CFA Institute - 2022 - CFA Certificate in ESG Investing. PDF

© CFA Institute. For candidate use only. Not for distribution. Investment Decision and Portfolio Construction and ESG Integration Techniques in Practice (Seven Cases) ► Would the business model suggest scope 2 would be a material matter? The fact that the scope 1 data has third-party assurance sho...

© CFA Institute. For candidate use only. Not for distribution. Investment Decision and Portfolio Construction and ESG Integration Techniques in Practice (Seven Cases) ► Would the business model suggest scope 2 would be a material matter? The fact that the scope 1 data has third-party assurance should, with all other matters being equal, give more weight to the disclosure. ► How long has the company been disclosing, and has management made other commitments to future disclosure? Answers and judgments to these types of questions will sway how an analyst rates a company (e.g., on a scorecard approach) or the discount rate they might use in a DCF or valuation. As a follow-up, the analyst could call the company and ask for an explanation of the data’s absence and the company view on its materiality, then judge its willingness to engage or commit to publishing the data. Or the analyst could estimate the data and find a third-party data source. ► A quantitative approach would have to consider how to deal with missing data. ► The analyst also has to judge the materiality of the missing information and might view cement as a carbon-intense industry. ► A disclosure on carbon intensity would be viewed as more material for a cement company than a software service business. ► A software service business would not be expected to be carbon intense. On occasion, a lack of disclosure can be enough to red flag an investment completely. For example, a company hires a new CEO but will not disclose in sufficient detail what the long-term incentive plans for management are based on. This might be too strong a red flag for the analyst to recommend any investment. Another factor to consider is the strength of environmental accounting. Consensus is currently lacking on how best to account for natural capital. Also, how selective disclosure affects firm value is unclear; academic and practitioner work is currently exploring this issue.12 The example also shows both qualitative ESG and QESG tools and demonstrates the intertwined nature with traditional assessments. INVESTMENT DECISION AND PORTFOLIO CONSTRUCTION AND ESG INTEGRATION TECHNIQUES IN PRACTICE (SEVEN CASES) 7.1.12 apply the range of approaches to ESG analysis and integration across a range of asset classes 12 Please refer to the following three articles: D. Crilly, M. Hansen, and M. Zollo, “The Grammar of Decoupling: A Cognitive-Linguistic Perspective on Firms’ Sustainability Claims and Stakeholders’ Interpretation,” Academy of Management Journal 59(2) (April 2016). https://​journals​.aom​.org/​doi/​10​ .5465/​amj​.2015​.0171. A. Saad and D. Strauss, “The New ‘Reasonable Investor’ and Changing Frontiers of Materiality: Increasing Investor Reliance on ESG Disclosures and Implications for Securities Litigation,” Berkeley Business Law Journal 17.2 (May 2020). https://​papers​.ssrn​.com/​sol3/​papers​.cfm​?abstract​_id​=​ 3590809. F. Zhang, X. Qin, and L. Liu, “The Interaction Effect between ESG and Green Innovation and Its Impact on Firm Value from the Perspective of Information Disclosure,” Sustainability 12(5) (March 2020). www​.mdpi​.com/​2071​-1050/​12/​5/​1866. 6 395 396 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration Several adapted case studies across equities and fixed income will be highlighted in this section. Although this section does not provide detailed case studies in private equity, infrastructure, or other alternative investments, many similar techniques can be used in those asset classes. The end of this section allows for some discussion. Unless mentioned otherwise, the case studies are adaptations from CFA Institute case studies (see the Further Reading section). We will look at the following case studies: ► Case Study 1 – Quantitative Systematic Approach to an Environmental Tilted Mandate in Global Equities ► Case Study 2 – Fundamental ESG Integration ► Case Study 3 – ESG Analysis Supporting a Premium Valuation Ratio ► Case Study 4 – ESG DCF Scenario Analysis ► Case Study 5 – Credit Analysis Integrating ESG ► Case Study 6 – Credit ESG Integration Practice ► Case Study 7 – Sovereign Debt Analysis A detailed look at how quantitative investment approaches work at a portfolio level is provided in Chapter 8. CASE STUDY 1 – QUANTITATIVE SYSTEMATIC APPROACH TO AN ENVIRONMENTAL TILTED MANDATE IN GLOBAL EQUITIES (This is a theoretical case study based on the author’s knowledge and experience.) A foundation endowment with an underlying mission to fund climate science wishes to invest part of its endowment funds in a systematic global equities strategy tilted to companies that have positive environmental characteristics. The endowment discusses a mandate with a quantitative systematic investment manager. The endowment decides that the following rules and factors are important: ► the use of at least two third-party ESG scoring systems ► a proprietary scoring system ► all invested companies have a publicly available environmental management policy ► the average blend of the rating systems meet a minimum criterion on an E score ► rebalance quarterly In practice, for specific mandates, many further detailed rules and conditions can be set on other aspects of ESG or other established quantitative and fundamental factors (e.g., quality or geography). The fund manager converts the third-party E scores through its own formula. They use the database to flag companies with no environmental management policy. The manager has an in-house team that uses a scorecard approach to score companies on material, relevant environmental risks and opportunities. This score is combined with the third-party scores and a minimum threshold set, where the bottom 20% of companies are deemed ineligible for the fund. See earlier parts of this chapter for more on the scorecard approach. The remaining companies are weighted to approximately match a specified global benchmark with respect to momentum, quality, and volatility factors, as well as other ESG factors, and within the bounds of other construction criteria, such as tracking error and market beta. © CFA Institute. For candidate use only. Not for distribution. Investment Decision and Portfolio Construction and ESG Integration Techniques in Practice (Seven Cases) These calculations are performed once a quarter, and the portfolio is adjusted accordingly. The rules are examined once a year in consultation with the end client. Performance and ESG measurements are recorded and assessed. An engagement or stewardship program could be implemented for companies not meeting, or in danger of not meeting, the specified environmental criteria. CASE STUDY 2 – FUNDAMENTAL ESG INTEGRATION This fund manager adjusts the most relevant financial forecasts (revenue, profits or returns on capital, capital and operational expenditures, and cash flows) based on material ESG