE 19: Do investors grant a
to matter only when they bring bad news, but are largely ignored                    premium to companies that are
when the corporate machine is working well. If only negative impact                 environmentally and socially
is factored in into the analysis and valuation, does this mean that                 responsible?
“bad” companies are punished for their misdeeds, but “        good”                                 Sell-side
companies are not rewarded for their “goodness”  ?
                                                                                                    4% 7%
We first posed this question to sell-side analysts and found that they
do not really believe that investors grant premium valuation                            25%
(typically expressed in terms of multiples such as P/E or
EV/EBITDA) to socially or environmentally responsible companies.                                                     35%
Even though our respondents were generally divided in their
responses, many of them suggested that environmental and social
responsibility works only one way, and is biased toward discount
rather than premium, thus acting as punishment, rather than reward:                           29%
                                                                                                    Definitely not
"In our view investors are only profit oriented and should act                                      Rather not
accordingly. Environmental or social issues would only be a question as                             Undecided
                                                                                                    Rather yes
long as they protect the company's revenues and profitability from erratic                          Definitely yes
changes. Nobody would pay a premium for a company that acts socially
or environmentally responsible; that would be considered a 'condition sine qua non.'"

However, some evidence also suggests that investors are willing to pay a premium for “good”companies.
                    30
Soyka and Feldman, who surveyed fund managers in the late 1990s, found that investors are willing to
pay a premium for companies who invest in environmental health and safety improvements. The already
quoted CSR Europe study from 2003 also found that 51% of fund managers and 37% of financial
analysts would grant a premium to socially responsible companies. However, after they looked more
closely at the responses, they observed that engagement in CSR seemed to be used as a proxy for
management quality, while poor social and environmental practices were likely to “trigger suspicion and
numerous questions.”Consequently, the "CSR premium" is mostly a "gut feeling" that the company is run
well, while the "CSR discount" simply reflects high risk characteristics, which is in line with our
observations of ESG factors' one-sided impact. As proposed by one of our buy-side respondents:

"I believe that, ceteris paribus, a company with high SRI standards will be, on the whole, a better-managed
company, more likely to succeed in the long term. I would therefore regard SRI issues as a 'health check' for my
investments."




30
                               Investor attitudes toward the value of corporate environmentalism.”In Environmental Quality
     Soyka and Feldman [1998], “
     Management.


ECCE – European Centre for Corporate Engagement                                                                            22
In order to better understand this link between ESG factors and valuation and expected returns, we
asked the buy-side respondents whether companies that score “            low“on each of the main ESG
                                                                 high”or “
                                                           average”companies, and whether they should
criteria should trade at a premium or discount relative to “
be associated with higher or lower returns. Our results show that the truth may well be somewhere in
between these two extreme views. This is a summary of the key patterns that emerge from our
responses:

•   Our respondents associate better ESG performance potentially with premium valuation and higher
    returns, while worse ESG performance gives rise to valuation at a discount by peers, and to lower
    returns.
•   The perceived effect of most ESG criteria is not very pronounced – roughly half of the respondents do
    not believe that environmental responsibility, human rights, employment practices and community
    involvement have any effect on valuation and returns.
•   Confirming a potential negative bias, “ badness”has a marginally stronger impact than “    goodness,”
    with more respondents expecting valuation discount and lower returns for “      bad” companies than
    valuation premium and higher returns for “     good” companies; however, this effect is not very
    pronounced.
•   Corporate governance factors stand out from the rest of the ESG factors by having a much stronger
    association with valuation and returns.
•   Buy-side analysts have a significantly more pronounced view of valuation and returns than do fund
    managers. Analysts associate “   bad”companies with more discount and lower returns, and “     good”
    companies with more premium and more higher returns, than fund managers do. This trend,
    however, does not work for corporate governance factors, which are treated equally by fund
    managers and buy-side analysts.
•   Fixed income specialists associate “ bad”corporate governance with significantly lower returns than
    do investors focusing on equities; however, there is no difference between these two groups as far as
    “good”corporate governance is concerned. There is also no difference with respect to the perceived
    impact on valuation.

We also noted some interesting observations on the differences between various investor types (long-
only asset manager, hedge funds and private banking) when assessing ESG factors' impact on valuation
and returns:
• Hedge funds associate “     bad”corporate governance with valuation discount to a greater extent than
    do other investor types. There is no difference between investor types in the perceived impact of
    scoring low on other ESG factors.
• There is no difference between investor types in their perceived impact of “            good” corporate
    governance; all investor types associate it with potential valuation premium to the same extent.
• Hedge funds are the least likely to expect premium valuation from companies that score highly on
    ESG factors other than corporate governance.

Our respondents seem to agree that extra-financial information is not fully priced into stock prices at this
time, which could mean that there is still money to be made from following SRI-focused investment
styles. In the words of one of our buy-side respondents:

"[As for] where socially responsible companies 'should' trade relative to the market, I would think that on most
issues they currently are not being priced in. However, this may change in the future, which will become a driver
of performance. I just don't think that move is happening yet."




