Chap 7 Flashcards
1
Q
ESG ANALYSIS, VALUATION AND INTEGRATION
A
There are many approaches to ESG analysis and a multitude of ESG integration tools and techniques.
These methods span from company analysis, asset valuation, portfolio decision making and into stewardship.
ESG analysis methods use various data sources ranging from commercially available databases to primary analytical research.
This chapter gives an overview of common and major techniques, a summary of major ESG research providers and case studies of ESG integration in practice across a range of investment strategies.
2
Q
WHY INVESTORS INTEGRATE ESG
A firm may have several different aims and objectives for integrating ESG into an investment process. These may include:
A
A. meeting requirements under fiduciary duty or regulations;
B. ***meeting client and beneficiary demands;
C. ***lowering investment risk;
D. ***increasing investment returns;
E. giving investment professionals more tools and
techniques to use in analysis;
F. ***improving the quality of engagement and stewardship activities; and
G. *** lowering reputational risk at a firm level and investment level.
We will look at each of these objectives in the following sections.
3
Q
A. and B. Meeting requirements under fiduciary duty or
regulations; or meeting client and beneficiary demands
A
A significant number of investment professionals still do not integrate ESG.
According to a 2017 CFA Institute global ESG survey, 24% of equity investors, 55% of fixed income investors and between 79% and 92% of alternative asset investors (across private equity, real estate, infrastructure and hedge funds) do not integrate ESG into their processes.
→ The global ESG survey is covered in Chap 8.
However, these investors, or their asset owner clients, may fall under certain country regulations, such as the EU Shareholder Rights Directive or the UK’s Department of Work and Pensions’ (DWP) regulations.
In these cases, the regulations or clients may demand a certain level of ESG integration even though the investor may not believe ESG integration enhances return or lowers risk. The aim is to meet minimum regulatory obligations or client demands.
4
Q
C. and D. Lowering investment risk and increasing investment returns
Many investors seek to integrate ESG into investment processes to better understand and lower investment risk. Some also seek to enhance returns via ESG by seeking higher alpha. Recent surveys suggest that more firms do so to lower the risk rather than enhance returns, but some firms do both.
A
E. and F. More tools and techniques to use in analysis and in improving the quality of engagement and stewardship activities
Judging by ESG surveys undertaken by both academics and investment practitioners, not all firms believe ESG integration leads to better risk-adjusted returns. However, many ESG integration tools, such as scorecards (see Section 2), can be used to engage with company management teams and aid stewardship activities. These same tools can also enhance the clarity of a company’s business model.
5
Q
G. Reputational risk at a firm level
A
G. Reputational risk at a firm level
6
Q
THE DIFFERENT APPROACHES TO INTEGRATING ESG
A
Describe different approaches to integrating ESG analysis into a firm’s investment process.
Describe quantitative approaches to ESG analysis across a range of asset classes: alternative investments; equities; fixed income.
Describe qualitative approaches to ESG analysis across a range of asset classes: alternative investments; equities; fixed income.
7
Q
Q or Q
A
It is important to note that ESG analysis can be either qualitative or quantitative.
Similarly, the way it is integrated can also be purely qualitative (e.g. opinion on quality of management added to the investment thesis) or quantified (e.g. impact on financial models/valuation).
There are some techniques that could be considered a hybrid of both techniques, for example, scorecards, where a qualitative judgment is turned into a quantitative score.
These tools and techniques cover different types of strategy
(passive, systematic, fundamental, active or activist) and different asset class.
8
Q
Qualitative ESG analysis
A
A. Investment teams analyse ESG data to form their opinion on the ability of the firm to manage certain ESG issues.
B. They combine this opinion with their financial analysis by linking specific aspects of the company’s ESG risk management strategy to different value drivers (such as costs, revenues, profits and capital expenditure requirements).
C. Analysts and portfolio managers then seek to integrate their opinion in a quantified way in their financial models by adjusting assumptions used in the model, such as growth, margins or costs of capital.
Certain qualitative techniques may be more suitable (or weighted differently) for different asset classes.
For instance, a judgment on management incentives (a part of G analysis) may have more weight in public equity and private equity,
less weight for fixed income investors and be deemed irrelevant for sovereign bond investors.
9
Q
Quantitative ESG analysis
A
Quantitative ESG analysis is likely to be used in investment processes that use quant models to identify attractive investment opportunities. In such cases, the ESG data is typically aggregated into an ESG factor (an ESG score), which is added to the quant models.
This could be a screen that creates the investment universe, or a quant model used to adjust valuations based on several factors (including ESG).
10
Q
Highlights between the quantitative approaches and qualitative approaches and terminology confusion
A
Combining this information can be confusing due to the different meanings investors give to the term ‘quantitative’.
As a description of an analytical technique, it tends to be used when a numeric score is assigned. But, it can also be used to describe a whole class of investment strategy that tends to use stock, bond, derivative or other security factor properties as the main basis for investment.
In terms of investment strategies, quantitative (sometimes contracted to ‘quant’) investing can be known as ‘systematic investing’. It can include strategies such as high-frequency trading, use of algorithms based on news or factors and statistical arbitrage, and can also include trend-following, risk parity or beta strategies. The approach tends to use heavy mathematical modelling, computing power and data analysis potentially including machine and natural language learning processes. Some firms solely use these approaches and some use them to supplement human decision-making.
Typically, computer and mathematical models are built and then backtested. Where these models use ESG data or information (for instance through raw data or ratings agencies), this is considered a form of ESG integration. This produces many challenges, as the length of time series for ESG data (usually between 7–15 years depending on the series) is much shorter than for financial data.
***This typically might be viewed as a quantitative investment form of integrating ESG.
11
Q
Qualitative forms of analysis typically use human judgment of non-numerical forms of analysis.
A
** However, advances in techniques are blurring these traditional boundaries. For instance, machine learning’s use of natural language processing and scanning of management commentary from meeting transcripts are using those qualitative words in a quantitative fashion.
12
Q
Classification on active versus passive
A
Another way of classifying strategies is by considering how ‘active’ or ‘passive’ a strategy is, or how human ‘discretionary’ or computer algorithm based the strategy is.
Investors debate this, with some investors considering certain quantitative investment strategies as more passive due to the limited human discretion (but noting that humans programme the algorithms);
however, other investors argue that the choices in quantitative investment strategies are still active choices.
An investment class that is often viewed as sitting between fundamental active and passive index tracking strategies is often called beta (or **smart beta) or factor strategies.
Here certain factors (such as momentum, which is a security characteristic not a business/company characteristic) are chosen as investment criteria.
It is worth noting whether certain ESG factors are valuable quantitative investment factors as well.
***Fundamental active strategies where human judgment is used will tend to use ESG techniques that have both qualitative and quantitative elements to them but are typically not considered quantitative investment.
And similarly, with quantitative investment strategies that use ESG ratings data, that ESG ratings data may be based on qualitative human judgment.
Overall, ESG techniques can be considered quantitative or qualitative or will have elements of both.
Investment strategies are typically classified as quantitative (systemic, algorithmic), fundamental, active, passive or beta.
Investors interchange the term ‘quantitative’, but provide different meanings when applied to overall investment strategies and processes as opposed to specific ESG integration techniques.
13
Q
Elements of ESG analysis
The elements of ESG analysis include:
A
▶ red flag indicators. Securities with high ESG risk are flagged and investigated further or excluded.
For instance, a company which has a board that lacks majority independence may be flagged for deep scrutiny on management incentives or simply be excluded from an investable universe.
▶ company questionnaires and management interviews.
For example, if there is insufficient detail on management aspects, or other material ESG information, the investor may ask the company for specific data.
Or the investor may have a prepared list of standard ESG data they ask for. These questionnaires are also used in parallel with regular company meetings, where investors and companies will meet to discuss the most material ESG issues.
▶ checks with outside experts.
For instance, an investor may interview key industry thought leaders or other stakeholders of the company including customers, suppliers or regulators. These may be complemented by interviews, surveys or third-party sourcing, such as the use of expert networks.
▶ watch lists.
These may include securities with high ESG risk added to a watch list for monitoring, or securities with high ESG opportunities which are put on a watch list for possible investment. For instance, once ESG risks/ opportunities are assessed by an investor, a news or stock price watchlist is created and monitored for stock price entry levels or for change in ESG events.
For example, a highly carbon-intense company identified with high E risk might be monitored against changing policies on carbon taxes.
▶ internal ESG research.
This may be based on a variety of techniques and data sources.
**Proprietary ESG research and analysis is performed and the output can be provided in scores, rankings or reports.
The research may be based on a variety of data sources, and proprietary ESG research or scores could be created.
Furthermore, research could consist of: **** » materiality frameworks; » ESG-integrated research notes; » research dashboards; » strengths, weaknesses, opportunities and threats (SWOT) analysis with ESG factors; » scenario analysis; and » relative rankings. *****
▶ external ESG research, where:
» sell-side, ESG specialists or third-party databases may all be used; and
» a materiality framework is created.
▶ ESG agenda items at investment committee or Chief Information Officer (CIO)-level meetings.
One technique to ensure consistent integration is to ensure an ESG section as a standing item at committee meetings. This may ensure scrutiny from senior level investors and signal importance to the investment firm.
14
Q
Elements of ESG integration
The elements of ESG integration include:
A
▶ adjusting forecast financials, for example revenue, operating cost, asset book value or capital expenditure;
▶ adjusting valuation models or multiples, for instance discount rates, terminal values or ratios;
▶ adjusting credit risk and duration;
▶ managing risk, including exposure limits, scenario analysis, value-at-risk models;
▶ ESG factor tilts;
▶ ESG momentum tilts;
▶ strategic asset allocation, including thematic and ESG objective tilts;
▶ tactical asset allocation; and
▶ ESG controversies and positive ESG events.
15
Q
Differences between company or business analysis and security analysis
A
There are two distinctions that many investment practitioners make in fundamental investment analysis:
▶ the difference between a company or business assessment; and
▶ a security, stock, bond or convertible (or other tradeable construct including derivatives) assessment.
While the differences are often interchanged in ordinary language, many investors give them different meanings. Stocks and bonds can have properties that companies do not, such as stock beta or volatility, which are potentially expressed in different ways.
A company or business assessment typically examines fundamental properties of a business, such as its competitive advantages (or lack of), sometimes described as a business moat (after the popular Warren Buffett Annual Letters).
These properties could appear in the company’s products or services,
suppliers, employees,
management, organisational structure,
incentives, corporate cultures or its resources (natural, intellectual or innovation).
