CFA Institute - CFA Certificate in ESG Investing Curriculum 2023 PDF

© CFA Institute. For candidate use only. Not for distribution. CHAPTER 7 ESG Analysis, Valuation, and Integration LEARNING OUTCOMES Mastery The candidate should be able to: 7.1.1 explain the aims and objectives of integrating ESG into the investment process 7.1.2 describe different approaches...

© CFA Institute. For candidate use only. Not for distribution. CHAPTER 7 ESG Analysis, Valuation, and Integration LEARNING OUTCOMES Mastery The candidate should be able to: 7.1.1 explain the aims and objectives of integrating ESG into the investment process 7.1.2 describe different approaches of integrating ESG analysis into the investment process 7.1.3 describe qualitative approaches to ESG analysis across a range of asset classes 7.1.4 describe quantitative approaches to ESG analysis across a range of asset classes 7.1.5 identify tangible and intangible material ESG-related factors through both qualitative and quantitative approaches 7.1.6 describe how scorecards may be developed and constructed to assess ESG factors 7.1.7 assess ESG issues using risk mapping methodologies 7.1.8 explain how ESG complements traditional financial analysis 7.1.9 analyze how ESG factors may affect industry and company performance 7.1.10 analyze how ESG factors may affect security valuation across a range of asset classes 7.1.11 interpret a company’s disclosure on selected ESG topics 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 7.1.16 explain the approaches taken across a range of ESG integration databases and software available, and the nature of the information provided 366 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration LEARNING OUTCOMES Mastery The candidate should be able to: 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 7.1.19 describe primary and secondary sources of ESG data and information 7.1.20 describe other uses of ESG and sustainability systems data 7.1.21 explain how Credit Rating Agencies (CRAs) approach ESG Credit Scoring 1 WHY INVESTORS INTEGRATE ESG 7.1.1 explain the aims and objectives of integrating ESG into the investment process Many approaches to ESG analysis are used, and a multitude of ESG integration tools and techniques are available. These methods include company analysis, asset valuation, portfolio decision making, and stewardship. ESG analysis methods use various data sources, ranging from commercially available databases to primary analytical research. This chapter gives an overview of common and major techniques, a summary of major ESG research providers, and case studies of ESG integration in practice across a range of investment strategies. Why Investors Integrate ESG An investment firm might have several different aims and objectives for integrating ESG into an investment process. These can include ► meeting requirements under fiduciary duty or regulations, ► meeting client and beneficiary demands, ► lowering investment risk, ► increasing investment returns, ► giving investment professionals more tools and techniques to use in analysis, ► improving the quality of engagement and stewardship activities, and ► lowering reputational risk at a firm level and investment level. We will look at each of these objectives in the following sections. The aims can differ depending on the nature of the firm. Some firms are pure asset managers, some are asset owners (e.g., pension plans), and some have mixed characteristics of both an asset manager and an asset owner (e.g., some insurance entities or large endowments that use both in-house asset managers and third-party firms). © CFA Institute. For candidate use only. Not for distribution. Why Investors Integrate ESG Meeting Requirements under Fiduciary Duty or Regulations, or Meeting Client and Beneficiary Demands A significant number of investment professionals still do not integrate ESG. According to a 2017 CFA Institute global ESG survey, 24% of equity investors, 55% of fixed income investors, and between 79% and 92% of alternative asset investors (across private equity, real estate, infrastructure, and hedge funds) do not integrate ESG into their processes. More recent studies continue to suggest ESG integration is not universally accepted. The Royal Bank of Canada 2020 Responsible Investment Survey noted that 25% of respondents and, on a regional basis, 36% of US respondents did not integrate ESG.1 However, these investors, or their asset owner clients, might fall under certain country regulations, such as the EU Shareholder Rights Directive, the UK Department for Work and Pensions’ regulations, or the UK Stewardship Code. In these cases, the regulations or clients could demand a certain level of ESG integration, even though the investor might not believe that ESG integration enhances return or lowers risk. The aim is to meet minimum regulatory obligations or client demands. The debate has evolved over the past two decades. Historically, legal questions arose as to whether some aspects of exclusionary strategies (e.g., excluding tobacco companies) were consistent with fiduciary duties (modeled on what a prudent person might do). Today, some legal and regulatory standards suggest that failing to integrate aspects of ESG might be inconsistent with fiduciary duties. The United Nations Environment Programme Finance Initiative (UNEP FI), along with legal firm Freshfields and the United Nations Principles for Responsible Investment (PRI), examined these questions over the past decade. Their analysis (across jurisdictions) argued that the fiduciary duties of investors require them to do the following: ► Incorporate ESG issues into investment analysis and decision-making processes, consistent with their investment time horizons ► Encourage high standards of ESG performance in the companies or other entities in which they invest ► Understand and incorporate beneficiaries’ and savers’ sustainability-related preferences, regardless of whether these preferences are financially material2 As of 2021, regulatory updates include the EU Shareholder Rights Directive II, the UK Stewardship Code, and guidance from the US Department of Labor (DoL). Of note, over the past decade, the tone of the US DoL guidance has fluctuated but regardless, the point has been that investors have to take note of regulatory requirements with respect to integrating ESG. See Chapter 6 on the main principles of stewardship codes and standards. Lowering Investment Risk and Increasing Investment Returns Many investors seek to integrate ESG into investment processes to better understand and lower investment risk. Some also wish to enhance returns via ESG by seeking higher alpha. Recent surveys suggest that more firms do so to lower risk rather than enhance returns, but some firms do so for both reasons.,3,4 1 RBC Global Asset Management, 2020 Responsible Investment Survey Key Findings (2020). www​ .rbcgam​.com/​documents/​en/​other/​esg​-key​-findings​.pdf. 2 United Nations Global Compact, United Nations Environment Programme (UNEP) Finance Initiative, PRI, and UNEP Inquiry (2019), Fiduciary Duty in the 21st Century. www​.unepfi​.org/​fileadmin/​ documents/​fiduciary​_duty​_21st​_century​.pdf. 3 CFA Institute (2017). Global Perceptions of Environmental, Social, and Governance Issues in Investing (2017). www​.cfainstitute​.org/​en/​research/​survey​-reports/​esg​-survey​-2017. 