CFA Certificate in ESG Investing Curriculum 2023 PDF

© CFA Institute. For candidate use only. Not for distribution. CHAPTER 1 Introduction to ESG Investing LEARNING OUTCOMES Mastery The candidate should be able to: 1.1.1 define ESG investment and different approaches to ESG investing: responsible investment, socially responsible investment, sustainable investment, best-in-class investment, ethical/values-driven investment, thematic investment, green investment, social investment, shareholder engagement 1.1.2 define the following sustainability-based concepts in terms of their strengths and limitations: corporate social responsibility and triple bottom line (TBL) accounting 1.1.3 describe the benefits and challenges of incorporating ESG in decision making, and the linkages between responsible investment and financial system stability 1.1.4 explain the concepts of the financial materiality of ESG integration, double materiality, and dynamic materiality and how they relate to ESG analysis, practices, and reporting 1.1.5 explain different ESG megatrends, their systemic nature, and their potential impact on companies and company practices 1.1.6 explain the three ways in which investors typically reflect ESG considerations in their investment process 1.1.7 explain the aims of key supranational ESG initiatives and organizations and the progress achieved to date INTRODUCTION There was a time when environmental, social, and governance (ESG) issues were the niche concern of a select group of ethical or socially responsible investors. That time is long gone. The consideration of ESG factors is becoming an integral part of investment management. Asset owners and investment managers are developing ways to incorporate ESG criteria into investment analysis and decision-making processes. The emergence of responsible investment proponents, such as the United Nations Principles for Responsible Investment (PRI), has encouraged a fundamental change in investment practices whereby investors explicitly employ ESG factor analysis to enhance returns 1 18 Chapter 1 © CFA Institute. For candidate use only. Not for distribution. Introduction to ESG Investing and better manage risks. Societal and client pressure and the growing evidence of the direct financial benefits of incorporating ESG analysis have led integration to become more mainstream. This chapter provides an overview of the concept of ESG investing, as well as the different types of responsible investment and their implications. It highlights the main benefits of integrating ESG factors and identifies ways in which ESG investing is implemented in practice. ESG investing sits within a broader context of sustainability; this chapter also highlights a number of key initiatives in the business and investment communities that seek to assist all parties to navigate the associated challenges. 2 WHAT IS ESG INVESTING? 1.1.1 define ESG investment and different approaches to ESG investing: responsible investment, socially responsible investment, sustainable investment, best-in-class investment, ethical/values-driven investment, thematic investment, green investment, social investment, shareholder engagement ESG investing is an approach to managing assets where investors explicitly incorporate environmental, social, and governance (ESG) factors in their investment decisions with the long-term return of an investment portfolio in mind. Long-Termism and ESG Investing Many stakeholders of investment, including finance regulators, have recognized the shortfalls of short-termism in investment practice and have sought to increase awareness of the value of long-termism and encourage this approach. Short-termism covers a wide range of activities. For the purpose of this topic, the two most relevant ones are ► trading practices, where investors trade based on short-term momentum and price movements rather than long-term value, and ► investors engaging with investee companies in a way that prioritizes maximizing quarterly financials. These short-term investing strategies might offer rewards but may have consequences for the long term. With its disproportionate focus on quarterly returns, short-termism may leave companies less willing to take on projects (such as research and development) that may take multiple years – and patient capital – to develop. This was indeed confirmed by a review conducted on the UK equity market and long-term decision-making by Professor John Kay for the UK Government in 2012.1 Instead of productive investment in the real economy, short-termism may promote bubbles, financial instability, and general economic underperformance. Furthermore, short-term investment strategies tend to ignore factors that are generally considered more long term, such as ESG factors. Because of the adverse effects mentioned, regulators are 1 John Kay, “The Kay Review of UK Equity Markets and Long-Term Decision Making: Final Report” (July 2012). What Is ESG Investing? © CFA Institute. For candidate use only. Not for distribution. catching up and taking action. For example, the Shareholder Rights Directive (SRD) was issued by the European Union (EU) in September 2020, requiring investors to be active owners and to act with a more long-term focus. In other words, ESG investing aims to correctly identify, evaluate, and price social, environmental, and economic risks and opportunities. ESG factors are defined in Exhibit 1. Exhibit 1: ESG Factors Defined Definition Environmental Factors Social Factors Factors pertaining to the natural world. These include the use of and interaction with renewable and non-renewable resources (e.g., water, minerals, ecosystems, and biodiversity). Factors that affect the lives of humans. The category includes the management of human capital, non-human animals, local communities, and clients. Governance Factors Factors that involve issues tied to countries and/or jurisdictions or are common practice in an industry, as well as the interests of broader stakeholder groups. The Definition and Scope of ESG Issues There is currently no universal standard for assigning “E,” “S,” and “G” issues, and they may overlap with one another. The assignment of these issues depends on the specific properties of investors, businesses, and their stakeholders. Stakeholders are members of groups without whose support an organization would cease to exist,2 as well as communities impacted by companies and regulators. Examples of the definition and scope of ESG issues can be illustrated by the two widely referenced organizations in Exhibit 2 and Exhibit 3. Exhibit 2: Examples of ESG Issues Environmental Social Governance ► Climate change ► Human rights ► Bribery and corruption ► Resource depletion ► Modern slavery ► Executive pay ► Waste ► Child labor ► Board diversity and structure ► Pollution ► Working conditions ► ► Deforestation ► Employee relations Trade association, lobbying, and donations ► Tax strategy Source: PRI, “What Is Responsible Investment? (2020). www.unpri.org/an-introduction-to-responsible -investment/what-is-responsible-investment/4780.article. 