16
Q
Many of these properties could be considered as under an ESG category.
For instance:
▶ natural capital as E;
▶ corporate culture or supplier analysis under S; and
▶ management structure or incentives under G.
A business may have strong aspects of ESG, which lead to an assessment of a strong or competitive advantage, which can lead to a judgment on that business or company.
The analysis of judgment on the properties of a stock or bond of a company may differ.
For instance, beta or stock volatility are properties of a stock, not of a company or business per se. This could also include a property of the company itself, although a company with very constant yearly sales may have a stock that has a low beta (of less than one).
A
This is important due to the debate amongst investors who use security factors to invest.
The debate here is whether they are ESG components that are robust quantitative ESG stock or bond factors.
This is an important debate because of how an assessment of the strength or weakness of a company or business can then lead to a valuation of its securities.
17
Q
TYPICAL STAGES OF INTEGRATED ESG ASSESSMENT
A
These can run alongside a financial analysis or have integrated aspects to the analysis. The stages typically are:
A. a research stage;
B. a valuation stage; and
C. a portfolio construction stage, which leads to investment decisions.
Each of these stages is considered in further detail in the following sub-sections.
18
Q
Research and idea generation stage
A
Gathering information
19
Q
Materiality assessments
A
The research stage typically contains a materiality assessment to identify the ESG issues that are likely to have an impact on the company’s financial performance.
Materiality is typically measured both in terms of the likelihood and magnitude of impact.
The materiality assessment is considered important as there is evidence that non-material factors do not impact financials, valuations or company business models.
It is **distinguished from some exclusionary socially responsible investing (SRI) strategies, which may also consider non-material factors, e.g. exclusion of pork-based product companies for certain religious stakeholders, which a typical investor would not deem a material ESG factor.
Investors who primarily see ESG analysis and ESG integration as a way to enhance investment processes
are likely to focus on ESG issues they consider *** financially material, i.e. a factor that will have a financial impact in the future, either positive or negative.
By contrast, investors that are primarily interested in the impacts that companies’ practices and products have on the
**environment and society are likely to focus on related ‘high impact’ ESG issues, even if these issues are not considered as the most material from a financial performance viewpoint.
This distinguishes an ‘ethical/impact investor’, who may judge factors affecting social or environmental returns, but minimal financial returns, from a responsible investor.
20
Q
Tangible versus intangible factors; different forms of capital
A tangible asset (or hard asset) are physical assets, whereas intangible assets are non-physical ones that are difficult or impossible to touch physically.
A
TANGIBLE ASSETS
- Land.
- Manufacturing plants. • Inventories.
- Furniture.
- Machinery.
INTANGIBLE ASSETS
• Goodwill. • Patents. • Copyrights. • Intellectual property and know-how. • Software and innovation assets. • Corporate culture. • Incentives. • Employee productivity. • Other forms of social and relationship assets.
APPLICABLE TO BOTH TANGIBLE AND INTANGIBLE ASSETS
- ESG analysis techniques.
- Materiality.
21
Q
Evaluating different forms of tangible or intangible factors
One framework for evaluating different forms of ‘capital’ or tangible or intangible factors was developed by the International Integrated Reporting Council (IIRC).
A
The IIRC framework (to which certain companies report) describes capitals (both intangible and tangible) as follows:
22
Q
▶ Financial capital – The pool of funds that is:
A
» available to an organisation for ***use in the production of goods or the provision of services; and
» obtained through financing, such as debt, equity or grants, or generated through operations or investments.
23
Q
▶ Manufactured capital – Manufactured physical objects (distinct from natural physical objects) that are available to an organisation for use in the production of goods or the provision of services,
including:
A
» buildings;
» equipment; and
» infrastructure (such as roads, ports, bridges, and waste and water treatment plants).
Manufactured capital is often created by other organisations, but includes assets manufactured by the reporting organisation for sale purposes or when they are retained for their own use.
24
Q
▶ Intellectual capital – Organisational, knowledge-based intangibles, including:
A
» intellectual property, such as patents, copyrights, software, rights and licences; and
» ‘organisational capital’, such as tacit knowledge, systems, procedures and protocols.
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▶ Human capital – People’s competencies, capabilities and experiences, and their motivations to innovate, including their:
» alignment with and support for an organisation’s governance framework, risk management approach, and ethical values;
» ability to understand, develop and implement an organisation’s strategy; and
» loyalties and motivations for improving processes, goods and services, including their ability to lead,
manage and collaborate.
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▶ Social and relationship capital – The institutions and relationships between communities, groups of stakeholders and other networks, and the ability to share information to enhance individual and collective well-being.
These include:
» shared norms, and common values and behaviours;
» key stakeholder relationships, and the trust and willingness to engage in an organisation that has
developed and strives to build and protect with external stakeholders;
» intangibles associated with the brand and reputation that an organisation has developed; and
» an organisation’s social licence to operate.
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▶ Natural capital – All renewable and non-renewable environmental resources and processes that provide goods or services that support the past, present or future prosperity of an organisation.
This includes:
» air, water, land, minerals and forests; and
» biodiversity and eco-system health.
It is clear to see how not all capitals (intangible or tangible) would be material or relevant to all companies, however this might require a materiality judgment (see later section on ‘Materiality assessments and risk mapping’)
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Many of the non-financial capitals would be considered under ESG, with a large number also intangible.
A qualitative identification and judgment would be considered a form of qualitative approach to ESG.
Generating ideas
Investment ideas can be generated from the data. Some practitioners start this stage using a valuation screen, or fundamental screen, which may incorporate ESG factors
– this may be a mix of positive (e.g. seek high G), negative (avoid low G) or momentum (seek rising G or avoid declining G) to create an attractive investment universe.
This is commonly referred to as ‘positive’ or ‘best-in-class’ screening.
Investment ideas can also be generated by themes associated with specific ESG megatrends.
For instance, an ESG opportunity theme might be to seek improving access to **clean water or to **energy services.
This is commonly referred to as ‘thematic’ investing.
At this stage, checklists – internal or externally-sourced – may ‘red flag’ companies and use that to narrow
the investable universe,
for instance, an acceptable low governance score or an unacceptable number of ESG controversies (real world ESG events that are contested by different stakeholders or impact society, e.g. a dam failing).
Red flag techniques can also be used in later stages.
These risks may be ESG risks judged on an absolute hurdle basis or judged against what may be ’priced into the asset’.
A materially negative assessment of a particular ESG factor or collection of factors may lead to a decision that an investment fails to meet a specified hurdle.
For example, an incentive structure deemed to be poorly aligned under a G assessment may disqualify a possible investment, the assessment triggers a ‘sell’ or ‘do not invest’ signal.
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This assessment can be:
quantitative, e.g. the carbon intensity of company A is too far above an index benchmark to meet a practitioner’s investment criteria; or
qualitative, e.g. the experience of the management team in managing environmental risk and the lack of disclosed policies may indicate risks too great for an investor on a qualitative basis.
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Scorecards can be used to assess ESG risk and opportunity
Describe how scorecards may be developed and constructed to assess ESG factors.
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As an example, a credit analyst identifies a company that has no third-party ESG rating available, but where the company is issuing investment grade bonds that might be investable.
In this case, the analyst creates their own ESG assessment. A custom ESG self-assessment tool that reflects the sector-specific risk issues relevant to the issuer is created, and the company management or investor relations team is asked to fill this out.
An ESG scorecard based on the self-assessment response is created with ESG factor scores out of 5, and high or low scores are then used in valuation or further assessment work.
Ethical marketing may, for example, be identified as a key ESG social risk (perhaps via a risk mapping process, which is covered in the next section) for pharmaceutical companies X, Y and Z:
▶ Company X has no policy and a history of violations, so they score 0.
▶ Company Y has a brief policy and no violations, so they score 3.
▶ Company Z has a detailed policy and one minor violation, so they score 4.
It may be that scores of 0 make a company unattractive and scores of 5 lead to further investment work.
Alternatively, total scores of all factors in the scorecard are used in further assessment or valuation work.
The scorecard can take a qualitative judgment of a factor and put a form of quantitative score on it.
ESG ratings agencies may provide scores and a form of scoring is typically used in commercially available ESG ratings services.
These can be used raw or adjusted by practitioners to reflect their own views. These scores can then be compiled for use in assessment or idea generation.
→ See Section 5 for more on ESG ratings agencies.
In summary, to develop a scorecard:
1. Identify sector or company specific ESG items.
2. Breakdown issues into a number of indicators (e.g. policy, measures, disclosure).
3. Determine a scoring system based on what good/best practice looks like for each indicator/issue.
4. Assess a company and give it a score.
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5. Calculate aggregated scores at issue level, dimension level (environmental, social or governance level) or total
score level (depending on the relative weight of each issue).
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6. Benchmark the company’s performance against industry averages or peer group (optional).
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Materiality assessments and risk mapping
Some ESG issues might be material for companies in a specific industry (e.g. water stress can disrupt the operations of mining or beverages companies, which rely heavily on clean water in their production processes), but not for other sectors (e.g. water stress has little impact on media or financial companies).
Determining which ESG issues are most material is not an exact science, and there might be important differences between what each investor considers most material, even when analysing the same company. This is because it is typically a forecast of judgment on how much one ESG or risk factor will impact a financial metric such as future cashflow.
Frameworks such as the materiality maps provided by the Sustainability Accounting Standards Board (SASB) are helpful in providing some guidance but investment professionals often develop their own view on what is most material.
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For instance, in the healthcare example (Figure 7.5) using the SASB materiality map, a pharmaceutical company is judged to have a material exposure to fair marketing practices.
▶ Pharmaceutical company A is judged to have a low risk to this factor because it has up-to-date policies, training programmes and has never had a regulatory warning letter.
▶ Pharmaceutical company B is judged to have a high risk to this factor because it lacks a strong policy, training is minimal and the company has received several fines and warnings from regulators.
▶ Pharmaceutical company C is judged to have no risk to this factor, as it only engages in pharmaceutical research and does not have any commercially marketed products.
Here we can see that even though the factor is material to the sector, it is of limited risk or arguably no risk to the company as the company is not exposed.
As seen earlier, the same technique can be applied to whole sectors or sub-sectors, as well as companies. For instance, biodiversity as an E factor is not seen to impact the whole pharmaceutical sector, but may have an impact on the agriculture sector.
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Using SASB as a baseline framework in a materiality assessment.
