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CIO Insights Special Act today to ensure our future – Understanding ESG

Note: All opinions and claims are based upon data on November 6, 2017 and may not come to pass. This information is subject to change at any time, based upon economic, market and other considerations and should not be construed as a recommendation. There can be no certainty that events will turn out as we have opined herein. Past Performance and forecasts are not reliable indicators of future performance. No assurance can be given that any forecast or target will be achieved. Forecasts are based on assumptions, estimates, opinions and hypothetical models or analysis which may prove to be incorrect.

CIO Office, Deutsche Bank Wealth Management, Deutsche Bank AG - Email: [email protected] 1

CIO Insights Special

Act today to ensure our future Understanding ESG

APAC Edition – November 2017




ESG Special

Preface

Authors:

Markus Müller Global Head CIO Office

Enrico Börger Financial Writer

Christian Nolting Global CIO

Investing on the basis of environmental, social and governance factors – or ESG for short – is not new. We have, for example, been able to invest in multiple socially-responsible stock indices for almost two decades. Concerns about individual firms’ impact on the environment and sustainability in general go back much further.

ESG investing is now, however, increasingly centre-stage. In part this is because digital news flow has made investors more continuously aware of the underlying issues. The debate around climate change and the Paris Accord (and, most recently, the COP23 meeting held in Germany) has contributed to this.

But I think that the rise of ESG investing also reflects two key changes in investor behaviour and aspirations. First, many private investors do not want a passive approach to investing: instead they want to use their investment knowledge to use their wealth in an active, objective-driven way. Second, there is a growing realisation that ESG is not just a step away from philanthropy. Private and institutional investors see that socially-responsible long term aims can be combined with attractive short and medium-term returns.

This report, which includes a contribution from the German Environment Agency, aims to provide an overview of the various types of ESG investing, along with opportunities and risks. I believe that this subject can only grow in importance.

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05

07

03

02

06

08

04

Sustainability – beyond philanthropy

Opportunities in Sustainable Investment VehiclesGuest comment by the German Ministry of the Environment

The caveats and the “ashes to ashes” analysis

Defining sustainable investment

– Environmental – Social – (Corporate) Governance

The financial return of ESG strategies and the role of specialist research agencies

Conclusion

The five levels of ESG approach – Exclusions – Adherence to norms – Best in class approach – Thematic investments – Engagement & Impact investing

The expectations of investors and the main investment vehicles

– Time to shake off the perceptions of the past

– Historic milestones – Demographic shifts among

investors and their effects on investors’ expectations

– The investment vehicles




“Don’t fell more trees than can grow back“. Thus spoke nobleman and ecologist Carl von Carlowitz in 1713 in his treaty on “Sylvicultura oeconomica”, unwittingly laying the foundation for what was later going to be known as sustainable investing.

At the time, the king‘s ore and silver smelteries were burning through a considerable amount of timber in order to produce armories and weapons for the king‘s army, as well as producing building material for infrastructure projects. The ensuing deforestation caused an extreme shortage of timber that prompted Carl von Carlowitz to question the sense of depleting natural resources for short-term gain. In 1987, the Brundtland report on the subject reiterated this very same point by defining that sustainable development “means that the present generation satisfies its needs, without endangering future generations satisfying their needs.“

Similarly, in the early 19th century, the German scientist Alexander von Humboldt noticed during his journey through the South American rainforests that the Valencia lake in Venezuela had started drying up since nearby woodlands had been felled in order to obtain arable land. Indeed, he first established a link between deforestation and droughts, going as far as inventing an energy-efficient fireplace to counter the problem.

Even before Carl von Carlowitz‘s time, however, we have evidence of what is known today as responsible and ethical investment practices. In the 17th century the Quakers in the newly established territories of Northern America decided to refuse making a profit from war and from the slave trade, which were incompatible with their ethical principles.

In modern times, the first recorded “responsible“ investment vehicle,

01 as it was called, was the US Pioneer Fund, launched in 1928 with the aim of declining to invest in alcohol and tobacco industries on the grounds of their negative effect on human health. Nearly half a century later, two Methodist ministers launched the Pax World Fund, an investment fund that excluded from its investment universe shares deemed ethically unfit, focusing instead on securities of companies that met certain criteria about the treatment of their employees and the environment. In 1972 a United Nations conference in Stockholm on the human environment first discussed the tradeoffs and the challenges of sustainability, economic growth and development for our planet. The same year, the Club of Rome published the book “Limits to Growth”. In 1980, two UN agencies published a paper co-authored by the World Wildlife Fund (WWF) titled “ Living Resource Conservation for Sustainable Development“. It was the first international document on living resource conservation produced with inputs from governments, non-governmental organizations.

In 1990 the Domini 400 Social Index became the world‘s first “socially responsible“ stock index, aimed at helping socially conscious investors weigh social and environmental factors in their investment choices by providing them with a benchmark. This index is today calculated by MSCI (MSCI KLD 400 Social Index) and is a leading index for socially responsible investments in the United States.

In general terms, however, the quest for sustainability is probably as old as mankind itself. The ancient Romans were known to store wine and water in amphorae made of terracotta and ceramic. At the end of their useful lives, these amphorae were pounded into chips and and converted into “opus signinum“, a type of concrete used as

Sustainability – beyond philanthropy




building material. In AD 77 Pliny the Elder describes in his Natural History how broken pottery “beaten to powder, and tempered with lime, becomes more solid and durable than other substances of a similar nature; forming the cement known as the “Signine“ composition, so extensively employed for even making the pavements of houses“. Fragments of recycled amphorae have been found in aqueducts and roads, revealing that a considerable part of ancient Rome was built on the basis of recycled materials, to a degree far exceeding what is achieved in this regard in our times. However, the technique for reusing second-hand amphorae predates even the ancient Romans; it is known to have originated in North Africa some time before 256 BC.

As the Brundtland report suggests, at its heart sustainability is the pursuit of a healthy balance between short-term profit and long-term preservation of resources. Intuitively, mankind has known this and for a long time. Shared ownership of grazing fields that are subject to strict guidelines to prevent future depletion of the soil‘s nourishing properties has been common in

agricultural communities throughout the middle ages, and survives to this day.

What is new about sustainability in our age is the consistent application of these concepts to investment strategies and the elevation of sustainability to an investment theme which, as we will see, is being articulated in many different ways. The starting point is the realization that any sort of investment can have unintended side effects, therefore investments are not ethically neutral. As an example, even if a certain investment pursues a worthy goal, it may use up resources that need to be preserved for future generations. Similarly, it is important to take into account what is known as the externalisation of costs, i.e. the effects of an economic activity on third parties, who may suffer from its negative side effects without participating in the financial return that is being generated. We therefore understand sustainability not just as the pursuit of noble goals but also as the appreciation of the direct and indirect effects of an investment on other people and on the environment. To this end, sustainable investing encompasses

environmental, social and governance (“ESG“) considerations and questions how each economic activity contributes to human welfare for current and future generations. Typical aspects taken into consideration are the protection of human dignity, the observance of certain labour and environmental standards as well as the aforementioned cautious use of resources.

It is important to differentiate between sustainable investment strategies and philanthropy. The latter consists of donating funds to a worthy cause without any expectation of financial gain. Hence, philanthropy by definition is not an investment strategy, it is a form of charitable giving. The present report focuses exclusively on investment strategies, defining sustainable investments as a pursuit of one or more of the following objectives: 1) achieve a positive environmental or social impact alongside financial returns; 2) align investments with personal values; and 3) improve portfolio risk/return characteristics. In short, sustainability can be defined as a fundamental step beyond philanthropy.

Environmental, social, governance aspects Roughly speaking, we differentiate between environmental, social and governance goals when talking about sustainable or responsible investments, hence the acronym “ESG“ which has imposed itself as the most common term in this regard. At the most basic level, social and ethical responsibility means an abstention from involvement in any industry or product line that is either harmful, i.e. polluting or unhealthy in other ways, or not up to ethical

standards, such as the production of chemical weapons, or business practices such as child labor, to quote two prominent examples. Of course, the definition of what is ethical is subjective and can vary between countries, cultures and people. However, roughly speaking “ethical“ investment is commonly understood to involve the protection of human dignity and the abstention from practices that are detrimental to human and societal welfare. The most common implementation of this approach is via an investment portfolio that filters out

Defining sustainable investment02




Best-in-classresponsibleinvestments

Impactinvesting

Top down, issue driven

Bottom up, company driven

Performance benefits(value)

Social benefits(value)

Screenedinvestments

Governanceand activeownership

Thematicinvesting

ESGIntegration

securities linked to companies that don‘t fulfill these standards. Specialised analysts research the product mix and the business practices of each corporation in the investable universe in order to rank them according to a set of criteria, with the aim of assessing their social, ethical and environmental impact on society and nature. Thus, an overlay can be created that filters out any security that doesn‘t fit in with these standards, obtaining an equity or bond portfolio that can be certified to be consistent with the desired conditions. This approach represents the entry level of responsible investing because it merely excludes irresponsible or unethical practices, rather than being an active quest for making a positive contribution to society. While it still is the most common approach to ESG investing, exclusion policies don‘t represent the main object of this paper, as we are more interested in discussing investment strategies that aim to make a positive impact by pursuing worthy causes rather than by excluding unworthy ones.

