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Frequently Asked Questions

Portfolio Impact Footprint in general

Traditional portfolio management theory says that every investment decision has a certain expected return and a certain expected risk, and that these tend to correlate. But an investment decision is also a capital allocation decision. The amount invested flows to the user of the capital, the investee. In the case of equity investment, it influences the flow of capital to the investee through cost of capital.

The use of capital by the investee creates an impact in terms of sustainable development that can be measured and managed.

Investment impact can also be understood as the third dimension to the previously two-dimensional modern portfolio theory based on risk and return.

Let's say you lend your friend 50 pounds, and he promises to pay it back in a week and buy you a nice cup of tea in return for the favour. The cup of tea is your expected return. Let's say there is small chance that your friend falls short and you lose the 50 pounds and the cup of tea. This is your expected risk. If you think your friend falling short is likely, you might want to ask for a cup of tea and a nice sandwich to compensate for that greater risk. This is how investment return and risk tend to correlate.

Unrelated to either of these is what your friend decides to do with the 50 pounds. Maybe he has been unemployed for a while, and he uses the money to buy new clothes for his upcoming interview. Armed with the help of the new clothes (and the accompanied self-confidence) he gets the job. Or maybe he decides to buy himself a DVD box set of his favourite TV show that he binge watches over the week, forgetting his job interview. Two very different outcomes, which constitute your investment impact.

This is how it works in a bigger context as well. When your savings, your pension, your insurance premiums, the sovereign wealth of your country, the endowment capital of your university, or any other wealth you invest (or is invested on your behalf) in capital markets, it creates an impact in terms of sustainable development. This impact can be either positive or negative, but most importantly, it exists (just like risk and return) regardless of whether you pay any attention to it.

It is a way to understand the impact of any one investment decision in terms of sustainable development. Various portfolio impact footprint tools exist in the market. We like to think of Impact Cubed Impact Measurement as being one of, if not the, best.

Sustainable development in general has many definitions but the most widely used one was formulated by the Brundlandt commission in the late 80's saying, 'Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.' This is obviously intellectually solid way of describing the concept but it is also too abstract to be used in measuring investment impact. Sustainable Development Goals (SDG's) approved by UN General Assembly in 2015 lists 17 goals and 169 targets to define what the 'development without compromising the future generations' mean for the present generation. This gives the investment community (and Impact Cubed) a meaningful framework to measure and manage sustainable investment impact. While any set of quantitative indicators cannot capture the full complexity of the 'needs of the future generations', we are confident that our selection of indicators takes us 99% there.

Find more information about Sustainable Development Goals at http://www.un.org/sustainabledevelopment/sustainable-development-goals/

It is based on well-established models of investment risk measurement. It basically measures the investment exposure to a set of ESG factors and uses that to determine what portion of the total risk was used to reach the ESG exposure.

Every investment decision, alongside its commonly measured and reported risk and return, also has an impact in terms of sustainability. This impact exists regardless of whether the investor is aware of it or not. And since what gets measured gets managed, impact measurement is a crucial departure point for managing the impact of our investments.

Individuals have three ways to influence the world at large. How they vote, how they consume, and how they invest. The importance of voting is well understood and even taught in primary schools. The importance of consumption decisions is less applied and understood, but nevertheless well established in public sphere. Compared to these the influence of investment decisions is poorly understood, applied and communicated. Measuring the impact is the first step in managing it.

More importantly, through the relative size and power of multinational corporations, and their sensitivity to access to capital, the influence of our investment decisions is multiplied.

The bottom-line is that your carefully considered and cultivated voting and consumer choices can be cancelled out by your investment decisions. Or by the investment decisions that are done on your behalf by your pension plan, your university endowment, your congregation, your municipality or your nations sovereign wealth. Auriel has published some white papers on this topic. They are available at http://www.aurielequities.com/auriel-equities-in-the-news/ if you are interested to know more.

All models are wrong, some are useful - Edward Box

Quantifying inherently qualitative issues like the needs of the future generations will always come with some unavoidable amount of error. A decade ago these models and the data they relied on was plagued with bad quality, costly to obtain, and difficult to use. Nowadays the situation is very different. There are thousands of companies reporting on their impact; their carbon emissions and water use for example. This corporate reporting is improving both in quality and quantity, making impact measurement more accurate today and even more accurate going forward.

Is it perfect? Probably not. Is it useful? Definitely. Well beyond point of being actionable.

The outcome of the model is simple and there are plenty of applications for it. For example, one can compare the impact of different investment strategies against each other, or the sustainability of investing in different markets. The model can also be used to measure the combined impact of all investments in several portfolios, or to attribute the impact of one portfolio to a combined portfolio. It can establish an impact from investing in one company (which from a model point of view is just a portfolio of one company), so that individual portfolio managers can use this framework to understand how investing in one company influences the overall impact of the portfolio.

