Investing In A Green Economy - theme, sector or hybrid?

Sustainable investment is an investment management theme that is growing. Sustainable investment is investment that fully considers all risks and rewards of a given investment. After the global financial meltdown, Madoff and Copenhagen in the past two years, how much better is sustainable investment understood by investors in London, New York, Stockholm, Amsterdam or Tokyo today? Billions of dollars of new investment in new technologies is needed to de-carbonize the global economy. In January the “2010 Investor Statement on Catalyzing Investments in a Low Carbon Economy” - issued by four investor groups representing more than USD 13 trillion in assets including INCR - called on Governments from their podium at the UN in NYC to take immediate steps to catalyse the development of a low-carbon economy and attract the necessary private capital. Their call even reached the Sundance Channel.

Do most institutional investors still fail to understand sustainable investment? Pension funds and institutional investors – with their advisors at private banks and hedge funds in wealth management centres like Geneva or Melbourne – are fiduciaries who should efficiently and effectively allocate and manage their assets. Looking at macro sustainability trends such as natural resources, urbanization and demographics change, how well are these funds and their advisors giving appropriate consideration to any factor which may materially affect the sustainable long term risk-adjusted performance of the Fund's investments, including environmental, social and governance factors, across all asset classes? Sustainable investment is opposed to the concept of externalities, the economic term for costs pushed onto society, and the planet. Nobel Prize-winning columnist Paul Krugman this week surveyed the “economics of climate change or, more precisely, the economics of lessening climate change”. Krugman describes externalities this way:

“What if you manufacture a widget and I buy it, to our mutual benefit, but the process of producing that widget involves dumping toxic sludge into other people’s drinking water? When there are “negative externalities” — costs that economic actors impose on others without paying a price for their actions — any presumption that the market economy, left to its own devices, will do the right thing goes out the window."

Some of that capital will come from High Net Worth [HNW] investors like those who manage their wealth through Switzerland’s established private banks and hedge funds. Returns are not guaranteed. In fact millions of Euros were thrown into the clean tech sector at companies that could never be competitive or commercially viable in the long term. But some high-risk, high return investors will be the first to back new technologies. We had a small but globally significant example in Vaud last week. The Solar Impulse first flight on 7 April in the commune of Payerne VD is a good example [see Wired video]: experimental technology co-funded by Swiss adventurer Bertrand Piccard with partners giving corporate funding for research and individuals providing project financing through subordinated loans. Seriously experimental - imagine sitting in that cockpit for an around-the-world flip? And of course, at the Geneve Auto Salon in February 2010, hybrids and electric cars were represented at most stands [seriously, a metallic green Ferrari 599 hybrid and I am meant to think it's green?!]. Actually the real pushing technology was in the dim and out-of-the-way green hall, away from all the flashy lighting and chick models. Credit Suisse posted a note on the "environmentally friendly stars was developed in Switzerland: The Lampo2 from the Protoscar think tank based in Ticino".

When we at SinCo design investment architecture for institutional investors, we design to integrate environmental, social and governance [ESG] factors. Major Swiss investor [and now Swiss big brother after UBS meltdown the past 2 years] Credit Suisse considers “Sustainable investment is no trend but a key sector for the future.” We disagree. Putting ESG into a bucket misses the innovation it offers. We prefer to describe sustainable investment as a theme – it is neither an asset class nor sector, but an approach to investment management that explicitly integrates all factors – including environmental, social and governance [ESG] factors – into the decisions.

Building Sustainability Indexes

Building sustainability indexes is a specialist function for index architects. The Domini 400 Social Index has been running since 1 May 1990 as a benchmark for the obvious question: including ESG factors in selecting large US companies, how does it impact performance. The ETF tracks at iShares FTSE KLD 400 Social Idx Fd (ETF) (Public, NYSE:DSI). Over the years the DS400 has come to send many other messages, and practitioners know the strengths and weaknesses of this specific index, but it has established the role for the sustainability index. The purpose of an index must be clear in order to create focus for any sustainable investment approach. At SinCo we recommend that any index must be succinctly defined. Sharpening the sustainable investment focus is critical. Criteria matter. So does longevity. Many interesting variations will emerge in the design, development and ongoing execution of the index, and tensions within the mission and current programs may be expected. Maintaining focus prevails on the choice of work and work partners and the design of selection criteria. The Dow Jones Sustainability Index is now 10 years old [see the latest review with DJ here] and some of the people who helped build it like Alex Barkawi have moved on.

