Chapter 7: ESG Analysis, Valuation and Integration Flashcards
1
Q
What are investors objectives to integrate ESG into investment process?
or
Which factors incentivize investors to integrate ESG?
A
- Meeting requirements of FIDUCIARY duties or regulations
- Meeting CLIENT or BENEFICIARIES’ demands
- Lowering investment RISK
- Increasing investment RETURNS-> seeking higher alpha
- Giving investment analysts more TOOLS and TECHNIQUES to use in analysis
- Improve QUALITY OF ENGAGEMENT & STEWARDSHIP activities
- Lowering REPUTATIONAL RISK
2
Q
What is qualitative ESG analysis?
A
- Used in investment process that is based on company-specific research, fundamental analysis and stock-picking
○ Investment teams analyze ESG data to form their opinion on the ability of the firm to manage certain ESG issues
○ They combine their opinion with financial analysis by linking specific aspects of the company’s ESG risk management strategy to different value drivers (e.g. costs, revenue etc) - Analysts and portfolio managers then seek to integrate their opinion in a quantified way in their financial model by adjusting assumptions such as growth, margins or costs of capital
3
Q
What is quantitative ESG analysis?
A
- Likely to be used in investment process that uses quantitative models to identify attractive investment opportunities
- ESG data is typically aggregated into ESG factor (score) which is added to a quantitative model
- Score could be used to screen or to adjust valuations
4
Q
What is a fundamental active investment strategy?
A
- Human judgement is used
- Will tend to use ESG techniques that have both qualitative and quantitative elements
- Not typically considered quantitative investment
5
Q
What are beta or factor investment strategies?
A
- Investment class that is often viewed as sitting between fundamental active and passive index tracking
6
Q
What is meant with active or passive investment?
A
- How human discretionary or computer algorithm based an investment strategy is
7
Q
What are elements of ESG analysis?
A
- Red flag indicators - Securities with high ESG risk flagged to be examined or excluded
- Company questionnaires and management interviews - Checks with outside experts
- Watch lists
- Internal ESG research
- External ESG research
- ESG agenda items at investment committee
- Chief Information Officer (CIO) level meetings
8
Q
What are elements of internal ESG research?
A
○ Proprietary ESG research and anlaysis is performed; output can be provided in SCORES, RANKINGS or REPORTS;
Research could consist of:
○ Materiality frameworks
○ ESG-integrated research notes
○ Research dashboards
○ SWOT analysis
○ Scenario analysis
- Relative rankings
9
Q
What are elements of external ESG research?
A
○ Sell-side research, ESG specialists or third-party data provider
- Materiality frameworks
10
Q
What are ELEMENTS of ESG INTEGRATION into investment?
A
- Adjusting FINANCIAL FORECASTS - for example revenue,
operating costs, capital expenditure - Adjusting VALUATION MODELS or multitudes - for
instance discount rates, ratios - Adjusting CREDIT RISK and DURATION
- Managing RISKS- by limiting exposure, scenario
analysis, value-at-risk models - ESG FACTOR tilts
- ESG MOMENTUM tilts
- STRATEGIC asset allocation
- TACTICAL asset allocation
- ESG CONTROVERSIES and POSITIVE ESG EVENTS
11
Q
What are the elements of the ESG INTEGRATION FRAMEWORK?
A
RSP:
- RESEARCH stage - Red flag indicators, watch lists, materiality framework, company survey, voting, SWOT analysis etc
- SECURITY level - Financial forecast, valuation modelling, credit risk etc, relative ranking
- PORTFOLIO level - Asset allocation, tilting, scenario analysis, Value-at risk analysis, weighting, ESG profile
12
Q
What are differences in company and business analysis and security analysis?
A
A COMPANY or BUSINESS assessment typically examines fundamental properties of a business:
○ Natural capital (G)
○ Corporate culture or supplier analysis (S)
- Management structure (G)
Stocks and bonds can have properties that companies don’t have, like stock beta or volatility
- Debate whether ESG components that are robust quantitative stock or bond factors
13
Q
What is materiality assessment?