2 R. Edward Freeman and David L. Reed, “Stockholders and Stakeholders: A New Perspective on Corporate Governance,” California Management Review 25 (April 1983): 88–106. www.researchgate .net/publication/238325277_Stockholders_and_Stakeholders_A_New_Perspective_on_Corporate _Governance. 19 20 © CFA Institute. For candidate use only. Not for distribution. Introduction to ESG Investing Chapter 1 Exhibit 3: Your Guide to ESG Reporting ESG Ratings Environmental Social Governance • Biodiversity • Labor Standards • Anti-Corruption • Climate Change • Human Rights • Corporate Governance • Pollution and Resources • Community • Risk Management • Water Security • Health and Safety • Tax Transparency • Pollution and Resources • Customer Responsibility Source: FTSE Russell, “FTSE Russell Stewardship, Transition and Engagement Program for Change: 2018 STEP Change Report” (2018). https://content.ftserussell.com/sites/default/files/ research/ftse_russell_step_change_2018_report.pdf. 3 TYPES OF RESPONSIBLE INVESTMENT 1.1.2 define the following sustainability-based concepts in terms of their strengths and limitations: corporate social responsibility and triple bottom line (TBL) accounting ESG investing is part of a group of approaches collectively referred to as responsible investment. ESG investing is concerned with how ESG issues can impact the long-term return of assets and securities, whereas other responsible investment approaches can also take into account non-financial value creation and reflect stakeholder values in an investment strategy. There is no standard set of criteria for identifying responsible investment. The main investment approaches are presented in this section to demonstrate the wide spectrum of different types of responsible investment. Responsible investment is an umbrella term for the various ways in which investors can consider ESG factors within security selection and portfolio construction. As such, it may combine financial and non-financial outcomes and complements traditional financial analysis and portfolio construction techniques. All forms of responsible investment except for engagement are ultimately related to portfolio construction (in other words, which securities a fund holds). Engagement, both by equity owners and bond holders, concerns whether and how an investor tries to encourage and influence an issuer’s behavior on ESG matters. There is no standard classification in the industry; the types of responsible investment overlap and evolve over time. Exhibit 4 illustrates some of the conceptual differences between these approaches and how they range from strictly “finance-only” investment, with no consideration of ESG factors, to the other end of the spectrum, where the investor may be prepared to accept below-market returns in exchange for the high positive impact the projects and © CFA Institute. For candidate use only. Not for distribution. Types of Responsible Investment 21 companies in the portfolio deliver. As investors move toward the left-hand side of the spectrum, they are increasingly interested in aligning their capital with ESG-related investment opportunities, in order to capture associated financial returns and/or to have a positive impact by financing solutions to societal challenges. Exhibit 4: A Spectrum of Capital Social impact investing Venture philanthropy Social investing Impact investment Sustainable & responsible investing Fully commercial companies/ investors Address societal challenges with venture investment approaches Investments with a focus on social and/or environmental outcomes and some expected financial return Investments with an intent to have a social and/or environmental as well as a financial return Adapt environmental, social and governance practices to enhance value or mitigate practices in order to protect value Limited or no regard for environmental, social or governance practices Social return focused Social return and sub- market financial market rate Social return and financial market rate Financial market rate focused Financial market rate only Traditional philanthropy Focus Return expectation Address societal challenges through the provision of grants Social return only Social impact Social and financial Primary intention Source: Organisation for Economic Co-Operation and Development (OECD) (2019), Social Impact Investment 2019: The Impact Imperative for Sustainable Development, OECD Publishing, Paris, doi.org/10.1787/9789264311299-en. Used with permission of OECD; permission conveyed through Copyright Clearance Center, Inc. Note: For illustrative purposes only. Responsible Investment Responsible investment is a strategy and practice to incorporate ESG factors into investment decisions and active ownership.3 It is sometimes used as an umbrella term for some (or all) of the investment approaches mentioned in the following subsections. At a minimum, responsible investment consists of mitigating risky ESG practices in order to protect value. To this end, it considers both how ESG might influence the risk-adjusted return of an asset and the stability of an economy and how investment in and engagement with assets and investees can impact society and the environment. Socially Responsible Investment Socially responsible investment (SRI) refers to approaches that apply social and environmental criteria in evaluating companies. Investors implementing SRI generally score companies using a chosen set of criteria, usually in conjunction with sector-specific 3 PRI, “What Is Responsible Investment?” Financial returns 22 © CFA Institute. For candidate use only. Not for distribution. Introduction to ESG Investing Chapter 1 weightings. A hurdle is established for qualification within the investment universe, based either on the full universe or sector by sector. This information serves as a first screen to create a list of SRI-qualified companies. SRI ranking can be used in combination with best-in-class investment, thematic funds, high-conviction funds, or quantitative investment strategies. Best-in-Class Investment Best-in-class investment (also known as “positive screening”) involves selecting only the companies that overcome a defined ranking hurdle, established using ESG criteria within each sector or industry. ► Typically, companies are scored on a variety of factors that are weighted according to the sector. ► The portfolio is then assembled from the list of qualified companies. Bear in mind, though, that not all best-in-class funds are considered “responsible investments.” Due to its all-sector approach, best-in-class investment is commonly used in investment strategies that try to maintain certain characteristics of an index. In these cases, security selection seeks to maintain regional and sectorial diversification along with a similar profile to the parent market-cap index while targeting companies with higher ESG ratings. The tracking error for MSCI World SRI, which is designed to represent the performance of companies with high ESG ratings and employs a best-in-class selection approach to target the top 25% companies in each sector, is only 1.79% (see Exhibit 5). Exhibit 5: Characteristics of an SRI Index Using a Best-in-Class Approach (not tested; for illustration