Chapter 7

Elements of ESG integration include: (a) ESG factor tilts. (b) Red flag indicators. (c) Company questionnaires and management interviews. (d) Watch lists

(a) ESG factor tilts.

An analyst assesses a company as below average on ESG metrics. All other matters being equal, she is most likely to: (a) Give a P/E premium to the stock. (b) Increase the company's cost of capital. (c) Increase the terminal growth rate assumption in a DCF model. (d) Reduce the risk of default in her forecast models

(b) Increase the company's cost of capital.

In relation to materiality assessment, which of the following is correct? (a) The materiality assessment is typically contained in the valuation stage. (b) Materiality is measured in terms of likelihood and magnitude of impact on a company's financial performance. (c) There is evidence that non-material factors impact financials, valuations and company business models. (d) Ethical or impact investors judge material factors affecting social, environmental and maximum financial returns

(b) Materiality is measured in terms of likelihood and magnitude of impact on a company's financial performance.

Which of the following is NOT utilised by a fixed income practitioner when evaluating ESG aspects? (a) Bankruptcy risk. (b) Proxy voting. (c) Negative credit events. (d) Time horizons.

(b) Proxy voting.

Qualitative analysts and portfolio managers seek to integrate their qualitative investment opinion by incorporating: (a) Negative screening. (b) Quantitative adjustments to financial models and valuations. (c) Qualitative measures only. (d) None of the above

(b) Quantitative adjustments to financial models and valuations.

This question relates to the case study focusing on the beverages company. Which of the following are examples of material environmental factors that should be considered? (a) Talent retention; recruitment strategy. (b) Water efficiency; greenhouse gas emissions. (c) Supplier code-of-conduct protocols; product mix. (d) Human rights strategy; anti-bribery policy

(b) Water efficiency; greenhouse gas emissions.

Which of these is NOT an ESG-integrated valuation technique? (a) Adjusting sales growth assumptions due to weak employee engagement scores. (b) Adjusting cost of capital due to poor governance ratings. (c) Adjusting cash flows due to cash tax adjustments. (d) Changing fair value price/earnings (P/E) ratio due to strong sustainability scores

(c) Adjusting cash flows due to cash tax adjustments.

Which of the following best represents factors least considered by credit ratings agencies (CRAs)? (a) Bankruptcy risk, standard credit ratio analysis, litigation risk. (b) Bankruptcy risk, litigation risk, human capital risk. (c) Environmental risk, religious / ethical risk. (d) Environmental risk, standard credit ratio analysis, governance risk

(c) Environmental risk, religious / ethical risk.

Which of the following factors is generally considered the most important when evaluating ESG considerations around sovereign debt? (a) Environmental factors. (b) Social factors. (c) Governance factors. (d) Human capital factors.

(c) Governance factors.

Which of these statements is NOT true? (a) The ESG integration framework is not meant to illustrate the perfect ESG-integrated investment process. (b) The ESG integration techniques of one firm are not necessarily the right techniques for all firms. (c) There is a consensus amongst firms on which techniques to use to identify and assess ESG factors (d) Every firm is unique and will use a selection of the techniques referenced in the ESG Integration Framework

(c) There is a consensus amongst firms on which techniques to use to identify and assess ESG factors

Qualitative ESG analysis is likely to be used in investment processes that are based on: (a) Company-specific research. (b) Fundamental analysis. (c) Stock-picking. (d) All of the above

(d) All of the above

challenges in ESG credit scoring:

- Time horizon (3 month paper or 50 year bonds) - Lack of proxy vote - Different levels of management engagement - Unique qualities of sovereign credit

The correlation between the various ESG ratings from major data and service providers is an important consideration. One study by Krosinsky (2018) calculated a correlation of:

0.3

Steps in calculating the final unmanaged risk score?