A
○ Assessment to identify ESG issues that are likely to have an impact on the company’s performance
○ Measured in terms of likelihood and impact
- Evidence that non-material factors don’t have financial impact
- Distinguished from some exclusionary investment strategies that also consider non-material factors
- Investors who see ESG analysis and integration as a way to enhance investment process are likely to focus on ESG issues that are financially material
- Investors that are interested in the positive and negative impact of companies will focus also on non-material factors
14
Q
What goes into generating ideas as part of the research and generation stage?
A
○ Can be helped with a valuation screen
○ Considering ESG megatrends
○ Checklist and Red flags can be used to narrow the investable universe
○ Negative materiality assessment may lead to decision that investment fails hurdle
- Assessment can be quantitative (CO2) or qualitative (management)
15
Q
Why and how can you develop a scorecard for ESG risk and opportunities?
A
WHY develop a scorecard?
- Needs to be developed if there is no third party information available that helps with assessment
- Converts qualitative judgment of a factor into a quantative score
- ESG analysis can be quant or qual.. or hybrid. Scorecard is example of hybrid.
I B D A C B - IBD ACB
How to develop scorecard?
1. Identify sector or company specific items
- Breakdown issues into number or indicator
- Determine scoring system based on what is good or bad practice
- Assess a company
- Calculate aggregate scores at issue level etc
- Benchmark
16
Q
What is risk mapping and how is it used in materiality assessment?
A
- Individual company or sector has its risk mapped to a specific theme or factors that is judged material
- SASB has developed materiality maps for sectors with material factors for different sectors
○ Risk mapping could also mean mapping a portfolio or investible universe against a specific risk to identify which sectors or companies contribute the most to this particular risk profile
- Mapping can also be done for material opportunities and risks and can be scored to combine scorecard and mapping technique
17
Q
What is the quantitative aproach to integrated ESG analysis?
A
- Quantitative factor investors typically integrate ESG factors alongside other factors
- ESG data is included in investment process and could result in upward or downward adjustment of the weights of securities
18
Q
What approaches to integrated ESG analysis exists?
A
QST
- Quantitative
- Systematic
- Thematic
19
Q
What is the systematic appraoch to integrated ESG analysis?
A
- Systematic approach - attempts to derive correlations to understand how ESG factors impact financial performance
- Passive index - tilting toward ESG, integration of ESG mandate
20
Q
What is the thematic approach to integrated ESG analysis?
A
- Assess alignment with priority themes
21
Q
What factors can change when integrating ESG assessment into valuation?
OR
After research stage & any relevant risk & materiality mapping, what might practitioners adjust with respect to assessing impact of material financial and ESG factors on corporate and investment performance of a company??
A
○ Forecasted financials
○ Valuation-model variables, such as cost of capital, terminal growth rates in discounted cash flow analysis
- Valuation multiples
○ Forecasted financial ratios
○ Internal credit assessment
- Assumptions in qualitative and quantitative models
CAN’T blanketly adjust return expectation
22
Q
How can weak or strong ESG complement traditional financial analysis?
A
Increase or decrease sales margin
Increase or decrease long term cash flow
Increase or decrease intrinsic value
Increase or decrease share price
- SALES MARGIN
- LONG-TERM CASH FLOW
- INTRINSIC VALUE
- SHARE PRICE
23
Q
What does a high carbon intensity mean for financial analysis?
A
- Increased risk from carbon tax
- Increased costs or debt from new projects
- Increased balance sheet risk of default on debt
- Change in debt rating
- Lower value of corporate debt
24
Q
What does weak governance mean for financial analysis?
A
- Increased risk of negative capital allocation
- Lower future cash flows or difficulty to do IPO
- Lower valuation or increase risk of bankruptcy risk
25
What are challenges related to ESG disclosure in investment analysis?