only) Parent Index (%) SRI Index (%) Information technology 18.1 19.6 Financials 15.4 14.6 Health care 12.9 13.4 Japan UK Industrials 11 11.1 Canada Consumer discretionary 10.3 10.9 France 3.7 4.3 Consumer staples 8.3 10.0 Other 15.7 19.2 Communication services 8.5 4.5 Materials 4.2 4.9 Energy 4.5 4.4 Utilities 3.6 3.2 Real estate 3.3 3.6 Sector Region Parent Index (%) SRI Index (%) US 63.8 8.1 ESG Rating Parent Index (%) SRI Index (%) 60.7 Leader 24 67 7.5 Average 65 33 5.3 — Laggard 10 0 3.4 3.8 Source: MSCI, “MSCI SRI Indexes” (2020). www.msci.com/msci-sri-indexes. © CFA Institute. For candidate use only. Not for distribution. Types of Responsible Investment Sustainable Investment Sustainable investment refers to the selection of assets that contribute in some way to a sustainable economy—that is, an asset that minimizes natural and social resource depletion. ► It is a broad term, with a broad range of interpretations that may be used for the consideration of typical ESG issues. ► It may include best-in-class and/or ESG integration, which considers how ESG issues impact a security’s risk and return profile. ► It is further used to describe companies with positive impact or companies that will benefit from sustainable macro-trends. The term “sustainable investment” can also be used to mean a strategy that screens out activities considered contrary to long-term environmental and social sustainability, such as coal mining or exploring for oil in the Arctic regions. Thematic Investment Thematic investment is investment in themes or assets specifically related to ESG factors, such as clean energy, green technology, sustainable agriculture, gender diversity, or affordable housing. This approach is often based on needs arising from economic or social trends. Two common investment themes focus on increased demand for energy and water and the availability of alternative sources of each. Global economic development has raised the demand for energy at the same time as increased greenhouse gas emissions are widely believed to negatively affect the earth’s climate. Similarly, rising global living standards and industrial needs have created a greater demand for water and the need to prevent drought or increase access to clean drinking water in certain regions of the world. While these themes are based on trends related to environmental issues (refer to the following subsection), social issues—such as access to affordable health care and nutrition, especially in the poorest countries in the world—are also of great interest to thematic investors (refer to the subsequent “Social Investment” section. Bear in mind, though, that not all thematic funds are considered to be responsible investments or best-in-class. Becoming such a fund depends not only on the theme of the fund but also on the ESG characteristics of the investee companies. Green Investment Green investment refers to allocating capital to assets that mitigate ► climate change, ► biodiversity loss, ► resource inefficiency, and ► other environmental challenges. These can include ► low-carbon power generation and vehicles, ► smart grids, ► energy efficiency, ► pollution control, ► recycling, ► waste management and waste of energy, and ► other technologies and processes that contribute to solving particular environmental problems. 23 24 Chapter 1 © CFA Institute. For candidate use only. Not for distribution. Introduction to ESG Investing Green investment can thus be considered a broad subcategory of thematic investing and/or impact investing. Green bonds, a type of fixed-income instrument that is specifically earmarked to raise money for climate and environmental projects, are commonly used in green investing. Further details on green investing and green bonds can be found in Chapter 3. Social Investment Social investment refers to allocating capital to assets that address social challenges. These can be products that address the bottom of the pyramid (BOP). “BOP” refers to the poorest two-thirds of the economic human pyramid, a group of more than four billion people living in poverty. More broadly, BOP refers to a market-based model of economic development that seeks to simultaneously alleviate poverty while providing growth and profits for businesses serving these communities. Examples include ► micro-finance and micro-insurance, ► access to basic telecommunication, ► access to improved nutrition and health care, and ► access to (clean) energy. Social investing can also include social impact bonds, which are a mechanism to contract with the public sector. This sector pays for better social outcomes in certain services and passes on part of the savings achieved to investors. Impact Investment Impact investing refers to investments made with the specific intent of generating positive, measurable social or environmental impact alongside a financial return (which differentiates it from philanthropy). It is a relatively smaller segment of the broader responsible investing market. Impact investing is usually associated with direct investments, such as in private debt, private equity, and real estate. However, in recent years, impact investing has increasingly become mainstream in the public markets. Impact investments can be made in both emerging and developed markets. They provide capital to address the world’s most pressing challenges. An example is investing in products or services that help achieve one (or more) of the 17 Sustainable Development Goals (SDGs) launched by the United Nations in 2015, such as the following: ► “SDG 6: Clean Water and Sanitation—Ensure availability and sustainable management of water and sanitation for all” ► “SDG 11: Sustainable Cities and Communities—Make cities and human settlements inclusive, safe, resilient and sustainable” 4 Measurement and tracking of the agreed-upon impact generally lie at the heart of the investment proposition. Impact investors have diverse financial return expectations. Some intentionally invest for below-market-rate returns in line with their strategic objectives. Others pursue market-competitive and market-beating returns, sometimes required by fiduciary responsibility. The Global Impact Investing Network (GIIN) estimated the size of the global impact investing market to be US$502 billion (£361billion); its 2019 annual survey indicated that 66% of investors in impact investing pursue competitive, market-rate returns.5 4 https://sdgs.un.org/goals. 