One level up from exclusion policies there is the active approach: instead of thinking in terms of exclusions, it thinks in terms of which investment opportunities can be found that make a positive contribution to society while at the same time generating positive returns. The key to making a positive contribution is to identify promising but untapped areas for sustainable development that are currently overlooked, or whose potential is not sufficiently appreciated by existing investment strategies. This implies a certain degree of risk that is inherent in any innovative initiative, but at the same time offers the chance to develop revenue generating markets or business sectors that benefit all the stakeholders along the value chain. A typical example is microfinance, which has exploited the innovative potential of applying a tried and tested business model (start-up financing) to a previously overlooked market, i.e. self-employed farmers and artisans in developing countries with no access to mainstream financial service providers.

Apart from these visible implementations there is another, subtler area where

ethical and socially responsible principles can be applied, namely corporate governance. Even when a public listed company is not involved in any business or product line that may offer potential for improvement in terms

of ethical or social responsibility, the way in which the corporation itself is governed matters a great deal, both in terms of business ethics and in terms of the sustainability of its revenues. The underlying assumption is that the more an enterprise abstains from short-term gains at the expense of the environment

At heart, sustainability is the pursuit of a healthy balance between short-term profit and long-term preservation of resources.

or the social context it operates in, and the more it pursues long-term goals in harmony with its environment, the more sustainable its revenues are likely to be in the long term. This is the concept of the “going concern“, the long-term

commitment to keep the company out of trouble by adopting a long-term vision about its business practices, the sectors it operates in and its staff. Included is a commitment to acting in the best interest of all stakeholders of the company, shareholders, staff and customers, in a way that assures meeting the long-

Figure 1: ESG: An acronym with many meanings A wide range of approaches and goals Source: Schroders, Deutsche Bank Wealth Management.




term requirements of each. Investment managers who specialise in analysing the corporate governance of public listed companies can identify practices and principles that promise to ensure long-term value creation independently of which business a company is in, unlocking value for investors that is not visible otherwise. Additionally, large investment funds that control a

meaningful percentage of voting rights in the shareholder assembly have the clout to actively influence a company‘s management board, thereby being able to steer key corporate decisions in line with certain principles of socially responsible corporate governance. Again, this offers the opportunity to unlock shareholder value in line with a sustainable investment approach,

regardless of the industry or business sector in which the company operates. An easily overlooked but important part of this is the avoidance of regulatory sanctions, reputational damage and lawsuits that a socially responsible and sustainable approach to corporate governance is meant to facilitate.

Figure 2: ESG keywords categorized Source: MSCI ESG Research, Sustainalytics.

Diversity issuesBribery and corruption Raw material sourcingWaste and recycling

Health and safety Transparency Voting proceduresNatural resource use

Anti-takeover measuresWater managementLabour management Working conditions

AccountabilityCarbon emissions Energy efficiencyEmployee safety

Climate change risks Executive compensation schemes Recycled material use

Biodiversity/land useBoard structure/size Employee relationsFair trade products

Weather events Clean technologyAdvertising ethicsBiodiversity programmes

Energy usageCEO dualityRegulatory/legal risks Human rights policy

Customer relations/product Diversity and discriminationCorporate governance

Ownership structure Shareholder rightsResponsible marketing and R&DBusiness ethics

Human capital managementHazardous waste management Anti-competitive practices

Supply chain managementCorruption and instability Anti-money laundering policy

Controversial business Product safety Anti-bribery policyCompensation disclosure

Community relations Union relationshipsGreen buildingsGender diversity of board

SocialEnvironmental Governance




Time to shake off the perceptions of the past In the past, ESG approaches have all too often been seen as compromising returns and standing in the way of profit maximisation. In this view, ESG investments are considered to be one step away from charitable donations, a sort of hybrid between investment and philanthropy. The fact that foundations and churches have been early adpoters of ESG-based investment strategies has only reinforced these views. However, these views no longer correspond to reality, if they ever did. Far from being a contradiction to positive investment returns, as mentioned above, ESG strategies offer the potential for unlocking otherwise untapped value while at the same time helping to achieve more sustainable, long-term revenue flows. Additionally, these strategies enable investors at the very least to avoid financing business practices they don‘t agree with, and possibly to make a positive impact on society by achieving particular ethical goals or improve human welfare, all while generating positive returns on their invested capital. The spectrum is very broad and deserves more detailed analysis.

Historic milestones Before delving into the matter further, it is worth looking at investors‘ expectations and opinions on the subject. During the 1980s, a succession of high profile corporate disasters made the public aware of the risks associated with lack of discipline in environmental and governance standards. Some of the most dramatic cases include the disaster in the Indian town of Bhopal that happend in 1984, when 40 tons of highly toxic chemicals leaked out of a factory owned by Union Carbide, with deadly consequences for the population and

03nefarious effects on the environment that persist to this day. Another prominent example was the oil spill of the tanker Exxon Valdez in 1989 that lead to the spillage of over 40 million litres of crude oil into the pristine waters of Alaska in what represents the region‘s most tragic environmental disaster in history. More recently, an altogether different scandal has served to highlight that it is not just the environment and local populations that can suffer from a lack of proper corporate governance but also the investors themselves, independently of where they are based. The bankruptcy of Enron in 2001, a once highly regarded American blue chip stock, wiped out billions of equity and debt holdings within a few days for reasons that can be attributed directly to grave faults in corporate governance and oversight. This case has highlighted the benefit of corporate governance in reducing portfolio risk: well-governed companies are less likely to cause bad surprises for investors because financial and reputational problems are harder to hide if corporate oversight is strong.

Changes in the attitudes and the expectations of investors, including demographic changes. There are additional factors that have helped ESG considerations become more popular among investors. On the one hand, growing levels of investor education in financial matters have increased the willingness to be actively involved in financial decisions by people who in the past may have been happy to delegate these entirely to their advisers. Secondly, institutional investors have become more concerned about sustainability in a way that mirrors the general shift in attitude from the sole quest for “quantity“ in the post-war

The expectations of investors and the main investment vehicles

Figure 3: A willingness to invest for longer in ESG investments Confirming our focus is right Source: Schroders Global Investor Study, conducted between 30 March and 25 April 2016.

3.2 yearsthe average period consumers usually

leave money in an investment (excluding property and pensions)

2.1 yearsthe average number of additional years

that investors would hold ESG investments compared to standard investments

82%of investors said they would hold an ESG

investment for longer than a standard investment




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economic expansion to the aim for “quality“ in growth that can be observed in all aspects of society and that goes hand in hand with rising prosperity. Additionally, public opinion surveys keep showing a growing interest in environmentally and socially responsible investments by younger generations, even though these surveys need to be taken with a pinch of salt because an interest to invest ethically and actual investments into ethical vehicles are two rather different things. Moreover, as the “millennial“ generation is just about entering adulthood, in aggregate it will take decades to acquire the investible assets needed to have an impact on financial markets similar to the clout of the current “baby boomer“ generation, except in those cases where the younger generations are the recipients of inheritances in the shape of liquid assets, a trend that acccording to actuarial studies is set to increase.

Another reason that drives the search for sustainable investment products is the sheer growth of the world population that forces us to look for new ways to limit the population‘s impact on the planet. Feeding more people requires an increase in food production which, other things being equal, requires more agricultural land, more displacement of native plants and animal species and more pollution. Similarly, the rapid advancement in living standards causes more and more people to live in metropolitan areas, especially in emerging Asia, which in turn confronts humanity with new environmental challenges.

Concerns about global warming represent yet another pillar of environmentally sustainable investment, especially in view of governmental targets for limits to CO2 production and for a containment of raising temperatures. A final pillar in this context is the shift from fossil energy to renewable energy which many governments are advocating. The guest comment by the German Environment Agency in Section 5 describes these aspects in more detail. Indeed, according to the World Economic Forum‘s Global Risk Report, in 2017 three out of the top five risks in terms of impact and two out of the top five risks in terms of likelihood

Figure 4: Motivation for social impact investing among respondents who own or are interested in owning1 1 2016 U.S. Trust Insights on Wealth and Worth – Annual survey of high-net-worth and ultra-high-net-worth Americans

Figure 5: How important are each of the following ESG issues to your choice of investments? (Scores out of 10) Source: Schroders Global Investor Survey (2016) - Global Consumers.

