Tag: approach

Constructing Social Portfolios: A Quantitative versus Screening Approach

By Alina Hofer, Lea Katharina Kasper & Dr. Kristjan Jespersen 

◦ 5 min read ◦

When we talk about ESG, one could argue that there is a strong bias focused on climate investing, reaching net zero targets as well as good corporate governance and diversity themes. But there is much more to ESG. The “Social” dimension of ESG is hugely under explored and developed and covers under studied issues such as how companies treat their employees and care for the responsibility of their products. Still further, assessments linked to human rights codes and social impacts is only now receiving the attention it truly deserves. Although the importance of these topics is undisputed, we see that attention to particularly address the social dimension has been lacking, whereas awareness of other ESG risks has been rising immensely during the past years. 

Not only is the general knowledge and focus on the social dimension of ESG limited, its overall  implementation in portfolio management has not been sufficiently experimented with and addressed.

The delay to properly implement the “S” in ESG is often explained because of the challenges to quantify, assess, and integrate social factors generally.

However, this argument should not be a sufficient justification for neglecting the “S” in ESG and for investigating a possible relationship between a good social rating and superior financial performance. To tackle this lack of awareness, we constructed two portfolios which integrate Refinitiv’s Social ratings based on different integration strategies and test their performance towards the market between 2012-2021.

When integrating social – or other ESG – ratings into the investment process, we find there is often disagreement on how to best consider these factors in portfolio construction. Currently, it is most common to apply screening or best-in-class strategies. These approaches aim to remove assets that do not fulfill certain criteria from a defined investment universe. Negative screening would mean to remove those companies that perform worst from the pool of assets. Inversely, an investor could also only continue with those firms who at least have a certain minimum rating. For both approaches, the portfolio weights are then allocated to the assets that remain. This is done using conventional indicators such as value, size or expected risk-adjusted returns. In our study, we, however observe a clear shortcoming of this approach: After screening out the worst 10% “social performers” and allocating weights based on a risk-return trade-off, the portfolio does not necessarily promise a higher overall ESG score than a portfolio would reach which does not consider the ratings at all. Although the portfolio yields a solid financial performance, this raises the question whether any ESG-related impact has been made with this integration approach.

To make sure an investor can improve his exposure to assets that score well in the social dimension, we integrate the rating scores directly into the optimization problem of our second portfolio. This leads to a very different outcome on the social rating:

Looking closer at the mechanics of this approach, we extend the traditional Sharpe Ratio with the ESG factor, meaning to add by how much it a company “outscores” the market average. This results in the following “Social Sharpe Ratio”:

We add a fifty percent weight split, which can be flexibly adjusted towards investor preferences. And we now balance a risk-return-social trade-off. This explains why the second approach over 9 years constantly beats the market average in respect to the integrated Social factor without sacrificing any performance on the financial side. In fact, we find that in 5 out of 9 years, the second strategy would have also led to higher risk-adjusted returns measured by the Sharpe ratio. Moreover, returns were consistently higher compared to the market benchmark. This result is quite remarkable, given that it is often questioned whether investors need to sacrifice returns in order to make their investments more socially responsible. 

Lastly, our study resulted in one more unforeseen twist when it comes to integrating ESG ratings. That is, the question whether we can actually trust the rating scores. To answer this, we must first understand how scores are created. Rating providers look at an immense amount of publicly disclosed information, reports and policies. And based on what company’s report, rating scores are aggregated. However, it is clear that a firm would only report on things they do well. In fact, we observe that with increased reporting, ESG scores also improve. But what about the real-life actions and impacts? Some rating providers offer a combined score, which also considers media reports on the involvement in controversial actions. As these scores are only available at an aggregate level, we calculate them on a single-pillar level using Refinitiv’s methodology, which adjusts for firm size and industry. Looking at specific examples in our portfolios, we found that the impact of such controversy involvement on the overall score could still be larger. Nevertheless, we stress that in order to have a complete picture of a firm’s ESG behavior, the impact of these controversies needs to be reflected in investment decisions. 

To sum up, given the results of our research, there are three things we aim to highlight:

  • It is crucial to increase investors’ awareness of “Social” matters and provide a better landscape for impact investments in this specific dimension.
  • Integrating ESG ratings does not always promise a better ESG performance for the whole portfolio. Therefore, it is necessary to focus on strategies that lead to actual impact.
  • Third, looking beyond the information that is disclosed by companies themselves, more attention should also be addressed to “real life actions” when making investment decisions. 

About the Authors

Lea Kasper has recently graduated with a MSc. in Finance and Investments (cand.merc.) from Copenhagen Business School. Her interest and enthusiasms about sustainability and how to more efficiently integrate non-financial factors in investment decision-making contributed to her choice to further investigate this topic throughout the master thesis. 

Alina Hofer has recently graduated with a MSc. in Finance and Investments (cand.merc.) from Copenhagen Business School. Being passionate about creating impact through ESG-aligned investments, she was excited to further focus on her interest in this field throughout the master thesis.

Kristjan Jespersen is an Associate Professor at the Copenhagen Business School. He studies on the growing development and management of Ecosystem Services in developing countries. Within the field, Kristjan focuses his attention on the institutional legitimacy of such initiatives and the overall compensation tools used to ensure compliance.

Image source: SustainIt

The year of corporate acting—does business need a new approach to palm oil?

By Amanda Williams, Steve Kennedy and Gail Whiteman.

2018 went down as the ‘year of corporate caring’ about the palm oil controversy. A banned TV advertisement promoting a Palm Oil free Christmas by the UK supermarket Iceland went viral on social media with over 5 million views in merely a couple of weeks. Shortly after, on the south bank in London, Iceland responded to the ban with a displaced Orangutan hanging from a Christmas tree surprising tourists and drawing attention to the loss of biodiversity due to the clearing of virgin rainforests. Debates about palm oil in Malaysia and Indonesia are far from new. But recent events are surely stirring up the conversation and attention to the issue is at an all time high.