5 A. Mudaliar, R. Bass, H. Dithrich, and N. Nova, “2019 Annual Impact Investor Survey”. Global Impact Investing Network (19 June 2019). https://thegiin.org/research/publication/impinv-survey-2019. © CFA Institute. For candidate use only. Not for distribution. Types of Responsible Investment Ethical (or Value-Driven) and Faith-Based Investment Ethical and faith-based investment refers to investing in line with certain principles, often using negative screening to avoid investing in companies whose products and services are deemed morally objectionable by the investor or certain religions, international declarations, conventions, or voluntary agreements. Typical exclusions include ► tobacco, ► alcohol, ► pornography, ► weapons, and ► significant breach of agreements, such as the Universal Declaration of Human Rights or the International Labour Organization’s Declaration on Fundamental Principles and Rights at Work. From religious individuals to large religious organizations, faith-based investors have a history of shareholder activism to improve the conduct of investee companies. Another popular strategy is portfolio building with a focus on screening out the negative; in other words, avoiding “sin stocks” or other assets at odds with their beliefs. In the following subsections, we cover a few examples of faith-based negative screening. Christian Investors wishing to put their money to work in a manner consistent with Christian values seek to avoid, in addition to the activities listed previously, investing in firms that ► facilitate abortion, contraceptives, or embryonic stem-cell research or ► are involved in the production and sale of weapons. They often favor firms that support human rights, environmental responsibility, and fair employment practices via the support of labor unions. Shari’a Investors seeking to follow Islamic religious principles cannot do the following: ► invest in firms that profit from alcohol, pornography, or gambling; ► invest in companies that carry heavy debt loans (and therefore pay interest); ► own investments that pay interest; ► liaise with firms that earn a substantial part of their revenue from interest; or ► invest in pork-related businesses. Exhibit 6 shows negative screening strategies for various types of funds. Exhibit 6: Negative Screening Strategies Negative Screening Christian Funds Islamic Funds SRI Funds Alcohol X X X Gambling X X X Tobacco X Pornography X X X Pork products X Interest-based financial services X 25 26 Chapter 1 © CFA Institute. For candidate use only. Not for distribution. Introduction to ESG Investing Negative Screening Christian Funds High leverage companies Islamic Funds SRI Funds X Anti-family entertainment X Marriage lifestyle X Abortion X Human rights X X X Workers’ rights X Bioethics X Weapons X X X Source: Adapted from Inspire Investing, “Faith-Based Investment and Sustainability” (2019). www .inspireinvesting.com/2019/03/26/faith-based-investment-and-sustainability/. Shareholder Engagement Shareholder engagement reflects active ownership by investors in which the investor seeks to influence a corporation’s decisions on ESG matters, either through dialogue with corporate officers or votes at a shareholder assembly (in the case of equity). It is seen as complementary to the previously mentioned approaches to responsible investment as a way to encourage companies to act more responsibly. Its efficacy usually depends on ► the scale of ownership (of the individual investor or the collective initiative), ► the quality of the engagement dialogue and method used, and ► whether the company has been informed by the investor that divestment is a possible sanction. For further details on the process of engagement, see Chapter 6. ESG investing also recognizes that the generation of long-term sustainable returns is dependent on stable, well-functioning and well-governed social, environmental and economic systems. This is the so-called triple bottom line coined by business writer John Elkington. However, since its inception, the concept of TBL evolved from a holistic approach to sustainability and further into an accounting tool to narrowly manage trade-offs. Therefore, Elkington “recalled” the term in a 2018 Harvard Business Review article.6 Ultimately, ESG investing recognizes the dynamic interrelationship between social, environmental, and governance issues and investment. It acknowledges that ► social, environmental, and governance issues may impact the risk, volatility, and long-term return of securities (as well as markets) and ► investments can have both a positive and a negative impact on society and the environment. Corporate Social Responsibility The concept of ESG investing is closely related to the concept of investees’ corporate sustainability. Corporate sustainability is an approach aiming to create long-term stakeholder value through the implementation of a business strategy that focuses on the ethical, social, environmental, cultural, and economic dimensions of doing 6 J. Elkington, “25 Years Ago I Coined the Phrase ‘Triple Bottom Line.’ Here’s Why It’s Time to Rethink It,” Harvard Business Review (25 June 2018). https://hbr.org/2018/06/25-years-ago-i-coined-the-phrase -triple-bottom-line-heres-why-im-giving-up-on-it. © CFA Institute. For candidate use only. Not for distribution. Macro-Level Debate on ESG Integration 27 business.7 Related to this approach, corporate social responsibility (CSR) is a broad business concept that describes a company’s commitment to conducting its business in an ethical way. Throughout the 20th century and until recently, many companies implemented CSR by contributing to society through philanthropy. While such philanthropy may indeed have a positive impact on communities, modern understanding of CSR recognizes that a principles-based behavior approach can play a strategic role in a firm’s business model, which led to the theory of TBL. The TBL accounting theory expands the traditional accounting framework focused only on profit to include two other performance areas: the social and environmental impacts of a company. These three bottom lines are often referred to as the three P's: 1. people, 2. planet, and 3. profit. While the term and concept are useful to know, including for historical reasons, they have been replaced in the industry with a broader framework of sustainability that is not restricted to accounting. Effective management of the company’s sustainability can ► reaffirm the company’s license to operate in the eyes of governments and civil society, ► increase efficiency, ► attend to increasing regulatory requirements, ► reduce the probability of fines, ► improve employee satisfaction and productivity, and ► drive innovation and introduce new product lines. ESG investing recognizes these benefits and aims to consider them in the context of security/asset selection and portfolio construction. There are many organizations and institutions contributing to the further exploration of interactions between society, environment, governance, and investment. This curriculum focuses on how professionals in the investment industry can better understand, assess, and integrate ESG issues when conducting stock selection, carrying out portfolio construction, and engaging with companies. MACRO-LEVEL DEBATE ON ESG INTEGRATION 1.1.3 describe the benefits and challenges of incorporating ESG in decision making, and the linkages between responsible investment and financial system stability There is a range of beliefs about the purpose and value, both to investors and to society more broadly, of integrating ESG considerations into investment decisions. Some of the main reasons for integrating ESG factors are detailed in this section. It starts 7 M. Ashrafi, M. Acciaro, T. R. Walker, G. M. Magnan, and M. Adams, “Corporate Sustainability in Canadian and US Maritime Ports,” Journal of Cleaner Production 220 (20 May 2019): 386–97. https://doi .org/10.1016/j.jclepro.2019.02.098. 