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Fuel emissions scandal puts ESG in the spotlight

By: Catherine Yoshimoto, Sr. Index Product Manager

When climate change forms the subject of Leonardo DiCaprio’s recent Academy Award Best Actor acceptance speech, you know the topic has become part of the mainstream national discussion in the US. In Europe and some other parts of the world, it already was. For market participants it is probably as good an indicator as any that climate change, and broader Environmental, Social and Governance (ESG) issues of which it forms a part, have become a factor to reckon with.

Back in September, for example, the US Environmental Protection Agency (EPA) discovered certain diesel car models from Volkswagen, one of the world largest car makers, temporarily lowered the amount of emissions they emitted when they detected that they were being tested. The cars were, unbeknownst to the public, emitting excessive harmful emissions. This episode raised basic issues of ethics and company behavior which increasingly have an influence of corporate valuations. It got me thinking. Even if the VW revelation had resulted in big price reductions on the company’s cars, I would have to ask myself two questions before rushing out to buy one: would I want a car from a company with this reputation, and if I bought one would it tell people that I supported the company’s approach to emissions?

In the wake of the EPA’s finding, the company’s stock lost about 40% of its value in three weeks. The whole episode sparked outcry not only from regulators and environmentalists, but from investors as well. Given allegations that the actions were intentional and that VW’s senior executives may have been aware of what was going on, investors inevitably question whether they should hold the stock. That said, it may not be in the investor’s interest to make a decision without a thorough evaluation.

Events like this are gaining more and more attention and prompt investors to think about ESG issues - what criteria to consider and what tools are available to evaluate stocks. Some people argue that ESG is pointless because eventually all investment processes will consider such criteria to meet younger investors’ preferences.[1] But, others argue that fiduciaries prioritize returns over ESG and may even blame passive investing for investors’ lack of awareness regarding their holdings.[2] Certainly, with California lawmakers requiring their two largest state government investment plans to divest holdings in thermal coal within 18 months,[3] asset managers are less likely to be able to ignore ESG and its implications.

One of the goals of an index provider is to create objective measures for the market, representing either the entire market or certain segments of the market. A pioneering index in the ESG arena is FTSE4Good, launched in 2001. FTSE4Good utilizes a 3-tiered rating system that considers 300 indicators that focus on operational issues. These 300 indicators feed into 14 themes, which in turn feed into the 3 pillars of Environment, Social, and Governance, to ultimately produce an ESG rating for each stock in a given index. An independent FTSE ESG Advisory Committee consists of industry experts who meet ahead of index reviews in June and December and advise FTSE Russell on the suspension of companies from the FTSE4Good index series following major incidents.

So, what about VW? When the FTSE ESG Criteria Working Group, a sub-committee, met on October 14, 2015, it investigated controversies that occurred since the previous semi-annual review, including VW. The FTSE ESG Advisory Committee then met on December 7, to evaluate whether to remove or retain stocks in the index. Following the committee meeting, FTSE Russell announced index changes publicly as with its regular index review process, including the suspension of VW from the FTSE4Good Index following an assessment through FTSE’s Controversy Monitor.[4] The consequence of suspension doesn’t end there – companies suspended from the FTSE4Good Index series are not eligible for re-inclusion for a minimum of 2 years.

The recent scandal is not unprecedented, and will not likely be the last of its kind, making it all the more important for investors to become informed on ESG issues, evaluation criteria, and tools to objectively and consistently measure companies. For now, though, I think I’ll hold off on buying a new car.








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