Chapter 7 - ESG Analysis Valuation and Integration Flashcards
Why Investors Integrate ESG
(7 Points)
- meeting requirements under fiduciary duty or regulations
- meeting client and beneficiary demands
- lowering investment risk
- increasing investment returns
- giving investment professionals more tools and techniques to use in analysis
- improving the quality of engagement and stewardship activities
- lowering reputational risk at a firm level and investment level
Meeting Requirements under Fiduciary Duty or Regulations
(5 Points)
Certain country Regulations could demand a certain level of ESG integration:
* EU Shareholder Rights Directive
* UK Stewardship Code
Fiduciary Duty of investors require them to do following:
* incorporate ESG issues into investment analysis and decision making, consistent with their investment time horizon
* encourage high standards of ESG performance in the companies or other entities in which they invest
* understand and incorporate beneficiaries’ and savers’ sustainability-related preferences, regardless whether they are financially material
Highest Reasons to consider ESG Information
(6 Reasons with Percentage)
- 63.1% ESG information is material to investment performance
- 33.1% growing client/stakeholder demand
- 32.6% believe such policy to be effective in bringing change at firms
- 32.6% it’s part of the investment product strategy
- 32.6% see it as an ehtical responsibility
- 31.7% anticipate it to become material in the future
Highest Reasons to reject ESG Information
(2 Reasons with Percentage)
- 26.7% no stakeholder demand for such policy
- 21.3% lack access to reliable nonfinancial (ESG) data
Business Roundtable’s “Statement on the Purpose of a Corporation”
(6 Points)
August 2019 and signed by 181 CEOs (including major investment banks and asset managers) who commit to:
* delivering value to customers: meeting or exceeding customer expectations
* investing in employees: compensating them fairly and providing important benefits; supporting them through training and education that help to develope new skills; foster diversity and inclusion, dignity and respect
* dealing fairly and ethically with suppliers: serving as good partners to other companies, large and small, that help us meet our missions
* supporting communities near operation: respect people in communities and protect environment by embracing sustainable practices across business
* generating long-term value for shareholders, who provide capital that allows companies to invest, grow and innovate; commited to transparency and efective engagement with shareholders
ESG Analysis Techniques
(3 Techniques)
- Qualitative ESG Analysis (e.g. opinion on quality of management)
- Quantitative ESG Analysis (e.g. impact of financial models or valuation)
- Hybrid of both Techniques (e.g. scorecards)
Qualitative ESG Analysis
(6 Points)
- human judgement of non-numerical ESG data for analysis
- company-specific research, fundamental analysis and stock picking
- analyze ESG data to form opinion on firm’s ability to manage cartain ESG issues
- link specific aspects of company’s ESG risk management strategy to value drivers (e.g. costs, revenues, profits, capital expenditure)
- analysts/portfolio managers integrate opinion in quantified way into financial models by adjusting assumptions in the model (e.g. growth, margins, cost of capital)
- qualitative techniques might be weigthed differently for different asset classes, e.g. judgement of management incentives have more weight in equity than for fixed income
Quantitative ESG Analysis
(4 Points)
- quantify ESG data by converting into an ESG factor (ESG score)
- used in investment processes that use quant models to identify investment opportunities
- source data may be based on mix of third-party database or internal proprietary data
- use heavy mathematical modeling, computing power and data analysis, potentially using AI or NLP
Systematic Approaches to Integrate ESG Analysis
(2 Steps)
- use correlations to understand how ESG factors might affect financial performance over time
- …then weight those ESG factors appropriately
Application Programming Interfaces (APIs)
(3 Points)
- investors use APIs to compile and assess data
- used to easily access and interface underlying databases and other datasets
- APIs needed because number of total unique ESG data points in on the rise
Artificial Intelligence and Algorithms
(4 Points)
Available ESG data from companies is unstructured, AI attemot to bring structure and numerical value to unstructured datasets.
