HC 10 Flashcards
How ESG affects equity valuation, Risk, and performance?
I. Cash flow Channel
II. Idiosyncratic Risk Channel
III. Valuation Channel
Cash flow channel:
- A strong ESG profile is associated with a competitive advantage
➢ More efficient use of resources
➢ Better human capital management & development
➢ Long-term business plans and incentives - Higher profitability is linked to paying higher dividends (Cash Flow)
→ Nominator: Effect on expected cash flows
Idiosyncratic Risk Channel
- A strong ESG profile is associated with better risk
management and compliance
➢ Better monitoring
➢ Less severe incidents, i.e., fraud, corruption,
litigation - Lower firm-specific downside risk
–> Denominator: effect on discount rate
Valuation channel:
- A strong ESG profile is associated lower exposure systematic risks (resilience)
➢ Less vulnerable to systematic market shocks (beta)
➢ Lower cost of capital (e.g., Chava, 2014) – higher valuation - Investor preferences: Larger investor base and higher valuation
–> Denominator: effect on discount rate
Sustainable Finance
“the process of taking environmental, social and governance (ESG) considerations into account when making investment decisions, leading to more long-term investments in sustainable economic activities and projects. “ European Commission (EC)
Socially Responsible Investing (SRI)
“The practice of investing money in companies and funds that have positive social impacts.”
Negative screening (SRI strategies)
Exclusion from investment universe
An approach that excludes specific investments such as
companies, sectors or countries.
Positive screening (SRI strategies)
Best-in-class investment selection: Leading or best-performing investments are selected or weighted
based on ESG criteria
Norms-based screening: Screening of investments according to their compliance with international standards and norms.
Integration of ESG factors in financial analysis: The explicit inclusion by asset managers of ESG risks and
opportunities into financial analysis.
Impact investing: Investments made in funds with the intention to generate social and environmental impact alongside a financial return.
Engagement (SRI sstrategy)
Engagement and voting on sustainability matters: Engagement activities through voting of shares and engagement with companies on ESG matters.
Shareholder Activism:
Typically focused on issues related to the interestss of shareholders only
Active Ownership:
Focuses on issues related to the interests of a broader range of stakeholders, including employees, customers, and creditors.
E. DIMSON, O. KARAKAŞ, and X. LI (2015) – Active ownership. Review of Financial Studies.
Bigger firms, firms with poor performance, higher reputational concerns and with potential collaborators are more likely to be engaged.
Engagements with firms with poorer performance and higher reputational concerns are more likely to
be successful.
Active ownership improves social welfare as it increases shareholder value when engagements are
successful and does not destroy firm value when engagements are not successful.
Active ownership attenuates managerial myopia and helps to minimize intertemporal losses of profits and negative externalities
Institutional investors practice strategy:
Passive index-based investment: hey pay little attention to risks and opportunities in individual companies. Consequently, limited resources monitoring or investment in new upcoming firms – less focus on ESG.
Concentrated ownership:
- Theoretically, more concentrated ownership helps shareholders to overcome the costs of collective action and therefore promotes active shareholder behavior.
- However: institutional investor differ considerably in their ability and economic incentives to exercise their shareholder rights.
SFRD’s aim
- Harmonized transparency to enable investors to be informed on the ESG impact and sustainability risks of financial products.
- It is designed to limit possible greenwashing where products or services marketed as sustainable or climate-friendly do not in practice satisfy those standards.