4 28 Chapter 1 © CFA Institute. For candidate use only. Not for distribution. Introduction to ESG Investing with an overview of some important perspectives in the debate on integrating ESG considerations, financial materiality of integration, and challenges in integrating ESG issues and finishes with integration and financial performance. Macro-Level Debate on Integrating ESG Considerations This subsection describes various perspectives from which, over the years, the debate on the purpose and value of integrating ESG factors has been held. These include perspectives of risk, fiduciary duty, economics, impact and ethics, client demand, and regulation. Risk Perspective Evidence of the risks current megatrends carry is illustrated by the World Economic Forum’s 2020 Global Risk Report, which for many years has highlighted the growing likelihood and impact of extreme weather events and the failure to address climate change.8 Note that Exhibit 7 highlights how risks related to the environment have been significantly increasing in importance in recent years while classic economic risks have disappeared from the top five risks. Environmental risks are high on the radar. Among all global risks, climate now tops the agenda. 8 World Economic Forum, “The Global Risks Report 2020” (15 January 2020). www.weforum.org/ reports/the-global-risks-report-2020. © CFA Institute. For candidate use only. Not for distribution. Macro-Level Debate on ESG Integration Exhibit 7: Top Global Risks Likelihood Impact 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 Economic Environmental Geopolitical Asset bubble Critical infrastructure failure Deflation Energy price shock Financial failure Fiscal crises Illicit trade Unemployment Unmanageable inflation Biodiversity loss Climate action failure Extreme weather Human-made environmental disaster Natural disasters Global governance failure Interstate conflict National governance failure State collapse Terrorist attacks Weapons of mass destruction Societal Technological Failure of urban planning Food crises Infectious diseases Involuntary migration Social instability Water crises Adverse technological advances Cyberattacks Data fraud or theft Information infrastructure breakdown Source: World Economic Forum, “The Global Risks Report 2020” (2020). www.weforum.org/ reports/the-global-risks-report-2020. Recognizing the change in profile of key risks to the economy, in 2015, Mark Carney, then governor of the Bank of England and chairman of the Financial Stability Board (the international body set up by the G20 to monitor risks to the financial system), referred to this challenge in a speech that became a cornerstone for the integration of climate change to financial regulators: 29 30 Chapter 1 © CFA Institute. For candidate use only. Not for distribution. Introduction to ESG Investing Climate change is the tragedy of the horizon. We don’t need an army of actuaries to tell us that the catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors—imposing a cost on future generations that the current generation has no direct incentive to fix. . . . The horizon for monetary policy extends out to two to three years. For financial stability it is a bit longer, but typically only to the outer boundaries of the credit cycle—about a decade. In other words, once climate change becomes a defining issue for financial stability, it may already be too late.9 In line with Carney, in his annual letter to chief executives in 2020,10 Larry Fink, the CEO of BlackRock, stated that the investment firm would step up its consideration of climate change in its investment considerations because it was reshaping the world’s financial system. Concretely, in a parallel letter to its clients, BlackRock committed to divesting from companies that generate more than 25% of their revenues from coal production for its actively managed portfolios and required reporting from investee companies on their climate-related risks and plans for operating under the goals of the Paris Agreement to limit global warming to less than 2°C (3.6°F).11 As the largest asset manager in the world, BlackRock’s decision could represent a new paradigm in the investment industry in which the integration of material ESG factors is mainstream. Prudent investors are engaging with companies to ask them to disclose not only what they are emitting today but also how they plan to achieve their transition to the net-zero world of the future. There is value in being able to spot winners and losers in a rapidly changing risk landscape. Investors that are attempting to take advantage of this usually operate over a longer time frame than the usual quarterly or one-year time horizon, with the objective of understanding emerging risks and new demands so that they can convert these into above-market performance. CASE STUDIES Water Depletion Due to Climate Change Companies are already experiencing risks in their manufacturing due to water depletion, which has been aggravated by acute impacts of climate change. Water has largely been considered a free raw material and therefore is used inefficiently, but many companies are now experiencing the higher costs of using the resource, as well as suffering an increasing frequency of extreme weather events. Pacific Gas and Electric Company (PG&E), a listed US utility, was driven to bankruptcy proceedings due to wildfire liabilities.12 The company’s equipment led to more than 1,500 fires between 2014 and 2017. As low humidity and strong winds worsen due to climate change, the fire hazard increases. In 2018, a problem with PG&E equipment was deemed to have led to fires that killed at least 85 people, forced about 180,000 to evacuate from their homes, and razed more than 18,800 structures. 9 M. Carney, “Breaking the Tragedy of the Horizon—Climate Change and Financial Stability,” Bank of England, speech given at Lloyd’s of London (29 September 2015). www.bankofengland.co.uk/speech/ 2015/breaking-the-tragedy-of-the-horizon-climate-change-and-financial-stability. 10 L. Fink, “A Fundamental Reshaping of Finance,” BlackRock (2020). www.blackrock.com/corporate/ investor-relations/2020-larry-fink-ceo-letter. 11 BlackRock, “Sustainability as BlackRock’s New Standard for Investing” (2020). www.blackrock.com/ au/individual/blackrock-client-letter. 