2.5 ESG Analysis

Question 1

ESG has been in existence for almost ______ and developed from trends in preceding decades, such as SRI and CSR. A big development for ESG occurred in ______with the SDGs and the PCA.

Answer 1

ESG has been in existence for almost two decades and developed from trends in preceding decades, such as socially responsible investing (SRI) and corporate social responsibility (CSR). A big development for ESG occurred in 2015 with the UN Sustainable Development Goals (SDGs) and the Paris Climate Agreement.

Question 2

What are the most frequently used guidelines/benchmark standards for ESG called? (G)

Answer 2

Global Reporting Initiative Standards (GRI Standards).

Topics including climate change, human rights, and social well-being are covered.

Question 3

A key objective of ESG investing is fairer distribution of _____ versus ________.

In practice this means -

Answer 3

A key objective of ESG investing is fairer distribution of returns between stakeholders versus maximizing shareholder returns

In practice, means that it is acceptable at times for other stakeholders to benefit (i.e. higher paid employees) vs simply maximising shareholder equity value

Question 4

What are the conclusions from various empirical studies on ESG?
1. whether esg is profitable or not:
2. one study shows that while effect on returns was not SS, it may reduce TR
3. SS tend to _____
4. in some years there is evidence to suggest that firms with high ESG have _____ but other years ____
5. market cares?
6. activist

Answer 4

1. whether esg is profitable or not is complex and dependent on context and circumstance
2. effect on returns was not statistically significant, it may reduce tail/extreme risks
3. sin stocks tend to outperform
4. some years show evidence that high esg firms have higher returns, but other years dont show this (e.g. around GFC)
5. some studies suggest the market does not care about ESG factors
6. evidence exists that activist ESG investors do add value for all stakeholders

Question 5

What was the conclusion of the study focusing on U.S. equity returns using factor analysis (ESG)?

Answer 5

That ESG investing in low risk, high quality, high price, large companies did not produce consistently above-average returns.

Question 6

Three drawbacks of most studies on ESG impact on equity returns?
1. one factor
2. historical accounting
3. sample bias

Answer 6

1. risk is adjusted minimally i.e. by only one factor
2. studies are based on historical accounting measures
3. there may be sample bias when using returns from prior to when the company received an ESG score

Question 7

A firm’s ESG rating may differ depending on whether it is rated based on…

Answer 7

A firm’s ESG rating may differ depending on whether it is rated based on its line of business (i.e. an oil company) or what it is is doing for ESG within its line of business (i.e. if it is the best oil company e.g. energy-efficient extracting procedures).

Question 8

Why is the accuracy and reliability of ESG ratings called into question?

Answer 8

There is little consistency between ESG rating agencies. With credit rating agencies, ratings tend to have 0.9 correlations between agencies. For ESG, it is only about 0.32.

Question 9

What does ESG materiality refer to?

Answer 9

The importance of an issue in the context of how it might reasonably be expected to change a stakeholder’s investment decision if the issue was disclosed.

i.e. is the thing important enough to tell people.

Question 10

What is the GRI principle for ESG materiality called?

Answer 10

The G4 materiality principle.
Says that the ESG report should cover issues that “may reasonably be considered important for reflecting the organization’s economic, environmental, and social impacts, or influencing the decisions of stakeholders

Question 11

What entity provides for benchmarking to peers in the same industry regarding ESG issues and is based on financial materiality as the determinant in ESG reporting?

Answer 11

The Sustainability Accounting Standards Board (SASB).

Question 12

What does the SASB mean/do?

Answer 12

The Sustainability Accounting Standards Board (SASB).

Provides for benchmarking to peers in the same industry regarding ESG issues and is based on financial materiality as the determinant in ESG reporting

Question 13

What does the TCFD mean/do?

Answer 13

The Task Force on Climate Related Financial Disclosure.
It creates optional disclosures that firms can provide to their stakeholders

Question 14

What entity creates optional disclosures that firms can provide to their stakeholders?

Answer 14

The TCFD

Question 15

What are the six steps to KPMG’s Framework for ESG Materiality Assessment?
1. I+A
2. A+P
3. I+I
4. M+M
5. A+R
6. E+R

Answer 15

1. identify and analyse
2. assess and plan
3. implement and integrate
4. monitor and measure
5. assure and report
6. evaluate and revise

(this is fucking bullshit)

Question 16

What are the two ways that the SASB Materiality Map looks at ESG?
What are the five ESG categories? How many subcategories?
How many categories/subcategories for industry? Result number of areas for the map?
What are the three possible ratings for an area?
What is the overall intention of the SASB MM?

