2012 ESG Trends to Watch

In this context, MSCI's ESG Research team is focusing on ten emerging trends for 2012, which are likely to affect government and corporate policy, profits, and market sentiments:

Accounting for Social Value
Civil Liberties Post Arab Spring
Accounting for Natural Capital
Shifting Debate on Climate Change
Bridging the Gap in Food Safety Infrastructure
Closing Corporate Tax Havens and Loopholes
Regulating Shale Gas
Labor Strife in China
Conflicting Water Demands
Broadening Threats to Privacy & Data Security

Accounting for Social Value

The Occupy Wall Street movement has been in many ways a lagged response to the 2008 financial crisis. Then, the public questioned the legitimacy and effectiveness of using tax payer money to bail out failing financial institutions and other companies. Three years on, with the European sovereign debt crisis already precipitating the bail out of one major financial institution with possibly many more in the pipeline, the public is questioning the fundamental legitimacy of the financial institutions themselves: do the banks generate enough value to society to be worth the cost?

Each year, we evaluate more than 175 financial institutions overall, with a focus on the largest banks in the world. To answer this question, we base our analysis on a combination of estimated economic value and social impact generated by core services and distribution of value to external stakeholders. When assessing all banks for which we had data, we were able to pinpoint a size at which banks, on average, produce the most efficient social value.

For investors, companies that fail to generate consistent social value represent a clear portfolio risk: as public and political will wanes, these banks are increasingly open to regulatory scrutiny, brand destruction, and even failure.

Our social value metrics for financials parallel the ability of extractives and oil & gas companies to secure and maintain a license to operate within local communities and governments by limiting resource use and pollution while maximizing returns.

We anticipate that the prolonged economic downturn in the US and the financial crisis in Europe will renew doubts about the outsized role played by financial institutions in the global economy. Furthermore, as job creation no longer seems to go hand in hand with strong corporate profits, high profile companies across other sectors could come to face the same pressures as those in the financial sector to provide a full accounting of the social and economic value they bring to the markets in which they operate.

Civil Liberties Post Arab Spring

In the wake of Arab Spring and mass protest movements in other unexpected areas such as Russia, authoritarian regimes everywhere are on watch to stem any potential outbursts in popular discontent. Although political pundits will continue to debate the role of social networking tools in these popular movements, increased monitoring of communications has clearly shot up to the top of the priority list for government security apparatus.

To the extent that many of these markets – China being the prime example – also represent big growth opportunities for the telecoms and IT sectors, we anticipate that many companies will be squeezed between building goodwill with regulators in these markets and building trust among their base of consumer users. Veering too far toward abetting government censors could precipitate a sharp fall off in users; holding the line on protecting users could lock companies out of these lucrative markets.

Currently in the MSCI World Index, nearly 100 companies are engaged in communications products and services including e-mail and internet services that we deem to be high risk in terms of potential violations of civil liberties that can trigger consumer backlash, negative headlines, and regulatory inquiries and actions in the US and Europe. Our analysis also indicates that in the integrated telecommunications industry alone, nearly half of the companies (around 20) currently have some exposure to markets with government activities in internet filtering and curtailment of press freedoms.

We anticipate that an increasing number of governments will step up their game in monitoring their populations – going from simple internet filtering to monitoring citizen communications.

The increasing sophistication and pervasiveness of their initiatives will implicate a much wider array of the information and technology sector, exposing companies that have not previously been at risk to these explosive issues.

Accounting for Natural Capital

The rapid degradation of ecosystems and depletion of natural resources will weigh on the long term sustainability of major economies around the world. According to the Global Footprint Network, humanity’s consumption surpassed earth's bio-capacity in 2006, and on current trends, we will require two earths to sustain our consumption by 2030. Already, effects such as water scarcity, desertification, soil erosion, and depletion of fisheries are impacting the ability of some regions and sectors to sustain business-as-usual. As investors become more aware of the risks to long term growth of degraded ecosystem services, the idea of accounting for 'natural capital' has started to take on momentum.

Assessing countries' ability to protect and harness their endowed resources will be a crucial step to integrating country-level risks into investment decisions. As part of MSCI's rating of countries' exposure to ESG-related risks, for example, we consider such factors as changes in forest area, renewable water resource, and environmental footprint of a country’s consumption versus its bio-capacity.