4 A. Amel-Zadeh and G. Serafeim, “Why and How Investors Use ESG Information: Evidence from a Global Survey,” Financial Analysts Journal 74(3) (2017): 87–103. http://​dx​.doi​.org/​10​.2139/​ssrn​.2925310. 367 368 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration Chapter 7 Exhibit 1: Why and How Investors Use ESG information: Evidence from a Global Survey All Survey responses to the following question: Do you consider ESG information when making investment decisions? (1) AUM size ESG Allocation Region (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) Significant difference in proportion vs. rows Large Small Diff. (3)−(4) High Low Diff. (6)−(7) US Europe Diff. 85.9% 80.3% 93.2% 75.0% *** 75.2% 84.4% * 69.3% 58.3% ** 55.7% 64.4% 35.3% 31.8% 33.0% 39.3% 46.0% 22.4% *** 25.8% 40.7% ** Ni=419 Yes, because … 82.1% 1 … ESG information is material to investment performance. 63.1% 2–8 60.3% 64.5% 2 … of growing client/ stakeholder demand. 33.1% 1, 7–8 54.3% 22.4% 3 … we believe such policy to be effective in bringing about change at firms. 32.6% 1, 7–8 31.9% 32.9% 4 … it is part of our investment product strategy. 32.6% 1, 7–8 43.1% 27.2% *** 38.7% 28.1% ** 47.4% 30.4% *** 5 … we see it as an ethical responsibility. 32.6% 1, 7–8 25.0% 36.4% ** 41.3% 26.0% *** 18.6% 40.7% *** 6 … we anticipate it to become material in the near future. 31.7% 1, 7–8 31.9% 31.6% 34.0% 30.2% 29.9% 37.0% 7 … of formal client mandates. 25.0% 1–3, 5–6, 8 37.1% 18.9% 33.3% 18.8% *** 23.7% 30.4% No, because ... 17.9% 14.1% 19.7% 6.8% 25.0% *** 24.8% 15.6% 1 … there is no stakeholder demand for such policy. 26.7% 3–5, 6–8 15.8% 30.4% 9. 1% 29.7% * 21.9% 24.0% 2 … we lack access to reliable nonfinancial data. 21.3% 6–7 21.1% 21.4% 9. 1% 23.4% 18.8% 32.0% 3 … ESG information is not material to investment performance. 13.3% 1, 7 5. 3% 16.1% 18.2% 12.5% 21.9% 4. 0% *** *** * ** © CFA Institute. For candidate use only. Not for distribution. Why Investors Integrate ESG All Survey responses to the following question: Do you consider ESG information when making investment decisions? (1) 4 … we believe such policy to be ineffective in inducing change at firms. AUM size 369 ESG Allocation Region (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) Significant difference in proportion vs. rows Large Small Diff. (3)−(4) High Low Diff. (6)−(7) US Europe Diff. 12.0% 1, 7 15.8% 10.7% 18.2% 10.9% 12.5% 16.0% 5 … it would violate our fiduciary duty to our stakeholders. 12.0% 1, 7 5. 3% 14.3% 9. 1% 12.5% 21.9% 8. 0% 6 … such information is not material to a diversified investment portfolio. 10.7% 1–2 5. 3% 12.5% 9. 1% 10.9% 6. 3% 16.0% 7 … including such information is detrimental to investment performance. 4. 0% 1–5, 8 5. 3% 3. 6% 0. 0% 4. 7% 6. 3% 4. 0% <0.001 <0.001 p-value of difference (yes vs. no) <0.001 <0.001 <0.001 * <0.001 <0.001 Ni = the number of respondents Source: Amel-Zadeh and Serafeim (2017).4 More Tools and Techniques to Use in Analysis and Improving the Quality of Engagement and Stewardship Activities Judging by ESG surveys undertaken by both academics and investment practitioners, not all firms believe that ESG integration leads to better risk-adjusted returns. However, many ESG integration tools, such as scorecards, can be used to engage with company management teams and aid stewardship activities. These same tools can also enhance the clarity of a company’s business model. Further details on this can be found in Chapter 6. Reputational Risk at a Firm Level Firms might view ESG integration as necessary to ensure a strong reputation and limit reputational risk with stakeholders. Evidence of varying views in the corporate world can be found in Business Roundtable’s “Statement on the Purpose of a Corporation” p-value of difference (yes vs. no) <0.001 <0.001 370 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration (August 2019) signed by 181 CEOs (including those of major investment banks and asset managers) who committed to lead their companies for the benefit of all stakeholders—customers, employees, suppliers, communities, and shareholders.5 These CEOs wrote: While each of our individual companies serves its own corporate purpose, we share a fundamental commitment to all of our stakeholders. We commit to: ► Delivering value to our customers. We will further the tradition of American companies leading the way in meeting or exceeding customer expectations. ► Investing in our employees. This starts with compensating them fairly and providing important benefits. It also includes supporting them through training and education that help develop new skills for a rapidly changing world. We foster diversity and inclusion, dignity and respect. ► Dealing fairly and ethically with our suppliers. We are dedicated to serving as good partners to the other companies, large and small, that help us meet our missions. ► Supporting the communities in which we work. We respect the people in our communities and protect the environment by embracing sustainable practices across our businesses. ► Generating long-term value for shareholders, who provide the capital that allows companies to invest, grow and innovate. We are committed to transparency and effective engagement with shareholders. Each of our stakeholders is essential. We commit to deliver value to all of them, for the future success of our companies, our communities and our country. A core component of consumer brand surveys are attitudes toward sustainability and climates, as well as perceptions of diversity and inclusion. Managing ESG risks and opportunities therefore becomes an important part of managing brand and reputational value. 2 THE DIFFERENT APPROACHES TO INTEGRATING ESG 7.1.2 describe different approaches of integrating ESG analysis into the investment process 7.1.3 describe qualitative approaches to ESG analysis across a range of asset classes 7.1.4 describe quantitative approaches to ESG analysis across a range of asset classes 5 Business Roundtable, Business Roundtable Redefines the Purpose of a Corporation to Promote “An Economy That Serves All Americans” (2019). www​.businessroundtable​.org/​business​-roundtable​-redefines​ -the​-purpose​-of​-a​-corporation​-to​-promote​-an​-economy​-that​-serves​-all​-americans. © CFA Institute. For candidate use only. Not for distribution. The Different Approaches to Integrating ESG A firm can use a multitude of approaches to integrate ESG analysis into its investment process. This section provides a summary of these approaches. What is important to note is that ESG analysis can be either qualitative or quantitative (sometimes contracted to “quant”). Similarly, the way the analysis is integrated can also be purely qualitative (e.g., opinion on quality of management added to the investment thesis) or quantified (e.g., impact on financial models or valuation). Some techniques could be considered a hybrid of both