2024-Final-Book.pdf

© CFA Institute. For candidate use only. Not for distribution. CERTIFICATE IN ESG INVESTING CURRICULUM 2024 © CFA Institute. For candidate use only. Not for distribution. COPYRIGHT © 2023 CFA Institute. All rights reserved. No part of this publication may be reproduced or transmitted in...

© CFA Institute. For candidate use only. Not for distribution. CERTIFICATE IN ESG INVESTING CURRICULUM 2024 © CFA Institute. For candidate use only. Not for distribution. COPYRIGHT © 2023 CFA Institute. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without permission of the copyright holder. To view a list of CFA Institute trademarks and the Guide for the Use of CFA Institute Marks, please visit our website at www​.cfainstitute​.org. ISBN: 978-1-953337-90-0 (paper) ISBN: 978-1-953337-91-7 (ebook) Authors Chapters 1 and 2 Clarisse Simonek, CFA, WeESG Thomas Verhagen, WeESG Chapter 3 Shuen Chan, Legal & General Investment Management (LGIM), Real Assets Iancu Daramus, Fulcrum Asset Management Chapter 4 Vincent van Bijleveld, Finance Ideas Sustainable Investment Consultants Rudy Verstappen, Altera Vastgoed Chapters 5, 6 and 9 Paul Lee, Redington Chapter 7 Ben Yeoh, CFA, RBC Global Asset Management Chapter 8 J. Jason Mitchell, Man Group plc CFA Institute would also like to sincerely thank the following contributors: Sylvia Solomon, ASIP Brishni Mukhopadhyay, CFA Monica Filkova, CFA Claudia Gollmeier, CFA, CIPM Matyas Horak, CFA, FRM Vincent Piscaer Maxine Wille, CFA Christopher Merker, CFA Priyanka Shukla, CFA, CIPM Peter Wilmshurst, CFA  © CFA Institute. For candidate use only. Not for distribution. CONTENTS Copyright   ii Authors   ii Introduction   xi ESG Update   xi Foreword by Marg Franklin   xii Chapter 1 Introduction to ESG Investing   13 Introduction   13 What Is ESG Investing?   14 Long-Termism and ESG Investing   14 ESG Definition and Scope   15 Types of Responsible Investment   16 Responsible Investment   17 Macro-Level Debate on ESG Incorporation   22 Macro-Level Debate on Integrating ESG Considerations   22 Financial Materiality of ESG Integration   30 Efficiency and Productivity   31 Reduced Risk of Fines and State Intervention   32 Improved Ability to Benefit from Sustainability Megatrends   36 Challenges in Integrating ESG Factors   39 ESG Factors’ Influence on Financial Performance   41 Putting ESG Investing into Practice   43 Investment Decisions   43 Shareholder Engagement   44 Policy Engagement   44 Key Initiatives   45 United Nations Initiatives   45 Reporting Initiatives   50 Key Facts   53 Further Reading   55 References   56 Practice Problems   60 Solutions   64 Chapter 2 The ESG Market   67 Introduction   67 ESG Investing in Numbers   68 Market Drivers of ESG and Challenges in ESG Integration   72 Asset Owners   74 Pension Funds   76 Insurance   80 Sovereign Wealth   80 Individual (Retail) Investors and Wealth Management   81 Asset Managers, Fund Promoters, and Financial Services   82 Asset Managers   82 Fund Promoters   83  © CFA Institute. 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Not for distribution. iv Contents The Role of the PRI for Consultants and Retail Financial Advisers   84 Investment Platforms   84 Fund Labelers   85 Financial Services   85 Policymakers, Regulators, Investees, Governments, Civil Society, and Academia   86 Examples of Policy and Regulatory Developments across the Globe   88 Investees   97 Governments   97 Civil Society   97 Academia   98 Key Facts   98 Further Reading   100 References   101 Practice Problems   104 Solutions   108 Chapter 3 Environmental Factors   111 Introduction   112 Key Environmental Issues—Climate Change    113 Tipping Elements   124 The Cost of Climate Change   125 Pressures on Natural Resources   132 Depletion of Natural Resources   133 Pollution, Waste, and a Circular Economy   139 Systemic Relationships between Business Activities and Environmental Issues   142 Systemic Risks to the Financial System: Physical and Transitional Risks   142 The Relationship between Natural Resources and Business   145 Supply, Operational, and Resource Management Issues   146 Supply Chain Transparency and Traceability   147 Key “Megatrends” and Drivers Influencing Environmental Change in Terms of Potential Impact on Companies and Their Environmental Practices   151 Growth of Environmental and Climate Policies   151 International Climate and Environmental Agreements and Conventions   151 Carbon