Answer 16

Looks at ESG from both an ESG category and the industry category.
Five ESG categories: environment, social capital, human capital, business model/innovation, leadership/governance. 25 subcategories in total.
10 industry cats, 75 sub cats.
2000 total areas - each is rated as likely to be material for >50% of firms, likely for <50% firms, or unlikely.
Intention is to make it easier to determine the effect of ESG in a given industry subgroup.

Question 17

How to determine ESG materiality (formula)?

Answer 17

ESG materiality = the probability of a material ESG event occurring * expected loss

i.e. a function of likelihood of impact and severity of impact

Question 18

What are three phases of the impact of adverse ESG events?
1. e
2. t
3. u

Answer 18

1. emerging (pre-financial) - change begins that eventually has ESG impacts for an industry
2. transitional - change is obvious but there is uncertainty regarding timing and monetary impact
3. ultimate (financial) - complete monetary impact of the ESG event is known

Question 19

What are the six UN PRIs?
1. incorporate
2. active/policies
3. disclosure
4. promote
5. implement
6. report

Answer 19

1. incorporate ESG issues into analysis and decision making
2. be active owner and incorporate ESG into policies/practices
3. seek disclosure on ESG issues by the entities invested
4. promote implementation of the principles within the investment industry
5. work together to enhance effectiveness in implementing the principles
6. report on activities and progress toward implementing the principles

Question 20

How many UN SDGs are there? Key themes are
1. better __ and ___
2. lowering __ and ___
3. reducing ___

Answer 20

17 Sustainable Development Goals.
Around themes of
1. better incomes and living conditions
2. lowering poverty/hunger and inequality
3. reducing effect of climate change

Question 21

What is ESG approach in the US?
1. IAA 1940 - two criteria, so means…
2. some client-imposed…
3. regulations require…
4. due to minimal regulations there is a risk of

Answer 21

1. Investment Advisors Act of 1940 - says ESG investing is allowed when it will enhance the client’s risk-adjusted return, and this is the sole objective when considering ESG.
2. in situations when ESG is client-imposed, there must be acknowledgment that it may reduce portfolio efficiency
3. regulations require public companies to discuss material ESG issues in key reporting documents
4. due to minimal regulations there is a risk of greenwashing

Question 22

What is the definition of greenwashing?

Answer 22

Greenwashing describes a situation where potential investors are deliberately misled about the positive social impacts of an investment

Question 23

ESG approach in Europe.
1. The EC has regulations on managers’ duties around sustainability and that are meant to increase the level of _____
2. in general there is
3. currently a lack of clarity around whether managers must accept

Answer 23

1. 1. The EC has regulations on managers’ duties around sustainability and that are meant to increase the level of transparency by portfolio companies’ ESG policies
2. in general, growing emphasis on ESG disclosure
3. lack of clarity around whether must accept potentially reduced risk-adjusted returns for their clients/beneficiaries in favour of the positive social outcomes of ESG

Question 24

ESG in Asia.
1. a large number of investors …
2. Hong Kong has introduced the HKSFfGF which is a major

Answer 24

1. a large number of investors have not considered ESG issues in investment selection to a meaningful degree, as they are not yet required to do so
2. HK has introduced the Hong Kong Strategic Framework for Green Finance which is a major step towards ESG

Question 25

Who is the most qualified staff member to manage a firm’s ESG compliance?
What can be do to address potential issues?
1. audit mm to check for…
2. develop p and p
3. put in place …
4. mitigation strats
5. audit IDs to check they are

Answer 25

The firm’s CCO is probably the best placed person.
1. audit marketing materials to check for potential greenwashing
2. develop policies and processes
3. put in place controls to ensure compliance with ESG requirements as stated in fund offerings
4. formulate mitigation strategies for ESG risks
5. audit investment decisions to check in line with policies

Question 26

What is a negative externality?

Answer 26

Collateral damage to innocent bystanders resulting from a business transaction between two or more parties. i.e. pollution

Question 27

Pollution can be said to be a NE.

Answer 27

Negative externality

Question 28

What is the phrase for the overconsumption and undervaluation of common-use (societal) assets for example leading to climate change (TOTC)

Answer 28

Tragedy of the commons

Question 29

What is the Coase Theorem? How does it apply to ESG?