factors. They also consider the potential ESG impact on the overall security valuation by adjusting the target multiples (discount or premium and discount rate) on ratio analysis. The chemical sector is analyzed. The following trends are assessed: ► aging populations that will require more health and well-being products ► regulations that influence a move toward biodegradable or bio-derived plastics ► evolving consumer sensitivity to “green” issues A company is sought after if it reflects positively on those trends. Company A is one of the world’s leading suppliers of specialty chemicals based on renewable raw materials that are used in personal care, life sciences, and industrial chemicals. It enjoys an industry-leading position in sustainability, having differentiated itself from its petrochemical-based specialty chemical peers. Two-thirds of Company A’s raw materials come from natural sources, and it is well positioned to participate in the trends described earlier. Company A has opened a new chemicals plant with a renewable-source, plant-based feed stock. The fund manager judges that the new plant will allow the company to capture more of the value chain in surfactants and to charge a premium because consumers are willing to pay more for sustainable products. This will improve revenue growth through increased share and pricing. The company is forecast to grow sales two whole percentage points above the industry average for the next 10 years for this. This is embedded in a DCF forecast and a value calculated. This value is then cross-checked with a P/E ratio. The fund manager is prepared to pay a 50% premium on a P/E basis because of the company’s strong sales and earnings growth. Company A currently trades at only a 10% P/E premium to the chemicals sector, and the DCF is forecast to have 35% target price upside. The company is selected to go into the fund manager’s portfolio. Thanks to Hyewon Kong for the case study example upon which this case study is based. 397 398 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration CASE STUDY 3 – ESG ANALYSIS SUPPORTING A PREMIUM VALUATION RATIO An investor is reviewing their portfolio. Company Z has been performing well and now has a 50% premium to the sector on a P/E basis. To achieve long-term value creation, in accordance with its investment philosophy, the investor needs to have a strong conviction regarding the company’s ability to maintain its industry-leading products and profitability. Key operational risks to the company include the following: ► the maintenance of the company’s technical leadership through investment in human and physical capital ► the potential for manufacturing delays or product defects that could affect its reputation and market share E and S data were assessed using third-party databases. The company ranked as a top 10% performer over the relevant criteria. The following three major areas were considered strong enough that an even higher P/E premium was recommended, and the company was kept in the portfolio: 1. Asset quality and efficiency: The company had industry-leading resource (water and energy) intensity per unit of revenue, higher performance regarding water and waste recycling, and lower carbon emission intensity than its peers. 2. Attracting and retaining talent: The investor evaluated employee engagement and compensation to help gauge the risks associated with attracting and retaining talent. The company’s average employee wage was significantly higher than that of its peers, and it had low employee turnover. In a highly complex research and development–intensive industry, this suggested that the company is well positioned to attract and retain top talent. This in turn should enhance the company’s innovation potential. 3. Sustainable business model: These elements were considered superior to those of the company’s competitors: ● its positioning as enabling smaller, faster, and more energy-efficient electronics ● its customer-centric approach of providing aftermarket enhancements and refurbishments to improve customers’ capital efficiency ● its culture of innovation and collaboration with internal and external stakeholders that have the potential to generate both new business opportunities and broader social benefits Thanks to GS Sustain for their case study example upon which this study is based. CASE STUDY 4 – ESG DCF SCENARIO ANALYSIS This investment team uses an integrated approach. Rather than having separate ESG analysts, the team’s portfolio managers perform and integrate ESG analysis. They believe this is a better way to value and assess stocks. The team uses multiple sources of ESG information as it represents an abundance of ESG-related opinions that require interpreting, and portfolio managers are best placed to filter this advice and ascertain how it relates to a company’s business model and valuation. © CFA Institute. For candidate use only. Not for distribution. Investment Decision and Portfolio Construction and ESG Integration Techniques in Practice (Seven Cases) The team starts with a fundamental analysis to identify any material positive or negative ESG factors. The team embed that assessment into an analysis of the competitive position and the sustainability of the business, which they put into valuation models. They aim to invest only in companies that perform strongly in four areas: 1. business model; 2. market share opportunity; 3. end-market growth; and 4. management and ESG. The Global Equities team identified several ESG risks (contingent liabilities) and ESG opportunities (contingent assets) for a leading health care insurer and a health care cost management and IT provider managing 5% of US health care spending. ESG Risks As custodians of the personal and medical details of millions of people, the company needs to keep the data secure: False savings here can have long-term consequences, including regulatory and political risks and the potential impairment of the company’s social contract with customers and the wider society. The team challenged management on the risk of privacy data breaches, asking how that risk is being managed and what policies are in place to mitigate that risk. Management acknowledged that information about their data security was not available on the company’s website, but several management members reassured the team about the quality of the policies, training, and general operation management of data handling and security that are in place. Nevertheless, the team modeled a DCF valuation scenario looking at the possible impact of privacy data breaches. ESG Opportunities The data analytics business was viewed as an ESG potential. The analytics business allows to create cheaper, better health care options for businesses, governments, and patients, creating strong competitive advantage and an ESG contingent asset. For instance, it identified 150 diabetic patients not taking their medication properly, 123 of whom were in Texas, which enabled its client to implement location-specific measures using preventive health care techniques. In another instance, using the company’s data analytics, a US state department discovered clusters of patients with asthma on certain