- Lack of disclosure could be good indicator of POOR MANAGEMENT
- Poor disclosure is a sign of market inefficiency - could be a source of superior risk-adjusted returns
26
Why does integration of ESG into bonds differ from equities?
- Equity securities tend not to have issues like credit quality, duration, currency etc, therefore bonds require different integration techniques
- Fixed income investors will often see similar principles in materiality and ESG frameworks, but adapt them
- Opportunity side of ESG may be less relevant for bond investors as the impact of ESG on the ability of a company to pay back its debt obligation are most important
- ESG analysis needs to integrate into credit risk analysis and investment decision
27
What are the main challenges for ESG integration in investment analysis and decision?
DCMI or DMCI..
1. Disclosure and data-related challenges (consistency, scarcity, incompleteness, audited data)
2. Comparability (ESG ratings, accounting standards, geographies, culturers, terminology)
3. Materiality and judgement challenges (difficult, uncertain, inconsistent)
4. ESG Integration across assets (different assets require different strategies)
28
What are the main criticisms against ESG integration?
TDQP or PTQD or QDPT QuiDProTo
1. Too inclusive of poor companies - ESG mutual funds and ETFs often hold investment in companies acknolwedged as 'bad actors' in one or more of the ESG spaces
2. Dubious assessment criteria - Criteria used for selecting ESG factors are too subjective and can reflect narrow or conflicting ideological or political viewpoints. Non-material factors or socio-political factors might be overemphasized. Materiality assessments might be considered flawed.
3. Quality of data - Information used for selecting ESG factors often comes unaudited or unassured from companies themselves. Complicates ability to verify, compare and standardize the info.
4. Potential lack of emphasis on long-term improvements - Some financial advisors screen investments first for performance and then for ESG factors. This intial emphasis on performance can exclude companies with high ESG practices that focus on longer-term performance
29
What could high-correlation between ESG rating mean?
- Could lead to group think - > Credit agencies in 2008
- Could also mean higher credibility and more consistent message
30
What are potential consequences of lack of correlation between ESG ratings?
- This means that information that investors receive is noisy
- ESG performance is less likely to be reflected in corporate stock or bonds prices, because investors struggle to agree which are the leaders and which are the laggards
- Divergence in ESG ratings also hampers companies ambition to improve ESG performance
- Difference in ratings also poses challenges for empirical research
31
What are different ESG rating techniques?
- Raw or partially transformed data
- Ratings based on backward looking reported data
- Ratings or information based on internet, third-party and web-reported data
- Aggregators of data or ratings
32
What should be considered when choosing an ESG rating provider?
- Number of companies covered
- Length of history of dataset
- Language
- Stability of methodology
- Regulatory of updates
33
What are the limitations of mutual fund manager ratings?
○ Different methodologies (some focus on investment
process, other on holdings)
○ Use of data sources and rating providers
○ Unaudited and limited data sources
○ Time resources to make comparison
- Non-transparent and non-comparable ways ratings are made
34
What are different types of COMPANY ESG ASSESSMENT and rating approaches?
FODANO
a. Fundamental including risk, business model, policies
and preparedness
b. Operational including carbon impact, water stress and capital managemnet
c. Disclosure-based
d. Algorithm-based
e. News-based
f. Opportunities
35
In Sustainalytics rating methodology, what does high-risk imply?
- High-risk reflect comparable degree of unmanaged risk
36
In Sustainalytics rating methodology, what does materiality address?
- Materiality depends on if presence or absence in financial reporting is likely to influence investor decisions
37
In Sustainalytics rating methodology, what does exposure mean?
-The extent to which a company is exposed to a material risk at the sub-industry level and adjusted at the individual level
38
In Sustainalytics rating methodology, what does relevance mean?
- Relevance depends on if the issue has potential substantial impact on the economic value of the company
39
How does Sustainalytics calculate its rating score?
