Using financial indices for responsible investment

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Jay Harding Will Oulton, Head of Responsible Investment FTSE Group and Jayn Harding, Principal Advisor, Responsible Investment FTSE Group

The Stern Review suggests that climate change threatens to cause the greatest and widest ranging market failure ever seen. Stern states, “...our actions over the coming few decades could create risks of major disruption to economic and social activity, later in this century and in the next, on a scale similar to those associated with the great wars and the economic depression of the first half of the 20th century.”

As a result, investors, governments and wider society expect companies to take rapid action in response to the varied and considerable risk that climate change poses. Financial indices, such as the Dow Jones Sustainability Index, and the FTSE4Good Index can help investors find companies doing just that. Here, the FTSE4Good Index is explored in more detail.

TWIN-TRACK STRATEGY

Climate change is the environmental challenge that has the clearest and most tangible economic implications. Costs are increasingly being allocated to carbon through regulatory and voluntary economic instruments, such as the European Union (EU) Emissions Trading Scheme, which are also leading to significant market opportunities arising for innovative companies. Investors expect companies to develop appropriate climate strategies, of which there are two key components:

Manage down risks and impacts – protect the value of existing company assets by reducing climate change risks and impacts through appropriate management systems and controls.

Maximise business and environmental benefits – identify and develop related business opportunities through value creation.

RISK MANAGEMENT – AND VALUE PROTECTION

Stern’s report highlighted that tougher and more comprehensive cap and trade international frameworks are essential and will lead to far more radical and far-reaching impacts on company valuations over the years ahead. A robust management system is vital in implementing aspects of a climate change strategy, see Table 1.

There are a range of well known standards for managing environmental and social risks, eg the Environmental Management System ISO 14001; SA8000. The FTSE4Good Index Series provides an extra-financial overlay to the FTSE All World Developed markets index using a range of environmental and social inclusion criteria. Detailed climate change requirements have already been added to FTSE4Good inclusion criteria to ensure the index series is aligned to one of the major concerns facing business and investors today.

Beginning with widespread market consultation with final criteria ratified by an independent committee of experts, the climate change criteria for the FTSE4Good index series are designed to encourage companies to mitigate climate change based on their operational and product impacts, see Table 2.

As with all FTSE4Good criteria, the climate change criteria are set to be challenging but achievable, rather than leading edge practice for a small number of companies. The index aims to encourage companies to address key environmental and social issues and work to improve performance continuously.

There are a variety of standards and initiatives that investors and companies can refer to in addressing climate change elements. Examples include the Greenhouse Gas (GHG) Protocol by the World Business Council for Sustainable Development, and the recently established Climate Disclosure Standards Board which aims to further standardise disclosure of GHG emissions. However, no single comprehensive standard has yet been established for the management of GHG reduction. The FTSE4Good climate change criteria form a useful standard for companies to aspire to and provide a reference point for investors.

There are a number of ways companies can achieve performance in the area of climate change reduction. Many are beginning to reduce their emissions by using the systems, support and infrastructure that already exists within the company. However, measuring emissions reduction is difficult as there is a lack of industry eco-efficiency metrics. The need for metrics presents a significant but worthwhile challenge for a number of sectors and there are still alternative means for companies to demonstrate performance and commitment to emissions reductions.

Table 1: verview of elements of a good management system.

Policy and strategy: publishing a clearly defined public policy and strategy with Board responsibility, which establishes broad goals and sets objectives and targets for improved performance.
Processes and structures: establishing procedures which define internal processes and structures to ensure policies are implemented and risks managed effectively.
Monitoring and performance: setting up appropriate performance monitoring mechanisms and key performance indicators to measure continually, quantify and improve corporate responsibility performance.
Reporting regularly to stakeholders on impacts, policies, management systems and performance.
Consulting with key stakeholders on these issues.

Table 2: Climate change criteria for the FTSE4Good index series.