techniques, such as scorecards, where a qualitative judgment is turned into a quantitative score. These tools and techniques cover different types of strategy (passive, systematic, fundamental, active or activist) and different asset classes. Certain tools tend to be asset class or strategy specific. Qualitative ESG Analysis Qualitative ESG analysis is likely to be used in investment processes that are based on company-specific research, fundamental analysis, and stock picking. ► Investment teams analyze ESG data to form an opinion on a firm’s ability to manage certain ESG issues. ► They combine this opinion with their financial analysis by linking specific aspects of the company’s ESG risk-management strategy to different value drivers (e.g., costs, revenues, profits, and capital expenditure requirements). ► Analysts and portfolio managers then seek to integrate their opinion in a quantified way into their financial models by adjusting assumptions used in the model (e.g., growth, margins, or costs of capital). Certain qualitative techniques might be more suitable (or weighted differently) for different asset classes. For instance, a judgment on management incentives (a part of G analysis) could have more weight in public equity and private equity, have less weight for fixed-income investors, and be deemed irrelevant for sovereign bond investors. Quantitative ESG Analysis Quantitative ESG (QESG) analysis is likely to be used in investment processes that use quant models to identify attractive investment opportunities. In such cases, the ESG data are typically aggregated into an ESG factor (an ESG score), which is added to the quant models. This could be a screen that creates the investment universe or a quant model used to adjust valuations based on several factors (including ESG). Quantitative, Systematic, and Thematic Approaches to Integrated ESG Analysis Quantitative practitioners might assess ESG factors at the research stage typically using a third-party database or a mix of third-party data and internal proprietary data. This assessment is typically done with large datasets of stocks or bonds, rather than individual company assessment, though some firms will create their own proprietary scores from individual company assessment. The data gathering can be similar to that done by fundamental investors but tends to be over larger datasets. For instance, a global dataset might contain 2,000 to 4,000 companies with 100 data points per company. Quantitative factor investors typically integrate ESG factors alongside other factors, such as value, size, momentum, growth, and volatility. Some of these factors might be from third-party models. ESG data are included in their investment processes and could result in upward or downward adjustments to the weights of securities, including to zero. For instance, a strong score on an environmental factor might be sought. Systematic approaches can attempt to derive correlations to understand how ESG factors might affect financial 371 372 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration performance over time and then weight those ESG factors appropriately. Investors can try to assess relationships in existing ESG third-party scores as well as proprietary scores. Algorithmic approaches use ESG data (e.g., scraped from internet news articles to adjust company or sector weights after parsing the ESG data through rules-based formulas). See further sections within this chapter for more information on data sources. Passive and index approaches might tilt toward ESG factors chosen by investors. For instance, the Japanese Government Pension Investment Fund has created, with index providers, gender-tilted, rules-based indexes to invest in. These could be considered rules-based strategies. This shows that asset owners can set certain mandate rules accordingly to integrate ESG across differing strategies and in line with their own ESG polices and philosophies. This is explored in further detail in Chapter 9. Thematic funds might assess alignment with priority themes, which could have an ESG nature (e.g., climate, gender). This alignment can be done with a material opportunity mapping process or using ESG data to adjust weights accordingly. Application Programming Interfaces Investors use application programming interfaces (APIs) to compile and assess data. APIs are used to more easily access and interface with underlying databases and other datasets. Companies are more forthcoming with their sustainability practices, and financial practitioners are increasingly using APIs to compile and integrate this rapidly growing dataset into their processes. The number of total unique ESG data points captured is on the rise.6 Artificial Intelligence and Algorithms Much of the ESG data available on companies is unstructured. Artificial intelligence (AI) and machine learning algorithms attempt to bring structure and numerical value to part of that unstructured dataset. Some practitioners ► focus on using AI techniques to measure ESG performance tied to measures developed by the Sustainability Accounting Standards Board (SASB), ► attempt to provide immediate access to scores based on material ESG events as they occur, or ► focus on intangible ESG factors, such as corporate culture, that could drive company value. Natural language processing (NLP) and other quantitative techniques are likely to continue to develop over time. NLP is broadly defined as the automatic manipulation of natural language, such as speech and text, by software. In particular, investors are interested in how to program computers to process and analyze large amounts of natural language data related to ESG. The aim is to obtain a computer capable of “understanding” the ESG contents of documents, including the contextual nuances of the language within them. The technology can then accurately extract information and insights contained in the documents as well as categorize and organize the documents themselves. 6 ProgrammableWeb, Growth in Financial Related (Financial, Banking, Payments, Monetization) APIs since 2005 (2020). www​.programmableweb​.com/​news/​financial​-apis​-have​-seen​-two​-growth​-spikes/​ research/​2017/​08/​09. © CFA Institute. For candidate use only. Not for distribution. The Different Approaches to Integrating ESG Highlights between the Quantitative Approaches and Qualitative Approaches and Terminology Confusion Combining this information can be confusing because of the different meanings investors give to the term quantitative. As a description of an analytical technique, it tends to be used when a numeric score is assigned. But it can also be used to describe a whole class of investment strategy that tends to use stock, bond, derivative, or other security factor properties as the main basis for investment. In terms of investment strategies, quantitative investing can be known as “systematic investing.” It can include the following strategies: ► high-frequency trading ► use of algorithms based on news or factors and statistical arbitrage ► trend following ► risk parity ► use of beta strategies The approach tends to use heavy