streets and in certain buildings, and found that those areas correlated with cockroach infestations, allowing the state department to successfully prosecute inefficient landlords and ultimately raise living standards for tenants. The team assessed the materiality of all this information and assigned a rating for the four components of the company’s strengths: ► business model; ► market share opportunity; ► end-market growth; and ► management and ESG. The team then performed a DCF scenario analysis embedding the material ESG risks and opportunities. The team prefers DCF and explicit model scenarios for sales, margins, and asset turns because they are judged to be a more accurate 399 400 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration method of modeling than an adjustment to a discount rate or terminal value for a company-specific assessment. Sum-of-the-parts and standard financial ratio assessments are also performed. The analysis was peer-reviewed within the team, and the assumptions were stress-tested, challenged, and refined before the rating and valuation were confirmed. In the peer review, assumptions are flexed in real time to see how further valuation scenarios change. These include: ► for the upside scenario: increasing EBIT margins and sales growth ► for the downside scenario: normalizing sales to a lower growth rate (3%) and looking at the sales impact over more than one year The core findings supported significant valuation upside and limited probability of mild downside. The stock was then added to the portfolio after a portfolio construction process. Adapted from RBC (Royal Bank of Canada) Global Asset Management example case study.13 CASE STUDY 5 – CREDIT ANALYSIS INTEGRATING ESG This credit investor, when analyzing a corporate bond for investment, evaluates an issuer’s business profile, market position, and competitive profile, as well as fundamental credit measures (such as margins, leverage, and cash flow). The analysis then turns to an evaluation of management and sector-specific material ESG indicators, such as carbon emissions, workplace injury rates, and the composition of the board of directors. The ESG analysis consists of a quantitative score and qualitative-based research. The quantitative score is derived from a proprietary framework that aggregates metrics from ESG research providers as well as from other third-party sources. The corporate credit analysts also perform a qualitative assessment by reviewing a company’s ESG policies and targets, which might be outlined in its corporate sustainability report or on its website, and consider information learned from the engagement call. The analyst evaluates both the score and qualitative research when assigning a sustainability rating for the company. This measure of an issuer’s ESG risk profile could affect the analyst’s overall internal rating. Specifically, the analyst might upgrade the internal rating to reflect a corporation’s low ESG risks or downgrade the rating if the ESG risks are considered high or poorly managed. A beverages company is examined. The research identifies several strengths and challenges, some of which might be material from a financial perspective. For example, because water is a key input for the ingredients used in the company’s beverage products, efforts to ensure a steady supply of water would be considered both an ESG strength and a credit strength. Furthermore, water management is a material issue for the sector because a lack of water can affect crop yields and prices, increasing the cost of goods sold. 13 CFA Institute and PRI, Guidance and Case Studies for ESG Integration: Equities and Fixed Income (2018). www​.unpri​.org/​investor​-tools/​guidance​-and​-case​-studies​-for​-esg​-integration​-equities​-and​-fixed​ -income/​3622​.article. © CFA Institute. For candidate use only. Not for distribution. Investment Decision and Portfolio Construction and ESG Integration Techniques in Practice (Seven Cases) The analyst weighs the strengths and challenges, and compares the performance of (hypothetical) beverage brands to its industry peers. Strengths and Challenges of Considered Brands Strengths E S G ► Collaboration with suppliers to improve water efficiency by 15% in high-risk areas ► Its GHG goal is aligned with a science-based target initiative. ► Challenges ► There is weak disclosure on progress being made to reduce packaging waste. It has a comprehensive human rights strategy and strong supplier code-of-conduct protocols. ► Certain talent retention and recruitment strategies trail best practices. ► Products are primarily sugary drinks, despite introduction of healthier brands. ► Robust antibribery policies govern interactions with suppliers. ► No significant challenges seen. ► Board of directors formally oversees sustainability initiatives. ► Rigorous, year-round stakeholder engagement includes consumer groups. The totality of material ESG information depicts a company judged to have a strong ESG profile, and a high sustainability rating is assigned, which is also incorporated into the company’s final internal credit rating. This credit rating was analyzed to be wrongly priced, so an investment was made. Thanks to Robert Fernandez for the original case study upon which this example is based. CASE STUDY 6 – CREDIT ESG INTEGRATION PRACTICE The credit team uses several inputs. It relies on a central ESG/responsibility team for firm policies, approaches, and investment tools. At a company-specific level, the credit team reviews the proprietary measures of ESG risk, that is, its quantitative ESG (QESG) score that the firm has developed. This QESG score represents a snapshot of the company’s overall ESG performance. The QESG score is supported by the company information provided by a separate steward and engagement team (whom some practitioners consider an active ownership team) to give a sense of the potential forward trajectory. A state-owned oil producer was examined. ESG factors emerged as recurring themes in the credit discussion: The company’s labor safety track record was below the industry average, and the company had experienced frequent oil spills and leaks in the past. Spills and leaks could result in fines and production downtime, damaging the company’s cash flow profile. After the initial credit committee analysis, an ESG score of 4 was assigned (below average on a scale of 1 to 5, with 1 being the best). Bonds acquired through the new issue process were kept, but because of the low ESG score, there was no further exposure to credit. 