Environmental Finance

Is the SEC Raising the Disclosure Stakes?

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Courtesy of Environmental Finance

The choice of constituents for the FTSE4Good family of equity indexes has puzzled many managers of socially responsible investment funds. But an early review of the list and a commitment to refine the selection process may placate some of the critics, says Graham Cooper.

The composition of the FTSE4Good family of equity indexes – revealed on 10 July – has run into criticism from many fund managers and contrasts sharply with rival indexes backed by Dow Jones aimed at the socially responsible investment (SRI) community.

FTSE International began real-time publication of six indexes on 31 July (see table 1). Leading SRI analysts say they are particularly puzzled by some omissions from the new indexes. But the constituent lists will be reviewed this month, notes Craig Greaves, FTSE’s corporate social responsibility coordinator. And, he says, “there are likely to be some changes.”

“I would question some of the constituents,” says Toby Belsom, a company analyst at Morley Asset Management, which manages £100 billion ($145 billion) for UK insurer CGNU. In particular, he cites the omission of UK gas giant BG.The company is “a global leader on several issues of concern to SRI investors,” he says. In particular, he cites health and safety and its policies on human rights and corporate whistle-blowing.

Yet it is precisely the human rights issue that FTSE blames for BG’s exclusion. The company produced “little or no evidence of a [human rights] policy” even though it is in a “strategic sector” and operating in countries with poor human rights records, says a spokesman for the Ethical Investment Research Service (Eiris), which analyses companies’ SRI performance on behalf of FTSE.

In Morley’s proprietary system for ranking companies on SRI criteria, BG rates significantly higher than oil majors BP and Shell, notes Belsom. BP, however, is the most heavily weighted stock in the FTSE4Good Europe 50 index, representing 8.48% of the index on 27 August. Royal Dutch Petroleum, the Netherlands-listed parent of Royal Dutch Shell is in fourth place with 5.37% while Shell Transport & Trading, the UK listed parent company has the seventh heaviest weighting with 3.52%.

Belsom says Morley prefers BG to BP in part because a business based on natural gas has fewer risks associated with climate change than one based on oil.

But the Eiris spokesman says much of the criticism stems from the fact that the FTSE4Good selection criteria are based on reporting and management systems rather than performance. The selection team believes that, at present, there is insufficient comparable data to rank SRI performance. In the FTSE4Good Global 100 index, one of the four tradable indexes intended to be used as the basis for derivatives contracts and other products, BP slips to second place

behind US software giant Microsoft. Of the top 10 stocks in the Global index, seven are from the US and three from the UK.

Margaret Mogford, group head of environment at BG, says the company was “surprised and disappointed” not to be included. It contacted Eiris immediately after the constituents were announced and “fully expects to be in the revised list,” she says. The ‘lack of evidence’ of its human rights policy was due to a communication failure, she says.

In addition to BG, “a fairly substantial number” of companies have applied to be considered for inclusion in this month’s review, says the Eiris spokesman. He declined to give any names.

“Some stocks were apparently excluded because of administrative errors. Surely these should have been tidied up,” says Tom Woolard, a director at UK environmental consultants ERM. Revising the indexes so soon after their launch “doesn’t give the impression of [it] having been very well thought out,” he adds. But FTSE’s Greaves notes that this month’s reappraisal is simply the first in a series of six-monthly reviews of the indexes.

Other surprising UK exclusions, says Belsom, include industrial gases group BOC and Royal Bank of Scotland (both for the same reason as BG) and food retailer Tesco which was deemed to have “insufficient environmental management systems and reporting”.

“I would certainly have put BG in,” agrees Jonathan Barber, managing director of SERM Rating Agency, a UK firm which assesses companies’ capital at risk due to social, environmental, safety and reputational risks. On these criteria, Royal Bank of Scotland and Tesco also deserve inclusion, he adds.They may not have the right policy statements but “implementation is the main thing,” he says.

The omission of BG is one of the most striking differences between the FTSE4Good indexes and the Dow Jones Sustainability Group (DJSG) indexes. According to Zurichbased SAM Sustainable Asset Management, which researches the constituents of these indexes, BG is the global ‘sustainability leader’ in the energy sector. It “clearly leads the industry in the fields of economic, environmental and social developments,” SAM says.

