Reading 2.5

Question 1

ESG’s origins are in which movements?

Answer 1

socially responsible investing (SRI) movement that dates back to at least the 1980s

AND

corporate social responsibility (CSR) that dates back to the late 1960s

Question 2

two landmark accords marked a turning point for SRI in 2015

Answer 2

1) signing of the United Nations Sustainable Development Goals (SDGs) by world leaders in September 2015,

2) the Paris Climate Agreement.

Question 3

What is the key issue with ESG reporting?

Answer 3

An issue in ESG is determining what and how an entity should report regarding ESG.

Question 4

Which organization helps businesses and governments understand and disclose their impact on key sustainability issues (e.g., climate change, human rights, governance, and social well-being).

Answer 4

The Global Reporting Initiative (GRI) is an independent, not-for-profit, non-governmental organization (NGO)

Question 5

When did the GRI release the GRI Standards,

Who developed them?

What does the GRI Standards help in the reporting of?

Answer 5

2016

the Global Sustainability Standards Board (GSSB)

ESG-related reporting standard that enables organizations to report publicly on their economic, environmental, and social impacts; to show how they contribute to sustainable development; and to be a reference for policy makers and regulators

Question 6

Auer and Schuhmacher, using a dataset on global ESG investing at the industry level, find that

Answer 6

selection of high- or low ESG rated stocks does not provide superior performance;

ESG investors’ performance in the U.S. and the Asia-Pacific region is similar to that of the market;

and ESG investors in Europe pay a price for SRI.

Question 7

Giese and Lee find that

Answer 7

most academic studies fail to reach consensus on whether ESG traits affect performance; however, they find that these traits had a positive effect on risk (in particular, mitigating tail risk).

Question 8

Belghitar, Clark, and Deshmukh find strong evidence that

Answer 8

ethical investors pay a price for investing ethically

Question 9

Hvidkjcer, based on a literature review of ESG investing, concludes the following:

Answer 9

1. Some authors seem to want to make the business case for ESG investing rather than applying an objective, scientific approach.
2. There is no simple answer to the question of the profitability of ESG investing.
3. The most consistent finding is that sin stocks outperform.
4. Evidence indicates that stocks with high ESG ratings exhibit high future returns, with the strongest evidence from 1991 to 2004. From 2005 to 2012, returns of stocks with high ESG ratings did not seem to differ from benchmarks, but evidence suggests high returns after 2012.
5. Event studies indicate that the stock market does not respond positively to firms taking ESG/CSR initiatives.
6. Evidence indicates that active ownership by ESG investors can create value for shareholders and other stakeholders. Specifically, successful ESG engagements by a large institutional investor into U.S. firms resulted in abnormal returns the following year.

Question 10

What are sin stocks?

Answer 10

stocks of companies engaged in activities considered to be unethical or immoral (e.g., gambling or alcohol sales).

Question 11

Rabener, based on a factor analysis of U.S. equity returns, suggests it is

Answer 11

unlikely that companies that care about the environment, look after their employees, and exhibit good governance outperform.

He maintains that, since 2009, performance drivers were common equity factors and, while factor exposure may change over time, ESG investors risk losing out if small and cheap stocks outperform low-risk and high-quality stocks as they have in the past.

Question 12

ESG ratings are compiled by:

Answer 12

1) financial rating firms (e.g., Moody’s and Fitch),

2) index providers (e.g., FTSE Russell and MSCI)

3) companies specializing in ESG-related issues (e.g., Sustainalytics and ISS).

Question 13

largest three ESG-rating firms

Answer 13

MSCI, Sustainalytics, and Reprisk

Question 14

ESG materiality refers to

Materiality is used in

Answer 14

having a considerable impact from the perspective of stakeholders in
the context of ESG principles.

evaluation and analyses (e.g., legal, business,
and regulatory) to denote issues requiring serious consideration

Question 15

The issue of ESG materiality includes matters that have sufficient
importance to warrant both of the following:

Answer 15

1. Consideration in a firm’s operational and investment decisions.
2. Disclosure to a firm’s investors and others.

Question 16

The GRI Standards’ fourth generation (referred to as G4) includes enhanced coverage of ESG materiality, including the G4 Materiality Principle that asserts

Answer 16

That an ESG-related report should cover aspects that reflect the organization’s significant economic, environmental, and social impacts; or influence stakeholders’ assessments and decisions.

the second of four steps in defining the boundaries of a report and as the process of “prioritization”

Question 17

KPMG’S FRAMEWORK FOR ESG MATERIALITY ASSESSMENTS
KPMG proposes a six-step process for materiality assessments:

The assessment is designed for?