Implementation by Practicioners:
* use AI to measure ESG performance tied to measures of SASB
* provide immediate access to scores based on material ESG events as they happen
* focus on intangible ESG factors that could drive company value, e.g. corporate culture
Natural Language Processing (NLP) in ESG Analysis
(3 Points)
- process and analyze large amounts of natural language data related to ESG
- understand the ESG contents of documents, including nuances of the language within them
- accurately extract information and insights to categorize and organize them
Quantitative/Systematic Investment Strategies
(5 Strategies)
- high-frequency trading
- use algorithms based on news or factors and statistical arbitrage
- trend following
- risk parity
- use of beta strategies
Investment Strategies Classification
(5 Points)
- quantitative (systematic, algorithmic): relies on mathematical models, statistical analysis and computer algorithms to make investment decisions based on patterns and trends in financial markets
- fundamental: investment strategy that evaluates various qualitative and quantitative factors to determine whether an asset is overvalued, undervalued or fairly priced
- active: investment strategy with target to outperform the market index by making active investment decisions
- passive: investment strategy that aims to replicate the performance of a specific market index rather than trying to outperform it
- beta: investment approach that aims to replicate a specific market index (e.g. S&P 500) with the target to outperform it by either taking more risk or reducing risk
Tools and Elements of ESG Analysis
(7 Tools)
- Red Flag Indicators: securities with high ESG risk are flagged and investigated further or excluded, e.g. company board with lack of majority independence lead to scrutiny on management incentives or exclusion
- Company Questionnaires and Management Interviews: if detail of material ESG information is insufficient, investor migh ask for specific data; prepare a list of standard ESG data to ask for
- Checks with Outside Experts: interview key industry through leaders or other stakeholders of the company (e.g. customers, suppliers, regulators)
- Watch Lists: securities with high ESG risk added to watchlist for monitoring, high ESG opportunities added to watchlist for possbile investment
- Internal ESG Research: research based on variety of techniques and data sources and output provided in scores, ranking or reports
- External ESG Research: research uses sell-side, ESG specialist or third-party databases to create materiality framework
- ESG Agenda Items at Investment Committee: ESG section as standing item at committee meetings
Methods of ESG Intergration into Portfolio
(9 Points)
- adjusting forecast financials, e.g. revenue, operating cost, capital expenditure
- adjusting valuation models or multiples, e.g. discount rates, terminal values, ratios
- adjusting credit risk and duration
- managing risk, including exposure limits, scenario analysis and value-at-risk models
- ESG factor tilts
- ESG momentum tilts
- strategic asset allocation, including thematic and ESG objective tilts
- tactical asset allocation
- ESG controversies and positive ESG events
ESG Assessment Technique Stages
(5 Points)
Stages are typically:
Research,
* gathering information
* materiality assessments
* tangible and intangible factors
* generating ideas
Valuation, and
Portfolio Construction.
Gathering Information as ESG Technique
(3 Points)
- gather financial and ESG information from multiple sources, e.g. company reports, third-party research and primary research
- qualitatitve data: company questionnaires, management interviews
- quantitative data: environmental emissions data
Materiality Assessments as ESG Technique
(3 Points)
- materiality is measured in terms of likelihood and magnitude of impact on a company’s financial performace
- nonmaterial factors do not affect financials, valuations or company business models
- “ethical” or “impact” investment strategies that may not be deemed material
Tangible Assets
(3 Points)
- physical asset (hard asset)
- e.g. land, manufacturing plants, inventories, furniture, machinery
- both tangible and intangible assets: ESG analysis techniques, materiality
Intangible Assets
(3 Points)
- non-physical asset that is diffcult or impossible to touch
- e.g. goodwill, patents, copyrights, intellectual property and know-how, software and innovative assets, corporate culture, incentives, employee productivity, other forms of social and relationship assets
- both tangible and intangible assets: ESG analysis techniques, materiality
International Integrated Reporting Council (IIRC) Framework
(6 Points)
Describes different forms of corporate capital (both intangible and tangible):
* financial capital: pool of funds available to organization obtained through financing (debt, equity or grants) or generated through operations
* manufactured capital: manufactured physical objects of organization for use in good production or service provision, e.g buildings, equipment and infrastructure (roads, ports, bridges and wast- and water-treatment plants)
* intellectual capital: knowledge-based intangibles, including intellectual property (e.g. patents, copyrights, software, rights and licenses) and “organizational capital” (e.g. tacit knowledge, systems, procedures and protocols)
