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Analyzing the information technology sector's outsize role in ESG funds

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Analyzing the information technology sector's outsize role in ESG funds

While the information technology sector has been plagued by bad press over data breaches, privacy issues and concerns about foreigners buying ads to influence U.S. politics, the industry has attracted much more positive scrutiny from asset managers, who have given it an outsized weighting in funds pegged to companies' progress on environmental, social and governance, or ESG, metrics.

An S&P Global Market Intelligence analysis of select ESG exchange-traded funds focused on U.S. equity markets found that four out of six funds were heavily weighted to the information technology sector. Among 11 total sectors, IT represented nearly one-quarter or more of each fund's holdings. Market experts see two primary reasons for this: First, a number of IT companies have taken steps to mitigate risks associated with prominent ESG issues, such as climate change and water scarcity; and second, these companies also have developed a reputation for better disclosure practices.

Of the six ESG exchange-traded funds analyzed by S&P Global Market Intelligence, the largest, with $624.4 million in assets under management as of Dec. 5, was BlackRock Inc.'s iShares MSCI USA ESG Select ETF. The fund is built around the MSCI USA ESG Select Index, which is designed to maximize exposure to positive ESG characteristics, while earning returns similar to a broader index. BlackRock also analyzes each eligible company's ESG performance using its own proprietary ratings based on environmental, social, governance and ethics criteria. Companies with relatively high overall ratings have a higher representation in the underlying index, the firm said. The IT sector represented 27% of the fund's holdings, including stakes in Microsoft Corp., Alphabet Inc., and Apple Inc.

Tony Campos, director of ESG product management at the stock market index provider FTSE Russell, said in an interview that it is "relatively easier" for information technology firms and other "lighter-touch companies" to get a higher rating in FTSE Russell's ESG indexes because "they are not as exposed to [ESG] issues to the same degree of magnitude" as an integrated oil and gas company, for instance.

Nuveen's NuShares ESG Large-Cap Growth ETF was the most heavily weighted toward the information technology sector of the six ESG exchange-traded funds analyzed by S&P Global Market Intelligence, at 36%. The fund is focused on growth stocks, or stocks expected to see share price gains. Nuveen's sister fund, the NuShares ESG Large-Cap Value ETF, is focused on value stocks, or stocks that tend to trade at a lower price relative to their fundamentals. As such, it is less heavily weighted toward more expensive IT stocks, with the sector representing only 12% of holdings.

Notably, among the six funds, all listed Microsoft as one of their top 10 holdings as of Dec. 5. According to the Reputation Institute's RepTrak, which measures public opinion of companies across more than 25 industries and more than 50 countries, Microsoft has the second highest corporate social responsibility reputation, second only to Lego.

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Microsoft CEO Satya Nadella
Source: Associated Press

One recent area of focus for Microsoft has been water scarcity. In March, the company launched a Water Risk Monetizer tool, which translates water scarcity risks into financial terms. The company then applied the tool at its own data center near San Antonio — which is located in a high water-stress region, according to the World Resources Institute's Water Risk Atlas — to better understand the financial and environmental risks facing the location. Many data centers use water to cool the heat that is generated from the electricity that powers a data center, considering water an energy-efficient alternative to chillers or air conditioning units. Josh Henretig, Microsoft's senior director of environmental sustainability, said in a blog post the Water Risk Monetizer tool showed Microsoft's risk-adjusted water bill was more than 11x greater than the bill Microsoft was paying to the San Antonio Water System. As a result of these findings, Microsoft developed a strategy to use recycled water, saving more than $140,000 in water costs per year, while also avoiding the use of 58.3 million gallons of potable water per year.

Google Inc.'s parent Alphabet, a top-10 holding on three of the six ESG funds analyzed and the No. 3 company listed on Reputation Institute's RepTrak report, also uses water to chill its data centers and powers two of its data centers with 100% recycled water. The company said it uses recycled water from various sources, with a facility in Douglas County, Ga., treating city waste water and a Belgium facility pulling water from an industrial canal. A facility in Finland uses sea water straight from the Gulf of Finland.

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Google data center
Source: Google Inc.

In a 2017 issue brief, the index provider MSCI Inc. included water scarcity as one of the major physical risks companies and investors will need to consider going forward. "Physical risk, not regulatory risk, is the exposure that companies may need to worry about," the MSCI brief said, describing water scarcity as "a starting point."

The focus on risk reduction is an essential factor in the rise of ESG investing, according to Matt Orsagh, director of capital markets policy at the global investment professional association CFA Institute. He said most large companies and institutional investors see ESG as a "value" proposition," not a "values" proposition.

Beyond water, both Microsoft and Google operate as carbon neutral companies thanks to a combination of energy-efficiency initiatives, renewable energy, and carbon offsets. According to Google, the company has been carbon neutral since 2007, meaning it has tallied no net release of carbon dioxide to the atmosphere for 10 years. Microsoft says it has been carbon neutral since 2012. In explaining the business benefits of these efforts, Google said in its 2017 environmental report, "The cheapest energy and water are what we don't use in the first place."

In additional to addressing environmental concerns, Reputation Institute Executive Partner and Chief Research Officer Stephen Hahn-Griffiths said Google CEO Sundar Pichai has "come out and taken a public stand on diversity issues and immigration issues, not just in the U.S. but around the world, and is trying to build a global culture of inclusiveness." Both Pichai and Microsoft CEO Satya Nadella have been among the tech CEOs to speak out publicly against a number of recent policy changes under the Trump administration — including various iterations of the travel ban, which restricts travel for citizens of six Muslim majority countries without a current visa; and President Donald Trump's decision to end the Deferred Action for Childhood Arrivals program, which shielded undocumented children and young adults from deportation. Hahn-Griffiths stressed the importance of companies not just having strong corporate social responsibility initiatives, but of talking about them publicly.

In a recent post on the financial search engine AlphaSense, Pamela Styles — principal of Next Level Investor Relations LLC, a consultancy specializing in both investor relations and ESG/sustainability practices — analyzed environmental, social responsibility and energy disclosures from the IT sector, and said she sees IT companies using the successes of their sustainability programs as part of a "competitive IR communications strategy."

Styles said in an interview she believes "sustainability could likely be a significant catalyst for the next large advancement" in investor relations strategy.

Of course, it has not all been positive news coming out around the IT sector, as various companies have dealt with data breaches, privacy issues and concerns around foreigners buying ads to influence U.S. political discourse. Campos at FTSE Russell said investors typically prefer to separate "controversial conduct measures" based on news headlines and other external sources from traditional ESG operational risk ratings. But he noted there does eventually come a point where bad headlines move from being an "emerging" issue to becoming an "embedded" concern. Campos said he has seen this happen in the past, especially around tax transparency.

"The [ESG] model is relatively early in its evolution and will continue to change as more issues become relevant to investors," he said.

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