1. 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 (manageable risk assessment). 2. At the company level, the degree to which a company has managed the manageable risk portion of its overall exposure, with regard to an issue being calculated based on the management assessment (overall management score assessment). 3. Finally, the unmanaged risk score is calculated by subtracting managed risks from a company's overall exposure score in relation to a material ESG issue (final unmanaged risk score calculation)

How to develop a scorecard?

1. Identify sector or company specific ESG items. 2. Breakdown issues into a number of indicators (e.g. policy, measures, disclosure). 3. Determine a scoring system based on what good/best practice looks like for each indicator/issue. 4. Assess a company and give it a score. 5. Calculate aggregated scores at issue level, dimension level (environmental, social or governance level) or total score level (depending on the relative weight of each issue). 6. Benchmark the company's performance against industry averages or peer group (optional).

3 steps for qualitative ESG analysis?

1. Investment teams analyse ESG data to form their opinion on the ability of the firm to manage certain ESG issues. 2. They combine this opinion with their financial analysis by linking specific aspects of the company's ESG risk management strategy to different value drivers (such as costs, revenues, profits and capital expenditure requirements). 3. 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.

Elements of ESG analysis?

1. Red flag indicators 2. Company questionnaires and management interviews 3. Checks with outside experts 4. Watch lists 5. Internal ESG research 6. External ESG research 7. ESG agenda items at investment committees or CIO-level meetings

3 steps in building ESG indices?

1. The index typically relies upon rules-based criteria assessed on underlying ESG scores or metrics. 2. These then go into a formula to tilt company weightings or exclude entire companies based on ESG scores and hurdles. 3. These scores may be sourced by other ESG service providers. For instance, Sustainalytics started providing FTSE Russell with underlying data from 2019 (and had provided Morningstar with data before this).

what are the 4 major consequences found from the Berg et al. study (low correlation/agreement between the various rating agenicies) ?

1. The information that decision-makers receive from ESG rating agencies is relatively noisy 2. ESG performance is less likely to be reflected in corporate stock and bond prices, as investors face a challenge when trying to identify out-performers and laggards. 3. the divergence hampers the ambition of companies to improve their ESG performance because they receive mixed signals from rating agencies about which actions are expected and will be valued to the market 4. The divergence of ratings poses a challenge for empirical research, as using one rating vs another may alter a study's results and conclusions.

4 concerns expressed by critics of ESG investing?

1. Too inclusive of poor companies. 2. Dubious assessment criteria. 3. Quality of data 4. Potential lack of emphasis of long-term improvements

Aims and objectives of integrating ESG into an investment process?

1. meeting requirements under fiduciary duty or regulations; 2. meeting client and beneficiary demands; 3. lowering investment risk; 4. increasing investment returns; 5. giving investment professionals more tools and techniques to use in analysis; 6. improving the quality of engagement and stewardship activities; and 7. lowering reputational risk at a firm level and investment level

examples of Unmanageable Risk being 1. Manageable and 2. not (fully) manageable?

1. risk of on the job injuries through - establishing safety procedures, having emergency response plans and safety drills, and promoting a safe culture 2. carbon emissions of aeroplanes in flight

The ESG Risk Rating scoring system for a company is best thought of as occurring in three stages on the issue level:

1. the starting point is exposure; 2. the next stage is management; and 3. the final stage is calculating unmanaged risk, using the concept of risk decomposition.

Business Roundtable statement (August 2019) was signed by how many CEOs?

181 (including major investment banks and asset managers)

According to a 2017 CFA Institute global ESG survey, what % of investment professionals still do not integrate ESG?

24% of equity investors, 55% of fixed income investors and between 79% and 92% of alternative asset investors (across private equity, real estate, infrastructure and hedge funds)

What is a business moat and where does the term come from?

A business' competitive advantage and comes from Warren Buffet's Annual Letters

How does MSCI consider a risk to be material?

A risk is material to an industry when it is likely that companies in a given industry will incur substantial costs in connection with it (for example, a regulatory ban on a key chemical input)

Steps in the research stage of integrated ESG assessment?