ECCE – European Centre for Corporate Engagement                                                                23
 FIGURE 20: Valuation level of companies scoring “         low”on ESG criteria relatively to companies
                                                  high”and “
         average”
 scoring “
                                  High ESG score                                                Low ESG score

  Environmental
                   13%           42%                     45%                           38%                     45%               16%
  Responsibility

  Human Rights 11%              35%                     54%                            37%                 41%                   21%

    Employment
               10%              38%                     52%                             43%                    41%               16%
     Practices

     Community
                5%        24%                     70%                                          66%                         28%     5%
    Involvement

    Corporate
                          37%                41%               22%              16%            31%                    50%
   Governance

                            Definitely a      Rather a           Neutral / no impact         Rather a           Definitely a
                            premium           premium            on valuation                discount           discount




                                                  high”and “
 FIGURE 21: Expected returns of companies scoring “        low”on ESG criteria relatively to companies
         average”
 scoring “

                                      High ESG score                                                 Low ESG score

    Environmental
                   12%                42%                 44%                            39%                      44%              13%
    Responsibility

    Human Rights     9%          34%                     54%                                 46%                     39%               12%

      Employment
                 9%               38%                    51%                                 45%                     39%               12%
       Practices

       Community
                  6%       21%                     72%                                             67%                       24%        7%
      Involvement

      Corporate
                          30%               40%                 29%                    27%               38%                 34%
     Governance

                            Definitely        Rather             Neutral / no impact         Rather             Definitely
                            higher            higher             on returns                  lower              lower




ECCE – European Centre for Corporate Engagement                                                                                              24
Sources of information on ESG issues
Given that the number of research providers offering dedicated ESG research products has risen
exponentially in recent years, we were interested to find the extent to which investors use ESG
information from various sources. We were inspired here by the Extel survey,31 which asked respondents
to rate the importance of various sources of SRI or extra-financial data. In our survey we replicated this
question and obtained similar results, although visibly lower in magnitude of importance.

         FIGURE 22: To what extent do you use the following sources of SRI/extra-financial data in your
         analysis and decision making?
                                                        Buy-side

                                    In-house research

                          Direct data from companies

                      Research from sell-side brokers

             Research from independent SRI providers

                            Government organisations

                     SRI/extra-financial specific media

                                                          1            2         3              4               5
                                                          Not at all                            To a great extent



It is remarkable that in-house research and direct data from companies seem to be the two most used
sources for extra-financial information. Hedge funds most often use data coming directly from companies,
while private banking investors use mainly research from sell-side brokers. Long-only investors (in
particular, large ones) are by far the primary users of research from independent SRI providers, as well
as information coming from SRI-specific media. All types of investors seem to use in-house research to a
similar extent.

Our findings are roughly in line with the study by CSR Europe and Deloitte,32 who found that written
information from companies is the main direct source of information on which investment decisions are
based. SRI-specific data, such as sustainability indices, were not found to be widely used as a guide to
CSR performance in either their or our study. A plausible explanation for this was put forward by one of
our buy-side respondents:

"Given a relative lack of data on these [ESG] issues, they have little impact on the stocks we chose to invest in. I
agree the issues are important, but we are constrained by data availability."
It seems that the existing SRI data providers do not provide the type of data that investors are really
looking for. This proposition is highlighted in the report prepared by SustainAbility and Mistra,33 which
pointed out that information coming from companies is rarely verified by these providers, and that ESG
issues are rarely analysed from the perspective of investment value drivers. Unfortunately, our study can
offer no further insight into this matter.


31
   Thomson Extel and UKSIF [2006], “     SRI & extra-financial survey 2006.”
32
   Deloitte, Euronext, CSR Europe [2003], “     Investing in responsible business – the 2003 survey of European fund managers,
   financial analysts and investor relations officers.”
33
   SustainAbility and Mistra [2004], “Values for money. Reviewing the quality of SRI research.”


ECCE – European Centre for Corporate Engagement                                                                            25
 ESG reporting by companies
We have already established that ESG factors matter both to                            FIGURE 23: Do you think that
investors and research analysts, but we also want to assess                            the communication practices
whether companies have caught up with this trend and incorporated                      with respect to ESG issues by the
information on environmental, social and governance factors into                       companies you cover have
their discussions with these parties. 72% of sell-side research                        improved over the past two
                                                                                       years?
analysts in our survey believe that company reporting with respect
to ESG factors has improved over the past two years. In contrast,                                    Sell-side
only 7% observed worsening ESG reporting quality.
                                                                                                       0%   6%
                                                                                               21%
The improved ESG reporting may have something to do with the
change in legislation on reporting material non-financial                                                          21%
sustainability information. The famous Article 46 of EU Council
Directive 78/660/EEC on the content of annual reports requires
disclosure of extra-financial information in annual reports – a trend
already incorporated into national legislation in Germany and a
number of other European countries. Hesse34 examined the extra-
                                                                                                     52%
financial reporting of DAX-listed German companies and found that
14 out of 16 companies studied planned to include non-financial                                Definitely not improved
                                                                                               Rather not improved
sustainability information into their 2005 annual report. This might                           Undecided
suggest that improved reporting of extra-financial information by                              Rather improved
companies may not be driven only by investors' needs.                                          Definitely improved

It also is not clear whether this improvement in company reporting is still considered sufficient by analysts
and investors. Only half of our sell-side respondents, and 43% of investors, believe that companies
provide sufficient information to allow the effective assessment of these factors' impact. This is in line with
the findings of the CSR Europe / Deloitte study,35 which found that the majority of fund managers and
analysts describe corporate reporting and communication as unsatisfactory. This similarity in responses
is somewhat surprising, given that that study was done over three years ago, while the quality of
corporate reporting seems to have significantly improved in the meantime.