Pricing   165 Assessment of Materiality of Environmental Issues   168 Corporate and Project Finance   169 Public Finance Initiatives   170 Asset Management   172 Approaches to Account for Material Environmental Analysis and Risk Management Strategies   174 Levels of Environmental Analysis   175 Analyzing Environmental Risks   177 Nature Assessment and TNFD Framework   185 Nature and Biodiversity   186 Assessing Nature   187  © CFA Institute. For candidate use only. Not for distribution. Contents v Applying Material Environmental Factors to Financial Modeling, Ratio Analysis, and Risk Assessment   191 Opportunities Relating to Climate Change and Environmental Issues   195 Circular Economy   196 Clean and Technological Innovation   197 Green and ESG-Related Products   203 Blue Economy   209 Key Facts   210 Appendix   212 The TNFD Disclosure Framework Approach   214 Further Reading   217 References   218 Practice Problems   235 Solutions   240 Chapter 4 Social Factors   243 Introduction   244 Social and Environmental Megatrends   244 What Are Social Megatrends?   244 Globalization   245 Automation and Artificial Intelligence (AI)   245 Inequality and Wealth Creation   246 Digital Disruption, Social Media, and Access to Electronic Devices   246 Changes to Work, Leisure Time, and Education   247 Changes to Individual Rights and Responsibilities and Family Structures   248 Changing Demographics, Including Health and Longevity   248 Investor Initiatives: Equitable Circulation of COVID-19 Vaccines   249 Urbanization   249 Religion   250 Environmental Megatrends with Social Impact   250 Key Social Issues and Business Activities   251 Internal Social Factors   252 Human Capital Development   252 Working Conditions, Health, and Safety   253 Human Rights   254 Labor Rights   257 External Social Factors   259 Stakeholder Opposition and Controversial Sourcing   259 Product Liability and Consumer Protection   260 Social Opportunities   261 Animal Welfare and Antimicrobial Resistance   261 Identifying Material Social Factors for Investors   261 Country   262 Sector   263 Company Level   264 Application of Social Factors in Investments   264 Materiality or Risk Assessment   264 Quality of Management   267  © CFA Institute. For candidate use only. Not for distribution. vi Contents Ratio Analysis and Financial Modeling   268 Key Facts   269 Megatrends   269 Further Reading   270 References   272 Practice Problems   274 Solutions   279 Chapter 5 Governance Factors   283 Corporate Governance: Accountability and Alignment   284 What Is Governance? Why Does It Matter?   284 Formalized Corporate Governance Frameworks   288 Corporate Governance Codes   288 Major Corporate Scandals: Governance Failures and Lessons Learned    290 Shareholder Engagement and Alignment   301 Characteristics of Effective Corporate Governance: Board Structure and Executive Remuneration   303 Board Structure, Diversity, Effectiveness, and Independence   304 Executive Remuneration   309 Characteristics of Effective Corporate Governance: Transparency, Capital Allocation, and Business Ethics   311 Reporting and Transparency   311 Financial Integrity and Capital Allocation   313 Business Ethics   314 Structural Corporate Governance Differences in Several Major World Markets   315 Examples from Developed Markets   316 Examples from Emerging Markets   323 Corporate Governance and the Independent Audit Function   328 Reviewing Financial Statements, Annual Reports, and Wider Reporting (including Sustainability Reports)   328 The Independence of Audit Firms and Conflicts of Interest   330 Auditor Rotation   330 Sampling and Audit Work   330 Enhanced Auditor Reports   331 Auditor Liability   332 Internal Audit   332 Corporate Governance and the Investment Decision-Making Process   333 Integrating Governance into Investment and Stewardship Processes   337 Key Facts   338 Further Reading   339 References   340 Practice Problems   342 Solutions   348 Chapter 6 Engagement and Stewardship   353 Introduction   353 Stewardship and Engagement: What’s Involved and Why It’s Important   354 What Is Stewardship? What Is Engagement?   354  © CFA Institute. For candidate use only. Not for distribution. Contents vii Why Engagement?   