A. Gathering information B. Materiality assessments C. Evaluating different forms of tangible vs intangible factors D. Generating ideas E. Scorecards can be used to assess ESG risk and opportunity F. Materiality assessments and risk mapping G. Using SASB as a baseline framework for materiality assessment H. ESG risk mapping methodologies E. Quantitative, systematic and thematic approaches to integrated ESG analysis

3 stages of integrated ESG assessment?

A. a research stage; B. a valuation stage; and C. a portfolio construction stage, which leads to investment decisions.

What attempts to bring structure and numerical value to part of that unstructured ESG dataset?

AI and machine learning algorithms

How does MSCI consider an opportunity to be material?

An opportunity is material to an industry when it is likely that companies in a given industry could capitalise on it for profit (for example, opportunities in clean technology for the LED lighting industry)

It is common for the information used for selecting ESG factors to come from the companies themselves. This complicates the ability to:

Analyse, assess and validate this information

Elements of ESG integration include?

ESG factor tilts

As ESG assessors, the aim of investment consultants is to form a view on the:

ESG integration practices and processes of different fund managers and strategies.

What are the 10 themes within the 3 ESG pillars that the MSCI ESG hierarchy identifies?

Environment: climate change, natural resources, pollution and waste, opportunities. Social: human capital, product liability, stakeholder opposition, social opportunities. Governance: corporate governance, corporate behaviour.

what factors are least considered by credit ratings agencies (CRAs)?

Environmental risk, religious / ethical risk

In collaboration with index providers, what has the Japanese Government Pension Investment Fund (GPIF) created?

Gender tilted rules-based indices to invest in

Which ESG factor is generally considered the most important when evaluating ESG considerations around sovereign debt?

Governance

Which factor remains more important to credit investors?

Governance

When is qualitative ESG analysis likely to be used in investment processes?

In investment processes that are based on company-specific research, fundamental analysis and stock-picking

When is quantitative ESG analysis likely to be used in investment processes?

In investment processes that use quant models to identify attractive investment opportunities (ESG data is typically aggregated into an ESG factor (an ESG score), which is added to the quant models)

An analyst assesses a company as below average on ESG metrics. All other matters being equal, she is most likely to:

Increase the company's cost of capital

Method to compile and integrate rapidly growing datasets into investment processes?

Investors use application programming interfaces (APIs)

Scope 3 carbon pollution impact?

It makes up more than 50% of the world's carbon pollution impact.

What companies have the largest market share in company-focused ESG ratings?

MSCI and Sustainalytics

Split incentive problem?

Occurs in real estate when the tenants and operators might think differently to the owners and constructors

Qualitative analysts and portfolio managers seek to integrate their qualitative investment opinion by incorporating:

Quantitative adjustments to financial models and valuations

Red flag indicators?

Securities with high ESG risk are flagged and investigated further or excluded

Materiality assessment?

Some ESG issues might be material for companies in a specific industry (e.g. water stress can disrupt the operations of mining or beverages companies, which rely heavily on clean water in their production processes), but not for other sectors (e.g. water stress has little impact on media or financial companies).

What is the chronological order for ESG scorecard development?

Step 1: Identify sector or company specific ESG items. Step 2: Breakdown issues into a number of indicators. Step 3: Determine a scoring system based on what good or best practice looks like for each indicator or issue. Step 4: Assess a company and give it a score. Step 5: Calculate aggregated scores at issue level, dimension level, or total score level. Step 6: Benchmark the company's performance against industry averages or peer group.

Quantitative investing is also know as?

Systematic investing

Company ESG disclosure might be:

Unaudited, not complete or not comparable.