401 402 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration Later that year, the ESG score was upgraded to 3 (from 4) to reflect the company’s improvement in the following ESG factors: 1. improvement in worker safety (injury frequency per million man-hours worked declined 35% year-over-year) 2. progress in reducing environmental waste and emissions (water reuse increased 66% year-over-year, while sulfur oxide emissions declined 45% year-over-year) After the score upgrade, the investors added to the bond position. The company’s ability to manage ESG risks was assessed to be improved and adequate. Thanks to Mitch Reznick and Audra Stundziaite for the original case study upon which this example is based. CASE STUDY 7 - SOVEREIGN DEBT ANALYSIS An investor uses ESG as an enhanced analysis of sovereigns to better assess their ESG-related risks and opportunities. The investor assigns a financial stability score (FSS) to a country based on the overall balance sheet strength and ESG factors. The FSS ranges from +4 to –4 for those countries and currencies deemed to make it into the opportunity set and will lead to exclusion for those rankings below –4. However, the FSS is determined after a review of the ESG factors, and a strong sovereign balance sheet might be heavily penalized because of weak ESG factors. In this example, a country with a strong balance sheet can be significantly negatively affected by ESG factors. At the time of analysis, the investor believed that the Russian 10-year government bonds offered an attractive real yield of 3% with a Russian ruble undervaluation of over 10% versus the US dollar in purchasing power parity. But the investor thought that the valuation needed to be considered in conjunction with a thorough balance sheet analysis and ESG factors to ascertain the underlying investment risk. The strength of the balance sheet was judged by looking at the following: ► gross domestic product (GDP) ► inflation ► government revenue ► fiscal balance ► gross debt ► current account ► currency reserves ► external debt It was given a strong score on this measure. Although Russia’s balance sheet is strong in this assessment, its governance factors rank very low according to the World Bank’s worldwide governance indicators. The investor believes the governance factor strongly influences the social and environmental factors because the government sets the policies for environmental and social matters and, in turn, influences the country’s long-term sustainable economic growth. © CFA Institute. For candidate use only. Not for distribution. Investment Decision and Portfolio Construction and ESG Integration Techniques in Practice (Seven Cases) These G factors were considered: ► political stability; ► absence of violence or terrorism; ► government effectiveness; ► regulatory quality; ► rule of law; ► control of corruption, and ► voice of accountability Third-party rating scores were used. The investor determined a low and deteriorating score on the government indicator. The rankings for rule of law and control of corruption were judged to be relatively low and unchanged over time. The investor believed that did not bode well for foreign direct investment inflows because of the absence of clearly defined property rights, international sanctions, and therefore long-term economic growth. These factors weighed on the FSS score. The investor then used the following indexes to judge social capital strength: ► a life expectancy index; ► an education index; and ► the human development index. The investor judged that Russia’s low levels of health spending, coupled with an unfavorable demographics profile, might affect life expectancy negatively. This, in turn, would reduce the overall future workforce, leading to lower productivity and future economic growth, and would likely negatively impact sovereign creditworthiness in the long term. Again, although the social aspect does not have an imminent economic impact, it was judged to be unfavorable in the long term with regard to the FSS. Combining all factors, Russia was given a −4 score on FSS, the lowest possible score. When completing portfolio construction between two countries with equal real yields, the one with the higher FSS will be favored. This happens because a country with higher standards on all or some factors is believed to have a better return outcome over the investment horizon. Thanks to Claudia Gollmeier for the original case study upon which this example is based. See the following section for a discussion on the challenges of sovereign analysis and ESG. 403 404 Chapter 7 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration DISCUSSION OF PRIVATE MARKETS, REAL ESTATE, AND INFRASTRUCTURE; DISCUSSION OF ESG IN FIXED INCOME AND DIFFERENCES TO EQUITY; AND CHALLENGES TO ESG INTEGRATION 7.1.12 apply the range of approaches to ESG analysis and integration across a range of asset classes 7.1.13 describe the challenges of undertaking ESG analysis across different geographic regions and cultures 7.1.14 describe the challenges of identifying and assessing material ESG issues 7.1.15 describe the challenges of integrating ESG analysis into a firm’s investment process Real assets (including vacant land, farmland, timber, infrastructure, intellectual property, commodities, and private real estate)14 carry certain advantages and challenges compared to the equities and corporate fixed income investment universe. In many cases, investors are majority owners or own the asset outright. Majority or full ownership stakes offer investors much greater control over the definition, application, and reporting of ESG data alongside or outside of existing reporting standards like those of the GRI or like the 2009 Global Real Estate Sustainability Benchmark (GRESB). The materiality frameworks used might have philosophical similarities—as in material ESG factors—but the identification of those factors can differ. GRESB’s full benchmark report (see Chapter 8) provides the following: ► 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 This type of report depends heavily on companies participating in the GRESB reporting assessment process. Looking at commercial and residential real estate historically, the sectors arguably had little regard for ESG factors (especially pre-2009, before GRESB). Often the tenants and operators might think differently from the owners and constructors (sometimes called a “split incentive problem”) because tenants must pay ongoing energy bills, whereas constructors do not. Buildings also have a carbon footprint. An integrated ESG view might look at reducing a building’s carbon footprint by using more efficient materials and standards and thereby lowering the risk of impact from carbon prices or deriving gains from energy efficiencies. 