ESG Analysis, Valuation and Integration Flashcards
Aims and objectives of integrating ESG into a firm’s inv. process
A. meeting requirements under fiduciary duty or regulations
b. meeting client and beneficiary demands
c. lowering inv. risk
d. increasing inv. returns
e. giving inv. professionals more tools and techniques to use in analysis
f. improving the quality of engagement and stewardship activities
g. lowering reputational risk at a firm level and investment level
A. meeting requirements under fiduciary duty or regulations
b. meeting client and beneficiary demands
ESG integration is not universally accepted.
but they fall under certain country regulations
EU Shareholder Rights Directve / UK’s Department of Work and Pension’ DWP regulation
/ UK’s Stewardship Code
UNEP FI
United Nations Environment Programme Finance Initiative and
UN PRI
United Nations Principles for Responsible Investment
argued that the fiduciary duties of investors require them to:
- incorporate ESG issues into inv. analysis and decision-making processes, consistent with their inv. 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 of whether these preferences are financial materials.
as of 2021, regulartory updates include:
- the EU Shareholder Rights Directive II
- the UK Stewardship Code
- guidance from the US Department of Labor DoL
c. lowering inv. risk
d. increasing inv. returns
Investors seek to integrate ESG into inv. processes to better understand and lower inv. risk.
Seek to enhance returns vis 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.
ESG analysis can be either qualitative or quantitative
Qualitative ESG analysis
based on company-specific research, fundamental analysis and stock-picking
Quantitative ESG analysis
use quant models to identify attractive inv. opportunities
Qualitative ESG analysis
a. inv. teams analyze 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
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
Quantitative, systematic and thematic approaches to integrated ESG analysis
quantitative factors:
value size momentum
growth volatility
passive/index approaches use rule based strategies
thematic assess alignment with priority themes such as climate and gender
AI and algorithms
- focus on using AI techniques to measure ESG performance tied to measures developed by the Sustainable Accounting Standards Board SASB
- attempt to provide immediate access to scores based on material ESG events as they occur
- focus on intangible ESG factor, such as corp. culture, that may drive company value.
NLP Natural language processing
automatic manipulation of natural language
aim to obtain a computer capable of ‘understanding’ the ESG contents of documents, including the contextual nuances of the languages within them.
quant investing can be known as ‘systematic investing’ such as
- high-frequency trading
- use of algorithms based on news or factors and
- statistical arbitrage
- trend-following
- risk parity
- use of beta strategies
Inv. strategies classification
quantitative (systematic, algorithmic) fundamental active passive beta
tools of ESG analysis
red flag indicators
company questionnaires and mgmt interviews
checks with outside experts
watch lists
internal ESG research
external ESG
ESG agenda items at investment committee or Chief Information Officer CIO - level meetings
internal ESG research
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
- Sell-side, ESG specialists or 3rd party databases may all be used
- a materiality framework is created
Elements of ESG integration
- adjusting forecast financials
- adjusting valuation models or multiples
- adjusting credit risk and duration
- managing risk
- ESG factor tilts
- ESG momentum tilts
- strategic asset allocation
- tactical asset allocation
- ESG controversies and positive ESG events
2 distinctions that many inv. practitioners make in fundamental inv. analysis:
- the difference b/w a company/business assessment
- a security, stock, bond or convertible assessment
stages of integrated ESG assessment
- a research page
- a valuation stage
- a portfolio construction stage, which leads to investment decisions
research and idea generation stage
- gather information
- materiality assessments
- tangible vs. intangible factors
- evaluating diff. forms of tangible or intangible factors
tangible asset
land manufacturing plants inventories furniture machinery
intangible assets
goodwill patents copyrights intellectual property and known-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
The IIRC Framework describes capital as:
(framework for evaluating diff. forms of capital or tangible or intangible factors)
IIRC International Integrated reporting Council
financial capital:
- available to an organization for use in the production of goods or the provision of services
- obtained through financing, such as debt, equity or grants, or generated through operations or investments
manufactured capital
intellectual capital
human capital
social and relationship capital
natural capital
a positive relationship with regulators may lead to less friction and litigation
the relationship is considered as an intangible asset
faster approval in pharm. companies positively impacts cashflow
as reputation and brand are intangible assets
affect risk-adj. DCF calculation
Generate ideas
positive or ‘best in class’ screening
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.
