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SinCo briefing on Institutional Investors, Sustainable Investment and ESG in Capital Budgeting

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Presentation to ERM client event focused on role of institutional investment, integration of ESG features, and impact on long-term capital budgeting (investment) decisions by companies in Africa. …

Presentation to ERM client event focused on role of institutional investment, integration of ESG features, and impact on long-term capital budgeting (investment) decisions by companies in Africa. Contact @SinCoESG www.sincosinco.com info[at]sincosinco.com.

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  • 1. Institutional Investors,Sustainable Investment andESG in Capital BudgetingGraham SinclairPrincipal, SinCo@esgarchitectgraham.sinclair@sincosinco.com"1sustainable investment consulting ERM Client Day: Capital Budgeting and SustainabilitySinCo does not hold copyright to this image Wikicommons license.© 2013 SinCo. All rights reserved.
  • 2. Understanding the growth of ESGSustainable investment by institutional investors1. Institutional investment is a competitive global industry. professionals manage portfolios across assetclasses, project and company types; financing/investing in stages of companies/projects business cycles. 2. Increasing materiality of environmental, social and governance (ESG) factors is driving investors, andtheir end-clients, to integrate sustainability concepts. $13.6 trillion globally, $229 billion in Africa reportsproactively using ESG in investment policy or process.3. Increasing quality of coverage of ESG flowing from professional ratings agencies and sharper focus. withmore coverage, opportunity to use of new ESG valuation models. Pursuit of "sustainability alpha"continues; ESG benchmarking and performance attribution growing.4. Improving African investment context is attracting capital. Benefit from making the sustainableinvestment case for the positive outcomes, or reduction in negative impacts. South Africa is 5th largestinvestor in Africa; 1-in-2 investment dollars in private equity in Sub-Saharan Africa is DFI-linked."2sustainable investment consulting© 2013 SinCo. All rights reserved.
  • 3. What do investors want?"3SinCo does not hold copyright to this image Wikicommons license.
  • 4. What do investors want?Investors are seeking net-of-fees, net-of-inflation, risk-adjusted positive investment returns, forexample equity (dividends market price increases) or fixed income (coupon payments and principalrepatriation). Investors value diversity, non-correlation and liquidity. Investors have a sense of long-term investment, but investor behavior may be irrational, herd-drivenon the fear-greed spectrum. Limits on scale, information and operational efficiency are parameters touniversal investment.Investors want to reduce their buy/hold/sell decision to 2 pages describing the investment structure(debt/equity), competitive advantages of firm and its products/services, quality of its management,operational efficiency and strategic prospects. investors always want to buy their investments for thelowest price, at the bottom of the J-curve (buy low-sell high)."4@SinCoESG I sincosinco.com I info@sincosinco.comsustainable investment consulting© 2013 SinCo. All rights reserved.
  • 5. "5Key developments in sustainable investment theme• $13.6 trillion (21.8%) of professionally managed assets reportingincorporating environmental, social and governance (ESG) factorsinto investment selection and management (Jan 2013 on 31 Dec2011 data). Positive/best-in-class screening stands at just over$1.0 trillion, while impact investing ($89 billion) and sustainability-themed investments ($83 billion) are comparatively small.• Investment in Africa reporting proactively investing using ESGfactors $228 billion AuM. Integration of ESG is $198 billion AuM.South Africa is 95% of Africa investment market; ESG-brandedinvestment products make up just 1% AuM.• According to Bloomberg ESG, "in 2010, 5,000 investors in 29countries accessed more than 50 million ESG indicators in theBloomberg platform— a 29 percent increase over 2011."• 40 percent of shareholder resolutions in 2012 in the USApertained to environmental and social concerns, up from 30percent during the prior proxy season. SinCo research reflectsRSA share owner activity increasing off low base, with examplesof global best practice using online reporting of proxy votes.• ESG performance studiesreflect sustainability mayincrease returns. ESG tiltsin listed equity performbest for buying ESG"improvers" and shorting"laggards" *2008-12• $10 billion annualsavings on U.S. electricbills from new lightbulbstandards. 59%proportion of emissions-reductions efforts pay forthemselves in 3 years.• 67% return from listedequity portfolio based onthe Carbon DisclosureLeadership Index since2006. 31% return of byCDP Leadership IndexsGlobal 500 peers duringthe same period.@SinCoESG I sincosinco.com I info@sincosinco.com © 2013 SinCo. All rights reserved.
