ubs research focus, sustainable investing, july 2013

7/28/2019 UBS Research Focus, Sustainable Investing, July 2013.

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CIO Wealth Management

July 2013

UBS Research Focus

Sustainable investing oerscompetitive investment results

Investors can direct their

assets to make an impact

and express their values

Companies are better

equipped to preserve and

create value for stakeholders

Sustainable investing

abThis report was originally published in the US on 11 July 2013.This report has been customized for outside the US distribution.


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ContentsSustainable investing

03 Editorial

05 Section 1What is sustainable investing?

09 Section 2What are the benets of sustainable investing?

15

Section 3How can sustainability be evaluated?

22 Section 4Considerations in building sustainable portfolios

27 Section 5Sustainability investment themes

34 Conclusion

35 Glossary

UBS Research Focus

This report has been prepared by

UBS Financial Services Inc. (UBS FS)

and UBS AG. Please see important disclaimers

and disclosures at the end of the document.

Past performance is no indication of future

performance. The market prices provided are

closing prices on the respective principal stock

exchange. This applies to all performance

charts and tables in this publication.

Publisher

UBS AG, CIO WM Research,

P.O. Box, CH-8098 Zurich

Authors

Bruno Bertocci, UBS Global Asset Management

Agathe Bolli, UBS Wealth ManagementAlexander S. Friedman, UBS Wealth Management

Julie Hudson, UBS Investment Bank

Maryam Khan, UBS Wealth Management

Kurt E. Reiman, UBS Wealth Management

Alexander Stiehler, UBS Wealth Management

Eva Zlotnicka, UBS Investment Bank

Editor

Marcy Tolko

Editorial deadline

11 July 2013

Project management

Paul Leeming

Nikki Ackermann

Rda MouhidSita L. Chavali*

Desktop

CIO Digital & Print Publishing

Pictures

getty images

Printer

Fotorotar AG, Egg, Switzerland

Translation

CLS Communication, Basel, Switzerland

24translate, St.Gallen, Switzerland

Languages

Published in English, German, Italian, French,

Spanish, Portuguese & Russian

Contact

[email protected]

UBS homepage: www.ubs.com

*We would like to thank Sita L. Chavali, an

employee of Cognizant Group, for her assistance

in preparing this research report. Cognizant sta

provide research support services to UBS.

SAP-Nr. 82092E-1301


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Sustainable investing July 2013 3

Dear readers,

Since the turn of the millennium, we have witnessed imploding assetbubbles in technology and housing, a long list of governance lapsesand accounting scandals, and the greatest nancial crisis of our time.In response, there appears to be an emerging baseline consensusamong investors that the unsustainable economic and industry trendsof recent years cannot be allowed to continue. Put simply, the socialfallout is too great.

And so, one of the megatrends building across the nancial landscape

is focused on how investors can express their values in their nancialdecisions and have a positive impact on the world around them. Theend goals are clear improve risk-adjusted performance, make a posi-tive social impact with capital allocation and incorporate ones val-ues and to pursue these goals and drive their portfolios accordingly,investors are now evaluating a broader array of information and tools.

This report is about incorporating sustainability considerations intoinvestment decisions information that has traditionally been viewedas external to the investment process but is increasingly seen as cen-tral. We argue that synthesizing material environmental, social andgovernance factors together with other traditional fundamental datain the investment analysis and decision-making process has the poten-

tial to yield better performance outcomes and enables investors toexpress their values and make an impact through their investments.

Todays economic circumstances demand such a shi. The globaleconomy faces threats from climate change, water scarcity, the deple-tion of other important natural resources, and other human-inducedfactors, which, if not managed well, will accelerate as the worldspopulation grows and more people are lied out of poverty. The2008-09 global nancial crisis exposed the excesses of unsustainablecredit-fueled growth and governance lapses and also created numer-ous social needs in its aermath, which governments have thus farfailed to address.

Meanwhile, a growing number of corporations are not only leadingthe way in adjusting to these new economic, environmental and socialrealities, but are also working in conjunction with nongovernmentalorganizations and other stakeholders to help improve the situation.These organizations see sustainability as a source of competitive advan-tage. In this, they act out of rational economic self-interest, but with awin-win result for both their shareholders and the greater public.

From an investment standpoint, the timing of this shi is serendipi-tous. Companies have an unprecedented volume of data at theirngertips to help manage risk as well as to help preserve and grow

Editorial

Alexander S. Friedman

Kurt E. Reiman

[continued]


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4 July 2013 UBS Research Focus

Alexander S. FriedmanGlobal Chief Investment Ofcer

Wealth Management

Kurt E. ReimanHead, Thematic Research

Wealth Management

Editorial

shareholder value just as eorts to standardize and integrate thereporting of sustainability factors are gaining momentum. Not only arecompanies thinking more strategically about a wider array of risks totheir businesses, but also investors are better equipped to incorporatethis information into their investment views.

But this is easier said than done. Sustainable investing is still unfa-miliar to many investors, even though the nancial services industryprovides a broader than ever range of investment solutions and ser-vices to its clients. The business community may be taking a moreholistic approach to managing risk and building value, but there is still

a long path ahead before investors have full transparency on corpo-rate sustainability eorts. And even when sustainability investmentsare applied to a portfolio, they are oen treated as a separate sleeverather than considered in the context of the entire spectrum of assets.

We invited practitioners and research professionals from acrossUBS Wealth Management, the Investment Bank and Global AssetManagement to share their insights on this evolving subject of howto invest with a sustainability mindset. We also interviewed outsideexperts who have developed specialized insights for measuring thevalue proposition of investing in sustainable companies and the reasonfor incorporating sustainability metrics to preserve and create value.

Our goal with this edition of UBS Research Focus is to evaluate theevolution of sustainable investing, anticipate future developments anddemonstrate why we believe a well-considered sustainability approachwill add value to your portfolio.

Your invested assets are already having an impact on the recipientscost of capital. The question that now needs to be asked should be:Is your money being invested in a way that reects your values andserves your long-term nancial interests and fully considers the wel -fare of future generations?


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Humble beginningsTodays sustainable investing strategies arerooted in early ethical investing approaches,which date back several hundred years to timeswhen Islamic, Jewish and Christian religionsmade economic and investment decisionsbased on their faith (see Fig. 1). The rst ethi-cally oriented investment fund the PioneerFund actually dates back to 1928 during theProhibition Era, when churches encouragedinvestors to avoid investments in alcohol, re-

arms, tobacco and other sin stocks.

The civil rights and environmental movementsin the 1960s and 1970s ushered in the mod-ern era of socially responsible investing (SRI) asevents of the time prompted many investors tocompletely reevaluate their investment decisions.SRI emerged as an extension of ethical investing,and its focus continued to rest on avoiding com-panies involved in activities that proved oensive

to certain investors, such as tobacco, alcohol,gambling, pornography, animal testing, geneti-cally modied organisms and military exposure.

Divestment from South Africa during the 1980swas credited as being one of the key forces thatended the apartheid regime. Meanwhile, theThree Mile Island partial nuclear meltdown in theUS, the Chernobyl nuclear fallout in Ukraine, theUnion Carbide explosion in Bhopal, India, andthe Exxon Valdez oil spill o the coast of Alaska

focused attention on environmental issues.Activist investing also emerged around this time,as major investors sought to not only inuencethe cost of capital of controversial companies butalso the decisions made by the board of directors.

Sustainability comes of ageThe concept of sustainability, however, rstemerged on the world stage more than a quar-ter century ago. It happened in 1987 when the

What is sustainableinvesting?Julie Hudson, Maryam Khan, Kurt E. Reiman, Alexander Stiehler

SECT ION 1

SUSTAINABLE DEVELOPMENT IS DEVELOPMENT THAT MEETS THE NEEDS OF THE PRESENT WITHOUT COMPROMISING

THE ABILITY OF FUTURE GENERATIONS TO MEET THEIR OWN NEEDS.

Brundtland Commission, Our Common Future


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Fig. 1: Evolution of sustainable investing

1500s 1940s 1950s 1960s 1970s

1928: The Pioneer Fund establishedto enable investors to avoid companiesinvolved in gambling, tobacco and alcohol.

1953: Howard Bowen coins the termCorporate Social Responsibility (CSR) inhis book Social Responsibilities of theBusinessman.

c. 1500s: Ethical investing begins with practices of religious believers who excluded certain invest-ments and activities to align with their faiths. c. 1970s: The SEC

begins permitting socialresponsibility issues toappear on proxy ballotsaer a landmark courtcase, Medical Committeefor Human Rights versusSEC.