assessment can be qualitative or quantitative.
scorecards can be used to assess ESG risk and opportunity
an ESG scorecard based on the self-assessment response is created with ESG factor scores ranging from 0 to 5, and high or low scores are then used in valuation or further assessment work.
score of 0 make a company unattractive and scores of 5 lead to further investment work
take a qualitative judgement of a factor and put a form of quantitative score on it.
can be used on private companies and public companies
but less likely to be rating agency score for a private company
to develop a scorecard:
- identify sector or company specific ESG items
- breakdown issues into a number of indicators
- 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) or total score level (depending on the relative weight of each issue)
- benchmark the company’s performance against industry averages or peer group
two types of risk for ESG risk (has not been managed)
- unmanageable risk, which cannot be addressed by company initiatives
- the mgmt gap which represents risks that could be managed by a company through suitable initiatives but which may not yet be managed
manageable risk:
- establishing stringent safety procedures
- having emergency response plans and safety drills
- promoting a safe culture
using SASB as a baseline framework in a materiality assessment
SASB/ Global Reporting Initiative GRI as analytical framework alongside standardized frameworks
ESG risk-mapping methodologies
such as carbon foot-printing or testing portfolios against different climate scenarios.
mapping can be done for material opportunities as well as risk.
can be scored on a 10-point scale or given a qualitative label.
assess the impact of material financial and ESG factors on the corporate and inv. performance of a company, leading to adjustments to
- forecasted financials
- valuation-model variables, such as cost of capital or terminal growth rates in DCF analysis
- valuation multiples
- forecasted financial ratios
- internal credit assessment
- assumptions in qualitative or quantitative models
DCF input adjustment
strong/weak company environmental management processes and policies
- cost of capital is adjusted down/up by 1%
Explicit sales/margin assumption maybe adjusted
strong mgmt of employees based on engagement/satisfaction metrics by the employee
- strong future customer satisfaction
- lead to sales forecasts to be raised to above the industry average to account for strong social factor score
adjustment can be made directly to b/s or capital expense lines
a forecast ESG impairment event may result in an impairment charge being made to bring the company’s book value down.
Valuation ratio adj. with ESG integration
- PE ratio premium/discount vs. its peers due to ESG factors
- high ESG risk- P/E discount
- strong ESG P/E premium
weak/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
high employee engagement or satisfaction
- high customer satisfaction
- higher sales growth than competition
- higher valuation than competition
judgement 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
High carbon intensity
- 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
judgement of a E factor, such as exposure to carbon, lead to analysis on the risk to debt pricing.
It complements a traditional take on default risk
Weak governance identifies in a private company
- increased risk of negative capital allocation decisions
- lower future cash flows or difficulty in IPO to capital markets
- lower valuation or increased bankruptcy risk
a judgement on a G factor in a private company impacts both a valuation and possible exist for a private equity investor
No disclosure relevant ESG Data does not necessarily mean it is managing its ESG risks or opportunities poorly.
Disclosure varies by geography and is influenced by company size and industry practice.
lack of disclosure could be an indicator of poor management and many investors prefer to see relevant disclosure so judgements can be made.
poor disclosure is a challenge to market efficiency, and could arguably be a source of superior risk-adjusted return for the skilled investor.
suggest investment analysis is about superior judgements concerning qualitative, non-computable factors and how things are likely to unfold in the future.
Questions an analyst might want to ask:
- what’s the size of the company
- does the presence of a narrative and strategy improve an analyst’s view on disclosure
- how well does the company compare to its competitors?
- are there any signs from reading the strategy or the size of the scope 1 data?
- would the business model suggest scope 2 would be a material matter?
- how long has the company been disclosing and has management made other commitments to future disclosure?
to follow up, the analyst could:
- call the company and ask for explanation of data’s absence and the company’s view on its materiality, and judge its willingness to engage or commit to publishing the data
- estimate the data and find a 3rd party data source
a quantitative approach would have to consider how to deal with missing data
has to judge the materiality of the missing information, and might view cement as a carbon-intense industry
a disclosure on carbon intensity would be viewed as more material for a cement company than a software service business
a software service business would not be expected t be carbon-intense
strength of environmental accounting
lack of consensus on how best to account for natural capital currently.