14 D.R. Chambers, K. Black, and N.J. Lacey, Alternative Investments: A Primer for Investment Professionals (CFA Institute Research Foundation, Research Foundation Books, 2018). www​.cfainstitute​ .org/​en/​research/​foundation/​2018/​alternative​-investments​-a​-primer​-for​-investment​-professionals. © CFA Institute. For candidate use only. Not for distribution. Discussion of Private Markets, Real Estate, and Infrastructure; Discussion of ESG in Fixed Income... Like unlisted credit and real asset private markets, ESG integration in private equity faces a number of challenges, foremost being the lack of public transparency, established reporting standards, regulatory oversight, and public market expectations around ESG. Current initiatives aim to address these challenges, such as the PRI’s reporting framework for infrastructure.15 In addition, smaller, private companies are often capacity challenged by ESG reporting requirements. Private equity investors might have to negotiate with a strong founder or founder team. But early investors and significant shareholders can be strategic and long-term oriented, creating a powerful incentive to establish a strong set of ESG KPIs early in the company’s life cycle or by setting important cultural values. Some investors will perform a materiality analysis much like public equity investors might do; the same SASB framework might be used or developed via the private equity industry, e.g. the British Venture Capital Association (BVCA) Responsible Investment Framework.16 Another way of looking at this is shown in the GRESB Benchmark Portfolio Report in Chapter 8. Two case study examples from recent years show the role governance analysis played in the IPO and valuation of Uber17 and the failed IPO of WeWork.18 These examples show how ESG can add or detract value. Asset owners might also assess private equity managers on ESG criteria, especially when they might be co-investors on an asset. A typical assessment might include policy, people, process, transparency, and collaboration assessments. Discussion of ESG in Fixed Income and Differences to Equity Historically, corporate bond practitioners adapted the materiality and sustainability frameworks, as well as the ESG techniques equity investors use, to meet their needs. More recently, newer techniques focused specifically on bonds have been used because bonds differ in the following ways: ► credit quality ► duration ► payment schedules ► embedded options ► seniority ► currencies ► collateral ► time horizon Equity securities tend to not have these qualities, so different integration techniques are needed. Fixed-income investors in corporate bonds might use principles in materiality and ESG frameworks that are similar to those used by equity investors but adapt them to where materiality is different between equity and bonds. Bond investors might 15 PRI, PRI Reporting Framework 2019:Direct – Infrastructure (2019). www​.unpri​.org/​Uploads/​l/​h/​o/​09​ .inf2019​_843342​.pdf. 16 British Private Equity & Venture Capital Association, Responsible Investment (2021). www​.bvca​.co​ .uk/​Our​-Industry/​Responsible​-Investment. 17 D.F. Larcker and B. Tayan, “Governance Gone Wild: Misbehavior at Uber Technologies,” Harvard Law School Forum on Corporate Governance (20 Jan. 2018). https://​corpgov​.law​.harvard​.edu/​2018/​01/​ 20/​governance​-gone​-wild​-misbehavior​-at​-uber​-technologies/​. 18 D.C. Langevoort and H.A. Sale, “Corporate Adolescence: Why Did ‘We’ Not Work?” (8 Jan. 2021). https://​papers​.ssrn​.com/​sol3/​papers​.cfm​?abstract​_id​=​3762718. 405 406 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration find ESG factors that affect balance sheet strength (and therefore, the risks of debt defaults) more material than equity investors, who might be more concerned about future growth opportunities. The opportunity side of ESG might be less relevant for bond investors because what is typically foremost in a bond investor’s analysis is the impact of ESG factors on a company’s ability to pay its debt obligations. For instance, an equity investor might view a green technology acquisition more favorably than a bond investor would because the equity investor is positive about future value from the technology, whereas the bond investor might be worried about the amount of debt required to fund the acquisition. ESG scores (whether third party or internal) go alongside or are integrated into internal credit analysis and investment decisions. Sovereign debt investors have started to analyze ESG, but borrowing the same materiality frameworks as equity or corporate debt investors has not been easy because some country-level factors (e.g., peace, corruption, ease of doing business, freedom of expression, education levels, and regulatory and legal robustness) might not be material to equity or corporate bond investors. Furthermore, a material factor (e.g., climate or carbon policy) will interact with analysis and valuations differently. Turning ESG analysis into meaningful judgments on the credit ratings or spreads for sovereign nations is therefore difficult. That said, investors have typically integrated certain ESG factors (e.g., political risk and governance factors) into sovereign debt, even if not explicitly labelled ESG. Municipal credit ESG analysis can differ as well. In the municipal space (region, state, or city) the issuer’s governance and management practices can both be assessed, as well as their ► overall transparency, ► reporting, ► corruption levels, ► budgetary practices, ► pension liabilities, and ► contracts. Some investors will view municipals investing for inclusive communities as lower-risk investment because of the social benefits. Alternatively, co-primary outcomes are possible, where market rate returns are expected alongside social impact. This differs from social impact, which is not always expected to make market rate (risk-adjusted) returns. Environmental factors (e.g., a region’s air quality and the associated health risks for its constituents) and the quality of public infrastructure (e.g., wastewater treatment plants) can all pose risks that could affect an issuer’s ability to repay its debt. Overall, while there are philosophical similarities in identifying material ESG factors and then applying those to the analysis, the type of factors used can differ across asset classes, as can the type of integration techniques. Challenges to ESG Integration There are many hurdles and challenges for ESG integration. These include: ► Disclosure and data-related challenges, such as: data consistency, data scarcity, data incompleteness, and a lack of audited data. ► Comparability difficulties include a lack of comparability between ESG ratings agencies, comparisons across different accounting and other standards, comparisons across geographies and cultures, and inconsistent use of jargon terminology. © CFA Institute. For candidate use only. Not for distribution. Discussion of Private Markets, Real Estate, and Infrastructure; Discussion of ESG in Fixed Income... ► Materiality and judgment challenges, such as: judgments that are difficult and uncertain, and judgments that are inconsistent. The challenges in ESG integration across asset classes arise because different types of assets and different strategies integrate ESG using different techniques. Challenges from Incomplete Datasets and Identifying and Assessing ESG Data As can be seen from the case studies and ESG techniques, many of the processes start with data gathering and original research gathering. However, a few challenges exist: ► ESG data are not consistently reported across companies, geographies, and sectors. ► Most ESG data are not audited. ► Some ESG data are not easily available in public databases and are difficult to obtain. ESG factors can be judged material and useful, but the data might be incomplete. For instance, carbon pollution is often judged material, but it can be measured in at least three scopes: scope 1, 2, and 3 emissions. Currently, in the top 2,000 companies in the world, few data are available on scope 3 (as of 2018, 10% of companies reported scope 3, and by 2020, this had increased to 18%),19 yet evidence indicates that scope 