1971: Pax World Fundsfounded as the rst ethi-cal mutual fund.

United Nations Brundtland Commission publishedits groundbreaking report entitled Our CommonFuture, which stated that sustainable develop-ment is development that meets the needs of thepresent without compromising the ability of futuregenerations to meet their own needs.1

But for much of the decade that followed, theplanets carrying capacity and the worlds socialfrictions were less of a priority to investors, giventhe steady decline in poverty rates, low and

falling commodity prices, above-trend rates ofeconomic growth in developing countries and agenerally muted business cycle.

However, perceptions began to change in theearly years of the new millennium because:

High-prole company failures and the USsubprime mortgage meltdown put the spot-light on questionable corporate governancepractices

Rising global consumption of commoditiesalongside economic development in highlypopulated emerging market economies beganto place upward pressure on the prices of mostnatural resources

Income inequality grew more widespread indeveloped and developing countries alike

Evidence of environmental degradation, suchas climate change, water scarcity, air pollutionand strip mining grew more widespread.

Section 1

Negative screening: Excludes specic investments or classes of investment from the investible universe such as companies, sectors and countries.

1977: The SullivanPrinciples developed,which encouraged divest-ment and ultimatelyforced businesses inSouth Africa to dracharter calling for endto apartheid.

Source: UBS, as of 5 June 2013


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Responding to pleas for companies to playa greater role in solving these problems, theUnited Nations launched its Principles forResponsible Investment (PRI) in 2006 to providevoluntary guidelines for nancial institutions andinvestors to integrate and address environmen-tal, social and governance (ESG) factors in theirinvestment decision-making process (see Fig. 2).

Consequently, sustainable investing hasevolved from its early focus on restricting

investments and divestiture to one that alsoincorporates sustainability considerations as apositive input when evaluating the underlyingvalue, risk and return potential of companies.At UBS, we have developed our own denitionof sustainable investing.

Building on traditional investmentapproaches, sustainable investing incor-porates environmental, social, governanceand other fundamental sustainability fac-tors into the investment decision-makingprocess to both preserve and create valuefor investors. This rounded approach toinvesting seeks to generate competitiverisk-adjusted returns. It also provides aframework that enables investors to havetheir values reected in their fnancial

portfolio and have a positive impact onsociety through their investments.

Sustainable investing, properly implemented,goes beyond the mere integration of ESG issueswithin the investment process. One could argue

What is sustainable investing?

1980s 1990s 2000s 2010s

Integration of ESG factors in nancial analysis: Explicit

inclusion of ESG risks and opportunities into traditional nancialanalysis and investment decisions based on systematic process.

Engagement and voting: Active ownership through voting of shares and engagement with companies on ESG matters. A long-term processseeking to inuence behavior or increase disclosure.

Impact investing: Investments made into companies, organizations andfunds with the intention of generating social and environmental impact along-side nancial return.

Sustainable theme investing: Investment in themes or assets linked to the develop-ment of sustainability. Thematic funds focus on specic or multiple ESG issues.

Best in class: Diversied active portfolio strategy where best-performing investments within a universe, category or class are selected based on ESG criteria.

1985: The Social Investment Forumestablished to advance investment prac-tices that factor in environmental, socialand governance (ESG) considerations.

1987: Brundtland Commissioncoins its sustainable develop-ment denition.

1989: The annual SRI in the

Rockies Conference begins.

1990: First SRI mutualfund the Domini SocialIndex created.

1999: The Global ReportingInitiative (GRI) launched; over11,000 companies now usethe GRI framework.

2006: The UN launches its Principles forResponsible Investment (PRI) with the goalof creating a sustainable nancial system.

2010: The International IntegratedReporting Council (IIRC) launched topromote corporate reporting of allaspects of value creation.


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Section 1

that it could simply be called investment,for it denotes the taking into account of all rel-evant inputs to the investment decision-makingprocess. Nevertheless, ESG integration is stilla much-needed discipline for the simple rea-son that economics and nancial analysis, andindeed corporate strategy and reporting, as cur-rently implemented, tend to work on the basis ofmodels in which environmental and social costs,benets, assets and liabilities are externalized.

This can make ESG integration a challenge, andinvestors need tools to help them deal with thedifcult job of seeing the forest for the treesin the increasingly available ESG-related data.Fortunately, common reporting and accountingstandards are emerging, as we discuss in Section3. Consequently the landscape of sustainability-relevant data is in the process of being ratio-nalized and put on the same quality plane astraditional nancial data.

Sustainability goes mainstreamSustainable investing strategies have seen

positive inows over the past several years,outpacing the overall growth of assets undermanagement in Europe and North America the regions where sustainability has had itsgreatest uptake (see Fig. 3).2 In its 2012 review,the Global Sustainable Investment Allianceestimated the size of the sustainable investingmarkets at $13.6 trillion globally, which repre-sents more than 20% of assets under manage-ment in the regions surveyed.3 The sustainable

investing strategies with the most investedassets are exclusion strategies (for example,negative screening) and those that integrateESG criteria. Impact investing, a relative new-comer in the sustainability arena, has fewerassets than other strategies but also has strongpotential for future growth.

We expect assets under management in sus-tainable investing strategies will continue togrow in the coming years thanks to intensifying

awareness among investors about environmen-tal, social and governance concerns. We alsobelieve greater information and transparency onESG considerations will enable investors to bet-ter manage risk and assess how companies arepreserving and creating value, as we discuss inSection 3. In Section 4, we consider the ques-tions investors need to ask when constructing asustainable portfolio. But rst, in Section 2, wewill take a look at the ways sustainable investingcan deliver improved risk-adjusted performance.

Source: PRI Association, UBS, as of 30 June 2013

1200

1000

800

600

400

200

0

1400

35

30

25

20

15

10

5

40

0

20072006 2009 201220112010 20132008

Fig. 2: Membership has grown since PRI's inception in 2006

Number of signatories Assets under management, in trillions of US dollars

Number of signatories

Assets under management

Fig. 3: Steady growth in sustainability assets in the US

Source: US SIF Foundation, UBS, as of 30 June 2013

Sustainability assets under management, in trillions of US dollars

0

1

2

4

3

2005 2007 2010 2012


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within the investment decision-making processdoes exactly that (see Fig. 1).

We see the rationale for a sustainability focus ininvestment portfolios as clear, in the sense thatit helps address these two signicant concernsabout volatility and risk. However, many investorscontinue to question the performance results,assuming that a focus on sustainability impliessome sort of trade-o. Although certain sustain-ability-oriented funds may have generated mixed

performance results in the past, this is no dier-ent than with any active investment approach.Moreover, there is evidence to indicate that com-panies with higher sustainability scores can anddo generate better nancial performance.

And as we wrote in Section 1, performancemay be only one consideration when investingthrough a sustainability lens; impact investing

Seeing the bigger pictureThe 2008-09 global nancial crisis and eco-nomic downturn may have shied investorattention to longer-term trends and themesand away from short-termism. We believeinvestors now place a greater premium onreducing volatility in their portfolio given thewide swings in equity markets since the turnof the millennium.

There are several possible approaches to a

strategy of risk reduction. One is to reduce riskassets in a portfolio. The shi to asset liabilitymanagement (and away from riskier assets suchas equities) currently visible in the dened ben-et pension fund market is a good example.An alternative approach is to search for waysto account for a broader spectrum of risks rel-evant to invested assets. The integration of envi-ronmental, social and governance (ESG) issues

What are the benets ofsustainable investing?Julie Hudson, Maryam Khan, Kurt E. Reiman, Alexander Stiehler, Eva Zlotnicka

SECT ION 2

Climate change

Environment policy

Sustainability best practice

Environment management

Water supply

Sustainable transport

Waste management

Consumer rights

Supply chain management

Health and safety

Product safety

Labor relationshipsincluding relationshipswith unions

Community relations

Stakeholder relations

Board structure

Executive pay

Shareowner rights

Accounting / audit

Fund governance

Advisory committeepowers andcomposition

Valuation issues

Business ethics

Conicts of interest

Fee structures

FUNDSCOMPANIES

Environmental Social Governance

Fig. 1: Examples of environmental, social and governance factors

Source: PRI Association, UBS, as of 30 June 2013

CEASE BEING INTIMIDATED BY THE ARGUMENT THAT A RIGHT ACTION IS IMPOSSIBLE BECAUSE IT DOES NOT YIELD

MAXIMUM PROFITS, OR THAT A WRONG ACTION IS TO BE CONDONED BECAUSE IT PAYS.