One example of where you might want to use SASB as a baseline framework in a fundamental active investment process might be for a bio-pharmaceutical company that has a cannabis plant as its raw active ingredient.
(This applies to the company GW Pharmaceuticals.)
As is shown in Figure 7.5, ‘materials sourcing’ is not considered a material ESG risk for biotechnology and pharmaceutical companies.
However, an analyst might judge that a cannabis-derived medication would be a material risk on two accounts:
1. Growing the plants is potentially a complex operation with enhanced risks compared to standard manufacturing.
2. The regulatory oversight is more complex as the drug regulator as well as the pharmaceutical regulator (in the USA, the Drug Enforcement Agency (DEA) and the Food and Drug Administration (FDA)) would both be involved. Whereas for a standard pharmaceutical, it would only be the pharmaceutical regulator that would be involved.
The analyst might further judge that there is an ESG opportunity here as well because of:
▶ the technology needed to harvest the plants;
▶ the knowledge protection around that technology; and
▶ the barriers involved in having to satisfy two regulators.
This might lead to longer intellectual property protection (and longer cashflows) as well as higher barriers to entry (and lower likelihood of competition).
In this example, the social impacts might be more complex to judge as well, whereas all the other aspects of the companies’ analysis may correspond to where SASB has judged most risk to be (e.g. energy, water and waste.
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As of 2019/20, there is a trend in company reporting to include more material ESG factors.
However, there is no agreement from various stakeholders on materiality and how to report, so developing proprietary materiality assessments may continue to be an important technique for investors to potentially develop their own analytical framework alongside standardised frameworks, such as SASB or the Global Reporting Initiative (GRI).
As SASB becomes more established as a leading materiality framework, it may be worth further investigation as there are increasing calls from stakeholders for such standardisation.
ESG risk mapping methodologies
ESG risk mapping may also be done at the research stage.
Here, an individual company (equity or credit) or sector has its risk mapped to a specific theme or factor, usually one that has been judged ‘material’.
Risk mapping could also mean mapping a portfolio or investable universe against a specific ESG risk (e.g. climate risk or water-related risks) to identify which sectors or companies contribute the most to this particular risk profile (e.g. carbon- or water-intensive companies).
Examples of risk mapping methodologies include carbon footprinting or testing portfolios against different climate scenarios.
Mapping can also be done for material opportunities (e.g. opportunity from recycling or the transition to renewable energy) as well as risks. It can be scored, for instance, on a ***10-point scale, or given a qualitative label, such as low or high risk.
This shows how the scorecard technique (described earlier) can be combined with a mapping technique.
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Quantitative, systematic and thematic approaches to integrated ESG analysis
Quantitative practitioners may assess ESG factors at the research stage typically using a third-party database, or a mix of third-party data or internal proprietary data.
This is typically done with large data sets of stocks or credits, rather than individual company assessment, although some firms will create their own proprietary scores from individual company assessment.
*** The data gathering can be similar to fundamental investors but tends to be over larger datasets.
For instance, a global dataset may contain 2,000 to 4,000 companies with 100 data points per company.
Quantitative factor investors typically integrate ESG factors alongside other factors, such as value, size, momentum, growth and volatility.
Some of these factors may be from third party models.
ESG data are included in their investment processes and could result in upward or downward adjustments to the weights of securities, including to zero.
For instance, a strong score on an environmental factor might be sought.
The aim could be to increase ESG factor returns or lower risk, or do both to increase risk-adjusted returns.
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Systematic approaches can attempt to derive correlations to understand how ESG factors might impact financial performance over time and then weight those ESG factors appropriately. They can try to assess relationships in existing ESG third-party scores as well as proprietary scores.
Algorithmic approaches use ESG data, for instance, scraped from internet news articles to adjust company or sector weights after parsing the ESG data through rules-based formulae.
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Passive and index approaches may tilt towards ESG factors chosen by investors. For instance, the Japanese Government Pension Investment Fund (GPIF) has created, with index providers, gender-tilted rules-based indices to invest in.
These could be considered ***smart-beta strategies, which shows that asset owners can set mandates accordingly to integrate ESG across differing strategies, and in line with their own ESG polices and philosophies.
Thematic funds may assess alignment with priority themes, which may have an ESG nature, e.g. climate, or gender.
This may be done with a material opportunity mapping process (as discussed earlier) or using ESG data to adjust weights accordingly.
Investors use application programming interfaces (APIs) to compile and assess data.
Companies are more forthcoming with their sustainability practices and financial practitioners are increasingly using APIs as a method to compile and integrate this rapidly growing dataset into their processes.
The number of total unique ESG data points captured is on the rise.
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Much of the ESG data available on companies is unstructured. Artificial intelligence (AI) and machine learning algorithms attempt to bring structure and numerical value to part of that unstructured dataset.
Some practitioners:
▶focus on using AI techniques to measure ESG performance tied to measures developed by the SASB;
▶attempt to provide immediate access to scores based on material ESG events as they occur; or
▶focus on intangible ESG factors, such as corporate culture, that may drive company value.
Natural language processing and other quantitative techniques are likely to continue to develop over time.
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Valuation and company integrated assessment stage
After the research stage and any relevant risk and materiality mapping (covered in section A), practitioners ***assess*** the impact of material financial and ESG factors on the corporate and investment performance of a company.
This can lead to adjustments to:
forecasted financials;
valuation-model variables, such as cost of capital or
terminal growth rates in discounted cash flow analysis;
valuation multiples;
forecasted financial ratios;
internal credit assessments; and
assumptions in qualitative or quantitative models.
Regardless of whether a hurdle process is used, adjustments in models can be made – positively or negatively – on assessment.
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Model adjustments based on ESG assessment
Discounted cash flow input adjustments
For example, a company’s environmental management processes and policies are judged strong or weak.
After this judgment, the cost of capital used to discount cash flows in a discounted cash flow (DCF) analysis is adjusted down or up by 1% to account for this.
This can also be on a country- or sector-basis, where a country or sector ESG risk factor may contribute to a change in a cost of capital or terminal value growth assumption.
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For example, the coal sector may be judged to have a negative environmental impact.
Note how the judgment on the E factor leads to a change in the financial model assumption. This is a complement. A higher cost of capital would lead – all other factors being equal – to a lower intrinsic value estimate from the model. This is an example of how the E factor then impacts a valuation model.
Also note the sizing of the adjustment is typically at the discretion of the analyst, although there may be guidelines the analyst utilises.
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Explicit profit and loss sales, balance sheet and margin adjustments from ESG assessment
Rather than changing model discount assumptions, ****explicit sales or margin assumptions*** may be adjusted.
For example, an analysis of a company’s strong management of its employees (as assessed by employee engagement or satisfaction metrics) leads to an assessment of strong future customer satisfaction, which in turn leads to sales forecasts five years out being raised to above the industry average to account for this strong social factor score.
An adjustment can be a direct impact, e.g. an assessment of an environmental litigation fine being US$400m (£307m), or the risk adjusted impact of a carbon tax might be forecast to be an absolute dollar amount per year in a model.
Adjustments can be made direct to the balance sheet or capital expense lines.
A practitioner may believe that ESG factors will lead a company to decrease or increase its future capital expenditure.
A forecast ESG impairment event, e.g. a sub-standard factory, may result in an impairment charge being made to bring the company’s book value down.
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Valuation ratio adjustments with ESG integration
Adjustments can also be made to valuation ratios. An investor may decide a company is worth a certain price/ earnings (PE) ratio premium/discount versus its peers due to ESG factors.
Alternatively, an investor may only be prepared to invest in a company with, for example, a 50% discount on a PE ratio versus an index benchmark because the company is judged to have a high ESG risk.
Or conversely, an investor may be willing to invest in a company at a 50% premium on a PE ratio due to strong ESG characteristics.
The adjustment may also be absolute.
For instance, the investor may assign a “fair value PE” of 16x to a strong ESG company vs 14x for an average ESG company and 12x for a weak ESG company.
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How ESG analysis can complement traditional financial analysis
A few theoretical examples can now be examined.
(These examples might be useful for thinking about how ESG factors affect industry and company performance. They show how integrated many ESG techniques and thinking are.)
One theoretical concept in fundamental analysis might be:
Weak or strong ESG factor:
```
→ weak or strong business driver or moat;
→ up or down sales or margins;
→ up or down long term cash flow;
→ up or down intrinsic value;
→ up or down share price.
```
This might be expressed as:
High employee engagement or satisfaction (proved by being number one vs. competition on surveys or 35% higher score):
→ high customer satisfaction (judged by high net promoter score);
→ higher sales growth than competition;
→ higher valuation than competition.
The judgment of an intangible ESG factor, such as employee relations, complements an analysis of customer satisfaction and the assumptions that lead into a model of sales growth (a traditional financial factor).
Alternatively:
High carbon intensity (proved by scope 1 and 2 carbon intensity being both absolute and relative to sector):
→ increased risk from carbon taxes;
→ increased cost of debt for new project financing;
→ higher taxes;
→ increased balance sheet risk of default on debt;
→ change in debt rating;
→ lower value of corporate debt.
Here, the judgment of an E factor, such as exposure to carbon, leads to analysis on the risk to debt pricing. It complements a traditional take on default risk.
Alternatively:
Weak governance identified in a private company (proved by board with poor skills, not independent, non- diversified thinking):
→ increased risk of negative capital allocation decisions;
→ lower future cash flows or difficulty in initial public offering (IPO) to capital markets;
→ lower valuation or increased bankruptcy risk.
Here, a judgment on a G factor in a private company impacts both a valuation and possible exit for a private equity investor.
46
Active ownership as an ESG technique
It is worth noting here how integration with a stewardship function – whether outsourced or part of the same investment team – might work here in an integrated ESG approach. For instance, a stewardship-led investment team may gain a commitment or an action to improve, e.g. weak governance by gaining a commitment to recruit independent board members and an independent chair – and thereby, influencing future cash flows and valuations.
Such strategies may come under an active ownership or ESG activist approach.
Information gained from an active engagement may also inform the ESG and traditional analysis, for instance, a management team’s unwillingness to disclose carbon emissions and not commit to future disclosure may impact an investment team’s ESG analysis.
47
The challenge of company disclosure on ESG topics
Companies have variable disclosure policies and reporting.
While for listed companies, minimum accounting reporting standards are adhered to, these standards vary in different regions.
Much ESG data is not compulsory under typical reporting standards.
Although ‘material factors impacting financials’ is a standard reporting idea, management has large flexibility in what is chosen to be reported.
Conversely, there can be a problem of over- disclosure – particularly of non-material ESG information.
