Integrating Sustainable Materiality into Investment Decisions

A research paper by Sem de Moel and Merle Rder

April 2017

de Moel, S April 2017 Rder, M

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Executive Summary

An increasing number of asset owners, investment managers, and service providers are committing

themselves to incorporating Environmental, Social and Governance (ESG) issues into investment

decisions. Consequently, market exposure to shocks related to ESG issues has made it essential for

investors to incorporate sustainability factors in order to optimise risk-adjusted returns. However,

literature has been divided as to whether investing in firms with high ESG performance leads to

outperformance. One theory that can be attributed to the mixed findings, is the lack of incorporating

materiality into the ESG decision making process. That is, selecting firms based on high performance

on ESG issues that are of material importance to the industry of the firm. This paper examines the

financial performance of firms that score high on material sustainable issues against the market and

high/low scoring (im)material firms in Europe. Using monthly firm stock return regressions, this

analysis finds that there is significant outperformance of high scoring material firms against the

market, and against high scoring immaterial and low scoring material firms. Additionally, a materiality

portfolio is constructed that is similar in diversification to one of ACTIAMs active portfolios, to

accurately compare the financial performance of material firms against other companies and the

market. The active portfolio and subsequent portfolio are all compared to the MSCI Europe Index. The

results show that the diversified material portfolio significantly outperforms both the active portfolio

and the market, suggesting investments in sustainability issues that are relevant to the industry are

value-enhancing. These findings have implications for fund managers who have committed to

integrate ESG related issues into their investment decisions.

We especially would like to thank Dirk F. Gerritsen (Assistant Professor for the chair Finance and

Financial Markets at the Utrecht University School of Economics) for all the effort he has put in helping

Sem and Merle and enable them to come up with this excellent paper.

de Moel, S April 2017 Rder, M

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Foreword

It is ones fiduciary duty to take ESG factors into investment decision making. Whether you like it or

not you will be forced to do so for several reasons; for example, as a result of rules and regulations

(UNPRI & MSCI, 2016). At the moment, most regulations are pressing on transparency and disclosure.

The aim is, that once this is achieved (and greater insight is ensured), there will be more rule based

regulation, such as those related to the Paris Agreement where commitments are made to keep the

average global increase of temperature well below 2 degrees. One of the most innovative and

effective examples is Article 173 of the Energy Transition Law in France. Other countries, like the

Netherlands, where the supervisor started with a principle based approach for pension funds, will

follow.

Growing demand from society and societal pressure are further influencing investors decision making

and are responsible for ESG becoming mainstream. Often there is a reference to the millennials who

are advocating for more sustainability. While this is true, the support for ESG is becoming more

widespread amongst all age categories.

The argument that is most often used for not taking ESG-factors into account, is that it is not the core

purpose of the financial markets. More specifically: ESG might lead to inferior returns because they

limit the number of potential investments with a potential attractive return (when excluding), or they

might generate extra costs because of increased research requirements. It is at this point where I get

confused and Ill explain why:

If I was a CEO of a company (or if I would do research on a company) my first goal is to build a business

model that is robust and tenable. The next goal is to optimize my returns and to minimize my

dependencies. This means that I will take into account everything that could be a possible threat to

my investments, no matter how this is labelled. This has nothing to do with ESG or sustainability as

such. It is, in fact, a matter of good governance; looking at things that are material to your business.

It seems so logical, and thus it is incomprehensible why so little companies do so. Research (Khan et

al., 2015) has proven that there are vast differences in the characteristics of firms. Their reports

highlights that some firms are unable to focus on elements that are highly material to their business,

with the reason being that management is incapable of distinguishing between immaterial factors and

real problems. The paper finds that there is also a clear link between focusing on high-material factors

(they differ per sector or industry group) and financial outperformance. In other words: material ESG-

factors as an alpha source.

A society grows great when old people plant trees whose shade they know they shall never

sit in ~ Greek Proverb

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Since that research was done based on US companies, and the main focus of ACTIAM is Europe, we

wanted to know if the same applies to European markets. And it does. Although more research is

needed, we think the case is strong enough to integrate the outcomes into our investment- and

engagement process. Especially this last instrument is a way of taking responsibility, driving

performance without limiting your set of opportunities.

I hope that this paper and outcome will inspire investors, asset owners, and companies to integrate

material (ESG-)factors in their way of thinking and in their processes. In the end it does not matter

what your motivation is (alpha, clients, society or your internal motivation), we all have to contribute

towards a sustainable future.

All the credits for this research-paper goes to Merle Rder and Sem de Moel. They did an outstanding

job working tirelessly researching and producing this paper. With their research and with their

personalities they leave their footprint within ACTIAM. I wish them all the best in the bright future

that clearly lies ahead of them.

Dennis van der Putten - Head of ESG Research / Responsible investing ACTIAM

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Table of Contents

Executive Summary ................................................................................................. 2

1. Introduction ....................................................................................................... 6

2. Research & Methodology ....................................................................................... 10

2.1 SASB Accounting Standards ................................................................................ 10

2.2 Sustainability Data Collection and Matching Process ................................................. 12

2.3 Research Question .......................................................................................... 13

2.4 Portfolio Construction ..................................................................................... 14

2.4.1 Return Estimation ..................................................................................... 14

2.4.2 Portfolio Optimisation ................................................................................ 15

3. Results & Discussion ............................................................................................ 18

3.1 Materiality versus Immateriality ......................................................................... 18

3.1.1 High material against low material portfolio performance ..................................... 19

3.1.2 High material against high immaterial portfolio performance ................................. 20

3.2 Materiality against the Active Portfolio and the Market ............................................. 20

3.3 Optimised Portfolio Performance ........................................................................ 22

3.4 Robustness ................................................................................................... 25

3.5 MSCI Score and Materiality Score: A Link to Outperformance? ...................................... 26

4. Conclusion & Areas of Future Research ..................................................................... 27

4.1 Conclusion ................................................................................................... 27

4.2 Areas of Further Research ................................................................................. 27

5. References ....................................................................................................... 29

6. Appendix .......................................................................................................... 31

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1. Introduction

Societys increasing awareness and expectations in regard to environmental, social and corporate

governance issues, has led to sig