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Magazine Issues » December 2010


waterfall_jungleEnvironmental factors are considered to be in the realm of specialist investors only, but Angele Spiteri Paris hears that traditional equity players should also take them into account

Sustainability and biodiversity may seem relevant only for socially responsible investors. But if these factors have an impact on corporate bottom lines, then isn’t every equity investor affected?

Take, for instance, regulation. Regulatory changes around certain environmental factors could introduce a cost for something that was previously free, affecting the operating profits of companies dependant on a particular resource.

An example is drug companies that have free access to chemical compounds or substances found in nature – so-called genetic resources, which play an important role in the development of new drugs and therefore contribute significantly to a drug company’s profitability. If, as a result of certain environmental agreements, certain governments decide to start charging for the use of their flora and fauna, the operating costs of those pharmaceutical companies could increase considerably.

Christophe Butz, a sustainability expert at Pictet Asset Management, says: “The pharmaceutical sector, for instance, is heavily afflicted by biodiversity concerns because a lot of the drug reactive agents are based on natural ingredients. Therefore, if biodiversity richness decreases, then the pool for new solutions becomes smaller and the companies will find it more difficult to remain competitive.”

When it comes down to it, most standard equity funds will hold some names whose share prices could be affected were things to change on the biodiversity or sustainability front.

Will Oulton, European head of responsible investment at Mercer, the investment consultancy, says: “ESG [environmental, social and governance] factors can have a material impact on the value and the VaR [value at risk] of a portfolio. Fund managers that do their research around these issues are in a better position as investors than those who don’t. Increasingly, analysts are having to take ESG factors into account.”

Problem spotting
But according to some, the practice is not widespread enough, with even socially responsible investors failing to factor in potential problems.

Ben Cotton, partner at Earth Capital Partners, says: “There are risks that are often not factored into the construction of traditional portfolios. BP is a typical example. Even ESG funds bought BP because it rated highly on the sustainability meter.”

Cotton is referring to the fact that until the oil spill debacle in the Gulf of Mexico, BP ticked all the sustainability boxes.

Martin Grosskopf, portfolio manager and director of sustainability research at Acuity Investment Management, says: “Until the disaster, BP screened very well for all the sustainability factors among social research firms. Therefore, I’m hesitant to say that by doing work on sustainability you’re going to uncover material short-term risks you wouldn’t have otherwise been aware of.”

According to Jon Williams, partner, sustainability and climate change, at consultancy PwC: “Analysts need to be able to at least identify biodiversity risks. We need to educate them to ask certain basic questions of companies for them to be able to raise red flags around that equity or credit name.”

Consumer goods producers are another example of companies that could be affected.

Williams says: “Environmental impacts will not affect the operations of a consumer goods company, but they can cause issues within its supply chain.”

Unilever has committed to buying all its palm oil – which it uses in various products – from certified sustainable sources by 2015. If Unilever’s palm oil supplier were to have its expansion plans quashed by local regulation, or if it ran into operating difficulties due to environmental regulation, then Unilever would unexpectedly have to find a new supplier, causing financial strain.

Bozena Jankowska, global head of sustainability research at investment manager RCM, gives an example from the mining industry. “Vedanta, an Indian mining company, had been looking for permission to expand a bauxite mine. The permit was rejected in August this year and that had a negative affect on the company share price because, among other things, they had to review their earnings outlook.”

Even the finance sector isn’t buffered from biodiversity and sustainability risks. Butz, at Pictet, says: “The exposure is indirect but it is still very real. Financial firms have their money invested in resource sectors and are therefore dependent on those sectors performing well.”

Oulton, at Mercer, says: “ESG factors can be material to the long-term protection of shareholder value and therefore should be embedded within a fund manager’s investment process.”

Although experts say the risk of value erosion to an equity portfolio due to a lack of awareness around biodiversity and sustainability is very real, they admit it’s  difficult to put a number on it.

Williams, at PwC, says: “It’s difficult to quantify how sustainability and biodiversity issues affect a company’s bottom line.”

Oulton says: “The challenge is, how do you prescribe a cost to any sensible work done around this? How do you account for these externalities?”

Missing link
Another difficulty is that although there are some companies that are aware that environmental issues are worth considering, the work they do around the subject does not always link back to the company financials.

As climate change climbs higher on corporate priority scales, several companies across various sectors have drawn up sustainability reports. This may look good from the outside, but most of those reports are essentially useless to investors and equity analysts because they fail to make the all-important link between these sustainability initiatives and company bottom lines.

Jankowska, at RCM, says: “Most company boards don’t make the link between ESG issues and their bottom line. The two are still seen as a separate exercise.”

Williams, at PwC, agrees: “Most sustainability reports have little connection to corporate strategy or company financials. Integrated reporting, which would see firms link their sustainability efforts with the financial performance of the company, would show how they create value within that firm.”

Cotton, at Earth Capital Partners, is optimistic that this will become a reality soon enough. He says: “We will begin to see companies produce integrated reporting. The big four accounting firms are capable of doing it so it’s plausible to create an auditable framework.”

Interestingly, one company that is making an effort to produce financial reports that include the ESG effort and show how this affects the company financials is a mining firm.

Xstrata was awarded the 2010 Building Public Trust Award for Sustainability Reporting in the FTSE 100 by PwC. Williams says: “It might seem incongruous that a mining group won this award but it stood out because it was one of the only companies that linked its efforts in sustainability with financial performance and corporate strategy.”

However, although the links are starting to be made, it’s still very difficult to quantify the effect of positive action around sustainability and ESG factors.

Karina Litvack, head of governance and sustainable investment at F&C Asset Management, says: “It is very difficult to put a number on sustainability and what it does for the profitability of companies. The Natural Value Initiative has made the most headway so far in developing an econometric model to capture the economic value-added of so-called ‘ecosystems services’ arising from biodiversity, ie value protection and creation resulting from biodiversity conservation and restoration.”

She said she would welcome a valuation technique that captured, through a charge on companies, the negative impacts their activities have on biodiversity and conversely, credits them commensurately with the value they protect or create by enhancing biodiversity.

“We’re impressed with the progress achieved so far. It’s extremely complex and a challenge to capture everything accurately, but it’s a lot better to have something that’s imperfect than to have nothing as we do now, because this effectively results in biodiversity being ascribed a value of zero. It’s no surprise there is so much value destruction when it is costless to destroy and there is no reward from avoiding that damage.”

 ©2010 funds europe