Answer 17

1. Identify and analyze.
2. Assess and plan.
3. Implement and integrate.
4. Monitor and measure.
5. Assure and report.
6. Evaluate and revise.

developing strategy, reporting regarding ESG, communicating importance, and identifying future trends.

Question 18

Sustainability Accounting Standards Board (SASB) main approach to materiality

Answer 18

SASB stresses financial materiality as the appropriate threshold for issuer reporting on ESG topics

Question 19

Task Force on Climate-Related Financial Disclosures (TCFD) mission?

Answer 19

To develop voluntary, consistent, climate-related financial risk disclosures for companies when providing information to stakeholders (e.g., investors, lenders, and insurers).

Question 20

Antea Group proposes a ____-step process for conducting a materiality assessment focused on ____ internal and external stakeholders who have been identified.

How to get the best results?

Why is this the best approach?

Answer 20

seven, surveying

To get the best results, materiality assessments should be formal, structured engagements with stakeholders (not informal Q&As or workshops).

Traditional survey format is suggested to make it easy for stakeholders to complete and easy for the results to be analyzed. In the survey, stakeholders should be asked to rate the importance and impact of each identified indicator on a numerical scale (e.g., 1-5). This
provides quantitative data that can be analyzed and explained visually. Additional space should be left for written insights and comments.

Question 21

The SASB Materiality Map provides firms and investors …

The map has had a dimension of about ___ ESG subcategories by ___industry subcategories for a total of almost ____ locations on the map

Answer 21

an indication of ESG-related issues that may or may not be material for various industries, which facilitates analysis of the impact of ESG-issues for an investment or a firm in an industry sub-group.

25 and 75, 2,000

Question 22

The SASB’s Materiality Map analyzes ESG-related issues along two key dimensions:

Describe both

Answer 22

1. ESG category: There are 5 ESG categories:
   i) environment,
   ii) social capital,
   iii) human capital,
   iv) business model and innovation, and
   v) leadership and governance;
   divided into more than 25 subcategories.
2. Industry: There are 10 industry categories (e.g., consumer goods, financials, and infrastructure) with several subcategories.

Question 23

Each location on the SASB map (i.e., each possible combination of subcategories) is rated as being in one of three categories.

Answer 23

1. Likely to be material for more than 50% of the firms.
2. Likely to be material for fewer than 50% of the firms.
3. Unlikely to be material.

Question 24

ESG materiality may be viewed as the …

Answer 24

likelihood of a material ESG issue multiplied by its expected financial loss

Question 25

Cornerstone describes three phases of the impact of adverse ESG events:

Answer 25

1. In the emerging or “pre-financial” phase of an ESG lifecycle, a shift (subtle or overt) begins that ultimately has ESG consequences for a sector.
2. In the “transitional” phase, the ESG shift becomes increasingly visible, but its timing and ultimate financial impact are not particularly clear.
3. In the ultimate or “financial” phase of the lifecycle, the full financial impacts of the ESG event are experienced.

Question 26

Cornerstone’s approach associates ESG ____. Particular risks associated with specific sectors may be associated with their ____.

Give an example

Answer 26

risks with metrics

Drivers

For instance, a social risk in the telecom sector is driven by data privacy and security. A metric of this ESG exposure may be the number of confirmed data breaches.

Question 27

The Principles for Responsible Investment (PRI), formerly known as the _____ is a non-exhaustive set of six voluntary and aspirational proposals that aims to provide a global standard for responsible investing related to environmental, social, and corporate governance (ESG) factors.