1. Manageable risk assessment - 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
2. Management score 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
3. Final Unmanaged risk score calculation - Unmanaged risk is calculated by subtracting managed risk from a company's overall exposure in relation to a material ESG issue
40
What is the principle difference between Sustainalytics and MSCI rating?
MSCI has a company focus and takes into account opportunities as well as risks.
41
According to MSCI what is the relation between exposure and management?
- A company with high exposure must also have strong management
- But, a company with low exposure can have a more modest management approach
42
What goes into a ESG index?
A. Index typically relies upon rules-based criteria assessed on underlying ESG scores and metrics
B. These criteria go into a formula to tilt company weightings or exclude entire companies based on ESG scores and hurdles
C.
43
What is secondary data for ESG assessment?
Transformation of primary data based on process of scoring, rating or formula.
44
What are potential impacts of ESG factors on the risk and performance of a bond at issuer and sector/industry level?
IC/IG
- Issuer or company level - affect only specific bond and not the entire market. Often governance related (governance, regulatory compliance, strength of balance sheet, company-specific items like brand reputation)
- Industry and geography/geographic level - affecting the entire industry, regulatory changes, technological changes (regulatory or legal factors, tech changes, markets it sources or sells to; for example, utilities relatively more exposed to climate change than media cos)
45
Why might ESG factors not actually affect issuer's creditworthiness?
- Because an ESG factor might not be considered to impact bankruptcy risk
- Difference between a rating analysis and asset valuation
46
What challenges are unique to ESG credit ratings?
- Time horizon
- Lack of proxy vote
- Different levels of management engagement
- Unique qualities of sovereign credit
47
What does credit risk analysis do?
- CRA assess the predictability and certainty of an issuer's ability to generate future cash flow to meet its debt obligation
- to this end, they look if company's can sell assets to meet their obligations
- Forward-looking with varying time horizon
- Composed of dynamic and relative measures
- Statement of the relative likelihood of default
48
What does CRA test in terms of ESG?
( Credit Risk Analysis? )
- How ESG factors affect the issuer's ability to convert assets into cash
- Impact that changing yields - due to an ESG event - may have on the cost of capital
- Extent to which ESG-related cost dent ability to generate profits
- How well an issuers' management uses the asset under its control to generate sales and profits (efficiency ratios)
49
Challenges with integration to ESG
- Data is relatively short-run
- ESG factors are not agreed upon
- Many ESG providers with different methodologies
- Uncertain to what degree ESG factors may correlate with other established quantitative factors like quality, value, momentum
50
What is Management Gap?
Management Gap is a situation where a risk could be managed by a company, but the company decides NOT to manage it
51
What types of ESG screening can be used to generate investment ideas?
Positive, Negative, or Momentum...
Positive: Seek high 'G'
Negative: Avoid low 'G'
Momenum: Seek rising 'G'; Avoid falling 'G'
52
Material items and the impact of ESG factor on financial performance?
Where materialiaty 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.
The impact of the ESG factor on FINANCIAL PERFORMANCE will be uncertain..
53
Cultural differences comparing viewpoints on ESG materiality
Japanese companies have much lower number of independent directors on boards than Euro or US average
Different countries put different weights on social factors..
US companies are less concerned about having a policy on work or labour unions than German companies
54
What is the order of stages for INTEGRATED ESG ASSESSMENT?
RVPcI or RVPI
1) Research stage
2) Valuation Stage
3) Portfolio construction stages
4) Investment Decision
55
What are the two components of a company's UNMANAGED RISK?
1) Unmanageable risk (cannot be addressed by company initiatives)
2) Management Gap (represents risks that could be managed by company through suitable initiatives, but not yet managed)
56
What does Real Impact Tracker (RIT) do?