Our experience of sustainability indexes provides the empirical basis for design directions and development, interpreted by experts in sustainable investment and the role of indexes. The emergence of country-level indexes rather than international (for example DJSI Global) or themes indexes (for example, carbon or water). South Africa is an obvious example in emerging markets with the JSE SRI Index [up this year, together with Brazil (BOVESPA ISE) launched by the IFC in 2005, and India (S&P CRISIL/KLD/IFC), as well as emerging country examples in Egypt, Spain and South Korea, together with newer thematic indexes such as the Healthy Living Index (SAM) and international initiatives like the Carbon Leaders Index – CDLI (CDP/Innovest).

• SAM Sustainable Healthy Living Fund is designed to invest from the global stock universe in the most attractive enterprises along the health value added chain. For this purpose those trends which influence the Healthy Living-sector decisively are investigated in the first step by means of macroeconomic analysis.
• Carbon Leaders Index – CDLI (CDP/Innovest) The CDLI scores for the Global 500, Europe, FTSE 350, and S&P 500 companies are now used by index provider Markit to create a family of equity indices.
  

Index architecture must map to the investment case and the index proposition. We will cover the impact of sustainability indices separately, other than to say now that sustainable investment indexes have an impact, but a complex model is needed to assess the impact. Indexes (and indexed portfolios) are actively managed investment instruments that are constructed according to objective criteria and are compiled and marketed by financial services firms such as FTSE Group/Financial Times [www.ftse.com/Indices], Morgan Stanley Capital International Indexes [www.msci.com], Standard & Poor’s Indexes [www.sandp.com] and Dow Jones Indexes [http://www.djindexes.com/].

Index membership literally confers “investment grade” on firms because numerous managed funds are benchmarked to, or directly invested in, these indexes. Where the index is themed, selection into the “club” confers a certain halo effect or positive association for that company because there has been a dramatic increase in the scale of funds that directly track market indexes. Gaining and maintaining membership in an “index club” is often a critically important goal for company executives. As with any differentiating characteristic, companies seek to gain competitive advantage with investors, prospective employees, and other stakeholders, and a high ranking in an index can give them such an advantage.

When a company is ranked or included in an influential or prestigious index such as the Dow Jones Sustainability Index (DJSI) or the Fortune 100 Best Companies to Work For, the company will reference that fact, especially when that firm is looking to present credentials as being “world-class”. For example, Brazil petroleum major Petrobras [Petroleo Brasileiro SA (ADR) (Public, NYSE:PBR)] lists five accreditations on a full-page color advertisement in a magazine targeted at investors and company executives (Bloomberg Markets magazine, December 2009), including membership in the DJSI. On the other hand, exclusion from an index can encourage companies to pledge changes. When Daimler [Daimler AG (Public, ETR:DAI] and Bayer [Bayer AG (Public, ETR:BAYN)] were excluded from the DJSI STOXX, their reaction in the German business paper Handelsblatt on 8 September 2008 ranged from pledges to improve (“We will definitely intensify our efforts regarding sustainability”, according to a spokeswoman from Daimler AG) to surprise at being excluded (Bayer commented, “We are not happy about it and we will try our best to be included again, since this is increasingly relevant to us on a financial basis. However, it will be more and more difficult to achieve inclusion in this benchmark.”). Our experience is that ratings, rankings and indexes may be a powerful tool for driving forward sustainability and creates a signaling effect across sectors and stakeholders. At this time we do not delve into the detail of ratings, rankings and indexes. There exist many different approaches, and characteristics of each of the three may be quite different, offering different value propositions that the index leadership must address at the outset of their goal and objective setting stages. Indexes are a feature of any discussion, a reference point, and quite literally a benchmark. Sustainability indexes can be even more so.