There are a few commercial 'SDG Measurement' and 'Impact Measurement' tools and frameworks available commercially. Some asset managers have also established in-house methods that they use to communicate how sustainable their portfolios are. Most of the existing models have their merits, but we would suggest looking out for few things.

  • How comprehensive is the model?

Some models and funds are 'one trick ponies', they might take care of one aspect of sustainability (like climate) and pay no attention to others (like gender) and vice versa.

  • Where does the data come from?

If the model uses proprietary inputs, for example composite sustainability ratings, there are two things to consider. First, be aware that you are buying in to someone's opinion. Second, by using proprietary data the model outcome is much harder to verify from outside.

  • Beware of anecdotes and stories

Most organisations providing (sustainable) financial services have an intensive to explain their operations to be as sustainable or impactful as possible. Without a balanced, comprehensive model that considers all holdings of the portfolio, you are susceptible to being given the impression that investment in one company makes the whole portfolio sustainable.

The Investment Impact model by Impact Cubed

It is based on well-established models of investment risk measurement. It basically measures the investment exposure to a set of ESG factors and uses that to determine what portion of the total risk was used to reach the ESG exposure.

An ESG index might have a tracking error (which means risk) of 80 bps (100bps is 1% in financial jargon). The model tells us that 60 bps of that is used to achieve its sustainable impact. This 60bps represents 75% of the total risk. This seems ok, indices are usually designed to have low tracking error. And ESG branded indices can be expected to spend most of it to achieve impact.

An active ESG fund could have much higher risk by design, let's say 500bps of tracking error. The model tells us that the fund has an active ESG weight of 25bps. This not only means that the fund is not particularly impactful, but also that of all the risk it takes on only about 5% is spent on impact.

It quickly tells you how much ESG impact there is in a portfolio, which is very helpful when comparing one portfolio to another across regions and investment styles.

In a bigger picture, more investment combined with more active ESG weight translates to more impact. The more there is impact, the more the cost of capital shifts in favour of sustainable firms at the expense of unsustainable firms. See our white paper for a full explanation http://www.aurielequities.com/auriel-equities-in-the-news/

The idea was to select a small set of ESG indicators to capture the cross-sectional variance of the company's impact against sustainable development.

It is a well based concept in mathematics and in finance. A multidimensional space can be represented with a finite set of variables. An abstract and multidimensional concept like sustainable development can be represented via a limited set of indicators or factors.

There are plenty of examples. Is any one person happy for example? It’s a difficult and multifaceted question, but it can be reliably approximated by looking at if the person is warm, safe and satisfied. Does the person have adequate safety nets for the future? Is the person loved? Does the person feel competent and confident? Does the person have a chance to fulfil individual wishes and dreams? None of these individual questions are necessarily decisive nor is the list exhaustive. But to determine if any one person is 'happy' this list already goes a long way.

It is the very same when measuring sustainable development. We try to capture the key ways in which large corporations influence sustainable development. We don't capture all the nuances, but we believe our list goes a long way in establishing overall sustainable impact.

The model requires enough indicators to 'span the sustainable development space'. There is no one indicator that can tell how sustainable a company is. At the same time, there is no need to measure the companies' sustainability hundreds of different ways. We argue that the number of indicators needed is quite low for two reasons.

  • ESG indicators themselves relate to one another

Companies’ climate action can be proxied by looking at the company's investment in clean energy and the company's carbon emissions. Makes perfect sense, except that a company's investment in clean energy will ultimately reduce their carbon emissions, resulting in double counting. There is no need to look at both, one is enough.

  • Companies' actions to address sustainable development correlate with one another

If company wants to manage their climate impact, they could invest in more efficient production mechanisms and better environmental tracking and accounting systems. The very same systems are very likely to address company's other emissions and water use as well.

As a result, there is a 'Goldilocks zone' of sustainable development indicators. There must be enough indicators to cover the key angles, but there can't be too many for a model to still be manageable.

The overall aim of selecting the indicators was to 'span the sustainable development space' as described earlier. But there is some other important requirements too.

  • Indicators are sector and region neutral

The ESG indicators tend to be sector and region specific. Charitable contributions for example are more relevant in India and access to medicines is only relevant for healthcare and pharmaceutical companies. The selected indicators in our model are relevant for every company regardless of their size, sector or the country they operate in.

  • All indicators are commonly accepted and recognized

Sustainability measurement has developed a lot during the past few years. There are various commercial models and rating systems in existence. But more importantly there are plenty of national (like stock exchange listing requirements) and international initiatives (GRI, SASB, GIIN) that define sets of ESG indicators. All the indicators used in our model are well established through these national and international initiatives.

  • All are outcome indicators

ESG indicators come in various shapes and sizes, and while all of them have their place and their significant use cases, we wanted to focus only on so-called outcome indicators. For example, we wanted to measure a company's carbon emissions (typical output indicator), not their plans around clean technologies or their investments in energy efficiency (which are typical input indicators). This is because we want to measure only companies’ actual impact, not their plans and intentions.