  • 6. Rationale for sustainable investmentGlobal pension investment best practice from AfricaRegulation 28 of Pension Funds Act 24/1956 effective 1 January 2012PREAMBLE "A fund has a fiduciary duty to act in the best interest of its members whosebenefits depend on the responsible management of fund assets. This duty supports theadoption of a responsible investment approach to deploying capital into markets that willearn adequate risk adjusted returns suitable for the fund’s specific member profile,liquidity needs and liabilities. Prudent investing should give appropriateconsideration to any factor which may materially affect the sustainable long-termperformance of a fund’s assets, including factors of an environmental, social andgovernance character. This concept applies across all assets and categories of assetsand should promote the interests of a fund in a stable and transparent environment.""6sustainable investment consulting@SinCoESG I sincosinco.com I info@sincosinco.com © 2013 SinCo. All rights reserved.
  • 7. Reputations and rules: ESG acts throughout theinvestment life cycle. Plays out regardless of rules.Driven by regulator pressure, client demand,increased exposure, and intangible value impacts.Investors prefer legislation and regulation(hard rules). But with weak regulationsand changing ESG issues, moving tovoluntary initiatives (soft rules)."7SinCo does not hold copyright to this image
  • 8. Material ESG factors impacting valuations now 1/2CARBON From SinCo research for Navigating Muddy Waters research series commissioned by WWF withSinCo, Trucost and Carbon Tracker, using GEPFs fixed income and equity portfolio as workedexample. Confirmed that investors attitudes to carbon & water scarcity risks ranged from ambivalentto concerned. Previous studies of the development of institutional investor approaches to sustainable investment inSouth Africa identified 1/3 had no knowledge of a carbon tax pricing scenario, another 1/3 had zero. *2015 carbon tax shifted valuations - Arcelormittal lost 6% on budget speech*Learn more about Navigating Muddy Waters project at http://www.sincosinco.com/portfolio-climate-risks.php"8sustainable investment consulting@SinCoESG I sincosinco.com I info@sincosinco.com © 2013 SinCo. All rights reserved.
  • 9. Material ESG factors impacting valuations now 2/2WATERAnalyst note from Standard Bank Equity Research on 14 resources companies: Most mining and industrialoperations in RSA in water-stressed areas: Waterberg and Witbank Coal fields, Witwatersrand goldcomplex, and Bushveld PGM igneous complex. Lonmin and SASOL have lowest scores on theirproprietary ratings for water management. "Anglo Platinum has the highest score, implying the lowest risk,it is still without IWUL at its key operations, based on public information available at date ofpublication...SA Resource sector is still only about one year into setting fixed targets and monitoring them"*Lonmin $LMI online self-reporting ".... The market price for PGMs can fluctuate widely... geologicalformations, unanticipated ground and water conditions"*Learn more about Navigating Muddy Waters project at http://www.sincosinco.com/portfolio-climate-risks.php"9sustainable investment consulting@SinCoESG I sincosinco.com I info@sincosinco.com © 2013 SinCo. All rights reserved.
  • 10. Investment case is sum of all operations and investments. ESG issues arematerial, but methods for valuing differ. Timing, shocks and impacts differ."10WHAT ESG ISSUES? All the the companies strategy,operational plans and realities are tested in the harsh lightof investment analyst presentations, and a public forumwhere stakeholders have a voice
  • 11. Integrating ESG factors leans on company insightsHow will the least possible ESG data delivered as information on sustainability leadto the maximum knowledge on the current value and future expected value of theand its franchise with consumers, employees, policymakers, regulators, investors,and other stakeholders?Investors do not want a list of "material issues" for sector or generic firm. Investorsneed the firm to explain the business critical sustainability issues, and ow the firmwith map and monitor and mitigate ESG risks, and maximize ESG opportunities."11sustainable investment consulting@SinCoESG I sincosinco.com I info@sincosinco.com © 2013 SinCo. All rights reserved.