         FIGURE 24: Do you think that companies you cover (sell-side) or invest in (buy-side) are
         providing sufficient appropriate information to enable effective assessment of ESG issues'
         impact?

                     Sell-side                           Buy-side
                   8%    2%                               4% 5%
                                 13%

                                                                          23%
                                                                                      Completely disagree
                                             39%                                      Disagree to some extent
                                                                                      Neutral
        42%                                                                           Agree to some extent
                                       35%                                            Completely agree


                                                                    29%



34
    Hesse [2006], “ Added value, long term. Non-financial sustainability key performance indicators on their way into financial
   reports of German companies.”Deloitte and German Federal Ministry of the Environment.
35
   Deloitte, Euronext, CSR Europe [2003], “     Investing in responsible business – the 2003 survey of European fund managers,
   financial analysts and investor relations officers.”


ECCE – European Centre for Corporate Engagement                                                                             26
The fact that companies may be reluctant to fully disclose their activities' impact on society or the
environment is not unexpected. After all, few companies would voluntarily admit that they abuse their
employees' rights or employ children in their factories. As one fund manager put it:

"Some of my [… ] clients have specific requirements that I avoid, e.g., child exploitation, but information on such
issues is hard to derive from companies - until it hits the front pages of the newspapers."

Even though direct data from companies continue to be one of the primary sources for ESG information,
there seem to be a mismatch between the information included in company reports and information
sought directly from the companies' representatives, such as Investor Relations officers. Only a third of
the research analysts, and less than a half of investors, discuss ESG practices with the companies to a
moderate or great extent, while 27% of analysts and 12% of investors do not discuss these issues at all
with companies. In addition, buy-side analysts discuss these issues with companies to a greater extent
than fund managers do, while fixed income investors discuss these issues to a lower extent than equity
investors do.

          FIGURE 25: To what extent do you discuss ESG practices with the representatives of the
          companies you cover (sell-side) or invest in / recommend (buy-side)?

                   Sell-side                        Buy-side

                     5%
                                                    9%         12%
                                 27%
                                                                                  Not at all
          28%                                                                     Only slight extent
                                                                                  Neutral (option only
                                                                     24%          given to buy-side)
                                          36%                                     Moderate extent
                                                                                  Great extent


                          40%                               19%



This finding corroborates the results of the Deloitte / CSR Europe study, which found that most Investor
Relations officers indicate that they rarely receive requests on social and environmental performance
from traditional mainstream fund managers and analysts, and that most of those requests come only from
SRI analysts working for screened funds or rating agencies, and from active asset managers with a
strong focus on social and environmental performance. In addition, some investors expressed concerns
that having a dedicated PR/IR team reporting on ESG issues might simply be counterproductive:

"Large corporations do have the tendency to build large departments to track these [ESG] tasks that might cost
tons of money without having any impact. So therefore I am somewhat cautious to which extent I want to be
informed by companies which might use these tasks more as a part of their PR department without any real
impact on the [way their business is conducted]."




ECCE – European Centre for Corporate Engagement                                                                 27
Differences between sectors

Most of our analysis is done on the very broad level of European sell-side analysts or buy-side investors.
However, a recent study conducted by the Ethical Investment Research Services (EIRIS) has found
major differences between different sectors in the importance they attach to the various ESG factors.36
Their findings confirm what common sense already tells us: that climate change is important to car
makers and electricity companies, that environmental degradation is on top of the agenda of companies
in the mining, oil and gas sectors, and that product safety is the top issue for food producers and food
and drug retailers. However, most studies of SRI look only at the overall picture, without looking at the
differences between various sectors. This shortcoming has been recognised by many of our respondents,
who find that studies done on this general level only do, in fact, miss the whole point of using ESG
information. Indeed, this was their main criticism of studies done in the SRI arena. In the words of four
buy-side respondents:

"We consider all the [ESG] issues important to varying degrees within different sectors. For example, there is
greater focus on EMS [Environmental Management Systems] for high environmental impact sectors, just as
there is a greater focus on human rights policies for sectors operating in areas of high political risk."
"Environmental standards are very important to a German solar manufacturer, where the elimination of child
labour [… ] is irrelevant, including in the context of their supply chain; whereas, a Chinese apparel
manufacturer should focus exactly on tackling child labour and should be expected to spend any spare funds they
do have on improving wages, not on implementing the GRI code."
"Because we do industry-specific and even company-specific analyses, it differs what issues are most important
to a certain company. It depends on that specific industry's/company's risks and opportunities and in what
context it operates."
"[The importance of ESG factors] varies enormously depending on the industry. For example, for a mining
company issues related to environmental policy and community relations would be paramount. For many other
companies they are irrelevant."

Going back to our analysis of the most important ESG factors for European sell-side analysts, we saw
that environmental factors do not seem to matter too much to analysts in general. However, we
suspected that if we looked at the different sectors we might see considerable differences between the
weights they attach to environmental information. For this purpose we compared the responses of sell-
side analysts covering companies in the traditionally environmentally-sensitive sectors37 to those covering
companies in other sectors and, indeed, we found that the research analysts covering these two groups
of companies have profoundly different approaches to environmental information. Management of
atmospheric emissions, waste management, protection of water resources, development of green
products and services, existence of environmental policy, fixed quantitative environmental targets and
certified environmental management systems are all far more important to these environmentally-
sensitive industries than to other sectors, and this difference is, in each case, significant at the 0.01 level.
However, there is very little difference between these two groups as far as other factors are concerned.
This clearly demonstrates that studies on the use of extra-financial information must be careful to
distinguish between the economy's different sectors, as their needs for information, whether
environmental, social or ethical, are not uniform.