Aldo Leopold, A Sand County Almanac


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shorter-run nancial performance assessmentsof, say, three to ve years may be inappropriate.Some of the opportunities and risks these fundstake into account can be uncertain in terms ofscope and timing. We note that this is not justa problem for sustainability funds it can hap-pen to other investment styles, too. Those withlong memories will remember the small-capeect (the belief that small companies outper-form large ones) which disappeared as soon as ithad been proven to exist in academic research;

or, more recently, the inescapable underperfor-mance of value funds during the tech bubblefollowed by their dramatic reversal in early 2000.

In addition to funds, investors can also assess thetrack record of broad sustainability indexes asa proxy for the relative performance of sustain-able investing strategies. For example, the MSCIKLD 400 Social Index is a well-known index thatincludes 400 US companies with strong ESG rat-ings and also screens out companies with certainpotentially objectionable business activities. Sinceits inception in the early 1990s, the index has

delivered competitive results when compared tothe broader US equity market but not substantialoutperformance (see Fig. 2).

Sustainable investing is not always about riskreduction, indeed some approaches are higherrisk, requiring a more sophisticated fund holder.These include thematic portfolios, which areless well-diversied than broader portfoliosbecause they focus on companies relevant to,

and values-based investing strategies may beequally or even more important than perfor-mance to some investors. We take a look atthese potential benets, too.

Sustainability funds manage to keep paceOne of the main concerns people have withsustainable investing funds is in the area of per-formance. The general perception is that inves-tors cannot achieve outperformance with thisinvestment approach and might even have to

sacrice returns.

This belief may ow from the enormousamount of academic research that has beenpublished about the nancial performance ofsustainable investing funds over the past severalyears.1 The literature concludes that sustainableinvesting strategies perform about in line withmainstream benchmarks.2 Finance theory holdsthat actively managed portfolios should divergefrom the benchmark in proportion to the risktaken the so-called tracking error. On aver-age, active funds are expected to underperform

by the investment costs. The unexciting con-clusion that it makes little dierence is there-fore noteworthy, since it suggests that ESG orsocially responsible investing (SRI) funds arenot consistently suering the return sacriceso oen heard in discussions of sustainableinvesting.

Some portfolios specializing in sustainable invest-ing take their cue from long-term trends. Thus,

Section 2

Source: Bloomberg, FactSet, UBS, as of 3 July 2013

MSCI US Index

MSCI KLD 400 Social Index

400

300

0

100

200

500

600

1990 1995 2000 2005 2010

Fig. 2: Sustainable investing offers competitive results

MSCI KLD 400 Social Index versus MSCI US Index (June 1990 = 100)

Source: Bloomberg, UBS, as of 3 July 2013

S&P Global Clean Energy Index

S&P Global Water Index

MSCI World Index

DJ Sustainability World Index

80

60

0

20

40

100

120

140

2010 2011 2012 2013

Fig. 3: Thematic funds offer different risk/return profile

Selected sustainability and broad equity market indexes (January 2010 = 100)


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What are the benets of sustainable investing?

for example, water scarcity mitigation or climatechange. To many, such portfolios seem muchmore promising than exclusion portfolios. Buteven a thematic approach has its limitations.Consider the concept of alternative energy.Conceptually speaking, alternative energy is con-nected to the idea of sustainability, but if deliv-ered through listed solar and wind companies,it immediately takes on sector risk characteris-tics that have little to do with sustainability. Forexample, a solar company is, in eect, a hybrid

of silicon (part semiconductor) and assembly(part industrial) indicating that this sector will beercely competitive, potentially cyclical and vola-tile in the short run in share price terms.

Many alternative energy companies were rela-tive startups in 2010, making it unlikely thatinvestors would see a return of cash in the formof dividends. The investor in any sector hav-ing this sort of risk prole competitive, cycli-cal, volatile, cash hungry needs a strong riskappetite and a exible time horizon. As Fig. 3illustrates, investors in the S&P Global Clean

Energy Index sacriced returns, not becausethey were invested in sustainability but becauseof the risks specically associated with the lim-ited universe of companies available to provideexposure to the theme.

The S&P Global Water Index, which is also asso-ciated with sustainability, appears to be less vola-tile and has behaved quite dierently. We stressthat this says nothing about future returns. Thekey point illustrated here is that investors shouldnot view the risks and opportunities associatedwith each sustainable investing theme in isola-

tion, but should consider them as part and par-cel of everything relevant to the fundamentals.

Better company performanceWhile funds and indexes may generate mixedresults compared to traditional equity bench-marks, there is evidence to show that sustainablecompanies generate outperformance. Academicresearch is virtually unanimous in showing thatsustainability eorts either through a focus onESG considerations or a broader corporate socialresponsibility commitment lower a rms costof capital and improve access to nancing.3 If

sustainability considerations can lower a rmscost of capital, there is reason to believe thatcompanies can also produce better nancialresults. And again, the vast majority of academic

studies conclude that ESG integration strategiesalso lead to better nancial performance.4

A landmark 2011 Harvard Business School studyanalyzed the benets to investors when com-panies pursue sustainability compared to thosethat follow a traditional approach.5 There is avery clear survivorship bias in the study, since the180 companies the authors selected were onesthat were in business for the entire survey periodfrom the early 1990s to 2010. Having said this,

the companies that incorporated the needs ofvarious stakeholders and took a broader view ofESG risks outperformed the companies that didnot by a wide margin, and they also experiencedlower volatility (see Fig. 4).

Several studies issued in the past few years tella similar story about the potential benets ofapplying a sustainability framework to the com-pany selection process. MSCI, using its own ESGmethodology, evaluated dierent sustainabilitystrategies negative screening, a tilt to higherESG scores and ESG ratings migration to see if

any achieved outperformance versus the broadermarket over a period spanning 2007 to 2012.6Although the window is too short to be deni-tive, each strategy boosted performance andresulted in better average portfolio ESG scores all while keeping the portfolio characteristicssimilar to the respective benchmark. Europeanresearchers also studied whether a best-in-classscreen would yield benets to investors.7 Theauthors selected 85 companies from among the

Source: Eccles et al. (2011), as of 3 July 2013

High sustainability firms

Low sustainability firms

20

15

0

5

10

25

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Fig. 4 : Sustainability culture yields outperformance

Evolution of $1 invested in stock market in value-weighted portfolios


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S&P 500 that had taken steps to integrate socialand environmental issues into their businessstrategy from 2006 through 2010 and foundthat these companies generated better perfor-mance and also withstood the nancial crisisbetter than the broader S&P 500 index.

Value creation and preservationIn our view, a sustainability focus can yield bet-ter company performance through two mainchannels: more robust risk management and

concentrated attention on long-term value cre-ation. Today, market participants focus muchmore on a companys intangible assets R&D,reputation, management of externalities forinsight into long-term performance, with anestimated 80% of market value today drivenby these factors (see Fig. 5).8 Therefore, under-standing corporate attitudes about ESG issuescan inform investors not only about a rmstrue valuation and potential for long-termsuccess but also about exposure to signicantbusiness and operational risks.

The concept of the triple bottom line isbecoming more mainstream the idea that asuccessful business is one that delivers economic,social and environmental benets.9 It rests onthe premise that businesses do not operate in avacuum, that they are embedded within largerenvironmental and social systems, and that theirsuccess directly depends on preserving and add-ing to the foundation on which they operate.

A stitch in time saves nineIn the past, many companies had an unstruc-tured approach to managing downside risk,

treating the cost of a range of potential nega-tive outcomes as externalities. These costswere silently borne by society and the environ-ment without much analysis into how dam-aging and expensive they actually were.Such attitudes were prevalent in extractiveindustries where managing resources inef-ciently or ignoring unsafe working conditionsproved harmful to society and the environmentat large, as well as business. But this mind-set also applied to a wide range of industries.Since so much shareholder value today is intan-gible, quantifying downside risk can be tricky.

However, capabilities exist both internallywithin rms and externally to calculate andattach a monetary value to these risks.

Section 2

Aer the volatility caused by years of short-term prot-maximizing strategies, investorshave begun to demand greater awarenessfrom corporations about a broader spectrum ofrisks. Simultaneously, companies have realizedthat these externalities are expensive for themas well, and can irreparably erode intangiblevalue drivers like brands, credibility and trust.Allegations of child labor in an Indonesian fac-tory, an oil spill in the Gulf of Mexico and mediaattention on job oshoring can cripple compa-

nies and destroy shareholder value; stock pricescan take years to recover.