  • All indicators are widely used and can be estimated if not properly reported

Relying on very basic financial information guarantees that information is widely available globally. When the model uses more specific information regarding climate for example, that is not part of the basic financial accounting framework, we use the very simple indicators like carbon emissions. All the indicators in the model that are not universally available can be reliably estimated.

  • Carbon efficiency
    • Tonnes for carbon equivalent emitted per unit of revenue
    • Based on publicly available company reporting on GHG emissions (scope 1&2)
    • Based on company reporting or regression where reported numbers are not available
    • This is usually called 'carbon footprint'
  • Waste efficiency
    • Tonnes of solid waste generated to create one unit of revenue
    • Based on publicly available company reporting on created waste
    • Based on company reporting or regression where reported numbers are not available
    • This is similar to standard 'carbon footprint' sometimes called 'waste footprint'
  • Water efficiency
    • Litres of fresh water used to create one unit of revenue
    • Based on publicly available company reporting on fresh water use and withdrawal
    • Based on company reporting or regression where reported numbers are not available
    • This is similar to 'carbon footprint' sometimes called 'water footprint'
  • Gender equality
    • Percentage of women in top management
    • Board level data used by default, backed up by executive/top management data where available
  • Executive pay
    • Ratio of companies' top management compensation compared to average employee compensation
  • Board independence
    • Percentage of independent board members
    • Based on board level data which is typically widely reported as a stock exchange listing requirement
  • Environmental good
    • Revenue from environmentally positive products i.e. clean technologies, for example:
      • Wind turbines, solar panels
      • Water purification, waste management
      • Electric vehicles
    • Pre-defined by existing industry classification systems
    • Drawn largely from the sustainable development goals
  • Social good
    • Revenue from socially positive products, for example:
      • Education
      • health care
      • access to financial services
    • Pre-defined by existing industry classification systems
    • Drawn largely from the sustainable development goals
    • Geographical component sometimes used i.e. access to financial services for example is counted only if it is provided in places where there is a lack of access to financial services
  • Avoiding environmental harm
    • positive signal for avoiding companies with revenue from environmentally negative products i.e. dirty technologies
      • Coal mining and coal based power generation
      • Factory farming
    • Pre-defined by existing industry classification systems
    • Drawn largely from the sustainable development goals
  • Avoiding social harm
    • positive signal for avoiding companies with revenue from socially negative products
      • Tobacco, alcohol
      • junk food
      • Weapons
    • Pre-defined by existing industry classification systems
  • Economic development
    • Revenue in least developed countries
    • Used as a proxy for an economic impact
    • Based on companies geographical spread of operations and countries GDP per capita
  • Avoiding water scarcity
    • Litres of water used in water scarce parts of the planet
    • Based on the companies use of freshwater and their operations in water scarce parts of the planet
  • Employment
    • How many employees company has in areas with high unemployment rates
    • Based on companies reporting on employees and publicly available unemployment rates
  • Tax gap
    • Tax gap i.e. how much companies pay taxes compared how much they would be expected to pay based on the geographical spread of their operations
    • Measured as companies' theoretical tax rate based on the geographical spread of their operations and their reported tax rate

The data largely comes from companies themselves. We use intermediates (there is plenty of global companies that provide this service) that collect the data points from company reporting and filings for convenience. But we do not (and will not) use third party interpretations or opinions of what is sustainable and what is not.

Some data points are not reported by all companies. Carbon emissions or water use for example while encouraged, is not mandatory to report in most jurisdictions in the world. In these cases, we use existing company reporting and our in-house modelling (again, no 3rd parties here) to estimate the data points that companies do not provide. As a side note, we wholeheartedly support any initiative that increases the quality and the quantity of the companies' ESG reporting. The better the company provided information is, the better results we get.

By design most of our data points are 100% available as part of standard financial reporting. What companies produce and where they operate for example. Our governance data points of board composition are usually a part of stock exchange listing requirements. For the few indicators where our coverage is not 100%, i.e. companies do not report a specific data point, we have ways to estimate missing values. If company produces certain amount of electricity by using natural gas for example, we can approximate how much water it used based on industry averages for the same electricity generation method.

At the moment, we have coverage of around 10,000 companies across 46 countries covering around 90% of the investable market in each country.

No problem. Most of the indicators we need are publicly available, and we can estimate the ones that are not. However, the more data that needs to be estimated, the greater the uncertainty. For instance, if a small cap Indian semiconductor manufacturer doesn't report water, we can estimate reasonably accurately its water use by assuming that their facilities have the average water efficiency of the industry and looking at their output to estimate water use. If they don't report gender balance, we would have to estimate it with the average semiconductor manufacturer in India, which is a bit more of a guess than the water, but still reasonable to use.

Impact Cubed - The Company

Impact Cubed was established as a separate company (currently seeking B-Corp Certification) in summer 2017 with the intention of becoming a self-sustaining service to the investment community. It is our hope that this service helps separate 'green advertising' from 'green investing' and empowers investors with data to engage their fund managers.