38%Believe companies

that have a positive impact have better

financial performance

40%Believe companies that

are good corporate citizens are less susceptible

to business risks

49%Want to make a positive

impact on the world

50%Strong feelings for certain

social, environmental or governance issues

53%Belief that corporate America should be held accountable

for its actions

54%It’s the right thing to do




1st 2nd 3rd 4th 5th

2017

2012

2007

Weapons of massdestruction

Extreme weatherevents

Major naturaldisasters

Failure of climate change mitigation

and adaption

Food shortage crisesWater supply crisesMajor systematicfinancial failure

Chronic financialimbalance

Extreme energyand agriculture price volatility

Pandemics Oil price shockAsset price collapse

Water crises

Interstate andcivil wars

Retrenchment fromglobalization

are considered to be environmental.

The investment vehicles Intituitively, most investors think of equities when considering ESG investments. In the past, it was indeed the case that the bulk of sustainable and responsible investment strategies focused on equities, especially within exclusion strategies. Even now, much of the attention of rating agencies that focus on assessing companies‘ adherence to ESG standards and the sustainability of their business practices think in terms of the equity market. However, a listed company by definition tends to be a large entity, which is inevitably involved in more than one single project and often in more than a single line of business. Indeed, most well-known stocks, especially those included in the main market indices, are complex creatures whose impact on the environment and on society is wide-ranging, making it difficult to pass a judgement on the contrasting positive and negative types of impact they have.

For instance, one firm that invests in pollution-reducing technology may at the same time own a division that itself constributes to pollution. Bonds, on the other hand, can be issued in a much more targeted way, as they can be directed at financing specific projects or specific market niches without carrying the “baggage“ of a complex enterprise with them. Additionally, the yield of a bond can be linked to an infinite range of criteria, indices and ventures so as to allow targeting fixed income instruments very specifically to certain endeavours in a way that is not possible to do with equities. The use of ESG filters on bond investments, possibly also mapping sovereign issuers, completes the picture for ESG-conscious investors, giving them the possibility to choose integrated and balanced approaches according to their individual risk profiles. This step represents the coming of age of ESG investments.

The potential of fixed income instruments for ESG investments is therefore vast

and still partly untapped. Moving away from stocks and bonds, the investment vehicles become rather less liquid. Private equity is a form of investment that is extremely well suited to targeted ESG aspects thanks to its flexibility. However, it is by definition illiquid and hence not suitable for all types of investor, at least as a direct investment. It becomes more accessible if it is offered as a fund on which a financial service provider guarantees a certain level of liquidity. On the other side of the spectrum we are seeing growing numbers of Exchange Traded Funds (ETFs), which represent the most liquid and most tradable type of mutual fund, specializing in ESG investments. While for the most part these funds pursue exclusion strategies, it is to be expected that over time these retail investment vehicles will be able to move into more active and more targeted types of ESG investment, making the sector more easily accessible to private investors.

Figure 6: Top 5 Global Risks in Terms of Impact Source: World Economic Forum “The matrix of top 5 risks from 2007 to 2017”.

Environmental Economic Geopolitical Societal




Exclusions As mentioned before, exclusions represent the entry level of ESG investment, being the simplest way to implement ESG criteria in a portfolio. At the most basic level, an exclusion policy takes any existing portfolio and filters out securities linked to companies that don‘t conform to a certain set of criteria, be it ethical or environmental concerns or issues linked to lack of sustainability or corporate governance. Firms involved in the arms trade or judged to have unethical labour standards are typical targets for exclusion. However, this approach suffers from two flaws: one is financial, one is conceptual. The financial flaw is that any existing investment portfolio is inevitably going to be

04 each other, rendering them mutually exclusive: either one chooses the original investment strategy at the cost of owning a portoflio that rewards unsustainable practices, or one has a sustainable portfolio at the cost of reducing the expected return. Investors who find neither of these two options appealing are better served by one of the following approaches to sustainable investments.

Adherence to norms This is a standardized way of constructing a portfolio based on companies‘ adherence to a set of industry standards and norms such as international “SRI“ guidelines and the United Nations principles. It is a “positive“ approach to ESG investing because the portfolios are built according to ESG criteria from the start, rather than being an overlay to an existing strategy. On the plus side, taking well-known norms as criteria for the inclusion into the investment portfolios allows for transparency and consistency. On the other hand, restricting oneself to such norms as the only criteria for defining the investment universe limits the choice of investable securities to those of generally larger companies that have taken the trouble to be certified by official agencies and institutions. While this approach can lead to good results, its shortcoming is that smaller companies for whom a formal certification is too onerous or simply too laborious will be missed out. Given that small and nimble companies are often the most interesting players in terms of innovative approaches to sustainability, this matters. Further, while official norms have a role to play in the standardization of minimum requirements and best practice benchmarks, an approach that is tilted towards “box ticking“ will always be most useful in defining a basic level from which to start, rather than the goal to aspire to. Further, some market participants fear that an eccessive reliance on formal criteria may stifle the momentum of

The five levels of ESG approach

The sheer growth of the world population forces us to look for new ways to limit the population‘s impact on the planet.

compromised by removing a certain part of its investment universe, for certainly each security was included in the first place for some good reason. In the case of passive strategies that track a market benchmark, taking out certain securities will increase the portfolio‘s tracking error. Conceptually, the flaw is that it‘s a negative approach to ESG criteria: one tries to do good not by adding to the investment process but by taking away from it. Merely eliminating certain companies from the investment universe does not represent an active approach to sustainability, nor is the underlying message a constructive one: there is no reward for exemplary corporate behavior, just the exclusion of the companies deemed unethical, a much weaker approach. Finally, the exclusion strategy pits ESG and return criteria against




Figure 7: A Spectrum of Approaches Source: Deutsche Bank Wealth Management

Exclusionary screening

Avoiding investing in companies or sectors that do not align with investor

values or meet other norms or standards

Positive screening

Actively seeking outcompanies deemed well

performing on certainESG measures

ThematicFocusing investments

according to interest inspecific environmentalor social themes, suchas clean energy, water,

education orhealthcare

Impactinvesting

Investing in companies orfunds with the intentionof generating positive,measurable social and/

or environmental impactalongside a financial

return

ESG integration

Integrating considerationof environmental, socialand governance issues,

where material, intoinvestment due diligence

and financial analysis

Sustainable Investing

EquitiesEquities have historically been the asset class most commonly utilized in sustainable investing approaches. Investors can access equity funds or managed accounts that:

Fixed IncomeFixed income is an asset class that is becoming more commonly employed in sustainable inesting approaches. For example, investors have growing access to products such as:

AlternativesAlternatives, including private market debt and equity investments and real estate, have seen momentum as an area of focus for sustainable investing. For example, investors have access to:

– Have been constructed to focus on ESG factors.– Negatively screen out companies based on certain ethical – norms or other criteria; or– Are specifically created to own companies that develop – solutions that help address social challenges, such as clean – energy or public health.– Engage with companies through dialogue with management – and by filing shareholder resolutions (via the asset manager).

– Green Bonds, which target proceeds to projects, or activities – such as clean energy, energy efficiency, green buildings or – water, among others.– Global issuance in the Green Bond market in 2016 was $81 – billion – almost double the volume issued in 2015– Social Impact Bonds, which are bilateral contracts that utilize – “pay for performance” models to achieve social outcomes on – issues such as education and recidivism

– Early-stage socially and environmentally driven enterprises.– Direct investments or funds that invest in companies or – projects with a thematic or impact-driven focus.– As with most private investments, the degree of liquidity in – these markets is a factor to consider




sustainable investments by rendering the process too bureaucratic, instead of creating an environment in which creative solutions can flourish.

Best in class approach – an example of active ESG integration The approach known as best in class represents a positive screening of ESG factors in order to generate a performance that is in line with — and often exceeds — market benchmarks. Like the strategies described further down, it represents an active integration of ESG themes in the investment process. The idea behind this approach is that the best companies strategically manage all aspects of the business and ensure that their investors, as well as other constituents of the company, have enough information to understand the drivers of their sustinable performance, as well as their risks. This is typically the case when a company manages, measures and reports on its access to raw materials and natural resources such as drinking water that may be used in one stage of the firm‘s production cycle, and its output of dirty water. Experience has shown that companies that manage their social and environmental impact carefully and are well-governed tend to use resources more efficiently, thus reducing waste, an advantage both from an environmental and from a financial point of view. Further, they tend to have more committed (and hence more productive) employees and are less at risk of regulatory fines and reputational damage.