mathematical modeling, computing power, and data analysis, potentially including machine and natural language learning processes. Some firms use these approaches exclusively, and some use them to supplement human decision making. Typically, computer and mathematical models are built and then backtested. Where these models use ESG data or information (e.g., through raw data or ratings agencies), this is considered a form of ESG integration. This produces many challenges because the length of time series for ESG data (usually 7–15 years, depending on the series) is much shorter than for financial data. This typically might be viewed as a quantitative investment form of integrating ESG technique. See Chapter 8 and further sections within this chapter for more on the types of challenges that can arise from ESG integration. Qualitative forms of analysis typically use human judgment of non-numerical forms of analysis. However, advances in techniques are blurring these traditional boundaries. For instance, machine learning’s use of natural language processing and scanning of management commentary from meeting transcripts are using those qualitative words in a quantitative fashion. See Chapter 8 for more on ESG and quantitative investment factors. Fundamental active strategies, where human judgment is used, tend to use ESG techniques that have both qualitative and quantitative elements to them but are typically not considered quantitative investment. And similarly, with quantitative investment strategies that use ESG ratings data, those ESG ratings data might be based on qualitative human judgment. Overall, ESG techniques can be considered quantitative or qualitative or have elements of both. Investment strategies are typically classified as ► quantitative (systematic, algorithmic), ► fundamental, ► active, ► passive, or ► beta. Investors interchange the term quantitative but provide different meanings when applying it to overall investment strategies and processes rather than specific ESG integration techniques. 373 374 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration Tools and Elements of ESG Analysis Regardless of whether the ESG analysis is classified as qualitative or quantitative, investors use many types of tools. These tools and elements of ESG analysis can include the following: ► Red flag indicators – Securities with high ESG risk are flagged and investigated further or excluded. For instance, a company that has a board that lacks majority independence might be flagged for deep scrutiny on management incentives or simply be excluded from an investable universe. ► Company questionnaires and management interviews – For example, if the detail on management aspects or other material ESG information is insufficient, the investor might ask the company for specific data. Or the investor might have a prepared list of standard ESG data they ask for. These questionnaires are also used in parallel with regular company meetings, where investors and companies meet to discuss the most material ESG issues. ► Checks with outside experts – For instance, an investor might interview key industry thought leaders or other stakeholders of the company, including customers, suppliers, or regulators. These checks might be complemented via interviews, surveys, or third-party sourcing, such as the use of expert networks. ► Watch lists – These lists might include securities with high ESG risk added to a watchlist for monitoring, or securities with high ESG opportunities that are put on a watchlist for possible investment. For instance, once an investor has assessed ESG risks or opportunities, a news or stock price watchlist is created and monitored for stock price entry levels or for change in ESG events. For example, a highly carbon-intense company identified with high E risk might be monitored against changing policies on carbon taxes. ► Internal ESG research – This research could be based on a variety of techniques and data sources. Proprietary ESG research and analysis is performed, and the output can be provided in scores, rankings, or reports. The research can be based on a variety of data sources, and proprietary ESG research or scores could be created. Furthermore, research could consist of the following: ● materiality frameworks; ● ESG-integrated research notes; ● research dashboards; ● strengths, weaknesses, opportunities, and threats (SWOT) analysis with ESG factors; ● scenario analysis; and ● relative rankings. ► External ESG research – For this research, sell-side, ESG specialists, or third-party databases can all be used, and a materiality framework is created. ► ESG agenda items at investment committee– or chief information officer– level meetings – One technique to ensure consistent integration is to ensure an ESG section as a standing item at committee meetings. This approach might guarantee scrutiny from senior level investors and signal importance to the investment firm. © CFA Institute. For candidate use only. Not for distribution. The Different Approaches to Integrating ESG Elements of ESG Integration The elements of ESG integration include the following: ► adjusting forecast financials (e.g., revenue, operating cost, asset book value, capital expenditure) ► adjusting valuation models or multiples (e.g., discount rates, terminal values, ratios) ► adjusting credit risk and duration ► managing risk, including exposure limits, scenario analysis, and value-at-risk models ► ESG factor tilts ► ESG momentum tilts ► strategic asset allocation, including thematic and ESG objective tilts ► tactical asset allocation ► ESG controversies and positive ESG events This can be summed up by the ESG integration framework shown in Exhibit 2. 375 Exhibit 2: ESG Integration Framework RIS KM AN ESG and financial risk exposures and limits Portfolio scenario analysis SE CU RIT Forecasted financials & ratios Internal credit assessment ESG-integrated research note S E C U R IT Y Tactical asset allocation Valuation multiples Relative ranking Centralised research dashboard ESG agenda at (committee) meetings Materiality framework ESG INTEGRATION SWOT analysis Individual/ collaborative/policy engagement ATIO VALU U IT LOC EQ T AL N— AS S E Watch lists Red-flag indicators Company questionnaires Value-at-risk analysis Relative value analysis/ spread analysis Voting Internal ESG research IE S IO AT Valuation-model variables YV OME INC ED FIX N— TIO UA AL RESEARCH Forecasted financial ratios T EN EM AG O RI IS YS AL AN Duration analysis ESG profile (vs. benchmark) N E QUI T I XE I E S /F D IN M CO Portfolio weightings Research level Security level T IO N Security sensitivity/ scenario analysis E UC Forecasted financials TR Strategic asset allocation NS Chapter 7 SC EN A 376 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration PO R O TF LI O CO Portfolio level Source: CFA Institute 2018, in collaboration with PRI.7 The ESG integration framework, shown in Exhibit 2, is not meant to illustrate the perfect ESG-integrated investment process. Because every firm is unique, the ESG integration techniques of one firm are not necessarily the right techniques for all firms. However, many firms will use a selection of the techniques referenced in the figure. Firms typically use various tools and techniques to identify material factors. These tools can be qualitative or quantitative, or a mix of both. Differences between Company or Business Analysis and Security Analysis Many investment practitioners make two distinctions in fundamental investment analysis: 1. the difference between a company or business assessment, and 2. a security, stock, bond, or convertible (or other tradeable construct, including derivatives) assessment. 