359 Engagement in practice   361 Codes and Standards   364 Code Revisions in 2020   366 Code Provisions   367 Engagement Styles   369 Styles: Top-Down and Bottom-Up   369 Styles: Issue-Based and Company-Focused   370 Effective Engagement: Forms, Goal Setting   370 Forms of Engagement   370 Success Factor Characteristics of Engagement Approach   371 Success Factor Characteristics of Investor Collaboration   371 Strategy and Tactics: Goal Setting and Resources   372 Strategy and Tactics: Investment Context   373 Setting Engagement Objectives   376 Practicalities of Engagement   377 Voting   377 Escalation of engagement   380 Collective engagement   382 Engagement across Different Asset Classes    385 Corporate Fixed Income   386 Sovereign Debt   387 Private Equity   388 Infrastructure   388 Property   389 Fund Investments   389 Key Facts   390 Further Reading   391 References   392 Practice Problems   395 Solutions   399 Chapter 7 ESG Analysis, Valuation, and Integration   403 The Different Approaches to ESG Integration   404 Qualitative ESG Analysis   404 Quantitative ESG Analysis   404 Tools and Elements of ESG Analysis   406 Challenges in ESG Integration   407 Criticism of ESG Integration   408 ESG Integration in Listed Equities   409 Idea Generation   410 Materiality Assessments and Gathering Information   410 Managed and Unmanaged Risks   416 Scorecards to Assess ESG Factors   417 The Challenges of Company Disclosures of ESG Information   417 ESG Integration in Listed Equities: Valuation Considerations   419 Discounted Cash Flow Input Adjustments   419 Adjustments to Valuation Multiples   423 ESG Integration in Other Asset Classes: Fixed Income   423  © CFA Institute. For candidate use only. Not for distribution. viii Contents ESG Integration in Sovereign and Investment-Grade Fixed Income   425 ESG Integration in Credit-Sensitive Fixed Income   427 ESG Integration in Credit Ratings   427 Potential Bias in Ratings   428 Green Bonds   428 ESG Integration in Other Asset Classes: Real Estate and Private Markets   429 ESG Integration in Real Estate Markets   429 ESG Integration in Private Equity   429 Case Studies in ESG Integration   431 ESG Integration Databases and Software   438 ESG Assessment and Ratings of Issuers   439 Mutual Fund and Fund Manager ESG Assessment and Other Uses of ESG Data   442 ESG Index Providers   443 Primary and Secondary ESG Data Sources   444 Conclusion   444 Key Facts   445 Further Reading   445 References   447 Practice Problems   449 Solutions   454 Chapter 8 Integrated Portfolio Construction and Management   459 Introduction   460 ESG Integration: Strategic Asset Allocation Models   460 ESG Integration: Asset Manager Selection   465 Approaches to ESG Integration: Portfolio-Level Framework   468 Approaches to ESG Integration: Role of Analysts, Portfolio Managers, and Internal and External Research   469 Role of Analysts   469 Role of Portfolio Managers   470 Complementing Internal Research with External ESG Resources   471 Measuring Portfolio Carbon Intensity   473 Approaches to ESG Integration: Quantitative Research Developments in ESG Investing   474 The Evolution of ESG Integration: Exclusionary Preferences and Their Application   476 Universal Exclusions   477 Conduct-Related Exclusions   478 Faith-Based Exclusions   478 Idiosyncratic Exclusions   478 Applying Exclusionary Preferences   478 ESG Screening within Portfolios and across Asset Classes: Fixed Income, Corporate Debt, and ESG Bonds   480 Fixed Income (Government, Sovereign, Corporate, and Other)   480 ESG Screening within Portfolios and across Asset Classes: Green Securitization and Sovereign Debt Green Securitization   484 ESG Screening within Portfolios and across Asset Classes: Listed and Private Equity   487  © CFA Institute. 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Contents ix Long–Short, Hedge Fund Equity Strategies   488 Private Equity   489 ESG Screening within Portfolios and across Asset Classes: Real Assets— Real Estate and Infrastructure   491 Integrating ESG Screens in Portfolios to Manage Risk and Generate Returns   495 ESG Integration to Manage Portfolio Risk   495 ESG Integration to Generate Investment Returns   495 Quantitative Approaches That Embed ESG Factors   496 Applying ESG Screenings to Individual Listed and Unlisted Companies and Collective Investment Funds   498 Listed Companies and Collective Investment Funds   498 Unlisted Companies and Collective Investment Funds   502 Managing the Risk and Return Dynamics of an ESG-Integrated Portfolio   503 Full ESG Integration, Exclusionary Screening, and Positive Alignment   505 Full ESG Integration   506 