Simply because a company does not disclose relevant ESG data does not necessarily mean it is managing
its ESG risks or opportunities poorly.
Smaller companies with fewer resources typically put less effort into reporting disclosure.
There are geographical differences in reporting, so cultural differences can lead companies to assume different judgments on the materiality of certain ESG factors.
Management may also assume certain information is of limited importance to investors or is commercially sensitive.
It might be that ESG information is available to other stakeholders e.g. supply chain information to suppliers, or supply chain audit to business customers, but is not publicly available to investors.
That said, a lack of disclosure could be an indicator of poor management and ****many investors prefer to see relevant disclosure so judgments can be made.
One common technique is to ask company management, often investor relations, to disclose, where possible, missing ESG data or ****explain why it might be missing.
Other issues are that an ESG disclosure when revealed might be ***unaudited, not complete or not comparable to other companies.
While poor disclosure is a challenge to market efficiency, this relative inefficiency could arguably be a source of superior risk-adjusted return for the skilled investor.
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Case study 4
ESG DCF scenario analysis
Adapted from RBC Global Equities, RBC Global Asset Management, example case study.4
This investment team uses an integrated approach. Rather than having separate ESG analysts,
the team’s portfolio managers perform and integrate ESG analysis. They believe this is a better
way to value and assess stocks. The team use multiple sources of ESG information as it represents an abundance of ESG-related opinions that require interpreting, and portfolio managers are best placed to filter this advice and ascertain how it relates to a company’s business model and valuation.
The team starts with a fundamental analysis to identify any material positive or negative ESG factors. The team embed that assessment into an analysis of the competitive position and the sustainability of the business, which they put into valuation models. They aim to invest only in companies that perform strongly in four areas:
▶ business model;
▶ market share opportunity;
▶ end-market growth; and
▶ management and ESG.
The Global Equities team identified several ESG risks (contingent liabilities) and ESG opportunities (contingent assets) for a leading healthcare insurer and a healthcare cost management and IT provider managing 5% of US healthcare spending.
ESG risks
As custodians of the personal and medical details of millions of people, the company needs to keep the data secure: false savings here can have long-term consequences, including regulatory risks, political risks and the potential impairment of the company’s social contract with customers and the wider society.
The team challenged management on the risk of privacy data breaches, asking how that risk is being managed and what policies are in place to mitigate that risk. Management acknowledged that information about their data security was not available on their website, but several management members reassured the team about the quality of the policies, training, and general operation management of data handling and security that are in place. Nevertheless, the team still modelled a DCF valuation scenario looking at the possible impact of privacy data breaches.
ESG opportunities
The data analytics business was viewed as an ESG potential. The analytics business allows it to create cheaper, better healthcare options for businesses, governments and patients, creating strong competitive advantage and an ESG contingent asset. For instance, it identified 150 diabetic patients not taking their medication properly, 123 of whom were in Texas, which enabled its client to implement location-specific measures utilising preventive healthcare techniques.
In another instance using its data analytics, a US state department discovered clusters of patients with asthma in certain streets and buildings, and found that those buildings correlated with cockroach infestations, allowing it to successfully prosecute inefficient landlords and ultimately raise living standards for tenants.
The team assessed the materiality of all of this information and assigned a rating for the four components of the company’s strengths:
business model;
▶ market share opportunity;
▶ end-market growth; and
▶ management and ESG.
The team then performed a DCF scenario analysis embedding the material ESG risks and opportunities. The team prefers DCF and explicit model scenarios for sales, margins and asset turns, because they are judged as a more accurate method of modelling than an adjustment to a discount rate or terminal value for a company specific assessment. Sum-of-the-parts and standard financial ratio assessments are also performed.
The analysis was peer-reviewed within the team and the assumptions were stress-tested, challenged and refined before the rating and valuation were confirmed. In the peer review, assumptions are flexed in real time to see how further valuation scenarios change. These include:
▶ for the upside scenario – increasing EBIT margins and sales growth; and
▶ for the downside scenario – normalising sales to a lower growth rate (3%) and
looking at the sales impact over more than one year.
The core findings supported significant valuation upside and limited probability of mild downside. The stock was then added to the portfolio after a portfolio construction process.
49
Case study 4
ESG DCF scenario analysis
Adapted from RBC Global Equities, RBC Global Asset Management, example case study.4
This investment team uses an integrated approach. Rather than having separate ESG analysts,
the team’s portfolio managers perform and integrate ESG analysis. They believe this is a better
way to value and assess stocks. The team use multiple sources of ESG information as it represents an abundance of ESG-related opinions that require interpreting, and portfolio managers are best placed to filter this advice and ascertain how it relates to a company’s business model and valuation.
The team starts with a fundamental analysis to identify any material positive or negative ESG factors. The team embed that assessment into an analysis of the competitive position and the sustainability of the business, which they put into valuation models. They aim to invest only in companies that perform strongly in four areas:
▶ business model;
▶ market share opportunity;
▶ end-market growth; and
▶ management and ESG.
The Global Equities team identified several ESG risks (contingent liabilities) and ESG opportunities (contingent assets) for a leading healthcare insurer and a healthcare cost management and IT provider managing 5% of US healthcare spending.
ESG risks
As custodians of the personal and medical details of millions of people, the company needs to keep the data secure: false savings here can have long-term consequences, including regulatory risks, political risks and the potential impairment of the company’s social contract with customers and the wider society.
The team challenged management on the risk of privacy data breaches, asking how that risk is being managed and what policies are in place to mitigate that risk. Management acknowledged that information about their data security was not available on their website, but several management members reassured the team about the quality of the policies, training, and general operation management of data handling and security that are in place. Nevertheless, the team still modelled a DCF valuation scenario looking at the possible impact of privacy data breaches.
ESG opportunities
The data analytics business was viewed as an ESG potential. The analytics business allows it to create cheaper, better healthcare options for businesses, governments and patients, creating strong competitive advantage and an ESG contingent asset. For instance, it identified 150 diabetic patients not taking their medication properly, 123 of whom were in Texas, which enabled its client to implement location-specific measures utilising preventive healthcare techniques.
In another instance using its data analytics, a US state department discovered clusters of patients with asthma in certain streets and buildings, and found that those buildings correlated with cockroach infestations, allowing it to successfully prosecute inefficient landlords and ultimately raise living standards for tenants.
The team assessed the materiality of all of this information and assigned a rating for the four components of the company’s strengths:
business model;
▶ market share opportunity;
▶ end-market growth; and
▶ management and ESG.
The team then performed a DCF scenario analysis embedding the material ESG risks and opportunities. The team prefers DCF and explicit model scenarios for sales, margins and asset turns, because they are judged as a more accurate method of modelling than an adjustment to a discount rate or terminal value for a company specific assessment. Sum-of-the-parts and standard financial ratio assessments are also performed.
The analysis was peer-reviewed within the team and the assumptions were stress-tested, challenged and refined before the rating and valuation were confirmed. In the peer review, assumptions are flexed in real time to see how further valuation scenarios change. These include:
▶ for the upside scenario – increasing EBIT margins and sales growth; and
▶ for the downside scenario – normalising sales to a lower growth rate (3%) and
looking at the sales impact over more than one year.
The core findings supported significant valuation upside and limited probability of mild downside. The stock was then added to the portfolio after a portfolio construction process.
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Discussion of private markets, real estate and infrastructure
Real assets (like real estate and infrastructure) carry certain advantages and challenges compared to the equities and corporate fixed income investment universe.
In many cases, investors are majority owners or own the asset outright.
Majority or full ownership stakes offer investors much greater control over the definition, application and reporting of ESG data alongside or outside existing reporting standards like that of the GRI, or use of Global Real Estate Sustainability Benchmark (GRESB, founded in 2009).
The materiality frameworks used may have philosophical similarities – as in material ESG factors – but the identification of those factors may differ.
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GRESB’s full benchmark report provides:
▶ a composite of peer group information;
▶ overall portfolio key performance indicator (KPI) performance;
▶ aggregate environmental data in terms of usage and efficiency gains;
▶ a GRESB score that weights management, policy and disclosure, risks and opportunities and monitoring and Environmental Management Systems (EMS);
▶ environmental impact reduction targets; and
▶ data validation and assurance.
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This type of report depends heavily on companies participating in the GRESB reporting assessment process.
Looking at commercial and residential real estate historically, the sectors arguably had little regard for ESG factors (especially pre-2009 before GRESB).
Often the tenants and operators might think differently to the owners and constructors (sometimes called a ‘split incentive problem’) as tenants must pay ongoing energy bills, which constructors do not.
Buildings also have a carbon footprint. An integrated ESG view may look at reducing the carbon footprint through building with more efficient materials and standards and hence, lowering the risk of impact from carbon prices or deriving gains from energy efficiencies.
Like unlisted credit and real asset private markets, ESG integration in private equity faces a number of challenges, foremost being the lack of public transparency, established reporting standards, regulatory oversight and public market expectations around ESG.
In addition, smaller, private companies are often capacity-challenged by ESG reporting requirements. Private equity investors may have to negotiate with a strong founder or founder team.
But, early investors and significant shareholders can be strategic and long-term oriented, creating a powerful incentive to establish a strong set of ESG KPIs early in the company’s life cycle; or by setting important cultural values.
Some investors will perform a materiality analysis much like public equity investors might do, the same SASB framework might be used or developed via the private equity industry, e.g. the British Venture Capital Association (BVCA) Responsible Investment Framework.
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Discussion of ESG in fixed income and differences to equity.
Historically, corporate bond practitioners adapted the materiality and sustainability frameworks as well as ESG techniques used by equity investors.
More recently, newer techniques specifically adapted to bonds have been used. This is because bonds differ by:
```
▶ credit quality;
▶ duration;
▶ payment schedules;
▶ embedded options;
▶ seniority;
▶ currencies;
▶ collateral; and
▶ time horizon.
```
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Fixed income investors (corporates) will often see similar principles in materiality and ESG frameworks but adapt to where a material item is different for a bond holder. '
The opportunity side of ESG may be less relevant for bond investors as it is typically the impact of ESG factors on a company’s ability to pay its debt obligations that are foremost in a bond investor’s analysis.
ESG scores (whether third party or internal) go along side or are integrated into **internal credit analysis and investment decisions.
Sovereign debt investors have started to analyse ESG, but it has not been easy to borrow the same materiality frameworks as equity or corporate debt investors.