Thus, while the “positive screening“ that defines this approach is based on non-financial criteria, the aim is to generate tangible financial benefits because of the attention to ESG criteria and not in spite of it. Therefore, this approach can be defined as a positive implementation of ESG concerns and promises good potential to evolve further in the future. Compared to the adherence to norms cited above, the criteria to use for positive screening are not as rigid, therefore allowing a large degree of innovation and adpatability to changing environmental and social circumstances. Positive screening is typically applied to equities and fixed income because the

constituents are generally measured against industry peers. Once a set of ESG measures has been defined, the portfolio manager can select those companies that best fulfill them. This approach relies on fundamental research, often by recurring to the help of specialized ESG research and rating agencies such as those cited in the Section 6 - "The financial return on ESG strategies and the role of specialist research agencies“. Even passive investment strategies can be made to adopt a positive screening approach by following an investable ESG benchmark index such as one of the Dow Jones Sustainability indices or a sustainable MSCI index, of which there are several.

Thematic investing Thematic investing represents a much more specific and targeted approach than any of those listed above. It selects a specific non-financial goal or a specific area in which the investor aims to achieve an ESG-related improvement,

Engagement & Impact investing Impact investing represents an even more targeted and active investment approach that aims to obtain a specific, measurable and targeted impact on society or the environment. It is a quest for concrete solutions to long-term social and environmental challenges. In the past, its popularity has been held back by the lack of scalable and liquid investment opportunities. While these limitations have not disappeared, and indeed impact investing is still in its infancy, given the strong interest in this strategy it is likely that investment vehicles suitable for a larger group of investors will increasingly become available in the future. Also, investment funds that specialize in impact investing will be able to build longer track records over time, thereby overcoming a key hurdle that so far prevents many institutional investors from stepping in. Impact investing has first been implemented via private equity

Microfinance provides uncorrelated returns, i.e. a payout that is not linked to the economic cycle nor to the ups and downs of financial markets.

then selects a fitting investment vehicle with which to realize this aim, while at the same time generating a financial return. Typical themes can focus on education, for instance on improving literacy in developing countries, investing in healthcare in deprived areas, providing clean drinking water in areas that suffer from poor sanitation or promoting sustainable agriculture, to name but a few. Often thematic investments include stakes in private companies due to the strategy‘s focus on certain specific goals that may not be obtainable by investing solely in public listed companies. Increasingly, thematic investors focus on technology companies that develop new solutions to old problems such as the lack of sustainable packaging, inefficient use of water in dry regions or the problems associated with battery storage.

or private debt, earning it a reputation for a highly illiquid niche strategy reserved for professional investors with considerable assets to commit. However, recently a growing number of funds that invest in a portfolio of companies that pursue specific ESG goals has become available, hence progressively reducing the barriers to entry. Critical considerations in the investment process are manager selection and liquidity

Microfinance and project finance represent two prominent subcategories of impact investing. Project finance is often linked to infrastructure development in emerging economies and inevitably remains a highly illiquid strategy to invest in. Microfinance, however, has been made more and more accessible to private investors over the last few years thanks to an increasing number of financial services




providers who offer funds that invest in this area, thereby removing the obstacle of illiquidity and lack of scalability that otherwise limits the access to this interesting market. Given that the funds invested in microfinance tend to be deployed in regions far away from where the typical investor is based, and that the loans are given to private individuals with no formal track record in loan repayment, profound local knowledge and a keen risk assessment are paramount to make this strategy work. Therefore, the role of the financial intermediary in providing this knowledge is what makes or breaks the success of any such investment. The credit risks need to be spread across industries and regions in a way that, for instance, one bad harvest in a specific region of a developing country doesn‘t wipe out the entire investment, which would be the case if a majority of the

funds deployed were to be allocated to farmers of a specific crop in a specific area. This is not a far-fetched scenario: it has happened before that the cluster risk of cotton farmers in a certain region was not sufficiently taken into account. Effective risk spreading among regions and professions (shop owners, farmers, merchants, entrepreneurs, and so forth, in different places) is a prerequisite, as are foreign exchange capabilities: investors commit hard currencies while the loans are paid out in a variety of different local currencies, hence an apt handling of exchange rate risk is crucial. The credit research capabilities needed to evaluate an investment in microfinance are inevitably very different from traditional credit assessments in developed countries. Therefore, providers of microfinance investments either need to commit resources to

building up this local knowledge by themselves, or need to rely on local partners that can provide this specialist knowledge for them.

In spite of these caveats, and of the costs involved, the idea behind microfinance, if well executed, is both financially clever and socially desirable. For investors, microfinance provides the much sought-after concept of uncorrelated return, i.e. a payout that is not linked to the economic cycle nor to the ups and downs of financial markets. For the recipients, these micro loans can make the difference between financial independence and famine. For the countries in which these recipients are based, microfinance can facilitate the transition from developing to developed economy.

Figure 8: The integration of social responsibility into the corporate business model Source: Deutsche Bank Wealth Management.

The Corporate Social Responsibility Model The Total Societal Impact Lens

ShareholderValue

SocialResponsibility

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The world faces great challenges. The global rise in temperature, the loss of biodiversity and the destruction of natural resources require a profound change in current economic practices. With the adoption of the United Nations Sustainability Goals and the Paris Agreement on efforts to combat climate change and adapt to its effects, a raft of countries agreed to put their economies towards an ecologically, economically and socially sustainable pathway. This transition provides new opportunities for investors.

Window of Opportunity The global financing needs for the transition to sustainable economic development and consumption is considerable. The sums required in order to reach the envisaged UN sustainability targets are estimated at anything between $3.9 and 4.5 trillion per annum.1 In Europe the financial requirements are similarly large. For the sole achievement of the EU‘s energy policy objectives for 2030, the required funds are estimated to reach €11.2 trillion in total.2

More and more investors recognize these opportunities as the growing markets for sustainable investments indicate. For example, a recent study on the market volume in 13 European countries finds that growth is consistent across all strategies at the European level, with rates ranging from 30% for Engagement and Voting, up to 385% for Impact Investing.3

Risks of Inaction ESG affects most investments since

05industrial projects, the exploitation of natural resources and the production of goods can negatively impact people and the environment. Currently, environmental catastrophes, consumer boycotts and regulatory and liability risks are neither fully assessed or disclosed nor completely managed. Nevertheless, such risks can decrease the economic returns on a large scale.

Disregarding ESG risks is increasingly criticized. Especially the discussion on climate-related risks is gaining further momentum due to the Paris Agreement. Upholding the 2°C limit may pose varying levels of financial and reputational risk to companies. Business models that mainly or exclusively rely on fossil fuels may involve such risks.

However, the degree of those risks depends on the transitional pathways taken too. The European Systemic Risk Board 4 distinguishes between a benign transitional pathway with a gradual transition to a low-carbon economy that includes manageable adjustment costs without entailing systemic risk and an adverse transitional pathway. In the adverse scenario, the transition to a low-carbon economy occurs late and abruptly so that control of Greenhouse-gas emissions could require a marked change in the use of fossil fuels. Thus, costs of the transition and risks involved will be correspondingly higher.

Risk Management and Disclosure Until now, it has been difficult to determine which companies are most

Opportunities of Sustainable Investment VehiclesBeate Hollweg, Umweltbundesamt (German Environment Agency)

1 UNCTAD (2014) World Investment Report 2014: Investing in the SDGs: An Action Plan, http://www.unctad.org/en/PublicationsLibrary/wir2014_en.pdf 2 EU High Level Expert Group on Sustainable Finance (2017) Financing a Sustainable European Economy, Interim Report, https://ec.europa.eu/info/sites/info/files/170713-sustainable-finance-report_en.pdf 3 The study covers Austria, Belgium, Denmark, Finland, France, Germany, Italy, Netherlands, Poland, Spain, Sweden, Switzerland and the United Kingdom. Eurosif (2016) European SRI study. http://www.eurosif.org/wp-content/uploads/2016/11/SRI-study-2016-HR.pdf4 The European Systemic Risk Board (2016) Too late, too sudden: Transition to a low-carbon economy and systemic risk, Reports of the Advisory Scientific Committee No 6 / February 2016 https://www.esrb.europa.eu/pub/html/index.en.html




fiduciary and disclosure requirements. Based on the final recommendations, the Commission is planning to present proposals for the restructuring of the financial sector in Europe in the spring of 2018.

The policy side can accelerate the transition as practitioners closely follow the political developments at national level. For example, the recent Article 173 of the French Energy Transition Law requires investors to report how they integrate ESG factors in general into their investment policies and risk management as well as specifically on how climate change is incorporated. Effective since the beginning of January 2016, the decree applies to a wide range of investors, including asset managers, insurance companies, public institutes and pension and social security funds.

A further, globally important development is the ongoing standardization process for assessing and disclosing “climate related risks“ and the definition of the requirements for “green bonds“ within the framework of the International Standardization Organization (ISO). However, ISO and the related national standards – such as the German DIN standards – are still not widely used in the financial sector.

