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ESG: Why & How


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ESG: Why & How

Master thesis Cand. Merc.

15/9/2016 STU: 212.535

Normal pages: 93

Supervisor: David Skovmand Authors:

Emil Nielsen (Cand. Merc. FIR) Naja Lydeking-Olsen (Cand. Merc. MIB)


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The purpose of the research paper, ESG: Why & How, is to investigate responsibility investing in general and ESG investing in particular. It uses several perspectives and explores the concept from several distinct angles. It is divided into three primary, distinct sections each based on a different perspective. It takes departure in Danish investors and global stock portfolios.

The first section explores the drivers behind the market from three different analytical levels; structural, organizational and individual. It concludes that strong pressures are present at all three levels. At the structural level the pressure mainly presents itself through legislative and social pressure; at the organizational level primarily through reputational risk mitigation; and at the individual level through unclear personal reasons and likely personal values.

The second section tests the effect that ESG integration has on the financial performance of portfolios, created from global stocks. 14 ESG-screened investment universes are defined and compared with the unscreened universe. The effect is tested through two types of tests, both concluding that ESG-screening in the investment decision has no significant effect on the financial performance of portfolios. It can therefore be considered a free add-on.

The third section is concerned with portfolio optimization and how to incorporate a third criterion in the process. Ordinarily portfolios are optimized according to two criteria; risk and return. In order to find the optimal portfolio in terms of ESG, a third variable is therefore necessary. In order to achieve this, a mean-variance-analysis is employed, as well as a proxy for an investor specific individual utility function. It is shown that it is possible to optimize portfolios on non-financial parameters and how to practically achieve this.


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2.4. DEFINITION ... 11


2.5.1. Sustainalytics’ ESG ranking ... 12

2.5.2. Asset4’s ESG rating ... 13

2.5.3. ESG approaches compared ... 14



3.1.1. Why do some investors have a preference for ESG? ... 16 Investor motivations ...17 Company motivations ...18 Competitive advantages through sustainable strategies for companies ...19

3.1.2. Where do the demand for ESG investing originate? ... 23 Market description ...24 PEST ...25 Investor demographics ...28


3.2.1. Research criteria: Reliability and validity ... 32

3.3. ANALYSIS ... 32

3.3.1. Sustainable investing and investor knowledge ... 32 Trends in the investor knowledge base ...34

3.3.2. The process of investing ... 35

3.3.3. Investor preferences ... 38

3.4. CONCLUSION ... 44



4.1.1. Doing good, but not well ... 46

4.1.2. Doing good and well ... 48

4.1.3. No difference ... 49

4.1.4. Findings from the literature review ... 50


4.2.1. Adapted portfolio performance test ... 51

4.2.2. Z-test ... 52

4.3. DATA ... 52

4.3.1. Descriptive statistics of the underlying universes of stocks ... 53

4.3.2. Adapted portfolio performance analysis ... 55


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4.3.3. Z-test analysis ... 60

4.4. CONCLUSION ... 64



5.1.1. Optimization based on a mean-variance approach ... 65

5.1.2. Optimization based on a utility function ... 67


5.2.1. Variance-Covariance-Matrix ... 69

5.2.2. Expected returns with the Black-Litterman approach ... 70

5.2.3. Methods for quantitative portfolio optimization ... 71

5.2.4. The efficient frontier and the capital allocation line ... 72


5.3.1. Creating the efficient surface ... 73

5.3.2. Locating the optimal responsible portfolio using utility theory ... 77


5.5. CONCLUSION ... 79





Appendix 1: Interview guide Appendix 2: Interview with Jacob Appendix 3: Interview with Anna Appendix 4: Interview with Maria Appendix 5: Interview with Christian

Appendix 6: Interview quotes (Danish + English) Appendix 7: VBA code for random portfolio generation

Appendix 8: Histograms of relative performance of the 14 universes Appendix 9: Expected returns (Black-Litterman)

Appendix 10: VBA code for ESG-solver Appendix 11: Efficient frontier data points Appendix 12: Utility calculations

Appendix 13: Robustness tests


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1. Introduction

In recent years there has been an increased interest in responsibility investing and especially whether an impact on risk and return can be established empirically. The following paper aims at investigating one of the many responsible investing concepts, ESG, further and from several angles. ESG is a measure of environmental, social and governance aspects considered to be non-financial indicators of future performance. ESG is one of the few responsible investing measures to have been operationalized by several organizations. This makes it a measure suited for quantitative data analysis and it will therefore be the main concept under investigation.

Up until now, many aspects of ESG have been disregarded in the literature, including different levels of drivers of the demand. We will as a consequence hereof investigate the motivations of both companies and individuals to engage with ESG from an organizational and investor perspective respectively. We will mainly look at the European market and in particular the Danish investors. The impact of including ESG in the screening of assets has been investigated more thoroughly, although primarily on the level of individual stocks. In the paper, we will use a portfolio approach, as it is more relevant for asset managers and thus gives a more realistic conclusion on whether or not performance is impacted. Instead of limiting the stock market by geographical restrictions, we will use the global stock market as the base for portfolio creation.

This will imitate the actual possibilities available to European and Danish investors or asset managers.

The paper is an interdisciplinary project between organizational and portfolio theory. It will therefore include elements from both, in an attempt to create a more complete understanding of ESG. It aims to have practical use for financial institutions and banks wishing to increase their awareness of the developing market of ESG, as well as funds wishing optimization of their overall ESG score.

Based on a vast amount of research on the topic, the paper will reproduce some prior studies and synthesize knowledge from others to create a complete overview of the phenomenon. It is based on the overall research question:

Where does ESG come from and does it affect financial performance?

In order to answer this question, the paper will be divided into seven primary sections, with the first being this introduction, sections 2-5 corresponds to the sub-research questions hereunder, while section 6 and 7 will be the overall conclusion and perspectives. The questions are:

 How is ESG defined and calculated?

 How does ESG benefit investors?

 How does ESG affect financial performance?

 How is an ESG portfolio optimized?