Thus, outside pressure coupled with evolvingattitudes within corporations has meant exter-nalities are now being internalized. Companymanagements are beginning to understand thatexternal shocks that damage reputation havesevere knock-on eects on brand equity and thesubsequent ability to position and price productsand services in a premium segment. Damage tobrand equity in an era of extremely rapid com-munications and social networking can cascade

to nancial damage very rapidly. In other words,a stitch in time approach actually saves com-panies money over the long run.

For investors, being on the lookout for rmswith better risk management techniques couldalso yield more stable returns in a portfolio.Firms that focus on delivering value to stake-holders not maximizing protability at theexpense of everything else are likely to be lesssusceptible to volatile ups and downs.

Source: Ocean Tomo (2010), UBS, as of 3 July 2013

80

60

40

0

100

2005199519851975 2009

20

Intangible assetsTangible assets

Fig. 5: Intangible assets comprise the bulk of market value

Components of S&P 500 market value, in %


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What are the benets of sustainable investing?

Beyond charity to value creationCreating value through sustainable businessinitiatives takes this concept one step further.In a deleveraging society where governmentshave had to cut corners on social programs, pri-vate companies can actually step in to ll socialneeds while increasing protability. Sustainablevalue creation adds to the concept of corpo-rate social responsibility and corporate philan-thropy and presents social and environmentalneeds as unique business opportunities (see Fig.

6).10

Innovation is critical to achieving this valuecreation; not only must management look foropportunities in previously unchartered territory,but they must reevaluate strategies and developnew products and services while simultaneouslyfullling business aims.

According to a Harvard Business Reviewarticleby Robert Eccles and George Serafeim, achievingnancial performance with the twin aim of ESGintegration actually depends on a rms ability toidentify the ESG issues most relevant to enhanc-ing shareholder value and consistently gener-

ate innovative products, processes and businessmodels in line with its sustainability priorities.11This means that despite eorts to standard-ize ESG practices, there will be nuances spe-cic to the core businesses and platforms thatrms must continually evaluate and leverage.We believe changes in company reporting andaccounting standards, as discussed in Section 3,can help steer these eorts. Future investmentreturns will be driven by the innovative, forward-looking and exible rms that are able to disrup-tively innovate to address societal challenges.12

From performance to making an impactFor some investors, the main objective may bethe medium- to long-term social impact of com-panies in a portfolio, with the expectation that,in well-run companies, nancial performancewill follow from skillful execution. It may, at theextreme, be impossible to prove in someoneslifetime that their investment approach was bestin class. On the other hand, major black swanevents, such as the credit crunch, have servedas a demonstration of the importance of takingapparently nonnancial issues (such as sustain-able lending practices) into account in invest-

ment choices. As recent events have shown, thelong run has an interesting habit of turning intothe short run with astonishing speed.

Impact investing, although still a niche market,oers investors a hands-on approach to solvingsocial and environmental problems while generat-ing a nominal nancial return (see Fig. 7). Unlikeother sustainable investing approaches whereprogress on social and environmental issues maybe a benecial side eect, making a measurablebenecial impact is an intentional part of impactinvesting strategies. The Rockefeller PhilanthropyAdvisors, early pioneers of impact investing,describes it as investments made into compa-

nies, organizations, and funds with the intentionto generate measurable social and environmentalimpact alongside a nancial return.13

For years, governments have invested in develop-ment projects through a range of vehicles, includ-ing private equity, debt and structured investments.At a time when developed country governmentshave more limited resources, private investors arelooking to ll the void with the aim of injectingcapital into businesses and funds they think willleverage the positive power of enterprise.14

Micronance is the most popular vehicle, oer-ing nancial services to startup enterprises andlow-income family businesses. The aim is toimprove living standards by providing nancial

Fig. 6: Creating corporate value from sustainability

Corporate Social Responsibility Creating Shared Value

Value: doing good

Citizenship, philanthropy,sustainability

Discretionary or in response toexternal pressure

Separate from prot maximization

Agenda is determined by externalreporting and personal preferences

Impact limited by corporate footprintand CSR budget

Example: Fair trade purchasing

Value: economic and societal ben-

ets relative to cost

Joint company and community valuecreation

Integral to competing

Integral to prot maximization

Agenda is company specic andinternally generated

Realigns the entire company budget

Example: Transforming procurement

to increase quality and yield

Source: M. Porter, M. Kramer (2011), UBS, as of 3 July 2013


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companies has its trade-os for investors seek-ing to make an impact. Investors who liquidatepositions in objectionable companies are nolonger able to vote their proxy to more directlyinuence boards of directors and company man-agement. Therefore, given the many dierentapproaches and philosophies available in theimpact investing arena, investors should carefullydene the approach that best suits their objec-tives, mission and values.

The values in sustainabilityOne nal point on the benets of sustainability:In the long run we are all dead. This well-known dictum is a good description of traditionaleconomics and may be read to suggest that sus-tainability is a matter of sacricing return to futuregenerations. However, it ignores issues such asintergenerational equity, which suggest that weshould leave the environment (the planet) as wewould like to nd it. In short, it ignores values,and the fact is that values matter to investorsfrom many perspectives whether that meansthinking in terms of the big picture and social jus-

tice or of their immediate situation; the desire tolook aer the interests of grandchildren; or familybusiness founders looking to leave a sustainablelegacy for the next generation.

resources and insurance to people with limitedaccess to lending. Impact investing also sup-ports small- and medium-sized enterprises in lessdeveloped countries to create jobs and access tobasic needs, such as food, shelter and energy.In this way, impact investors generate a positivesocial impact by facilitating sustainable economicdevelopment at the local level.15

Examples of impact investing range from large-scale community lending platforms like Grameen

Bank to citywide housing funds to online micro-lending social enterprises like Kiva, where aninvestment of as little as $25 can help supportsmall-scale business in the developing world.Along with investing in new businesses, impactinvesting is available as a xed income vehiclethrough initiatives like World Bank green bondsand social impact bonds (SIBs). First introducedin the UK in 2009 to support prisoner rehabilita-tion, SIBs aim to connect funding for social proj-ects with private investors who will earn a returnif certain goals are met. Although pay for suc-cess programs like this are still in their infancy,

Australia and some US municipalities have intro-duced similar incentive programs to lower therecidivism rate.

In the broadest sense, investors make an impactwith the capital they deploy whether intentionalor not. Taking sustainability considerations intoaccount already begins the process of redirectingcapital to reward certain companies and penal-ize others. However, complete divestment of

Section 2

Note: If an investor reports using two strategies for certain assets, the assets are counted twice

(once in each strategy).

Source: Global Sustainable Investment Alliance (GSIA), UBS, as of 30 June 2013

Norms-based screening

Positive/best-in-class screening

Impact/community investing

Sustainability themed investing

Integration

Corporate engagement and shareholder action

Negative/exclusionary screening

Europe

US

Canada

Australia / New Zealand

Asia ex-Japan

Japan

Africa

86420 10

Fig. 7: Negative screening still dominates sustainability

Sustainability assets under management, in trillions of US dollars


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deemed material for evaluating companieswithin a particular industry. Another nongov-ernmental organization (NGO), the InternationalIntegrated Reporting Council (IIRC) is undertak-ing an important initiative, a reporting frame-work rooted in the general accounting principlethat company reports should provide a true andfair account of company activity.

Discovering a companys intrinsic value

Information forms the basis of all invest-ment decisions. Benjamin Graham and DavidDodds 1934 guide to valuing securities enti-tled Security Analysis provides investors witha logical, fact-based framework for makinginvestment decisions driven by fundamentalinformation.1 The book was at least partly areaction to the market collapse of the 1930sand the subsequent discovery that many stockshad been priced based on emotional consid-erations, rumors or other forces that were nottied to business fundamentals. At the heart ofthis approach was intrinsic value, an esti-

mated value based on nancial statements andother available information that could be com-pared to market prices.

It is important to note that the determination ofintrinsic value, according to Graham and Dodd,not only required statistical data from nancialstatements, but also qualitative factors (such as) the nature of the business; the rela-tive position of the company in the industry;physical, geographical and operating characteris-tics; the character of the management; [and] the[longer-term outlook] for the unit, industry and

business in general.2 Clearly, Graham and Doddmeant that nancial projections or measures ofvaluation would be inuenced by these factorsand that the investor would place a premium or

How can sustainabilitybe evaluated?Bruno Bertocci, Julie Hudson, Maryam Khan, Kurt E. Reiman, Eva Zlotnicka

The next evolution in reportingIn addition to greater awareness of and atten-tion to environmental, social and governance(ESG) factors, the steady growth in sustainableinvesting strategies is also the result of morewidely available information and greater trans-parency on these issues. Never have companiesreported or analysts tracked as much data andinformation as they do today. Yet as we said ear-lier, traditional company reports are incomplete

in that they do not account for the myriad ofintangibles that constitute a companys valua-tion. Investors can try to close the informationgap by seeking relevant facts about ESG issuesand directing their assets in a way that makes animpact and reects their values.

