Topic 2 P2 Notes PDF

Topic 2 P2 Notes Values Approach to Investing Risks Risk management is critical for aligning financial systems with sustainability. Risks can be broadly categorized into physical and transition risks, both of which affect asset values and business ope...

Topic 2 P2 Notes Values Approach to Investing Risks Risk management is critical for aligning financial systems with sustainability. Risks can be broadly categorized into physical and transition risks, both of which affect asset values and business operations. Physical Risks Acute Physical Risks: Sudden climate-related events (Hurricanes, floods, wildfires, and other extreme weather events) which → immediate severe damage to infrastructure, disrupting businesses and supply chains. Chronic Physical Risks: Long-term shifts in climate patterns such as Sea-level rise, Increased temperatures, and Changing precipitation patterns → increase depreciation of physical assets, leading to higher operating costs, repair expenses, and insurance premiums. Transition Risks Transition risks arise from the economic shift toward low-carbon and sustainable business practices. Regulatory and Policy Risks: Cash Flow Effect: Regulatory changes that may increase costs (e.g., carbon taxes, stricter environmental regulations) or limit revenue opportunities (e.g., mandatory green energy usage). Fines from failing to comply with climate laws are also significant. Discount Rate Effect: Increased risk from uncertainty in future changes to laws, regulations and policies. This can also impact a firm’s attractiveness or risk → increased transparency and accountability. Legal Risks increase uncertainty about future earnings and liabilities. Technology Risks: Cash Flow effect: The potential for disruption due to failure to adopt emerging technologies reducing net revenue such as renewable energy. This includes higher capital expenditures (capex) for adopting green technologies. Discount Rate Effect: Innovation Risk → lack of investment and failure to adopt Greentech and unsuccessful attempts in innovation investment. Market Risks: Cash Flow Effect: Shifts in consumer preferences → sustainable products → reduce demand for traditional, carbon-intensive industries. In turn, this affects commodity prices and supply chains → increased production costs. Discount Rate Effect: Greater uncertainty in market → increased uncertainty over future earnings, future costs from SC and operational resilience, repricing of assets. Reputational Risks: Cash Flow: Public perceptions of a firm's environmental impact can affect access to capital and consumer loyalty e.g. boycotts/action. While Investor perception can lead to reduced access to capital and higher costs from negative impacts on workforce management and planning. Discount Rate: Sectors like oil and mining are particularly vulnerable to this form of stigmatization due to perceived greater risk to future earnings. The Role of Time in Transition Risk Transition risk is non-linear, unpredictable and evolves over time due to feedback loops (endogeneity) - policy → market → risk assessment → revised/new policies (loop) Temporal variation - probabilities, impacts Path Dependence - Delaying emissions reductions increases risk and makes future targets harder to achieve → where current policies lock in certain future outcomes. Corporate Concerns of Risk Management: Reporting and disparities among regions concerning significance of diff climate risks (e.g. climate risk concerns are lower in Europe, UK, US than Asia and Latin Am). Strobel & Wurgler (2021) findings → top risk for businesses - regulatory risk next 5 yrs and top risk physical risk next 30 yrs. Anticipated effects on commercial real-estate Cash flow → Income → Reduced rent, occupancy rate, longer to re-let, changes to feasible uses → Outgoings → Increased operating costs, capital costs, higher insurance premiums, property taxes increase Capitalization rate → Risk Premium → Greater cash flow volatility, reduced liquidity, reduced insurability, higher site/location risks → Expected growth → Reduced rental prospects and future occupancy rates, increased depreciation and costs Financing → Cost of finance → higher margins due to increased risk and higher debt service cover ratios to cover cash flow fluctuations. → Availability of finance → reduced willingness to lend, lower amounts, fewer potential equity partners. Is climate risk fully priced in assets? The key idea is whether these risks are reflected in the prices investors are willing to pay for assets, such as stocks, bonds, real estate, or commodities. Topic 2 P2 Notes 1  If markets properly price these risks, it would mean: Assets exposed to high climate risks → lower valuations. Resilient or sustainable investments → higher valuations. However, if these risks are under-priced or overlooked, it indicates a disconnect between asset values and the long-term impact of climate risks. → Information Gaps - incomplete or inconsistent data on climate risk + lack of standardized metrics. → Market inefficiencies - not efficient in pricing long-term/uncertain risks + behavioural biases may lead investors to underestimate the impact of climate risks. → Investors prioritize short term gains over long term systemic risks. → Fragmented