Answer 27

UN Principles for Responsible Investment (UN PRI)

1. We will incorporate ESG issues into investment analysis and decision- making processes.
2. We will be active owners and incorporate ESG issues into our ownership policies and practices.
3. We will seek appropriate disclosure on ESG issues by the entities in which we invest.
4. We will promote acceptance and implementation of the Principles within the investment industry.
5. We will work together to enhance our effectiveness in implementing the Principles.
6. We will each report on our activities and progress towards implementing the Principles.

Question 28

In 2015, the UN published 17 goals to improve the plight of the human race by improving incomes and living conditions and reducing poverty and inequality, while aiming to stop or reverse the impact of climate change.

Answer 28

1. No poverty
2. Zero hunger
3. Good health and well-being
4. Quality education
5. Gender equality
6. Clean water and sanitation
7. Affordable and clean energy
8. Decent work and economic growth
9. Industry, innovation and infrastructure
10. Reduced inequalities
11. Sustainable cities and communities
12. Responsible consumption and
    production
13. Climate action
14. Life below water
15. Life on land
16. Peace, justice and strong institutions
17. Partnerships for the goals

Question 29

Per the 1940 Investment Advisers Act, fiduciary duties cannot conflict with clients’ best interests. Schanzenbach and Sitkoff show that ESG investing is permissible under trust fiduciary law if two conditions are satisfied.

Answer 29

1. The fiduciary reasonably concludes that ESG investing will benefit the beneficiary directly by improving risk-adjusted return.
2. The fiduciary’s exclusive motive for ESG investing is to obtain this direct benefit.

Question 30

What is the fiduciary duty in relation to managing a Trust in the US?

Answer 30

Schanzenbach and Sitkoff note that, in the context of a private trust, a trustee must conduct the trust’s investment program for the SOLE INTEREST of the beneficiary as defined by the trust’s terms and purpose.

Question 31

What is Greenwashing and why is it still an issue?

Answer 31

investment promoters misleading prospective investors with overstated claims about the likely social impact of an investment

Because there are no standardized reporting requirements

Question 32

In ___, the European Commission (EC) published a proposal to require disclosure of and transparency regarding sustainable finance (i.e., ESG-related issues). This regulation clarifies …

Answer 32

2019;

asset managers’ and institutional investors’ duties regarding sustainability and strengthens the transparency of companies on their ESG policies.

Question 33

Regarding ESG investing, Hong Kong is slightly ahead of other Asian countries. In 2018, the Hong Kong Strategic Framework for Green Finance was announced by the Securities and Futures Commission to promote Hong Kong as an international green finance center. The goal of the framework is to

Answer 33

facilitate development of green-related investments (including listed, unlisted, and OTC green products) with disclosure guidance, harmonized criteria, and disclosure and reporting frameworks.

Question 34

A firm’s compliance and risk management framework should address the following areas:

Answer 34

1. Reviewing marketing materials to confirm no greenwashing.
2. Creating ESG policies and procedures tailored to the firm’s ESG fund offerings.
3. Implementing controls around the portfolio management process to ensure adherence to:
   i. ESG-related commitment/ directives in client management agreements and fund offering documents.
   ii. ESG-related investment objectives, strategies, and policies.
4. For private fund management companies, considering whether they align with ESG principles of the fund and/ or its adviser.
5. Developing methods to analyze and act on ESG-related investment risks.
6. Testing investment decisions over time to measure contributions to or exceptions from ESG policies and/ or strategies.

Question 35

There are four broad methods of ESG investments:

Answer 35

1) negative or exclusionary screening,
2) positive or inclusionary screening,
3) engagement and proxy voting, and
4) impact investing.

Question 36

NEGATIVE SCREENING ESG Investment, example

Answer 36

Negative or exclusionary screening involves not investing in industries of publicly-traded firms due to their involvement in objectionable activities, sometimes based on moral or religion grounds.

For instance, negative screening excludes investments in sin stocks (e.g., stocks of firms that profit from gambling, tobacco, or alcohol sales). Many early investors that engaged in SRI focused on negative screening.