36
     EIRIS [2007], “  Valuing ESG issues – a survey of investors.”
37
     Sectors classified here as environmentally-sensitive are: automotive, chemicals, energy, heavy industrials, mining, oil & gas,
      steel and utilities.


ECCE – European Centre for Corporate Engagement                                                                                 28
  FIGURE 26: Difference in importance of environmental issues between environmentally-sensitive sectors
  and other sectors
                                                  Sell-side

               Management of atmospheric emissions

                                  Waste management

                        Protection of w ater resources

       Development of "green" products and services

                     Existence of environmental policy

              Fixed quantitative environmental targets

        Certified environmental management systems

                                                         1.0     1.5    2.0    2.5       3.0    3.5     4.0      4.5    5.0
                                                       Not important at all                               Very important
                                                               Environmentally-sensitive sectors              Other sectors


Given that environmental information is of particular interest to environmentally-sensitive sectors, we also
looked at the other extra-financial factors and examined whether they are associated with any particular
sectors. The table below shows which sector-focused analysts find these factors important (rating of 4.0
or higher on our 1-5 importance scale) in cases of significant differences between sectors.

                      ESG Factor                                                Particularly important for:
    Environmental     Existence of environmental policy                         Steel, Mining, Energy
    Responsibility    Development of "green" products and services              Energy, Industrials
                      Management of atmospheric emissions                       Energy, Utilities, Steel, Mining
                      Protection of water resources                             Mining, Industrials, Energy
                      Waste management                                          Energy, Mining, Steel

    Human Rights      Respect for human rights                                  Consumer Goods, Retail, Luxury, Leisure
                      Elimination of child / forced labour                      Consumer Goods, Retail, Luxury, Leisure

     Employment       Improvements of health and safety conditions              Mining, Steel, Chemicals
      Practices

      Community       Promotion of social and economic development              Steel, Mining
     Involvement      Details about community involvement                       Mining


It is altogether not surprising that analysts covering more ESG-sensitive sectors are also more receptive
to their employers' ESG policies. Research analysts responsible for the automotive, energy, oil & gas and
steel sectors are more aware of the existence of ESG policies, research products and personnel in their
institutions than are analysts covering other sectors. Analysts covering pharmaceuticals, mining and steel
companies are most satisfied with the ESG disclosure of the companies they cover, while chemical,
industrial, mining, steel, pharmaceutical and utility specialists discuss ESG practices with the companies
they cover to the greatest extent. These sector specialists have also observed the biggest improvement
in ESG practices, perhaps as a result of this increased dialogue.




ECCE – European Centre for Corporate Engagement                                                                               29
We also looked at the link between the relative importance of various ESG factors and the sector
coverage of our buy-side respondents. The results are presented in the table below.

                 ESG Factor                                     Particularly important for:
Environmental    Existence of environmental policy              Metals Mining & Steel, Transport, Utilities
Responsibility   Fixed quantitative environmental targets       Industrials, Retail
                 Development of "green" products and services   Automotive, Utilities
                 Management of atmospheric emissions            Automotive, Metals Mining & Steel, Transport, Utilities
                 Protection of water resources                  Metals Mining & Steel, Utilities
                 Waste management                               Industrials, Metals Mining & Steel, Retail, Utilities

 Human Rights    Respect for human rights                       Healthcare & Pharma, Consumer goods, Leisure & Luxury
                 Elimination of child / forced labour           Healthcare & Pharma, Consumer goods, Leisure & Luxury

 Employment      Improvements of health and safety              Chemicals, Infrastructure
  Practices      Management of working hours                    Metals Mining & Steel, Retail, Telecoms
                 Training and development                       Healthcare & Pharma, Chemicals, Foods & Beverages

  Community      Promotion of social and economic development Metals Mining & Steel
 Involvement     Details about community involvement            Metals Mining & Steel


Several trends seem to emerge when we look at and comparing these two tables. Even though we used
different terminology to distinguish sectors between the two groups, the results are very similar.
Environmental issues seem to play an important role for the more “   polluting”sectors: automotive (where
the main concern is the management of carbon emissions, including the development of carbon-neutral
cars); mining, metals and steel (where the most focus is on water resources and waste management);
                                               green”electricity). Human rights issues are a concern for
and utilities (especially in the production of “
makers of household and consumer goods (whose production facilities are typically located in less
developed countries) and, to some degree, also healthcare and pharmaceutical companies (presumably
related to testing pipeline drugs). Employment practices are important for retailers (management of the
typically long working hours) and companies in the chemicals and natural resources sectors (especially
focusing on employees' health and safety). Finally, impact on the community plays a major role for
mining, steel and metals companies.

Even though these trends are very clear, we must also give a word of warning. Our questionnaire was not
designed to capture sector effects and the methodology we used does not allow for tests of statistical
significance to be conducted. Consequently, our results of sector differences should be treated with
caution, as additional insight rather than definite proof.