12 M. McFall-Johnsen, “Over 1,500 California Fires in the Past 6 Years—Including the Deadliest Ever— Were Caused by One Company: PG&E. Here’s What It Could Have Done but Didn’t,” Business Insider (3 November 2019). www.businessinsider.com/pge-caused-california-wildfires-safety-measures-2019-10?r =US&IR=T. © CFA Institute. For candidate use only. Not for distribution. Macro-Level Debate on ESG Integration Coca-Cola Company faced a water shortage in India that forced it to shut down one of its plants in 2004. The company has since invested US$2 billion (£1.4 billion) to reduce water use and improve water quality in the communities in which it operates. SABMiller, a multinational brewing and beverage company, has also invested heavily in water conservation, including US$6 million (£4.3 million) to improve equipment at a facility in Tanzania affected by deteriorating water quality. In extreme cases, assets can become stranded—in other words, obsolete due to regulatory, environmental, or market constraints. In Peru, for example, social conflict related to disruptions to water supplies resulted in the indefinite suspension of US$21.5 billion (£15.5 billion) in mining projects since 2010. There are many ways in which ESG factors can impact a company’s bottom line. Nonetheless, identifying those issues that are genuinely material to a sector and company is one of the most active challenges in ESG investment. Each company is unique and faces its own challenges related to its culture, particular business model, supply chain structure, and so on. So not only are there substantial differences between sectors, but there are also differences between what is most material to individual companies within a single sector. For further details on how to assess materiality and what tools are available, refer to Chapters 7 and 8. Fiduciary Duty Perspective For many years, fiduciary duty was considered a barrier to considering ESG factors in investments. In the modern investment system, financial institutions or individuals, known as fiduciaries, manage money or other assets on behalf of beneficiaries and investors. Fiduciary duties exist to ensure that those who manage other people’s money act in their beneficiaries’ interests, rather than serving their own. Beneficiaries and investors rely on these fiduciaries to act in their best interests, which are typically defined exclusively in financial terms. Due to the misconception that ESG factors are not financially material, some investors have used the concept of fiduciary duty as a reason not to incorporate ESG issues. In 2005, the United Nations Environment Programme Finance Initiative (UNEP FI) commissioned the law firm Freshfields Bruckhaus Deringer to publish a report titled “A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment” (commonly referred to as the Freshfields report). The authors argued that “integrating ESG considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions.”13 Despite the conclusions of the report, many investors continue to point to their fiduciary duties and the need to deliver financial returns to their beneficiaries as reasons why they cannot do more in terms of responsible investment. However, an increasing number of academic studies and work undertaken over the last decade by progressive investment associations, including the UNEP FI and Principles for Responsible Investment (PRI), on the topic have clarified that financially material ESG factors must be incorporated into investment decision making. 13 Freshfields Bruckhaus Deringer, “A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment,” UNEP Finance Initiative (October 2005): p. 13. www.unepfi.org/publications/investment-publications/a-legal-framework-for-the-integration-of -environmental-social-and-governance-issues-into-institutional-investment. 31 32 Chapter 1 © CFA Institute. For candidate use only. Not for distribution. Introduction to ESG Investing The 2005 UNEP FI report14 and the more recent report published by the PRI in 201915 both argue that failing to consider long-term investment value drivers—which include ESG issues—in investment practice is a failure of fiduciary duty. The 2019 PRI report concluded that modern fiduciary duties require investors to do the following: ► Incorporate financially material ESG factors into their investment decision making, consistent with the time frame of the obligation. ► Understand and incorporate into their decision making the sustainability preferences of beneficiaries or clients, regardless of whether these preferences are financially material. ► Be active owners, encouraging high standards of ESG performance in the companies or other entities in which they are invested. ► Support the stability and resilience of the financial system. ► Disclose their investment approach in a clear and understandable manner, including how preferences are incorporated into the scheme’s investment approach. For further details on fiduciary duty, see Chapter 2. Economic Perspective Another reason for implementing ESG stems from the recognition that negative megatrends will, over time, create a drag on economic prosperity as basic inputs (such as water, energy, and land) become increasingly scarce and expensive and that the prevalence of health and income inequalities increase instability both within countries and between the “global north and south.” There is an understanding that unless these trends are reversed, economies will be weakened, exposed to sustainability-led bubbles and spikes. While this may not have a significant impact on asset managers whose performance is judged by their ability to provide alpha, it may considerably affect asset owners, who depend on total returns in the long term to pay out pensions and their liabilities. As mentioned previously, the Financial Stability Board (FSB) has already identified climate change as a potential systemic risk, which may also be the case for other issues. The economic implications of these environmental issues (such as climate change, resource scarcity, biodiversity loss, and deforestation) and social challenges (such as poverty, income inequality, and human rights) are increasingly being recognized. In fact, the Stockholm Resilience Centre identified nine “planetary boundaries” (see Exhibit 8) within which humanity can continue to develop and thrive for generations to come16 and in 2015, it found that four of them—climate change, loss of biosphere integrity, land-system change, and altered biogeochemical cycles (phosphorus and nitrogen)—have been crossed. Two of these—climate change and biosphere integrity—are deemed “core boundaries,” for which significant alteration would “drive the Earth System into a new state.” 14 Freshfields Bruckhaus Deringer, “A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment.” 15 PRI, “Fiduciary Duty in the 21st Century: Executive Summary” (2019). www.unpri.org/fiduciary -duty/fiduciary-duty-in-the-21st-century/244.article. 