Company reporting is constantly evolving. UScompanies were forced to standardize report-ing following the Great Crash of 1929 andthe Great Depression. The Securities ExchangeAct of 1934, which created the SEC, called forcompanies to periodically report their nancial

statements, as well as immediately announceany material changes that could aect thestock price all with the aim of helping to pro-tect investors and provide greater transparencyaround the health of publicly listed companies.Information that most investors take for grantedtoday was actually quite novel in the 1930s and1940s. We expect sustainability accounting stan-dards and integrated reporting to form the nextphase in this evolution.

Sustainability data are steadily becoming morecomprehensive, despite the many dierent

ways to account for it(see box on page 16).The Sustainability Accounting Standards Board(SASB) produces a Sustainability Matrix, amatrix of key performance indicators that are

SECT ION 3

A MATTER IS MATERIAL IF THERE IS A SUBSTANTIAL LIKELIHOOD THAT A REASONABLE PERSONRELYING UPON

THE REPORT WOULD HAVE BEEN CHANGED OR INFLUENCED BY THE INCLUSION OR CORRECTION OF THE ITEM.

FINANCIAL MANAGEMENT AND THE AUDITOR MUST CONSIDER BOTH QUANTITATIVE AND QUALITATIVE FACTORS IN

ASSESSING AN ITEMS MATERIALITY.

Securities and Exchange Commission


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Accounting for sustainability

Around the world, accounting regimes fall into two categories: principles-based and rules-based.Principles-based accounting (such as International Financial Reporting Standards) is a concep-

tual framework of objectives, whereas rules-based accounting (such as US Generally AcceptedAccounting Principles) has a strict set of detailed rules. The two are gradually converging toaccommodate globalization, but both are valid and valuable for measuring, reporting and evalu-ating sustainability.

In the US, sustainability accounting is currently more rules-based, which does not lend itself tonuanced decision making as readily as the principles-based standards that are more common out-side the US. As accounting standards for sustainability information are developed and standard-ized, however, we believe that the data will increasingly move toward a more principles-basedmethodology and will be integrated into corporate nancial statements.

At UBS, our mostly principles-driven approach to ESG analysis recognizes the challenges inherentin measuring, reporting and evaluating sustainability an indicator or metric may say something

about a companys exposure to an issue, but does not necessarily indicate whether any givencompany will respond successfully to it in the context of competitive industry conditions. As thissuggests, there is room for both approaches, and, at times, they may be complementary.

discount on the business based on the relativemerits of these factors.

Uncovering the material informationIn modern, knowledge-based businesses withfewer physical and more intangible assets, fun-damental sustainability factors are especiallyhelpful. Todays nancial statements shed lesslight on the business model that created themthan those of an industrial manufacturing busi-ness in 1934 when nancial reporting was rst

mandated.

We believe ESG factors are no dierent from themany other pieces of information considered ininvestment analysis and regarded as nancial.One way to identify these factors is simply tolist the possible issues or values one might careabout and identify data points that give infor-mation about those issues. There are numerousdata and index providers who handle the enu-meration and collection of such data by siingthrough public reports and by issuing surveys forcompanies to complete.

Another approach, and one we apply throughour research products and investment decisionsat UBS, is to begin by framing the competitiveand strategic forces that have a material eecton an industrys future dynamics and equipinvestors and analysts with the know-how toevaluate a companys exposure to and handlingof those forces. If competitive conditions are fullydescribed, by denition relevant ESG drivers willbe present in the analysis. The key in the latterapproach is to be sector- and context-specic

in order to address the all-important materialityquestion facing investors.

At UBS, the Global ESG Analyser a reportthat compiles this evaluation from across UBSInvestment Bank equity research can be avaluable addition for investors that want an all-around perspective on sectors and companiesthat takes sustainability into account. It is dier-entiated from traditional ESG indices3 becauseUBS analysts identify and frame the risks andsubstantive issues aecting companies in theircoverage universe.

Section 3


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can lead to product obsolescence; excessive debtcan cause a credit problem. On the other hand,desirable products sell at a premium to the com-petition and generate high margins.

Fundamental sustainability metrics can helpreveal these dierences and allow investors tomake better, more informed investment deci-sions. The fuel efciency of an auto manufac-turers eet, the defect rate, JD Power crash testscores, labor accident statistics and other data

all help describe the dierence between oneautomotive business model and another becausethey ultimately help explain brand equity, mar-ket positioning, pricing and customer demand.In the extractive industries, we would see safetyas absolutely core to the business, not just anESG issue. In view of this, we would expect fullytransparent reporting to include numbers suchas near misses, which are recognized as hav-ing predictive power.

Information is material if it aects company valu-ation through future earnings prospects, assetsand liabilities, and risks, as well as the long-runcompetitive landscape and strategic drivers of anindustry (see Fig. 1). If ESG factors can aect theitems that need to be assessed in order to reachan estimation of intrinsic value, then the dataare material. By overlooking or excluding ESGfactors, investors could create an incomplete orpossibly erroneous assessment of intrinsic value.Errors in this assessment can lead to mistakes,

such as overlooking a valuable asset or excludingan asset impairment or potential tail risk.

Material sustainability data lend rigor to the anal-ysis of companies. For example, a company cangenerate a high return on equity (ROE) in manyways, including constraining capital investment,levering the balance sheet or generating highmargins. While the reported ROE might be thesame in all three cases, there are profound impli-cations for future outcomes. Underinvestment

How can sustainability be evaluated?

Fig. 1: Identifying when a sustainability issue is material to a sector

Source: UBS Investment Bank, UBS, as of 8 July 2013

Sustainabilityissues mostrelevant tosector

Universeof potentialsustainabilityissues

Financial impacts / risksIssues that may have a nancial impact or may pose a risk to the sector in the short-,medium- or long-term (e.g., product safety).

Legal / regulatory / policy driversSectoral issues that are being shaped by emerging or evolving government policy andregulation (e.g., carbon emissions regulation).

Industry norms / competitive issuesSustainability issues that companies in the sector tend to report on and recognize asimportant drivers in their line of business (e.g., safety in the airline industry).

Stakeholder concerns / social trendsIssues that are of high importance to stakeholders, including communities, non-gov-ernmental organizations and the general public, and / or reect social and consumertrends (e.g., consumer push against genetically modied ingredients).

Opportunities for innovationAreas where the potential exists to explore innovative solutions that benet theenvironment, customers and other stakeholders, demonstrate sector leadership and

create competitive advantage.


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the interplay of sustainability issues material orpotentially material to the core business are asimportant as how companies communicate thisinformation to investors. We also stress that inte-grated reporting is not equivalent to sustainabil-ity; a good-quality integrated report would bringtogether all the information that is core to thecompany strategy, including sustainability issues.

Thus, the current integrated reporting discussionenvisages a multi-stakeholder report in which the

company strategy is the focal point, and technol-ogy allows the users to nd the information rel-evant to them, with a full understanding of howit relates to the business. This suggests that whilethe specic information needed by individualstakeholders may vary, the result is essentially stillthe same image of the company no matter theangle of approach. Integrated reporting is stillin its infancy and until it becomes more main-stream, investors are going to have to rely ontheir own know-how and the resources availableto make their own decisions.

From shareholder to stakeholderAs we mentioned in Sections 1 and 2 of thisreport, traditional capital market models that pri-marily focus on the shareholder are being ques-tioned in the aermath of the 2008-09 globalnancial crisis. The search for a more robust

Quality communicationInvestors are clearly well-served by using thebroadest material data they can obtain, but sus-tainability reporting will only improve investmentoutcomes if it is done the right way.

In essence, high-quality company reports enableinsightful connections among key pieces ofinformation in the context of the investmentdecision-making process. Such reports give aclear view of the relevant elements of the rms

strategy and progress, not forgetting risks andchallenges, and how the company is dealingwith them. Good disclosure allows long-termunquantiable risks or opportunities to betaken into account, and also makes it clear howrelevant material ESG issues link to the corestrategy. However, most companies treat nan-cial reporting separately from their corporatesustainability and responsibility reports. The lat-est push is to integrate nancial and sustainabil-ity information within the context of the overallbusiness strategy an eort known as inte-grated reporting (see Fig. 2).

