1. SIRP is funded by Mistra, the foundation for strategic environmental research The Economic Value of ESG/SRI Lars G Hassel Program Director Mistra The Norwegian Business School – November 15, 2012

2. SIRP is funded by Mistra, the foundation for strategic environmental research

3. Programme objective 2006 Find out how sustainable investment practices can create added value for institutional investors and identify barriers to mainstreaming such practices Research on: – Economic value of ESG/SRI – Sustainable value and reporting – Incentive Systems – Fiduciary duty

4. SIRP is funded by Mistra, the foundation for strategic environmental research SIRP vision Investors expect to create value added by exploiting sustainable investments by asset management …but there are barriers because of uncertainty of financial outcomes and the strict financial focus of fiduciary duty …institutional investors have the strength to improve the market mechanism to drive companies towards a more sustainable development.

5. SIRP is funded by Mistra, the foundation for strategic environmental research …the evidence suggests that there does not appear to be a performance penalty from taking ESG factors into account in the portfolio management process (2007) Academic research continues to support the hypothesis that specific environmental, social and corporate governance (ESG) factors can make a positive contribution to investment performance (2009)

6. SIRP is funded by Mistra, the foundation for strategic environmental research ESG and Economic Value – Firm Level Is there a correlation? – Innovest eco efficiency ratings of U.S. firms positively associated with firm value and operating performance (Guenster et al. 2011) – GES environmental ratings of Swedish large-cap firms positively associated with firm value and operating performance (Semenova and Hassel, 2011) – Green buildings in U.S. with a LEED or Energy Star certificate have higher rental rates (Eicholtz et al 2010) – Environmental performance associated with higher credit ratings and lower cost of debt of U.S. firms (Hahn and Bauer, 2010) Sustainable business practices add economic value to assets! Costs of practices drop (learning and scale) and future benefits increase First mover advantage

7. SIRP is funded by Mistra, the foundation for strategic environmental research SRI Risk/Returns Is there an alpha? SRI funds and portfolios seem to perform neutrally (Olsson, 2007; Derwall and Koedijk (2009); Herzel at al, 2012) Performance can be different in different SRI segments (Derwall et al 2011) – Values driven (exclusion) and profit-seeking (alpha) segments ESG portolios have outperformed in the past (e.g. Derwall et al 2005) – Investors are more sophisticated and have learned. – Can mis-pricing of large-cap firms continue? (Borgers et al 2012)

8. SIRP is funded by Mistra, the foundation for strategic environmental research SRI- a theoretical perspective Efficient Market Hypothesis: Prices reflect all publicly available information and prices instantaneously adjust to reflect any new public information If all information is incorporated in prices – No predictive power for future returns – It is not possible to use ESG information to earn abnormal returns (as long as this information is available to more investors) SRI restrictions – Restricting the universe worsens portfolio’s risk-return tradeoff – SRI portfolios underperform

9. SIRP is funded by Mistra, the foundation for strategic environmental research Empirical Research Two main strategies have been studied: 1.ESG opportunity (select best-in-class) 2.ESG risk management (exclude sin stocks) Portfolio construction: Top: leading best performers on E, S, or G Bottom: lagging worst performers on E, S, or G Abnormal returns or “Risk-adjusted” returns Different risk-factors (4 factor model) accounted for

10. SIRP is funded by Mistra, the foundation for strategic environmental research Derwall et al (FAJ 2005): RISK- AND STYLE-ADJUSTED PORTFOLIO RETURNS (ALPHA) BASED ON INNOVEST ECO-EFFICIENCY RATINGS (U.S companies 1995-2003) alpha %R m -R f Market Risk β SmB Small Firm Risk HmL Price/book Risk MOM Momentum Effect R2R2 Best-in-Class Portfolio 4.15**0.92***-0.19***0.02-0.09***0.88 Worst-in- Class Portfolio -1.811.03***0.040.23***-0.08***0.86 Difference5.96**-0.12***-0.23***-0.22***-0.010.17 Abnormal Return! Mispricing or another risk factor? Liquidity; downside risk, takeover factors

11. SIRP is funded by Mistra, the foundation for strategic environmental research ESG opportunity portfolios in the U.S. Best-in-class outperformance fades out over time when investors learn! StudyPeriodCSR dataPortfolio selection criterionAlpha high- ranked portfolio Alpha low- ranked portfolio Derwall et al. (2005)1995-2003InnovestEco-Efficiency4.15% *-1.81% Kempf &Osthoff (2007)1991-2004KLDEnvironmental performance3.60% *0.59% Statman & Glushkov (2007) 1992-2007KLDEmployee relations3.73% *n/a Edmans (2009)1984-2005FortuneBest Companies to work for4.08%*n/a Derwall et al. (2011) 1992-2004 1992-2008 KLDEmployee relations 5.62 2.81 n/a Borgers et al.(2012) 1992-2004 2004-2009 KLDStakeholder Index 3.52* -2.80 n/a Gompers et al. (2003)1990-1999IRCCCorporate governance8.5%*n/a Bebchuck et al (2011) 1990-1999 2000-2004 IRCCCorporate governance 5.88* to 14.76* -3.60* to 4.2* n/a

12. SIRP is funded by Mistra, the foundation for strategic environmental research ESG Risk Management Controversial stocks/industries are excluded based on norms The Price of Sin…(Hong and Kacperczyk JFE 2009) –Lower institutional ownership and less analysts’ coverage –Price/book ratios for sin stocks lower –Superior returns 1926-64; 1965-2003 (4 factor α) KLD controversials –Shunned stocks outperform peers (Kempf & Osthoff EFM 2007; Statman & Glushkov FAJ 2009) European Sample –Sin stocks outperform peers, especially under high litigation risk and protestant faith (Salaber 2007)

13. SIRP is funded by Mistra, the foundation for strategic environmental research Performance of controversial stocks Controversial stocks continue to outperform their peers! An unintended consequence of RI Study Region and Period Tobac.Alc.GameWeap.NukeBiotechAdultAlpha Hong and Kacperzyk (2009) U.S. 1926-2006 XXXXPositive Kempf and Osthoff (2007) U.S. 1991-2004 XXXXX Positive (non-significant) Statman and Glushkov (2009) U.S. 1992-2007 XXXXX Positive (non-significant) Salaber (2007) Europe 1975-2006 XXXPositive Fabozzi et al. (2009) 21 countries 1970-2007 XXXXXXXPositive Derwall et al. (2011) U.S. 1992-2002 1992-2008 XXX X X 2.86* 2.64*

14. SIRP is funded by Mistra, the foundation for strategic environmental research SRI/ESG- what have we learned? Sustainable business practices add economic value to assets –Costs of the practices drop because of learning and economics of scale –Expected benefits of the practices will increase As sustainability creates economic value, this value is priced, and does not necessarily result in higher risk- adjusted returns of portfolios

15. SIRP is funded by Mistra, the foundation for strategic environmental research Sustainable Investment Opportunities Worst Practices Best Practices Product Strategic EmergingMomentumEstablished Sustainable Products Best CSR Practice Unsustainable loosers EXclude Product Innovations Compliance with legislation and norms Mature INclude Sustainable Ventures

16. SIRP is funded by Mistra, the foundation for strategic environmental research Benchmarking ESG ratings and rankings have improved the transparency and market efficiency for large caps and return opportunities come now from – Engagement – ESG rising stars (timing) Benchmarking needed on – Small-cap firms – Private equity – venture capital Global Real Estate Sustainability Benchmark (GRESB)

17. SIRP is funded by Mistra, the foundation for strategic environmental research THANK YOU! WWW.SIRP.SE