This is because some factors (such as peace, corruption, ease of doing business, freedom of expression, education levels and regulatory and legal robustness) may be the ESG factor to consider, which are typically not material in the same way as to equity or corporate equity or bond investors.
Furthermore, a material factor (such as climate or carbon policy) will interact with analysis and valuations differently.
This makes turning ESG analysis into meaningful judgments on the credit ratings or spreads for sovereign nations difficult.
That said, certain ESG factors (such as political risk and governance factors) have typically been integrated into sovereign debt investors even if not explicitly labelled ESG.
55
Municipal credit ESG analysis can differ again. In the municipal space (region, state or city) both the issuer’s governance and management practices can be assessed as well as their:
```
▶ overall transparency;
▶ reporting;
▶ corruption levels;
▶ budgetary practices;
▶ pension liabilities; and
▶ contracts.
```
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Some investors will view municipals investing for inclusive communities as lower risk investment due to the social benefits.
Alternatively, there can be co-primary outcomes, where market rate returns are expected alongside social impact.
This differs from social impact, which is not always expected to make market rate (risk-adjusted) returns.
Environmental factors (such as the region’s air quality and associated health risks for its constituents) and the quality of public infrastructure (such as wastewater treatment plants) can all pose risks that may affect an issuer’s ability to repay its debt.
Overall, while there are philosophical similarities in identifying material ESG factors and then applying those to the analysis, the type of factors can differ across asset classes and the type of integration techniques can alter as well.
57
Challenges to ESG integration
There are many hurdles and challenges for ESG integration.
These include:
```
▶ Disclosure and data-related challenges, such as:
» data consistency;
» data scarcity;
» data incompleteness; and
» lack of audited data.
```
▶ comparability difficulties, such as:
» lack of comparability between ESG ratings agencies;
» comparing across different accounting and other standards;
» comparisons across geographies and cultures; and
» inconsistent use of jargon terminology.
▶ materiality and judgment challenges, such as:
» judgments that are difficult and uncertain; and
» judgments that are inconsistent.
▶ ESG integration challenges across asset classes:
» different types of assets and different strategies integrate ESG using different techniques.
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Challenges from incomplete data sets and identifying and
assessing ESG data
As can be seen from the case studies and ESG techniques, many of the processes start with data and research gathering. However, there are a few challenges:
▶ ESG data is not consistently reported across companies, geographies and sectors;
▶ most ESG data is not audited; and
▶ some ESG data is not easily available in public databases and is difficult to obtain.
59
ESG factors can be judged material and useful, but also, the data may be incomplete. For instance, carbon pollution is often judged material, but it can be measured in at least three scopes – scope 1, scope 2 and scope 3.
Currently, in the top 2,000 companies in the world, there is little data on scope 3 (as of 2018, 10% of companies have this) yet there is evidence that scope 3 makes up more than 50% of the world’s carbon (and greenhouse gas equivalent) pollution impact.
ESG data can be incomplete, unaudited, unavailable or not comparable between companies due to different reporting methodologies. This makes assessment of ESG factors impossible in certain situations. A lack of data or a company unwilling to disclose information can make identification of relevant ESG factors difficult.
60
Challenges from incomplete data sets and identifying and
assessing ESG data
Data disclosure challenge
There is an ongoing debate over ESG data disclosures at a company level. These disclosures vary between companies and regionally. There are ongoing efforts via organisations such as SASB or the GRI, and continuous evolution from the IASB on ‘broader corporate reporting’.
Surveys suggest (see Section 1) that a range of investors view ESG disclosure at companies as inadequate.
This may partly be because investors and management teams view ‘materiality’ differently and may also have conflicting aims. Investors may claim that it is hard to assess a material piece of ESG information if there is no data disclosure. Companies can argue that the vast range of possible ESG data and the differing demands of investors, stakeholders and rating agencies make the resource demands unreasonable.
A further challenge is that there is no consensus agreement on the details of what good ESG disclosure may look like (although again see SASB’s evolving work here) and that this may differ by strategy and asset class.
Historically, public markets disclosure had been higher than private markets disclosure, and the needs of fixed income and sovereign bond investors can differ from equity investors.
ok
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Comparability and materiality judgment challenges
ESG ratings agencies use different techniques and assessments so that the ratings are not easily comparable. ESG ratings do not correlate like bond credit ratings, nor do agencies use the same methods of scoring.
Judgments on ESG materiality may differ between analysts.
Many ESG terms are used inconsistently and are difficult for non-specialists to interpret.
These differences can be magnified with cultural or regional differences.
For instance, different countries have different governance best practices or differing views on risk and materiality.
Japanese companies have a much lower number of independent directors on their boards than the European or US average, which is reflected in the Corporate Governance Code of Japan.
Different countries may also put different weights on social factors (e.g. US companies are less concerned about having a policy on work unions than German companies).
Where materiality can be judged, it can be hard to assess the level of impact and there is uncertainty on how ESG factors interact with financial performance over time.
There are many jargon terms in the field (to name a few: responsible, impact, sustainable, socially responsible, ethical and green investment).
Many of these terms are not used consistently by specialists and are confusing to non-specialists.
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Integration challenges
Due to the different third-party databases, many quantitative ESG factors are not agreed upon, and the data is relatively short run.
It is also uncertain to what degree the ESG factors may correlate with other established quantitative factors, such as ‘quality’, ‘value’ or ‘momentum’.
This means index tilting strategies may not reflect desired factors appropriately.
Many investment firms have separate ESG analysts to the ‘main’ investment team.
This can move higher ESG expertise away from investment decision makers and therefore, provide a challenge to integration.
It may be that ESG analysts are more junior (potentially driven by the only recent focus on this area at, for example, business school level) and therefore, lower weight is put on their views and providing a challenge.
In fundamental active strategies, many ESG factors are difficult to judge and quantify.
Impacts to cash flows, growth rates or DCF assumptions are also hard to express.
As noted earlier, in quantitative strategies limited consensus remains and historical data provides an integration challenge.
63
Investment firm culture challenge
There remains a significant number of investment professionals who do not integrate ESG or believe ESG has limited financial impact; this can be challenging for teams and within firms. Firms may not have significant resources to buy third-party ESG data, or a firm’s global nature may make culturally different attitudes to ESG factors difficult to integrate globally across the firm.
ESG integration is often different across asset classes, which can make it difficult to be consistent or to explain across a firm. Investors are likely to make differing judgments on materiality or weight factors, which causes a lack of comparability or a difference of opinion, even within firms.
There are typically additional resources needed for ESG integration, finances and personnel, which raises both financial and operational challenges within firms.
ESG integration techniques have only recently started to become part of the curriculum at business schools and within universities.
Typically, this means that investment professionals would not have had as much detailed training on how to deal with a challenge for integration.
Despite advances in techniques and understanding, there remain significant challenges to ESG integration.
64
Criticism for ESG integration
One of the most common criticisms of ESG investing is the difficulty for investors to correctly identify, and appropriately weigh, ESG factors in investment selection.
Critics express concerns about the precision, validity and reliability of ESG investment strategies, and tend to express four concerns:
1. Too inclusive of poor companies. ESG mutual funds and ETFs often hold investments in companies that may be acknowledged as ‘bad actors’ in one or more of the ESG spaces.
2. Dubious assessment criteria. The criteria used for selecting ESG factors are too subjective and can reflect narrow or conflicting ideological or political viewpoints. Non-material or socio-political factors may be over- emphasised. Materiality assessments might be considered flawed.
3. Quality of data. The information used for selecting ESG factors often comes (unaudited or assured) from the companies themselves. This complicates the ability to verify, compare and standardise this information.
4. Potential lack of emphasis of long-term improvements. Some financial advisers screen investments first for performance and only after that for ESG factors. This initial emphasis on performance can exclude companies with high ESG practices that focus on longer-term performance.
Finally, some critics would argue that evidence for the benefits of ESG are mixed.
65
Range of ESG integration databases and software available
Explain the approaches taken across a range of ESG integration databases and software available, and the nature of the information provided.
7.1.12
Identify the main providers of screening services or tools, similarities and differences in their methodologies, and the aims, benefits and limitations of using them.
7.1.14
Describe the limitations and constraints of information provided by ESG integration databases.
66
The sources of information used to assess ESG investments also vary across the ESG tools.
```
Information can be collected:
▶ directly via:
» surveys;
» company communication;
» company reports;
» presentations; and
» public documents; or
```
▶ indirectly via:
» news articles;
» third-party reports; and
» analysis.
The assessments can be given in a raw form, or used to determine index weights or processed to determine specific ratings and scores.
Another consideration to consider when thinking of providers is where they have come from and which stakeholders are served. Here you might have:
▶ ‘Traditional’ ESG data and research providers: Founded from the SRI industry to provide investors with sustainability data and ratings about primarily large, publicly traded companies. More recent consolidation activity has turned these providers into conglomerates with different offerings and research focuses. The level of automation is low or medium, as human judgment is still used.
▶ ‘Non-traditional’ ESG data and research providers: More recently, non-traditional providers, such as credit- rating agencies (S&P and Moody’s), entered the space by acquiring Trucost (2016) and Vigeo Eiris (2019), respectively. As above, the level of automation is low or medium, as human judgment is still used.
▶ AI or algorithm-driven ESG research: Launched more recently, in the last five years, these providers use new technologies, such as Natural Language Processing, to identify ESG risks and opportunities from web-based sources. The level of automation is high.
67
Some of these providers may serve corporate issuers and bank and insurance companies as well as asset owners and asset managers.
One way to think about these ratings and data providers is through their broad technique styles:
▶raw or partially transformed data (e.g. absolute carbon emissions, or carbon intensity which is emissions or sales);
▶ratings based on backward looking reported data;
▶ratings or information based on internet, third-party and web-reported data, aiming to be current;
▶or aggregators of data or ratings.
The considerations that investors should take into account when choosing providers include:
```
the number of companies covered;
the length of history of datasets;
the languages used;
the stability of methodology;
and the regularity of updates.
```
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MUTUAL FUND AND FUND MANAGER ESG ASSESSMENT
Morningstar sustainability ratings and Real Impact Tracker (RIT) are examples of ESG fund and fund manager assessments.
Morningstar’s sustainability ratings
As of 2018, Morningstar covered over 20,000 mutual funds and over 2,000 ETFs with a 1 to 5 score.
It uses company-level ratings from Sustainalytics to develop its fund ratings and the headline rating is freely available.
Morningstar takes a ‘holdings-based approach’–a weighted average of portfolio companies’ ESG scores.
