Sustainability and Financial Markets Lars Hassel Aronia seminar - PowerPoint PPT Presentation

Sustainability and Financial Markets Lars Hassel Aronia seminar 16.09.2010

Sustainable Investments Research Program • Vision – Institutional Investors can take a leading role in promoting Sustainable Development (SD) by changing the behaviour of companies in which they invest. • Objective – Find out how Sustainable Investment (SI) practices can create added value for institutional investors and identify barriers to mainstreaming such practices among asset owners and managers – SI have to go beyond the business case and aspire to make a contribution to SD

Research Agenda • SI and Fiduciary Responsibility – ESG in conflict with interpretation of fiduciary duty? – Balance between short term gains and long term values • The Investment Case – Evaluate SI strategies in different asset classes • How sustainable can SI be? • Company Behaviour – Explain mechanisms through which SI can influence company behaviour towards SD • How sustainable can companies become?

Conflicting Evidence of Risk ‐ Adjusted SRI Returns? Best-in-class Derwall et al, FAJ 2005 ´The eco ‐ • Superior returns efficiency premium puzzle’ • No difference in risk adjusted returns between ethical and conventional Conventional risk/return mutual funds or back ‐ tested trade-off portfolios • Demystifying RI… (Mercer 2007) ’No Harm’ • Shedding light on RI… (Mercer 2009) • Hong & Kacperczyk, JFE 2009, The price of sin: The effects of social norms on markets Sin or shunned stocks • Statman & Glushkow, FAJ 2009 ’The Superior returns wages of social responsibility’

Neutral Returns on SRI Funds? • SRI mutual funds – Conventional wisdom ; SRI and conventional mutual funds produce similar risk adjusted returns ; 4 ‐ factor α , (Bauer et al JB&F 2005) – Applies also to fixed ‐ income SRI funds (Derwall and Koedijk JBF&A 2009) – Volatility of flows and sensitivity to past returns generally lower in SRI funds (Bollen, JF&QA 2007) – Willingness to accept losses applies to negative SRI screens (Renneboog et al 2009) – Different SRI retail market segments found in Swedish survey (Nilsson, IJBM 2009) – SRI investors have different motives

SRI Strategy – Negative Screens and Exclusion • Shunned Stock Hypothesis • Sin stocks in conflict with societal norms (norms ‐ constrained investor) • Shunned stocks trade at discount and have a higher expected return The Price of Sin…(Hong & Kacperczyk JFE 2009) • – Lower institutional ownership and less analysts’ coverage – Price/book ratios for sin stocks lower – Superior returns 1926 ‐ 64; 1965 ‐ 2003 (4 factor α ) • KLD controversials – Shunned stocks outperform peers (Kempf & Osthoff EFM 2007; Statman & Glushkov FAJ 2009) European Sample • – Sin stocks outperform peers, especially under high litigation risk and protestant faith (Salaber 2007)

Fabozzi et al (JPM 2008): Sin Stock Returns

SIN Funds

SRI Strategy: Positive Selection of Best ‐ in ‐ Class • Errors ‐ in ‐ expectations hypothesis – CSR information value relevant but not well understood by market – Abnormal risk ‐ adjusted returns only when investors underestimate CSR as a driver of future expected cash ‐ flows. • Innovest eco ‐ efficient portfolios – U.S. Portfolio outperformed industry peers (Derwall et al FAJ 2005). • KLD social investment indicators – High ‐ ranked portfolios outperform lowest ‐ ranked portolios (Kempf & Osthoff EFM 2007; Statman & Glushkow FAJ 2009. • Employee satisfaction as an intangible – Fortune’s classification provided abnormal returns (Edmans, 2009)

Derwall et al (FAJ 2005): RISK ‐ AND STYLE ‐ ADJUSTED PORTFOLIO RETURNS (ALPHA) BASED ON INNOVEST ECO ‐ EFFICIENCY RATINGS (U.S companies 1995 ‐ 2003) alpha % R m -R f SmB HmL MOM R 2 Small Firm Price/book Momentum Market Risk Risk Risk Effect β Best-in-Class 4.15** 0.92*** -0.19*** 0.02 -0.09*** 0.88 Portfolio Worst-in- -1.81 1.03*** 0.04 0.23*** -0.08*** 0.86 Class Portfolio 5.96** -0.12*** -0.23*** -0.22*** -0.01 0.17 Difference Abnormal Return! Mispricing or another risk factor? 19

Concluding Studies on SRI Portfolio Strategies • SRI markets serve different motives and SRI has become a multidimensional concept (Derwall et al 2010) • Back ‐ testing based on ESG ratings suggests – Values driven investors shun controversial stocks at the expense of financial returns – Profit seeking investors hunt best ‐ in ‐ class stocks • The abnormal returns have faded out in recent years when E & G (S) risks and opportunities are priced • The value relevance of ESG increases over time

Social and Financial Performance on Firm Level Doing good while doing well – win ‐ win situation Economic Value: - Environmental ‐ Social Operating profit +/- Market value ‐ Governance and ‐ ratings Cost of Equity Capital 21

ESG and Extra ‐ Financial Value – Firm Level • Back ‐ testing confirms E and G (S) factors bring added value – ESG metrics and financial measures (MSCI: U.S.) – ROI (+/ ‐ ) – Market premium, Tobin’s Q (+) – Cost of Equity Capital ( ‐ ) • Innovest eco ‐ efficiency rating (Guenster et al, 2006) • GES environmental index (Semenova &Hassel SD 2008) • KLD ESG sub ‐ dimensions (Derwall & Verwijmeren, 2008) • Commercial property and housing markets – Green office buildings U.S (Eichholtz et el AER 2009) – Energy efficient housing NL (Brounen & Kook 2009) 22

Semenova, Hassel & Nilsson (2010): The Value Relevance of Environmental and Social Performance for Swedish SIX 300 Companies Market Value = Tangible Information + Intangible Information Cash Flows/Reputation Market Value Past performance Environmental and Earnings and Book Value Social Performance Value relevant?

Sample: SIX 300 Companies Classified by Sectors and Market Capitalization

Environmental and Social Performance for SIX 300 Companies 2005 ‐ 2008 (U.S. Companies) ES Data Provider: GES - Investment Services

Environmental Performance Value Relevant for Large and Mid Cap (not Small Cap) on OMX Stockholm 2005 ‐ 2008 Random Effects Market Value of Equity/Total Assets = Net Income/TA Book Value of Equity/TA Environmental performance Social performance Sales Growth Firm Age Industry dummies Year dummies

Concluding Studies on ESG and Firm Value • An upward market price correction of environmental leaders over time – MSCI U.S • Market assigns more value relevance to environmental information in Large Cap firms • Companies with potential to improve ESG can provide excess returns • ESG in Small Cap companies is not priced – lower disclosure and transparency – less analysts’ coverage – small firm ESG risk

Thank You !