3 makes up more than 50% of the world’s carbon (and GHG equivalent) pollution impact. ESG data can be incomplete, unaudited, unavailable, or incomparable between companies because of the different reporting methodologies used. These issues make the assessment of ESG factors impossible in certain situations. A lack of data or a company unwilling to disclose information can make identification of relevant ESG factors difficult. Data Disclosure Challenge A debate is ongoing over ESG data disclosures at a company level. These disclosures vary between companies and regionally. Also ongoing are efforts via organizations such as the SASB and the GRI, and continuous evolution from the IASB on “broader corporate reporting.”20 Surveys suggest that a range of investors view ESG disclosure at companies as inadequate. This might be partly because investors and management teams view materiality differently and might also have conflicting aims. Investors could claim that assessing a material piece of ESG information is difficult without data disclosure. Companies can argue that the vast range of possible ESG data and the differing demands of investors, stakeholders, and rating agencies make the resource demands unreasonable. A further challenge is that there is no consensus agreement on the details of what good ESG disclosure might look like (although again, see the SASB’s evolving work here) and that this might differ by strategy and asset class. Historically, public markets disclosure has been higher than private markets disclosure. The needs of fixed-income and sovereign bond investors can (and do) differ from those of equity investors. See earlier parts of this section for more information on company disclosure. 19 B. Baker, “Scope 3 Carbon Emissions: Seeing the Full Picture,” MSCI Blog (17 Sep. 2020). www​.msci​ .com/​www/​blog​-posts/​scope​-3​-carbon​-emissions​-seeing/​02092372761. 20 IFRS, Management Commentary (2021). www​.ifrs​.org/​projects/​work​-plan/​management​ -commentary/​. 407 408 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration Comparability and Materiality Judgment Challenges ESG ratings agencies use different techniques and assessments so that their ratings are not easily comparable. ESG ratings do not correlate like bond credit ratings, nor do agencies use the same methods of scoring. Judgments on ESG materiality might differ between analysts. Many ESG terms are used inconsistently and are difficult for non-specialists to interpret. These differences can be magnified by cultural or regional differences. For instance, different countries have different governance best practices or differing views on risk and materiality. Japanese companies have a much lower number of independent directors on their boards than European and US companies do on average, which is reflected in the Corporate Governance Code of Japan. Different countries might also put different weights on social factors (e.g., US companies are less concerned about having a policy on work or labor unions than German companies are). Where materiality can be judged, assessing the level of impact can be difficult, and how ESG factors interact with financial performance over time is uncertain. The field has many jargon terms (e.g., responsible, impact, sustainable, socially responsible, and ethical and green investment). Many of these terms are not used consistently by specialists and are confusing to non-specialists. Integration Challenges Because of the different third-party databases, many QESG factors are not agreed upon, and the data are relatively short run. Also, to what degree the ESG factors might correlate with other established quantitative factors, such as “quality,” “value,” or “momentum,” is uncertain. Index-tilting strategies might therefore fail to reflect desired factors appropriately. Many investment firms have separate ESG analyst teams. This separation can move ESG expertise away from investment decision makers and thereby create a challenge to integration. Perhaps ESG analysts are more junior (perhaps because the focus on this area at, for example, the business school level is still recent), so lower weight is given to their views and providing a challenge. In fundamental active strategies, many ESG factors are difficult to judge and quantify. Impacts to cash flows, growth rates, or DCF assumptions are also hard to express. As noted earlier, in quantitative strategies, limited consensus remains, and historical data provide an integration challenge. See Chapter 8 for a detailed discussion on this topic. Investment Firm Culture Challenge A significant number of investment professionals still do not integrate ESG or believe that ESG has limited financial impact; this can be challenging for teams and within firms. Firms might not have significant resources to buy third-party ESG data, or a firm’s global nature might make culturally different attitudes to ESG factors difficult to integrate globally across the firm. ESG integration is often different across asset classes, which can make being consistent or explaining across a firm difficult. Investors are likely to make differing judgments on materiality or weight factors, which causes a lack of comparability or a difference of opinion, even within firms. Additional resources are typically needed for ESG integration, finances, and personnel, which raises both financial and operational challenges within firms. ESG integration techniques have only recently started to become part of the curriculum at business schools and within universities. Typically, this means that investment professionals would not have had as much detailed training on how to deal with the challenge of integration. © CFA Institute. For candidate use only. Not for distribution. Discussion of Private Markets, Real Estate, and Infrastructure; Discussion of ESG in Fixed Income... 409 Despite advances in techniques and understanding, significant challenges to ESG integration remain. Criticism for ESG Integration One of the most common criticisms of ESG investing is the difficulty for investors to correctly identify, and appropriately weigh, ESG factors in investment selection. Critics tend to express four primary concerns about the precision, validity, and reliability of ESG investment strategies: 1. Too inclusive of poor companies – ESG mutual funds and exchange-traded funds (ETFs) often hold investments in companies that might be seen as “bad actors” in one or more of the ESG spaces. 2. Dubious assessment criteria – The criteria used for selecting ESG factors are too subjective and can reflect narrow or conflicting ideological or political viewpoints. Non-material or sociopolitical factors might be overemphasized. Materiality assessments might be considered flawed. 3. Quality of data – The information used for selecting ESG factors often comes (unaudited, or assured) from the companies themselves. This complicates the ability to verify, compare, and standardize this information. 