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CFA ESG Investment > Chapter 7: ESG Analysis, Valuation and Integration > Flashcards

Chapter 7: ESG Analysis, Valuation and Integration Flashcards

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1
Q

What are investors objectives to integrate ESG into investment process?

A
  1. Meeting requirements of fiduciary duties or Regulation
  2. Meeting client or beneficiaries demands
  3. Lowering investment risk
  4. Increasing investment returns -> seeking higher alpha
  5. Giving investment analysts more tools and techniques to use
  6. Improve quality of engagement and stewardship activities
  7. Lower reputational risk
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2
Q

What is qualitative ESG analysis?

A
  • Used in investment process that are based on company-specific research, fundamental analysis and stock-picking
    ○ Investment teams analysis 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)
  • Analysist 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
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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
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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
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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
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6
Q

What is meant with active of passive investment?

A
  • How human discretionary or computer algorithm based an investment strategy is
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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
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8
Q

What are elemets of internal ESG research?

A 
○ Proprietary ESG research data and techniques, 
    scores and rankings
○ Materiality frameworks
○ ESG-integrated research notes
○ Research dashboards
○ SWOT analysis
○ Scenario analysis
- Relative rankings
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9
Q

What are elements of external ESG research?

A

○ Sell-side research, ESG specialists or third-party data provider
- Materiality frameworks

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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, rations
  • 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
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11
Q

What are the elements of the ESG Integration Framework?

A
  1. Research stage - Red flag indicators, watch lists, materiality framework, company survey, voting, SWOT analysis etc
  2. Security level - Financial forecast, valuation modelling, Credit risk etc, relative ranking
  3. Portfolio level - Asset allocation, tilting, scenario analysis, Value-at risk analysis, weighting, ESG profile
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12
Q

What are differences in company and business analysis and security analysis?

A
  • A company of 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
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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
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14
Q

What goes into generating ideas as part of the research adn 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)

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15
Q

Why and how can you developed a scorecard for ESG risk and opportunities?

A

○ Needs to be developed if there is no no-third party information available that helps with assessment

  1. Identify sector or company specific items
  2. Breakdown issues into number or indicator
  3. Determine scoring system based on what’s good or bad practice
  4. Assess a company
  5. Calculate aggregate scores at issue level etc
  6. Benchmark
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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
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17
Q

What is the quantitative appraoch 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

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18
Q

What appraoches to integrated ESG analysis exists?

A
  • Quantitative
  • Systematic
    Thematic
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19
Q

What is the systematic appraoch to integrated ESG analysis?

A

○ Systemic approach - attempts to derive correlations to understand how ESG factors impact financial performance
- Passive index - tilting toward ESG, integration of ESG mandate

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20
Q

What is the thematic appraoch to integrated ESG analysis?

A
  • Assess alignment with priority themes
21
Q

What factors can change when integrating ESG assessment into valuation?

A

○ Forecasted financials
○ Valuation-model variables, such as cost of capital, terminal growth rates in discounted cash flow analysis
○ Forecasted financial ratios
○ Internal credit assessment
- Assumptions in qualitative and quantitative models

22
Q

How can weak or strong ESG complement traditional financial analysis?

A

§ Up or down sales margin
§ Up or down long term cash flow
§ Up or down intrinsic value
- Up or down 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
Q

What are challenges related to ESG disclosure in investment analsys?

A
  • lack of disclosure could be good indicator of poor managemnet
  • Poor disclosure sign of market inefficiency - could be source of superior risk-adjusted returns
26
Q

Why does integration of ESG into bonds differ from equities?

A
  • 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
Q

What are the main challenges for ESG integration in investment analysis and decision?

A
  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 (difficutly, uncertain, inconsistent)
  4. ESG integration across assets (different assets require different strategies)
28
Q

What are the main criticisms against ESG integration?

A
  1. Too inclusive or poor companies - ESG mutual funds and ETFs often hold investment in bad companies
  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 might be overemphasized
  3. Quality of data - Information used for selecting ESG factors often comes unaudited or unassured from companies
  4. Potential lack of emphasis on long-term improvements - Some financial advisers screen investments first for performance and then for ESG factors
29
Q

What could high-correlation between ESG rating mean?

A
  • could lead to group think - > credit agencies in 2008

- could also mean higher credibility and more consistent message

30
Q

What are potential consequences of lack of correlation between ESG ratings?

A
  • This means that information that investors receive is noisy
  • ESG performance is less likely to be reflected in corporate stock of 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
Q

What are different ESG rating techniques?

A
  • 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
Q

What should be considered when choosing an ESG rating provider?

A
  • Number of companies covered
  • Length of history of dataset
  • Language
  • Stability of methodology
  • Regulatory of updates
33
Q

What are the limitations of mutual fund manager ratings?

A

○ 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
Q

What are different types of company ESG assessment and rating appraoches?

A

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
Q

In Sustainalytics rating methdology, what means high-risk?

A
  • High-risk reflect comparable degree of unmanaged risk
36
Q

In Sustainalytics rating methdology, what means means materiality?

A
  • Materiality depends on if presence or absence in financial reporting is likely to influence investor decisions
37
Q

In Sustainalytics rating methdology, what means means exposure?

A

-The extent to which a company is exposed to a material risk at the sub-industry level and adjusted at the individual level

38
Q

In Sustainalytics rating methdology, what means means relevance?

A
  • Relevance depends on if the issue has potential substantial impact on the economic value of the company
39
Q

How does Sustainablytics calculate its rating score?

A
  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, which 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
Q

What is the principle difference between Sustainalytics and MSCI rating?

A

MSCI has a company focus and takes into account opportunities as well as risks.

41
Q

According to MSCI what is the relation between exposure and management?

A

○ A company with high exposure must also have strong management

  • But, a company with low exposure can have a more modest management approach
42
Q

What goes into a ESG index?

A

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
Q

What is secondary data for ESG assessment?

A

Transformation of primary data based on process of scoring, rating or formula.

44
Q

What are potential impacts of ESG factors on the risk and performanc of a bond at issuer and sector/industry level?

A
  • Issuer or company level - affect only specific bond and not the entire market. Often governance related
  • Industry and geography level - affecting the entire industry, regulatory changes, technological changes
45
Q

Why ESG factors might not actually affect issuer’s creditworthyness?

A
  • because an ESG factor might not be considered to impact bankruptcy risk
  • difference between a rating analysis and asset valuation
46
Q

What challenges ar unique to ESG credit ratings?

A

○ Time horizon -
○ Lack of proxy vote
○ Different levels of management engagement
- Unique qualities of sovereign credit

47
Q

What does credit risk analysis do?

A
  • 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
Q

What does CRA test in terms of ESG?

A

○ 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 rations)

CFA ESG Investment (9 decks)

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