Integrated reporting is much more than aneort to staple together a companys nancialstatement, and its sustainability report into aone-size-ts-all report. The ways companiesare looking at their own core strategies and at

Section 3

Fig. 2: Integrated reporting fuses nancial, strategic and sustainability factors

Source: Q-Series: What is Integrated Reporting?, UBS Investment Research, J. Hudson, H. Jeaneau, E. Zlotnicka, 20 June 2012

Financials

Strategy

SustainabilityReport

Sustainability specialists

Regulators, NGOs

Short- to medium-term investors

Integratedreporting

Long-term investors


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investment approach has enhanced the valueand importance of ESG integration and has

drawn attention to a broader array of stakehold-ers rather than just shareholders. The integratedinvestment model rests on integrated analysiswhich in turn relies on an integrated reportingmodel, only possible if it is underpinned by thefully integrated business model in which goodgovernance delivers the right balance amongstakeholders short- to medium- and long-terminvestors, sustainability specialists, regulators,nongovernmental organizations, customers,suppliers, and the community and its environ-ment. For stakeholder models to do their job in

How can sustainability be evaluated?

delivering a sustainable approach to investment(from all perspectives), ESG integration in eco-

nomics, investment decision making and invest-ment analysis, corporate strategy and reportingis required.


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Reengergized

assets more holistically. Currently, too much ofthis work is done in silos. There are CFOs whouse their models and have a certain understand-ing of risk. Then there are chief sustainabilityofcers trying to demonstrate the company isdoing less bad, or the human resource man-agers who are trying to cultivate a productiveand innovative culture. Integrated reporting,as envisioned by the International IntegratedReporting Council, is designed to help removethe walls among these groups and have themapply integrated thinking.

But is this all just downside?For those companies who look at environmen-tal and social risks as an opportunity to improvebusiness processes, strengthen the social licenseto operate, and gain a competitive advantage,we should be able to see a nancial impact. Todate, there have been few attempts at quantify-ing the upside of proactive management of envi-ronmental and social issues.

Can you give us an example ofvalue creation?

Scholars at Wharton analyzed the nancialimpact of stakeholder relations in the gold min-ing industry and found evidence of value cre-ation.2 Mines with better stakeholder relationsachieved higher nancial valuation, becauseit reduced the risk of costly delays and otherdisruptions at the mine. For riskier mines, it isa dierent story: reduced likelihood of extract-ing the gold on schedule, higher discount rate,lower valuation and riskier investment. Thescholars concluded that the quality of stake-holder engagement explains the dierencebetween a high value company and a low value

company, all else being equal. Its a signicantvalue-add estimated at twice the value of thegold in the ground. We may see similar eects inwater extraction, extractive industries in general

Why might a focus on sustainability be soimportant to investors?The challenge of sustainability is that it is pri-marily a matter of environmental and socialexternalities, which are typically not fully pricedin the goods and services that are bought andsold. Consequently, something that has inher-ent value is treated as if it were free in our mar-ket economy, such as a healthy and productiveecosystem or stable climate. That said, over thepast 40 years, scientists have been getting betterat evaluating the impact of industrial activity on

human health and the environment rangingfrom industrial accidents to unsafe labor policies and it is possible to provide a dollar estimate ofthe impact. As it increases, so does the risk thatsociety will no longer accept the rising cost tohuman health and well-being.

For investors, the challenge is anticipating whensociety is no longer willing to bear the costs.There can be protests, boycotts, public shamingor media reports, which individually or combinedcan put a company in the hot seat when a socialor environmental issue arises anywhere in its

value chain. The longer a company ignores theissue, the greater the potential for nancial andreputational damage. For investors, this is down-side risk and drives down stock price.1 Estimatingwhen something might go wrong and how bigthe impact might be on a company will becomeincreasingly important.

Can you measure the value of these envi-ronmental and social externalities?You have to be creative and willing to thinkoutside the box. Much of the knowledge willnot come from traditional business analytics or

what is taught in the standard business schoolcurriculum. This is an interdisciplinary challengeand people are needed from a variety of back-grounds to evaluate environmental and social

Interview with Dinah A. Koehler, ScD

Dinah Koehler, ScD conducts research on sustainability at DeloitteResearch the research division of the Deloitte US rm. Sheholds a Doctor of Science in Environmental Science and RiskManagement from Harvards School of Public Health and hasworked in the public and private sectors and academia.

20 July 2013 UBSResearch Focus

This page contains investment recommendations issued by units outside CIO WM Research.

These units are not subject to all the legal provisions governing the independence of nancial analysis.


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linked, an integrated report has the potential toincrease investors understanding of a companys

value-creation potential.

How does a company prepare anintegrated report?It is challenging for most managers to thinkmore broadly, across multiple nancial and non-nancial dimensions and in terms of systems.The integrated report should aim to inform howan organizations strategy, governance, perfor-mance and prospects lead to the creation ofvalue over the short, medium and long term.This will require an efcient and comprehen-sive process of evaluating what is important to

a company in various time frames and acrossthe capitals. The real challenge may be navigat-ing the inter-dependencies and uncertainties.Humans in general are not very good at makingcomplex decisions under uncertainty. The goodnews is that techniques have been developed indecision sciences a multidisciplinary treat-ment of the relevant issues in making a decision to address these kinds of problems and theyneed to be deployed more eectively in the cor-porate context.5

In ve years, can we look back and say

that the way a company reported was soantiquated?Perhaps, although the debate on what com-panies ought to disclose will likely continue.Investors play a role here by asking those toughquestions about how corporate leadership is pre-paring for the future. Generally speaking, stake-holders will continue to become increasinglyaware of and concerned with the impact onenvironmental and human well-being associatedwith how we produce and consume goods, andmay become less willing to pay the price.

About DeloitteDeloitte refers to one or more of Deloitte Touche Tohmatsu

Limited, a UK private company limited by guarantee, and its

network of member rms, each of which is a legally separate

and independent entity. Please see www.deloitte.com/about

for a detailed description of the legal structure of Deloitte

Touche Tohmatsu Limited and its member rms. Please see

www.deloitte.com/us/about for a detailed description of the

legal structure of Deloitte LLP and its subsidiaries. Certain ser-

vices may not be available to attest clients under the rules and

regulations of public accounting.

Copyright 2013 Deloitte Development LLC

and with those companies who have long-livedassets whose successful deployment depends on

a strong license to operate and grow.

What can investors gain from greatertransparency?Reporting on environmental and social issues isan evolving area, voluntary and not standard-ized. The result is a general lack of consistencyin what companies share with their investorsabout what they monitor, and why. As alreadymentioned, the full cost of social and environ-mental externalities is not priced in the market-place, although the risks and costs to societyand companies are ever-present. Its important

to consider the risks and whether managementhas established a track record of managing themeectively. If they dont eectively manage therisk, the likelihood that something goes wrongcan increase.

This is akin to insurance: The investment pays owhen something bad happens and the companydoes not have to pay the full cost. Indeed, thebest return on an insurance policy is no returnat all.3 Because environmental and social issuestend to pose a downside risk for companies,managing the risk really means reducing the loss.

Its very hard for companies to hide informa-tion on their environmental and social impactin todays social media world. As the publicbecomes more aware of the impact and tra-ditional and social media broadcast the infor-mation, opinions are formed. This dynamicstrengthens the business case for investors topay closer attention to environmental and socialissues as they evolve. No matter how big or smallthe impact on near-term cash ows, a compa-nys reputation and brand can be at risk, alongwith future cash ows.

What could integrated reporting tell inves-tors about companies?Integrated reporting is a process that is guidedby integrated thinking. An integrated report,which is only one output of the process, couldhelp a company better communicate to its inves-tors about the companys ability to create valuein the short, medium and long term. The ideais to make clear what a company is doing interms of value creation across six capitals: nan-cial, manufactured, intellectual, human, socialand relationship, and natural.4 Value would be

assessed by investors based on information inthe integrated report about the various capi-tals that the company uses and aects. By mak-ing more explicit how these various capitals are


This page contains investment recommendations issued by units outside CIO WM Research.

These units are not subject to all the legal provisions governing the independence of nancial analysis.


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Fixed income

Despite being overlooked for years, sustainabilityconsiderations are just as important in the worldof xed income as they are for equities, perhapseven more so given the size of the global bondmarket compared to other nancial assets (seeFig. 1). While there is less research about the linkbetween sustainability factors and the perfor-mance of xed income investments than there isfor stocks, the message is similar: Protect down-

side without sacricing performance.