Performance of Sustainable Financial Investments It is often feared that sustainable financial investments underperform in comparison to their traditional counterparts. For example, the Norwegian Government Pension Fund recently reported low yield losses by excluding the stocks of arms and tobacco producers. The exclusion of coal producers, on the other hand, had led to a profit increase, as did the withdrawal from companies involved in the deforestation of rainforests.7

Research in this area comes to a clear conclusion. In a study that examined 2,250 scientific papers on the performance of sustainable financial investments, the researchers Friede, Busch and Bassen (2015) found that almost 63% of all studies report a positive relationship between ESG criteria and performance and only 10% report negative results.8

vulnerable to climate related risks, which are best prepared, and which are taking action. To fill in this gap, the G20 Task Force on Climate Related Financial Disclosure has recently provided a framework for assessing and reporting climate related risk.5

The United Nations' Principles of Responsible Investment (PRI) are an example of how to cover ESG factors. Asset managers who commit themselves to these principles agree to integrate ESG criteria into investment analysis, decision-making and asset management. In August 2017, 1,773 signatories, who together manage 50% of globally managed assets, have voted for these principles. Compliance with the principles is, however, voluntary and there is no supervisory body.6

Another voluntary set of rules for compliance with environmental and social standards in project financing are the Equator Principles as well as the Green Bond Principles, the Sustainable Bond Principles and the Principles for Positive Impact Finance.

However, since these approaches have not yet been standardized, there is a risk of confusing or misguiding potential investors. The declaration of an investment as green for portfolios that covers few green and many brown projects as well as the simple shift of assets that has no impact on the real economy are kinds of green-washing. Internationally there are also considerable differences in perspective. For example, “green coal bonds“ in the Chinese market could be considered to be incompatible with sustainable financial investment principles from a European perspective.

Current developments An important step forward for the standardization of sustainable financial investments comes from the European Commission. A group of experts convened by the Commission preliminary proposes among others a uniform classification of sustainable financial investments and standards and labels for bonds and other investment classes for the European Union. In addition, the experts recommend binding rules on

Thus, sustainable investments do not only help to master the current social and ecological challenges but generally perform better than their traditional counterparts. Based on the increasing pressure on the natural environment, assessing ESG risks and taking those risks into account will become significantly more important in the future. Disregarding social and ecological costs means that specific investments are not appropriately evaluated. And only precise and clear disclosure of risks allows the investor to make a comprehensive decision according to his or her best interest.

5 Task Force on Climate-related Financial Disclosures (2017) Final Report: Recommendations of the Task Force on Climate-related Financial Disclosures. https://www.fsb-tcfd.org/wp-content/uploads/2017/06/FINAL-TCFD-Report-062817.pdf 6 http://www.unpri.org 7 Ministry of Finance (2017) The Management of the Government Pension Fund in 2016 — Meld. St. 26 (2016–2017) Report to the Storting (white paper), https://www.regjeringen.no/en/dokumenter/meld.-st.-26-20162017/id2545354/sec18 Friede, G., Busch, T., Bassen, A. (2015) ESG and Financial Performance: Aggregated Evidence from More than 2000 Empirical Studies, Journal of Sustainable Finance & Investment, Volume 5, Issue 4, p. 210-233, 2015.




Corporate accounting performance4310

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ESG is a rapidly growing sector. According to the Global Impact Investing Network, in 2015 globally around $60 billion went into impact investing alone. According to JP Morgan this figure is set to reach $1 trillion by 2020.

A recent study by Morgan Stanley, which evaluated more than 10,000 funds and managed accounts, shows that “Investing in sustainability has usually met, and often exceeded, the performance of comparable traditional investments.” This is on both an absolute and a risk-adjusted basis, across asset classes and over time.1 This study illustrates the outperformance of the MSCI KLD 400 (an index containing firms that meet a very high ESG standard),

06which achieved an annualized return of 10.2% since 1990. During this same span, the S&P 500 achieved an annualized return of 9.7%, a difference of 45 basis points.

In 1998 the journalist Milton Moskowitz analysed the corporate governance aspect of responsible investments, looking at how the companies were managed, what the stockholder relationships were and how the employees were treated. He found that improving corporate governance procedures did not damage financial performance, on the contrary it maximised productivity, ensured corporate efficiency and led to the sourcing and utilising of superior management talents.

According to a study undertaken by Shu Min Hu at the EDHEC Business School in France2 in 2013, in order to evaluate the performance of ESG-oriented strategies, it is advisable to look at indices rather than funds, because funds integrate biasing factors such as transaction costs, management fees or management style. Hu‘s analysis led to the conclusion that between 2008 and 2013 the MSCI World Sustainable Indices outperformed the MSCI World Index both in terms of cumulative returns and risk-adjusted ratios (Sharpe Ratio, Treynor Ratio).

Finally, various meta-studies published by Deutsche Bank AG reinforce the link between sustainability and performance. In 2012, a study found strong evidence of positive correlation between ESG factors and financial performance3.

The financial return of ESG strategies and the role of specialist research agencies

Figure 9: Studies on the Correlations Between ESG Factors and Financial Performance Source: DB Climate Change Advisors 'Sustainable Investing Establishing Long Term Value and Performance' (Deutsche Bank, June 2012); 'From the Stakeholder to the Stockholder', Clark, G., Feiner, A., Vierbs, M. (Oxford 2014)

Positive Neutral Mixed Negative

1 ”Report on US Sustainable, Responsible and Impact Investing Trends, 2014,” The Forum for Sustainable and Responsible Investment website, http://www.ussif.org/Files/Publications/SIF_Trends_14.F.ES.pdf, accessed 1 June 2016. ”Study Shines Light On Sustainable Investing,” Morgan Stanley website, http://www.morganstanley.com/ideas/sustainable-investing-performance-potential, accessed 1 June 2016. ”Sustainable Signals: The Individual Investor Perspective,” Morgan Stanley website, https://www.morganstanley.com/sustainableinvesting/pdf/Sustainable_Signals.pdf, accessed 1 June 2016. 2 Responsible Investing: performing well by doing good?", EDHEC, Paris, 2013. 3 DB Climate Change Advisors “Sustainable Investing. Establishing Long-Term Value and Performance” (2012)




Even though from a traditional portfolio theory point of view a Responsible Investing approach would have a lower risk-adjusted return, there are several factors that suggest better financial performance of ESG-oriented companies. As they have a better reputation, they may attract more customers or more motivated employees. Moreover, companies that invest in clean technologies for instance can benefit from a competitive advantage that will have positive effects on their long-term performance by anticipating future regulations.

A study undertaken by the University of Oxford in conjunction with Arabesque Asset Management in 20144 found that firms with significant environmental concerns pay higher credit spreads, that a well governed firm can have an equity cost advantage between 0.8 to 1.32%, and that good corporate social governance can lead to a 1.8% reduction in the cost of equity. Moreover, in 88% of cases there was a positive relationship

Investing in sustainability has usually met, and often exceeded, the performance of comparable traditional investments, on both an absolute and a risk-adjusted basis, across asset classes and over time.

4 From the Stockholder to the Stakeholder, Smith School of Enterprise and the Environment, University of Oxford and Arabesque Asset Management, September 2014. Sustainable investing. Establishing Long-Term Value and Performance, Fulton, June 2012.

Figure 10: The Global ESG market, Assets by region Source: ‘2016 Global Sustainable Investment Review’, Global Sustainable Investment Alliance (GSIA) Proportion of SRI assets relative to total managed assets.

TOTAL GLOBAL ASSETS

$22,890bn26.3%

Australia/NZ$516bn

Asia ex Japan$52bn

Japan$474bn

Europe$12,040bn

Canada$1,086bn

USA$8,723bn




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between sustainable companies and operational performance. Finally, it was noted that rating agencies tend to give better ratings to issuers with good ESG policies.

According to research undertaken by the Boston Consulting Group‘s Henderson Institute, nonfinancial performance (as captured by the ESG metrics) is statistically significant in predicting the valuation multiples of companies in all the industries they analyze. In each industry, investors rewarded the top performers in specific ESG topics with valuation multiples that were 3% to 19% higher, all else being equal, than those of the median performers in those topics. Top performers in certain ESG topics had margins that were up to 12.4 percentage points higher, all else being equal, than those of the median performers in those topics. The Henderson Institute concludes by stating that “today, it‘s not enough for companies to pursue societal issues as a side activity“.

Extra-financial Analysis of Companies According to the overview of extra-financial agencies made by Novethic (a French research institute on Socially Responsible Investments), in order to analyze companies, extra-financial rating agencies use information from several sources:

– Companies themselves (face-to-face contact, questionnaires, telephone, publicly available documents…)

– Stakeholders (trade unions, governmental organizations, NGOs…)

– Media

As there are no worldwide standards, each rating agency has developed its own methodology, although most of the agencies use the same set of standards. These agencies analyze companies according to environmental, social and governance apsects as well as testing for adherence to international standards such as the International Labor Organization conventions and the United Nations Global Compact, to name but two. There are different criteria in place for different business sectors.