The second section will provide an in-depth understanding of the underlying concepts, the history of responsible investing, different generations of sustainable investing, as well as more specifically how ESG is calculated by different data providers. The three following sections are all structured in accordance with the classical format of research papers; starting with the relevant theory, followed by a section on methods, the analysis and a conclusion.


Page 6 of 88 The third section explores the drivers and perceived benefits of ESG from several perspectives. It looks at both the structural pressures through a PEST analysis, as well as both the company and individual investor motivations behind ESG and responsible investing. It is therefore an analysis on macro-, meso- and micro- level aimed at shedding light at the drivers of responsible investing in general and ESG investing in particular. The two primary types of investors, private and institutional, are included in the analysis. For the theoretical section, however, the institutional investors are largely disregarded, as we have not come across any theories specifically aimed at exploring their motivations, but, as the analysis will show, the motivations for companies are transferable to institutional investors. The section also includes a current overview of the market and explores different indications of the direction of the future development. The analysis will be supported through primary data from expert interviews and secondary data, predominantly in the form of surveys.

In the fourth and fifth sections, the focus of the paper becomes more practical. In contrast to much prior research on the topic, this paper is based on a portfolio perspective. Whereas the general literature investigates whether or not ESG optimization will generate excess return for the whole optimized universe, we will also account for the fact that funds tend to invest in a smaller population than a couple of hundred stocks (this critique is in accordance with Humphrey and Tan (2013)). This and prior research on the topic will be elaborated on in section 4. In both section 4 and 5, portfolios of global stocks will be created and used in the analyses. The paper will adhere to the general fund requirements and therefore disregard the option of shorting.

In the fourth section, the effect of ESG on financial performance will be tested. The section will start with an overview of the literature concerned with responsible investing’s impact on financial performance and go through the three mayor schools of thought hereof; “doing good, but not well”, “doing good and well”

and “no difference”. In order to test an unscreened universe against ones screened on ESG, we will use two types of performance tests; our own adapted portfolio performance test (modelled after Humphrey and Tan (2013)) and a z-test (an ordinary statistical hypothesis test). We will introduce 14 different investment universes in the analysis, all of which will be compared with the unscreened one. The analysis will conclude on whether or not screening on ESG significantly affects the financial performance of portfolios made up of global stocks.

In the fifth section, the focus shifts to the practical aspects of creating ESG optimized portfolios. Ordinary portfolio optimization only accounts for two criteria; risk and return. In order to account for ESG, it is therefore necessary to add a third. Jessen (2012) developed two different methods of achieving this, both of which we will use and expand on in the analysis. The section will show how to create ESG screened portfolios through the use of Excel and visualize them through R (a programming language for statistical computing).

In the conclusion, all of these different analyses will be synthesized to create an overview and conclude on the overall research questions. Areas for further research will be presented in the following perspectives section.


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2. How is ESG defined and calculated?

There are several concepts trying to capture the essence of responsible investing, ranging from well- established quantitative standards to more loosely structured concepts emerging and disappearing in the public, professional and academic spheres. The concepts include corporate social responsibility (CSR),

“environment, social and governance” (ESG), ethical investment, and social responsible investment (SRI); to name some of the more common ones.

The overlap between the different concepts is considerable and most of the definitions are vague and broad. Summing all of them up in one sentence would go something along the lines of “only investing in things that do not do harm or is in alignment with personal values”. This is naturally a simplification and in reality there are distinct differences between the concepts, which we will return to in section 2.3.

There are several reasons why this paper makes use of the ESG concept. Most pronounced because ESG have a clear set of definitions (although still broad and over-encompassing in nature). It is also a highly accepted measure and it is possible to integrate it in modern portfolio management. This is proven by the quantification and standardization by several organizations, with the sole purpose of providing useful information for financial analyses.

Immediately, two dominant sources of ESG rating spring to mind. One is Sustainalytics (via Bloomberg), the other is Asset4 (owned by Thompson Reuters and available via DataStream). We will take a closer look at both of these rating companies’ methodologies in section 2.5 and conclude the section with a discussion of their respective strengths and weaknesses.

Firstly, however, section 2.1 will provide a short overview of the history of ethical investment, and an overview of the different generations of ethical investment will follow in section 2.2.

2.1. The history of ethical investing and the emergence of ESG

Historically, financial performance has been the dominating criteria for placement of assets. Secondary to this, there have always been other concerns and interests to account for as well, among the crucial ones are politics, ethics and religious beliefs (Louche and Lydenberg 2011). The first documented instance takes place in the 1920’s where the UK Methodist Church began to avoid “sin stocks” and in 1928 the first responsible investments fond is established; the Pioneer Fund (Louche and Lydenberg 2011). Twenty years later, during the 50’s and 60’s, it becomes more prevalent for pension funds to use their investments for philanthropic purposes, through impact investing in e.g. housing and health (Louche and Lydenberg 2011).

This development became highly opposed by economists like Milton Friedman. In his famous book

“Capitalism & Freedom”, he states that “There is one and only one social responsibility of business — to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud” (Friedman, Capitalism & Freedom 1962). In 1970, he elaborated on this statement in a New York Times Magazine article titled “The Social Responsibility of Business is to Increase its Profits”. In this article, Friedman argues that from a shareholder perspective, large corporations should leave the choices of social responsibility to


Page 8 of 88 the individual investor. He argues that a business as a whole cannot have responsibilities, but businessmen can. Friedman describes the difficulty of measuring executive performance and how it is further muddled when social responsibility is included (Friedman, The Social Responsibility of Business is to Increase its Profits 1970).

In the 70’s, apartheid in South Africa, the war in Vietnam, the nuclear arms race as part of the cold war between the Soviet Union and the US, and the Civil Right Movement in the US, all led to sanctions and faith based organizations selling stocks in affiliated companies (Renneboog, Horst and Zhang 2008).

In the following decade, the disastrous Exxon-Valdez oil spill in Alaska led to increased focus on risk management and an evaluation of the role of companies in protecting the global environment. The nonprofit sustainability group CERES is created as a response by several investors, with the declared mission of “mobilizing investors and business leaders to build a thriving, sustainable global economy”. With this mission, CERES united buy-side investors to put pressure on companies (Ceres 2014).