That said, the link may also be harder to prove.Bonds are less volatile than stocks and moreof the total return comes from income pay-ments than price uctuations. Moreover, whileESG risks can pose a substantial threat to acompanys earnings outlook and valuation,these same risks are unlikely to materially com-promise a companys ability to make interestpayments on its debt. But while performance

Looking beyond stocksFor many years, sustainable investing was pri-marily geared toward investments in stocks perhaps because equities are lower in the capitalstructure (and therefore potentially more suscep-tible to losses if environmental, social and gov-ernance, or ESG, risks emerge), or because stockinvestors are technically owners of companies(and therefore accountable for its business prac-tices). As a result, sustainable investing strate-

gies were typically directed toward only a slice ofthe overall portfolio or just treated as a satellitedivorced from the core.

A more comprehensive approach to sustainableinvesting would evaluate ESG risks within eachasset class, not just stocks, to ensure consistencyacross the entire portfolio. Why evaluate metalsand mining equities according to human rightsconsiderations only to have oending companiesfrom this same sector appear within the xedincome allocation, not to mention exposureto physical commodities, such as gold, where

human rights issues are a serious concern formany investors?

Getting the pieces to t togetherWith relevant ESG information becomingincreasingly available across dierent assets,todays sustainable investing mandates are bet-ter equipped to deliver comprehensive solutionsacross entire portfolios. That said, applying sus-tainability factors to asset classes beyond theequity market is still fertile ground and opento considerable evolution in coming years.Moreover, portfolio construction is a deeply per-

sonal endeavor and investors will have dierentincentives for incorporating sustainability factorsinto their decision-making process, as well as theshare of various assets in the overall portfolio.

Considerations in buildingsustainable portfoliosAgathe Bolli, Maryam Khan, Kurt E. Reiman

SECT ION 4

Fig. 1: Bond market overshadows equities

Note: Data are as of the end of the period and held constant at 2011 exchange rates.

Source: McKinsey Global Institute Financial Assets Database, UBS, as of 30 June 2013

Global stock of debt and equity outstanding, in trillions of US dollars

200

150

100

50

0

250

200520001990 1995 2007 2008 2009 20112010 2Q122006

Government bonds

Equity

Financial bonds

Corporate bonds

Non-securitized loans

Securitized loans

WE OUGHT TO GAIN ALL WE CAN GAINBUT THIS IT IS CERTAIN WE OUGHT NOT TO DO; WE OUGHT NOT TO

GAIN MONEY AT THE EXPENSE OF LIFE, NORAT THE EXPENSE OF OUR HEALTH.

John Wesley, The Use of Money


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Considerations in building sustainable portfolios

Sustainable competitiveness

The World Economic Forum introduced a sustainable competitiveness index in 2012 thatblends a wide range of environmental and social factors into their standard internationalcompetitiveness rankings.1 Unsurprisingly, weaker social and environmental scores tend to gohand in hand with lower competitiveness rankings and vice versa, eectively widening thecompetitiveness gap between countries. In other words, nations are not penalized in termsof competitiveness for pursuing sustainable economic growth. Investors in emerging marketsovereign bonds who wish to express their values, make an impact or simply make a betterinvestment can leverage information like this to screen out countries with sustainability scoresthat worsen their competitiveness ranking. Meanwhile, performance-oriented investors mayalso look to countries with sustainability attributes that boost their overall competitivenessstanding as a way of minimizing risk.

considerations may not necessarily warrant asustainability focus in xed income, there areviable approaches that investors can employ toeither express their values through their bondportfolio or make an impact.

Unlike equities, xed income markets involveinvestments in both sovereign and corporatebonds. Perhaps unsurprisingly, sustainabilityconsiderations dier markedly between gov-ernments and companies. For companies, the

same sustainability criteria that are relevantfor a companys stock are true for its debt.Investors seeking to express their values andmake an impact can apply positive and negativescreening approaches to corporate bonds justas they do for equities. In addition, the UnitedNations Principles for Responsible Investmentis working to achieve greater transparency andguidance on how to evaluate corporate bondsaccording to ESG risks and to promote greatercompany disclosure.

Meanwhile, how one judges the sustainability

of governments and their debt securities is lessclear. There are some straightforward examplesof exclusion criteria that could help screen outcertain governments, such as: military conict;human rights track records; access to health-care, clean water, education and other basicneeds; the trajectory of a nations debt-to-GDPratio; income inequality; and the health of theenvironment. MSCI ESG Sovereign Ratings

service oers comprehensive coverage of ESGrisks in 90 countries, providing xed incomeinvestors with additional information to evalu-ate the sustainability prole of governmentbonds in their portfolios. This information couldbe particularly useful to investors in emergingmarket sovereign bonds where governance isa critical factor in estimating expected returns(see box below).

Commodities

Sustainability-minded investors have a lot toconsider when investing in commodities, andyet the social and environmental risks asso-ciated with this asset class are oen poorlyunderstood (see Fig. 2). Production of physicalcommodities is associated with environmentaldegradation, resulting from mining, drilling, landclearing, water use and generally higher levelsof pollution. Another notable concern in min-eral production and distribution is the violationof human rights in conict areas, such as theDemocratic Republic of the Congo. Additionally,investors in commodity derivatives, as distinct

from physical commodities, have been accusedof raising the price volatility of basic necessities,such as food and energy.

Eorts to promote sustainable practices in com-modities production and investing have broad-ened in recent years, but compliance with ESGcriteria is by no means uniform or widespread.Natural resources extraction will always have


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environmental consequences no matter howmuch eort goes into cleaning up businesspractices and raising awareness. With respectto human rights, the World Gold Councilintroduced the Conict-Free Gold Standard toencourage better sourcing and greater transpar-ency throughout the gold supply chain.2 TheOrganisation for Economic Co-operation andDevelopment (OECD) published a study thatseeks to ensure that companies operating inconict zones and high-risk areas avoid human

rights violations and encourage sustainable eco-nomic development.3

How investors react to these realities withinthe commodities market will vary from oneindividual to the next. If commodities investingconicts with an individuals values because ofperceived links to social concerns, environmen-tal degradation or human rights violations, theymay wish to not invest in the asset class alto-gether. Alternatively, investors may opt to directcapital to companies that are enabling substitu-tion away from high-risk commodities (switch-

ing from thermal coal to natural gas), improvingharvesting technology (artisanal gold, sustain-able palm oil, farming and forestry) or reduc-ing demand for natural resources altogether(increased recyclable content, energy efciencyupgrades, reduced water use).

Nontraditional assets

Nontraditional assets, which include hedgefunds, private equity and private real estate,oer certain opportunities for investors to directtheir investments in a specic direction to impactsustainability objectives. A thematic sustainabilityfocus could take the form of a renewable energyprivate equity fund, energy efcient commer-cial real estate, or a sustainability-minded hedgefund, for example.

These assets are not without their drawbacks:research linking the hedge fund and privateequity industries to higher rates of incomeinequality, as well as disputes over the taxtreatment of carried interest in the US, may irksome sustainability-minded investors. A limitedproduct shelf and high minimum investmentamounts also restrict the degree to which inves-tors can build sustainability into their portfoliothrough nontraditional assets. However, whatmay be a small product oering today hasthe potential to grow as sustainable investingbecomes more mainstream.

Considerations to keep in mind when thinkingabout how nontraditional investments can play arole in a sustainable portfolio include:

Section 4

Source: PRI Association, as of 30 June 2013

Real productive assets such as forests oragricultural land

Direct exposure to issues such as environmental sustainability, laborand human rights, existing land and resource rights

Debt or equity investments in companies thatown commodity producing assets or relatedbusinesses in the commodity value chain

Direct exposure to ESG issues such as tailings waste produced bymines, labor standards in the supply chain, water scarcity, pollutionlevels

Physical commodities Indirect exposure to the potential impacts of investment in physicalcommodities. Additionally, signicant ESG issues can be associatedwith the production of physical commodities, including externalizedcosts

Commodity derivatives which can be tradedon exchanges or over-the-counter

Certain investments in commodity derivatives have been accusedof impacting price volatility and greater stability of nancialmarkets

Fig. 2: Sustainability considerations in commodities

Type of investment ESG issues to consider


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Considerations in building sustainable portfolios

Private real estate. Sustainable real estatedevelopment will likely become the norm overtime, as new technologies and innovation areadopted. Interestingly, the newest buildingsand the oldest buildings are the ones that tendto rate better on sustainability criteria. In thefuture, we may see a discount for non-sustain-able buildings, as opposed to a rent premiumfor sustainable buildings. Mitigating policyrisk is very real. Tighter regulations and greaterdisclosure of building sustainability levels will

likely continue.4

Private equity. Private equity managers havebeen criticized for their sometimes brutal pursuitof efciency gains at the expense of job lossesand community decay. However, keep in mindthat private equity rms have also focused onboosting nancial performance through eco-efciency goals, such as reduced consumption ofscarce natural resources like water and energy,and less waste.