What approach does Morningstar take to asses companies on ESG?

a 'holdings-based approach' - a weighted average of portfolio companies' ESG scores; usually backward looking

What is utilised by a fixed income practitioner when evaluating ESG aspects?

bankruptcy risk, negative credit events, and time horizons

Which investment class is often viewed as sitting between fundamental active and passive index tracking strategies?

beta (or smart beta) or factor strategies

What term typically used to describe the analysis of ESG datasets through the use of algorithms and natural language processes to determine company quality, reputational risk and many forward-looking aspects of business strength and valuation?

big data analytics

How is Materiality measured?

both in terms of the likelihood and magnitude of impact (of an ESG issue)

The aims and objectives for integrating ESG into an investment process may include: (a) Meeting requirements under PRI regulations. (b) Increasing reputational risk at a firm and investment level. (c) Meeting internal audit demands. (d) Improving the quality of engagement and stewardship activities, and increasing investment returns.

d) Improving the quality of engagement and stewardship activities, and increasing investment returns.

What are security level components for equities?

forecast financial ratios; valuation multiples; valuation model variables; and forecast financials

How is materiality measured?

in terms of likelihood and magnitude of impact on a company's financial performance

What are security level components for fixed income?

internal credit assessment; forecast financial ratios; relative ranking; relative value analysis/spread analysis; and duration analysis

controversy case?

is defined as an instance, or ongoing situation, in which company operations or products allegedly have a negative environmental, social or governance impact

The most common criticisms of ESG investing?

is the difficulty for investors to correctly identify, and appropriately weigh, ESG factors in investment selection.

How do Sustainalytics define materiality within the ESG risk rating?

issues that may potentially have an impact on the economic value of a company

What is the 'exposure dimension' incorporated in the ESG risk rating's emphasis on materiality?

it reflects the extent to which a company is exposed to material ESG risks identified at industry-level and affects the overall rating score for a company as well as its rating score for each material ESG issue.

Management gap (as a component of unmanaged risk)

it speaks to the manageable part of the material ESG risks a company is facing and reflects the failure of a company in managing these risks sufficiently, as reflected in the company's management score.

What is Mercer's ESG rating approach?

it will rate the ESG capabilities at a fund strategy level

What data sources are typically used by MSCI and Sustainalytics when determining their ESG ratings?

macro data at the segment and/or geographic level (from academic, government, and non-governmental organisation (NGO) datasets), along with company disclosure (e.g. 10-K filings, sustainability report, proxy report, AGM results).

What is the second dimension incorporated in the ESG risk rating's emphasis on materiality?

management - can be considered as a set of company commitments and actions that demonstrate how a company approaches and handles an ESG issue through policies, programmes, quantitative performance and involvement in controversies, as well as its management of corporate governance

Unmanaged Risk

material ESG risk that has not been managed by a company. It includes two types of risk: ▶ unmanageable risk, which cannot be addressed by company initiatives; and ▶ the management gap, which represents risks that could be managed by a company through suitable initiatives but which may not yet be managed.

Sustainalytics' ESG Risk Rating?

measures the degree to which a company's economic value is at risk driven by ESG factors or, more technically speaking, the magnitude of a company's unmanaged ESG risks. The rating system gives points for specific risk factors. Points will add up across issues to create overall scores, which are then rated. The rating sorts companies into 5 risk categories. (assessment is absolute)

What tends to cause the problem of over- disclosure?

non-material ESG information

As of 2018, how many mutual funds and ETFs were covered by Morningstar?

over 20,000 mutual funds and over 2,000 ETFs with a 1-5 score.

5 Investment strategiy classifications?

quantitative (systemic, algorithmic), fundamental, active, passive or beta

According to recent surveys, do more firms integrate ESG into investment processes in order to lower investment risk or to increase investment return?

recent surveys suggest that more firms do so to lower the risk rather than enhance returns

What technique in integrating ESG analysis is both qualitative and quantitative?

scorecards

What type of securities are added to the watch list?

securities with high ESG risk added to a watch list for monitoring, or securities with high ESG opportunities which are put on a watch list for possible investment

Types of Model adjustments based on ESG assessment?

the analyst may: (1) Make explicit forecast profit and loss, balance sheet and cash flows adjustments for specific factors such as litigation, stranded asset write-offs, etc.; (2) Adjust the cost of capital used in any discounted cash flow (DCF) model for changing ESG risk levels; (3) Make valuation ratio adjustments based on peer group comparisons.