Exclusionary Screening   507 Positive Alignment or Best in Class   507 ESG Strategies, Objectives, Investment Considerations, and Risks: Thematic and Impact Investing   508 Thematic Investing   508 Impact Investing   509 ESG Integration in Index-Based Portfolios and Established Datasets   512 Relying on Established Datasets   515 Key Facts   517 Further Reading   518 References   522 Practice Problems   526 Solutions   531 Chapter 9 Investment Mandates, Portfolio Analytics, and Client Reporting   535 Introduction   535 Accountability to Clients and Alignment with Them   536 Clarifying Client Needs: Defining the ESG Investment Strategy    538 Fully Aligning Investment with Client ESG Beliefs   540 Developing Client-Relevant ESG-Aware Investment Mandates   544 Holding Fund Managers Accountable   544 Evaluating Managers' Investment Strategies   545 The RFP Process   546 Assessing Stewardship and Engagement   548 Investment Integration   549 Engagement and Voting   550 Assessing the Quality of Engagement and Voting   551 Greenwashing and Its Consequence   552 Categories of Misrepresentation   552 Reputational Consequences   553 Using Data to Combat Greenwashing   554 Assessing Indirect and Direct Impacts of Greenwashing   555 Addressing Greenwashing   556  © CFA Institute. For candidate use only. Not for distribution. x Contents Misleading statements   557 Core Greenwashing Characteristics   557 Regulation, Code, Guidelines   558 Tailoring the ESG Investment Approach to Client Expectations   565 Holding Managers to Account: Monitoring Delivery   568 Portfolio-Wide Assessment   573 Holding Managers to Account: Measurement and Reporting   575 Annual Reports   576 Real World Impacts   577 Disclosures   577 Key Facts   579 Appendix: CFA Institute Disclosure Standards and SFDR Disclosures   579 Global ESG Disclosure Standards for Investment Products   579 SFDR Disclosures   580 ESMA Supervisory Briefing on Sustainability   581 Further Reading   582 References   584 Practice Problems   588 Solutions   593  © CFA Institute. For candidate use only. Not for distribution. xi INTRODUCTION This curriculum provides essential reading for candidates of the Certificate in ESG Investing, including examples, key facts and self-assessment questions. Content is valid for examinations taken beginning 1 February 2024. Candidates must confirm that the version of the curriculum they are preparing from corresponds to and is valid for the period when they intend to take the examination. ESG Update Changes will be made as necessary to keep the curriculum up to date. Details of the date of the latest change and of any outstanding corrections or amendments can be found at CFAInstitute.org. Candidates should check the website on a regular basis to ensure their study material is up to date. Curriculum errata are periodically updated and posted by test date online on the Curriculum Errata webpage (www​.cfainstitute​.org/​en/​programs/​submit​-errata). If you believe you have found an error in the curriculum, you can submit your con- cerns through our curriculum errata reporting process found at the bottom of the Curriculum Errata webpage. The exam is made up of one unit, covering the following topic areas: 1. Introduction to ESG Investing 2. The ESG market 3. Environmental factors 4. Social factors 5. Governance factors 6. Engagement and stewardship 7. ESG analysis, valuation and integration 8. Integrated Portfolio Construction and Management 9. Investment mandates, portfolio analytics and client reporting The curriculum provides broad coverage and excellent preparation for the examinations. The Certificate in ESG Investing is developed, administered and awarded by CFA Institute.  © CFA Institute. For candidate use only. Not for distribution. xii FOREWORD BY MARG FRANKLIN At CFA Institute, our long history demonstrates that while many things change in our industry over time, finance will always require highly educated, ethical profes- sionals who pledge to put their clients’ interests first. As an organization, we remain committed to providing financial education that investment professionals need from career entry through to career exit. These efforts speak directly to our mission: to lead the investment profession globally by promoting the highest standards of ethics, education, and professional excellence for the ultimate benefit of society. Investment professionals play a vital role in understanding, analyzing, and