Up until now, responsibility investments have largely been excelled by specific events or issues that investors have wished to distance themselves from. In 1994, the concept “the triple bottom line” is developed by John Elkington and it becomes one of the first tangible tools for a company to gain competitive advantages and become more attractive on the capital market through the use of non-financial measures (Elkington 1994). The trend moves to responsible investing becoming less confrontational and more based on collaboration, which in turn propels the growth of CSR-organizations. The Global Reporting Initiative (GRI) is then founded in 1997 by CERES and the UN to provide companies with clear guidelines and reporting standards. GRI first published the general GRI Guidelines and later came guidelines targeted sectors facing unique issues, like noise from airports or resettlement of people in mining (GRI n.d.). Two years later in 1999, The UN Global Compact was established to encourage companies to adopt sustainable strategies and report on their implementation of ten principles for sustainable strategies (Williams 2008).

These two initiatives made a vast amount of data available for evaluating the responsible investment performance of companies and gave birth to several providers of ESG data, who later merged into a few.

The need for ESG data became clear when the UN in 2006 launched UN PRI (Principle for Responsible Investing), where ESG was included explicitly in two of the six principles that the signatories promise to apply to their investment process (Humphrey, Lee and Shen 2012).

When reaching the 00’s, the predominant view continues to be that sustainability measures affects financial performance negatively. Of the three legs of ESG, the first two are the ones generally receiving the most attention, especially as a consequence of focus on worker’s conditions and climate changes. The last leg, governance, is not put on the agenda until Moskowitz and Levering started listing the 100 best companies to work for in America in 1998 and researchers conclude that improvement in corporate governance can be achieved free of charge by the offset in increased productivity and talent utilization (Filbeck and Preece 2003).

The beginning of the century is also the time when more companies start to publish CSR-reports and the number of ESG-funds increases. In 2005, the United Nations Environment Programme Finance Initiative (UNEP FI) note worthily concludes that investment advisors in general have a legal duty to include ESG considerations in investment decisions presented to investors (UNEP FI 2005).


Page 9 of 88 The focus and attention on ESG measures continues by 2015 where Morningstar, a leading provider of independent investment research, announced to be working on a rating for mainstream funds based on ESG factors. Measuring investment opportunities on ESG (or other ethical measures) have evolved to the point where it is something no company can escape. Companies prioritize ESG to avoid sanctions and bad press - and in the future it may even impact their ability to obtain competitive financing in the capital markets because fund managers will shun low ESG assets (Mooney 2016).

2.2. Generations of sustainable investment strategies

As apparent through the historical overview of ethical investments and development in organizational attention, the practical approach to responsible investments has evolved with time as well. There are generally considered to be five generations of sustainable investment strategies (Louche and Lydenberg 2011, 25).

The first generation was purely concerned with avoidance of “sin stocks” or, in other words, based on a negative list containing industries or areas where investments should not take place.

The second generation turned this around to “positive lists”, otherwise known as “inclusion”, specifying which specific areas were considered good to invest in. This could for example be investments in wind energy; due to the normative discourse that green energies are better for the environment than coal or oil combustion, and investing in this way would thus have a positive societal impact.

The third generation is known as “relative selection”; here investors select the industry leaders based on ESG ratings. This strategy is based on a belief that is offers a superior investment strategy.

The fourth generation is a more actively involved strategy; here it translates to an active engagement from the investors in shaping the future strategy of a given company – something that generally requires a substantial share of stocks. It is known as “engagement” or “impact investing”.

The fifth generation has similarities with the third generation and is based on the perception the integrating non-financial performance indicators in general and ESG issues in particular into the investment decision can help mitigate risk. As an example, a good governance score would be considered to lower the chance of issues arising in regards to ethical behavior of the company, which would impact the stock price and thereby the quality of the investment. It is known as “integration”.

Figure 1: Generations of sustainable investment strategies

1 •Negative lists/avoidance 2 •Positive lists/inclusion 3 •Relative selection

4 •Engagement/Impact investing 5 •Integration


Page 10 of 88 Figure 1 shows an overview of the five generations of sustainable investment strategies. As the generations often offer different perspectives rather than building on each other, it is possible to combine them as one sees fit. Where the two first generations are very distinct from each other, both of them can be combined with e.g. relative selection. It is possible to disregard (or only invest in) certain industries and simultaneously use relative selection to pick the best ranked companies in terms of ESG. On top of this, an investor can choose specific companies in the portfolio to engage further (fourth strategy). The strategies therefore offer combinations of different options for the responsible investor.

Most funds in Europe use negative lists to ensure against investing in illegal activities through companies known to e.g. support terror organizations or use child labor (the activity may not be illegal in the country where the company invested in operates, but in the home country of the investor). Besides the legal requirement, most negative lists span the following industries; weapons manufacturing, nuclear power, tobacco, alcohol, porn and gambling (Humphrey and Tan 2013).

In the later sections of this paper, we will use the strategies “relative selection” and “integration” to respectively investigate whether ESG affects financial performance (sections 4) and to show how a portfolio can be optimized while taking these considerations into account (section 5).

2.3. Differences between concepts

Until now, we have used the different concepts presented in the introduction of this section as interchangeable and to a large extent synonymous, and although this does not pose large discrepancies there are notable distinctions between some, which is important to highlight. According to Humphrey et al.

(2012) there is a common confusion between ethical investment1 and ESG investments; although both take their departure in deliberate decision on the part of the investor, only ethical investment “reflects investors’ particular ethical or normative preferences” (627). In opposition hereto “ESG investment is more concerned with the material long-term economic impact of a firm's ESG profile rather than moral or ethical considerations” (627).

In other words, engaging in ESG investments have a different motivation, one which does not necessarily depart from a wish of bettering the planet or investing in what one deems to be good. Instead it is possible that the motivation to optimize based on ESG ratings is rooted in the belief that better ESG ratings equate lower idiosyncratic risk2.

This distinction makes ESG a very interesting measure to investigate more in depth. On top of this comes the fact that most responsible investment measures are highly qualitative in nature and therefore difficult to compare across large amounts of companies. But since the concept of ESG has been operationalized by several larger companies, who rate individual companies on several parameters contained in the overall three categories “environment, social, and governance”, it provides the opportunity of quantitative data analysis. For our purposes, it is therefore the most suited measure for responsible investments.

