Components of Sustainability Gail Doolin, CFADec. 8, 2010

Agenda

• Overview of Sustainability

• ASSET4 ESG Data at Thomson Reuters

• Correlation of ESG scores with CDS spreads & Earnings Surprises

• ESG scores as Predictor of Future Returns

• Combining ESG with Earnings Quality Model

• Q&A

Sustainability - Finally Moving Mainstream?

“Quants and Do-Gooders Unite”The Wall Street Journal, November 2, 2010

“A Quant’s Take on ESG”responsible-investor.com, September 17, 2009

“Are all Components of ESG Scores Equally Important?”

The Financial Professionals Post, July 14, 2010

“Asset Managers Find New Sources Of Alpha –

Responsible Investing”Institutional Investor, November 2010

Concept of Sustainability

Sustainable development “meets the needs of the present without compromising the ability of future generations to meet their own needs” (The Brundlant Commission, 1987)

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ESG: The Corporate View

• According to an Issue of The McKinsey Quarterly:80% of CFOs and CIOs believe that ESG information can serve as a proxy for the quality of a company’s management.

• An 2009 IBM Survey of business leaders revealed:More than 2/3 of organizations surveyed “focus on CSR as part of an integrated business strategy to grow new revenue streams and control costs.”

Source: The McKinsey Quarterly, Feb. 2009

Key Sustainability Concerns

Environmental

Social

• New environmental regulations • Reputation damage from waste, pollution, spills, • Continued access to natural resources•Physical property damage from climate change

Governance

• Ability to hire & retain talent•Labor related controversies• Product related complaints • Human rights

• Reputation damage & legal costs • Shareholder controversies

• Higher raw material costs• Increased legal costs • Fines and legal judgments• Supply chain interruption• Higher insurance costs• Revenue impact due to consumer backlash• Higher costs to attract talent• Increased cost of capital

Financial Impact

Economic

• Supply Chain risk• Customer loyalty

Corporate Reporting Continues to Grow

Source: CorporateRegister.com

What are the Characteristics of ESG Content?

• Reporting is largely voluntary so it is heavily skewed to large, publicly traded companies

• Despite the GRI’s efforts, what is reported and how it is reported still lacks standardization from firm to firm even within the same country/industry.

• Trend is toward more industry specific measures

• Europe has highest concentration of reporting companies, followed by U.S. In Asia, Australia has greatest interest.

• CSR reports are updated annually

• There is a limited amount of history

Asset4’s Content Attributes

• Content collection practices– Rely on publicly available sources

– Link back to source document for verification

• Standardization methodology– Calculate KPIs from raw data points

– Multiple levels of ratings

• Coverage– Cover >3,000 companies globally including coverage for MSCI World,

MSCI Europe, DJ Stoxx 600, Russell 1000 and FTSE 350

• History– History back to 2002 (approx 950 companies)

– Minimum of 3 years of history

• Dynamic ratings – Factor in the impact of news controversies

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ASSET4 ESG Data Sources and Products

Annual Reports

CSRReports

CompanyWebsites

NewsSources

NGOWebsites

Stock Exchange Filings

ObjectiveESG Database

Data Collection

Negative Screening News MonitoringData Feeds Excel Add-in

Data Analysis

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EconomicPerformance

Environmental Performance

SocialPerformance

Corporate Governance Performance

Pillars

Client Loyalty

Performance

Shareholders Loyalty

Resource Reduction

Emission Reduction

Product Innovation

Employment Quality

Health & Safety

Training & Develop.

Diversity

Human Rights

Community

Product Responsibility

Board Structure

Compensation Policy

Board Functions

Shareholders Rights

Vision and Strategy

Categories

Overall performanceCompany overview

Link to public data sources (Raw Data)

Indicators More than 250 indicators (calculated from data point values)

ESG Data and Framework

More than 750 data pointsDataPoints

Data Roll-up Example

Standardization Allows for Peer Comparison

Asset4 Coverage Growth by Region

Access to ESG Related News Stories

Dynamic Ratings News stories pertaining to specific types of controversies impact KPIs so ratings can change due to events throughout the year.

