CAIA L2 - 2.5 - ESG Analysis and Application

Question 1

Explain

Fairer distribution of returns between stakeholders
vs
maximizing shareholder returns

2.5 - ESG Analysis and Application

Answer 1

“Fairer distribution of returns between stakeholders”
is a key objective of ESG investing
and it assumes that it is
acceptable at times for other stakeholders to benefit
(e.g., higher-paid employees or corporate contributions to the community)
at somewhat of a cost to equity shareholders
(e.g., lower investment returns).

2.5 - ESG Analysis and Application

Question 2

Discuss

ESG investing
add value / enhance risk return?

2.5 - ESG Analysis and Application

Answer 2

• Not conclusive that enhance risk-return
• Mitigates tail risk
• activist ESG investors do add value for all stakeholders
• Sin-stocks outperform
• No evidence to reduce discount rate (2.5.8)

2.5 - ESG Analysis and Application

Question 3

Compare

ESG ratings
x
Credit ratings

2.5 - ESG Analysis and Application

Answer 3

ESG ratings of same firm ~0.32 from different rating agencies
Credit ratings of same firm ~0.90 from different rating agencies
‘–
ESG ratings => each rating consider different features of ESG grading

2.5 - ESG Analysis and Application

Question 4

Define

ESG materiality
(GRI - Global Reporting Initiative - Standards)

2.5 - ESG Analysis and Application

Answer 4

Issue is important enough that it could change a investment decision?

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.

In other words,
the issue is important enough to be included in the firm’s operational and investment decisions and to be disclosed to the stakeholders?
‘—
GRI
G4 materiality principle clearly states that
an 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, and, therefore, potentially merit inclusion in the report.”

According to the G4 (the fourth set of GRI Standards),
the attention given to materiality is intended to
make ESG reports more meaningful, credible, and useful to the reader.

2.5 - ESG Analysis and Application

Question 5

List

6 steps
KPMG’s Framework
for ESG Materiality Assessment

2.5 - ESG Analysis and Application

Answer 5

Materiality IP-I-MRR (implement = mid of process)
1. Identify and analyze
2. Assess and plan
3. Implement and integrate
4. Monitor and measure
5. Assure and report
6. Evaluate and revise

2.5 - ESG Analysis and Application

Question 6

Explain

Location grade
of the
SASB Materiality Map

2.5 - ESG Analysis and Application

Answer 6

SASB focuses on financial materiality

Each location get a grade of:
1. likely to be material for > 50% of firms,
2. likely to be material for < 50% of firms, or
3. unlikely to be material.

Location:
Each spot in the materiality map
=> a matrix of
25 ESG subcategories (5 categories)
x
75 industry subcategories (10 categories)
‘=
1875

2.5 - ESG Analysis and Application

Question 7

Formula

ESG materiality

2.5 - ESG Analysis and Application

Answer 7

ESG materiality = probability of occurrence of a material ESG event × expected loss

2.5 - ESG Analysis and Application

Question 8

List

3 phases
of the impact of
adverse ESG events
(ESG life cycle in industries)

2.5 - ESG Analysis and Application

Answer 8

1. Emerging (pre-financial)
   A change begins that eventually has ESG impacts for an industry.
2. Transitional
   That ESG change is obvious but there is uncertainty regarding timing and monetary impact.
3. Ultimate (financial)
   The complete monetary impact of the ESG event is known

2.5 - ESG Analysis and Application

Question 9

List

6 Principles
for Responsible Investment (PRI)

2.5 - ESG Analysis and Application

Answer 9

1. ESG in decision-making processes - Incorporate ESG issues into investment analysis and decision-making processes.
2. ESG in policies and practices - Be active owners and incorporate ESG issues into ownership policies and practices.
3. ESG disclosure in invested - Seek appropriate disclosure on ESG issues by the entities invested.
4. Promote principles in industry - Promote acceptance and implementation of the principles within the investment industry.
5. Work together to implement principles - Work together to enhance effectiveness in implementing the principles.
6. Report progress implementing principles - Report on activities and progress toward implementing the principles.