MSCI rating range?

the best (AAA) and the worst (CCC) - not absolute

ESG factors can affect the price performance and credit risk of a bond at what 3 levels?

the issuer level, the industry level and the geographic level

Manageable risk factor (MRF)?

the share of risk that is manageable vs the share of risk that is unmanageable on a material ESG issue. ranging from 30% (unmanageable) to 100% (fully manageable)

How does MSCI assess material risks and opportunities for each industry?

through a quantitative model that compares ranges and average values in each industry for externalised impacts (such as carbon intensity, water intensity and injury rates)

in recent studies, why do investors integrate ESG?

to lower investment risk (rather than enhance returns, but some firms do both)

Proprietary ESG research could 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.

Types of ESG score and ratings providers?

▶ 'Traditional' ESG data and research providers ▶ 'Non-traditional' ESG data and research providers ▶ AI or algorithm-driven ESG research

Challenges to ESG integration?

▶ Disclosure and data-related challenges ▶ comparability difficulties ▶ materiality and judgment challenges ▶ ESG integration challenges across asset classes

Challenges in data and research gathering?

▶ ESG data is not consistently reported across companies, geographies and sectors; ▶ most ESG data is not audited; and ▶ some ESG data is not easily available in public databases and is difficult to obtain.

the International Integrated Reporting Council (IIRC) framework describes capital as?

▶ Financial capital ▶ Manufactured capital ▶ Intellectual capital ▶ Human capital ▶ Social and relationship capital ▶ Natural capital

For MSCI to score a company highly on a key issue, the management needs to be judged commensurate with the level of exposure:

▶ a company with high exposure must also have very strong management; but ▶ a company with limited exposure can have a more modest approach

What does the Global Real Estate Sustainability Benchmark (GRESB, founded in 2009) report provide?

▶ a composite of peer group information; ▶ overall portfolio key performance indicator (KPI) performance; ▶ aggregate environmental 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.

Elements of ESG integration?

▶ adjusting forecast financials, for example revenue, operating cost, asset book value or capital expenditure; ▶ adjusting valuation models or multiples, for instance discount rates, terminal values or ratios; ▶ adjusting credit risk and duration; ▶ managing risk, including exposure limits, scenario analysis, value-at-risk models; ▶ ESG factor tilts; ▶ ESG momentum tilts; ▶ strategic asset allocation, including thematic and ESG objective tilts; ▶ tactical asset allocation; and ▶ ESG controversies and positive ESG events

What does the Real Impact Tracker (RIT) assess to assess a company for ESG?

▶ culture; ▶ philosophy; ▶ process impact; and ▶ public policy efforts

MSCI ESG opportunities combine:

▶ exposure indicates the relevance of the opportunity to a given company based on its current business and geographic segments; and ▶ management indicates the company's capacity to take advantage of the opportunity

According to the MSCI ESG Rating, ESG risks and opportunities are posed by:

▶ large scale trends (e.g. climate change, resource scarcity or demographic shifts); and ▶ the nature of the company's operations

What are the 5 risk categories that the ratings sort companies in (Sustainalytics' ESG Risk Rating process)?

▶ negligible; ▶ low; ▶ medium; ▶ high; and ▶ severe

Indirect sources of ESG data?

▶ news articles; ▶ third-party reports and analysis; and ▶ investment and consulting research

Primary Data?

▶ surveys; ▶ direct company communication; and ▶ company reports, presentations and public document

The two distinctions that many investment practitioners make in fundamental investment analysis?

▶ the difference between a company or business assessment; and ▶ a security, stock, bond or convertible (or other tradeable construct including derivatives) assessment.

MSCI argues that to understand whether a company is adequately managing a key ESG risk, it is essential to understand both:

▶ what management strategies it has employed (i.e. risk management); and ▶ how exposed it is to the risk (i.e. risk exposure)