1 In Humphrey et al. (2012) the concept of ethical investment corresponds to the second generation of sustainable investment strategies presented in the previous section.

2 Humphrey et al. (2012), however, concluded that there was no evidence supporting this belief in the UK market in the time period 2002 to 2010.


Page 11 of 88 The next natural question is to ask for a more concrete definition of ESG, and this will be tackled in the following section.

2.4. Definition

SustainAbility, a strategic management consultancy and think-tank on sustainability issues, has a project named “Rate the Raters”. The project aims “to better understand the universe of external sustainability ratings and to influence and improve the quality and transparency of such ratings.” (2013, 3). It consists of several reports, hereunder an expert survey that has been undertaken three times so far, once in 2010, 2012, and 2013 as the latest. The experts are drawn from different organizational types and are above 700 in numbers.

In one of these reports, SustainAbility asked investors to assess the importance of issues under E, S, and G.

The issues considered “very important” or “important” can be seen in Figure 2. Although E, S, and G can encompass several hundred different aspects or parameters, the five to seven items attached to each give a clear indication of which topics are considered to belong where (SustainAbility 2012).

Figure 2: ESG issues (SustainAbility, Rate the Raters Phase Five: The Investor View 2012)


1) Energy efficiency 2) Water

3) Green product and service opportunities 4) Waste

5) Climate change / GHG emissions reductions


1) Customer Relationship Management 2) Health and safety

3) Employee training and development 4) Human rights

5) Diversity

6) Social product and service opportunities 7) Philanthropy


1) Ethics

2) Board independence

3) Separation of Chair and CEO positions 4) Executive remuneration

5) Board diversity

6) Board-level accountability for env. and social issues


Page 12 of 88 As mentioned in the introduction of this section, several companies provide investors with ESG ratings on a wide range of companies. Some of the large finance companies (e.g. Paxworld and Hermes (Louche and Lydenberg 2011, 31)) have in-house teams analyzing ESG, whereas others simply rely on external data providers. In this paper, we will use one of these complex databases of several thousand companies, each of which are rated on hundreds of data points. Two of the most widely used database providers are Sustainalytics and Asset4, but many more are available (e.g. KLD, SAM Group and MSCI ESG (Louche and Lydenberg 2011)). In the following sections, we will go more into detail with the two first mentioned;

compare and contrast their methodologies, and conclude by choosing one for our analysis. Both sources are deemed to provide credible data (SustainAbility and GlobeScan 2013) and are accessible for most institutional investors through either Bloomberg or Datastream.

2.5. Calculation and analysis

In order to decide between the two data sources, Sustainalytics and Asset4, the following section will give a short overview of how they are structured. Following this, section 2.5.3 will compare and contrast, as well as conclude which is more suited for the purposes of this paper.

2.5.1. Sustainalytics’ ESG ranking

Both Bloomberg and Sustainalytics provide ESG ranking data through the Bloomberg terminal, which are therefore easily combined.

Bloomberg itself calculates an ESG Disclosure Score, which measures the amount of data publicized by each company on different parameters. It does not look at whether the data gives indications of being either positive or negative, but rather indicates whether the company takes ESG serious and has a culture of making data transparent to stakeholder (GISR n.d.).

Sustainalytics has a much more intricate ranking system, with more than 70 indicators for each company.

These are divided in both core and industry specific indicators. Each indicator is assessed by an analyst through a survey. The surveys include proprietary information on the companies that may not be available to the public (it is difficult to ascertain, since Sustainalytics share neither survey nor results) (van den Heuvel 2012). The indicators are aggregated into 10 categories, which in turn are combined into the three pillars E, S and G (see Figure 3) (van den Heuvel 2012, 15). Sustainalytics operates with 42 global industries and each industry is assigned unique weights to the different indicators, categories and pillars. This makes the scores dynamic and practically impossible to disassemble. The weights total to 100% and the average weight of the pillars are 35,8%, 38,4% and 25,8%, for E, S and G respectively (ibid, 17), although they chance from industry to industry.

Besides this, Sustainalytics operates with two levels of assessments; senior and junior companies (ibid.).

This distinction is related to the amount of information analyzed and used in the rating, thus senior companies are assessed on around 65-80 indicators, whereas junior companies are only assessed on 40-50.

Prior to 2009, the number of companies analyzed by Sustainalytics was just above 1100. In 2009, however, a merger took place between the Canadian company Jantzi and Sustainalytics (Sustainalytics.com 2015) and


Page 13 of 88 after the merger, the number of companies rated therefore jumped to above 4100. In the following years the number has reached 4500, according to RateSustainability.org (2015).

Only the most crucial of Sustainalytics key figures are accessible through the Bloomberg terminal, namely the aggregated E, S, and G scores, as well as the weighted, overall ESG score. In order to access the underlying category scores a specific subscription to the Sustainalytics database is necessary; this is a subscription we did not have access to.

Figure 3: Sustainalytics’ rating framework

2.5.2. Asset4’s ESG rating

Asset4 rating data can be accessed through DataStream and builds on a similar intricate framework as Sustainalytics. Instead of operating with three underlying pillars, however, Asset4 has added a fourth economic pillar. Instead of 10 categories, 18 are used. These 18 categories are based on 250+ general and industry specific indicators, which are estimated by analysts. In opposition to Sustainalytics, Asset4’s underlying source of information is purely public data and reports, thus making it theoretically possible to scrutinize a company and arrive at the same conclusion as the analysts. Asset4 assigns unique weights to the four pillars, when calculating the overall ESG score. It is not transparent what these weights are (van den Heuvel 2012, 18), although the analysis in section 4 will show that a small emphasis is put on the economic pillar and almost equal weights are assigned to the other three.

Asset4 has more than 5000 companies in their database (Thompson Reuters 2016), thus making it somewhat larger than the one of Sustainalytics.

ESG score



Contractors & Supply Chain Products & Services



Contractors & Supply Chain Customers

Society & Community


Business Ethics Coporate Governance

Public Policy

70+ indicators (general and industry specific)

Company surveys, public data etc.