Policy and regulatory landscape → Physical & Transition Risks → Need for forward looking models to undertake scenario analysis Opportunities Resource Efficiency Cash flow - improving resource efficiency lowers operational costs e.g. reducing water usage, raw materials as inputs and waste. Discount rate - better prepared for regulations related to resource usage and price volatility in raw materials. Energy Efficiency - transitioning to renewable/clean energy sources; Cash flow - higher & more predictable cash flows while reducing long-term energy costs and exposure to fossil fuel volatility. Discount rate - lower risk due to reduced exposure to climate-related regulation and in alignment investor preferences for greener companies. Products and Services Cash flow effect - more demand from environmentally conscious consumers and business Discount rate - producing climate-aligned products & services →forward thinking & resilient to future transition risks. e.g. green/sustainable credit, green bonds & mortgages Resilience Cash flow - operations, supply chains and infrastructure are more resilient minimize climate-related loses and preserve/enhance future cash flows. Discount rate - strong resilience to climate risks → less vulnerable to future climate disruptions and viewed as less risky. Markets Cash flow - new markets for climate-related goods →more revenue streams discount rate - reduced exposure to traditional carbon-intensive sectors (which face more regulatory & market risks). E.g. Market for ESG metrics, indices and ratings (MSCI, Sustainalytics etc.) → want to be dominant provider but lack standardized framework → low correlation of ESG Scores among top providers → Design Limitations - do not cover material issues for investors only focused on operations and not nature of product (e.g. coal mining and tobacco firms have high scores), biased in favour of bigger firms (since they provide more data). flowchart LR %% Top-left: Transition & Physical Risks %% A1["Transition Risk"] --> B1["Policy and Legal"] A1 --> B2["Technology"] A1 --> B3["Market"] A1 --> B4["Reputation"] A2["Physical Risk"] --> B5["Acute"] A2 --> B6["Chronic"] %% Top-center: Strategic Planning and Risk Management %% B3 -->|Risks| C1["Strategic Planning and Risk Management"] B5 -->|Risks| C1 B6 -->|Risks| C1 C1 -->|Financial Impact| D1["Financial Impact"] %% Top-right: Opportunities %% D2["Resource Efficiency"] --> F1["Products & Services"] D3["Energy Source"] --> F1 D4["Markets"] --> F1 D5["Resilience"] --> F1 F1 -->|Opportunities| C1 %% Bottom-center: Financial Impact to Statements %% D1 --> E1["Income Statement"] D1 --> E2["Cash Flow Statement"] D1 --> E3["Balance Sheet"] %% Bottom-left: Revenues & Expenditures %% G1["Revenues"] -->|Linked| E1 G2["Expenditures"] -->|Linked| E1 Topic 2 P2 Notes 2  %% Bottom-right: Assets & Liabilities %% H1["Assets"] -->|Linked| E3 H2["Liabilities"] -->|Linked| E3 H3["Capital & Financing"] -->|Linked| E3 %% Styling and Flow %% style A1 fill:#e6e6fa,stroke:#333,stroke-width:2px style A2 fill:#e6e6fa,stroke:#333,stroke-width:2px style F1 fill:#e6e6fa,stroke:#333,stroke-width:2px style C1 fill:#e6e6fa,stroke:#333,stroke-width:2px style D1 fill:#e6e6fa,stroke:#333,stroke-width:2px style E1 fill:#e6e6fa,stroke:#333,stroke-width:1px style E2 fill:#e6e6fa,stroke:#333,stroke-width:1px style E3 fill:#e6e6fa,stroke:#333,stroke-width:1px Values based Investing Values, Beliefs, Perceptions, Social Norms, Habits and Preferences This section emphasizes the integration of societal values, including social norms, beliefs, and perceptions, into financial decisions. This approach focuses on long-term value creation by embedding environmental and social goals into corporate strategy. Investors increasingly prioritize social and environmental impact alongside financial returns. Tools such as the Global Impact Investing Network (GIIN), UN Principles for Responsible Investment (PRI), Science Based Targets initiative (SBTi) and Global Reporting Initiative (GRI) support this shift by offering guidelines to incorporate ESG factors into investment strategies. influenced through dialogue/engagement, subtle intervention to encourage sustainable behaviour, options more attractive & accessible, education/awareness and regulation. firms and investors willing to trade-off maximizing profit to achieve sustainability goals → investing to create positive ESG + financial return - includes covering brown/impaired assets to green/sustainable assets. → Incorporating environmental objectives into business strategies - focus on +/-ve screening → Consumers willing to pay more and consume less (changes to preferences and habits) Capture long-term value → 6 capitals (natural, social, human, intellectual, financial and manufactured capital) to wealth creation with a feedback loop to preserve stocks. → Addressed climate change risk + achieving UNSDGs by firms, investors internalize the externalities. → Sustainable Finance Model 3 - SF1 (exclusionary screening), SF2 (ESG integration) and SF3 (Impact Investing). flowchart LR A1["Earth (natural capital, ecological services)"] --> |Sustainable Lending| B1["Government"] A2["Financial system(capital)"] --> |Sustainable Lending and investing| B2["Corporates"] A3["Society, intellectual