No credit or assessment is given to managers’ efforts on shareholder engagement and public advocacy or on their sophistication, culture and investment strategy.
One key critique on this approach is that holdings-based approaches ignore intentional ESG strategy and the approach is necessarily backward-looking.
Given that the correlation of the two major rating systems (Sustainalytics and MSCI) is low and Morningstar uses only the Sustainalytics data for its calculations,
there is limited comparability between the ratings and others.
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MUTUAL FUND AND FUND MANAGER ESG ASSESSMENT
Morningstar sustainability ratings and Real Impact Tracker (RIT) are examples of ESG fund and fund manager assessments.
Morningstar’s sustainability ratings
As of 2018, Morningstar covered over 20,000 mutual funds and over 2,000 ETFs with a 1 to 5 score.
It uses company-level ratings from Sustainalytics to develop its fund ratings and the headline rating is freely available.
Morningstar takes a ‘holdings-based approach’–a weighted average of portfolio companies’ ESG scores.
No credit or assessment is given to managers’ efforts on shareholder engagement and public advocacy or on their sophistication, culture and investment strategy.
One key critique on this approach is that holdings-based approaches ignore intentional ESG strategy and the approach is necessarily backward-looking.
Given that the correlation of the two major rating systems (Sustainalytics and MSCI) is low and Morningstar uses only the Sustainalytics data for its calculations,
there is limited comparability between the ratings and others.
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Real Impact Tracker
The RIT takes a more holistic approach, doing deep dive due diligence on its manager assessments. Its ‘certified community’ is publicly available with details of the assessment undertaken.
Rather than use a ‘holdings-based approach’, the RIT will assess:
▶ culture;
▶ philosophy;
▶ process impact; and
▶ public policy efforts
Mercer’s point system
Investment consultants, such as Mercer, will also rate the ESG capabilities of fund managers, which is often done at a fund strategy level.
Mercer has a 4-point score, where its highest rating of ESG = 1 is given to less than 5% of investment teams.
Potential features that Mercer’s investment consultants look for are:
▶ A demonstration that ESG factors are featured in investment teams’ decision-making process and corporate culture.
▶ An effort has been made to build ESG factors into valuation metrics, using the investment team’s own judgment about materiality and time frames.
▶ There is a long-term investment horizon and low portfolio turnover.
▶ Ownership policies and practices include sufficient oversight, integration with investment
decision-making and transparency.
▶ For alternative assets, there is evidence of pursuing best practices in transparency and evaluation, with monitoring and improvement of ESG performance as relevant for portfolio companies and sectors.
▶ There is a demonstrated willingness to collaborate with other institutional investors to improve company, sector or market performance.
▶ Commitment to ESG integration across the organisation.
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The aim of these type of ESG assessors is to form a view on the ESG integration practices and processes of different fund managers and strategies to enable end users both retail and institutional to match ESG and investments needs with funds providing the best fit services.
Their limitations include:
▶different methodologies (some focus on investment processes, others on portfolio holdings);
▶the use of different data sources or rating providers;
▶the unaudited limited data sources;
▶the time resource to make the comparisons; and
▶the relatively non-transparent and non-comparable way these assessments are performed
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COMPANY ESG ASSESSMENT AND RATINGS
In 2018, MSCI and Sustainalytics had the largest market shares in company-focused ESG ratings.
Both rating agencies have grown by acquiring other ESG ratings providers over the last decade.
However, new entrants are still entering.
There are several types of assessment, including:
fundamental including risk, business model, policies and preparedness; operational including carbon impact, water stress and human capital management; disclosure-based assessment; and
algorithm and news-based including controversies (Truvalue Labs and RepRisk predominantly use this assessment whereas fundamental, operational and disclosure-based are used by most ratings companies).
A few ESG ratings companies have attempted to look at the opportunities side of ESG factors as well.
As noted earlier, each provider has different methodologies and differing benefits and limitations.
There is limited consensus between the databases.
Below we consider the approaches of two ESG risk rating systems – Sustainalytics’ ESG Risk Rating and MSCI risk rating.
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COMPANY ESG ASSESSMENT AND RATINGS
In 2018, MSCI and Sustainalytics had the largest market shares in company-focused ESG ratings.
Both rating agencies have grown by acquiring other ESG ratings providers over the last decade.
However, new entrants are still entering.
There are several types of assessment, including:
fundamental including risk, business model, policies and preparedness; operational including carbon impact, water stress and human capital management; disclosure-based assessment; and
algorithm and news-based including controversies (Truvalue Labs and RepRisk predominantly use this assessment whereas fundamental, operational and disclosure-based are used by most ratings companies).
A few ESG ratings companies have attempted to look at the opportunities side of ESG factors as well.
As noted earlier, each provider has different methodologies and differing benefits and limitations.
There is limited consensus between the databases.
Below we consider the approaches of two ESG risk rating systems – Sustainalytics’ ESG Risk Rating and MSCI risk rating.
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The Sustainalytics’ ESG Risk Rating
The Sustainalytics’ ESG Risk Rating measures the degree to which a company’s economic value is at risk driven by ESG factors or, more technically speaking, the magnitude of a company’s unmanaged ESG risks.
The rating system gives points for specific risk factors.
Each point of risk is equivalent, no matter which company or issue it applies to. Points will add up across issues to create overall scores, which are then rated.
```
The rating sorts companies into five risk categories:
▶ negligible;
▶ low;
▶ medium;
▶ high; and
▶ severe.
```
These risk categories are absolute, meaning that a ‘high’ risk assessment reflects a comparable degree of unmanaged ESG risk across the research universe, whether it refers to an agriculture company, a utility or any other type of company.
According to Sustainalytics, an issue is considered ‘material’ within the ESG Risk Rating if its presence or absence in financial reporting is likely to influence the decisions made by a reasonable investor.
To be considered ‘relevant’ in the risk rating, the issue must have a potentially substantial impact on the economic value of a company and, hence, the financial risk and return profile of an investor investing in the company.
It is important to distinguish the ESG risk rating’s use of materiality as a concept from narrower legal or accounting-focused definitions.
Not every issue Sustainalytics considers as ‘material’ in the rating is legally required to be disclosed in company reporting.
Some issues are ‘material’ from an ESG perspective, even if the financial consequences are not fully measurable today.
The ESG risk rating’s emphasis on materiality incorporates an additional dimension – the exposure dimension.
It reflects the extent to which a company is exposed to material ESG risks identified at industry-level and affects the overall rating score for a company as well as its rating score for each material ESG issue.
ESG issue risk exposure is estimated at sub-industry level and further adjusted at individual company level.
The ESG risk rating’s second dimension is management.
ESG management can be considered as a set of company commitments and actions that demonstrate how a company approaches and handles an ESG issue through policies, programmes, quantitative performance and involvement in controversies, as well as its management of corporate governance.
Sustainalytics considers management in the ESG risk rating, as company commitments and actions provide signals about whether companies are managing ESG risks.
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Unmanaged risk: how Sustainalytics arrives at the scores
The ESG Risk Rating scoring system for a company is best thought of as occurring in three stages on the issue level:
1. the starting point is exposure;
2. the next stage is management; and
3. the final stage is calculating unmanaged risk, using the concept of risk decomposition.
The final ESG risk rating score is a measure of unmanaged risk. This is defined as material ESG risk that has not been managed by a company. It includes two types of risk:
▶ unmanageable risk, which cannot be addressed by company initiatives; and
▶ the management gap, which represents risks that could be managed by a company through suitable initiatives but which may not yet be managed.
Under this model, some risks are manageable, like the risk of on-the-job injuries, which can be managed, for example, through:
▶ establishing stringent safety procedures;
▶ having emergency response plans and safety drills; and
▶ promoting a safe culture.
Some risks are not (fully) manageable, such as the carbon emissions of aeroplanes in flight.
An airline can manage some of the issue (for example, by modernising aircraft, installing winglets, working on ICT systems to minimise time that airplanes spend idling on the runway), but it cannot easily manage all of an airplane’s flight emissions.
This means that an airline has some unmanageable risk on carbon emissions, which should contribute to its unmanaged risk score on that issue.
Unmanageable risk is only one of the two components of unmanaged risk. The second component is the management gap.
It speaks to the manageable part of the material ESG risks a company is facing and reflects the failure of the company in managing these risks sufficiently, as reflected in the company’s management score.
The share of risk that is manageable versus the share of risk that is unmanageable on a material ESG issue
is predefined at a sub-industry level by a manageable risk factor.
Every material ESG issue has an issue manageable risk factor (MRF), ranging from 30% (indicating that a high level of the issue risk is unmanageable) to 100% (indicating that the issue risk is considered fully manageable).
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Example
Human capital
Human capital is difficult to manage. A company can employ hundreds of thousands of people, and it is very hard to imagine management programmes that can eliminate all risk of sexual harassment, low morale or high turnover. But it is expected that the company has full control over these policies.
Moreover, Sustainalytics has confidence that strong policies can effectively promote a working culture that limits material risk from sexual harassment or a workplace with destructive low morale and turnover.
However, companies cannot control the labour supply, potentially leading to financial consequences due to lack of available talent.
Therefore, a manageable risk factor is applied to distinguish that some risk within the issue cannot be managed.
Calculating the final unmanaged risk score
The assessment of unmanaged risk (the final ESG Risk Rating score) requires three steps:
Assess the share of the overall exposure of companies and compare to a material ESG issue in a given sub-
industry that can be managed by a company (manageable risk assessment).
At the company level, the degree to which a company has managed the manageable risk portion of its overall exposure, with regard to an issue being calculated based on the management assessment (overall management score assessment).
Finally, the unmanaged risk score is calculated by subtracting managed risks from a company’s overall exposure score in relation to a material ESG issue (final unmanaged risk score calculation).
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MSCI ESG Rating
According to the MSCI ESG Rating, ESG risks and opportunities are posed by:
▶ large scale trends (e.g. climate change, resource scarcity or demographic shifts); and
▶ the nature of the company’s operations.
The MSCI considers a risk or an opportunity to be material to industry as follows:
▶ A risk is material to an industry when it is likely that companies in a given industry will incur substantial costs in connection with it (for example, a regulatory ban on a key chemical input).
▶ An opportunity is material to an industry when it is likely that companies in a given industry could capitalise on it for profit (for example, opportunities in clean technology for the LED lighting industry).
Note that this definition of ‘materiality’ is different to that of Sustainalytics, but still a judgment (and may differ from other investors’ judgments).