Page 14 of 88 Figure 4: Asset4's rating framework

2.5.3. ESG approaches compared

The two approaches to ESG ratings exemplified above with Sustainalytics and Asset4 are both highly intensive in terms of analytical power used in calculating the ratings. Van den Heuvel (2012) created a statistical comparison of both databases with the aim to measure the overlap in their respective definitions of ESG. In order to do so, he disassembles their indicators and weights, followed by an attempt to realign them better. This is done down to the indicator level, since the definitions of the 10 and 18 categories respectively employed in each database overlap in different ways. In other words and as an example; some of the indicators under Asset4’s economic pillar are likely to be found in one of the other three in Sustainalytics’ database. He concludes that there is a “substantial convergence between Sustainalytics and ASSET4” (ibid. 40). Van den Heuvel’s (2012) analysis specifically shows that the R2 lies somewhere between .37 and .70 for the time period 2008-10, which is a measure for how much of the variance in one of the ratings can be explained by the same variance in the other.

More theoretically, the consequence of this is that although there is some overlap in the operationalized measure of ESG of both the rating companies, it also shows that a unified definition of ESG is not present on the indicator level and the information obtained from the two sources does not necessarily measure the same aspects of ESG.

ESG score


Resource reduction Emission reduction Product innovation


Employment quality Health & safety

Training and development Diversity Human rights

Commnity Product responsibility


Board structure Compensation policy

Board functions Shareholders rights Vision and strategy


Client loyalty Performance Shareholder loyalty

250+ indicators (general and industry specific)

600+ data points with links to public data


Page 15 of 88 Although the two approaches to calculating ESG scores differ vastly in some aspects, both are recognized as objective and trustworthy sources.

Whereas Sustainalytics rank the companies in their database on a “best in industry” approach, Asset4 uses an objective rating based on clearly defined indicators. According to van den Heuvel (2012), the information gathering conducted by Sustainalytics on the indicator level offer more room for interpretation and subjectivity than does Asset4’s. Due to both the higher level of transparency, the likely higher level of objectivity and the larger number of companies in the database (which equate a larger investable universe later on), we have chosen Asset4 for use in our analysis.

In the next section of the paper, we will investigate the benefit investors perceive ESG to give, through looking at the motivations for both companies and individuals to have an interest in sustainability.


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3. How does ESG benefit investors?

3.1. Theoretical overview

3.1.1. Why do some investors have a preference for ESG?

Referring back to section 2, concerned with the definition of ESG, it is clear that consideration of wrong and right have been a topic of interest for humans throughout time. That this therefore also permeates the area of how to create value is unsurprising. When an individual finds itself in the situation where it has accumulated enough wealth to invest and defer consumption, it is therefore logical that investment of this wealth has to be aligned with the overall values guiding the individual.

The growing awareness of worker conditions and environmental impact (among other issues) has already had a clear impact on how money is invested. In 2014, the Global Sustainable Investment Alliance (GSIA) reported that the proportion of total managed assets in SRI-funds had increased to 30,2%, from 21,5% two years earlier (GSIA 2014, 7). This translates to a monetary increase of $1.611 billion or 61%3. This is a trend that impacts both societies at large and companies specifically. The perceived tradeoff for the investor often lies between benefitting societies at large, while potentially losing out on financial performance on a personal level.

The connection between society at large and the impact of organizations on both their local environments and the planet has gotten increasing amounts of attention. According to Porter and Kramer (2011), this is a development born out of increased globalization and awareness. In their 2011 paper on shared value creation, they described it thus:

“The capitalist system is under siege. In recent years business increasingly has been viewed as a major cause of social, environmental, and economic problems. Companies are widely perceived to be prospering at the expense of the broader community. Even worse, the more business has begun to embrace corporate responsibility, the more it has been blamed for society’s failures. The legitimacy of business has fallen to levels not seen in recent history. This diminished trust in business leads political leaders to set policies that undermine competitiveness and sap economic growth. Business is caught in a vicious circle.” (Porter and Kramer 2011, 64)

A tension has arisen, which nations and collaborations between nations are scrambling to ensure against the capitalist business owners only interested in increased profits (under the assumption that this adheres to the vast majority of businesses). The fact that external environmental effects have not been incorporated into the price of doing business has been called one of capitalisms greatest failures (Porter and Kramer 2011, 67). A concrete example of this is the fact that CO2 emissions have not, until recent sustainable movements, been considered part of a company’s responsibilities. Even politically, emissions have not been anchored on the company level, since no country in the world has enforced a CO2tax (ibid.).

3 The total global investments in SRI assets in 2012 amounted to $13.261. By 2014, this number was $21.358. The relative increase is 61% (GSIA 2014, 8).


Page 17 of 88 Out of this predicament of businesses, responsible investing has arisen to provide one, among many, mitigating options. Classical economic theory has treated individuals as rational utility and profit optimizing agents, acting from a pure self-serving rationale. In other words, individuals are homo economicus. More recently the perspective has been broadened and the academic branch behavioral finance has been born to account for the inherent irrationalities and cognitive biases in actual humans. With academic interest in understanding investment strategies, increased focus is giving to the psychological study of values and priorities. One such priority could in an investment strategy be expressed as a wish to avoid industries known for large emissions of greenhouse gasses, hereunder CO2, such as fossil fuel, gas and oil, based on a wish to ensure a livable planet for future generations. An investor prioritizing responsibility issues in his investment strategy is known as a responsible investor.

The following section is a theoretical analysis of the motivations held by both individual investors and companies for engaging in sustainable investing and/or initiatives. Investor motivations

Based on prior research, Chatterji et al. (2009) derived four distinct motivations for responsible investors.

These motivations can be combined and thus specific individuals might be driven by one, some or all of them. The motivations are: (1) Financial, (2) deontological, (3) consequentialist and (4) expressive (ibid.

129)4. The motivations are concerned specifically with environmental performance, but are generic enough to be used overall on ESG after necessary modifications. We have therefore adapted the definitions. They are documented in Figure 5.