* human capital: people’s competencies, capabilities and experiences, and their motivations to innovate, including alignment and support of governance framework, risk management and ethical values; ability to understand, develope and implement and organization’s strategy; loyalities and motivations for improving processes, goods and services, including ability to lead, manage and collaborate
* social and relationship capital: institutions and relationships between communities, groups of stakeholders and other networks; ability to share information to enhance individual and collective well-being, e.g. shared norms; common values and behaviors; brand and reputation that organization has developed; organization’s social licenses to operate
* natural capital: environmental resources, including air, water, land, minerals, forests, biodiversity and ecosystem health
Companies that Profit from positive Relationship with Regulators
(6 Points)
Good Relationship to Regulators is Intangible Asset:
* social media and avertising companies
* pharmaceutical companies
* airlines
* financial services
* any company that has significant regulator
Examples of Forms of Intangible Corporate Capital
(5 Forms)
- relationship with regulators
- customer satisfaction
- company reputation
- employee satisfaction
- supplier relationships
Generating ESG Investment Ideas
(5 Points)
- valuation screen (fundamental screen): mix of positive (seek high G), negative (avoid low G) or momentum (seek rising G, avoid declining G) ESG factors to create attractive investment universe
- thematic investment: work on ESG megatrends, like access to clean water or energy services
- red flag: naroow investable universe by flagging companies, e.g. acceptable low governance score, unacceptable number of ESG controversies
- priced in: ESG risk judged against what can be priced into the asset
- materially negative assessment: negative assessment of a ESG factor or collection of factors could lead to investment failing to meet a specified hurdle, triggering a “sell” or “do not invest” signal
ESG Scorecard Development Steps
(6 Steps)
- identify sector- or company-specific ESG items
- break down issues into a number of indicators, e.g. policy, measures, disclosure
- determine a scoring system based on what good/best practice looks like for each indicator/issue
- assess a company and give it a score
- calculate aggregated scores at issue level, dimension level (ESG level) or total score level (relative weight of each issue)
- benchmark the company’s performance against industry averages or peer group (optional)
Types of unmanaged Material ESG Risk
(2 Points)
- unmanageable risk: which cannot be addressed by company initiatives
- e.g. carbon emissions of airplanes in flight
- management gap: which is risks that could be managed through suitable initiatives, but might not yet be managed
Determining Materiality on ESG Issues
(3 Points)
- forecasting how much one ESG issue will affect future cash flow is matter of personal judgement
- investment professionals often develop own view what is most material
- SASB Materiality Map provides framework to guide on most material ESG factors per sector
Material Risk of Cannabis Plant
(2 Points)
- growing plants is complex operation with enhanced risk compared to standard manufacturing
- regulatory oversight is more complex as drug regulators and pharmaceutical regulators are involved
ESG Risk-Mapping Methodologies
(3 Methodologies)
- research stage: company or sector has its risk mapped to a specific theme or factor that has be judged material
- risk mapping methodology: mapping portfolio or investible universe against specific ESG risk (e.g. climate risk, water-related risk) to identify which sectors or companies have highest risk; examples include carbon-footprinting or testing portfolios against different climate scenarios
- mapping for material opportunities and risks: score on 10-point scale or qualitative label (low or high risk), combination of scorecard technique and mapping technique
Adjustment Models based on Assessment of Material ESG Factors
(6 Points)
- forecasted financials, e.g. assessment of environmental litigation fee, higher sales forecast due to customer satisfaction
- valuation-model variables, e.g. cost of capital or terminal growth rates in discounted cash flow analysis
- valuation multiples, e.g. different P/E ratios for companies with different ESG performance
- forecasted financial rations
- internal credit assessments
- assumptions in qualitative or quanitative models
Discounted Cash Flow Input Adjustments based on ESG Assessment
(3 Points)
- company’s environmental management processes are judged “strong” or “weak”
- cost of capital used to discount cash flows in DCF analysis is adjusted down or up by 1%
- can also be on country or sector basis
Balance Sheet and Margin Adjustments based on ESG Assessment
(3 Points)
- adjustment can be direct impact (environmental fine) or risk-adjusted impact of a carbon tax
- adjustments are either directly to balance sheet or capital expense
- e.g. company’s strong management of its employees leads to assessment of strong future customer satisfaction, which leads to raised sales forecast in 5 years