MSCI assess material risks and opportunities for each industry through a quantitative model that compares ranges and average values in each industry for externalised impacts (such as carbon intensity, water intensity and injury rates).
Exceptions are allowed for companies with diversified business models or that are facing controversies, or based on industry rules.
Once identified, these ‘key issues’ are assigned to each industry and company.
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Final MSCI ESG Ratings are derived by the weighted averages of the key issue scores.
These scores are aggregated and companies’ scores are normalised by their industries.
After any overrides are factored in, each company’s final industry-adjusted score corresponds to a rating between the best (AAA) and the worst (CCC).
These assessments of company performance are not absolute, but are explicitly intended to be relative to the standards and performance of a company’s industry peers.
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MSCI ESG risk score
MSCI argues that to understand whether a company is adequately managing a key ESG risk, it is essential to understand both:
▶ what management strategies it has employed (i.e. risk management); and
▶ how exposed it is to the risk (i.e. risk exposure).
The MSCI ESG Ratings model attempts to measure both of these. For MSCI to score a company highly on a key issue, the management needs to be judged commensurate with the level of exposure:
▶ a company with high exposure must also have very strong management; but
▶ a company with limited exposure can have a more modest approach.
The risk exposure and management scores are combined so that a higher level of exposure requires a higher level of demonstrated management capability in order to achieve the same overall key issue score.
Key issue scores are also on a 0 to 10 scale, where 0 is very poor and 10 is very good.
MSCI ESG opportunity score
The assessment of MSCI ESG opportunities works similarly to risks, but the model for combining exposure and management differs:
▶ exposure indicates the relevance of the opportunity to a given company based on its current business and geographic segments; and
▶ management indicates the company’s capacity to take advantage of the opportunity.
Where exposure is limited, the key issue score is constrained toward the middle of the 0 to 10 range, while high exposure allows for both higher and lower scores.
MSCI controversy assessment
MSCI ESG Ratings also reviews controversies, which may indicate structural problems with a company’s risk management capabilities.
A controversy case is defined as an instance, or ongoing situation, in which company operations or products allegedly have a negative environmental, social or governance impact.
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MSCI final letter rating summary
To arrive at a final letter rating, the weighted average key issue score is normalised by industry.
The range of scores for each industry is established annually by taking a rolling three-year average of the top and bottom scores among the MSCI ACWI Index constituents; the values are set at the 97.5th and 2.5th percentile.
Using these ranges, the weighted average key issue score is converted to an industry-adjusted score from 0 to 10, where 0 is worst and 10 is best.
The industry-adjusted score corresponds to a rating between best (AAA) and worst (CCC).
ESG index providers
The likes of FTSE Russell and MSCI provide ESG index benchmarks.
These indices can be custom built to an investor’s preferences (typically at institutional level) and are generally commercially available in more standard versions.
1. The index typically relies upon rules-based criteria assessed on underlying ESG scores or metrics.
2. These then go into a formula to tilt company weightings or exclude entire companies based on ESG scores and
hurdles.
3. These scores may be sourced by other ESG service providers.
For instance, Sustainalytics started providing FTSE Russell with underlying data from 2019 (and had provided Morningstar with data before this).
These indices can be used as benchmarks for fund managers to be measured against, or as model funds for investors to directly invest into in a form of beta or passive management.
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MSCI final letter rating summary
To arrive at a final letter rating, the weighted average key issue score is normalised by industry.
The range of scores for each industry is established annually by taking a rolling three-year average of the top and bottom scores among the MSCI ACWI Index constituents; the values are set at the 97.5th and 2.5th percentile.
Using these ranges, the weighted average key issue score is converted to an industry-adjusted score from 0 to 10, where 0 is worst and 10 is best.
The industry-adjusted score corresponds to a rating between best (AAA) and worst (CCC).
ESG index providers
The likes of FTSE Russell and MSCI provide ESG index benchmarks.
These indices can be custom built to an investor’s preferences (typically at institutional level) and are generally commercially available in more standard versions.
1. The index typically relies upon rules-based criteria assessed on underlying ESG scores or metrics.
2. These then go into a formula to tilt company weightings or exclude entire companies based on ESG scores and
hurdles.
3. These scores may be sourced by other ESG service providers.
For instance, Sustainalytics started providing FTSE Russell with underlying data from 2019 (and had provided Morningstar with data before this).
These indices can be used as benchmarks for fund managers to be measured against, or as model funds for investors to directly invest into in a form of beta or passive management.
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PRIMARY AND SECONDARY ESG DATA SOURCES
Describe primary and secondary sources of ESG data and information.
Many ESG databases provide secondary ESG data or ratings.
These are assessments transformed by a process of scoring or a formula from a primary data source.
Some providers, e.g. Bloomberg, will provide primary data sourced from company reports in an easier or consistent form to digest, along with a secondary rating (e.g. Bloomberg Disclosure score).
Primary data can be sourced from companies directly:
▶ surveys;
▶ direct company communication; and
▶ company reports, presentations and public documents.
These public documents may be sourced from non-profit organisations, such as the UN Global Compact or the GRI, as well as the companies’ own websites.
A primary source may be audited or not audited, but as of 2020, many ESG performance indicators are not audited (although the number has increased since 2018 and is expected to continue to increase – verification and auditing of carbon emissions being one important data point that is increasingly audited).
Alternatively, the source may be indirect, via:
▶ news articles;
▶ third-party reports and analysis; and
▶ investment and consulting research.
Indirect assessment can be via a third-party source (such as Glassdoor for employee satisfaction data and scores, which are directly sourced from employee surveys).
They could also come from government, regulatory bodies or non-governmental organisation (NGO) reports into different segments of ESG.
Some of this data or assessment may be used widely between organisations.
For instance, CDP carbon data is used as an input to many of the major ESG ratings providers, such as FTSE Russell, MSCI and Sustainalytics.
Secondary data sources typically involve a non-reporting entity transforming the primary ESG data in some way and creating new scores, assessments or ratings based on these transformations. These are available from commercial organisations, both financial and non-financial, as well as regulators, NGOs and other non-profit or charitable bodies.
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OTHER USES OF ESG AND SUSTAINABILITY SYSTEMS DATA
Describe other uses of ESG and sustainability systems data.
Looking at all aspects, it clear to see that ESG data has wide and varied uses within investment. This section presents some other techniques that can go beyond a company assessment but are useful for companies and analysts to consider.
‘Big data’ analysis of multiple ESG factors
As can be seen in Section 2 of this chapter, regarding quantitative analysis, ESG data sets are being used by algorithms and natural language processes to determine company quality, reputational risk and many forward- looking aspects of business strength and valuation.
These trends can also be analysed at industry or country level. Companies themselves are starting to use big data analysis of various ESG factors in their strategic and operational analysis.
Resource, supply and operational risk mitigation
Assessment here is not only at a company level, but can be carried out at a systems or sector level.
This would include assessments of supply chain risk (e.g. from forced labour or supply constraints) or policy changes (e.g. on carbon pricing or water usage).
These risks may include climate adaptation and transition risk to physical infrastructure or location of human resources in risk areas – environmentally or politically.
This then ties into resource-, supply- and operations-related decision-making in terms of investments and capital allocation, where investors and companies might decide to invest further money (e.g. low-carbon technology) or withdraw further funding (e.g. thermal coal mines).
Evidence to support and guide sustainability strategy
ESG data is vital in guiding practice both at a company and investor level, but also at a regulator and government level. For instance, in carbon pricing, or areas of unmet need.
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Modelling future sustainability scenarios, including climate change, wage growth and social effects.
Future scenarios can be useful at the country-, industry- or company-level, as well as for investors.
One example is climate change scenarios. One set of scenarios examines different policy interventions (e.g. levels of carbon tax).
These different policy assumptions then lead to contrasting impacts from varying levels of warming on fires and storms.
These natural disasters could then impact companies (for example, with insurers and their infrastructure) as well as countries via human migration.
The World Economic Forum (WEF, 2019) shows two examples of risk mapping at this level (see Figures 7.8 and 7.9).
Furthermore, the analysis in Figure 7.9 would be considered by some to be a form of risk mapping.
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Real-time dynamic analysis
The analysis at the frontiers of data science is being extended to real-time analysis.
For instance:
```
▶ using geospatial data to track:
» de-forestation;
» mining;
» construction;
» shipping; and
» traffic; or
```
▶ using natural language processes to track social sentiment on the internet.
Overall, ESG investment analysis does not occur in a vacuum. The techniques and analysis are intersectional with the real world, as well as with the impact and risk on companies and countries.
FIXED INCOME, CREDIT RATING AGENCIES AND ESG CREDIT SCORING
Explain how credit rating agencies (CRAs) approach ESG credit scoring, and the extent to which CRA ratings can be relied upon for ESG investing: PRI Statement on ESG in Credit Ratings; main ESG CRA methodologies; quantitative ESG scores (QESGs); relationship between scores and ratings, and other indicators e.g. credit default swap (CDS) spread; key challenges: transparency, consistency and comparability.
The direct physical infrastructure impact of climate change, corporate scandals and the importance of human capital are all reminders of why oversight, lack of transparency and accountability can negatively affect fixed income market pricing, volatility and financial stability. And not only equities, which historically had investor focus.
ESG integration techniques can extend across asset classes. This section concentrates on the fixed income asset class.
Broadly speaking, ESG factors can affect the price performance of a bond and its credit risk at different levels.
▶ ***Issuer and company level: These are risks that affect a specific bond issue and not the whole market. They are related to factors such as
***the governance of an issuer, its regulatory compliance, the strength of its balance sheet and company-specific items such as brand reputation. For example, the yield on the corporate debt of the car manufacturer Volkswagen rose and stayed high for a prolonged period of time in the aftermath of the fraudulent emission scandal.
▶ Industry and geographic level: These risks stem from wider-ranging issues affecting the entire industry or region.
They can be related to regulatory and legal factors, technological changes associated with the business activity the company is involved in, and the markets it sources or sells to.
For example, the idea that utilities are relatively more exposed to climate change risks than media companies.
For some investors, there is an assumption that some ESG factors may impact a bond’s price performance. But it may not actually influence an issuer’s creditworthiness. This is because an ESG factor might not be considered to impact bankruptcy risk, even if it might have a potential impact on price performance. This would highlight a difference between a rating analysis and an asset valuation.
Good ESG risk management not only affects asset prices, but can fundamentally protect people’s lives.
For instance, nobody was injured in the 2013 landslide at a Rio Tinto mine in Utah, USA.