(1) The financial motivation is purely based on believing that optimizing based on ESG is a superior investment strategy. In other words, companies with high ESG scores also perform better than the market portfolio. Investors with this motive are not guided by personal values or a wish to make the world a better place, but rather wish to optimize their own financial gain. Section 4 will investigate whether or not there is empirical evidence for this belief.

(2) Investors with a deontological motivation aim at avoiding earning profits from what is considered unethical behavior. It is therefore a motivation closely related to the first generation of sustainable investment strategies. The motivation is based on personal convictions and beliefs and is thus value-based.

Whether there is an impact on the expected return is therefore likely to be less important for investors with this motivation.

(3) The investor with a consequentialist motivation wishes to impact the market and believes that investing in responsible companies will impact the cost of capital. In this way, responsible companies will attain a lower cost of capital than irresponsible ones. In the long term, this would impact the level of investments undertaken by the responsible companies and they would slowly increase their market value – whereas misbehaving companies will slowly shrink. This motivation is also subjective and value-based. Whether or not it is founded in empirical evidence is unclear and an investigation of this lies outside of the scope of this paper.

4 Do note that it is unclear how many of these have been tested empirically.


Page 18 of 88 (4) The fourth motivation is the expressive. It is completely value-based and in opposition to the deontological motivation, it is closely related to the second generation of sustainable investment strategies.

Based on subjective beliefs and values, this investor therefore determines which industries and/or companies will contribute to creating a better world and invests accordingly. This investor might also be driven by how others perceive them and their actions.

Figure 5: Investor motivations for ESG investments (adapted from Chatterji et al. (2009, 130)).

None of these investor motivations can be said to be based on objective measures. Rather the individual is guided by personal biases and cognitive irregularities characterizing the nature of humans. Company motivations

There are several reasons for companies to be mindful of their CSR reputation. According to Chatterji et al.

(2009) four of these are: (1) attraction of socially responsible customers, (2) reduction of the threat of regulation, (3) improved reputation and (4) reduced concern from activist groups and NGO’s (Chatterji, Levine and Toffel 2009, 129).

(1) Attraction of socially responsible customers will be easier for companies in certain industries and will generally be an option for B2C businesses (Orsato 2009). Since other businesses tend to make decisions more aligned with the elusive homo economicus, B2B business will face greater difficulty in attaining a competitive edge from e.g. more environmentally friendly products. Industries where this a good strategy will generally be ones where there is a direct brand value for customers, e.g. food stuffs, skincare and cosmetics. Two examples of this would be the Danish brand Urtekram, producing organic groceries and known for their high quality, or BodyShop, a global skincare and cosmetics brand originating from UK and known for not using animal testing.

(2) Whereas the aim to attract responsible customers can and is undertaken on the individual company level to gain competitive advantages, reducing the threat of regulation can only happen when new industry standards are being set. This could occur through increased waste reduction in an attempt to lower overall costs and with the byproduct of being more environmentally friendly than competitors. As a consequence

• Financial investors believe that superior performance on ESG leads to superior financial performance as well.


• Deontological investors seek to avoid investments in companies that act irresponsibly, since they consider it unethical to earn profits from these companies.


• Consequentialist investors seek to direct their funds to raise the cost of capital for misbehaving firms and lower it for responsible ones.


• Expressive investors base their investment decisions on their own personal values and others perception of them as ethical and accounting for the impact of their investments.



Page 19 of 88 of lower costs, the rest of the industry might aim to copy the process and inadvertently, overall industry waste reduction and emissions are lowered, and so political intervention through regulation becomes less likely. Reducing the threat of regulation is therefore more an indirect consequence of other strategies in a company, than a specific target set by a single one.

(3) One of the most crucial reasons for companies to engage in CSR initiatives is to mitigate reputational risk. In the words of Warren Buffet; “It takes 20 years to build a reputation and five minutes to ruin it.” On top of this, comes the fact that reputational risk is one of the most elusive risk disciplines in business. Every error in an organization has the potential to become a reputational risk event, depending on impact and scale. In large companies, small mistakes occur every single day. The only guard against reputational risk is complete ethical and proper behavior in every aspects of the business. However, it is not always completely clear where the line is. Even if a police investigation concludes no foul play, the reputation of the company can have taken serious damage in the meantime.

(4) The fourth motivation of companies to engage in CSR initiatives is to reduce concern from activist groups and NGO’s. Again, this is a motivation more pronounced in industries more prone to scrutiny, than others. Examples of such are fuel and oil companies, as well as others in more inherently “dirty” industries.

Here the aim is to be best-in-class in terms of environmental impact and thus let competitors deal with grass root and activist organizations attention and displeasure. This motivation ties closely to the mitigation of reputational risk in the prior paragraph. While examples of companies succeeding with this strategy are difficult to identify, the ones that did not are more readily available due to a higher degree of negative media coverage. One example of such is Shell’s endeavor to drill in the Artic, a plan intensely covered and obstructed by Greenpeace (GreenPeace n.d., Macalister 2015).

Common for all of the motivations for companies to be mindful of their responsible impact is the relation to their reputation. It underlies the three other motivations to some extent. Not all of the other motivations will be relevant for all types of companies, but the motivations indicate that sustainability is becoming a strategic option for creating a competitive advantage. Competitive advantages through sustainable strategies for companies

This edge can be achieved through five distinct business model strategies, according to Orsato (2009); (1) eco-efficiency, (2) beyond compliance leadership, (3) eco-branding, (4) environmental cost leadership and (5) sustainable value innovation (ibid.). Four of these strategies are related to competing in existing markets, whereas the last one is a blue ocean strategy, aiming at tapping into a new market space. We will therefore treat the fifth strategy more separately than the four prior ones concerned with competitiveness, as it is defined by traits not easily compared and contrasted to these.

Of the four competitive strategies, the two first are related to the organizational processes of a company, whereas the two last relates to the products and services offered. Processes are, by definition, interlinked activities, often complex and involving equipment, machinery and personnel. This makes it more costly and difficult to change in practice. Products and services are, in opposition hereto, easier to adjust and isolate.

