Sustainable Investment: Opportunities for Mainstream Investors

CFA Ireland

Steven A. Falci, CFAVice President-Sustainable Investment

KBC Asset Management Ltd. January 21st 2009

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Evolution of SRI

•Socially Responsible Investing •Sustainable Investing•Responsible Investing •Environmental, Social and Governance (ESG)

1st Generation SRI 2nd Generation SRI 3rd Generation SRI

• Ethics• Exclusion

• Ethics • Inclusion• Exclusion

• Sustainability • Materiality• Investment Return

•Exclusionary Screening •Positive Screening•Best in Class•Pioneer Screening

•ESG Integration – Active Management•Thematic Products – Active Management

•Engagement - ethical • Engagement – performance/ethical

•Retail•Institutional – Values Driven (F&E, charities, i.e)

• Institutional Mainstream Market• Differentiated Retail Products • High Net Worth Individuals

Exclude•Alcohol•Tobacco•Weapons•Gambling etc.

•Best in Class Companies (challenging industries)•Companies with positive environmental initiatives

•Leading companies providing innovative solutions to sustainability challenges•Companies with strong sustainability and financial profiles

Terms

Mercer

Emphasis

Broad Vehicles

Primary MarketFocus

Examples

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SRI ↔ Sustainable Investment

1st Generation SRI Sustainable investing

Historical Future

Separate Integrated

Ethical

Exclusionary

Materiality

Inclusionary

Criteria

Focus

ESG / Investment Process

Time Orientation

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Global Market Size

Hard to precisely define – But various Indicators point to a Large and Growing Market

Eurosif – €5 trilliono European Social Investment Forumo Begin to distinguish approaches (Core and Broad)

UNPRI – $14 trilliono 380 Asset Owners and Asset Managerso Assert intention to integrate Environmental, Social and

Governance Factors into investment process

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Global Growth SRI

2003 €1.9 Trillion

84%

16% 0%North America84%Europe 16%

Australia/Asia0%

2005 €2.6 Trillion

64%

35%1%North America

64%Europe 35%

Australia / Asia1%

2007 €5 Trillion

39%

53%

8%North America39%Europe 53%

Australia/Asia8%

Source: Eurosif

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Sustainable Investment Strategies

Thematic Strategieso Investment opportunities in companies providing

solutions to our most pressing global challengeso Renewable Energy, Water, Climate Change

ESG Integrationo Material risks and opportunities related to

Environmental, Social and Governance factors are an integral part of investment analysis

o Companies with strong sustainability and financial profiles

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Global Mega Trends

World’s changing demographic profileo The combination of population growth, industrialization, economic growth and

urbanization will continue to test the limits of our eco–system and will require investment in innovation and infrastructure in the developed and developing world to meet the needs of growing, more affluent global population.

Natural resource supply/demand imbalanceo A growing, more affluent global population has and will continue to put increasing

pressure on the supply of natural resources. Meeting the needs for energy, water and food is a major challenge of the 21st century.

Climate change -and operating in a carbon constrained worldo Sustained pressure for lower carbon economies continue to gain momentum

through efforts to mitigate and adapt too combat the effects of climate change. The growing demand for energy will need to be met through less reliance on the historically dominant carbon emitting sources of oil and coal and with more reliance on renewable alternative energy and energy efficiency.

Innovation to meet challenges to our environment are driven by 3 Global Mega Trends.

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Alternative Energy Investment Thesis

1. Global Energy Demand – Population & Industrialization

2. Limited Supply of Fossil Fuel Energy

3. Falling Costs of Renewable Energy – Technology & Investment

4. Security of Fuel Supply – Local Source Necessary

5. Climate Change – Political & Regulatory Support

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Renewables as % of Energy Mix

Other3.6%

Ocean (tidal)0.0%

Nuclear16.0%

Conventional65.5%

Large Hydro14.9%

Small hydro1.3%

Wind Power1.2%

Solar Thermal0.0%

Solar PV0.1%

Geothermal0.2%

Biomass0.9%

Renewable Energy• Wind• Solar • Biofuels• Fuel Cells • Waste to Energy

International Energy Agency:30% of all energy related

Investments in next 30 years willbe in renewables

Renewable electricity capacity, share of 2005 electricity production

Source: Renewables Global Status Report 2006 Update, REN 21

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Falling Costs of Renewables Renewable energy actual cost of production — cents/kWh

Expected cumulative reduction in costs of renewable technologies by 2020

Source: United Nations Economic and Social Council

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Alternative Energy Portfolio Summary

Source: KBCAM Data as at 31.12.08.

