Category: Sustainable Investing

Chemical Footprint: Screening Stocks for Chemicals of Concern

Chemicals are in virtually every product we buy from clothing, cosmetics, furniture, shampoo, fragrances, and building products to the food we eat and, of course, the pharmaceuticals used to treat illnesses. In short, life as we know it would not exist without chemicals.

Yet, chemicals also can be harmful and pose risks to human health depending upon their nature and the amount of time we’re exposed to them. So as a consumer, investor or business executive, it’s critical to understand your exposure to “chemicals of concern.”

Chemicals of Concern

Across the world, various regulatory, industry and government agencies have established lists of chemicals of concern. Any chemical that can potentially cause harm can be considered hazardous. However, certain chemicals can persist in the environment (air, water, land, plants and animals), build up in animal tissues and be toxic—causing different types of harm ranging from mild skin irritations to cancer.

Chemicals of high concern (CoHCs), as defined under the California Candidate Chemical List, include:

  • Carcinogens, mutagens or reproductive toxins (CMR)
  • Persistent bioaccumulative and toxic substances (PBT)
  • Other chemicals for which there is scientific evidence of probable serious effects on human health or the environment
  • A chemical whose breakdown products result in a CoHC that meets any of the above criteria

Sounds complicated but extremely important, right? Absolutely, socially responsible investors recognize that the improper use of chemicals can cause materially adverse investment performance and even greater harm to society. Therefore, it’s important that your investment manager conduct a broad screening for chemicals of concern when selecting stocks for your portfolio. Let’s look at a real-world example.

Lumber Liquidators (LL) – Linked to Health and Safety Violations

On March 1, 2015, Anderson Cooper, CBS News correspondent, reported on 60 Minutes that the laminate flooring sold by Lumber Liquidators (LL) may fail to meet health and safety standards because it contained high levels offormaldehyde, a known cancer causing chemical. As shown below, the stock price fell sharply just before and immediately following the report—then down 72% since the start of the year.

Source: Wall Street Journal Online

What went wrong?  Allegedly, it appears that Lumber Liquidators failed to properly control its supply chain by sourcing lower-cost, formaldehyde-tainted laminate flooring manufactured overseas. The flooring was tested by 3 independent labs and failed to meet California formaldehyde emissions standards (CARB-2) with levels, on average, six or seven times higher than allowed and in some cases as high as twenty times higher than allowed.

What were the repercussions? Lumber Liquidator’s CEO, Robert Lynch, resigned on June 16, 2015, and the company announced it would discontinue the sale of the laminate flooring manufactured overseas. Now, the company faces a growing number of product liability and securities lawsuits including allegations that its directors breached their fiduciary duties by failing to properly oversee the laminate flooring manufactured overseas.

This story offers an interesting case study on the importance of Socially Responsible Investing (SRI) and the value of careful environmental, social and governance (ESG) screening. Here are a couple of key takeaways:

I. Watch the Profit Margins  – 60 Minutes reported that Whitney Tilson, a hedge fund manager, correctly identified that Lumber Liquidators had doubled its profit margins in just two years. An unusual gain in a commodity business. These gains should have led more analysts to question the sustainability of the increased profits and the underlying business drivers.

II. Don’t forget the “S” in ESG – Some key social factors that can have a material impact on the value of a stock include (1) customer satisfaction (2) product safety and liability (3) supply chain management and (4) occupational health and safety.

In this case, Lumber Liquidators frequently advertised images of children playing on new hardwood and laminate flooring. Unfortunately, due to their size, children are also the most likely to first show symptoms of exposure to harmful chemicals. So, the risks of providing an unsafe product, used by children and in the home, ultimately destroyed customer satisfaction and caused homeowners to immediately rip the flooring out. Responsible investors should evaluate if the supply chain is sustainable and provides occupational health and safety to its workers.

Sustainable Investing: The ESG Approach

A sustainable approach to investing incorporates the analysis of material, non-financial ESG factors into the investment decision-making process and helps determine the final selection of securities for your portfolio. Analyzing material ESG factors ultimately helps investors rank order stocks before making final investment decisions.