  • 12. Modeling equity in mining companies in Africa 1/2• VALUATION 101. A typical equity valuation in the mining sector in South Africa willseek to build a valuation/price comparison based on financial data and "futureprospects". Mining firms are typically valued using a discounted cashflow (DCF)model with an adjusted terminal value of zero at the end of the mine life, net ofclosure costs. The sum-of-the-parts DCF model will price the sum of the aboveground and below ground operations and future projects, using this methodologyto value the firm in isolation and against sector and/or regional peers.• DISCOUNTING FOR CAPITAL AND TIME-VALUE. The nominal weighted averagecost of capital (WACC) applied to cash flows is estimated using the investmentanalysts views of future commodity prices and inflation, with a multiple applied tothe DCF-derived net asset value reflecting the investment analysts’ views on thecompany, especially relative to the cross-rates of the mining firms operationalcosts and dollar-based commodity prices. Academic research has tested forimproved WACC for firms with better sustainability performance, some evidence tosupport."12@SinCoESG I sincosinco.com I info@sincosinco.com © 2013 SinCo. All rights reserved.
  • 13. Modeling equity in mining companies in Africa 2/2• RISKS AND ASSUMPTIONS. The model will include some risks to the targetprice/s, typically including the increase in exploration, sustaining and developmentcapital expenditure plans. Assumptions about trends in commodity pricing,success in above- and below-ground operational management, taxes (on average30% across regions in the medium-to-long term), and input costs, such as labor.Risks include assumptions about productivity, and work-safety stoppages relatedto accidents and fatalities in operations.• INTEGRATING ESG. ESG issues typically enter the modeling as costs and/orrisks, for example environmental remediation. But may also reasonably bemodeled as governance factors, for example the license to operate being grantedor renewed based on offering a non-corrupt, transparent and community-validatedapproach to managing stakeholder relationships. Environmental issues may alsobring mining exploration or operating to a halt: for example where minescontravene the National Environmental Management Act or the National WaterAct. In South Africa, courts are increasingly siding with civil society and consumerswhere rights are threatened by state or private sector."13@SinCoESG I sincosinco.com I info@sincosinco.com © 2013 SinCo. All rights reserved.
  • 14. HEADLINE RISK TO INVESTORSESG is a factor throughoutinvestment life cycleImpacts of all investor portfoliocompanies/securities/projectssums to portfolio-level ESG."14SinCo does not hold copyright to this image. All rights beyond to Zapiro, purchase at www.zapiro.com
  • 15. ESG data supply for investorsInputs to institutional investor decisions 1/2• ESG analysis must balance top-down thematic issues with bottom-up company context. analysis startswith an overarching view. What is an accurate point-in-time, retrospective and prospective qualitativevalue of firm sustainability? Companies have influential and persuasive role in making the case toinvestors for materiality of ESG risks and opportunities.• All analysis is also a competitive struggle for fastest, freshest and most accurate data offeringinformation interpreted for knowledge of current and future value of investment opportunity. ESG dataavailability has ramped up since 2000, but still issues of frameworks (GRI vs integrated reporting vsSASB), availability, reliability, verification, auditing, comparability.• ESG• Social - Child Labor, Consumer Product Safety, Diversity, Labor Relations• Environmental - Environmental Performance, Global Sanctions, Superfund sites, Toxic Chemicals• Tracking framework - Spills, Fines, Sites. Relative and absolute measures - for example, sites / $10billion domestic company revenue, lbs / $1,000 domestic company revenue, Spills / $10 billiondomestic company revenue"15@SinCoESG I sincosinco.com I info@sincosinco.com © 2013 SinCo. All rights reserved.