ultimately placing value on plans and intentions around environmental, social, and governance (ESG) factors. This idea is not new or novel to us. We have been focused on the impact of ESG considerations for years and have remained steadfast in our commitment to arming investment professionals with the information and tools they need to address it head on. We need to understand the investment implications, both from a risk and oppor- tunity perspective, to ensure we are well prepared to act in the best interest of and at the behest of our clients globally. Since we first globalized the Certificate in ESG Investing, the consistent demand underscores the very need that the Certificate addresses, closing a critical skills gap that persists throughout the investment industry. We’ve seen commitment from asset managers, asset owners, and other investors to offer the Certificate to their staffs, and we applaud these employers for their ability to recognize the benefits of continuing education for practitioners at their firms, for the benefit of their clients. We continue to invest in the curriculum for the Certificate in ESG Investing, applying the same rigorous standards that we apply across our Education portfolio. We are proud of our teams and partners who work tirelessly to interpret, understand, and incorporate the latest concepts into the Certificate in ESG Investing, connecting with practitioners throughout the industry, ensuring that learners are educated on the entire ESG-ecosystem. Thank you to everyone who has played a role in the continued success of the Certificate in ESG Investing. We remain committed to the creation of educational opportunities and resources that equip investment professionals with the tools nec- essary to navigate the complex ESG landscape. Margaret Franklin, CFA President and CEO, CFA Institute  © CFA Institute. For candidate use only. Not for distribution. CHAPTER 1 Introduction to ESG Investing LEARNING OUTCOMES Mastery The candidate should be able to: 1.1.1 define ESG investment and different approaches to ESG investing: responsible investment, socially responsible investment, sustainable investment, best-in-class investment, ethical/values-driven investment, thematic investment, green investment, social investment, shareholder engagement 1.1.2 define the following sustainability-based concepts in terms of their strengths and limitations: corporate social responsibility and triple bottom line (TBL) accounting 1.1.3 describe the benefits and challenges of incorporating ESG in decision making, and the linkages between responsible investment and financial system stability 1.1.4 explain the concepts of the financial materiality of ESG integration, double materiality, and dynamic materiality and how they relate to ESG analysis, practices, and reporting 1.1.5 explain different ESG megatrends, their systemic nature, and their potential impact on companies and company practices 1.1.6 explain the three ways in which investors typically reflect ESG considerations in their investment process 1.1.7 explain the aims of key supranational ESG initiatives and organizations and the progress achieved to date INTRODUCTION There was a time when environmental, social, and governance (ESG) issues were the 1 niche concern of a select group of ethical or socially responsible investors. That time is long gone. The consideration of ESG factors is becoming an integral part of investment man- agement. Asset owners and investment managers are developing ways to incorporate ESG criteria into investment analysis and decision-making processes. The emer- gence of responsible investment proponents, such as the Principles for Responsible Investment (PRI), has encouraged a fundamental change in investment practices whereby investors explicitly employ ESG factor analysis to enhance returns and better  © CFA Institute. For candidate use only. Not for distribution. 14 Chapter 1 Introduction to ESG Investing manage risks. Societal, regulatory, and client pressure and the growing evidence of the direct financial benefits of incorporating ESG analysis have led integration to become more mainstream. This chapter provides an overview of the concept of ESG investing, as well as the different types of responsible investment approaches and their implications. It high- lights the main benefits of integrating ESG factors and identifies ways in which ESG investing is implemented in practice. ESG investing sits within a broader context of sustainability; this chapter also highlights a number of key initiatives in the business and investment communities that seek to assist all parties to navigate the associated challenges. 