ECCE – European Centre for Corporate Engagement                                                                           30
Differences between regions

Many studies relating to SRI or ESG try to distinguish between responses from different regions and/or
countries. Mercer split their European respondents into UK and Continental Europe, while CSR and
Deloitte drilled down to country level for nine European countries. However, we are concerned that in the
truly global world of investments these differences have at least blurred, if not disappeared completely.
The investment culture of any particular investment company or broker must have been affected by the
increasingly international mix of finance professionals employed there, as well as the broad and varied
range of companies included in portfolio allocation or research coverage. In addition, we believe that
national trends can be blurred by the extreme variety of investors, such as long-term focused pension
funds, private banking boutiques, insurance companies, hedge funds and diversified asset managers.
Consequently, any generalisations on the national level are unlikely to show meaningful patterns.
Nevertheless, we did investigate whether such patterns emerge within the European market.

In our survey of sell-side research analysts we distinguished    FIGURE 27: Geographical split of buy-
only between UK-based on Continental Europe-based                side respondents
analysts, and found no meaningful differences between
                                                                                         Other
these two groups. For the buy-side survey, location is closely                   Italy
                                                                                          4%
linked to investor type. Most European hedge funds are                            5%
                                                                       Nordic
London-based, while private wealth management companies                 8%                                  UK &
are typically located in Switzerland or Luxembourg. Long-                                                  Ireland
only institutions are split more evenly across Europe,             France
                                                                                                             36%
although the bulk of them (31% of all long-only respondents          9%
in our study) are UK-based.

As far as generalisations go, French and Spanish investors        Germany
                                                                    9%
seem to be most focused on extra-financial information
                                                                      Sw itzer
across the whole spectrum of ESG factors, while investors
                                                                       land                      Benelux
from Denmark focus mostly on human rights issues.                      13%                        16%
Investors from Austria and Luxembourg are the least
concerned about ESG factors. There is no significant
difference between countries and regions when it comes to
corporate governance criteria.




ECCE – European Centre for Corporate Engagement                                                                      31
                  s
Implications: What’ missing?

In the process of conducting this survey we received a large number of comments from both buy-side
and sell-side participants. Many of them are included in the text to illustrate a particular point, but one
particular concern was mentioned so often that it deserves special attention. Indeed, it is a concern that
lies at the very heart of SRI research. Many of our respondents indicated that investing in environment-
friendly or ethical companies is all great in theory, but in reality investments are all about the bottom line:
profits. Whether seen as return on equity, stock price appreciation or increase in market value, it is simply
the increase in the value of their investments that investors most want to see. In the words of our buy-
side respondents:

"Money follows profits, not ideals!"
"I believe the market is focused on return on equity. It looks at the performance and doesn't look at other things.
I know that it isn't right, but it is so."
"We adopt socially responsible views but many foundations / charities clients do not want anything other than
the best returns. Often this is a paradox."
The general observation from our study is that financial community does not fully see the direct benefits
of incorporating extra-financial information into their analysis and valuation. In addition, what affects
reputation does not necessarily affect financial performance, so a company that makes the headlines of
daily newspapers for all the wrong reasons does not necessarily see any more lasting impact on its share
price than merely a temporary hiccup. On the other side of the coin, there is little incentive to invest in
companies that score high on ESG criteria. Yes, it might mean that they are better run, but given that all
this effort, time and money spent on SRI screening does not really result in better financial performance,
why bother?

One thing that many of our respondents seem to miss is the theoretically sound, tested and documented
relationship between being “ better”and share price performance or valuation level. Chances are that if
such a relationship were present, investors would be interested in benefiting from it. In fact, many of our
respondents indicated that they are indeed looking for empirical evidence linking ESG criteria and
investment returns. In the words of one of our buy-side respondents:

"In order to promote SRI companies through all types of funds, and not only through SRI funds, there must
exist an independent notion that incites investors to select better governed companies. This notion through
[academic] research should prove to investors that they would be rewarded better than the market average for
investing in SRI companies. For the time being, investment decisions are made solely on financial criteria and
very little on SRI criteria, and that is a shame because the incentives are not there and the qualifications are too
often opaque and biased."

Unfortunately, prospective returns depend on so many things that ESG factors are extremely difficult to
incorporate into the performance analysis. Nonetheless, a body of academic research has set out to
investigate the effect of SRI investments on financial returns. Even though they do not present irrefutable
evidence that SRI investments generate higher returns than “      normal”investments, most studies have
found that they do not result in worse performance, either, while, at the same time, they might actually
decrease risk exposure. The table below summarises the findings of a number of recent academic and
industry-backed studies in this field.




