Sustainability Research Ratings and Indexes

The fact that ratings of corporate sustainability performance exist and are marketed to investors has been one of the most public manifestations of action where sustain-ability issues meet capital markets. Obviously, there is an appetite for this research and for investment products that are based on it. Approximately three billion euros are invested based on the Dow Jones Sustainability Index.33

There are, however, relatively few signs that this has moved from being a niche activity to being part of the mainstream world of investment. For example, only three of 35 SRI research organizations evaluated by SustainAbility in Values for Money are found to "currently analyze the link between social/environmental issues and material impacts on investment value drivers" (Beloe et al., 2004). These are SAM Research, Innovest, and CoreRatings. These have the greatest potential to cross over into more widespread use among mainstream investors.

31See http://unepfi.net/stocks/oilandgas_gsachs.pdf.

32See http://www.incr.com/.

33See http://www.sustainability-indexes.com/djsi_pdf/news/PressReleases/DJSI_PressRelease_040902_ Review.pdf. Baruch Lev, "Grey Matters: CFO's Third Annual Knowledge Capital Scorecard," CFO Magazine, April 2001b.

Mainstream investors face big challenges in trying to apply research about corporate sustainability into their existing investment process. They can use the indexes or the ratings themselves as a part of the quantitative investment approach, but most investors use more traditional methods of stock picking and it is not obvious how to apply sustainability research to that process.

One of the leading solutions to this problem is to think of the sustainability capability of companies as being one of several "nonfinancial" factors or intangible assets of the company. The whole area of valuing intangible assets is a rapidly emerging issue in investing overall. There is a high degree of acceptance that these assets are a huge and growing portion of the market value of companies, but there is little agreement about how to value these assets. Forty to fifty percent of market capitalization of the S&P 500 is from intangible assets and the figure is much higher for some companies (Lev, 2001b).

One of the proposed approaches to the general problem of valuing intangible assets includes explicit reference to social and environmental performance. Jonathan Low, Pamela Cohen Kalafut and others formerly with Cap Gemini Ernst & Young's, Center for Business Innovation have pioneered a means of measuring the financial value of intangibles such as brand equity, leadership, reputation, and innovation. Their Value Creation Index includes Environment among these value drivers.34 While this topic does not consistently rate among the top intangible assets in all industries in its effect on market value, it is significant enough to include in the model and is statistically significant in the chemical industry. Other aspects of sustainability also contribute to the value of intangible assets. For example, diversity and employee relations are key components of human capital and environmental performance is a key part of brand equity.35

Overall, these various attempts to measure sustainability performance and relate it to shareholder value reflect the understanding that the ability to handle the complexity of sustainability reflects good management and that good management performs financially.

Sustainability research and ratings remain a niche market, but they have made some significant progress in capturing initial sales, including some very demanding mainstream investors. Several have also successfully forged alliances with big-time mainstream institutions, such as SAM's work with Dow Jones on the Dow Jones Sustainability Index and ABP's ownership interest in Innovest after having become a customer. Perhaps most importantly, several of these research and rating providers have successfully made the transition from merely gathering what data happened to be available to seeking out the right information to answer the right questions about how these factors do or do not connect to value.

While the strides forward for corporate sustainability research have been impressive, the reality remains that only a small minority of institutional investors use this research. There is little consensus about how this analysis should be

34See www.invisibleadvantage.com and http://www.gemi.org/docs/conf2002/graphics/gemi2002/ Session8/GEMI_JonLow.ppt.

35See Clear Advantage: Building Shareholder Value, GEMI, 2004, available at http://www.gemi.org/ GEMI%20Clear%20Advantage.pdf.

done, with at least two primary differences. The first is between using standardized questionnaires to gather information, which has resulted in significant "questionnaire fatigue," and relying on analyst contact with the company. The second goes straight to the heart of what is in fact being measured. We have moved beyond just gathering publicly available data on measures of environmental performance (e.g., TRI), but some ratings put the emphasis on the existence of the right sustain-ability policies while others explicitly seek to make a judgment about ability of management to handle risks related to social and environmental issues.

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