Answer 29

The Coase Theorem states that in normal markets, government intervention regarding property rights has no impact on efficient production and distribution. Applying this to ESG, suggests that the creators and sufferers of negative externalities do not require the application of the law to come up with the best solution to a dispute. e.g. can and trade programs

Question 30

What is a cap and trade program?

Answer 30

Government program that allows for the trading of pollution allotments or other rights that have negative externalities. Cap and trade programs seek to offer results-based incentives for reducing these externalities or creating positive externalities.

Question 31

Impact investing refers to the integration of ESG into the asset allocation and security selection decisions with the dual objective of:

Answer 31

Maximizing risk-adjusted financial returns alongside the creation of a positive social and environmental effect.

Question 32

What categories of investments are the best candidates for impact investing because they often involve ventures that would not normally be financed in regular markets/

Answer 32

VC and PE.

Question 33

The GIIN (means?) outlines three aspects of impact investing:
1. I
2. FR
3. IM

Answer 33

The Global Impact Investing Network (GIIN) outlines three aspects of impact investing:

1. intention - deliberate attempt to add value to society and the environment
2. financial returns - required return is positive (e.g., nonzero) and can be anywhere from a below-market to risk-adjusted return
3. impact measurement - clear duty to measure and report investment performance from a societal and environmental perspective

Question 34

Three categories of impact investing in the US?
1. M
2. P
3. E

Answer 34

1. MRI - mission-related investments: aim to provide reasonable risk-adjusted returns together with an ESG effect
2. PRI - program-related investments: provide below-average or no risk-adjusted returns together with an ESG effect
3. enviropreneurship - dual objective of earning profits and meeting ESG goals, with opportunities emanating from entrepreneur

Question 35

Difference between MRI and PRI?
- tax
- 3 characteristics of PRI (main reason, low priority, political)

Answer 35

MRI (mission-related investment) seeks to generate reasonable risk-adjusted returns together with an ESG effect, while PRI (program-related investment) seeks below-average or no risk-adjusted returns together with an ESG effect.

Difference is important because US tax rules allow tax free distributions from a PRI to a nonprofit entity.

Three characteristics:
1. main reason is to address the foundation’s purpose(s) that qualifies for tax exemption
2. cap gains/investment income is low priority
3. no lobbying or political objectives

Question 36

Five typical steps for impact investing implementation:
1. specify M and V - general purpose and intended outcomes
2. creating impact T (narrow down, E-S-G, materiality used)
3. develop P (targets for single investment, within portfolio use graph -see graph)
4. create and assess DF
5. PC and M (TD and BU)

Answer 36

1. specify mission and values - ie. general purpose and ensure everyone on same page re intended outcomes
2. creating impact themes - i.e. narrowing down the focus, is it on E, S or G, or combination. Materiality could be used as a constraint to determine which themes are given greater priority based on potential impact
3. develop policy - for a single investment consider three targets of risk, return and impact. At a portfolio level these will vary, and can be shown on a graph (triangle graph between the three targets)
4. create and assess deal flow
5. portfolio construction and management (top down and bottom up).

Question 37

Study showed impact PE fund returns were lower than non-impact by _____
Variation in willingness to sacrifice returns dependent on ___ and ____.

Answer 37

Lower by 3.4% - 4.7% (IRR).
Variation depending on industry (bank, insurance company) and geography (Europe, Africa). The same was true for program-focused investors and those with political or regulatory constraints

Question 38

ESG impact valuations - numerator and denominator example. What is this suggesting?

Answer 38

ESG has clear impact on future cash flows (numerator of valuation equation), but also perhaps should be assigned a lower discount rate (denominator of valuation equation), thereby implying lower risk and resulting in a higher valuation?

i.e. implication that firms with higher ESG scores have future cash flows that are less risky and, therefore, deserve a higher valuation

Question 39

Three reasons for an against Special Consideration of ESG Issues?

For:
1. Returns after relevant adjustments (single-factor models)
2. Moral obligation ESG risk
3. Intangible benefits

Against:
1. Returns after relevant adjustments (multifactor models)
2. Fiduciary duty
3. Personal view

Answer 39

For:
1. Returns after relevant adjustments (single-factor models) for firms embracing ESG are equal to or slightly better
2. Managers have moral obligation to shield their investors from harm caused by ESG risks (e.g., lawsuits, fines)
3. Creates intangible benefits to investors and the general population

Against:
1. Returns after relevant adjustments (multifactor models) for firms embracing ESG are equal to
2. Managers have a fiduciary duty to maximize risk-adjusted returns for the client
3. Taking into consideration consideration their own personal beliefs which should be irrelevant when investing money for others