However, as is the case for any business strategy, embarking on a strategy requires the organization to take choices and commit. Any differentiation strategy requires reflections on cost-benefit and this is no different


Page 20 of 88 for the five sustainability strategies. Due to the fact that the four strategies of competition can be divided into these two camps, companies can choose to combine them as it suits their specific business.

(1) Eco-efficiency is the first of the process-related strategies. On the onset, eco-efficiency looks akin to traditional waste-management and resource optimization strategies – often simply referred to as “lean”.

There are, however, additional benefits to be gleaned from the environmental perspective. By specifically strategizing on how to lower the non-product related output produced by the company, it is possible to achieve lower operational costs and extra revenues from newfound synergies, e.g. through the transformation of by-products and waste (Orsato 2009). Adding the environmental perspective on this, however, may require companies to come up with completely novel and radical innovations to solve the challenge. One of the aims will naturally be to decrease the overall emissions and this could also lead to the company generating carbon credits, which could then be sold and thus create a new revenue stream.

Taken to the next level, this thinking leads to industrial symbioses. Here a cluster of companies collectively aims at lowering their total environmental impact. If e.g. waste water from one facility is pure enough to be used in some process in another company, they take the necessary initiatives to make it happen and thus might lower overall operational costs to a level that could not be achieved separately. Naturally eco- efficiency as a strategy fits some industries better than others, although some levels are usually possible to achieve (e.g. shutting of the lights at night in the offices). Although service industries, tech and the financial sector are less likely candidates for this strategy, sometimes radical eco-efficiency innovations do take place. A great example of this is the server farm operated by Google in Finland. Here they implemented the novel solution to cool it, using sea water (Rooney 2011). However, the best strategic fit is found in companies in industrial markets or with relatively high levels of processing costs and creation of waste or by-products. The motivations for companies to engage in this strategy are primarily related to cost-cutting and reputation protection. Besides this, the strategy may also help in reducing the threat of regulation.

(2) The second process-related strategy is “beyond compliance leadership”. This strategy is closely related to the three last company motivations presented in the previous section; reduction of the threat of regulation, improved reputation and reduced concern from activist groups and NGO’s. The primary reason for companies to employ this strategy is to retain their “license to operate” (Orsato 2009). It is therefore a strategy fitting for companies in industries subjected to strong external pressures; be it from the political sphere or the general public. Examples include financial institutions and oil and gas companies. The strategy becomes a consequence of the company’s overall risk management strategy. It is usually based on the decision that the company wishes to be best-in-class, when it comes to risk management.

One way of engaging with this strategy, without necessarily striving to be the best, is to participate in

“green clubs”. These clubs are created to legitimize the business, through setting a minimum bar that a company needs to fulfill to obtain membership. Examples of such clubs include the different ISO certifications5 and the UN Global Compact. The value created for a company by gaining membership largely depends on how memberships are dispersed within the industry. If only few other companies within the sector hold memberships, customers and stakeholders may attribute a larger importance to the membership. If, on the other hand, it is quite common to hold the membership, it acts more as a simple

5 ISO certificates are based on international standards, which can either be voluntary to follow or, in “some industries, certification is a legal or contractual requirement.” (ISO 2016)


Page 21 of 88 repercussion against bad reputation to attain one. Aiming for a beyond compliance leadership, however, requires the company to actively build a positive reputation instead. It therefore needs to act proactively and engage stakeholders in negotiation and dialogue to deal with criticism (Orsato 2009). The strategy is therefore mid to long term.

(3) The third sustainability and the first product-related strategy is eco-branding. Eco-branding is a strategy where companies distinguish their product(s) based on environmental attributes. The motivation for companies to employ this strategy is thus primarily to attract socially responsible customers. Where an ordinary brand usually caters purely to private benefits, an eco-brand needs to appeal to both private and public benefits, such as biodiversity, water recycling or CO2-reduction (Orsato 2009). The selling point is that customers believe that these public benefits are worth paying extra for. One of the ways to achieve this perception is by using eco-labels. In essence, these are similar to the green clubs employed by the

“beyond compliance leadership”-strategy. Where those green clubs are related to process standards, the ones for eco-branding is for product standards. There are three different types of eco-labels, where the first and third type are considered objective. The second is created and provided by the manufacturer, and it is thus difficult to evaluate in any objective manner. The first type is based on a multiparty agreement on certain criteria and relies on a third party to certify. The third type is based on measurable data and a life cycle analysis, but otherwise has the same requirements as “type I” labels. The third type is therefore the strongest indicator of a product being more sustainable than its peers. The third type includes examples such as the European flower and the Nordic Swan.

Following the eco-branding strategy, this need to be built around a brand the customer can rely on having the attributes required to live up to different eco-labels (these will differ depending on the product category). Examples of brands, which have successfully managed to differentiate themselves based on eco- branding, are Änglamark (Coop’s organic house brand), Urtekram and the BodyShop. Whereas the two first use different type III eco-labels depending on whether the product is related to food stuff or personal care products, the BodyShop generally do not rely on eco-labels. Instead, the brand was originally built to take environmental manners into account and was successful in convincing customers that this was the case.

This strategy is primarily suited to businesses targeting private customers, as it is less likely to prove successful in a B2B setting. The argument is that businesses tend to be more rational in their purchasing behavior and unwilling to pay a premium for more eco-friendly products; in other words, businesses do not perceive an added value.

(4) The fourth strategy, environmental cost leadership, is very difficult to implement in practice. In order for this strategy to be successful, it requires the company to be both successful in its traditional cost leadership strategy and simultaneously seek solutions for lowering its environmental impact. This strategy is therefore often a byproduct of pursuing a general cost leadership strategy and only successful for companies that are able to compete on price, in markets with thin margins, and irrespective of whether customers value the eco-attributes of the product. This strategy does offer long term competitive advantages, by potentially opening new market segments up for the company by putting it in a position, where it is poised to take advantage of increasing demands for eco-friendly products, irrespective of the origin of these demands (regulators and/or customers) (Orsato 2009). In opposition to eco-branding, this strategy is therefore also suited for B2B markets, since the primary selling point will be the low cost.