Case 1
Quantitative systematic approach to an environmental titled mandate in global equities
covert 3rd-party E scores through its own formula
use db to flag companies with no environmental mgmt policy
use a scorecard approach to score companies on material relevant environmental risks and opportunities
Case 2
Fundamental ESG intergration
fund manager adj. the move relevant financial forecasts based on material ESG factors, and adjust the target multiples on ratio analysis.
Case 3
ESG Analysis supporting a premium valuation ratio
operational risk
maintenance of the company’s technical leadership through inv. in human and physical capital
potential for manufacturing delays or product defects that may impact its reputation and market share
E&S assessed using 3rd party db
could apply higher PE premium
when the below are strong enough:
- asset quality and efficiency
- attracting and retaining talent
- sustainable business model
Case 4
ESG DCF scenario analysis
start with fundamental analysis to identify any material positive or negative ESG factors
embed assessment into an analysis of the competitive position and the sustainability of the business
materiality of the below: business models market share opportunity end-market growth management and ESG
Case 5
Credit analysis integrating ESG
ESG analysis consists of a quantitative score and qualitative-based research.
weights the strengths and challenges, and compares the performance of beverage brands to its industry peers.
Case 6
Credit ESG integration practice
relies on a central ESG/responsibility team for firm policies, approaches and inv. tools.
reviews quantitative ESG (QESG) score that the firm has developed, the score is a snapshot of the company’s overall ESG performance
a score 1-5 will be assigned after the initial committee analysis
Case 7
Sovereign debt analysis
investor assigns a financial stability score FSS to a country based on the overall balance sheet strength and ESG factors. FSS ranges from +4 to -4 for those countries and currencies.
strength of the b/s was judged by looking at: gross domestic product GDP inflation government revenue fiscal balance gross debt current account currency reserves external debt
these G factors are considered: political stability absence of violence or terrorism government effectiveness regulatory quality rule of law control of corruption voice of accountability
judge of social capital strength:
a life expectancy index
an education index
the human development index
Real assets own asset directly, full ownership offer greater control over
definition, application and reporting of ESG data alongside or outside existing reporting standards like that of the GRO or use of the Global Real Estate Sustainability Benchmark (GRESB)
Global Real Estate Sustainability Benchmark (GRESB)
provides:
- a composite of peer group information
- overall portfolio key performance indicator KPI performance
- aggregate environment 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
ESG integration in private equity faces challenges
lack of public transparency
established reporting standards
regulatory oversight and public market expectations around ESG
Capital-challenged by ESG reporting requirements
typical assessment include: policy people process transparency and collaboration assessments
bond ESG techniques differ by:
- credit quality
- duration
- payment schedules
- embedded options
- seniority
- currencies
- collateral and
- time horizon
bonds investors may find ESG factors that impact balance sheet strength more material than equity investors
equity investor is positive about future value from technology whereas bond investor might be worried about the amount of debt required to fund the acquisition.
Soverign debt cannot easily borrow the same materiality fraomeworks as equity or corp. debt investors
because some country-level factors may not be material to equity or corporate bond investors.
Certain ESG factors (political risk/ governance factors) have typically been integrated into sovereign debt by investors even if not explicitly labelled ESG
Municipal credit ESG analysis can be assessed by
overall transparency reporting corruption levels budgetary practices pension liabilities contracts
many hurdles and challenges for ESG integration, inlcude:
1. disclosure and data-related challenges such as data consistency data scarcity data incompleteness lack of audited data
- comparability difficulties
lack of comparability between ESG ratings agencies
comparing across different accounting and other standards
comparisons across geographies and cultures
inconsistent use of jargon terminology - materiality and judgement challenges
judgements that are difficult and uncertain
judgements that are inconsistent - ESG integration challenges across asset classes
diff. types of assets and different strategies integrates ESG using diff. techniques
Challenges from incomplete data sets and identifying and assessing ESG data
ESG data is not consistently reported across companies, geographies and sectors
most ESG data is not audited
some ESG data is not easily available in public databases and is difficult to obtain
Data disclosure challenges
ongoing debate over ESG data disclosure at a company level
vary b/w companies and regionally
ongoing efforts via organizations such as SASB or the GRI, and continuous evolution from the IASB on ‘broader corporate reporting’.
no consensus agreements on the details of what good ESG disclosure may look like.