7 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. Typical Stages of Integrated ESG Assessment (Research and Idea Generation Stage) 377 While the differences are often interchanged in ordinary language, many investors give them different meanings. Stocks and bonds can have properties that companies do not, such as stock beta or volatility, which are potentially expressed in different ways. A company or business assessment typically examines fundamental properties of a business, such as its competitive advantages (or lack of ), sometimes described as a business moat (after the popular Warren Buffett Annual Letters). These properties could appear in the company’s products or services, suppliers, employees, management, organizational structure, incentives, corporate culture, or resources (natural, intellectual, or innovation). Many of these properties could be considered as under an ESG category. For instance, natural capital could be under E, corporate culture or supplier analysis under S, and management structure or incentives under G. A business might have strong aspects of ESG, which lead to an assessment of a strong or competitive advantage, that can then lead to a positive judgment on that business or company. The statistical properties of a company stock or bond might differ from its fundamental business properties. For instance, beta or stock volatility are properties of a stock, not of a company or business per se. This distinction is important because of the debate among investors who use security factors to invest. The debate here is whether these properties are ESG components that are robust QESG stock or bond factors. See Chapter 8 for more detail on this debate. This debate is important because of how an assessment of the strength or weakness of a company or business can then lead to a valuation of its securities. TYPICAL STAGES OF INTEGRATED ESG ASSESSMENT (RESEARCH AND IDEA GENERATION STAGE) 7.1.5 identify tangible and intangible material ESG-related factors through both qualitative and quantitative approaches Firms and investment teams might not have ESG factors embedded in their philosophy but still use ESG techniques within investment processes. These techniques can run alongside a financial analysis or have integrated aspects to the analysis. The stages typically are research, valuation, and portfolio construction, which leads to investment decisions. Each of these stages is considered in further detail in the following subsections. Research and Idea Generation Stage Gathering Information Practitioners gather financial and ESG information from multiple sources, typically a mix of company reports, third-party research, and primary research, and the data might be qualitative or quantitative, or both. For example, qualitative data might include company questionnaires and management interviews, whereas quantitative data might include environmental emissions data. 3 378 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration Materiality Assessments The research stage typically includes a materiality assessment to identify the ESG issues that are likely to have an impact on the company’s financial performance. Materiality is typically measured in terms of both the likelihood and magnitude of impact. The materiality assessment is considered important because evidence shows that nonmaterial factors do not affect financials, valuations, or company business models.8 It is distinguished from some exclusionary socially responsible investing strategies, which might also consider nonmaterial factors (e.g., exclusion of pork-based product companies for certain religious stakeholders) that a typical investor would not deem a material ESG factor. Investors who primarily see ESG analysis and ESG integration as a way to enhance investment processes are likely to focus on ESG issues they consider financially material (i.e., a factor that they consider likely to have a financial impact in the future, either positive or negative). As of 2021, debates are ongoing about the taxonomy and definitions to be used surrounding ESG and sustainability. For instance, the EU is proposing a taxonomy on sustainability investments.9 Also, some investors label their strategies as either “ethical” or “impact.” Such ethical strategies might consider issues that an ESG-integrated investor does not deem as being material. Tangible versus Intangible Factors; Different Forms of Capital A tangible asset (or a hard asset) is a physical asset, whereas an intangible asset is a non-physical one that is difficult or impossible to touch physically. Exhibit 3: Examples of Tangible and Intangible Assets Tangible Assets Intangible Assets Applicable to Both Tangible and Intangible Assets ► Land ► Goodwill ► ESG analysis techniques ► Manufacturing plants ► Patents ► Materiality ► Inventories ► Copyrights ► Furniture ► ► Machinery Intellectual property and know-how ► Software and innovation assets ► Corporate culture ► Incentives ► Employee productivity ► Other forms of social and relationship assets Evaluating Different Forms of Tangible or Intangible Factors One framework for evaluating different forms of “capital” or tangible or intangible factors was developed by the International Integrated Reporting Council (IIRC). 8 M. Khan, G. Serafeim, and A. Yoon, “Corporate Sustainability: First Evidence on Materiality,” The Accounting Review 91(6) (2016): 1697–724. https://​ssrn​.com/​abstract​=​2575912. 9 European Commission, EU Taxonomy for Sustainable Activities (2021). https://​ec​.europa​.eu/​info/​ business​-economy​-euro/​banking​-and​-finance/​sustainable​-finance/​eu​-taxonomy​-sustainable​-activities​ _en. © CFA Institute. For candidate use only. Not for distribution. Typical Stages of Integrated ESG Assessment (Research and Idea Generation Stage) The IIRC Framework (to which certain companies report) describes capitals (both intangible and tangible) as follows: ► Financial capital — the pool of funds that is available to an organization for use in the production of goods or the provision of services and that is obtained through financing, such as debt, equity, or grants or generated through operations or investments. ► Manufactured capital — manufactured physical objects (distinct from natural physical objects) that are available to an organization for use in the production of goods or the provision of services, including buildings, equipment, and infrastructure (e.g., roads, ports, bridges, and waste and water treatment plants). ● Manufactured capital is often created by other organizations but includes