Private equity typically has a long-term focus,

with capital committed for roughly 10-15 years.This becomes useful when investing in early-stage technologies that can yield material envi-ronmental benets and become viable newbusinesses, which then yields positive social ben-ets. This means that private equity is particu-larly well suited to pursue specialized investmentopportunities, ranging from renewable energiesto new protein sources to underfunded businessopportunities in disadvantaged communities.Impact investing, an up-and-coming investmentstrategy with roots in traditional private equity,pursues both positive social and nancial returns

(see more detailed discussion in Section 2).

Hedge funds. Very few sustainability-orientedhedge funds have emerged, despite being well-suited to take ESG factors into account. Aerall, better risk-adjusted returns is the valueproposition of both hedge funds and sustain-able investing. Growth in hedge fund strategiesthat incorporate ESG factors into their invest-ment process could become more common-place if managers become more convinced ofthe benets of taking sustainability consider-ations into account.

A personalized approachEach clients motivation for pursuing sustain-able investing strategies performance, values,impact or some combination of these willdetermine whether and how they shouldmake changes to their asset allocation. Forexample, performance-oriented investors mayseek a higher allocation to private equity totake advantage of specic ESG opportunitiesnot available in public markets. Values-basedinvestors may not want to invest in commodi-

ties and hedge funds. Even institutional inves-tors, because of benchmark and duciaryconstraints, will take a dierent approach fromindividuals who may wish to implement moreextreme positions to reect their sustainabilitypreferences (seebox on page 26). Ultimately,the decision to alter an asset allocation basedon sustainable investing strategies is not aboutgenerating better portfolio efciency; its aboutgenerating better risk-adjusted returns in allasset classes while also reecting investors val-ues and making an impact.


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Section 4

Sustainability the Norwegian way

The Norwegian government operates two sovereign wealth funds to invest proceeds fromits petroleum wealth. Norways Government Pension Fund Global is one of the largest publicinvestment funds in the world and invests internationally with two distinct aims: to preservepetroleum wealth and ensure stability in the Norwegian economy. Given its size and consider-able position in a number of multinational companies, the fund has sought ways to incorporateethical considerations into its investment strategy over the years. The sustainable focus of thefund was institutionalized in 2004 and is currently implemented by the Norwegian Ministry of

Finance and Norges Bank Investment Management (NBIM) administrative arms overseen bythe Norwegian Parliament. The Ministry of Finance establishes the responsible investment guide-lines and, together with the Council on Ethics, determines which companies should be excluded.Meanwhile NBIM exercises the funds ownership rights through sponsoring and supportingshareholder resolutions, proxy voting and corporate engagement (see Fig. 3). An evaluation ofthe funds responsible investment guidelines in 2009 concluded that more emphasis should begiven to inuencing positive change in companies,5 presumably through active ownership andgreater engagement with boards of directors.

Source: Government of Norway Ministry of Finance, as of 30 June 2013

Fig. 3: Division of roles to achieve a sustainability focus

Norges Bank

Exercises ownershiprights in individual cases.

Reports on active ownershipactivities on a quarterly basis.

Council on Ethics

Gives advice on exclusion ofcompanies from the Fundsinvestment universe.

The Ministry of Finance

Establishes underlying principles for theexercise of ownership rights.

Establishes criteria for exclusion of companies.


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Sustainability investmentthemesJulie Hudson, Kurt E. Reiman, Alexander Stiehler, Eva Zlotnicka

SECT ION 5

A thematic approachIn addition to weaving sustainability consider-ations throughout a portfolio, investors mayalso wish to build exposure to specic invest-ment themes that aim to address a range ofenvironmental, social and governance concerns.By directing assets to identiable themes, inves-tors can pursue potential growth opportunities,express their values in their nancial portfolioand make an impact on the world around them.

While there are many trends that could conceiv-ably fall under a sustainable investing umbrella,we focus on some of the more readily investibleand compelling long-term themes, such as: Food availability and access to nutrition Obesity and related medical conditions Renewable energy and energy efciency Water management

Growing economies and populations are increas-ing global demand for lifes basics: food, medi-cine, energy and water. We are confronted daily,

both in the news and at the pump, with highenergy prices. In many parts of the world, higherprices for basic foodstus are threatening socialstability. Poor diets and lifestyle choices are low-ering life expectancies and forcing a resource-constrained healthcare industry to nd solutions.And the lack of clean water has enormoushealth (and cost) implications globally, today andtomorrow. In this section, we consider the ques-tion of impending food, healthcare, energy andwater scarcities, and we take a look at some ofthe innovative ideas to redress these decits.

Food supplyMaking nutrition available

Population and income growth in emerg-ing market countries points to an increasinglystretched human food system. Steadily higherdemand and constrained supply inevitably leadto collisions. Releasing more land for crops bychanging land use is no longer a viable strategy

from an environmental perspective. Historically,new technology has made it possible to staveo a global nutritional crisis of Malthusian pro-portions. (Economist Thomas Malthus foundthat population, which tends to increase fasterthan its means of subsistence, willif leuncheckedhave disastrous results.) However,human beings now dominate the ecosystem,and economies continue to operate on the basisof a cost-externalizing growth model in whichresource constraints tend to be neglected until

Fig. 1: Agriculture prices declined despite population growth

Note: Series deflated using US consumer price index.Source: Bureau of Labor Statistics, World Bank, UBS, as of 30 June 2013

Inflation-adjusted agriculture commodity price index (2005 = 100)

400

350

300

250

200

0

100

50

150

450

1960 1970 1980 1990 2000 2010

WE DO NOT INHERIT THE EARTH FROM OUR ANCESTORS; WE BORROW IT FROM OUR CHILDREN.

Native American proverb


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they bite. Without another technological revolu-tion, cheap agricultural commodities may soonbecome a thing of the past (see Fig. 1).

The consequences of any collision betweendemand and supply in food are never equallydistributed. Malnutrition results from inequality(a social issue), and it also undermines econo-mies (an economic and nancial issue in thebigger picture). Food is a socioeconomic hybridand therefore cannot be le to markets to sort

out demand-supply collisions. However, impactinvesting may be particularly well suited for the

necessary mix of social and nancial insights tofacilitate a sustainable investment approach infood and nutrition.

Moreover, the low-hanging fruit in food iswaste,1 also not always readily handled throughmarkets. A study by the Swedish Institute forFood and Biotechnology for the Food andAgriculture Organization of the United Nations(FAO) in 2011 found that roughly one-thirdof food produced for human consumption

is lost or wasted globally.2

Raw materials,such as water and agrochemicals, are used

Access to Nutrition Index

The Access to Nutrition Index (ATNI), launched in 2013, highlights the strategic and reputational importance of nutritionfor food and beverage companies (see Fig. 2).3 The ATNI helps point the way toward better transparency and traceabilityin food sectors, and toward greater accountability in agriculture, commodities, processing, retailing and waste.

Fig. 2: 2013 Access to Nutrition Index

* Company did not provide information to ATNI's research partner during the research phase.

Source: Access to Nutrition Index, UBS, as of 30 June 2013

Overall global ranking (maximum score = 10)

Products

Governance

Marketing

Accessibility

Labeling

Lifestyles Engagement

0 721 3 654

Danone SAUnilever

Nestl SAPepsiCo Inc.

Kra Foods, Inc.Grupo Bimbo SAB de CV

ConAgra FoodsH. J. Heinz Company

The Coca-Cola CompanyThe Kellogg Company

General Mills, Inc.*Barilla SpA

Campbell Soup CompanyFerrero SpA

Sigma AlimentosMars, Inc.

Ajinomoto Co., Inc.The Hershey Company

FrieslandCampina*Brasil Foods SA*

Nichirei CorporationGroupe Lactalis*

Lotte Co. Ltd.*Nissin Food Holdings Co., Ltd.*

Tingyi Holding Corp.*

Section 5


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Sustainability investment themes

wastefully. Meat-heavy diets are wasteful ofwater, energy and land. A shocking proportionof food is thrown away uneaten because of aninadequate storage and transport infrastruc-ture, which is oen a problem in developingcountries and because of the pile it high, sellit cheap marketing practices in some devel-oped countries. Eating habits are also wastefulthrough the

ubs research focus, sustainable investing, july 2013

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