Figure 11: ESG Percentage growth – Investing globally according to strategy Source: 2014 Global Sustainable Investment Review as per December 31st 2013 All figures in trillion USD. Double counting may arise through multiple usage of different strategies.

Figure 12: Difference in credit rating between top and bottom tier of ESG rating Source: MSCI ESG Research; Barclays Research; Sustainalytics Error bars indicate variation over time




Each criterion is analyzed according to the policies set out by the company and the execution of these measures. Finally, agencies determine a rating for each of the criteria and then a rating for the overall company. Regarding small and medium-sized companies, as there is less or no publicly available information, rating agencies rely more on on-site visits and face-to-face contacts. There are no worldwide recognized screening criteria, but there are several rating agencies that offer good research on extra-financial ratings. In general, extra-financial rating agencies use traditional indices to create a Responsible Investing Index according to their analysis methodology (for instance the FTSE for the FTSE4Good). The main extra-financial rating agencies are the following:

– Vigeo (France) was set up in 2002 after the takeover of ARESE and has then itself taken over several other rating agencies across Europe. Vigeo offers ESG ratings of companies, organizations and countries. It is the reference for the ASPI Eurozone and the Ethibel Sustainability Index.

– EIRIS was set up in 1993 in the United Kingdom and was initially mainly focused on negative screening. Since the 2000s, it also includes

ESG screening. EIRIS, along with the UNICEF are the references for the FTSE4Good Sustainable Index construction methodology.

– MSCI ESG Research (United States) was formed in 2010 after several takeovers and belongs to the MSCI (Morgan Stanley Capital International) Group. It is the reference for the MSCI ESG Indices and has helped to build four indices based of different screening approaches: Best-in-Class (positive screening), Socially Responsible (negative screening), Ex Controversial Weapons and Environmental.

– SAM (Switzerland) considers economic, environmental and social criteria when assessing companies and is the reference for the Dow Jones Sustainability Indices.

– Oekom was created in Germany in 1993. Initially, Oekom provided only environmental ratings. Today, it also provides information on ESG performance of companies. Oekom is the reference for the Global Challenges Index. Today, it also provides information on ESG performance of companies (listed and non-listed, but

bond issuers), as well as mid caps and sovereigns, both in developed and emerging markets.

– Sustainalytics (the Netherlands) was formed in 2008 from the merger of several rating agencies. It assesses and analyses the ESG performance of companies using sector-specifies ESG indicators. It is the reference for the Jantzi Social Index and the STOXX Global ESG Leaders Indices.

Meanwhile, the standard financial rating agencies are working on integrating non-financial aspects that reflect ESG considerations into their financial ratings.

Figure 13: Overview of the main ESG market indices Source: Deutsche Bank Wealth Management

Name of Index

Dow Jones Sustainability Index World ex US ex All

Dow Jones Sustainability Index North America ex All

Dow Jones Sustainability Index Eurozone ex All

FTSE4Good UK Index

FTSE4Good Japan Index

2,500 companies in the Dow Jones Global Stock Market except US companies

60 largest Canadian and US companies in the Dow Jones Global Stock Market

600 largest Eurozone companies in the Dow Jones Global Stock Market

630 UK companies in the FTSE All-Share Index

460 Japanese companies in the FTSE Japan Index

– Exclusion of assets involved in alcohol, gambling, tobacco, and firearms – Best-in-class approach (top 10% of companies with the best extra-

financial ratings for each industry)


financial ratings for each industry


financial ratings for each industry

– Exclusion of assets involved in alcohol, gambling, tobacco, and firearms – Selected companies must promote environmental protection and

human rights and develop positive relationships with all stakeholders

– Exclusion of assets involved in alcohol, gambling, tobacco, and firearms – Selected companies must promote environmental protection and

human rights and develop positive relationships with all stakeholders

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Any effort to aid in the development of a certain sector in a specific country needs to be evaluated in a global context, rather than focusing simply on trying to resolve one specific problem. In other words, economic development never happens in a vacuum, it is always related to developments in other parts of the world, with the result that a project carried out with the best intentions may end up producing more harm than good once its unintended consequences are taken into account. One such example from the past is the development of coffee plantations in Vietnam, supported by international

07The global coffee price depression of the late 1990s and early 2000s is remembered to this day as an example of a project that tried to improve the livelihoods of a small community of farmers in one country but ended up destroying the livelihoods of large communities of farmers the world over.1

More generally, apart from a lack of understanding of economic causalities, this anecdote examplifies another pitfall that every well-intentioned investor should be aware of: if a certain crop has never been farmed in a certain country, perhaps there is a reason for that. Perhaps the climate or the soil are not conducive to raising that particular crop, meaning that it can only grow thanks to large quantities of articial fertilizers that pollute the soil and harm consumers. In the case of coffee, which grows extremely well in its native Ethiopia and in some parts of Latin America without the need of chemical aid, the soil and the climate in Vietnam turned out to be so inappropriate that even after intensive fertilization the beans were essentially undrinkable: they had to be flavored with artifical vanilla extract in order to obtain an acceptable taste. This explains the fashion for flavored coffee at the turn of the millennium, but more importantly shows that it is counterproductive and unwise to introduce new crops anywhere without fully appreciating the agricultural aspects of that plant, on top of the long-term consequences on local soil, on global supplies and on the whole industry of that particular crop.

Similarly, the environmental impact of transportation technologies needs to be evaluated taking into account the total emissions of each mode of transport and its harmful effects on humans and the environment. A zealous focus on the

The caveats and the “ashes to ashes” analysis

A zealous focus on the achievement of one single goal should not lead to the selection of suboptimal solutions once all aspects are taken into consideration.

developmental organizations with the aim of alleviating the plight of Vietnamese farmers who struggled to make a living from their existing crops. In the short term, the introduction of coffee plants and the training of farmers in how to cultivate them helped give Vietnamese agriculture a significant boost, leading this experiment to being hailed as a success story in developmental aid. However, what was ignored was that the sudden arrival of large new quantities of coffee on the market depressed its price on a global scale, ruining coffee farmers all over South America before eventually ruining the Vietnamese coffee farmers as well, once the price had fallen too low even for them to make a living from coffee.

1 “So You Say There‘s a Coffee Crisis“, Mark Prince, November 7, 2002; Crisis in a Coffee Cup, Fortune Magazine, Nicholas Stein, December 9, 2002; Waking Up to a World Coffee Crisis, St. Petersburg Times, David Adams, August 11, 2002; Glut Brews in Coffee Market, Eagle-Tribune, Rebecca Griffen, July 30, 2002.




achievement of one single goal should not lead to the selection of suboptimal solutions once all aspects are taken into consideration. The recent scandal surrounding diesel engines is one example in kind. For decades, European governments have subsidized diesel engines because of their lower CO2 (carbon dioxide) emissions compared to petrol (gasoline), as CO2 is deemed to contribute to global warming. However, in so doing they ignored that, compared to petrol, diesel emits much higher quantities of NOx, a highly toxic substance blamed for tens of thousands of early deaths per year. In other words, an overly narrow focus on reducing CO2, which spurs global warming but is harmless for human health, led to an increase of nitrogen oxide (NOx), which is lethal. It is for this reason that in some countries, such as Singapore, diesel has always been banned for private vehicles, rather than subsidized.

Another important consideration to take into account is the “ashes to ashes“ balance. This examines a product‘s total impact on the environment from the moment the raw materials for its production are ordered (the creation “from ashes“) to the moment that it is disposed of and either recycled or left to decompose (thus being reduced to ashes again). This is a crucial aspect because the long-term effects on the environment often go well beyond what the consumer can see. For instance, the development of ever more powerful batteries is an absolute necessity if more and more motor vehicles are intended to be powered by electricity. Indeed, electric automotive development is one key area of ESG investments, promising good potential for financial returns and a means towards reducing urban pollution. However, from a holistic point of view, it is no good reducing air pollution by producing batteries before a satisfying solution for disposing of these batteries in an environmentally friendly way is ensured, something important given that batteries contain a variety of toxic substances. It would not be in the spirit of ESG criteria to consider an electric car an example of environmental progress if instead of polluting the air it simply polluted the soil once the batteries have reached the end of their useful lives.

It is often overlooked that many of the batteries that power electric vehicles are transported by fuel-burning ships around the world (the production cycle is often spread among different countries) before the finished car has even run its first mile. The carbon emissions necessary in the production and in the disposal need to be taken into account in order to evaluate the product‘s full lifecycle environmental impact.

