ESG scoring and Svetlana Borovkova performance metrics

1 ESG scores

 What are ESG scores and where do they come from?

➢ Sustainalytics

➢ Thomson Reuters ESG Scores

➢ MSCI ESG ratings

➢ …

 Data providers collect sustainability reports and other (internal AND external) info of companies, generating scores across many dimensions (E, S, G)

 Scores are now available for +/-10 years

 This enables an objective assessment and analysis of e.g., ESG vs return of firms and portfolios 2 ESG scoring

 Inclusion of high(er) ESG scoring firms in portfolio

 Reporting ESG metrics of your portfolio

 Quantitative analysis and investment strategies taking ESG into account

3 Example of data

Company Name Periods Ticker Sustain Total Score Sustain E Score Sustain S Score Sustain G Score

Aberdeen Asset Management PLC 12/31/2015 ADN-GB 74.41 70.88 71.70 79.91 Amec Foster Wheeler plc 12/31/2015 0P7J-GB 73.10 71.17 74.88 74.19 Antofagasta plc 12/31/2015 ANTO-GB 74.95 80.39 69.13 77.61 Ashtead Group plc 12/31/2015 AHT-GB 53.92 52.67 50.36 61.69 BHP Billiton Plc 12/31/2015 BLT-GB #N/A #N/A #N/A #N/A ARM Holdings plc 12/31/2015 ARM-GB #N/A #N/A #N/A #N/A WS Atkins plc 12/31/2015 ATK-GB 61.81 61.01 58.02 66.98 Barratt Developments PLC 12/31/2015 BDEV-GB 86.26 92.48 82.12 85.98 Bellway p.l.c. 12/31/2015 BWY-GB 61.97 75.03 56.02 50.98 Balfour Beatty plc 12/31/2015 BBY-GB 63.67 55.28 65.43 69.42 BTG plc 12/31/2015 BTG-GB 65.33 61.92 53.01 87.00 British Land Company PLC 12/31/2015 BLND-GB 83.02 86.04 85.03 77.00 Sky plc 12/31/2015 SKY-GB 75.04 78.93 75.20 70.84 Tullow Oil plc 12/31/2015 TLW-GB 74.69 66.59 71.39 91.37 Aviva plc 12/31/2015 AV-GB 80.87 80.99 78.43 83.03 Diageo plc 12/31/2015 DGE-GB 76.87 75.52 82.64 70.49 Schroders PLC 12/31/2015 SDR-GB 62.99 63.87 54.15 70.98 Elementis plc 12/31/2015 ELM-GB 60.67 53.26 62.98 68.01 DCC Plc 12/31/2015 DCC-GB 54.80 52.56 43.97 75.12 BAE Systems plc 12/31/2015 BA-GB 59.31 54.71 52.73 73.01

Derwent London plc 12/31/2015 DLN-GB 68.49 81.43 4 63.99 55.82 British American Tobacco p.l.c. 12/31/2015 BATS-GB 70.22 74.15 66.98 69.77 What is current evidence on ESG vs return?

 No consensus in academic literature

 On company level: ½ of studies claim positive relationship, the rest – negative or none, especially with E scores

 On portfolio level: only 1/4 of studies claim positive relationship

 Most of these studies are relatively old (prior to 2015)

 BUT: asset managers expect the same return when taking ESG into account

5 Simple examples Return by ESG score total Return by change of ESG score total 150.00 150.00

100.00 100.00

50.00 50.00

0.00 0.00 0.00 20.00 40.00 60.00 80.00 100.00 -15.00 -10.00 -5.00 0.00 5.00 10.00 15.00 -50.00 -50.00

-100.00 -100.00

-150.00 -150.00

Vol by change of ESG score total Vol by ESG score total 100.00 100.00 90.00 90.00 80.00 80.00 70.00 70.00 60.00 60.00 50.00 50.00 40.00 40.00 30.00 30.00 20.00 20.00 10.00 10.00 0.00 0.00 -15.00 -10.00 -5.00 0.00 5.00 10.00 15.00 0.00 20.00 40.00 60.00 80.00 100.00 6 But recently, we found that:

 In recent years (2016-2017), we observe higher returns for highly ESG-scoring firms than for lower scoring firms.

 For example, in 2016, out of EUROSTOXX600, ESG-top 10% had average return of 4.8%, while ESG-bottom 10%: -0.5%, with the same average vol of 30%.

 Causality or reverse causality?

 Furthermore:

❑ Improvement of ESG scores for low/medium scoring firms seems to have positive relationship with return

❑ Portfolios with high G scores have lower subsequent volatility

❑ Low scoring ESG firms have higher credit spread 7 Recent ESG data (2016)

Average return per decile of ESG 15

10

5

0 1 2 3 4 5 6 7 8 9 10

-5

-10

-15

8 ESG ratings vs credit spreads

9 Pitfalls

 Portfolios with high ESG scores have significant size tilt (towards large companies) and sector tilt (away from e.g., energy or food sectors and into e.g., consumer staples)

 This skews such a portfolio return–risk profile, but has fundamentally has nothing to do with ESG

 Solution to sector tilt: include “best in class”, i.e., comparing to industry/sector peers

 Need a similar solution to size tilt: bucketing by size and select again “best in

size” 10 Consequences for return and risk

11 How to add a third dimension (ESG)?

 Need a comprehensive way of going from two dimensions (risk and return) to three dimensions (ESG score)

 This will enable proper benchmarking of ESG investments (major problem right now)

 Sharpe-like ESG ratio: excess/loss of return wrt a benchmark per unit of loss/extra ESG score, again wrt benchmark

 More precisely, 푟푝−푟푏푒푛푐ℎ푚푎푟푘 푆퐸푆퐺푝 = * sign(푟푏푒푛푐ℎ푚푎푟푘 − 푟푝) 퐸푆퐺푝−퐸푆퐺푏푒푛푐ℎ푚푎푟푘 12 Examples

 Let benchmark return be 5% p/a and average ESG score of assets in benchmark is 70.

 A portfolio with higher return AND higher ESG score is always preferred.

 But:

1. Which one is better: portfolio A with return of 6% and ESG score of 60 or portfolio B with return of 7% and ESG score of 55?

2. Which one is better: portfolio C with return of 4% and ESG score of 75 or portfolio D with return of 3.5% and ESG score of 85?

➢ We still have non-matching volatility problem.

13 Solution 1: proper sector diversification

14 Solution 2: volatility matching

15 Sharpe-like ESG ratio 푆퐸푆퐺푝

푟푝−푟푏푒푛푐ℎ푚푎푟푘 푆퐸푆퐺푝 = * sign(푟푏푒푛푐ℎ푚푎푟푘 − 푟푝) 퐸푆퐺푝−퐸푆퐺푏푒푛푐ℎ푚푎푟푘

 We believe this is a right way of benchmarking of your portfolio with respect to the global index or peers

 Different aspects of ESG can be assessed by this metrics, by amending ESG score according to your criteria

 Volatility can be dealt with with leveraging/deleveraging or diversification Would like to know more?

 www.probability.nl

 Dr. Svetlana Borovkova: [email protected]

 +31 6 10566786