2 WHAT IS ESG INVESTING? 1.1.1 define ESG investment and different approaches to ESG investing: responsible investment, socially responsible investment, sustainable investment, best-in-class investment, ethical/values-driven investment, thematic investment, green investment, social investment, shareholder engagement ESG investing is an approach to managing assets where investors explicitly incorporate environmental, social, and governance (ESG) factors in their investment decisions with the long-term return of an investment portfolio in mind. Long-Termism and ESG Investing Many investment industry stakeholders, including finance regulators, have recognized the shortfalls of short-termism in investment practice and have sought to increase awareness of the value of long-termism and encourage this approach. Short-termism covers a wide range of activities. For the purpose of this topic, the two most relevant ones are ► trading practices, where investors trade based on anticipation of short-term price movements rather than long-term value, and ► investors engaging with investee companies in a way that prioritizes maxi- mizing near-term financial results, over long-term value creation. These short-term strategies might offer rewards but may have adverse long-term consequences. With its disproportionate focus on immediate returns, short-termism may leave companies less willing to take on projects (such as research and develop- ment) that may take multiple years—and patient capital—to develop. This was indeed confirmed by a review conducted on the UK equity market and long-term decision making by Professor John Kay (2012) for the UK Government. Instead of productive investment in the real economy, short-termism may promote bubbles, financial insta- bility, and general economic underperformance. Furthermore, short-term investment strategies tend to ignore factors that are generally considered more long term, such as ESG factors. Because of the adverse effects mentioned, regulators are catching up and taking action. For example, the Shareholder Rights Directive (SRD) was issued by the European Union (EU) in September 2020, requiring investors to be active owners and to act with a more long-term focus.  © CFA Institute. For candidate use only. Not for distribution. What Is ESG Investing? 15 In other words, ESG investing aims to correctly identify, evaluate, and price social, environmental, and economic risks and opportunities. ESG factors are defined in Exhibit 1. Exhibit 1: ESG Factors Defined Environmental Factors Social Factors Governance Factors Definition Pertain to the natural Affect the lives Involve issues tied world. These include the of humans. The to countries and/or use of and interaction category includes jurisdictions or are with renewable and the management common practice in non-renewable resources of human capital, an industry, as well as (e.g., water, minerals, non-human the interests of broader ecosystems, and animals, local stakeholder groups. biodiversity). communities, and clients. ESG Definition and Scope There is currently no universal standard for what factors are included under the “E,” “S,” and “G” definitions, and they may overlap with one another. For example, animals and animal well-being may be considered in both environmental and social factors. How these factors are split among themselves varies depending on those who are defining them (for example, for an ESG framework) and their stakeholders. Stakeholders are members of groups without whose support an organization would cease to exist (Freeman and Reed 1983), as well as communities impacted by com- panies and regulators. Examples of the definition and scope of ESG issues can be illustrated by Exhibit 2. Exhibit 2: Examples of ESG Topics Environmental Social Governance Climate change Human rights Bribery and corruption Resource depletion Modern slavery Executive pay Waste Health and safety Board diversity and Pollution Working conditions structure Deforestation Employee relations Trade association, lobbying, and donations Tax strategy Source: PRI (2020).  © CFA Institute. For candidate use only. Not for distribution. 