Currently, in over two-thirds of the 156 countries in our dataset, the consumption and production levels have already exceeded their bio-capacity.

We anticipate that these countries' attractiveness as investment destinations will increasingly be called into question by investors concerned about the long-term competitiveness and sustainability of their economic models.

Shifting Debate on Climate Change

Although climate-related legislation has not come fast enough or far enough for many environmental advocates, there has been a slow and upward trend in increased legal certainty around the shape of a low carbon economy in many markets. Most notably in 2011, the Australian legislation put a price on greenhouse gas emissions and could link to other international trading schemes such as the European or the California one. (See 'Australian Carbon Tax Impact: Steelmakers to come out ahead' for financial implications of the new carbon tax regulations for Australian companies.) Decisions coming from the Durban conference include an agreed pathway for a new international climate change treaty that will include developed as well as developing countries with legally binding targets for the first time.

According to the International Energy Agency, for every five dollars needed to tackle climate change, four will have to come from the private sector. Hence increased clarity in regulatory frameworks provides greater legal certainties to the private sector signals that are crucial for companies to prepare for a low carbon economy. We anticipate that as the vision of a low carbon economy takes hold, attention of consumers and policymakers will shift away from the obvious sectors with high direct carbon emissions.

Instead, the reality of a global economy that is driven by upstream processes that generate substantial emissions will shift the debate to the issue of climate change and the spotlight on industries and products that currently receive scant attention.

Our research has shown for some time that the textile & apparel industry, for example, is among the sectors with high carbon intensity in its supply chain. Yet, only one in every four companies in our coverage universe has management strategies in place to identify the scope and extent of their risk exposure to higher energy costs throughout its supply chain. With respect to product offering, among major global industrial conglomerates, only one in every five companies offers products on energy efficiency or renewable energy.

We anticipate that a growing swath of downstream consumer and industrial companies will have to pony up the investments into a more efficient, low-emission supply chain, creating incentives for innovations in low-carbon technologies such as iron making through hydrogen and CO2 separation and recovery (30% less carbon intensive) or thermo acoustic refrigeration (HFC free, which has 22,000 times the global warming potential of CO2).

Bridging the Gap in Food Safety Infrastructure

Food safety scares seemingly pop up randomly, implicating anything from tomatoes to infant formula, from processed meats to organic sprouts. No country seems immune. Despite consumer prejudice against imports, the source of the e. Coli outbreak in Germany and radioactive traces in Japan this year were home-grown. There is a natural tendency to point to foreign countries as the weak link in the food supply chain. Mexico is often a target among US consumers, as Spain was an early suspect in the initial stages of the e. Coli outbreak in Germany that would ultimately kill 39 people. The origin of the contamination was in fact an organic farm outside of Hamburg, although some argue that the seeds originally came from South Europe and Asia.

The scope and complexity of the food supply chain – whether ingredients are sourced globally or locally – have vastly outpaced the ability of regulatory systems to ensure food safety.

Budget constraints are likely to significantly curtail any efforts to upgrade the regulatory system, at least in developed markets. Ultimately, the onus is on food manufacturers and retailers themselves to institute robust internal systems to offset the gaps in the global food safety system. Yet, our assessment of food manufacturers and retailers indicate that the vast majority of companies continue to rely on a compliance approach that is dependent on a spotty regulatory system. Of 45 global packaged foods companies that we analyzed, only 14 currently have a system in place to trace ingredients; 22 provide no indication of in-house or third-party ingredient testing.

For companies pursuing growth in markets with underdeveloped food infrastructure, such as India, China, and Southeast Asia, the cost of building a logistics infrastructure suitable for local conditions injects an added layer of complexity. Additionally, insuring consistent quality across global operations has proved challenging, leading some companies such as Starbucks in China to acquire or strategically partner with local growers and processors to gain direct control over food safety standards.

The explosive nature of food safety concerns, however, poses a strong reputational and operational risk for food purveyors, especially for brand name Western companies in emerging markets. Wal-Mart's run in with mislabeling its pork products in China led to weeks of negative headlines, closure of 13 stores for two weeks, detainment of 37 employees with arrest of two, and resignation of Wal-Mart China's CEO.

