Gareth Mee | EY - Can you generate alpha and minimise beta through ESG?

Sustainable finance and integrated thinking Gareth Mee, EY

Three special numbers

9

10

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ESG - Generating alpha and minimising beta

Can you generate alpha and minimise beta through ESG?

The better the question. The better the answer.

The better the world works.

Hypotheses

1.

2.

3.

4.

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The market is not pricing in the impact of COP21 Long term value is broader than financial value “Sin stocks” have outperformed in the past but will not in the future “E”, “S”, “G” are equally important for long term value differentiators

ESG - Generating alpha and minimising beta

COP 21

Delayed action scenario shows downside Baseline projections - prices

250

Equity Return (Real GDP)

200

Gilts (10yr)

150 100

Price Level (CPI)

50

Corporate bonds (AA)

2007

120

2017

2027

Equity projections – delayed action

110 100 90

Equities follow historical trends based on GDP data

80

70 60

Energy networks and suppliers react to carbon tax which causes gradually decline in equity prices

Further advances in technologies leads to decarbonisat ion

50 40 *Projections based on Oxford Economics Projections, with a 2007 baseline

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ESG - Generating alpha and minimising beta

Long term value framework

What is the Long Term Value framework?

Defining long term value Context

►

Context, Purpose, Strategy and Governance determine the outcomes the organisation needs to deliver to its stakeholders

►

Value Creation levers define the types of value an organisation creates

Stakeholders Stakeholder outcomes

Outcome metrics Value creation

Value protection

Strategic assets Governance

►

Value Protection levers define the types of risks and threats an organisation manages to protect value

►

Outcome Metrics measure the achievement of stakeholder outcomes

►

Strategic Assets are the capabilities and resources that are required to deliver stakeholder outcomes

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ESG - Generating alpha and minimising beta

Value creators and value protectors Value creation Value protection Financial value

Consumer value

Human value

Societal value

Traditional yardstick to measure an organisation’s performance

The value an organisation creates through the utilisation of goods and services to meet customer needs, including innovation

The value an organization creates through the utilisation of the skills, behaviours and engagement of its people

The value created through the relationships between an organisation and all other external stakeholders

► Revenue

► Functional

► Leadership

► Environmental

► Margin

► Comparative

► Workforce

► Social

► Cash

► Brand

flow conversion

► Capital

structure

alignment ► Workforce

performance ► Engagement

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ESG - Generating alpha and minimising beta

► Economic

Hidden value Components of market value No business is likely to thrive long term if its leaders are able to influence only 20% of what generates value.

Capital captured in financial statement Financial capital

Strategic Finance, June 2016 Manufactured capital

Components of S&P 500 market value

Visible in annual accounts

Incomplete, but visible in annual accounts

Valuation methodology

100 90

Human capital

80

80%

70

84%

68%

60 50

Intellectual capital

40 30

32%

20 10

Partially visible

Social and

17%

relationship capital

Partially visible

FTE & salary expenses

Training and innovation expenditures

(almost) (almost) invisible invisible

0 1975

1985 Tangible assets

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1995

2005

Intangible assets

2015

Natural capital

ESG - Generating alpha and minimising beta

Invisible

Sin stocks

Alpha depends on the sector

Source: Kumar et al (2016), Journal of Sustainable Finance & Investment; Fidelity International, March 2018.

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ESG - Generating alpha and minimising beta

But conduct even more important than sector

Effect of ESG exclusions on returns, 2006-2017, annualised. Source: NBIM, Fidelity International, March 2018.

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ESG - Generating alpha and minimising beta

E, S & G

Responsible Investment: Strategy & Communication A

B

C

D

E

F

H

I

J

K

L

M

N

RI Investment Strategy

1

3

1

1

4

2

5

3

1

5

3

4

1

RI Governance

1

3

1

1

3

1

3

3

1

4

3

2

1

Communication & Reporting

1

3

1

2

3

3

3

3

2

4

3

3

3

Prioritisation of RI Themes

1

5

1

1

3

1

3

4

1

4

3

1

1

Regulatory Preparedness

2

3

2

2

3

1

4

3

3

3

3

3

1

Climate Change Initiatives

2

4

5

3

3

4

3

2

3

5

1

2

1

RI Resourcing*

1

1

1

1

5

1

1

1

1

3

1

1

1

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ESG - Generating alpha and minimising beta

Company

Summary and conclusions

Summary

1.

2.

3.

4.

The market is not pricing in the impact of COP21 Long term value is broader than financial value “Sin stocks” have outperformed in the past but MAY not in the future “G” and “E” are clear, “S” is harder

Given this, we think you can generate alpha and minimize beta, but it’s not straightforward.

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ESG - Generating alpha and minimising beta

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