and human capital"] --> |Sustainable Lending| B3["Households"] B1["Government"] --> |Responsible Spending| C1["Long-Term Value Creation"] B2["Corporates"] --> |Sustianable Practices| C1["Long-Term Value Creation"] B3["Households"] --> |Responsible Consumption| C1["Long-Term Value Creation"] style A1 fill:#e6e6fa,stroke:#333,stroke-width:2px style A2 fill:#e6e6fa,stroke:#333,stroke-width:2px style A3 fill:#e6e6fa,stroke:#333,stroke-width:2px style B1 fill:#e6e6fa,stroke:#333,stroke-width:2px style B2 fill:#e6e6fa,stroke:#333,stroke-width:2px style B3 fill:#e6e6fa,stroke:#333,stroke-width:2px style C1 fill:#e6e6fa,stroke:#333,stroke-width:2px Pushback Against Sustainability Recently, some companies have retreated from their prior commitments to sustainability due to: Political and shareholder resistance against ESG initiatives. The complexity of implementing sustainability goals, often leading to unrealistic targets and greenwashing allegations. Growing awareness that returns on sustainability investments do not always meet expectations, forcing firms to re-evaluate their goals. E.g. Unilever, JPMorgan, Tractor Supply Co (eliminated jobs focused on DE&I+ carbon emission goals), Nike, BlackRock Rational Sustainability →focus on ESG factors → create long term value but don't impair financial performance. Impact on Asset Pricing Topic 2 P2 Notes 3  Sustainability affects asset prices in two primary ways: Brown Discount: Assets exposed to physical and transition risks, such as fossil-fuel-based industries, and negative screening in selection are subject to reduced market valuations. Green Premium: Assets aligned with sustainable practices and future regulatory trends may have increased valuation due to their resilience and growth potential. However, currently it remains challenging to distinguish the relative contributions of risk exposure and sustainability opportunities to these pricing effects. Fragmentation of Interests in Investment Chains graph LR A1["Beneficiaries, Clients"] --> B1["Asset Owners"] --> C1["Asset Managers"] A1["Beneficiaries, Clients"] --> C1["Asset Managers"] C1["Asset Managers"] --> Equities C1["Asset Managers"] --> Bonds Investment chains are often long and complex, creating principal-agent problems where investors (principals) delegate tasks to fund managers (agents). Key challenges include: Asymmetric Information: Investors may not have the information needed to assess the performance of fund managers, leading to a knowledge gap. Moral Hazard: Managers might prioritize personal gains over investors' sustainability goals. Adverse Selection: investors cannot assess the agent’s abilities/intentions leading to mismatch in objectives. Incentive Misalignment: The objectives of investors (e.g., managing climate risks) may not align with those of fund managers (e.g., maximizing short-term returns). Solutions: Incentive alignment → include ESG criteria in reporting and incorporate values approach to investing. Reduce asymmetric information & adverse selection → transparency (metrics, disclosures, standardizing and adopting more benchmarks) Moral hazard → shareholder engagement and activism E.g. Performance gap in energy efficiency for buildings → compliance with building regulations achieve energy efficiency in theory but not in practice → therefore, a performance exists between original design intent and in-use. → due to misalignment of interests & financial incentives between landlords and occupiers + lack of monitoring systems since operational performance is not reported and invisible to market. ESG in Portfolios - Investment Strategy Integrating ESG factors into portfolio management has both benefits and challenges. Portfolio returns → weighted aggregation of individual asset returns. Asset price depends on fundamental value + ESG investor preferences. graph LR A1["ESG Score"]--> A2["Fundamental Value £"] A1["ESG Score"]--> A3["Asset Price £"] A2["Fundamental Value £"]--> A3["Asset Price £"] A3["Asset Price £"]--> A4["Asset Return"] ESG-aware portfolios often outperform traditional portfolios in the long run by: Providing diversification benefits as ESG factors become increasingly relevant for investors. Capturing investor preferences for sustainable investments, which can lead to higher Sharpe Ratios (risk-adjusted returns). Modern Portfolio Theory → Large scale investors asset allocation (investing in combination of asset classes). Diversified portfolio → maximizes returns while minimizing risk - enhances investment performance → diversification benefits (hedging against specific risks) Equity Funds - type of portfolio where money is pooled from multiple investors and collectively invested in a diversified group of stocks. → Modern Portfolio Theory (MPT) seeks to construct mixed asset portfolios that maximize returns for a given risk level or minimize risk for a given level of return. Portfolio Total Return - weighted average individual asset returns in the portfolio. Portfolio Risk - weighted avg. of individual asset risks - asset correlation → diversification to reduce risk. Interpreting Correlations Perfect -ve → -1.00 No correlation 0.0 Perfect +ve → 1.00 Moderate -ve → -0.50 Moderate +ve → 0.50 Conceptual notion → understand how diversification benefits arise Topic 2 