We anticipate that as food safety problems prove damaging to consumer trust, more companies will be forced to invest far more resources into systems for tracing, testing, and training throughout their far-flung network of growers, distributors, factories, warehouses, and retail locations.

Closing Corporate Tax Havens and Loopholes

Companies point to the taxes they pay as a vital component of the economic and social value they contribute to society. But as governments in the US and Europe look to raise revenues, the public and media are shining a spotlight on how much some of the largest and most high profile global companies are in fact contributing. ActionAid in the UK compiled data on top 100 listed UK companies and reported that roughly a quarter of these companies' subsidiaries are located in 'tax havens'. The Center for Tax Justice in the US reported that among 280 consistently profitable companies on the Fortune 500, 24% paid less than 10% of profits in federal taxes between 2008-2010, including 11% of companies that paid zero or had a tax benefit.

The message is not subtle: many of the world's most admired companies could in fact be shirking on their social contribution, according to these media reports. Companies have most likely been perfectly above board in using the tax code to their advantage. And, in fact, they rightly claim that shareholders demand that the companies operate as tax-efficiently as possible.

Nevertheless, in a climate of fiscal austerity and public sensitivity to issues of fairness, we see a move toward elimination of tax loopholes, tax havens, and pressure to more fully disclose tax strategies and contributions.

For investors, understanding how much earnings are reliant on aggressive tax strategies can provide a clearer picture of the quality of the business as well as protect against future changes in tax treatment.

Regulating Shale Gas

A growing percentage of reserves in the oil & gas sector are composed of unconventional sources, including shale gas and oil sands. The discovery of huge shale deposits throughout the world is shifting the balance of trade in energy and subtly altering the energy security calculus of major economies including the US and China. Despite the rush to drill, the boon to major oil and gas players in this space could be held in check by public concerns over the health and environmental effects of hydraulic fracturing, the controversial technique used to extract shale deposits. We see significant operational and legal risks to companies involved in shale plays that may be not be fully valued by investors. (See 'Shale Gas and Hydraulic Fracturing in the US: Opportunity or Underestimated Risk?' for an assessment of the current state of play among major oil and gas players.)

The intense media attention to shale gas controversies has ratcheted up the pressure on policymakers to demand better disclosure from companies and institute stringent guidelines on operations. Despite loud and passionate protests by some local communities and environmental advocates, we see a low probability of outright bans on hydraulic fracturing in the US, although a temporary moratorium is in place in New York State. However, reports such as the recent one from the Environmental Protection Agency linking water contamination to fracking fluid in Wyoming, is pushing regulators to step up the pace of potential regulations.

Policymakers and environmental advocates around the world are watching the EPA and the major players in the US market closely, as shale gas development is currently far more advanced in the US than elsewhere. Major global players such as Exxon and Shell will transfer the experience and know-how honed from US drilling to other major deposits globally. Already, Shell has announced that it will be helping China National Petroleum Corporation to explore shale gas in Central China, where geological formation is reportedly more complex than in the US.

We anticipate that regulatory adjustments will push up operating cost and cleanup liabilities, which in turn could spur technological improvements, including but not restricted to innovations in fracking fluids formulation.

In fact, we view stricter operating standards and 'green' fracking fluids as both paramount and unavoidable, should shale gas developments reach the potential envisioned by estimated resources.

Labor Strife in China

Labor strife has been on the rise throughout 2011, with public sector workers taking center stage in major European markets. The slumping economy going into 2012 will prove to be doubly difficult for many companies as workers across diverse sectors, in developed as well as emerging markets protest against wage cuts and job losses. China, following last year's burst of labor unrest, is again facing serious labor conflicts in a number of manufacturing hubs as the European economies have stalled in 2011, driving factories to lay off workers or cut overtime pay.

While the immediate catalyst for the recent protests in Shenzhen, Dongguan, and around Shanghai appears to be driven by the business cycle, the demographic and cultural drivers for these labor protests will only strengthen going forward and demand particular caution from high profile companies across both manufacturing and service sectors.

Since the 2010 outbursts of labor strife in China and elsewhere in Asia, our analysis shows evidence that labor practices among suppliers and in companies' local factories have gotten the attention of top executives in industries beyond textiles, toys, and other low margin consumer products. Contract manufacturers for high profile brands are especially vulnerable as a younger generation of workers not only are better informed about their labor rights, better connected to peers across sectors through communications technologies, but also demonstrate a far savvier sense for the leverage they hold over the brand reputation of global companies.