Other sector leaders in the DJSG indexes are: BMW (consumer cyclical); Bristol-Myers Squibb (pharmaceuticals); Credit Suisse (financial); Deutsche Telekom (telecommunications); Dofasco (basic materials); Fujitsu (technology); Procter & Gamble (consumer, non-cyclical); Sulzer (industrial); and Thames Water (utilities). Only three of these 10 stocks appear in the 100-stock FTSE4Good Global index.

But the philosophy behind the two approaches is quite different, acknowledges Alex Barkawi, managing director of DJSGI GmbH.FTSE4Good is concerned with companies achieving certain basic standards, he says, whereas the DJSGI tries to identify industry leaders. Its indexes contain only those companies judged to be among the top 10% in terms of SRI in each industry sector.And, he notes, a new list of DJSGI constituents is due to be announced on 4 September, following an annual review process.

The heaviest weighted sectors in the FTSE4Good Global tradable index are banks (14.3%), telecommunication services (13.2%), information technology hardware (10.5%), pharmaceuticals (9.4%) and software and computer services (9.0%). This represents a substantial overweighting for telecommunications and software compared with the nonscreened FTSE Developed Large Cap Index, in which the weightings of these five sectors are: 13.7%, 8.9%, 10.3%, 11.3% and 4.7% respectively. Only companies in the Developed Large Cap index are eligible for inclusion in the FTSE4Good Global index (see table 1).

The FTSE4Good selection process was developed by Eiris, a UK nonprofit, in consultation with fund managers. But the final decision on the choice of constituents was made by a 14- strong advisory committee comprising fund managers, bankers and representatives of the United Nations Childrens’ Fund (Unicef).

The first stage of the selection process is to exclude tobacco producers, manufacturers of weapons systems and owners/operators of nuclear power systems. Those which are not excluded on these grounds are then assessed on three main criteria: environmental sustainability; relationships with stakeholders; and support for human rights. Qualifying companies are then ranked by market capitalisation, adjusted for ‘free float’ (the percentage of total shares deemed available for trading). If necessary, the resulting weightings will be adjusted at this month’s review to ensure that no stock accounts for more than 10% of the index.

The aim of the selection criteria is to “reflect excellence both in the management and in the performance of corporate social responsibility,” says FTSE. It intends to raise the current standards “as the number of companies meeting the criteria increases and as a greater volume of data on social, environmental and ethical performance is provided by companies”.

Six priorities have been identified for refining the selection criteria:

  • to try to develop suitable performance criteriacriteria for sectors that are currently excluded;
  • to investigate the addition of banks and other financial companies to the list of ‘high impact’ industries;
  • to measure labour standards in companies’ supply chains;
  • to strengthen the human rights criteria;
  • to examine suitable performance criteria for bribery and corruption; and
  • to consider adopting the WHO Breast Milk Substitutes Code in full.

FTSE says it hopes to introduce suitable criteria in some of these areas in September 2002. The most pressing need is to remove the exclusion criteria, say many SRI fund managers. “It relies on negative screens [so] it is essentially an ethical investment product,” rather than a true SRI product, says Morley’s Belsom.

Martin Whittaker of US environmental research firm Innovest agrees. “FTSE4Good seems rooted too firmly in old-style ethical investing,” he says. He would prefer to see a more integrated approach to sustainability rather than ethical screening. And ERM’s Woolard predicts that “the era of exclusion will die out”, in favour of a best-in-class approach to stock selection.

But FTSE itself is keen to dispense with the exclusion criteria.“The eventual aim is to have no exclusions,” says FTSE’s Greaves.“We are looking to engage the excluded companies in dialogue about what they regard as best practice,” he adds.

And, despite the criticisms, most SRI specialists says the new indexes are good for the market as a whole. Belsom says FTSE4Good will raise the profile of the SRI business, although Morley does not intend to use the new indexes for its own funds.

Similarly, Carole Arumainayagam, director responsible for SRI investment research at Société Générale Asset Management in London, says “there is certainly retail demand for these products.” She says she will crossrefer to the FTSE4Good indexes but does not intend to base investment decision on them.“I just don’t understand the [selection] criteria,” she says.

But, for all the controversy surrounding FTSE4Good, it is significantly better, in SRI terms, than a non-screened index. In SERM’s rating system, which runs from AAA– to C–, the FTSE All-share index was rated A– while the FTSE4Good 50 got an A.

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