ECCE – European Centre for Corporate Engagement                                                                  32
     Authors                             Year    Market studied      Period studied    Outcome38
     Bauer, Koedijk, Otten               2004    Germany, UK, US       1990-2001       No difference
     Bello                               2005    US                    1994-2001       No difference
     Boutin-Dufresne, Savaria            2004    Canada                1995-1999       No difference
     Derwall, Guenster, Bauer, Koedijk   2003    US                    1997-2002       Good”stocks outperform
                                                                                       “
     Derwall, Guenster, Bauer, Koedijk   2005    US                    1995-2003       Good”stocks outperform
                                                                                       “
     Foerster, Asmundson                 2001    Canada                1995-1999       No difference
     Gluck, Becker                       2004    US                    1998-2003       Incorporating SRI à higher alpha
     Hong, Kacperczyk                    2006    US                    1962-2003       Bad”stocks outperform
                                                                                       “
     Kempf, Osthoff                      2006    US                    1991-2004       Good”stocks outperform
                                                                                       “
     Mill                                2002    N/A                   1982-2002       No difference
     SRI World Group                     2002    US                    1999-2001       No difference
     Statman                             2000    US                    1990-1998       No difference
     Statman                             2005    US                    1990-2004       No difference



Unfortunately, our respondents complain that a lot of academic research in this field is directed at
academicians rather than practitioners, and arguably that it often fails to reach the audience that could
benefit the most from the evidence contained therein. However, a number of sell-side brokers have been
using academic findings to publish dedicated SRI research analyses that prove that incorporating
broadly-understood sustainability into investment decisions can generate additional alpha.39 Having said
that, we strongly believe that there is a serious lack of research on the alpha-generating possibilities of
SRI investments. We believe that academic studies in this field should, in particular:
• establish a solid theoretical background for the rationale for socially responsible investing
• focus on recent datasets
• use methodology that tackles the flaws common in existing studies in this field40
• be made accessible to the wider public, and not just to other academicians
Our findings suggest that as long as no satisfactory evidence exists to support the proposition that
investors can become better off by incorporating extra-financial information in their analyses and
investment decisions, any studies of the SRI market will just be preaching to the choir, while mainstream
investors will continue to focus on quarterly earnings and short-term share price performance without
looking at the bigger picture and considering the wider impact of their investments.




38
    Unless stated otherwise, “outcome”means the difference between the risk-adjusted returns of SRI funds and conventional
                       no
   investments, and “ difference”means no statistically and economically significant difference.
39
                                                                     More gain than pain: Sustainability pays off.”
   See, e.g., Garz and Volk (WestLB, 2002 and revised 2003 edition), “
40
   See, e.g., Phillips, Hagen & North Investment Management, Ltd. [2003], “Does socially responsible investing hurt investment
   returns?”for discussion.


ECCE – European Centre for Corporate Engagement                                                                            33
Appendices
Appendix A
List of sell-side institutions whose research analysts participated in the survey
ABN AMRO (UK)                                     Helvea (Switzerland)
Ahorro (Spain)                                    HQ Bank (Sweden)
Alpha Finance (Greece)                            HSBC (UK)
Altium Securities (UK)                            HVB (Germany)
Arete Research (UK)                               Independent Research (Germany)
Atout Capital (France)                            ING (Belgium, Netherlands)
Banca Akros (Italy)                               Investec (UK)
BBVA (Spain)                                      IXIS (France)
Banco Millennium (Portugal)                       JP Morgan (UK)
Banesto Bolsa (Spain)                             Kaupthing (Finland, Sweden)
Bank Sarasin (Switzerland)                        KB Banki (Iceland)
Bank Vontobel (Austria, Switzerland)              KBC Peel Hunt (UK)
Bayerische Landesbank (Germany)                   KBC Securities (Belgium)
Berenberg Bank (Germany)                          Kempen & Co (Netherlands)
BHF Bank (Germany)                                Kepler Equities (Germany, Netherlands)
BPI (Portugal)                                    Landesbank Baden-Wuerttemberg (Germany)
Bear Stearns (UK)                                 Lehman Brothers (UK)
CA Cheuvreux (France)                             Merrill Lynch (UK)
CA IB (Austria)                                   Morgan Stanley (UK)
Caja Madrid Bolsa (Spain)                         Natexis Bleichroeder (France)
Carnegie (Sweden, Denmark)                        Nomura (UK)
Citigroup (UK)                                    Oddo Securities (France)
CM-CIC Securities (France)                        Ohman Fondkommission (Sweden)
Collins Stewart (UK)                              Oppenheim Research (Germany)
Commerzbank (Germany)                             Oriel Securities (UK)
Credit Suisse (UK)                                Panmure Gordon (UK)
Daiwa (UK)                                        Pareto Securities (Norway)
Danske Equities (Denmark)                         Petercam (Belgium)
Davy Stockbrokers (Ireland)                       Portzamparc (France)
Delta Lloyd Securities (Belgium)                  Proton Securities (Greece)
Dexia Bank (Belgium)                              Rabo Securities (Netherlands)
Dresdner Kleinwort (UK)                           Raiffeisen Centrobank (Austria)
DZ Bank (Germany)                                 Rasbank (Italy)
Equinet (Germany)                                 Raymond James (France)
Erste Bank (Austria)                              Redburn Partners (UK)
Espirito Santo (Spain)                            SEB Enskilda (Norway, Sweden)
Evolution Securities (UK)                         Seymour Pierce (UK)
Exane BNP Paribas (France)                        SNS Securities (Netherlands)
First Berlin Equity Research (Germany)            Societe Generale (France)
Fondsfinans (Norway)                              Teather & Greenwood (UK)
Fortis Bank (Belgium, Netherlands)                Theodoor Gilissen (Netherlands)
Fox-Pitt Kelton (UK)                              UBS (UK)
Goldman Sachs (UK)                                WestLB (Germany, UK)
Goodbody (Ireland)                                Zuercher Kantonalbank (Switzerland)




