Indices rise to the sustainability challenge

A new breed of indices is being added to the established SRI benchmarks.

Increasing investor interest in sustainability is closely linked to the changing mainstream perception of the link to long-term shareholder value. Investors can now choose from a growing suite of sustainability focused indices as benchmarking tools, investment universes or as underlyings for passive mandates, according to the size of their desired investment universe. Two examples are, the “very-best-in- class” indices such as the Dow Jones Sustainability series (DJSI), which capture the best 10% by sector- around 300 companies- and the “best-in-class” approach as measured by the recently launched KLD Sustainability indices representing 37.5% of global sector capitalisation. Another provider, Ethibel, does not set a target market capitalization but like the others applies global standards in the company selection process, eschewing a country weighted approach. SAM Indexes defines sustainability leaders as companies best managing the risks and opportunities of trends such as demand for greater corporate transparency, aging population, impending C02 emissions and recycling legislation. While the selection methodologies between sustainability index providers may differ widely, the compilers of best-in-class indices are united bythe challenge of maintaining their relevance to investors by consistently identifying these leaders.
In the wake of the Enron and WorldCom scandals, investor attention has resulted in significant improvement in corporate governance to the extent it has become more difficult to differentiate leaders from laggards.
Two widely recognised sustainability issues facing companies are increasing fossil fuel prices and CO2 emissions legislation. While some low carbon impact companies may wonder what climate change has to do with them, these are nevertheless critical trends for facilitating the differentiation of the best from the rest across a variety of industries. Take eco-efficiency as an example. Against a back drop of USD90 per barrel oil prices and rising coal (+40%) and gas (+60%) prices during the last 5 years, in spring 2006 the European Union adopted a Directive to enhance energy efficiency and reduce energy consumption by 9% by 2016. These realities may well provide the impetus for companies to move energy efficiency up the corporate agenda.
This has yet to become the norm, however; the significant difference in eco-efficiency score between
companies selected for the DJSI World index and those not included is compelling evidence of this. Companies which see investing in such sustainability related issues as a cost with little benefit should consider the examples of players such as BT and DuPont, which have made energy savings totaling $214m and $2bn respectively in the last 25 years. In the area of emissions, last month, the Kansas Department of Health refused a clean air permit for Sunflower Electric’s proposed $3.5bn investment in a coal fired 700MWatt electricity plant. This example focuses the investor’s primary attention on the importance of utilities companies mitigating the risks of emissions legislation. Additionally, it shows how environmental governance attitudes to project investment in banks could affect profits.
It is unsurprising that companies which aspire to be sustainability leaders are setting inclusion in such indices as a corporate goal, seeing this as a strong signal to mainstream investors that they take these issues seriously when planning for the future. Interestingly, in at least one case, Westpac, executive remuneration is determined in part by the company being a constituent in the DJSI.
A recent development has been the large-scale introduction of “sustainability opportunity” indices. Investment in renewable energy production grew to $100bn in 2006, while the expansion of wind energy is
gathering pace: in 2006, a 25% global capacity increase created demand for €18 billion of generating equipment and brought global wind power capacity up to more than 74GW. Honda president Takeo Fukui recently said he saw no future for the auto industry without fuel cell cars.Investors have been attracted by eye-catching returns in these sustainability “themes”. For example, the Société Générale European Renewable Energy Index (ERIX) of the ten largest regional renewable energy firms has gained 51% in 2007. SOLEX, which follows the largest ten companies in the worldwide solar energy industry has increased 64.5% over the same period. Themes such as water – perhaps the most important commodity of the 21st century – healthy living, recycling and waste management have also attracted significant investment inflows.

“It is unsurprising that companies which aspire to be sustainability leaders are setting inclusion in such indices as a corporate goal.”

SAM, HSBC, S&P, WilderHill and FTSE are among a growing list of providers of these opportunity indices. In contrast to mainstream sustainability indices the majority do not use qualitative screens in the selection of constituents. Instead they identify eligible companies solely by revenue source and apply size and liquidity screens to ensure investibility. SAM considers a company to be eligible for an index only if its primary revenue source stems from the theme. S&P theme methodology specifies companies must derive a significant portion of revenue from the theme revenue to merit consideration. In practice this means a company such as General Electric, which generates less than 10% of its 2006 USD164bn revenues from energy technology,
would be ineligible for inclusion in a renewable energy index despite being one of the largest global manufacturers of wind turbine machinery.
Reflecting the dynamic nature of corporate sustainability assessment and rating it is likely this opportunity investment set will evolve further to include extra-financial screens. Forestry and Paper indices are one such possibility. The UN Food and Agriculture Organisation predicts that world consumption of wood and related products will increase 60% by 2032, with demand easily outstripping supply. Arguably the most sustainable timber companies will be best placed tocapitalise in this environment. Mainstream and customised sustainability indices will continue to provide market participants with a range of options to reflect their particular views on sustainability investing. Whatever their choice, the desire to better manage risk, generate strong returns and to offer an ever stronger incentive for companies to improve will continue to grow demand for objective sustainability mainstream and theme indices.
Jon Winslade is a senior relationship manager at SAM Indexes in Zürich