Proponents are reacting to the complete ban of palm oil with statistics on the efficiency yields from the fruit of oil palm trees and claim boycotting palm oil would simply shift demand to other types of vegetable oil to meet demand. Palm oil has climbed the charts in popularity because it is cheap, versatile and efficient. While others argue that despite the efficiency benefits of the crop, new approaches are needed to tackle this pressing humanitarian and environmental issue.

Business and Palm Oil

CEOs of multi-national corporations that depend on palm oil and tropical timber in their supply chains are well aware of their impacts and the consequences of deforestation. Outgoing Unilever CEO Paul Polman already stated back in 2015:

“We are seeing the effect of climate change in our own business. Shipping routes cancelled because of hurricanes in the Philippines. Factories closing because of extreme cold weather in the United States. Distribution networks in disarray because of floods in the UK. Reduced productivity on our tea plantations in Kenya because of weather changes linked to deforestation of the Mau forest. We estimate that geo-political and climate related factors cost Unilever currently up to €300 million a year.”

Many companies are working hard to address the issue. The Roundtable on Sustainable Palm Oil, established in 2004, brings together palm oil producers, traders, consumer goods manufacturers, retailers and NGOs to improve environmental and social criteria for the certification of sustainable palm oil. The roundtable boasts that 13.20 million tons of palm oil is RSPO certified, amounting to 19% of the global volume. Palm oil certification is expensive for farmers to obtain and has yet to solve issues of deforestation or poverty.

Yet, ambitious corporate targets are not translating into concrete results on the ground.

Beyond certification, companies are setting ambitious targets. Unilever’s touchstone Sustainable Living Plan aims to become carbon positive by 2030 and halt deforestation by 2020. And Nestle is ‘striving for zero’ environmental impact including emissions and deforestation. Yet, ambitious corporate targets are not translating into concrete results on the ground. Recent reports demonstrate that emissions and deforestation rates are still rising. In advance of 2020, at the Consumer Good Forum, brands admitted that reaching zero deforestation targets by the end of the decade is unlikely. The head of sustainability and procurement at Mars, Barry Parkin, is calling for strategies that go beyond certification that consider “new theories of change.”

Current efforts aren’t cutting it

Despite these ambitious efforts, the situation in Malaysia and Indonesia remains bleak and deforestation continues at alarming rates. In Borneo, only 43 percent of its original lowland rainforests remained by 2015. Lowland rainforests are optimal for palm oil production plants but are also home to many rare species. The consequences of deforestation extend beyond biodiversity loss to land degradation, droughts and forest fires, which interact to further increase emissions.

Even if companies successfully meet ambitious zero deforestation targets, halting deforestation may prevent further increases in emissions, but is unlikely to restore societal and environmental resilience to future shocks. If certification and deforestation targets are not the solution, then what is?

Lessons for business

How can business leaders approach palm oil production differently? Based on our latest article, we offer several suggestions:

  1. Focus on a different scale. Firm-centric approaches, such as mitigation and adaptation to the effects of climate change, may keep companies afloat in the meantime, but are unlikely to offer a long-term solution. Mitigation and adaptation aim to enhance firm performance and respond to the effects of the problem, but do little to consider the eco-systems on which the companies depend. Complex interactions in local societies and ecosystems go unnoticed and leave companies vulnerable to future disturbances. New approaches should consider how to develop healthy ecosystems that can continue to provide services for the local community and companies for decades to come.
  2. Look closer. When considering the intricacies of ecosystems, managers can monitor slow variables and feedbacks. Slow variables such as the amount of soil organic matter, insect populations or the level of rainfall can control how an ecosystem functions. Managers can identify the slow variables that govern how ecosystems behave and what levels of these variables puts the ecosystem at danger. Feedbacks offer managers warning signals that changes are occurring and allow to detect when ecosystems may be at risk. Managers can seek to tighten their recognition and action to feedback loops in order to minimize time delays and improve chances of avoiding ecosystem collapse.
  3. Manage ecosystem diversity and redundancy. Moderate levels of diversity and redundancy allow ecosystems to thrive. When a disturbance strikes, response diversity allows ecosystems to react in numerous ways. Redundancy provides substitute functions when elements that preform similar functions fail. When diversity and redundancy are compromised, ecosystems become brittle and vulnerable to even small disturbances. Firms can move beyond halting deforestation by actively building viable business models for land restoration. For example, effective cropping system diversification can lead to landscape restoration, increased economic viability and enhanced ecosystem resilience.

As companies such as Mars are calling for an overhaul in corporate efforts to tackle deforestation, we hope these lessons offer some inspiration.

Authors

Amanda Williams is a Senior Researcher at ETH Zurich in the Sustainability and Technology Group. She recently completed her PhD from Rotterdam School of Management, Erasmus University. Currently, she is a part of Copenhagen Business School’s Governing Responsible Business (GRB) World Class Research Environment Fellowship program. With Steve Kennedy (Rotterdam School of Management) and Gail Whiteman (Lancaster University) she wrote this blog post and an article on cross-scale perspective for studies of organizational resilience (see below).

Citation:

Williams, A., Whiteman, G., & Kennedy, S. (2019). Cross-Scale Systemic Resilience: Implications for Organization Studies. Business & Society. https://doi.org/10.1177/0007650319825870

By the same author

In November 2018, Amanda Williams has written an article about Corporate contributions to United Nations’ Sustainable Development Goals. Find it right here.

Photo by Marufish on flickr.