A recent study by the investment bank Morgan Stanley illustrates this point. The bank grouped “climate-change impact stocks” into four sector categories: utilities, renewable manufacturers, green infrastructure companies and transportation stocks. It analyzed them on a number of metrics, including “the CO2 savings achieved from the products and services sold by the companies,” as well as factors centered around the environmental impact of the making of these products. “Whilst the electric vehicles and lithium batteries do indeed help to reduce direct CO2 emissions from vehicles, electricity is needed to power them,” Morgan Stanley finds. “And with their primary markets still largely weighted towards fossil-fuel power (72% in the U.S. and 75% in China), the CO2 emissions from this electricity generation are still material.” Hence, “the carbon emissions generated by the electricity required for electric vehicles are greater than those saved by cutting out direct vehicle emissions.” According to Morgan Stanley‘s calculations, an investment of $1 million in a leading solar panel company results in approximately 15,300 metric tons of carbon dioxide being saved every year, while for a manufacturer of electric vehicles, such an investment adds nearly one-third of a metric ton of CO2.

Wind energy presents different challenges. According to data compiled by the International Energy Agency in its 2016 Key Renewables Trends report, wind provided 0.46% of global energy consumption in 2014. While emission-free once in use, wind turbines generate carbon emissions that only become apparent once their production is accounted for. Apart from their fiberglass blades, they are made mostly of steel, with concrete bases. Steel is

made from coal, not just to provide the heat for smelting ore, but to supply the carbon in the alloy. Cement is also often made using coal. A two-megawatt wind turbine weighs about 250 tonnes, including the tower, nacelle, rotor and blades. Globally, it takes about half a tonne of coal to make a tonne of steel, to which 25 tonnes of coal are added for making the cement, leading to 150 tonnes of coal per turbine. Hence, wind turbines do not replace fossil fuels, rather they depend on fossil fuels for their production. Additionally, the rare earth metals used in wind turbines often come from poorly regulated mines in developing countries which leak toxic and radioactive waste into nearby lakes. It is an ethical imperative not to adopt an “out of sight, out of mind” attitude on this aspect. It is therefore incorrect to call an investment in wind energy “green“ unless the rare earth metals employed come a from a certified source, unless it can yield more energy than the fossil energy spent during its production and unless the CO2 savings realized during the turbine‘s lifetime exceed the CO2 emitted when it was built.

Developing countries often face particular challenges given their different level of industrial advancement. For instance, some African countries rich in coal are plagued by electricity shortages that cause great distress and stand in the way of eradicating poverty. However, they struggle to receive funding to put their coal to work in order to generate electricity because in developed nations, where the investment capital resides, coal is discredited for being a dirty source of electricity. While the focus on clean energy is laudable, in the case of these countries a blanket ban on the use of fossil energy is short-sighted and ultimately counterproductive. Not only does it hold entire countries back from advancing, trapping their populations in poverty, but ignores that given the lack of a reliable electricity grid, in order to cover their needs for electricity, households and firms rely on diesel generators that are even more polluting than coal. This is one prominent example where two of the United Nations sustainability goals, namely turning away from fossil energy and eradicating poverty, clash with each other. A more differentiated approach




that takes into account the specific point on the developmental ladder at which each country finds itself may lead to a better outcome once all aspects of the issue at hand are taken into consideration.

Finally, every ESG investment needs to be evaluated in light of its opportunity

cost – i.e. the question of whether money spent for one particular aim wouldn‘t be better spent somewhere else. Given the finite nature of resources available, this question is crucial. For instance, every dollar spent on counteracting the global rise in temperatures is a dollar not spent on alleviating world poverty. These trade offs, while unpleasant, need to be taken

into account if an increase in global welfare is to be the ultimate goal of the ESG investment being considered. They are also crucial as a precaution against potential future accusations of having financed a venture or a technology that, with hindsight, turned out to do more harm than good.

Regardless of the timeless nature of mankind‘s concerns about sustainability, we are only at the beginning of the ESG “story“ in the realm of investment management. Started by institutional investors such as churches and charitable organizations, then progressively adopted by pension fund trustees, the quest for ESG investments is finding favor with growing numbers of individual investors and hence entering the investment “mainstream“. In the past, whenever ESG strategies have outperformed traditional investment strategies, this has been due in no small part thanks to smaller drawdowns, in other words, thanks to fewer losses in times of falling markets. This suggests that a consideration for ESG-related topics can help prevent risks, including risks for investors. For this reason, ESG strategies can outperform their non-ESG peers even if in good times their returns look less spectacular: by benefiting from milder slumps, they don‘t have to bounce back as much when the market turns in order to claw back into positive territory.

It is often said that people overestimate innovation in the short run but underestimate any longer-term impact. In the case of ESG investing, there are many who consider the subject overhyped, while a significant minority

is increasingly vocal about its immediate transformative effect on the financial industry. We believe that the former camp may be underestimating its long-term potential, while the latter may be overestimating its short-term impact. Financial markets, like anything else, never stop evolving. We advise investors to grasp the long-term impact that ESG considerations are likely to have on investment management and on financial markets at large. On the other hand, it would be naive to assume that the ESG bandwagon is going to disrupt everything overnight. Far from considering this to be a problem, we see it as an opportunity: exactly because many investors are skeptical about ESG-oriented investing and because the market for this approach won‘t reach maturity overnight, there are opportunities to exploit for early movers, especially those who care to look at chances that others haven‘t tried to see. A slow and gradual evolution of financial markets towards a better understanding of ESG issues presents opportunities for investors whose understanding of these matters evolves just a bit faster than the average. In this spirit, we hope this essay has given investors some hints, some caveats and, most importantly, we hope that it has allowed investors to appreciate the potential of this complex but promising theme.

Conclusion08




Glossary

The Brundtland report refers to a 1987 UN document on sustainable development titled "Our Common Future".

ESG investing pursues environmental, social and corporate governance goals.

Exchange Traded Funds (ETFs) are investment funds traded on stock exchanges.

Millennials is a term used to refer to people born in the 1980s and 1990s, although this definition can vary.

Microfinance refers to the provision of loans or other financial services to low-income households without access to traditional financial institutions.

The Paris Agreement refers to a 2015 agreement under the framework of the United Nations Framework Convention on Climate Change.

The United Nations Sustainable Development Goals, finalised in 2015, include 17 sustainable development goals and 169 targets.




Contact us on [email protected]

Global Chief Investment OfficerChristian Nolting1

Regional Chief Investment OfficerLarry V. Adam4

CIO Americas

Tuan Huynh5

CIO Asia

Stéphane Junod8

CIO EMEA

Johannes Müller1

CIO Germany

International locations1. Deutsche Bank AG

Mainzer Landstrasse 11-17 60329 Frankfurt am Main Germany

2. Deutsche Bank AG, London Zig Zag Building, 70 Victoria Street London SW1E 6SP United Kingdom

3. Deutsche Bank Trust Company 345 Park Avenue 10154-0004 New York, NY United States

4. Deutsche Bank Securities 1 South Street 21202-3298 Baltimore, MD United States

5. Deutsche Bank AG, Singapore One Raffles Quay, South Tower 048583 Singapore Singapore

6. Deutsche Bank AG, Hong Kong 1 Austin Road West Hong Kong Hong Kong

7. Deutsche Bank (Switzerland) Ltd. Hardstrasse 201 8005 Zurich Switzerland

8. Deutsche Bank (Switzerland) Ltd. Place des Bergues 3 1211 Geneva 1 Switzerland

9. Deutsche Bank Trust Company Floor 1, 5022 Gate Parkway, Suite 400 32256 Jacksonville, FL United States

Strategy GroupLarry V. Adam4

Global Chief Strategist

Matt Barry4

Investment Strategy Analyst

Moshe Levin4 Investment Strategy Analyst

Dr. Helmut Kaiser1

Chief Strategist Germany

Daniel Kunz7

Senior Strategist EMEA

Chief Investment OfficeMarkus Müller1

Global Head CIO Office

Sebastian Janker1

Head CIO Office Germany

Jürg Schmid7

Head CIO Office EMEA

Graham Richardson2

Financial Writer, CIO Office

Khoi Dang9

CIO Office Americas

Enrico Börger8

CIO Office EMEA

Contacts CIO Wealth Management




Important information

Deutsche Bank Wealth Management is the brand name of the Wealth Management business unit of Deutsche Bank Group, offering high net worth client a broad range of traditional and alternative investment solutions, providing a holistic service for all aspects of Wealth Management.

This document has been prepared without consideration of the investment needs, objectives or financial circumstances of any investor. Before making an investment decision, investors need to consider, with or without the assistance of an investment adviser, whether the investments and strategies described or provided by Deutsche Bank, are appropriate, in light of their particular investment needs, objectives and financial circumstances. Furthermore, this document is for information/discussion purposes only and does not constitute an offer, recommendation or solicitation to conclude a transaction and should not be treated as giving investment advice.