Question 37

POSITIVE SCREENING ESG Investment, example

Answer 37

Focusing on publicly-traded firms with operations that performed
in an exemplary manner on ESG issues.

For instance, positive screening may involve investing in a company that uses renewable energy sources to power its operations, has equitable pay for all genders, or has diversity in board and executive positions. Positive screening investors may believe that funds invested in the sustainable companies may offer lower downside risk than the market.

Question 38

ENGAGEMENT AND PROXY VOTING STRATEGIES ESG Investment, example

Answer 38

Some investors believe that a company’s operations are not advantaged by someone buying the company’s stock or are not penalized by someone selling the stock; thus, buying or selling stock does not induce a company to change or improve its ESG standing.

Therefore, these investors do not pursue positive or negative screening; instead, those with a long position in a stock may employ an engagement strategy, which involves starting a dialogue with the publicly-traded company with a specific agenda on improving its ESG standing.

EX: Investors in energy or manufacturing companies, the
agenda is often to improve the companies’ environmental footprint.

Question 39

IMPACT INVESTING ESG Investment, example

Successful impact investing is often described as

Where is it considered the most effective and why?

Answer 39

Focuses on asset allocation and prioritization of investments by the perceived degree of materiality or influence that the investment provides regarding non-financial issues addressed by ESG concerns.

Successful impact investing is often described as optimizing the combination of risk-adjusted return and ESG-related impact.

Many consider impact investing is most effective in venture capital and private equity, where an investment is targeted to a new project that would not otherwise receive funding (e.g., entrepreneurs or water quality in emerging markets).

Question 40

According to the Global Impact Investing Network (GIIN), impact investments can be made across asset classes and tenets of impact investing include the following.

Answer 40

i. Intentionality - Impact investments intentionally contribute to social and environmental solutions.

ii. Financial returns - Impact investments aim for a financial return on capital that may range from below market rate to risk-adjusted market rate. This distinguishes them from philanthropy.

iii. Impact measurement - investors are commitment to measure and report the investment’s social and environmental performance.

Question 41

There are two categories of impact investing based on U.S. tax rules for not-for-profit organizations (e.g., foundations):

Answer 41

1. Mission-related investments (MRIs) - ESG impact and financial return (often a competitive risk-adjusted return).
2. Program-related investments (PRIs) - ESG impact and no financial return or a sub-competitive risk adjusted return.

Question 42

The U.S. Internal Revenue Service specifies three characteristics of a program-related investment (PRIs):

PRIs additional benefit?

Answer 42

i. The primary purpose is to accomplish one or more of the foundation’s exempt purposes.

ii. Production of income or appreciation of property is not a significant purpose of the investment.

iii. Influencing legislation or taking part in political campaigns on behalf of candidates is not a purpose.

PRIs qualify for tax advantages to charitable organizations in the U.S. For instance, PRis are treated as a qualifying distribution for a foundation similar to charitable grants.

Question 43

Enviropreneurship definition

Answer 43

Emerging branch of entrepreneurship that stems from opportunities created by entrepreneurs (not directed by investors or governments) and combines profit-seeking and concern for ESG issues, using entrepreneurship to address environmental issues.

Question 44

There are five common steps to implementing impact investing:

Answer 44

1. Articulating mission and values (clarify and build consensus regarding the mission and values, expressed in part as identification of target areas)
2. Creating impact themes or theses (narrowing from general themes of ESG to certain bullet points or theses)
3. Developing impact investment policy (how the impact investing program’s ESG-related targets will be included in the portfolio construction and management processes)
4. Generate and evaluate deal flow (finding and executing impact investment transactions. ESG ratings and materiality analysis may be used to assess the likely impact of various investments)
5. Portfolio construction and management (top-down or bottom-up approach)

Question 45

Describe:
1) The top-down asset allocation approach
2) Bottom-up asset allocation approach

Answer 45

1) Investors begin by examining the overall market and economic conditions to identify sectors or asset classes that offer opportunities for achieving their goals, which may include maximizing returns, minimizing risks, and addressing ESG concerns.

2) Investors focus on examining specific investment options one by one for the ESG impact. They look closely at each investment’s specific qualities and how it aligns with their ESG goals, rather than making decisions based solely on broader economic trends or market conditions.