Page 22 of 88 One successful innovation, aligned with this strategy, was IKEAs decision to package their furniture as flat packages and leave assembly to the customer. This strategic decision instantly made the company the cost leader in the furniture market, but also made it possible to reduce transportation costs and emissions substantially compared to competitors. Where smaller adjustments may be relatively easy to implement for large companies with great bargaining power, such as exchanging fuel used by logistics to biofuel, true innovation and environmental cost leadership is more difficult to attain. Tying back to the section on company motivations, this strategy primarily aids in mitigating reputational risk and may secondarily attract socially responsible customers.

(5) The fifth sustainability strategy, sustainable value innovation, contrasts from the other four as the intent is to discover new markets. The first and foremost motivation of companies pursuing this strategy is to “do good business”, where the environmental angle may somewhat attribute to mitigation of reputational risk and attraction of socially responsible customers. The strategy is closely related to the concept of blue ocean strategies, where the aim is to avoid competing for advantage with other companies (sharks) in existing markets (red oceans) (Thompson, Strickland and Gamble 2010, 171). Instead the focus is on creating a new market, by tapping into unfulfilled demands of customers. This is done through innovation; by offering a higher valued product or service to customers. In order to succeed with the fifth strategy, the new business model needs to take into account both the economic costs and environmental impact. In terms of the value proposition, both the value for customers and the overall contribution to society needs to be accounted for. In order to do this, companies need to identify the ultimate service a product is supposed to be providing. Many of the blue ocean strategies that have succeeded in the last decades have been focused on increased flexibility for the consumer; Apple’s iTunes service and Netflix are good examples of blue ocean strategies succeeding, although not direct examples of a sustainable value innovation.

One example of a sustainable value innovation can be found in the transportation industry (Parisi 2015).

Parisi divides the industry into the four market spaces shown in Figure 6. Two of these have been relatively underexploited compared to the spaces “private cars” and “public transportation” (and hence they cannot be captured in one headline, like public transportation and private cars can). The market for private cars have shown increased interest in reduced environmental impact by offering smaller cars, cleaner fuels and developing electric and hybrid cars. Public transportation has always been relatively cleaner than private cars, if nothing else, then purely due to number of people the emissions can be divided out onto (this naturally is dependent of a large utilization of the public offer; see Morris (2012) for further arguments and calculations). Here, however, initiatives are also being implemented to lower emissions. This is done through different initiatives, e.g. by switching ordinary diesel busses out with hybrids, biofuel or natural gas fueled busses (Miller 2011, Movia 2011). In Denmark, august 2016, the public transportation company Movia even started experimenting with electrically powered busses (Hinrichsen 2016); potentially lowering the overall CO2 emissions of Copenhagen with 2-3%.

The other two markets are where the example of sustainable value innovation can be found (primarily in the private property/collective use top corner). Zipcar is one example of this, and if not the first mover, then one of the first ones. The concept is to provide cars that could be booked at leisure of the customer and returned the same way. The rental period is flexible, anywhere from a few hours to days, depending on need. The service provide access to different types of vehicles, thus catering to different needs and 30% of users have either sold or delayed buying a car because of this (Parisi 2015, 51). This service taps into the


Page 23 of 88 underserved segment needing private transportation occasionally. Overall, sustainable value innovation strategies often rely more on business model innovation than technological breakthroughs (Parisi 2015).

Figure 6: Market spaces in transportation (Parisi 2015, 50).

The strategies presented above all offer insight into how business models can be focused or altered to incorporate an environmental aspect. Some are more suited for certain industries, but most can pursue one or more in differing degrees.

The aim of this overall section was to answer the question “Why do some investors have a preference for ESG?” The simplest answer to this is that investors believe that through guiding their investments to more responsible companies, they help make the world a better place. This conviction in turn effect companies and compel them to engage in sustainable initiatives, e.g. aiming at mitigating reputational risk through proper behavior or even adopt a sustainability strategy.

3.1.2. Where do the demand for ESG investing originate?

The previous sections gave insight into the motivations of individuals and companies, but these motivations do not necessarily transfer to the origin of the demand for ESG investing. There might be more structural forces in play as well. Before diving into the analysis of these forces, a short overview of the current market will be presented


Page 24 of 88 Market description

According to GSIA (2014), different regions of the world differ vastly in terms of the SRI’s market size (globally 30,2%). The potential for growth is therefore also very dependent on which part of the world is specifically under investigation. Table 1 shows the relative proportion of funds invested in SRI for the different regions of the world accounted for in the GSIA (2014) report. As of 2014, Europe was unrivaled when it came to funds in responsible investments, with 58,8% of all managed assets being subject to some form of sustainable investment strategy. At the other end of the scale is Asia, with less than one percent in SRI at the same point in time. The global market experienced a 61% growth from 2012 to 2014 (GSIA 2014, 8)

2012 2014

Europe 49,0% 58,8%

Canada 20,2% 31,3%

USA 11,2% 17,9%

Australia 12,5% 16,6%

Asia 0,6% 0,8%

Global 21,5% 30,2%

Table 1: SRI relative to total managed assets (GSIA 2014, 7)

Of the world’s SRI, totaling USD 21,4 trillion, Europe accounts for close to 64% of all investments. The split in relative market sizes of the different regions is shown in Figure 7 (where the numbers sum to 100%).

Figure 7: Relative market size of SRI (GSIA 2014, 7)

These funds are invested in a range of different instruments, the predominant remaining to be negative screening (USD 14,4 trillion). In the time period 2012-2014, however, ESG integration experienced growth of 117%. The sum of funds subjected to some form of ESG integration thus reached a total of USD 12,9 trillion in assets worldwide6. It is the second most widespread responsible investment strategy, with negative screening still being the most common screening technique globally. However, on a more local level, ESG screening has become the dominant strategy in the US, Australian, New Zealand and Asia. (GSIA 2014, 8)

6 As reflected on in section 2.2, funds can be subjected to more than one strategy at a time, explaining why the two most widely used strategies alone totals more than the complete market (USD 27,3 trillion (14,4 + 12,9) in the two strategies, compared with a total market of USD 21,4 trillion).

Europe 63,7%

USA 30,8%

Canada 4,4%

Australia & New Zealand 0,8%

Asia 0,2%

USD 21,4 trillion