2.5 - ESG Analysis and Application

Question 10

List

17 goals
of SDG
Sustainable Development Goals

2.5 - ESG Analysis and Application

Answer 10

17 Goals of SDG:

1: No poverty
2: No hunger
3: Good health and well-being
4: Quality education
5: Gender equality
6: Clean water and sanitation
7: Affordable and clean energy
8: Decent work and economic growth
9: Industry, Innovation and Infrastructure
10: Reduced inequality
11: Sustainable cities and communities
12: Responsible consumption and production
13: Climate action
14: Life below water
15: Life on land
16: Peace, justice and strong institutions
17: Partnership for the goals

2.5 - ESG Analysis and Application

Question 11

Discuss

Fiduciary responsibilities
within the US
as they relate to ESG

2.5 - ESG Analysis and Application

Answer 11

• Advisers may include ESG issues if they will enhance investment performance
• ESG is client-imposed => with the acknowledgment that it may reduce portfolio efficiency
• Because of minimal ESG investing regulations in the United States at this time, greenwashing is a real danger

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

2.5 - ESG Analysis and Application

Question 12

Discuss

Fiduciary responsibilities
within the EU
as they relate to ESG

2.5 - ESG Analysis and Application

Answer 12

• Growing emphasis on required ESG disclosure
• No clear legislation if managers must accept risk of ESG risk-return
• Clear legislation to minimize negative environmental impacts, cut down on emissions, and reduce waste

2.5 - ESG Analysis and Application

Question 13

Complete

____ is likely the most qualified staff member
to manage the firm’s ESG compliance

and

list how to address potential ESG issues

2.5 - ESG Analysis and Application

Answer 13

chief compliance officer is likely the most qualified staff member to manage the firm’s ESG compliance

Reasons:
1. Audit marketing materials to check for greenwashing.
2. Develop ESG policies and processes that are congruent with the firm’s ESG fund offerings.
3. ESG Controls - Put controls in place that ensure compliance with ESG requirements stated in client agreements and fund offerings.
4. ESG congruence - For private fund management firms, consider the level of congruence with the ESG philosophy of the fund or adviser.
5. Mitigations to ESG risks - Formulate mitigation strategies for ESG investment risks.
6. Conduct time-series audits of investment decisions to determine congruence with the firm’s ESG policies and strategies.

2.5 - ESG Analysis and Application

Question 14

List and Explain

4 methods
of ESG investing
(selecting assets)

2.5 - ESG Analysis and Application

Answer 14

Negative Screening (exclusionary screening)
* Avoiding specific industries (tobacco, gambling, alcohol - sin stocks)

Positive Screening
* Firms with high ESG scores
* Focus here = risk reduction (not return maximization)

Engagement + Proxy voting (more active than screening)
* active engagement with investee to improve ESG standing
* In extreme cases, a proxy vote to force changes may be initiated

Impact investing
* Integrating ESG objectives into the investment process alongside financial objectives

2.5 - ESG Analysis and Application

Question 15

List

3 aspects
of impact investing
(according to GIIN
Global Impact Investing Network)

2.5 - ESG Analysis and Application

Answer 15

• Intention. There is a deliberate attempt to add value to society and the environment.
• Financial returns. The required return is positive (e.g., nonzero) and can be anywhere from a below-market to risk-adjusted return.
• Impact measurement. There is a clear duty to measure and report investment performance from a societal and environmental perspective.

2.5 - ESG Analysis and Application

Question 16

List

2 Categories
of impact Investing
(classification in US)

2.5 - ESG Analysis and Application

Answer 16

Mission-related investments (MRIs)
aim to provide reasonable risk-adjusted
returns together with an ESG effect.

Program-related investments (PRIs)
provide below-average or no risk-adjusted
returns together with an ESG effect.

’–
PRI
=> nonprofit entities make PRI => can make tax-free distributions from those investments
3 characteristics:
1. PRI for foundations purposes (tax exemption)
2. Capital gains / investment income = low priority
3. No lobbying or political objectives

2.5 - ESG Analysis and Application

Question 17

Define

Enviropreneurship

2.5 - ESG Analysis and Application

Answer 17

dual objective of
earning profits and
meeting ESG goals.