  • 16. ESG data supply for investorsInputs to institutional investor decisions 2/2WORKED EXAMPLE - MINING & MINERALS SECTOR - Industry Trends flagged by MSCI ESG, Jan 2013• Social licenses to operate, obtained through community engagement and sustainability management, areever more essential to mining companies’ ability to run a successful mine.• The industry is faced with many tough decisions. Management at many companies must choosebetween layoffs or profits. Others are forced to choose between ramping up production of low grademines – the result could mean higher carbon emissions, wastes, and costs - or move operations deeperinto regions with high uncertainty due to risks of corruption, social changes, or sensitive environmentsthat can block projects from going forward.• The increasingly scarce high grade projects are also often in regions where safety and environmentalstandards need to be drastically upgraded to meet international standards. Poor social andenvironmental performances also significantly raise risks of resource nationalization and higher paymentdemands.• Labor cost inflation reaches double digits for many companies and diminishes long term confidence thathigh margin mines in areas of unrest will remain strong investments. Mining companies face additionalrisks of cost hikes through increased regulatory pressure, expanding carbon regulations, and higher costsfor energy and supplies"16@SinCoESG I sincosinco.com I info@sincosinco.com © 2013 SinCo. All rights reserved.
  • 17. Investor approaches - modeling investment case in miningcompanies in Africa 1/2: ESG in multi-asset boutiques• 1. Macro thematic issues relevant to mining or extractives - for example water scarcity, carbontaxes, labour relations. Themes inform sense of "investment conviction" about how sector,industry and firm may manage key issues in strategy and operations. Differs according toinvestment philosophy, views of ESG, sense of long term investment holding periods• 2. Key value creators/destroyers - at sector and company levels, filters for best/worst in class;tempers financial data with sense of prospects. for example, firm may be estimated to have 35%upside but be worst performer vs peers on key issues, implies portfolio management approachto change weighting or company engagement seeking changes. Scenario and sensitivityanalyses will cHeck assumptions effects on models, for example work stoppages, mineclosures, or water shortages. May need to update model with additional valuation line items andreview assumptions.• 3. Active ownership over time - using ESG information as active shareholder to steer companyaway from high-risk, low-reward situations or binary issues with negative reputation impacts.Investor uses all available tools, and wants to be seen to be acting. voluntary initiatives likeCRISA, PRI, EITI, Equator Principles or CDP play a role."17@SinCoESG I sincosinco.com I info@sincosinco.com © 2013 SinCo. All rights reserved.
  • 18. Investor approaches - modeling investment case in miningcompanies in Africa 2/2: ESG in listed Africa equities• Approach of active investment manager is to drill down to fundamental value - key factor is sociallicense to operate, without which the firm or mine does not have a business. Sustainabilityperformance through ESG factors all impact on the single biggest risk for mines - title risk, biggerthan above/below ground risks. 50-year mine in geological terms may be expropriated after 2 years?• In Africa fewer data points and harder to compare to peers in context. Some ESG metrics may helpimprove context for financial valuation, for example % of local labour (including mine management),tax contribution to local fiscus, extent of beneficiation, net socio-economic footprint (job creation),long-term infrastructure value added (potable water, energy, roads, telecoms, schools), displacementof people and how this is managed, biodiversity impact (receiving environment), sustainabilitypractices (pollution control, mitigation for tailings dam contamination of soil and surface andgroundwater courses), ethical backbone of management team (zero tolerance of bribes andcorruption in securing title), or sustainability practices (rehabilitation of mine footprint, off balancesheet legacy liabilities).• Investor is paid to return net-of-fees, net-of-inflation, risk-adjusted investment performance.Sustainable investment practice tends to factor material ESG factors in more aggressively, potentiallyleading to very different fair value versus investment management competitors."18@SinCoESG I sincosinco.com I info@sincosinco.com © 2013 SinCo. All rights reserved.
  • 19. Frameworks for ESG - global and localFuture filled with "high context" business relationships; investing in multi-polar world"19@SinCoESG I sincosinco.com I info@sincosinco.com
  • 20. Understanding the growth of ESGSustainable investment by institutional investors1. Institutional investment is a competitive global industry. professionals manage portfolios across assetclasses, project and company types; financing/investing in stages of companies/projects business cycles. 2. Increasing materiality of environmental, social and governance (ESG) factors is driving investors, andtheir end-clients, to integrate sustainability concepts. $13.6 trillion globally, $229 billion in Africa reportsproactively using ESG in investment policy or process.3. Increasing quality of coverage of ESG flowing from professional ratings agencies and sharper focus. withmore coverage, opportunity to use of new ESG valuation models. Pursuit of "sustainability alpha"continues; ESG benchmarking and performance attribution growing.4. Improving African investment context is attracting capital. Benefit from making the sustainableinvestment case for the positive outcomes, or reduction in negative impacts. South Africa is 5th largestinvestor in Africa; 1-in-2 investment dollars in private equity in Sub-Saharan Africa is DFI-linked."20sustainable investment consulting© 2013 SinCo. All rights reserved.