4. Potential lack of emphasis on long-term improvements – Some financial advisers screen investments first for performance and only after that for ESG factors. This initial emphasis on performance can exclude companies with high ESG practices that focus on longer-term performance. Finally, some critics would argue that evidence for the benefits of ESG are mixed or not proven.21 These critics suggest that the time horizon for assessing ESG is too short to prove benefits. Critics also point out time periods during which certain sectors that are often excluded (e.g., tobacco) perform well as evidence that ESG detracts value. Note that as discussed earlier, exclusionary strategies are only one type of strategy, which some investors do not consider part of ESG integration but rather a separate type of investment process. RANGE OF ESG INTEGRATION DATABASES AND SOFTWARE AVAILABLE 7.1.16 explain the approaches taken across a range of ESG integration databases and software available, and the nature of the information provided 7.1.17 identify the main providers of screening services or tools, similarities and differences in their methodologies, and the aims, benefits and limitations of using them 7.1.18 describe the limitations and constraints of information provided by ESG integration databases 21 D. Vogel, The Market for Virtue: The Potential and Limits of Corporate Social Responsibility (Washington, DC: Brookings Institution Press, 2005). 8 410 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration Typical mainstream investment research often includes an ESG or sustainability offering, and most major investment research departments (the “sell-side”) will have analysts producing research in this area. One way of classifying providers is by business type: ► For-profit large providers that offer multiple ESG-related products and services, as well as non-ESG-related products and services (e.g., MSCI, S&P, Sustainalytics, Fitch, and Moody’s) ► For-profit boutique providers that offer speciality ESG products and services (e.g., RepRisk, Urgentum, Truvalue Labs [prior to its October 2020 acquisition by FactSet], and ISS [prior to its November 2020 acquisition by Deutsche Börse AG]) ► Nonprofit providers that offer ESG-related products and services (e.g., Carbon Disclosure Project [CDP], IMF economic data, and World Bank, with the World Bank’s ESG data portal; these services are free to the general public and in the public domain) Another way of thinking about the services is by type of product or service; this is a non-exhaustive list: ► ► ► ► ► ► ► ► ESG data – quantitative or qualitative information on the environmental, social, economic and corporate governance practices of companies. ESG ratings – quantitative or qualitative evaluations of a company, country, financial product, or fund, based on a comparative assessment of their approach, disclosure, strategy, or performance on ESG issues. Different methodologies are discussed later. ESG screening – tools that evaluate companies, countries, and bonds based on their exposure or involvement-specific factors, sectors, products, or services Voting and governance advice – typically, proxy vote advisory services. These include voting guidelines on governance and other proxy voting items, including compensation and board directorships. ESG benchmarks and indexes – a set of securities (e.g., stocks, bonds) designed to represent some aspect of the total market by including some ESG criteria in the selection ESG news and controversy alerts – a company or a country conducts assessments that highlight events, behaviors, and practices that might lead to reputational and business risks and opportunities Integrated research – typically sell-side (investment bank or broker reports) research of contextualized, data-informed, analytical opinion designed to support investment decision making Advisory services – ESG strategy, integration, investment process, reporting, and corporate advice. Within this are also many specific ESG-related services, such as the following: ● class action litigation ● Sustainable Development Goals (SDGs) reporting and alignment ● carbon and water analysis ● norms and sanctions ● policy development ● real estate assessment ● factor databases © CFA Institute. For candidate use only. Not for distribution. Range of ESG Integration Databases and Software Available ● supply chain assessment ● assurance services Exhibit 7 provides a non-exhaustive list of ESG ratings and database providers. New entrants, as of 2020, are continuing to appear. MSCI ESG ratings and Sustainalytics ESG ratings are examined in greater detail later, and SASB materiality maps were examined earlier in this chapter. See also the exhibit titled “Examples of ESG Indexes, Benchmarks, and Their Methodologies” in Chapter 8. Many ESG tools look at a broad range of ESG factors, although some, such as CDP, which has an environmental focus, are more specific. One challenge is that the agreement or correlation between the various ratings agencies is low. ► A study by Chatterji, Levine, and Toffel (2009) finds an approximate 0.3 correlation.22 (Or more technically, this analysis found pairwise tetrachoric correlations for three years among the six raters, with a mean correlation of 0.30 [about two standard deviations].) However, this also included some negative ones’ correlations, meaning that what one rater found responsible another found “irresponsible.”) A 2019 study by Gibson, Krueger, and Schmidt shows a range of correlations (see Exhibit 8). ► Yet another study by Berg, Koelbel, and Rigobon (2019) shows a range of correlations as well; Berg et al. look at a dataset of ESG ratings from six different raters: KLD (MSCI Stats), Sustainalytics, Vigeo Eiris (Moody’s), RobecoSAM (S&P Global), Asset4 (Refinitiv), and MSCI. The correlations between the ratings are on average 0.54 and range from 0.38 to 0.71. Berg et al. note, “This means that the information that decision-makers receive from ESG rating agencies is relatively noisy.”23 Berg et al. further suggest: Three major consequences follow: ► First, ESG performance is less likely to be reflected in corporate stock and bond prices, as investors face a challenge when trying to identify outperformers and laggards. Investor tastes can influence asset prices, but only when a large enough fraction of the market holds and implements a uniform nonfinancial preference. Therefore, even if a large fraction of investors have a preference for ESG performance, the divergence of the ratings disperses the effect of these preferences on asset prices. ► Second, 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 by the market. ► Third, the divergence of ratings poses a challenge for empirical research, as using one rater versus another may alter a study’s results and conclusions. Taken together, the ambiguity around ESG ratings represents a challenge for decision-makers.23 22 A. Chatterji, D.I. Levine, and M.W. Toffel, “How Well Do Social Ratings Actually Measure Corporate Social Responsibility?” Journal of Economics & Management Strategy 18(1) (2009): 125–69. https://​ssrn​ .com/​abstract​=​1394704. 23 F. Berg, J.F. Koelbel, and R. Rigobon, “Aggregate Confusion: The Divergence of ESG Ratings” (2019). https://​papers​.ssrn​.com/​sol3/​papers​.cfm​?abstract​_id​=​3438533. 