Such investment opportunities usually emanate from the entrepreneur as opposed to being suggested by investors or governments.

2.5 - ESG Analysis and Application

Question 18

List

5 steps
in implementing
Impact Investing

2.5 - ESG Analysis and Application

Answer 18

1. Specify mission and values
2. Creating impact themes
3. Develop impact investment policy (risk, return, and impact triangle)
4. Create and assess deal flow (ESG ratings and data from ESG materiality analysis)
5. Portfolio construction and management

2.5 - ESG Analysis and Application

Question 19

Contrast

Return (IRR) of
impact funds
vs
regular venture capital funds
‘–
Impact fund investor willing to sacrifice IRR
vs
other PE funds

2.5 - ESG Analysis and Application

Answer 19

IRR 4.7% lower
“Somewhat lower, according to Schweser”
for impact funds compared to
regular venture capital funds

Impact fund investors
were willing to sacrifice 3.4% in IRR (on average)
compared to other PE funds

2.5 - ESG Analysis and Application

Question 20

Define

Negative externalities

2.5 - ESG Analysis and Application

Answer 20

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

Examples of ESG-related externalities include
pollution and noise.

2.5 - ESG Analysis and Application

Question 21

Define

Tragedy of the commons

2.5 - ESG Analysis and Application

Answer 21

overconsumption and undervaluation of common-use (societal) assets
such as water, roads, and public parks.

Because the costs of such items are largely or completely pooled and divided amongst everyone, there is no incentive to limit consumption.

Good example of Tragedy of the commons => Climate change

In applying that concept in the context of ESG, consider the issue of climate change, which is long-term harm to the billions of inhabitants of the world caused by perhaps millions of entities. However, a single entity contributes only an infinitesimal portion to climate change, so there is very little incentive for the single entity to change its business practices because it may not feel that the harm it causes is significant.

2.5 - ESG Analysis and Application

Question 22

Define

Coase Theorem

2.5 - ESG Analysis and Application

Answer 22

Coase Theorem applied on ESG states that the best solution in a ESG issue (negative externality created from one party that affects another) is reached between them, without necessity of a legal intervention

The Coase Theorem states that under ideal economic conditions, where there is a conflict of property rights, the involved parties can bargain or negotiate terms that will accurately reflect the full costs and underlying values of the property rights at issue, resulting in the most efficient outcome.

In applying the concept to the ESG world, the creators of negative externalities and the sufferers of negative externalities do not require the application of the law to come up with the best solution to a dispute.

2.5 - ESG Analysis and Application

Question 23

Define

Cap and Trade
(in ESG issues)

2.5 - ESG Analysis and Application

Answer 23

Government program to trade and desincentivate negative externalities

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.

2.5 - ESG Analysis and Application

Question 24

List

Reasons
for and against
Special Consideration

2.5 - ESG Analysis and Application

Answer 24

Reasons for Special Consideration

1. positive evidence on returns on single-factor models - After accounting for all relevant adjustments (single-factor models), the past returns of firms that embrace ESG issues are either equal to or slightly better than those that do not.
2. Reduce ESG risks - Managers have a moral obligation to shield their investors from harm caused by ESG risks (e.g., lawsuits, fines).
3. Intangibles to investors and population - Managers who actively integrate ESG into investment decisions create intangible benefits to investors and the general population.

Reasons Against Special Consideration

1. no evidence of additional returns on multifactor models - After accounting for all relevant adjustments (multifactor models), the past returns of firms that embrace ESG issues are equal to those that do not.
2. Managers with fiduciary duty to maximize risk-adjusted returns - Managers generally have a fiduciary duty to maximize risk-adjusted returns for the client.
3. Managers ESG beliefs with others money - Managers who actively integrate ESG into investment decisions are taking into consideration their own personal beliefs, which should be irrelevant when investing money for others.

2.5 - ESG Analysis and Application