Start with the Chemicals of Concern by Industry

When screening prospective investments, it’s helpful to start by identifying the chemicals of concern used in the industry you’re evaluating. Then determine the level of revenues from products containing those substances and explore the firm’s processes and controls for managing its chemicals. Look for information from industry, regulatory and government sources such as:

Benchmark and Rank Order Your Investments

After you’ve gained a broad perspective on the industry, it’s time to collect the sustainability metrics. In the Household and Personal Products industry, for example, the Sustainable Accounting Standards Board (SASB) suggests the following four metrics regarding chemicals of concern under its Product Environmental, Health and Safety Performance topic:

  1. Revenues from products that contain REACH substances of very high concern (SVHC) (Metric CN0602-05)
  2. Revenue from products that contain substances on the California DTSC Candidate Chemicals List. (Metric CN0602-06)
  3. Discussion of process to identify and manage emerging materials and chemicals of concern. (Metric CN0602-07)
  4. Revenues from products designed with green chemistry principals (Metric CN0602-08)

Ultimately, we’re trying to identify the firm’s “chemical footprint.” To that end, the Chemical Footprint Project (CFP) Assessment Tool (released on June 19, 2015) also provides a good resource for publicly benchmarking chemical use and management. It’s backed by over $1.1 trillion in purchasing and investment power with signatories that include Aviva Investors, BNP Paribas IP, Boston Common Asset Management, Calvert Investments, Miller/Howard InvestmentsTrillium Asset Management, Zevin Asset Management, Dignity Health, Kaiser Permanente, Staples, Target and many others.

In the final analysis, we’re looking for best-in-class performers and screening out firms with significant risks. In the long-term, integrating ESG analysis into the investment decision-making process will help identify companies with business models that are more sustainable, socially responsible and profitable.

Investing in a Changing Climate

Investing in a Changing Climate

Is climate change for real? The short answer is yes. According to Doug Sisterson, co-author with Seth B. Darling of How to Change Minds About Our Changing Climate…about 98% of climate scientists believe that the Earth’s climate systems are changing due to “anthropogenic” (caused or produced by humans) greenhouse gas (GHG) emissions.

Based on peer-reviewed scientific reports, The International Panel on Climate Change (IPCC) concludes that the effects of greenhouse gas emissions, and their anthropogenic drivers, are extremely likely (95% – 100%) to have been the dominate cause of global warming since the mid-20th century in its Climate Change 2014 Synthesis Report Summary for Policymakers (4). The IPCC describes the causes of climate as follows:

SPM 1.2 Causes of Climate Change

“Anthropogenic greenhouse gas emissions have increased since the pre-industrial era, driven largely by economic and population growth, and are now higher than ever. This has led to atmospheric concentrations of carbon dioxide, methane and nitrous oxide that are unprecedented in at least the last 800,000 years. Their effects, together with those of other anthropogenic drivers, have been detected throughout the climate system and are extremely likely to have been the dominant cause of the observed warming since the mid-20th century.  {1.2, 1.3.1}” (4).

The IPCC presents an interesting graphical view of GHG emissions (in gigatonne of CO2-equivalent per year, Gt CO2-eq/yr) for the period of 1970 to 2010 (shown below). Interestingly, annual CO2 emissions from fossil fuel combustion andindustrial processes accounted for 65% of the 49 Gt total. Other major sources include methane (CH4) at 16%, CO2 from Forestry and Other Land Use (FOLU) at 11% and Nitrous Oxide (NO2) at 6.2%.

What are the risks of climate change?