Sector Distribution % Actual Weight Neutral WeightUTILITIES 16.0% 15.0%

WIND ENERGY 37.4% 30.0%

SOLAR 26.7% 30.0%

FUEL CELLS 6.5% 10.0%

BIOMASS 10.5% 10.0%

OTHER 2.9% 5.0%

Top 10 Holdings %

IBERDROLA RENOVABLES 7.6%

EDP RENOVAVIES 6.2%

GAMESA 5.6%

FPL 4.9%

FORTUM 4.3%

VESTAS 4.1%

RENEWABLE ENERGY CORP 4.1%

KYOCERA 4.0%

JOHNSON MATTHEY 3.9%

FIRST SOLAR 3.9%

Market Weights %

N. AMERICA 28.4

EUROZONE 41.1

REST OF EUROPE 20.1

REST OF WORLD 10.4

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Water Investment Thesis

1. Demand – Population growth / Demographics

2. Supply problems – Availability, Infrastructure & Pollution

3. Regulatory Drivers

4. Technological Advancements

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1% of Water Useable

Less than 1% of all water is available for human consumption

There is no substitute for water; that’s why it is rapidly becoming such a valuable resource.

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Water and Population Growth Chart

0100200300400500600700800900

1000

1900 1940 1950 1960 1970 1980 1990 1995 2000 2010 2025

Global Population Global Water Consumption

Sources: US Census Bureau / German Ministry of Environment

Economic Growth

Population Growth

Standard of Living

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Population/Water Divergence

Source: UNESCO

Asia has 36% of the world’s water

supply and 60% of the population

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Investment Required

Source: Boenning & Scattergood

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Water Portfolio Summary

Sector Distribution % Actual Weight Neutral WeightWATER INFRASTRUCTURE 37.3% 40.0%

WATER/WASTEWATER UTILITIES 35.7% 35.0%

WATER TECHNOLOGY 27.0% 25.0%

Top 10 Holdings %VEOLIA ENVIRONNEMENT 5.8%

SUEZ 5.3%

ROPER INDUSTRIES 4.5%

PENTAIR 4.4%

AGILENT TECH 3.8%

ITRON INC 3.3%

GEBERIT 3.3%

SEVERN TRENT 3.1%

MUELLER WATER 3.1%

FLOWSERVE CORP 3.0%

Market Weights %

N. AMERICA 48.5

EUROZONE 19.2

REST OF EUROPE 12.9

REST OF WORLD 19.4

Source: KBCAM, Data as at 31.12.08.

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Climate Change Investment Thesis

1. Growing Population, Industrialization and Urbanization has led to increased carbon emissions.

2. Immediate action required to mitigate long term human, environmental and economic costs

3. Demand for Cleaner Energy, Energy Efficiency & Waste Management

4. Technological Advancements

5. Political, Regulatory & Popular Support

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Regulatory and Policy Initiatives continue to support increasing investment

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Energy Efficiency Multiplier Effect

Fuel = Coal

Transmission Lines

Power Plant65% Loss

10% Loss

Every 1 unit of energy saved at home or business represents up to 4 units saved at the power plant

Source: Sustainable Energy, Choosing Among Options (Tester, Drake, Driscoll, Golay, Peters), UBS Research

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2/3 of Projected Co2 emission savings to come from energy efficiency

Source: International Energy Agency

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Climate Change Portfolio Summary

Sector Distribution % Actual Weight Neutral WeightWATER 15.0% 15.0%

RENEWABLE ENERGY 23.2% 25.0%

CLEAN ENERGY 9.1% 10.0%

ENERGY EFFICIENCY 34.8% 35.0%

WASTE MGT/RECYCLING/NEW MATERIALS 10.7% 10.0%

CARBON TRADING 6.4% 5.0%

Top 10 Holdings %WASTE MANAGEMENT 6.0%

E.ON 5.4%

ABB 4.5%

EAST JAPAN RAILWAY 3.7%

EMERSON ELECTRIC 3.3%

CLIMATE EXCHANGE 3.1%

SCHNEIDER ELECTRIC 3.0%

KONICO PHILLIPS 3.0%

SAINT GOBAIN 2.9%

CANADIAN NATIONAL RAIL 2.7%

Market Weights %

N. AMERICA 39.6

EUROZONE 33.0

REST OF EUROPE 19.1

REST OF WORLD 8.4

Source: KBCAM. Data as at 31.12.08.

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ESG Integration

Environment Social

Governance

GHG Emissions

Eco EfficiencyEnvironmental Management Systems Environmental Products

Environmental LiabilityWater Consumption

Human Capital Practices

Health and Safety Issues

Consumer Markets

Labor Markets

Supply Chain Management

Human Rights

• Costs and Revenues

• Cost of Capital

• Balance Sheet Risk

• Brand and Reputation Risk

• Competitive Advantage

• Valuation

• Executive Comp Tied to Performance

• Board Structure and Accountability

• Transparency

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ESG Integration – Opportunities and Challenges

Opportunitieso Capture sources of Intangible Value

Approximately 80% of market value driven by intangibles - Prof Baruch Lev, NYU Stern School of Business

Opportunities and Risks o Underpriced in market place

Challengeso Assessing materiality over timeo Assessing materiality across industries / sectors / regionso Quantification and measurement

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Goldman Sachs Sustain - Integrated Process

Management Quality(ESG)

