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April 13, 2011
New Sustainability Indexes to Feature Transparent Methodology
    by Robert Kropp

STOXX and Sustainalytics partner on a series of environmental, social, and governance (ESG) whose transparent methodology allows investors to understand factors determining company ratings.

Until the Gulf of Mexico oil spill disaster last April, BP had been listed on a number of sustainability indexes, including the Dow Jones Sustainability Indexes (DJSI) and the FTSE4Good Index Series, despite the fact that safety violations by BP had become almost commonplace, even before the Gulf disaster. The company was subsequently removed from both sustainability indexes.

BP's apparently undeserved reputation as a top sustainable company led many investors to question the methodology used in selecting stocks for sustainability indexes, but their search for answers was often frustrated by proprietary platforms whose methodology is not disclosed.

STOXX, a European index provider, and Sustainalytics, the environmental, social, and governance (ESG) investment research firm, have collaborated on a new series of ESG indexes, whose methodology, the partners state, is fully transparent, allowing "investors to fully understand which factors determine a company's ESG rating and their respective importance."

The series, which went live on April 4th and was made public on Monday, consists of four indexes: Global ESG Leaders, Global ESG Environmental Leaders, Global ESG Social Leaders, and Global ESG Governance Leaders. The methodology adapted by Sustainalytics for the indexes is based on the
KPIs (Key Performance Indicators) for ESG 3.0 standard published in 2010 by the Society of Investment Professionals in Germany (DVFA) and the European Society of Financial Analysts Societies (EFFAS).

Sustainalytics also excludes from the indexes companies involved in controversial weapons, and those that derive revenues from tobacco products. In addition, companies that the firm concludes are in breach of the
United Nations Global Compact are excluded as well.

As an example, a review of the
selection list provided by STOXX reveals that Chevron is excluded on account of its activities in Burma, and BP is specifically excluded due to environmental pollution.

On the other hand, US-based companies whose ESG ratings earned them places on all four indexes include Applied Materials, Kellogg, Campbell Soup, and Marriott International, to name a few. spoke with Konrad Sippel, Executive Director of Sell-Side Business at STOXX, and Bob Mann, Managing Director, North America for Sustainalytics, about the new index series.

Noting that STOXX already maintains a series of sustainability indexes, with analysis processed by Bank Sarasin, Sippel said, "What we offer in our sustainability indices, and what our competitors offer, is very much a research provider-driven approach, where an external party is determining whether a company is sustainable or not, with limited disclosure on how that is actually done. It's usually based on a proprietary approach developed by the external party."

"Our new approach is a more transparent way of going about it," he continued. "We create a rating and select companies, but do so based on a transparent model. The model itself is based on key performance indicators that Sustainalytics generates. We disclose which KPI carries which weight in determining a company's sustainability score."

"The indices are based on 42 industry sectors, and the KPIs are definitely sector specific," Mann said. "We have our own historical model, and that model was augmented using the key performance indicators set out in the KPIs for ESG 3.0 report. In our grouping you'll see a smaller set of indicators than is typical of sustainability indices."

"These indices are groundbreaking in the amount of disclosure we're providing," Mann continued. "We're providing the exact list of indicators, and we're telling you how we're rating them and how the subratings go. So if you have the data points, you can recreate the score. Investors can see if what we position as important areas are consistent with what they believe is important."

Sippel added, "The reason this project has come together is we've seen explicit demand for a different type of ESG benchmark that makes transparent what the ratings are. There's been some criticism of the black box approach, and we've put out a model that we think is a very good market-ready approach to defining sustainability."

"Not everyone is going to agree with us," he continued. "Different investors have different definitions of sustainability. Our platform enables asset owners and asset managers to specifically use the weightings that they have in mind."

KPIs for ESG 3.0 states, "The basis for consolidation of ESG data is identical with the basis for consolidation of financials," and Mann was asked if the transparent use of KPIs in the indexes might contribute to efforts toward integrated reporting.

"One of the difficulties the industry has traditionally faced is data collection," he said. "Integrated reporting is an outcome we all desire, and we hope this adds some momentum to it."

"By publishing our ratings, we give companies clear incentives to improve their ratings," Sippel added.

Asked about the potential for outperformance by the indexes, Sippel replied, "Typically, sustainable investment factors act on performance on a long-term basis. Sustainability criteria have become of relevance to the broader investment community over the past few years. What we would want to be measured against is, if we speak again in 15 years, our index needs to create outperformance in actual terms."

"There are other aspects of this that are quite innovative as well," Mann added, "And the link between sustainability and financial performance should play out over the long term.
But this is an index that really focuses on sustainability performance, and will be defined by its sustainability performance."

For retail investors, Sippel said, a series of exchange-traded funds (ETFs) based on all four indexes will be available soon.

"We are finalizing discussions with a ETF issuer and are expecting ETFs on
these indices to be out within a month," he said.


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