Criticism for ESG integration
- too inclusive of poor companies
- dubious assessment criteria
too subjective and can reflect narrow or conflicting ideological or political viewpoints - quality of data
- potential lack of emphasis of long-term iprovements
time horizon for assessing ESG is too short to prove benefits
classify provider by business type
for-profit large providers
- offer multiple ESG-related products and services, as well as non-ESG-related products and services
for-profit boutique providers
- offer specialty ESG products and services and ISS
non-profit providers
- offer ESG-related products and services
by type of product or service
ESG DATA ESG rating ESG screening Voting and governance advice ESG benchmarks and indices ESG news and controversy alerts Integrated research Advosory services
specific ESG-related services
class action litigation sustainable development Goal SDG reporting and alignment carbon and water analysis norms and sanctions policy development real estate assessment factor databases supply chain assessment assurance services
one challenge is that the agreement or correlation between the various ratings agencies is low
a study finds 0.3 correlation
another find it negative
another show a range of correlations as well on average 0.54 and range from 0.38 to 0.71
factors debated by investors:
what the correlations are
the timeframe over which they are studies
the relevance of any potential correlation
practitioners debate how important correlations are:
- high correlation could lead to group think and a lock of rigorous thinking
to some, a low correlation is a healthy and useful outcome for ESG ratings providers noting the distinction between ratings and raw data - simplicity and correlation may bring credibility to ESG ratings as a discipline and give more consistent msg to companies
ESG information can be collected directly via
surveys company communication company reports presentations public documents
ESG info can be indirectly collect from
news articles
3rd party reports
analysis
Berg study argues low correlations pose challenges
- sustainability performance is less likely to be reflected in company stock and bon prices
- divergence restricts companies from being able to improve their ESG performance because they receive mixed signals from ESG rating providers about which actions are expected and will be valued by the market
- low correlation poses a challenge for academic and empirical research
some investors argue variability in methodology and output to be a source of investor insight and beneficial for investors
as long as there’s transparency on how they are derived.
where providers have come from
which stakeholders are serviced:
‘Traditional’ ESG data and research providers:
founded from SRI industry to provide investors with sustainability data and ratings about primarily large, publicly traded companies.
level of automation is low or medium, as human judgment is still used.
‘Non-traditional’ ESG data and research providers:
such as credit-rating agencies
level of automation os low or medium, as human judgment is still used
AI or algorithm-driven ESG research
automation is high
ratings/data provider styles and techniques:
- raw or partially transformed data
- ratings based on backward looking reported data
- ratings or information based on internet, 3rd party and web-reported data, aiming to be current
- aggregators of data or ratings
considerations that investors could 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
- the regularity of updates
- asset class coverage
- the quality of methodology
- the range of datasets
- the range of tools and services offered
investors often focus on these types of issues over and above what rating agencies do:
- sub-sectors and company-specific material issues
- a focus on product impacts and actual financial or extra-financial performance
- more focus on interpreting raw data
- drawing deeper insights into associated financial risks for companies
Morningstar’s sustainability ratings
1-5 score
uses company-level ratings from Sustainalytics
takes a ‘holding based approach’ weighted avg. of portfolio companies’ ESG scores
it ignores intentional ESG strategy and the approach is necessarily backward-looking.
Real Impact Tracker RIT
more holistic approach
‘Certified community’ is publicly available with details of the assessment undertaken.