Among the many incidents of labor protests this fall, for example, is a relatively small case in terms of number of workers: five former employees of Gucci's flagship store in Shenzhen issued an open letter on the Internet accusing the company of running a high-end 'sweatshop'. Chinese micro-blogging site Sina Weibo spewed criticisms of the company, the workers are suing for unpaid overtime, and the local labor and human resources bureau reportedly started an investigation.

Without far stronger attention to labor management throughout the value chain, we anticipate that a media savvy generation of workers will pose increased operational and reputational risk for brand-name companies vying for a piece of the Chinese market.

Conflicting Water Demands

Acute water shortages accounted for an estimated economic value loss of up to USD 5 billion to the agricultural sector in the state of Texas this year, where at least one-third of the wheat crop was lost to the worst drought in over 100 years. A drought in northern China, the heart of its wheat growing region, contributed to a spike in wheat prices early in the year. Meanwhile, many parts of Europe faced the driest conditions in a century.

Water shortages will increasingly pit industrial users against agricultural and residential users. In our analysis, some of the highly intensive users of water from a lifecycle perspective include utilities, food, beverages, steel, and semiconductor industries. For some companies in these industries, a substantial portion of their assets are located in high water stress regions that carry increased risk of operational disruptions from water shortages. Our analysis of the semi-conductor industry, which maps the facilities of each company to water basins based on data from the International Water Management Institute and Yale and Columbia's Environmental Performance Index, shows, for example, that of the 15 companies facing the highest risks, only 4 have strong risk management approaches with comprehensive strategies, quantitative reduction targets, and high water recycling rates.

We are able to estimate with growing accuracy the level of risks companies face on water shortages to their operations. However, our analysis finds that most companies continue to ignore these risks.

In our analysis of the steel industry, we find that only 3 of 45 companies currently report their water use to the Water Disclosure Project. Yet, for some steel companies, water availability is already an obstacle to ambitious growth plans.

In eastern India, where agrarian society conflicts with economically-advantageous mineral deposits for the steel industry, multi-national steel companies, such as ArcelorMittal and POSCO have hit roadblocks stemming from community opposition to water withdrawals and land acquisition. For POSCO, their USD 12 billion investment in an integrated steel plant has languished for the past six years as the company has struggled to acquire land and ensure local farmers that their water supplies will be unaffected. While India represents a huge growth opportunity for foreign steel companies, continued industrial growth in these regions will only put more stress on water resources, which in turn will lead to greater conflict with local communities.

We anticipate that as fixed water supplies collide with strong demands from population growth and industrial uses, conflicts with local communities will become a regular feature for companies seeking growth in water stressed regions.

Broadening Threats to Privacy & Data Security

The challenge of securing the vast amount of personal data collected by businesses across sectors is growing beyond the capabilities of many companies. The number of data breaches and cyber-attacks is multiplying, with Symantec reporting last month that the number of daily targeted attacks had quadrupled since the beginning of the year, with most of them seeking access to confidential data. High profile breaches this year involving brand names as diverse as Sony, RSA (EMC) and Citigroup highlight the difficulties that even the largest companies have in protecting their systems from cyber attacks. (See MSCI ESG's webinar: 'Integrating Technology and Data Security Risks into the Investment Process'.)

Going forward, we see the issue posing a material risk for a much wider range of companies, beyond the IT sector. In fact, the largest data breaches involve consumer data collected by the retail and hospitality sectors, rather than in the financial and defense industries that tend to garner more media attention, particularly with regards to cyber attacks.

While consumers so far seem sanguine about the loss of personal data in cases of data breach, the exponential growth in aggressive collection and use of personal data escalate the risks that companies will face large-scale litigation, regulatory action, and reputational damage if they fail to build capabilities to secure data or take excessive liberties in their commercial uses of consumers’ data.

In the worst case scenario, public outcry could elicit regulatory actions that render some business models unviable.

We anticipate that companies across all sectors will be forced to make greater investments to secure their data. These investments will create upside opportunities in the software space, where we anticipate seeing big players acquiring start-ups with innovative privacy technologies, as well as in the hardware sector, where both device and component makers are scrambling to bake in security measures.