  • 21. Graham SinclairPrincipal, SinCo@esgarchitectgraham.sinclair@sincosinco.com"21sustainable investment consultingwww.africasif.org@AfricaSIFafricasif@gmail.comwww.sincosinco.com@SinCoESGinfo@sincosinco.comSinCo acknowledges the input and research by Old MutualInvestment Group South Africa, Sustainable Capital, IFC,Bloomberg ESG and MSCI ESG used in this presentation.Analysis and opinions are solely SinCo. All rights reserved. March 2013.Thank you.
  • 22. About SinCoSinCo - sustainable investment consulting- is a boutique sustainable investmentadvisory firm specializing in environment,social and governance (ESG) architecturein frontier and emerging markets. Since2006 SinCo has delivered sustainableinvestment architecture globally topension funds, asset managers, privateequity funds, stock exchanges andinternational organizations integratingESG factors into investment practice forsustainable long-term investmentperformance. Learn from our experience atsincosinco.com/portfolio-of-work.phpwww.sincosinco.com | @SinCoESG |info@sincosinco.comSinCo is a Massachusetts Limited Liability Company (General Laws, Chapter 156C)incorporated in February 2007 registered with the Secretary of State of theCommonwealth of Massachusetts USA. 1009795 #1208. In 2013, SinCo isundergoing the B Corp Certification Process to formally recognize our mission-driven business model in sustainable investment. B.Corp is used by the world’sleading social entrepreneurs to assess, compare, and to improve the company’ssocial and environmental performance."22
  • 23. Indemnity and disclosuresThis ESG research by SinCo includes funds, firms, securities and initiatives that may be clients of SinCo, or the parent of, oraffiliated with, a client of SinCo. SinCo ESG research reports, articles and profiles have not been submitted to, nor receivedapproval from, the United States Securities and Exchange Commission or any other regulatory body. While we haveexercised due care in compiling the information, we make no warranty, express or implied, regarding the accuracy,completeness or usefulness of the information and assume no liability with respect to the consequences of relying on theinformation for investment or other purposes. In particular, SinCo ESG research is not intended to constitute an offer,solicitation or advice to buy or sell securities.This material is provided for informational purposes only and should not be construed as investment advice or an offer orsolicitation to buy or sell securities. The economic and market forecasts presented herein have been generated by SinCo forinformational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved.This information discusses general market activity, industry or sector trends, or other broad-based economic, market orpolitical conditions and should not be construed as research or investment advice.Without limiting any of the foregoing and to the maximum extent permitted by law, in no event shall SinCo have any liabilityregarding any of the Information for any direct, indirect, special, punitive, consequential (including lost profits) or any otherdamages even if notified of the possibility of such damages. The foregoing shall not exclude or limit any liability that may notby applicable law be excluded or limited.The views and opinions expressed in this body of work are the authors own and may not reflect the views and opinions ofSinCo unless the author is authorized by SinCo to express such views or opinions on its behalf.© 2013 SinCo. All rights reserved."23sustainable investment consulting@SinCoESG I sincosinco.com I info@sincosinco.com
  • 24. About AfricaSIF.orgAfrica Sustainable Investment Forumis an independent,Pan-African, not-for-profit network, knowledgebase andadvocate promoting investment insustainable development across thecontinent. Launched in June 2010, theAfricaSIF.org Project is run by volunteersbuilding a network of institutions andindividuals promoting sustainableinvestment in Africa by investors inpublic, private and philanthropy sectorsacross asset classes, countries andstakeholders from our platform atwww.africasif.org."24www.africasif.org I @AfricaSIF I. africasif@gmail.com