RIT does NOT provide ESG ratings
RIT takes more holistic approach; does deep dive due dilligence on manager assessments
RIT's 'certified community' is publicly available with details of assessment undertaken
Rather than use 'holdings-based' approach, RIT assesses:
- Culture
- Philosophy
- Process impact
- Public policy efforts
CPPP
CuPhPrPu CuhPhuhPruhPuu
57
What is the most important ESG factor for sovereign debt?
G.
Credit investors say G is most important because:
- downside risk (bankruptcy risk & risk of losing investor's entire capital) is more important than upside or opportunity risk
'Opportunity' would be more important to EQUITY investors...
As G is directly related to preventing downside risk, its direct relevance is easier to trace for credit investors
58
Do all companies need to report on ESG?
No.
Companies have variable disclosure policies and reporting
Listed companies must provide minimum accounting / reporting standards, but these vary region to region
Disclosure of ESG data is often 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 repoted
Conversely, there can be a prolem of OVER-disclosure, particularly of non-material ESG info
59
What is the definition of MATERIAL RISK
A risk is MATERIAL to an industry when it is likely that the companies in a given industry will incur substantial costs in connection with it
60
At what levels can DCF be adjusted?
DCF can be adjusted at:
COMPANY
SECTOR
COUNTRY
levels
(CSC)
61
What is ESG Mapping?
ESG mapping is a technique for determining which ESG issues may be most material to companies
Some ESG issues may be material for some companies in a specific industry (water stress on mining or beverage companies, which rely heavily on clean water in their production process); but not for other sectors (water stress has little impact on media or financial companies)
Frameworks like materiality maps provided by SASB are helpful in providing some guidance, but investment pros often develop their own view on what is most material
62
When might credit analyst create own ESG assessment?
Credit analyst might create own ESG assessment when third-party ESG rating is NOT AVAILABLE, but where the company is issuing investment grade bonds that might be investable
In this case, credit analyst may create their own ESG assessment
63
What are some direct methods of ESG information collection?
Public documents
Surveys
Company presentation
Company communication
Public documents
64
What are some INDIRECT methods of ESG information collection?
News articles
Third-party reports
Analysis
65
What levels can materiality mapping be applied to?
SECTOR level
SUB-SECTOR level
COMPANY level
66
Japanese Governemtn Pension Investment Fund has created _____-tilted rules-based indices
GENDER
Japanese Government Pension Investment Fund has created gender-tilted rules-based indices to invest in
67
What are the five risk categories for Sustainalytics ESG risk rating?
FIVE risk categories for Sustainalytics ESG Risk
1) Negligible
2) Low
3) Medium
4) High
5) Severe
68
Sustainalytics ESG rating measures 'management gap', meaning
Sustainalytics MANAGEMENT GAP stands for:
The magnitude of a company's unmanaged ESG risks
Sustainalytics ESG Risk Rating measures the degree to which a company's ecnoomic value is at risk driven by ESG factors, or more technically speaking the magnitude of a company's unmanaged ESG risks
69
What are the four main hurdles and challenges relating to COMPARABILITY difficulties for ESG integration?
1) Lack of comparability between ESG ratings agencies
2) Comparing across different accounting and other standards
3) Comparisons across geographies and cultures
4) Inconsistent use of jargon terminology
70
What is the major flaw of 'Holdings-Based Approach' used by Morningstar Sustainability Rating?
Holdings-based approach calculated weighted average of portfolio companies ESG scores
- No credit or assessment is given to manager's efforts on shareholder engagement and public advocacy
- No credit to sophistication, culture, and invt strategy
- Holdings-based approach ignores INTENTIONAL ESG STRATEGY
- Approach is BACKWARD-LOOKING
71
What are five types of Investment Strategies? (5, broad)
- Quantitative (Systematic, Algorithmic)
- Fundamental
- Active
- Passive
- Beta
72
What is the appropriate weighting for emerging market countries?
E = 25%; S = 25%; G= 50% <-- Governance factor strongly influences oscial and environmental factors
73
How do thematic funds incorporate ESG analysis into decision-making
- Use a MATERIALITY MAPPING process
- Use ESG data to adjust weights
74
What are DISCLOSURE and DATA related challenges for ESG integration?