	High operational impact	Medium operational impact	Additional high product impact
Policy and Governance	Board level or senior executive responsibility for climate change related issues (individual or committee). Public statement/policy identifying climate change as relevant to business activities and the need to address climate change as a key concern.	Board level or senior executive responsibility for climate change related issues (individual or committee). Public statement/policy identifying climate change or energy consumption as relevant to business activities and the need to address climate change as a key concern.	Responsibility: no additional requirement. Public statement/policy should also include a commitment to reduce product-related emissions or climate change impact.
Management and Strategy	At least one of the following must be met (unless the company meets the performance requirements): Long term strategic goal of significant quantified reductions of operational GHG emissions or carbon intensity improvement over more than five years, which should be publicly available. Short/medium term management targets for quantified GHG operational emissions reduction over less than five years.	No requirements yet: criteria for medium impact companies are initially focused on disclosure.	No requirements yet: for companies with product-related emissions reduction management targets are currently regarded as impractical.
Disclosure	Public disclosure of both the following: Total operational CO2 or GHG emissions as tonnes of CO2 equivalent. Sector metric where established as an industry norm, eg, for cement companies, kg CO2 per tonne of cement; or efficiency ratio.	Public disclosure of one of the following: Total operational CO2 or GHG emissions as tonnes of CO2 equivalent or operational energy consumption. Sector metric where established as an industry norm. eg kg CO2/t cement; or efficiency ratio.	Public disclosure of product-related emissions/efficiency. This will vary for different sectors: Oil & gas: end user emissions. Coal mining: end user emissions. Automobiles: fuel efficiency. Aerospace: fuel efficiency.
Performance	At least one of the following must be met: At least a five per cent reduction in carbon intensity over the last two years. The company is able to demonstrate that for the previous two years it is in the top quartile of companies in its sub-sector when assessed on accepted carbon efficiency metrics. A Transformational initiative or a combination, providing they are quantified and significant.	No requirements yet: as understanding of how to measure performance increases, performance requirements will be introduced for medium impact companies.	Automobile and aerospace companies must meet one of the following: Emissions reductions: fuel efficiency improvements above average for sub-sector. Eco-efficiency: above average fuel efficiency relative to sub-sector peers. A Transformational initiative to reduce product emissions. NB: Oil & gas and mining: no further “product” requirement at this time, but still need to meet performance criteria for their operational impact.

TRANSFORMATIONAL INITIATIVES AND VALUE CREATION

Some companies are undertaking major projects and investments to develop methods to reduce GHG emissions. These could deliver more significant global GHG reductions and business opportunities than incremental company efficiencies. The FTSE4Good climate change criteria recognise transformational initiatives as a measure of performance as they play an important role alongside energy efficiency and renewables in addressing climate change. Quantification may include: percentage emissions reduction actual or predicted; expenditure as a percentage of research and development budget; or percentage of the market.

SUPPORTING TECHNOLOGY SOLUTIONS COMPANIES

Companies providing climate change solutions are those with core business in the development and operation of solutions-driven clean technologies. Clean technologies include: alternative energy or energy efficiency which uses cleaner and more efficient methods of energy production; water technologies and pollution control which employ clean technologies to reduce the contamination of air, water, and soil; recycling and sustainable waste management which help to address environmental resource problems.
Investor perceptions have changed and these environmental technology companies are now seen as providing exciting opportunities for growth. There is also significant risk in this sector and diversified tracker funds following recognised indices from respected international index providers are attractive. FTSE recently launched the global environmental technology index, the FTSE ET 50 Index in partnership with Impax, the respected boutique clean tech specialist.

THE ROLE OF BENCHMARKING

Benchmarking is a useful tool for both companies and investors. The FTSE4Good indices are used as benchmarks for a range of investment funds, and as a tool for identifying best in class companies. Many companies also use FTSE4Good indices in developing strategy and policy, designing programmes and initiatives, and setting goals and targets.

Through FTSE’s expanding responsible investment portfolio of index products, investors have a variety of tools to assess company performance on corporate responsibility. Conversely, these instruments provide companies with a means of demonstrating risk management and creating stakeholder confidence.

Table 3: Definition and examples of transformational initiatives.
DEFINITION: A transformational initiative is a strategic initiative that makes a significant contribution to the reduction of GHG emissions.

