Guido Giese

Melbourne, October 2018

ESG AND CORPORATE FINANCIAL PERFORMANCE:

A STUDY ON CORRELATION AND CAUSALITY

INTRODUCING MSCI ESG RESEARCH

2

1 Source: MSCI ESG Research as of April 2018. Includes full time employees and allocated staff performing non-investment advisory tasks.2 Based on latest P&I AUM data and MSCI clients as of December 2017

Paris

London

Frankfurt

Geneva

Beijing

Hong Kong

Manila

SydneyCape Town

Mumbai

San Francisco

Boston

New York

Gaithersburg

Monterrey

Toronto Portland

Tokyo

185+ ESG analysts1

(325+ FTE)

1200+clients

46of 50Global asset managers2

TOP

900+ESG equity & fixed income indices use MSCI ESG Research

ratings and data

Stockholm

Chicago

Seoul

MSCI ESG RATING METHODOLOGY

3Sources: MSCI ESG Research

Identify leaders and laggards within each

industry

Industry-Relative ESG Ratings (AAA-CCC)

Focus on most relevant ESG factors by industry

Quantitative Approach + Annual Consultation

Focus on risk exposure not just disclosure

Scoring Models Assess Risk Exposure + Risk Management

Analysis begins with a deepgovernance assessment

Ownership, Board, Pay, Accounting, Corporate Behavior

MSCI ESG RATING MODEL

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ENVIRONMENT PILLAR

Climate Change

Carbon Emissions

Product Carbon Footprint

Financing Environmental

Impact

Climate Change Vulnerability

Natural Capital

Water Stress

Biodiversity & Land Use

Raw Material Sourcing

Pollution & Waste

Toxic Emissions & Waste

Packaging Material &

Waste

Electronic Waste

Env. Opportunities

Clean Tech

Green Building

Renewable Energy

SOCIAL PILLAR

Human Capital

Labor Management

Health & Safety

Human Capital Development

Supply Chain Labor Standards

Product Liability

Product Safety & Quality

Chemical Safety

Financial Product Safety

Privacy & Data Security

Responsible Investment

Insuring Health & Demographic

Risk

Stakeholder Opposition

Controversial Sourcing

Social Opportunities

Access to Communication

Access to Finance

Access to Health Care

Opportunities in Nutrition &

Health

GOVERNANCE PILLAR

Corporate Governance

Board

Pay

Ownership

Accounting

Corporate Behavior

Business Ethics

Anti-Competitive Practices

Corruption & Instability

Financial System Instability

Tax Transparency

Three-Step Process1) Identify Key Issues By Industry 2) Measure Risk Exposure for each Key Issue3) Measure Risk Management for each Key Issue

DISCLOSURE ISN'T EVERYTHING……. RISK EXPOSURE MATTERS

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COMPANY A✓ Policy: Child Labor✓ Policy: Wages & Hours✓ Compliance Audits Corrective Action Plan Engagement with NGOs

COMPANY B✓ Policy: Child Labor✓ Policy: Wages & Hours✓ Compliance Audits✓ Corrective Action Plan✓ Engagement with NGOs

1,500 Suppliers

Production in Bangladesh300,000 Units

$20bn Revenue at Risk

200 Suppliers

Production in Australia10,000 Units

$100m Revenue at Risk

FOUNDATIONS OF ESG - PART 1: WHY ESG MATTERS

Research objectives

Step 1:

Fundamental research

• Establish fundamental channels from ESG to financial values

• Elaborate what dependencies we can expect

• Mitigate risk of ‘correlation mining’

Step 2:

Empirical validation

• Validate dependencies using empirical analysis for each channel

• Differentiate between correlation and causality

Step 3:

Conclusions for investors

• Highlight areas of asset management where ESG integration can add value

• Derive methodology recommendations for ESG integration

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RESEARCH METHODOLOGY

Understand channels from ESG to financial values

DCF Model frameworkESG ratings

Profitability Dividend yield

Incidents risksTail risks

VolatilityBeta

Valuation

Denominator: Required rate of returnSystematic risks

Numerator: Expected cash-flows

Cash-flow channel

Valuation channel

Stock-specific risk channel

Stock-specific opportunities

Stock-specific risks

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STOCK-SPECIFIC CHANNELS

Cash-flow channel

Strong ESG profile1. More

competitive2. Higher

profitability3. Higher dividends

Economic rationale:

1. More competitive due to more efficient use of resources & human capital development & better innovation management.

2. Generate abnormal returns, which ultimately leads to higher profitability.

3. Higher profitability results in higher dividends.

Profitability of ESG quintiles

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STOCK-SPECIFIC CHANNELS

Stock-specific risk channel

Strong ESG profile1. Better Risk Management

2. Lower risk of severe incidents

3. Lower tail risk

Economic rationale:

1. Better risk management and corporate governance standards.

2. Less frequent incidents such as fraud, embezzlement, corruption or litigation cases etc.

3. Lower tail risk in the company’s stock price.

Incident Frequency of Top and Bottom ESG Quintile

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SELECTED INCIDENTS AND PERFORMANCE IMPACT

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Firm Benchmark Incident date 1 year active performance after incident

Weight in benchmark (%, as of incident date)

BP MSCI World April 1, 2010 0.31% 0.80

VW MSCI World September 21,2015 0.02% 0.09

Equifax MSCI World September 11, 2017 0.01% 0.04

Petrobras MSCI ACWI May 27, 2014 0.09% 0.15

Petrobras MSCI EM May 27, 2014 0.73% 1.39

Wells Fargo MSCI World September 12, 2016 0.07% 0.71

Facebook MSCI World March 17, 2018 0.10% 1.08

SYSTEMATIC CHANNEL

Valuation channel

Strong ESG profile1. Low

systematic risk2. Low cost of

capital3. High

valuation

Economic rationale:

1. High ESG rating companies are less vulnerable to systematic market risks such as commodity prices or changes in regulation.