Deutsche Bank does not give tax or legal advice. Investors should seek advice from their own tax experts and lawyers, in considering investments and strategies suggested by Deutsche Bank. Investments with Deutsche Bank are not guaranteed, unless specified.

Investments are subject to various risks, including market fluctuations, regulatory change, possible delays in repayment and loss of income and principal invested. The value of investments can fall as well as rise and you might not get back the amount originally invested at any point in time. Furthermore, substantial fluctuations of the value of the investment are possible even over short periods of time.

The terms of any investment will be exclusively subject to the detailed provisions, including risk considerations, contained in the offering documents. When making an investment decision, you should rely on the final documentation relating to the transaction and not the summary contained herein.

Past performance is no guarantee of current or future performance. Nothing contained herein shall constitute any representation or warranty as to future performance.

Although the information herein has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. Opinions and estimates may be changed without notice and involve a number of assumptions which may not prove valid. The document was not produced, reviewed or edited by any research department within Deutsche Bank and is not investment research. Therefore, laws and regulations relating to investment research do not apply to it. Any opinions expressed herein may differ from the opinions expressed by other Deutsche Bank departments including research departments.

As a diversified global financial services firm, Deutsche Bank and its affiliates engage in a broad spectrum of activities including commercial and investment banking, lending, principal investing, financial and merger and acquisition advisory services, underwriting, investment management activities, fund administration, providing depositary bank and custody services, sponsoring and managing private investment funds, brokerage, trustee and similar activities on a world-wide basis. In the ordinary course of business, Deutsche Bank and its affiliates may engage in activities in which their interests or the interests of their clients may conflict with the interests of the investors. We or our affiliates or persons associated with us or such affiliates (“Associated Persons”) may (i) maintain a long or short position in securities referred to herein, or in related futures or options, and (ii) purchase or sell, make a market in, or engage in any other transaction involving such securities, and earn brokerage or other compensation.

This document may contain forward looking statements. Forward looking statements include, but are not limited to assumptions, estimates, projections, opinions, models and hypothetical performance analysis. The forward looking statements expressed constitute the author’s judgment as of the date of this material. Forward looking statements involve significant elements of subjective judgments and analyses and changes thereto and/or consideration of different or additional factors could have a material impact on the results indicated. Therefore, actual results may vary, perhaps materially, from the results contained herein. No representation or warranty is made by Deutsche Bank as to the reasonableness or completeness of such forward looking statements or to any other financial information contained herein.

This document may not be reproduced or circulated without our written authority. The manner of circulation and distribution of this document may be restricted by law or regulation in certain countries, including the United States. This document is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction, including the United States, where such distribution, publication, availability or use would be contrary to law or regulation or which would subject Deutsche Bank to any registration or licensing requirement within such jurisdiction not currently met within such jurisdiction.

Persons into whose possession this document may come are required to inform themselves of, and to observe, such restrictions.

Unless notified to the contrary in a particular case, investment instruments are not insured by the Federal Deposit Insurance Corporation (“FDIC”) or any other governmental entity, and are not guaranteed by or obligations of Deutsche Bank AG or its affiliates.




Important information

Hong Kong The contents of this document have not been reviewed by any regulatory authority in Hong Kong. You are advised to exercise caution in relation to the investments contained herein. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice.

This document has not been approved by the Securities and Futures Commission in Hong Kong nor has a copy of this document been registered by the Registrar of Companies in Hong Kong and, accordingly, (a) the investments (except for investments which are a “structured product” as defined in the Securities and Futures Ordinance (Cap. 571 of the Laws of Hong Kong) (the “SFO”)) may not be offered or sold in Hong Kong by means of this document or any other document other than to “professional investors” within the meaning of the SFO and any rules made thereunder, or in other circumstances which do not result in the document being a “prospectus” as defined in the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32 of the Laws of Hong Kong) (“CO”) or which do not constitute an offer to the public within the meaning of the CO and (b) no person shall issue or possess for the purposes of issue, whether in Hong Kong or elsewhere, any advertisement, invitation or document relating to the investments which is directed at, or the contents of which are likely to be accessed or read by, the public in Hong Kong (except if permitted to do so under the securities laws of Hong Kong) other than with respect to the investments which are or are intended to be disposed of only to persons outside Hong Kong or only to “professional investors” within the meaning of the SFO and any rules made thereunder.

Singapore The contents of this document have not been reviewed by the Monetary Authority of Singapore (MAS). The investments mentioned herein are not allowed to be made to the public or any members of the public in Singapore other than (i) to an institutional investor under Section 274 or 304 of the Securities and Futures Act (Cap 289) (“SFA”), as the case may be, (ii) to a relevant person (which includes an Accredited Investor) pursuant to Section 275 or 305 and in accordance with other conditions specified in Section 275 or 305 respectively of the SFA, as the case may be, or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. © 2017 Deutsche Bank AG




Risk Warning

Investments are subject to investment risk, including market fluctuations, regulatory change, possible delays in repayment and loss of income and principal invested. The value of investments can fall as well as rise and you might not get back the amount originally invested at any point in time.

Investments in Foreign Countries - Such investments may be in countries that prove to be politically or economically unstable. Furthermore, in the case of investments in foreign securities or other assets, any fluctuations in currency exchange rates will affect the value of the investments and any restrictions imposed to prevent capital flight may make it difficult or impossible to exchange or repatriate foreign currency.

Foreign Exchange/Currency - Such transactions involve multiple risks, including currency risk and settlement risk. Economic or financial instability, lack of timely or reliable financial information or unfavorable political or legal developments may substantially and permanently alter the conditions, terms, marketability or price of a foreign currency. Profits and losses in transactions in foreign exchange will also be affected by fluctuations in currency where there is a need to convert the product’s denomination(s) to another currency. Time zone differences may cause several hours to elapse between a payment being made in one currency and an offsetting payment in another currency. Relevant movements in currencies during the settlement period may seriously erode potential profits or significantly increase any losses.

High Yield Fixed Income Securities - Investing in high yield bonds, which tend to be more volatile than investment grade fixed income securities, is speculative. These bonds are affected by interest rate changes and the creditworthiness of the issuers, and investing in high yield bonds poses additional credit risk, as well as greater risk of default.

Hedge Funds - An investment in hedge funds is speculative and involves a high degree of risk, and is suitable only for “Qualified Purchasers” as defined by the US Investment Company Act of 1940 and “Accredited Investors” as defined in Regulation D of the 1933 Securities Act. No assurance can be given that a hedge fund’s investment objective will be achieved, or that investors will receive a return of all or part of their investment.

Commodities - The risk of loss in trading commodities can be substantial. The price of commodities (e.g., raw industrial materials such as gold, copper and aluminium) may be subject to substantial fluctuations over short periods of time and may be affected by unpredicted international monetary and political policies. Additionally, valuations of commodities may be susceptible to such adverse global economic, political or regulatory developments. Prospective investors must independently assess the appropriateness of an investment in commodities in light of their own financial condition and objectives. Not all affiliates or subsidiaries of Deutsche Bank Group offer commodities or commodities-related products and services.

Investment in private equity funds is speculative and involves significant risks including illiquidity, heightened potential for loss and lack of transparency. The environment for private equity investments is increasingly volatile and competitive, and an investor should only invest in the fund if the investor can withstand a total loss. In light of the fact that there are restrictions on withdrawals, transfers and redemptions, and the Funds are not registered under the securities laws of any jurisdictions, an investment in the funds will be illiquid. Investors should be prepared to bear the financial risks of their investments for an indefinite period of time.

Investment in real estate may be or become nonperforming after acquisition for a wide variety of reasons. Nonperforming real estate investment may require substantial workout negotiations and/ or restructuring.

Environmental liabilities may pose a risk such that the owner or operator of real property may become liable for the costs of removal or remediation of certain hazardous substances released on, about, under, or in its property. Additionally, to the extent real estate investments are made in foreign countries, such countries may prove to be politically or economically unstable. Finally, exposure to fluctuations in currency exchange rates may affect the value of a real estate investment.

Structured solutions are not suitable for all investors due to potential illiquidity, optionality, time to redemption, and the payoff profile of the strategy. We or our affiliates or persons associated with us or such affiliates may: maintain a long or short position in securities referred to herein, or in related futures or options, purchase or sell, make a market in, or engage in any other transaction involving such securities, and earn brokerage or other compensation. Calculations of returns on the instruments may be linked to a referenced index or interest rate. In such cases, the investments may not be suitable for persons unfamiliar with such index or interest rates, or unwilling or unable to bear the risks associated with the transaction. Products denominated in a currency, other than the investor’s home currency, will be subject to changes in exchange rates, which may have an adverse effect on the value, price or income return of the products. These products may not be readily realizable investments and are not traded on any regulated market.

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