assets manufactured by the reporting organization for sale purposes or when they are retained for their own use. ► Intellectual capital – organizational, knowledge-based intangibles, including intellectual property (e.g., patents, copyrights, software, rights, and licenses) and “organizational capital” (e.g., tacit knowledge, systems, procedures, and protocols). ► Human capital – people’s competencies, capabilities, and experiences and their motivations to innovate, including the following: ► ► ● their alignment with and support for an organization’s governance framework, risk management approach, and ethical values ● the ability to understand, develop, and implement an organization’s strategy ● their loyalties and motivations for improving processes, goods, and services, including their ability to lead, manage, and collaborate Social and relationship capital – the institutions and relationships between communities, groups of stakeholders, and other networks and the ability to share information to enhance individual and collective well-being. These include the following: ● shared norms and common values and behaviors ● intangibles associated with the brand and reputation that an organization has developed ● an organization’s social license to operate Natural capital – all renewable and non-renewable environmental resources and processes that provide goods or services that support the past, present, or future prosperity of an organization (see Chapter 3 in particular), including air, water, land, minerals, and forests, as well as biodiversity and ecosystem health. Clearly, not all forms of capital (intangible or tangible) would be material or relevant to all companies; however, determining this might require a materiality judgment (see the later section on materiality assessments and risk mapping). Many of the nonfinancial capitals would be considered under ESG, with a large number also intangible. A qualitative identification and judgment would be considered a form of qualitative approach to ESG. We will now briefly examine how some of these forms of capital can be assessed with some examples across company constituents, such as regulators, customers, employees, and suppliers. 379 380 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration A positive relationship with regulators could lead to less friction and litigation. Examples include ► social media and advertising companies, ► pharmaceutical companies, ► airlines, ► financial services, and ► any company that has a significant regulator, which could be found in many industries. The relationship between a regulator and a company would be considered an intangible asset (or a liability if the relationship is negative). A negative relationship might be more likely to lead to litigation, which adds to costs and could lead to penalties, both of which affect cash flows. The amount of capital that banks and insurers are required to hold might depend on an analyst’s view of their relationships and on their reputation with regulators and the public. This in turn could affect return on capital metrics, cash flows, and valuation estimates. Pharmaceutical companies with a positive reputation and products that meet previously unmet medical needs might have quicker or more certain regulatory approval pathways. This can be assessed by differing estimates of probability of success for future products. For example, the probability of success might be lowered from an industry average of 70% to 60% for a company with a poor reputation, or it could be raised to 80% for a company with a positive reputation. This adjustment would affect risk-adjusted discounted cash flow (DCF) calculations: Faster approval positively affects cash flows, so reputation and brand are intangible assets. Customer service, perceived brand value, and overall customer satisfaction can be inputs to determine future sales growth rates and therefore cash flows. Differing growth rates might be affected by an investor’s view of reputation and brand value for both positive opportunity and negative risk. A company with high customer satisfaction or strong brand reputation might be expected to grow revenue faster than the industry average in investor estimates. High employee satisfaction might also affect forward estimates by investors. For instance, a hotel group with high employee satisfaction might find recruiting new talent easier and might be assessed to provide a better customer experience, which could lead to higher repeat revenue modeled by investors, or by investors prepared to assign higher valuation ratios (e.g., prepared to buy stocks with higher P/E ratios or bonds at lower credit spreads). A poor supply chain or a weak relationship with suppliers might lead to a lower forecast by investors or lower valuation ratios, for instance, in food supply chains for supermarkets when a poor supply chain has led to instances of horse meat in lasagna food products. Alternatively, this could be seen in the questioning of the sustainable sourcing of supply chains. On the other hand, strong supply chain management in agile, fast inventory management from short robust supply chains might lead to a more positive view from investors. These factors can be intersectional. For instance, a poor supply chain and labor practices might be negatively affected by modern slavery laws or regulation, which might incorporate both a regulator assessment and a supply chain assessment from investors. © CFA Institute. For candidate use only. Not for distribution. Typical Stages of Integrated ESG Assessment (Scorecards Can Be Used to Assess ESG Risk... 381 Generating Ideas Investment ideas can be generated from the data. Some practitioners begin this stage using a valuation screen, or fundamental screen, which might incorporate ESG factors—perhaps a mix of positive (seek high G), negative (avoid low G), or momentum (seek rising G or avoid declining G)—to create an attractive investment universe. This is commonly referred to as “positive” or “best-in-class” screening. Investment ideas can also be generated by themes associated with specific ESG megatrends. For instance, an ESG opportunity theme might be to seek improving access to clean water or to energy services. This approach is commonly referred to as “thematic” investing. At this stage, checklists—internal or externally sourced—might “red flag” companies and be used to narrow the investable universe. For instance, an acceptable low governance score or an unacceptable number of ESG controversies (real-world ESG events that are contested by different stakeholders or that affect society, such as a dam failing). Red flag techniques can also be used in later stages. These risks might be ESG risks judged on an absolute hurdle basis or judged against what can be “priced into the asset.” A materially negative assessment of a particular ESG factor or collection of factors could lead to a decision that an investment fails to meet a specified hurdle. For example, an incentive structure deemed to be poorly aligned under a G assessment might disqualify a possible investment and, the assessment triggers a “sell” or “do not invest” signal. This assessment could be either quantitative (e.g., the carbon intensity of company A is too far above an index benchmark to meet a practitioner’s investment criteria) or qualitative (e.g., the experience of the management team in managing environmental risk and the lack of disclosed policies might indicate risks too great for an investor on a qualitative basis). TYPICAL STAGES OF INTEGRATED ESG ASSESSMENT (SCORECARDS CAN BE USED TO ASSESS ESG RISK AND OPPORTUNITY, AND MATERIALITY ASSESSMENTS AND RISK MAPPING) 7.1.6 describe how scorecards may be developed and constructed to assess ESG factors 7.1.7 assess ESG issues using risk mapping methodologies As an example, a credit analyst identifies a company that has no third-party ESG rating available but that is issuing investment-grade bonds that might be investable. In this case, the analyst creates their own ESG assessment. A custom ESG self-assessment tool that reflects the sector-specific risk issues relevant to the issuer is created, and the company management or investor relations team is asked to fill this out. An ESG scorecard based on the self-assessment response is created with ESG factor scores ranging from 0 to 5, and high or low scores are then used in valuation or further assessment work. 4 382 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration Ethical marketing might, for example, be identified as a key ESG social risk (perhaps via a risk-mapping process, which is covered in the next subsection) for pharmaceutical companies X, Y, and Z: ► Company X has no policy and a history of violations, so it scores a 0. ► Company Y has a brief policy and no violations, so it scores a 3. ► Company Z has a detailed policy and one minor violation, so it scores a 4. Scores of 0 could make a company unattractive, and scores of 5 could lead to further investment work. Alternatively, total scores of all factors in the scorecard are used in further assessment or valuation work. The scorecard can take a qualitative judgment of a factor and put a form of quantitative score on it. ESG rating agencies can provide scores, and a form of scoring is typically used in commercially available ESG rating services. These can be used raw or adjusted by practitioners to reflect their own views. These scores can then be compiled for use in assessment or idea generation. The scorecard technique could be used on private companies as well as public companies. Challenges to creating private company scorecards is that a rating agency score is less likely to be available for a private company, and less information about it is available in the public domain. This scorecard technique can be adapted to scoring countries for sovereign bond analysis or to infrastructure and real estate. For example, environmental policies could be scored for infrastructure and commitments to a carbon net zero plan, or corruption levels could be scored for countries. See more on ESG ratings agencies later in this chapter. In summary, developing a scorecard involves the following steps: 1. Identify sector- or company-specific ESG items. 2. Break down issues into a number of indicators (e.g., policy, measures, disclosure). 3. Determine a scoring system based on what good/best practice looks like for each indicator/issue. 4. Assess a company and give it a score. 5. Calculate aggregated scores at issue level, dimension level (ESG level), or total score level (depending on the relative weight of each issue). 6. Benchmark the company’s performance against industry averages or peer group (optional). Materiality Assessments and Risk Mapping Some ESG issues might be material for companies in a specific industry (e.g., water stress can disrupt the operations of mining or beverages companies, which rely heavily on clean water in their production processes) but not for those in other sectors (e.g., water stress has little affect on media or financial companies). One should note that not all risks can be managed. Material ESG risk that has not been managed by a company takes two types: (1) unmanageable risk, which cannot be addressed by company initiatives, and (2) the management gap, which represents risks that could be managed by a company through suitable initiatives but which might not yet be managed. As explained, some risks are manageable, such as the risk of on-the-job injuries, which can be managed, for example, through establishing stringent safety procedures, having emergency response plans and safety drills, and promoting a safe culture. © CFA Institute. For candidate use only. Not for distribution. Typical Stages of Integrated ESG Assessment (Scorecards Can Be Used to Assess ESG Risk... Some risks are not (fully) manageable, such as the carbon emissions of airplanes in flight. An airline can manage some of the issues (e.g., by modernizing aircraft, installing winglets, and working on information and communication technology systems to minimize the time that airplanes spend idling on the runway), but it cannot easily manage all of an airplane’s flight emissions. As a result, the airline has some unmanageable risk on carbon emissions, which should contribute to its unmanaged risk score on that issue. Unmanageable risk is only one of the two components of unmanaged risk. The second component is the management gap, which relates to the manageable part of a company’s material ESG risks and reflects the failure of the company in managing these risks sufficiently, as reflected in the company’s management score. EXAMPLE 1 Human Capital Human capital is difficult to manage. A company can employ hundreds of thousands of people, and imagining a management program that could eliminate all risk of sexual harassment, low morale, or high turnover is very hard. But companies are expected to have full control over these policies. Moreover, Sustainalytics has confidence that strong policies can effectively promote a working culture that limits material risk from sexual harassment or a workplace with destructive low morale and turnover. However, companies have challenges in mitigating risks in the labor supply chain. Therefore, a manageable risk factor is applied to distinguish that some risk within the issue cannot be managed. In terms of a company’s risk management capabilities, a review of controversy cases can be helpful. A controversy case is defined as an instance, or ongoing situation, in which a company’s operations or products allegedly have a negative ESG impact. Determining which ESG issues are most material is not an exact science, and there might be important differences between what each investor considers most material, even when analyzing the same company. Determining which ESG issues are most material is not an exact science, and there might be important differences between what each investor considers most material, even when analyzing the same company. This is because forecasting how much one ESG or risk factor will affect a financial metric such as future cash flow is typically a matter of judgement. Frameworks such as the materiality maps provided by the SASB are helpful in providing some guidance, but