2. Lower systematic risk means investors demand a lower required rate of return = cost of capital.

3. Lower cost of capital leads to higher valuation.

Systematic volatility of ESG quintiles

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DERIVED CHANNEL: ESG MOMENTUM

From the static relationship

We derive the dynamic relationship

ESG Momentum ( = change in ESG rating)• Was verified by empirical analysis• Is an indication for causality in the three transmission channels• Was found to be a performance driver in empirical analysis

ESG ratings 3 channelsProfitability

RiskValuation

Change in ESG rating

3 channels

Change in Profitability

RiskValuation

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DERIVED CHANNEL: ESG MOMENTUM

Financial performance of ESG momentum: Top versus bottom quintile

Cumulative performance differential of the top ESG Momentum quintile versus the bottom ESG Momentum quintile. ESG Momentum is defined as the 12 month change in ESG score.13

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

17-May-09 29-Sep-10 11-Feb-12 25-Jun-13 7-Nov-14 21-Mar-16 3-Aug-17

Cu

mu

lati

ve p

erf

orm

ance

Developed Markets

Emerging Markets

CASE STUDY:MSCI EMERGING MARKETSESG LEADERS INDEX

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ESG LEADERS INDEX METHODOLOGY

ACWI

All

LIQ

UID

an

d IN

VES

TAB

LE

GO

OD

ESG

P

ERFO

RM

ERS

PO

OR

ESG

P

ERFO

RM

ERS

ACWI ESG LEADERS

Worst offenders

AAA

CCC

50%

Incentive to improve through reweight 50% Selection Best-in-class

(Selection per region and GICS sector to avoid biases)

Minimum ESG standards

Avoid most-problematic companies

BB

NO ESG BUILT-IN ESG INTEGRATION

PERFORMANCE IN LIVE TRACK (MAY 2013 – MARCH 2018)

16*See https://www.unpri.org

Key Metrics

MSCI EM (Emerging

Markets) Index

MSCI EM (Emerging

Markets) ESG

Leaders Index

Total Return* (%) 5.9 9.0

Total Risk (%) 15.2 14.5

Return/Risk 0.39 0.62

Sharpe Ratio 0.36 0.59

Active Return (%) 0.0 3.1

Tracking Error (%) 0.0 2.8

Information Ratio NaN 1.10

Historical Beta 1.00 0.94

No of Stocks*** 833 373

Turnover** (%) 4.9 7.1

Price To Book*** 1.5 1.9

Price to Earnings*** 13.6 15.5

Dividend Yield*** (%) 2.6 2.5

Period: 31-May-2013 to 30-Mar-2018

* Gross returns annualized in USD

** Annualized one-way index turnover over index reviews

*** Monthly averages

The definitions of all statistical parameters are available in the Appendix

MSCI EMERGING MARKETS ESG LEADERS ALLOCATION

Index: MSCI EM (Emerging Markets) ESG Leaders Index

Period: 31-May-2013 to 30-Mar-2018

Return (%)

Risk (% Std Dev)

0.13

0.02 0.02 0.02 0.05 0.08 0.05 0.07 0.12

Growth Liquidity

-0.01 0.01 0.02 0.04 0.05 -0.01 0.09

Leverage Earn. Qlty Inv. Qlty Profitability Earn. Var. Div. Yield

0.28 0.110.16 0.13 0.13 0.10 0.03 0.31

-0.22 0.09-0.14 -0.04 0.06 -0.04 -0.02 0.23

Beta Res. Vol.BtoP Earn. Yield LT Reversal Size Mid Cap Momentum

2.15

0 0.71 0.00 0.98 0.73 0.75 1.51

0 0.33 0.00 -0.12 0.47 0.25

Risk Indices Asset

Currency Currency Equity Selection

Explicit Implicit World Countries Industries

0.33 0 2.75 N/A N/A

0.71 0 2.53 N/A N/A

Active Trading Transaction

Selection Equity Equity Cost

5.94 3.09

15.17 2.80

Currency Cash

Annualized Gross Returns

Total

9.03

14.46

Benchmark Active

Performance attribution for MSCI Emerging Markets ESG Leaders Index (live track, May 2013 till March 2018)

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CONCLUSIONS FOR INVESTORS

1. MSCI ESG Ratings and MSCI ESG ratings trend (ESG momentum) have shown a financially significant impact on valuation, profitability and risk and therefore may be used in financial analysis as well as portfolio construction.

2. ESG integration into portfolio management requires a long-term horizon.

3. Stock selection based on MSCI ESG Ratings has shown a positive impact on performance and risk in life history for global MSCI ESG equity indexes.

4. Bloomberg Barclays MSCI ESG indexes for corporate bonds have shown risk reduction and slightly better performance compared to benchmark.

18ESG

Risk & Performance

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