ECCE – European Centre for Corporate Engagement                                         34
Appendix B
List of buy-side institutions whose portfolio managers or analysts participated in
the survey
Aberdeen AM (UK)                                  BPN (Portugal)
ABN Amro AM (France, Netherlands)                 Brummer (Sweden)
ABP Investments (Netherlands)                     Bryan Garnier (France)
Abrias IM (Switzerland)                           CAAM (Italy)
ACP Partners (UK)                                 Canada Life (UK)
ActienInvest (Switzerland)                        Capital Group (Switzerland)
Adam & Company IM (UK)                            Carnegie AM (Finland, Sweden)
AGF AM (France)                                   Cassa Lombarda (Italy)
AIG (UK)                                          Cavendish Unit Managers (UK)
Aktia AM (Finland)                                CCLA IM (UK)
Aletti Gestielle (Italy)                          CE AM (Switzerland)
Allchurches IM (UK)                               Centaurus Capital (UK)
AllianceBernstein (UK)                            Cheviot AM (UK)
AMB Generali AM (Germany)                         Cheyne Capital (UK)
Amiral Gestion (France)                           Clariden Bank (Switzerland)
Anchorage Capital (UK)                            CM-CIC (France)
Anglo Irish Bank (Switzerland)                    Cominvest AM (Germany)
Antonveneta ABN Amro (Italy)                      Convivo Capital (UK)
AP3 (Sweden)                                      Coutts Bank von Ernst (Switzerland)
Arca (Italy)                                      Credit Agricole AM (France)
Artemis (UK)                                      Credit Agricole PB (Luxembourg, Switzerland)
Asset Value Investors (UK)                        Credit Suisse AM (Switzerland)
Aviva (France, Spain)                             Credit Suisse PB (Italy, Switzerland)
AXA IM (France, UK)                               Cycladic Capital (UK)
Azimut (Italy)                                    Dalton Strategic Partnership (UK)
BAE Systems Pension Fund (UK)                     Danske Capital (Finland)
Baillie Gifford (UK)                              Deka Investments (Germany)
BankInvest (Denmark)                              Delta Lloyd AM (Netherlands)
Bank Sarasin (Switzerland)                        Deutsche AM (Germany)
Banque Degroof (Belgium, Luxembourg)              Deutsche Bank Private Wealth (Belgium, UK)
Banque Delen (Belgium)                            Dexia AM (Belgium, Luxembourg)
Banque Syz (Switzerland)                          DIT (Germany)
Barclays Global Investors (UK)                    DnB NOR AM (Norway)
Barclays Wealth Management (UK)                   Dresdner Bank (Luxembourg)
Baring AM (UK)                                    DWS (Germany, Italy, Switzerland)
Bayerische Landesbank (Germany)                   Eagle Star (Ireland)
BayernInvest (Germany)                            Ecofin (UK)
BBVA (Spain)                                      Edinburgh Partners (UK)
Bedlam AM (UK)                                    Effe Gestioni (Italy)
BFT (France)                                      Egerton Capital (UK)
BlackRock IM (UK)                                 Epsilon (Italy)
BlueCrest Capital (UK)                            eQ Bank (Finland)
BNL Gestioni (Italy)                              Eurizon (Italy)
BNP Paribas PB (France, Luxembourg)               Euronova AM (UK)
Bordier (Switzerland)                             Evli (Finland)
BP IM (UK)                                        F&C AM (UK)


ECCE – European Centre for Corporate Engagement                                              35
FGS Capital (UK)                                  KLP AM (Norway)
Fidelity (UK)                                     Kredietrust (Luxembourg)
Fideuram (Italy)                                  L.H. Ward (UK)
FIM AM (Finland)                                  La Banque Postale AM (France)
Financiere de l’  Echiquier (France)              LaSalle IM (Netherlands)
Finanduero (Spain)                                LCF Rothschild (France)
First Arrow IM (UK)                               LCL (France)
First State Investments (UK)                      Legal & General IM (UK)
Forester Investments (UK)                         Linde Partners (Luxembourg)
Fortis IM (France, Germany, Spain, UK)            Liontrust AM (UK)
Fortis PB (France, UK)                            Lloyds TSB (Switzerland)
Frankfurt PM (Germany)                            Lombard Odier (Switzerland)
Frankfurt Trust (Germany)                         Martin Currie IM (UK)
Fundamentum AM (Luxembourg)                       Merrion Capital (Ireland)
Fusion AM (UK)                                    Metzler AM (Germany)
Gartmore IM (UK)                                  MFC Global IM (UK)
Gautier (Switzerland)                             Mirabaud (Switzerland)
Genesis IM (UK)                                   MMA Finance (France)
Gesmadrid (Spain)                                 Montanaro IM (UK)
Gestion NV (Netherlands)                          Monte Paschi AM (Italy)
Gottardo Gestion (Spain)                          Morgan Stanley Quilter (Ireland)
Gutmann (Austria)                                 Morgan Stanley Private Wealth (Switzerland)
Gutzwiller (Switzerland)                          Morley Fund Management (UK)
HBM Partners (Switzerland)                        New Star AM (UK)
Headstart Advisers (UK)                           Newton IM (UK)
Henderson Global Investors (UK)                   NLI Investments (UK)
Hermes Focus AM (UK)                              Nordea Bank (Luxembourg)
Hexam Capital (UK)                                Nordea IM (Finland, Norway, Sweden)
HMG Finance (France)                              Oddo AM (France)
Houlihan Rovers (Belgium)                         OKO AM (Finland)
HSBC Trinkaus (Germany)                           Old Mutual AM (UK)
I.DE.A.M. (France)                                Optimix (Netherlands)
Indexchange (Germany)                             Orbis IM (UK)
Indus Capial (UK)                                 OZ Bankers (Switzerland)
ING IM (Belgium, Netherlands)                     Pareto (Norway)
Insinger de Beaufort (Netherlands)                Park Place Capital (UK)
InverCaixa (Spain)                                PCE Investors (UK)
INVESCO (Germany)                                 Petercam (Belgium, Netherlands)
Investec AM (UK)                                  Pioneer IM (Austria, Germany, Ireland)
Irish Life IM (Ireland)                           Polunin Capital (UK)
IXIS AM (France)                                  Praktikertjanst (Sweden)
J O Hambro (UK)                                   Prigest (France)
JP Morgan AM (UK)                                 Principal Global Investors (UK)
Julius Baer AM (Switzerland)                      Progressive Alternative Investments (UK)
Julius Meinl (Austria)                            Putnam Investments (UK)
Jupiter AM (UK)                                   Pyrford International (UK)
Kathrein (Austria)                                RAB Capital (UK)
KBC AM (Belgium, Ireland)                         Raiffeisen Capital (Austria)
Kempen Capital (Netherlands)                      Rathbone IM (UK)
Killik (UK)                                       RCM (UK)
Kinsale Capital (Ireland)                         Rexiter (UK)