Rio Tinto’s laser scanning system sent early warning signals, enabling a prompt evacuation of the site. On the flip side, the recent Vale dam failure in Brazil in 2019 cost many lives.
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Continuing evolution for credit and ESG since PRI releases
Practice in the area of credit and ESG has evolved in the last few years.
By 2020, CRAs are in a different place than when the first observations were made by the PRI in 2016/17, which was when the PRI’s Statement on ESG in credit risk and ratings and its report on CRAs were both released.
The PRI Statement was designed to commit CRAs and fixed income investors to incorporate ESG into credit ratings and analysis in a systematic and transparent way. As of January 2020, the statement remains open for investors and CRAs to sign.
Global and regional credit ratings agencies
There are global and regional CRAs. Historically, the global CRAs have shown more advanced thinking about ESG than regional players, but as of 2020, the gap is arguably closing.
Back in 2016, CRA ESG analysis was not considered, or developed, to be an ESG equity rating service provider.
Since then, there have been significant changes that have arguably closed the gap when considering the different techniques that need to be used.
A major evolutionary step was taken by S&P (a global CRA) when they rolled out ESG as part of their credit assessments in 2019.
Time horizons and sovereign credits versus corporate credits all impact ESG and credit assessment.
Surveys from investors suggest that the G factor remains more important to credit investors than E and S.
Credit investors argue this is because downside risk (as in bankruptcy risk and therefore, the chance of losing
a credit investor’s entire capital) is more important than any upside or opportunity risk.
Opportunity is more important to equity investors. Upside is limited for most credit investors, but downside risk from bankruptcy will hurt returns.
Credit investors view fraud prevention and governance as important factors in protecting from downside risk (negative credit events).
As G is directly related to preventing downside risk, its direct relevance is easier to trace for credit investors.
Many of the challenges are similar to equity ESG ratings (as discussed in Section 1):
▶ transparency;
▶ consistency; and
▶ comparability.
Similar challenges (see earlier section as the same challenges apply for these) include:
▶ the lack of transparency;
▶ inconsistent or changing methodologies;
▶ the use of estimated data; and
▶ the lack of comparability through time and between providers and companies.
The following also give some specific fixed income challenges (see also case studies and discussion of sovereign and fixed income expressions of ESG in Section 2):
▶ time horizon (e.g. three-month paper or 50-year bonds);
▶ lack of proxy vote;
▶ different levels of management engagement; and
▶ unique qualities of sovereign credit.
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Continuing evolution for credit and ESG since PRI releases
Practice in the area of credit and ESG has evolved in the last few years.
By 2020, CRAs are in a different place than when the first observations were made by the PRI in 2016/17, which was when the PRI’s Statement on ESG in credit risk and ratings and its report on CRAs were both released.
The PRI Statement was designed to commit CRAs and fixed income investors to incorporate ESG into credit ratings and analysis in a systematic and transparent way. As of January 2020, the statement remains open for investors and CRAs to sign.
Global and regional credit ratings agencies
There are global and regional CRAs. Historically, the global CRAs have shown more advanced thinking about ESG than regional players, but as of 2020, the gap is arguably closing.
Back in 2016, CRA ESG analysis was not considered, or developed, to be an ESG equity rating service provider.
Since then, there have been significant changes that have arguably closed the gap when considering the different techniques that need to be used.
A major evolutionary step was taken by S&P (a global CRA) when they rolled out ESG as part of their credit assessments in 2019.
Time horizons and sovereign credits versus corporate credits all impact ESG and credit assessment.
Surveys from investors suggest that the G factor remains more important to credit investors than E and S.
Credit investors argue this is because downside risk (as in bankruptcy risk and therefore, the chance of losing
a credit investor’s entire capital) is more important than any upside or opportunity risk.
Opportunity is more important to equity investors. Upside is limited for most credit investors, but downside risk from bankruptcy will hurt returns.
Credit investors view fraud prevention and governance as important factors in protecting from downside risk (negative credit events).
As G is directly related to preventing downside risk, its direct relevance is easier to trace for credit investors.
Many of the challenges are similar to equity ESG ratings (as discussed in Section 1):
▶ transparency;
▶ consistency; and
▶ comparability.
Similar challenges (see earlier section as the same challenges apply for these) include:
▶ the lack of transparency;
▶ inconsistent or changing methodologies;
▶ the use of estimated data; and
▶ the lack of comparability through time and between providers and companies.
The following also give some specific fixed income challenges (see also case studies and discussion of sovereign and fixed income expressions of ESG in Section 2):
▶ time horizon (e.g. three-month paper or 50-year bonds);
▶ lack of proxy vote;
▶ different levels of management engagement; and
▶ unique qualities of sovereign credit.
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Corporate credit risk assessments
When assessing credit risk, pre-2016 CRAs typically did not attempt to capture the environmental, ethical or social impact of a bond issue.
For example, CRAs may have somewhat ignored environmental damage measurements (e.g. CO2 emissions of a company) or environmental opportunities.
Before 2016, when analysing a carbon-intense company, CRAs might have typically focused on other material impacts – including financial, regulatory and legal factors – that could affect the company’s credit profile.
By 2020 though, many CRAs look at a range of ESG factors (and judge materiality).
They judge the company’s response to ESG risks and ‘ESG events’, and link that back to potential financial and balance sheet or cash flow considerations, such as the ability to meet debt obligations.
In addition, during 2018/19, Moody’s and S&P developed further ESG evaluation systems, which continue to evolve today.
Certain fixed income investors use quantitative ESG scores
Certain fixed income investors use quantitative ESG scores (QESGs) – not to be confused with what investors often mean by quantitative investing (see Section 2) – in their fixed income assessments.
These QESGs might be based on quantitative data (such as carbon intensity) or be judgments based on data and/or policy (e.g. policy or commitment to align business model to science-based targets).
Not all investors use the term and different investors may be referring to different proprietary systems when referring to QESGs.
Green bonds considered a different class of credit
Green bonds (bonds financing green projects) or bonds assessed to meet B-corp criteria are often considered a different class of credit.
Once certain ESG or sustainability criteria are met, a green bond’s credit risk is generally assessed in the same manner as a standard credit. (Note, B-corporation certification is a private certification issued to for-profit companies by B Lab, a global non-profit organisation that verifies social and environmental performance, public transparency and legal accountability to balance profit and purpose.)
Typically, CRAs assess the predictability and certainty of an issuer’s ability to generate future cash flow to meet its debt obligations.
To this end, they look at whether companies can sell their assets to cover obligations (and certain assets might be impaired through ESG concerns, e.g. coal assets).
The levels of litigation risk are often analysed as well, including:
▶ environmental litigation;
▶ employment litigation; or
▶ human rights violations (e.g. modern slavery laws).
To that degree, ESG risk, which comes to litigation, has always been incorporated into CRA analysis.
On the quantitative side, CRA analysis focuses on:
▶ the issuer’s overall bankruptcy risk;
▶ the strength of its balance sheet; and
▶ how it compares to other issuers.
Using standard credit ratio analysis, CRAs may test:
▶ how ESG factors affect an issuer’s ability to convert assets into cash (profitability and cash flow analysis);
▶ the impact that changing yields – due to an ESG event – may have on the cost of capital, depending on the share of debt used in the issuer’s capital structure (interest coverage ratio and capital structure analysis);
▶ the extent to which ESG-related costs dent the ability of an issuer to generate profits and add to refinancing risks; and
▶ how well an issuer’s management uses the assets under its control to generate sales and profit (efficiency ratios).
In summary, a CRA rating is typically:
▶ based on analytical judgment (both quantitative and qualitative), using all the information deemed material by the analysts;
▶ forward-looking with a varying time horizon;
▶ composed of dynamic and relative measures; and
▶ a statement of the relative likelihood of default.
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An interested fixed income investor may conduct different materiality assessments or judgments to a CRA (see case studies). This is considered true of equity ESG ratings by many investors as well.
Indeed, credit investors typically use the information provided by credit ratings to help them price, trade and assess the credit risk of fixed income securities, and to determine whether these are suitable investments, but ratings are not the only input.
A combination of investor research, analysis and judgment determines the suitability of a bond investment based on a range of factors, of which credit ratings may be one.
Other factors may include proprietary indicators and recommendations by security analysts. It’s notable that not all credit will have a rating.
With that said, credit ratings have an important role in the credit risk assessment of a bond issue and are typically used to define and limit investment mandates set by pension funds.
Many investors in investment grade credit have limited or no ability to invest in high-yield speculative-grade credit, for example.
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ESG and credit ratings:
Discussion over relationship
The link between ESG ratings and credit ratings is still hotly debated amongst investors. Proponents might point to a Barclays’ study (see Chapter 8) looking at a high ESG portfolio versus a low ESG portfolio.
The case for sustainable bond investing strengthens, but critics would point out the flaws of correlational studies as well as the short 2009 to 2018 time period.
Critics further point out that the factor attributions post- 2008/09 (the financial crisis) and some ESG ratings correlate with quality factors (although not all).
Portfolio managers are developing more sophisticated approaches beyond simple ESG tilts.
Figure 8.13 in Chapter 8 illustrates some of the ratings distribution features developed by a fixed income specialist asset manager within its portfolio ESG evaluation framework.
The framework uses third-party ESG data, but combines the data to produce proprietary ESG metrics for that firm including a fundamental, absolute-oriented ESG rating and a relative investment ESG score.
The internal investment teams can see an ESG risk from the single issuer level to the portfolio level which is a value added part of the process.
It is possible to see the impact in the credit default swap (CDS) market as well as on a single issuer basis, for instance, with Volkswagen and emissions testing.
This would be an argument for the impact an ESG event can have on CDS.
However, the timing of subsequent CDS do not perfectly correspond to when all the information was first released.
The lag in timing might suggest inefficient markets or the lagged delays that market participants have in assessing material ESG information into CDS prices.
The research on ESG and credit is historically less well developed than in equity, but interest continues to
grow and techniques are developing, with CRAs recently embedding ESG into their processes.
There is some evidence that ESG ratings and CDSs may have a relationship. Still, the overall principles of gathering ESG data or ratings, assessing material ESG factors and then embedding them into asset assessment and valuation hold.
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9 CONCLUSION
There are many techniques for ESG integration across asset classes, although most investors are aligned
in seeking to maximise risk-adjusted returns in using these ESG tools.
While certain tools are asset class specific, the overall framework of identifying material ESG factors and then embedding them in valuation and assessment remains similar.
As of 2020, the field remains dynamic and expert techniques and tools for analysis continue to evolve.