Industry Positioning

Return on capital

Source: Goldman Sachs Research

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GS Sustain – ESG Weightings

Energy Basic

MaterialsCapital Goods Media

Consumer Staples Healthcare Banks Insurance

Technology Hardware

Corporate Governance 24% 24% 25% 33% 26% 27% 32% 39% 27%

Leadership 8% 8% 8% 17% 9% 9% 11% 11% 9%

Employees 28% 28% 29% 23% 22% 18% 26% 17% 23%

Stakeholders 12% 20% 13% 13% 22% 27% 21% 22% 14%

Environment 28% 20% 25% 14% 22% 18% 11% 11% 27%

Man

agem

ent Q

ualit

y (E

SG)

Soci al

Source: Goldman Sachs Research

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Relative Carbon Exposure

FPL Group   Expected Case Minimum Case Maximum Case

Carbon Price $28 $18 $45

Annual Cost of Compliance ($1000) $349,150 $212,840 $560,335

Exposure (% of EBITDA) 11.80% 7.20% 18.90%

NPV of Abatement Costs ($1000) $1,584,034 $1,006,866 $2,543,329

Exposure (% of market cap) 5.70% 3.60% 9.20%

   

American Electric Power

  Expected Case Minimum Case Maximum Case

Carbon Price $28 $18 $45

Annual Cost of Compliance ($1000) $1,187,710 $724,024 $1,906,103

Exposure (% of EBITDA) 34.40% 21% 50%

NPV of Abatement Costs ($1000) $5,388,442 $3,425,077 $8,651,697

Exposure (% of market cap) 29% 18.40% 46.60%

Source: CFA Magazine / Sept-Oct 2008

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Innovest Sustainability Matrix

10

9

8

7

6

5

4

3

2

1

00 1 2 3 4 5 6 7 8 9 10

Perf

orm

ance

of C

ompa

ny

Alpha Intensity of Sub-FactorStrategic Governance Environment

Human Capital Stakeholder Capital

Source: Innovest Strategic Value Advisors

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Proposed DCF framework for integration of ESG Factors

Issue 1

Issue 2

Issue 3

Issue 4

Issue 5

Issue 6

Issue 7

Issue 8

Issue 9

Issue 10

Exposure to ESG issues

Strategy, policies, management systems

Transmission Factors

Financial value drivers

Valuation components

Litigation and regulatory risks

Operational risks

Reputation andbrands

Operational efficiency

Innovation

Access to new /existing markets

Access toKnowledge and skills

Access to keyresources

Others

Risk premiums

Costs

Revenues

Others (tax, reinvestment

rates)

WACC

Free cash flows

Shareholder

value

Source: Expanding the Investment Frontier – The Conference Board

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ESG Ratings Development

Materiality of ESG Factor for Sector Comparative Ranking Support Wide Array of Implementation Options

o Top Quintile ESG & Top Quintileo ESG Tilto ESG Betao Hybrid Strategies – Quant / Fundamental Blend

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Performance Studies –Definitional Challenges

SRI vs Sustainable Investment

Risk characteristics in individual strategies

Time period, market conditions, geographic markets

Performance impact of specific ESG factors

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SRI vs Sustainable Investment

Cary Krosinsky –The Rise of Sustainable Investing in Sustainable Investing the Art of Long Term Investing – 2008

o Time Period 2002-2007o 135 mutual funds

Meir Statman – The Wages of Social Responsibility –December 2008 Time Period 1992-2007

o KLD Research Scoreso Tilt toward stocks with positive SRI scores – Positive Return Impacto Exclusionary practices detracted from returns

Sustainable Investing 18.7%Ethical 13.8%Style Drift SRI 11.6%MSCI World 17.0%S&P 500 13.2%

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Performance Reviews

Demystifying Responsible Investment Performance o 2007 UNEP-FI Asset Management Working Group / Mercer

Consultingo Compilation of 20 Academic Studies and 10 Broker Research

13 positive 10 neutral 4 neutral / positive or neutral / negative 3 negative

Lloyd Kurtz-Answers to Four Questions o SRI Performance and Risko Positive ESG Alpha

Environment – 13 studies Governance – 7 studies Employment Practice – 6 studies

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Studies on ESG Factors

Environmento Derwall, Guenster, Baver, Koedijk “The Eco-Efficiency

Premium Puzzle” 2005o Gluck and Becker “ Can Environmental Factors Improve

Stock Selection” 2004

Socialo Edmans “ Does the Stock Market Fully Value Intangibles?

Employee Satisfaction and Equity Prices” 2008

Governanceo Gompers, Ishii, Metrick “Corporate Governance and

Equity Prices” 2003

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Conclusion

As with all active management what matters most

o Rigorous Investment Processo Unique Insightso Innovationo Vision

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Reading - Sustainability, Investing and Business

Matthew Kiernan Investing in a Sustainable World (2008)

Cary Krosinsky and Nick Robbins, eds. Sustainable Investing: The Art of Long Term Performance (2008)

Thomas Friedman Hot Flat and Crowded (2008)

Holiday, Schmidheiny, Watts Walking the Talk: The Business Case for Sustainable Development (2002)

Mark Epstein, Making Sustainability Work (2008)