The risks associated with global warming are expected to create widespread impacts across the planet—and include more severe weather-related events. In Asia, IPCC identifies increased drought-related water and food shortages, more heat-related human mortality and increased flood damage to infrastructure, livelihoods and settlements. Europe faces increased damage from river and costal floods, increased water restrictions and increased damage from extreme heat events and wildfires. North America faces similar problems with increased damage from wildfires, increased heat-related human mortality and increased damage from river and costal urban flooding. The oceans face reduced fisheries catch potential, mass coral bleaching/mortality and increased damage from costal inundation and loss of habitat (14). While this is not an exhaustive list, the point is that the effects are widespread and can impact human health, agriculture, housing, infrastructure and many other industries too—think of massive insurance claims after extreme weather events.

What’s the global plan?

In order to limit the harmful effects of global warming, The United Nations Framework Convention on Climate Change (2010) established a global accord in Copenhagen that attempts to limit the future increase in global temperature to 2 degree Celsius from pre-industrial temperatures. Since scientists estimate an almost linear relationship between cumulative CO2 emissions and projected global temperature change to the year 2100; this effectively means that a “carbon budget” on CO2 emissions has been established between 430 to 530 Gt CO2. The graph below illustrates the relationship between the carbon budget (CO2 emissions permitted below a 2 degree temperature increase) and climate change.

Problem solved?

Not so fast. Under this carbon budget, the International Energy Agency (IEA) reports that no more than one-third of proven fossil fuel reserves can be consumed prior to 2050, unless carbon capture and storage (CCS) is widely deployed in its 2012 World Energy Outlook.

No more than one-third of proven reserves of fossil fuels can be consumed prior to 2050 if the world is to achieve the 2 °C goal, unless carbon capture and storage (CCS) technology is widely deployed” (3).

This dilemma has led some to conclude that fossil fuel reserves may become “stranded assets” that won’t or can’t be used in the future—which could lead to asset write downs (impairment) on balance sheets and imply that current stock prices are overvalued. The Carbon Tracker Initiative notes that assets can be stranded for regulatory, economic or physical reasons.

Stranded assets are fossil fuel energy and generation resources which, at some time prior to the end of their economic life (as assumed at the investment decision point), are no longer able to earn an economic return (i.e. meet the company’s internal rate of return), as a result of changes in the market and regulatory environment associated with the transition to a low-carbon economy.” Carbon Tracker Initiative: Resources: Stranded Assets, Web. June 2015.

However, according to Julie Fox Gorte, Ph.D., senior vice president for Sustainable Investing at Pax World Investments, “Factually, unburnable carbon doesn’t exist.” In short, Dr. Fox Gorte correctly points out that in order for fossil fuel reserves to become stranded (unburnable) assets there would need to be new regulations that don’t exist today in Pax World’s ESG MattersEven still, I believe new environmental regulations, legislation and carbon markets will develop and we must pay very close attention to them.

I know of no nation that has or is considering legislation to make it either illegal or uneconomic to extract remaining coal, oil or natural gas reserves and burn them in the engine of commerce, mostly to produce energy” (1).

What can investors do? 

First, recognize that the problem is real. Second, understand that the timing, magnitude and consequences of climate change are evolving issues. Consequently, one could develop an investment strategy that evolves as new scientific information, technology, environmental markets (for greenhouse gases, carbon, water, weather risk, etc.) and legislative or regulatory policies emerge.

Many colleges, universities, foundations, cities and other civic, charitable and religious institutions have opted to divest from fossil fuels (see Go Fossil Free Divestment Commitments). Others have opted to influence change through corporate engagement. And still others use low carbon indexes to increase exposure, while reducing tracking error, to more carbon-efficient companies (seeMSCI Beyond Divestment: Using Low Carbon Indexes).

Finally, let’s not forget that climate change will create new investment opportunities and environmental markets. Surprisingly, the best trade can be counterintuitive.Richard L. Sandor, Ph.D., Chairman and Chief Executive Officer, Environmental Financial Products, LLC, recently talked about his new book Sustainable Investing and Environmental Markets: Opportunities in a New Asset Class by authors Sandor, Clark, Kanakasabai and Marques in Chicago. Sandor explained that environmental markets often over-estimate the cost of compliance with new regulations so the best trade could be to short the carbon market—even though your gut is telling you that the price will go up.