ECCE – European Centre for Corporate Engagement                                                 36
Robur (Sweden)                                    Swiss Life AM (Switzerland)
SAM Sustainable AM (Switzerland)                  Swiss Re AM (Switzerland)
SanPaolo AM (Italy, Luxembourg)                   Synchrony AM (Switzerland)
Sarasin Expertise (France)                        T. Rowe Price International (UK)
Schretlen (Netherlands)                           Taylor-Young IM (UK)
Schroder IM (Switzerland, UK)                     Thames River (UK)
Scottish Widows (UK)                              Theodoor Gilissen (Netherlands)
SEB AM (Denmark, Germany)                         Threadneedle (UK)
SEB Gyllenberg (Finland)                          Tilney IM (UK)
Sella Gestioni (Italy)                            Triodos Bank (Netherlands)
Setanta AM (Ireland)                              TT International (UK)
SG AM (France, UK)                                UBS Global AM (France, Switzerland)
SG PB (Belgium)                                   UBS O’  Connor (UK)
Silver Point (UK)                                 UBS Wealth Management (UK)
Singer & Friedlander IM (UK)                      Unigestion AM (Switzerland)
Smith & Williamson IM (UK)                        Union Investment (Germany)
Sofaer Capital (UK)                               Union PanAgora AM (Germany)
State Street Global Advisors (UK)                 Veritas AM (UK)
Storebrand (Norway)                               Walter Scott (UK)
SVG Capital (UK)                                  WestHarbor Capital (UK)
SVM AM (UK)                                       WestLB Mellon AM (Germany, UK)
Svolder (Sweden)                                  Williams de Broe (UK)
Swisscanto AM (Switzerland)                       Zuercher Kantonalbank AM (Switzerland)




ECCE – European Centre for Corporate Engagement                                            37
About ECCE
ECCE - The European Centre for Corporate Engagement - is an internationally oriented research
consortium devoted to delivering research in the fields of corporate engagement and sustainable finance.
Founded by researchers from universities in Maastricht and Rotterdam in the Netherlands, and supported
                                                                                                  s
by a grant from the Swedish Foundation for Strategic Environmental Research (Mistra), ECCE’ mission is
to develop, communicate and promote a thought-provoking and innovative body of knowledge concerning
sustainable business and finance. The objective is to expand the knowledge of how businesses and
financial markets can promote sustainable development by considering environmental, social and
corporate governance (ESG) issues. To ensure that its research deliverables have both academic stature
and practical relevance, ECCE cultivates a close dialogue and interdisciplinary cooperation with market
players in its daily operations. The resulting international and continuously expanding network includes
companies like ABP Investments, who provides input for research projects and is co-involved in translating
results into concrete policies; and Fortis, who supports the ECCE initiative with a Sustainable Finance chair
at Erasmus University. International ties have also been established with Innovest Strategic Value
Advisors, Governance Metrics International (GMI), Institutional Shareholder Services (ISS), and the
Swedish partners MISTRA and Umeå School of Business.

For more details on ECCE, please visit http://www.corporate-engagement.com or contact Els van
Aernsbergen at +31 43 388 3838 or info@corporate-engagement.com


About the author

William Jaworski joined ECCE in 2006 as a PhD researcher focusing on the use and valuation of extra-
financial information, shareholder activism and corporate governance. Prior to that he worked in London in
a top-tier global investment bank, where he was involved in the origination, structuring and execution of
                                                                                 s
IPOs and secondary equity transactions in Europe. William holds a Master’ degree in International
Business (Finance) from Maastricht University in the Netherlands. He can be contacted at
w.jaworski@finance.unimaas.nl.




ECCE – European Centre for Corporate Engagement                                                         38

								
To top