411 ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ MSCI ✓ ✓ ✓ ✓ ✓ ✓ LSE (FTSE Reuters Russell) (Refinitiv) ✓ ✓ ✓ ✓ Moody’s (Vigeo Eiris) ✓ ✓ CDP ✓ Real Impact Tracker ✓ Mercer / Other Investment Consultants ✓ World Bank Source: Benjamin Yeoh (2020); also see Publications Office of the European Union, Study on Sustainability-Related Ratings, Data and Research (2021). https://​op​.europa​.eu/​en/​publication​-detail/​-/​ publication/​d7d85036​-509c​-11eb​-b59f​-01aa75ed71a1/​language​-en/​format​-PDF/​source​-183474104​%E2​%80​%9D. ✓ ✓ Controversies ✓ ✓ ✓ Benchmarks ✓ ✓ ✓ ✓ ✓ RepRisk FactSet (TruValue Labs) Chapter 7 Voting advisory Screening ✓ ✓ ✓ Ratings ✓ ✓ ✓ Bloomberg Data Product Deutsche Morningstar / Börse Sustainalytics (ISS) Exhibit 7: Summary of Major ESG Service Providers 412 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration © CFA Institute. For candidate use only. Not for distribution. Range of ESG Integration Databases and Software Available 413 Most of the tools are available only commercially. However, the completeness of coverage varies substantially across ESG tools. The correlations might well change with time, as providers evolve the way ratings are produced. For example, Sustainalytics experienced a major change in its ESG ratings system in 2019, and all main providers are currently evolving their processes, annually at least. This is expected for some time to come. This evolving process also makes historic comparisons difficult. The different methodologies might also mean like-for-like comparisons are not being made in the correlations between rating agencies. Many factors are still debated by investors: ► what the correlations are ► the timeframe over which they are studied ► the relevance of any potential correlations (could be spurious data-mined) Practitioners debate how important strong correlations are. ► On one hand, high correlations could lead to groupthink and a lack of rigorous thinking. Some think this was one of the problems with credit rating agencies’ (CRAs’) (highly correlated) assessment of mortgage-backed bonds in the financial crisis (2007–2009). To some, a low correlation is a healthy and useful outcome from ESG rating providers noting the distinction between ratings and raw data. ► On the other hand, simplicity and correlation could bring credibility to ESG ratings as a discipline and give more consistent messages to companies. As described in the quantitative investment sections, quantitative investors use these data differently than they do fundamental active investor judgments. This area is expected to be discussed for some time to come. Exhibit 8: ESG Rating Correlation Among Six Third-Party Data Providers N Mean Median StdDev (1) (2) (3) (4) Pearson Correlations (5) (6) (7) (8) (9) Asset 4 Sust. Inrate Bloom. KLD Panel A: Total Rating Asset 4 31424 0.501 0.501 0.289 Sustainalytics 32703 0.501 0.499 0.289 0.762 Inrate 25945 0.501 0.534 0.284 0.233 0.303 Bloomberg 32410 0.501 0.501 0.289 0.749 0.708 0.122 KLD 32485 0.501 0.507 0.288 0.584 0.619 0.290 0.538 MSCI IVA 32450 0.501 0.502 0.289 0.418 0.460 0.319 0.308 Average correlation 0.458 Panel B: Environmental Pillar Asset 4 31261 0.501 0.501 0.289 Sustainalytics 32532 0.501 0.501 0.289 0.710 Inrate 25880 0.501 0.518 0.286 0.305 0.488 Bloomberg 28258 0.501 0.501 0.289 0.651 0.566 0.206 KLD 32403 0.501 0.498 0.281 0.629 0.654 0.422 0.472 0.452 414 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration Chapter 7 MSCI IVA N Mean Median StdDev (1) (2) (3) (4) 32361 0.501 0.502 0.289 Pearson Correlations (5) (6) (7) (8) (9) Asset 4 Sust. Inrate Bloom. KLD 0.174 0.325 0.403 0.140 0.284 Average correlation 0.429 Panel C: Social Pillar Asset 4 31424 0.501 0.501 0.289 Sustainalytics 32703 0.501 0.504 0.289 0.617 Inrate 25945 0.501 0.522 0.288 0.133 0.143 Bloomberg 32322 0.501 0.507 0.288 0.682 0.530 0.061 KLD 32485 0.501 0.505 0.288 0.397 0.423 0.128 0.302 MSCI IVA 32450 0.501 0.500 0.289 0.282 0.323 0.236 0.207 Average correlation 0.321 Panel D: Governance Pillar Asset 4 31424 0.501 0.501 0.289 Sustainalytics 32703 0.501 0.504 0.289 0.312 Inrate 25945 0.501 0.502 0.283 0.297 0.401 Bloomberg 32410 0.501 0.487 0.283 0.421 0.340 0.343 KLD 32485 0.501 0.489 0.237 0.059 0.034 0.083 0.095 MSCI IVA 32450 0.501 0.501 0.288 0.141 0.129 0.144 0.045 Average correlation 0.152 0.200 Source: © Rajna Gibson Brandon, Philipp Krueger and Peter S. Schmidt 2021.24 The sources of information used to assess ESG investments also vary across the ESG tools. Information can be collected directly (via surveys, company communication, company reports, presentations, and public documents) or indirectly (via news articles, third-party reports, and analysis). The assessments can be given in raw form or used to determine index weights or processed to determine specific ratings and scores. The Berg et al. study23 also argues that low correlations pose these challenges: ► Sustainability performance is less likely to be reflected in company stock and bond prices. Investors are not able to easily identify sustainability outperformers and laggards. Low correlation could have consequences for investors who rely on one single ESG rating in their investment strategies and fail to account for sustainability-related rating disagreement among rating and data providers. ► Divergence restricts companies from being able to improve their ESG performance because they receive mixed signals from ESG rating providers about which actions are expected and will be valued by the market. ► Low correlation poses a challenge for academic and empirical research. Using one rating provider versus another might alter a study’s conclusions. 24 R. Gibson, P. Krueger, and P. S. Schmidt, “ESG Rating Disagreement and Stock Returns,” Swiss Finance Institute Research Paper No. 19-67 (2019). https://​papers​.ssrn​.com/​sol3/​papers​.cfm​?abstract​_id​ =​3433728. © CFA Institute. For candidate use only. Not for distribution. Range of ESG Integration Databases and Software Available However, some investors argue that variability in methodology and output can be beneficial for investors and a source of insight, as long as there is transparency about how they have been derived. Another consideration when thinking of providers is where they have come from and which stakeholders are served. Here are some examples: ► “Traditional” ESG data and research providers: founded from the SRI industry to provide investors with sustainability data and ratings about primarily large, publicly traded companies. More recent consolidation activity has turned these providers into conglomerates with different offerings and research focuses. The level of automation is low or medium because human judgment is still used. ► “Nontraditional” ESG data and research providers: More recently, nontraditional providers, such as credit-rating agencies (e.g., Fitch, Moody’s, and S&P), entered the space by acquiring Trucost (2016) and Vigeo Eiris (2019), respectively. As with traditional ESG data and research providers, the level of automation is low or medium because human judgment is still used. ► AI or algorithm-driven ESG research: Launched more recently, in the past five years, these providers use new technologies, such as Natural Language Processing, to identify E