16 Stockholm Resilience Centre, “The Nine Planetary Boundaries” (2015). www.stockholmresilience .org/research/planetary-boundaries/planetary-boundaries/about-the-research/the-nine-planetary -boundaries.html. © CFA Institute. For candidate use only. Not for distribution. Macro-Level Debate on ESG Integration CLIMATE CHANGE BIOSPHERE INTEGRITY E/MSY BII (Not yet quantified) Increasing risk Exhibit 8: Stockholm Resilience Centre’s Nine Planetary Boundaries FRESHWATER CHANGE Green water Freshwater use (Blue water) STRATOSPHERIC OZONE DEPLETION erating spac e op e Saf ATMOSPHERIC AEROSOL LOADING LAND-SYSTEM CHANGE (Not yet quantified) OCEAN ACIDIFICATION NOVEL ENTITIES P N BIOGEOCHEMICAL FLOWS Source: Stockholm Resilience Centre, “New Assessment Reveals Dramatic Changes to the Global Water Cycle, with Parts of the Amazon Drying Out” (2022). www.stockholmresilience.org/ research/research-news/2022-04-26-freshwater-boundary-exceeds-safe-limits.html. A popular framework that builds on that of “planetary boundaries” is doughnut economics. Exhibit 9 shows this visual framework. It is a diagram developed by economist Kate Raworth that combines planetary boundaries with the complementary concept of social boundaries. The name comes from the shape of the diagram, a disc with a hole. 33 Exhibit 9: Doughnut Economics Beyond the boundary Boundary not quantified climate change oz o de ECO L OG I C A L C EI L I NG ter wa en er SO C food UN IA L FO DATI O N T he h o u si la e q cial u it y nd co nv e ac p e s ti c ju e so ers io n al p o li t i c v oi c e os t ph rog or en us & loa din g & nd ge ual eq e it y r ni ng ty r si ve b i o di ss lo inc om wo e & rk chemical pollution tion uca ed L AL TF OR SH OV OO SH ER th al gy ac oc id e ifi c n an tio a r ye la n ne etio pl networ ks Chapter 1 air pollu tion 34 © CFA Institute. For candidate use only. Not for distribution. Introduction to ESG Investing ph r at e fre s h w s wal a r d h t wi DOUGHNUT ECONOMICS ACTION LAB doughnuteconomics.org 21st Source: K. Raworth, Doughnut Economics: Seven Ways to Think Like a Century Economist (White River Junction, VT: Chelsea Green Publishing, 2017). Social issues are also having a significant impact on the wider economy. Income inequality in OECD countries is at its highest level for 30 years, and Oxfam estimated that as of January 2022, the wealth of the 10 richest billionaires has doubled since the beginning of the COVID-19 pandemic; together, they own as many assets as the 3.8 billion people who make up the poorest half of the planet’s population.17 This significant level of income inequality is creating a number of social stresses, including security-related issues.18 In 2014, the world spent 9.1% of its gross domestic product (GDP) on costs associated with violence. Undernutrition is also still common in developing economies and has severe economic consequences: The economic cost of undernutrition in Ethiopia alone is just under US$70 million (£50 million) a year. While the number of undernourished people in the world has declined sharply, one out of eight people suffers from chronic malnutrition. Large institutional investors have holdings that, due to their size, are highly diversified across all sectors, asset classes, and regions. As a result, the portfolios of universal owners, as they are known, are sufficiently representative of global capital markets that they effectively hold a slice of the overall market. Their investment 17 A. Ratcliff, “Billionaire Fortunes Grew by $2.5 Billion a Day Last Year As Poorest Saw Their Wealth Fall,” Oxfam International (21 January 2019). www.oxfam.org/en/press-releases/billionaire-fortunes -grew-25-billion-day-last-year-poorest-saw-their-wealth-fall. 18 PRI, “The SDG Investment Case—Macro Risks: Universal Ownership” (12 October 2017). www .unpri.org/sdgs/the-sdgs-are-an-unavoidable-consideration-for-universal-owners/306.article. © CFA Institute. For candidate use only. Not for distribution. Macro-Level Debate on ESG Integration returns are thus dependent on the continuing good health of the overall economy. Inefficiently allocating capital to companies with high negative externalities can damage the profitability of other portfolio companies and the overall market return. It is in their interests to act to reduce the economic risk presented by sustainability challenges to improve their total, long-term financial performance. There is therefore a growing school of thought that investors should integrate the price of externalities into the investment process and take into account the wider effects of investments by considering the impact on society and environment and in the economy as a whole. For that reason, investors increasingly call for governments to set policies in line with the fundamental challenges to our future. The UN’s Sustainable Development Goals (SDGs),19 an agreed framework for all UN member state governments to work toward in aligning with global priorities (such as the transition to a low-carbon economy and the elimination of human rights abuses in corporate supply chains), were welcomed by the investment community. Impact and Ethics Perspective Yet another reason for practicing responsible investment is some investors’ belief that investments can or should serve society alongside providing financial return. This belief translates into focusing on investments with a positive impact and/or avoiding those with a negative impact. ► ► Those investing for positive impact see investment as a means of tackling the world’s social and environmental problems through effective deployment of capital. The aim is to put beneficiaries’ money to good use rather than to invest it in any activity that could be construed as doing harm—essentially a moral argument. This idea is giving rise to the growing area of impact investment, itself a response to the limits of philanthropy and a recognition of the potential to align returns with positive impacts. Those avoiding negative impact, at times for religious reasons, usually do not invest (negative screening) in securities from controversial sectors (such as arms, gambling, alcohol, tobacco, and pornography). Client Demand Perspective Clients and pension fund beneficiaries (defined in more detail in Chapter 2) are increasingly calling for greater transparency about how and where their money is invested. This effort is driven by the following: ► ► Growing awareness that ESG factors influence ● Company value ● Returns ● Reputation Increasing focus on the environmental and social impacts of the companies they are invested in Asset owners, such as pension funds and insurers (as defined in Chapter 2), are instrumental for responsible investment because they make the decisions about how their assets, representing on average around 34% of GDP in OECD countries, are 19 United Nations, “Take Action for the Sustainable Development Goals” (2020). www.un.org/sus tainabledevelopment/sustainable-development-goals/. 35 36 Chapter 1 © CFA Institute. For candidate use only. Not for distribution. Introduction to ESG Investing managed.20 The number of them that are integrating ESG considerations continues to grow. In 2020–2021, 88 asset owners signed on to the PRI for the first time. In 2020, a group of asset owners launched the Net-Zero Asset Owner Alliance under the auspices of the UN, committing to transition their investment portfolios to net-zero greenhouse gas (GHG) emissions by 2050. Further details on the demand for, and supply of, responsible investment, as well as the market more broadly, are discussed in Chapter 2. Regulatory Perspective Finally, regardless of their views or beliefs, some investors are being required to increasingly consider ESG matters. Since the mid-1990s, responsible investment regulation has increased significantly, with a particular surge in policy interventions since the 2008 financial crisis. Regulatory change has also been driven by a realization among national and international regulators that the financial sector can play an important role in meeting global challenges, such as combating