Example of initiative	Description
1 Buying low carbon electricityand fuel switching	Where there is a substantial reduction in the carbon intensity of electricity that is purchased/ used by the company, or an alternative, less carbon-intensive, fuel is selected.
2 Demand side management	The company has a programme to reduce the energy use of its clients. This would include development of new products that helped clients reduce energy use.
3 esearch and development in technologies	Total R&D investment in low carbon technologies. eg carbon sequestration, renewables, or technologies low carbon which significantly reduce the energy needs of current technology.
4 Production of low carbon technologies	Energy and technology companies bringing new low carbon technologies to market.
5 Generation of renewable energy	Utility/electricity companies – build significant renewable generation capacity. Other companies may generate own renewable energy.
6 Product/service innovation	Quantified reductions in energy requirements of new products and services (GRI EN7).
7 arbon capture and storage (sequestration)	Total CO2 sequestered.
8 Supply chain/upstream	Reducing the upstream carbon intensity, eg reducing the ‘embedded’ CO2 emissions (reducing energy input into the processing of components); switching raw material input to less carbon intensive one, eg from steel to aluminium; or reducing energy used by suppliers.
9 New business model	Owning and addressing the whole lifecycle and GHG footprint of a product or service, eg switching from products to services with associated GHG savings. Provision of mobility services, or owning and running a vehicle that is then used by consumers instead of selling vehicles and leaving the fuel consumption/emissions responsibility to the consumer.
10 Breakthrough project	Any single initiative that dramatically reduces GHG emissions. Redesign of production process, building redesign or redesign of transport fleet.

CONCLUSION

Setting international targets for global CO2 concentrations is a task for governments, not for the financial services sector. However, among the investment community there is expectation of increasing costs associated with carbon and that those companies with the greatest carbon efficiencies will be better positioned to deliver greater returns. The FTSE4Good climate change criteria, as well as the FTSE4Good ratings service will help investors identify those companies. More importantly, they will encourage improvements in management systems across hundreds of companies and in this way support international efforts to curb emissions.

© FTSE International Limited (“FTSE”) and Ethical Investment Research Services (“EIRIS”) 2007. All rights reserved. “FTSE®”, “FT-SE®” and “Footsie®” are trade marks jointly owned by the London Stock Exchange Plc and The Financial Times Limited and are used by FTSE under licence. All rights in and to the FTSE4Good Ratings and Indices vest in FTSE and/or EIRIS. The information and opinions contained in this document which has been prepared by FTSE are not intended to be a comprehensive study, nor to provide any advice, and should not be relied on as such. No representation or warranty is given by FTSE or EIRIS as to the accuracy or completeness of the information or opinions contained in this document and no liability is accepted for any such information or opinions. No liability can be accepted by FTSE and/or EIRIS for any errors or for any loss arising from use of this publication.

Detailed climate change requirements have already been added to FTSE4Good inclusion criteria to ensure the index series is aligned to one of the major concerns facing business and investors today.

Authors

Will Oulton heads up FTSE’s Responsible Investment Unit. In this role, he provides a consultative role to FTSE’s Chief Executive in defining FTSE’s role in the responsible investment arena, including managing and developing socially responsible investing (SRI). He is widely recognised as a leading thinker in
the SRI world and is a regular commentator in
the media.
Jayn Harding leads the direction and development of criteria and standards in corporate responsibility for FTSE’s responsible investment products. Prior to joining FTSE Group, Jayn was Environmental Manager at Sainsbury’s, the UK based food retailer and was responsible for managing all environmental issues, as well as socially-responsible sourcing
and CSR.

Organisation

FTSE4Good is an innovative series of real-time indices designed by FTSE Group to reflect the performance of socially responsible equities. It covers five markets:
UK, Europe, Japan, US and Global with four tradable
and five benchmark indices. A committee of independent practitioners in SRI and CSR review the indices to ensure they are an accurate reflection of current CR best practice. FTSE Group contributes income including licence fees for FTSE4Good to UNICEF, the global charity.

Enquiries

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Picture credit: FTSEGroup 2005

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