- Data consistency
- Data scarcity
- Data incompleteness
- Lack of audited data
75
What are MATERIALITY and JUDGMENT challenges for ESG integration?
Judgments that are difficult and uncertain
Judgments that are inconsistent
76
What are the two main considerations of MSCI ESG Risk?
Risk Exposure & Risk Management
Risk Management
- What management strategies it has employed
Risk Exposure
- How exposed it is to the risk
77
What is the main challenge of SASB's efforts to map materiality?
Determining which ESG issues are the most material is not an exact science
Might be important differences between what each investor considers most material, even when analyzing 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 cash flow
78
What are examples of intangible factors?
- Goodwill
- Patents
- Copyrights
- Intellectual property and know-how
- Software and innovation assets
- Corporate culture
- Incentives
- Employee productivity
- Other forms of social and relationship assets
79
What are some remaining challenges regarding ESG integration?
- Significant number of investments pros who do not integrate ESG
- Significant number of investment pros still believes ESG has limited financial impact
- Firms may not have significant resources to buy third-party ESG data
80
What is detraction level and how is it calculated?
Company E score MINUS Benchmark E score = Detraction level
81
Two parameters to measure materiality
LIKELIHOOD
and
MAGNITUDE
82
What are some fixed-income specific challenges managers face when incorporating ESG?
- Time horizon
- Lack of proxy vote
- Different levels of management engagement
- Unique qualities of sovereign credit
83
What is the most popular method of materiality mapping?
Most managers and investment pros develop their own materiality maps (rather than use SASB or third party info)
84
What methodology does Morningstar ESG Risk Rating use?
Holdings-based approach
85
Which sector does SASB view compensation and benefits as material?
Financials
86
What is a green bond?
Bonds that finance green projects
Bonds assessed to meet B-Corp criteria
Once certain ESG or sustainability criteria are met, green bond's credit risk often assessed in the same manner as a standard credit
Typically, green bond is a fixed income instrument tied to projects that create an environmental benefit
Issuers use proceeds for a variety of activities aimed at contributing to climate change mitigation, adaptation, or some other environmental benefit such as conservation or pollution control
87
What are the components of the SECURITY VALUATION portion of ESG INTEGRATION framework?
- Forecasted financials
- Valuation-model variables
- Valuation multiples
- Forecasted financial ratios
- Internal credit assessment
- Forecasted financials & ratios
- Relative ranking
- Relative value analysis / spread analysis
- Duration analysis
- Security sensitivity / scenario analysis
This security valuation portion of the ESG integration framework was developed by CFA Institute in collaboration with UNPRI
88
What is definition of controversy?
A case or ongoing situation in which a company operation or products allegedly have a negative impact on the environmental, social or governance factor
89
Qualitative ESG analysis is used in what type of investment analysis methods?
Company-specific research
Fundamental analysis
Stock-picking
CFS
90
What are some factors or techniques beyond 'company assessment' that are useful for companies and analysts to consider with regards to ESG data?
- 'Big data' analysis of multiple ESG factors
- Resource, supply, and operational risk mitigation
- Modelling future sustainability scenarios
- Real-time dynamic analysis
BRMR
91
Data sources at MSCI and Sustainalytics are similar and include:
- Macro data at geographic level
- Macro data at segmental level
- Company Sustainability report
- Company annual report filings
Macro data from academic, government, and NGO datasets
Company disclosure
- annual report filings
- sustainability report
- proxy report
- annual general meeting (AGM) results
92
What are the TWO dimensions of Sustainalytics ESG Risk Rating?
Exposure & Management
93
What are some challenges for real estate sector when integrating ESG?
Tenants and operators may have different operational and financial motivations
Called 'split incentive problem' as tenants must pay ongoing bills, which constructors do not