Question 46

Barber, Morse, and Yasuda examined whether investors in private equity (PE) funds have sacrificed expected returns for social impact. They studied the performance of 159 impact PE funds (venture capital [VC] and growth equity) that asserted a dual purpose of financial return and ESG related goals over the period 1995-2014 relative to a sample of over 5,000 funds; and found the results below.

Answer 46

1. Lower internal rates of return (IRRs) for impact funds (Impact funds’ 4.7% points lower than those of traditional VC funds)
2. Lower IRRs accepted by some investors (logit models indicated that the average investor is willing to pay 3.4% points in expected excess IRR for impact funds)
3. Lower IRRs accepted by particular types of investors (Organizations more willing to pay for impact were development organizations; banks and insurance companies; public pension funds; UN PRI signatories; and investors in Europe, Latin America, and Africa.

However, investors required to maximize risk-adjusted financial returns (i.e., to be shareholder-wealth maximizers) were not willing to accept lower IRRs for social impact.

Question 47

Negative externalities are

Answer 47

Adverse consequences (e.g., pollution, noise, and congestion) suffered by third parties caused by contracts or transactions controlled by two or more primary parties. The issue of negative externalities is related to the tragedy of the commons.

Question 48

Coase theorem asserts that

Example of theorem at play

Answer 48

In competitive and frictionless markets, parties can negotiate the most efficient resolution to a dispute so that they can share the net benefits (or least costs) regardless of whether the law sides with the victims of negative externalities or with shareholders who claim a right to generate negative externalities.

EX: Manufacturing building generates noise that adversely affects a nearby hotel’s ability to satisfy guests. Soundproofing the hotel costs $2 million, soundproofing the manufacturer’s building costs $3 million, and the hotel’s loss in revenues and guest satisfaction due to the noise has a present value cost of $1 million. If the hotel sues the manufacturer,
according to the Coase theorem, given no transactions costs, the optimal solution will result regardless of the court’s ruling: the total wealth-maximizing solution is that the hotel does not install soundproofing since the cost thereof exceeds its value.

Question 49

Cap and trade definition

What is the reasoning behind it?

Answer 49

Government program involving pollution or other externalities that specifies
caps (i.e., allowances) on each entity’s activity (e.g., polluting), while permitting the entity to trade (or exchange) its rights (e.g., to pollute).

According to economic reasoning, these exchange rights serve as a mechanism through which pollution reduction (or other goals) will be generated by entities who can achieve the reductions at the lowest financial cost (i.e., least economic burdens to society based on market prices).

Question 50

Three primary justifications may be hypothesized for special consideration of ESG issues (i.e., beyond an investment’s direct effects on expected cash flows and risk).

Answer 50

1. Historical total returns of portfolios of listed securities based on ESG concerns and adjusted for risk based on single-market-factor methods are seemingly equally attractive, and in some cases or jurisdictions more attractive, than portfolios that ignore or avoid ESG concerns.
2. Investment managers have a duty to protect shareholders from harmful effects of ESG-related risks (e.g., litigation, penalties, and adverse public images of firms that do not aggressively incorporate ESG issues in their corporate policies).
3. Investment managers who favor ESG-compatible investments with higher allocations contribute to a better world, which in turn provides non-cash benefits to investors and other living beings.

Question 51

Three primary justifications may be hypothesized against special consideration of ESG issues (i.e., not adding value beyond direct effects on expected cash flows to estimated valuations of investments with favorable ESG profiles).

Answer 51

1. Historical total returns of portfolios based on ESG concerns and adjusted for risk based on multi-factor methods are seemingly only equally attractive to portfolios with similar factor exposures that ignore or avoid ESG concerns.
2. Investment managers, unless directed otherwise by their clients, have a fiduciary duty in the U.S. and possibly elsewhere to invest solely to financially benefit the client.
3. Investment managers who favor ESG-compatible investments with higher allocations for nonfinancial reasons or by applying lower risk-adjusted discount rates are redirecting their clients’ wealth to personal causes.