The types of controversies that can change ratings include:

Indigenous PeopleInsider DealingsIntellectual PropertyManagement CompensationProduct Impact MediaProduct Quality and ResponsibilityPublic HealthSocial ExclusionSpills and PollutionTax FraudWages or Working Conditions (Company)Wages or Working Conditions (Contractor)

AccountingAnti-CompetitionBiodiversityBusiness EthicsChild LaborConsumerCritical CountriesDiversity and OpportunityEmployee Health & SafetyFreedom of AssociationFDA Warning LettersGeneral Shareholder RightsHuman Rights

TR Studies Related to ESG Data

Examination of ESG Performance & CDS Spreads

• CDS Spreads measure the cost of ensuring against default and the riskiness of a bond

• Examined the relationship between CDS spreads and ESG scores – Segregated ESG performers into 4 quartile groupings

– 2005-2007

– 2008-present

• Hypothesis: Higher ESG performers should have lower CDS spreads

CDS Spreads vs. ESG Performance 2005-2007

CDS Spreads and ESG Scores 2008-present

Examination of Reported Earnings vs. Estimates and ASSET4 ESG scores

• ESG as proxy of management quality– Greater awareness of business performance

– Transparency with investors on information

– Should be reflected in better earnings results

• Examination of I/B/E/S estimates vs. actuals

• Companies with higher ESG scores should out-perform those with lower scores

Methodology of Study

• Actual earnings announcements compared to I/B/E/S estimates for companies in the ASSET4 Universe– Placed into quartile groupings corresponding to the

ASSET4 scores at the time

• Percentage of announcements above or below the estimates within each ASSET4 scoring group compared

• Annual announcements examined 2005-present

• Quarterly announcements examined 2008-present

Frequency of US Annual Earnings Above Estimates

Frequency of US Annual Earnings Below Estimates

Gap between ESG leaders and laggards – Annual earnings above estimates

Gap Between ESG Leaders and Laggards –Annual Earnings Below Estimates

Information Coefficient of ESG Factors

-0.01 0.00 0.01 0.02 0.03 0.04 0.05 0.06

Social

Environmental

Economic

CorporateGovernance

IntegratedRating

Information coefficient

ESG

fact

orGlobal IC's of ESG Factors

with Future Returns

12 month

6 month

3 month

1 month

Combining ESG with Earnings Quality Model

0.00

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0% 20% 40% 60% 80% 100%

Info

rmati

on c

oeffi

cien

t

All ESG All EQWeight on EQ

Linear Combos of ASSET4 Overall Score with EQ

12 month

6 month

3 month

1 month

Filtering with ESG Improves Risk-Adjusted Returns

0% 5% 10% 15% 20% 25% 30%50 0.669 0.787 0.919 0.830 0.754 0.749 0.746

100 0.772 0.919 0.972 0.998 1.042 0.988 1.053200 0.957 1.054 1.079 1.115 1.182 1.292 1.156

0% 5% 10% 15% 20% 25% 30%50 0.0% 17.6% 37.4% 24.1% 12.7% 12.0% 11.6%

100 0.0% 19.1% 25.9% 29.3% 35.0% 28.0% 36.5%200 0.0% 10.2% 12.8% 16.6% 23.5% 35.0% 20.8%

Percent of universe eliminated by ESG score

Number of stocks in long

and short sides

Percent of universe eliminated by ESG score

Number of stocks in long

and short sides

Risk-adjusted returns of long-short portfolio

Percent improvements in risk-adjusted returns

Observations & Conclusions

• Like KPIs, interest in industry specific ESG measures will continue to grow

• Events will become more embedded in sustainability ratings, allowing them to evolve more quickly

• As more companies report, large cap bias will weaken

• As expected, ESG scores are positively correlated with earnings surprises and negatively with CDS spreads

• Starmine’s research shows that ESG scores add value on an absolute and risk-adjusted basis