investment professionals often develop their own view on what is most material. This spectrum of opinions concerning materiality is exemplified through the different examples of materiality maps provided in Exhibit 4, Exhibit 5, and Exhibit 6, which highlight the differing views investors might take. 383 384 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration Exhibit 4: Example Materiality Map of High-Level Sectors Across ESG Factors 6 Business ethics and culture Business ethics and culture 5 4 Ownership and control Ownership and control Executive remuneration Ownership and control Business ethics and culture Health and safety Product responsibility 3 Community development Product responsibility Board structure Business ethics and culture Business ethics and culture Ownership and control Product responsibility Regulatory threshold and compliance Assessment and disclosure Board structure 2 Employment quality Resource management Customer privacy and protection Product responsibility Product responsibility Business ethics and culture Resource management Resource management Climate change impact Product responsibility Climate change impact Regulatory threshold and compliance Community development Community development Resource management Regulatory threshold and compliance Regulatory threshold and compliance Climate change impact Resource management Resource management Airlines Autos Banks (DM) Banks (EM) Beverages Capital goods Chemicals Construction materials Food and home and personal care Food retail 1 Executive remuneration 6 5 Executive remuneration Business ethics and culture Ownership and control 4 Ownership and control Health and safety Business ethics and culture Business ethics and culture Regulatory threshold and compliance Customer privacy and protection Assessment and disclosure Health and safety Human rights 2 Climate change impact Human rights Resource management Resource management 1 Assessment and disclosure Resource management Regulatory threshold and compliance Climate change impact Leisure Luxury Mining Oil and gas 3 Ownership and control Business ethics and culture Ownership and control Community development Product responsibility Employment quality Customer privacy and protection control Customer privacy and protection Regulatory threshold and compliance Health and safety Health and safety Community development Resource management Community development Assessment and disclosure Pollution of air, water and soll Product responsibility Resource management Climate change impact Product responsibility Climate change impact Resource management Pollution of air, water and soll Regulatory threshold and compliance Regulatory threshold and compliance Pharma Real estate Retailing Technology Telecoms Utilities KEY Environmental Social Governance Source: HSBC (2016).10 Exhibit 4 highlights the numerous and shifting nature of many ESG factors. One publicly available sector materiality assessment is provided by the SASB (see Exhibit 5). This shows that different industries can have different exposures (compare with Exhibit 6 on health care). One can deduce that individual companies in the same market-defined sector might be judged to have different material ESG factors affecting their business. For instance, within insurance, a US health care insurer will have different factors affecting it than a car insurance firm would. Investors can find more direct comparisons useful in analysis. In the health care industry example (Exhibit 6), using the SASB materiality map, a pharmaceutical company is judged to have a material exposure to fair marketing practices. ► Pharmaceutical company A is judged to have a low risk exposure to this factor because it has up-to-date policies and training programs and has never had a regulatory warning letter. ► Pharmaceutical company B is judged to have a high risk to this factor because it lacks a strong policy, training is minimal, and the company has received several fines and warnings from regulators. ► Pharmaceutical company C is judged to have no risk to this factor because it engages only in pharmaceutical research and does not have any commercially marketed products. Here we can see that even though the factor is material to the sector, it is of limited risk or arguably no risk to the company because the company is not exposed. These pharmaceutical companies can be more directly assessed on this same factor compared to each other. 10 HSBC and Equity Strategy, Global ESG Sector Playbook (2016). x x x Water and wastewater management Waste and hazardous materials management x x x x Customer welfare Data security and customer privacy Fair disclosure and labelling Fair marketing and advertising Human capital x x x x Access and affordability x x x Human rights and community relations Social capital x Biodiversity impacts x x x x Fuel management x x x x x x x x x x x x x Technology and Non-renewable Communications Resources Transportation x x Financials Energy management Health Care Air quality Greenhouse gas (GHG) emissions Environment Issues Exhibit 5: Example x x x x x x x x x x x Services x x x x x x x x x x x x x x x x x Resource Transformation Consumption x x x x x x x x Renewable Resources and Alternative Energy x x x x x x x x x x Infrastructure © CFA Institute. For candidate use only. Not for distribution. Typical Stages of Integrated ESG Assessment (Scorecards Can Be Used to Assess ESG Risk... 385 x x x Environmental, social impacts on assets and operations Product packaging Product quality and safety Accident and safety management Systemic risk management Leadership and governance x Lifecycle impacts of products and services Business model and innovation x x x x x Compensation and benefits Recruitment, development, and retention x x x x x x x x x x x x x x x x x x x x x x x x x x x x Services x x x x x x x x x x x x x x x Resource Transformation Consumption x x x x x x x x x x Infrastructure Chapter 7 Diversity and inclusion x Employee health, safety and well-being x x Technology and Non-renewable Communications Resources Transportation x Financials Fair labor practices Health Care Labor relations Issues Renewable Resources and Alternative Energy 386 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration x x x x x x x x x x x Technology and Non-renewable Communications Resources Transportation Supply chain management x x Financials x x x Health Care Materials sourcing Regulatory risk Competitive behavior Business ethics and transparency payments Issues x x x x Services x x x x x x x x x Infrastructure Source: SASB, SASB Materiality Map (2018). https://​materiality​.sasb​.org/​. x x x x x Resource Transformation Consumption Renewable Resources and Alternative Energy © CFA Institute. For candidate use only. Not for distribution. Typical Stages of Integrated ESG Assessment (Scorecards Can Be Used to Assess ESG Risk... 387 388 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration As seen earlier, the same technique can be applied to whole sectors or sub-sectors, as well as companies. For instance, biodiversity as an E factor is not seen to affect the whole pharmaceutical sect