climate change, modern slavery, and tax avoidance. Among the world’s 50 largest economies, the PRI found that 48 have some form of policy designed to help investors consider sustainability risks, opportunities, or outcomes. In fact, among these economies, there have been over 730 hard and soft law policy revisions that encourage or require investors to consider long-term value drivers, including ESG factors. Hard laws are actual binding legal instruments and laws. Soft laws are quasi-legal instruments that do not have legally binding force or whose binding force is somewhat weaker than the binding force of traditional law. Soft law over time may become hard law. For further details on how regulation has played a key role in increased demand for responsible investment, refer to Chapter 2. Exhibit 10: Cumulative Number of Policy Interventions per Year Source: PRI, “Regulation Database” (updated April 2022). www.unpri.org/sustainable-markets/ regulation-map. 20 R. Sievänen, H. Rita, and B. Scholtens, “The Drivers of Responsible Investment: The Case of European Pension Funds,” Journal of Business Ethics 117 (September 2012): 137–51. www.researchgate.net/publication/236667333_The_Drivers_of_Responsible_Investment_ The_Case_of_European_Pension_Funds. © CFA Institute. For candidate use only. Not for distribution. Financial Materiality of ESG Integration FINANCIAL MATERIALITY OF ESG INTEGRATION 1.1.4 explain the concepts of the financial materiality of ESG integration, double materiality, and dynamic materiality and how they relate to ESG analysis, practices, and reporting 1.1.5 explain different ESG megatrends, their systemic nature, and their potential impact on companies and company practices One of the main reasons for ESG integration is recognizing that ESG investing can reduce risk and enhance returns because it considers additional risks and injects new and forward-looking insights into the investment process. ESG integration may therefore lead to 1. reduced cost and increased efficiency, 2. reduced risk of fines and state intervention, 3. reduced negative externalities, and 4. improved ability to benefit from sustainability megatrends. Each of these outcomes is described in greater detail in the following subsections Efficiency and Productivity Sustainable business practices build efficiencies by ► conserving resources, ► reducing costs, and ► enhancing productivity. Sustainability was once perceived by businesses and investors as requiring sacrifices, but the perception today is very different. Significant cost reductions can result from improving operational efficiency through better management of natural resources, such as water and energy, as well as from minimizing waste. Research conducted by McKinsey & Company found that resource efficiency can affect operating profits by as much as 60% and that more broadly, resource efficiency of companies across various sectors is significantly correlated with the companies’ financial performance.21 A study analyzing data from the global climate database provided by CDP (formerly, the Climate Disclosure Project) estimated that companies experience an average internal rate of return of 27%–80% on their low-carbon investments.22 A strong ESG proposition can help companies attract and retain quality employees and enhance employee motivation and productivity overall. Employee satisfaction is positively correlated with shareholder returns. The London Business School’s Alex Edmans found that the companies that made Fortune’s 100 Best Companies to Work For list generated 2.3%–3.8% higher stock returns a year than their peers over a horizon of longer than 25 years.23 21 W. Henisz, T. Koller, and R. Nuttall, “Five Ways That ESG Creates Value,” McKinsey Quarterly (November 2019). www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/ five-ways-that-esg-creates-value?cid=soc-web. 22 We Mean Business Coalition, “The Climate Has Changed,” (21 September 2014). www.wem eanbusinesscoalition.org/blog/the-climate-has-changed/. 23 A. Edmans, “Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices,” Journal of Financial Economics 101 (September 2011): 621–40. www.sciencedirect.com/science/ article/abs/pii/S0304405X11000869. 37 5 38 Chapter 1 © CFA Institute. For candidate use only. Not for distribution. Introduction to ESG Investing CASE STUDIES Savings from Efficiency Measures The Dow Chemical Company Between 1994 and 2010, The Dow Chemical Company invested nearly US$2 billion (£1.4 billion) in improving resource efficiency and saved US$9.8 billion (£7 billion) from reduced energy and wastewater consumption in manufacturing.24 The company’s long-established focus on resource efficiency cost reductions enabled it to achieve savings of US$31 million (£22.3 million) on its raw materials alone, compared to a net income of approximately US$4 billion (£2.9 billion), in 2018. General Electric In 2013, General Electric reduced its GHG emissions by 32% and water use by 45% compared to the 2004 and 2006 baselines, respectively. This resulted in savings of US$300 million (£215.7 million).25 Aeon Group Between 2015 and 2018, the Japanese retail group Aeon achieved a decrease of 9.7% in food waste, which was equal to 32.14 kg or ¥1 million (£6,826) in net sales.26 Walmart Within 10 years, Walmart improved the fuel efficiency of its fleet by approximately 87% through better routing, cargo loading, and driver training. In 2014 alone, these improvements resulted in avoiding 15,000 metric tons of CO2 emissions and savings of nearly US$11 million (£7.9 million).27 Nike Almost half (40%) of Nike’s footwear manufacturing waste is generated by cutting scraps from materials such as textiles, leather, synthetic leather, and foams. In 2018, modern cutting equipment, which can achieve smaller gaps between cut parts than traditional die-cutting can, was deployed to various factories. The estimated value of savings was US$12 million (£8.6 million), compared to its net income of US$1.1 billion (£0.8 billion), and nearly 1.2 million kilograms of material for that fiscal year.28 Reduced Risk of Fines and State Intervention With all the discussion regarding climate change, dwindling energy resources, and environmental impact, it is no surprise that state and federal government agencies are enacting regulations to protect the environment. Integrating sustainability into a business will position it to anticipate changing regulations in a timely manner. For 24 T. Whelan and C. Fink, “The Comprehensive Business Case for Sustainability,” Harvard Business Review (21 October 2016). https://hbr.org/2016/10/the-comprehensive-business-case-for-sustainability. 25 GE, “GE Works: 2013 Annual Report,” letter to shareowners (2014). www.ge.com/jp/sites/www.ge .com.jp/files/GE_AR13.pdf. 26 Aeon, “Aeon Sustainability Data Book 2019” (2019). www.aeon.info/export/sites/default/common/ images/en/environment/report/e_2019pdf/19_data_en_a4.pdf. 27 T. Whelan and C. Fink, “The Comprehensive Business Case for Sustainability.” 28 M. Parker, “Letter to Shareholders,” NIKE, Inc. (24 July 2018). https://s1.q4cdn.com/806093406/fi

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