P2 Notes 4  Portfolios can move along the Efficient Frontier, where each point offers the highest return for a specific risk level. Risk averse choose a portfolio with lower risk & moderate returns. Efficient frontier → assets expected returns & risk + paired correlations. Sharpe Ratio R p ​− R f ​ S= , ​ ​ σp ​ ​ ​ S is the Sharpe ratio, Rp (expected return) and Rf (risk free rate of return) and σp SD which is the volatility/variability of portfolio’s returns. ​ ​ ​ Higher Sharpe Ratio → better risk-adjusted returns Lower Sharpe Ratio → Returns are not sufficient to justify risk Negative Sharpe Ratio → portfolio underperformed the risk-free rate, even with the risk taken. A Sharpe Ratio above 1 is generally considered good; above 2 is excellent. used to evaluate the risk-adjusted return of an investment or portfolio. It helps investors understand how much additional return they are receiving for the extra risk they take on, compared to a risk-free investment. The graph shows how investors can optimize their portfolios based on risk tolerance and desired returns. Where returns diminish for taking on additional risk as you move along the Efficient Frontier. → Efficient Frontier (EF) Represents the set of optimal portfolios that provide the maximum return for a given level of risk. Only portfolios on this curve are considered efficient because they dominate portfolios below it (which provide lower returns for the same risk). → Capital Market Line (CML) Starts from the risk-free rate and is tangent to the Efficient Frontier at the Market Portfolio. Risk tolerance is reflected by moving along the CML. Represents the risk-return trade-off for portfolios combining the risk-free asset and risky portfolios. Portfolios on the CML have higher Sharpe Ratios → better risk-adjusted returns compared to other portfolios. → Risk-Free Rate: Indicates a zero-risk investment like government bonds. Adding the risk-free rate allows for better diversification. → Market Portfolio: The tangency point of CML & EF → highest risk-adjusted return achievable with only risky assets. → Minimum Variance Portfolio: The portfolio with the lowest possible risk (volatility) among all risky portfolios. → Achievable Region: Below the Efficient Frontier, representing portfolios that are suboptimal because they offer lower returns for a given level of risk. ESG Investments and Return ESG integration modifies the frontier by adding dimensions like social preferences, creating a more complex balance of risk, return, and sustainability. Optimal portfolios in terms of risk-adjusted returns and ESG impact How ESG Affects the Efficient Frontier: Constraints - exclusion of stocks/sectors which do not align with ESG → reduce the investment landscape, potentially lowering returns or increasing risk. Risk Management - Companies with higher ESG scores are often seen as less risky → an improve risk-adjusted returns and shift the frontier upward. Long-term benefits - Companies with strong ESG performance are believed to deliver better long-term financial performance. Mean variance frontiers for all assets and portfolios with certain ESG Score Sharpe Ratio vs ESG score Topic 2 P2 Notes 5  Short & Long Run ESG Investment ESG-CAPM incorporates the idea that ESG-motivated and aware investors demand higher or lower returns based on ESG risks or alignment. High ESG Assets: Lower expected returns due to higher prices. Viewed as less risky over the long term. Low ESG Assets: Higher expected returns due to higher perceived risks (e.g., stranded assets, litigation, or regulatory risks). E.g. S&P 500 ESG Index measures the performance of securities which meet the sustainability criteria and maintain similar overall industry group weights as the S&P 500. → increases divergences in market capitalization indices. Market Dominated by: ESG-Unaware Investors ESG-Aware Investors ESG-Motivated Investors ESG risks are mispriced or ignored. ESG risks are partially priced into assets. Assets with strong ESG performance receive Assets with poor ESG performance might be Assets with higher ESG scores attract some significant demand, leading to higher prices overvalued, leading to a potential "carbon premium, while poor ESG performers are and lower expected returns. bubble". slightly penalized. Poor ESG performers are heavily penalized, Over time shocks from ESG-related risks (e.g., Market is relatively stable, but full ESG with higher required returns or lower prices. carbon taxes, stranded assets) might lead to integration may not occur. Long-run stability as ESG is fully integrated abrupt repricing, causing market instability. into asset pricing, but some investors may Flat or minimal slope Steep upward slope perceive trade-offs in financial performance. Steep downward slope as high ESG assets are heavily favoured Conclusion Sustainable finance is reshaping how investments are managed by factoring in long-term risks like climate change and evolving societal expectations. As firms and investors navigate physical and transition risks, opportunities emerge in resource efficiency, new markets, and ESG-driven investments. Understanding and managing these dynamics is key to fostering resilient financial systems that align with global sustainability goals. Topic 2 P2 Notes 6