assess: culture philosophy process impact public policy efforts
Mercer’s point system
4 point score
highest rating of ESG=1 is given to less than 5% of inv. teams
assess: ESG in decision making ownership policies pursue best practice in transparency and evaluation willingness to collaborate commitment to ESG integration
limitation of diff. types of ESG assessors
- diff. methodologies
- the use of different data sources or rating providers
- the unaudited limited data sources
- the time resource to make the comparison
- the relative non-transparent and non-comparable way these assessments are performed
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
- algorithm and news-based including controversies
climate risk measure to assess forward-looking risk informed by the Paris Agreement and initiatives
such as Task Force on Climate-related Financial Disclosures (TCFD)
many ESG ratings based on historical company data
to produce a rating, perform the following tasks:
- identify indicators that determine which ESG indicators are most material to the sector in question
- gather a set of data points for the identified indicators on the company in question from the company public disclosures, survey responses, unstructured company data/3-partd data
- quantify qualitative data point through scoring or ranking methodologies; score or evaluate quantitative data points through scoring or ranking methodologies
combine these data points with regard to the predetermined weighting system applied to the indicators to create either:
- a sector-relative score for a company that assesses its performance relative to its peer group or
- an absolute score
ESG index providers
- the index typically relies upon rules-based criteria assessed on underlying ESG scores or metrics
- these then go into a formula to tilt company weightings or exclude entire companies based on ESG scores and hurdles
- These scores maybe sourced by other ESG service providers. Sustainalytics started providing FTSE Russell with underlying data from 2019.
Primary data can be sourced from companies directly:
- surveys
- direct company communication
- company reports, presentations and public documents
indirect source:
- news articles
- 3rd-party reports and analysis and
- investment and consulting research
Secondary data sources typically involve
transforming the primary ESG data in some way and creating new scores, assessments or ratings based on these transformations.
ESG data sets used by
AI
Supply Chain Risk
climate change scenarios analysis
- algorithms and natural language processes to determine company quality, reputational risk and many forward-looking aspects of business strength and valuation
- assessment of supply chain risk, including climate adaptation and transition risk to physical infrastructure or location of human resources in environment or politics
- used for country, industry or company level risk for climate change scenarios such as policy interventions
Global risk landscape 2019
Economic Environmental Geopolitical Societal Technological
Top 10 risks in terms of Likelihood:
- extreme weather events
- failure of climate-change mitigation and adaptation
- natural disasters
- Data fraud or theft
- Cyber-attacks
- man-made environmental disasters
- Large-scale involuntary migration
- Biodiversity loss and ecosystem collapse
- water crises
- asset bubbles in a major economy
Top 10 risks in terms of Impact:
- weapons of mass destruction
- failure of climate-change mitigation and adaptation
- extreme weather events
- water crises
- natural disasters
- biodiversity loss and ecosystem collapse
- cyber-attacks
- critical information infrastructure breakdown
- man-made environmental disasters
- spread of infectious diseases
Real-time dynamic analysis
using geospatial data to track:
- de-forestation
- mining
- construction
- shipping and
- traffic
using natural language processes to track social sentiment on the internet
how CRAs credit Rating Agencies approach ESG credit scoring:
- ESG factors affect price performance of a bond and its credit risk at diff. levels
- CRAs assess the predictability and certainty of an issuer’s ability to generate future cash flow to meet its debt obligations
- litigation been incorporated into CRA analysis
- on the quantitative side, CRA analysis focus 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
ESG factors affect price performance of a bond and its credit risk at diff. levels:
- issuer and company level
2. industry and geographic level
Challenges in FI similar to equity ESG ratings:
- lack of transparency
- inconsistent or changing methodologies
- the use of estimated data
- the lack of comparability through time and between providers and companies
specific to Fixed income challenges:
- time horizon
- lack of proxy vote
- diff. levels of management engagement and
- unique qualities of sovereign credit
using standard credit ratio analysis, CRA may test
- how esg factors affect an issuer’s ability to convert assets into cash
- 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
- the extend to which ESG-related costs dent the ability of an issuer to generate profits and add to refinancing risks
- how well an issuer’s management uses the assets under its control to generate sales and profit (efficiency raitos)
in summary, a CRA rating is typically:
- based on analytical judgement
- forward-looking with a varying time horizon
- composed of dynamic and relative measures and
- a statement of the relative likelihood of default
Certain fixed income investors use QESGs quantitative ESG scores
based on quantitative data or be judgements based on data and/or policy.
Green bonds /bonds assessed to meet B-corp criteria - considered a diff. class of credit
tied to green projects that create an environmental benefits
sovereign credit risk assessment
many ESG factors to take into account, including the availability and management of:
- resources
- emerging technologies and
- government regulations and policies
a CRA is typically most interested in a government’s ability to generate enough revenues to repay its financial debt obligations:
- economic growth
2. governance
Potential bias in ratings:
Company size bias
geographical bias
industry and sector bias