16 Chapter 1 Introduction to ESG Investing 3 TYPES OF RESPONSIBLE INVESTMENT 1.1.2 define the following sustainability-based concepts in terms of their strengths and limitations: corporate social responsibility and triple bottom line (TBL) accounting ESG investing is part of a group of approaches collectively referred to as responsible investment. ESG investing is concerned with how ESG issues can impact the long-term return of assets and securities, whereas other responsible investment approaches can also take into account non-financial value creation and reflect stakeholder values in an investment strategy. The main investment approaches are presented in this section to demonstrate the wide spectrum of responsible investment activities. Responsible investment is an umbrella term for the various ways in which investors can consider ESG factors within security selection and portfolio construction. As such, it may combine financial and non-financial outcomes and complements traditional financial analysis and portfolio construction techniques. All forms of responsible investment (except for engagement) are ultimately related to portfolio construction (in other words, which securities a fund holds). The excep- tion of engagement (both by equity owners and bond holders) concerns whether and how an investor tries to influence an issuer’s behavior on ESG matters. There is no standard classification in the industry; the types of responsible investment overlap and evolve over time. Exhibit 3 illustrates some of the conceptual differences between these approaches and how they range from strictly “finance-only” investment, with limited or no con- sideration of ESG factors, to the other end of the spectrum, where the investor may be prepared to accept below-market returns in exchange for the high positive impact the projects and companies in the portfolio can deliver. As investors move toward the left-hand side of the spectrum, they are increasingly interested in aligning their capital with contributing to positive environmental and/or social outcomes. Exhibit 3: A Spectrum of Capital Social impact investing Sustainable & Fully commercial Traditional Venture Social investing Impact investment responsible companies/ philanthropy philanthropy investing investors Adapt Investments with a environmental, Investments with Limited or no focus on social social and Address societal Address societal an intent to have a regard for and/or governance challenges through challenges with social and/or environmental, Focus environmental practices to the provision of venture investment environmental as social or outcomes and enhance value or grants approaches well as a financial governance some expected mitigate practices return practices financial return in order to protect value Social return and Social return and Return Social return sub- market Financial market Financial market Social return only financial market expectation focused financial market rate focused rate only rate rate Social impact Social and financial Financial returns Primary intention Note: For illustrative purposes only. Source: OECD (2019). Used with permission of OECD; permission conveyed through Copyright Clearance Center, Inc.  © CFA Institute. For candidate use only. Not for distribution. Types of Responsible Investment 17 Responsible Investment Responsible investment is a strategy and practice to incorporate ESG factors into investment decisions and active ownership (PRI 2020). It is sometimes used as an umbrella term for some (or all) of the investment approaches mentioned in the fol- lowing subsections. At a minimum, responsible investment consists of mitigating risky ESG practices in order to protect value. To this end, responsible investment encompasses how ESG factors might influence the risk-adjusted return of an asset and the stability of an economy and how investment in and engagement with assets and investees can impact society and the environment. The key investment approaches falling under responsible investment are discusses next. These approaches are not mutually exclusive, and they can be combined into a single portfolio. Socially Responsible Investment Socially responsible investment (SRI) refers to approaches that apply social and envi- ronmental criteria in evaluating companies. Investors implementing SRI generally score companies using a chosen set of criteria, usually in conjunction with sector-specific weightings. A hurdle is established for qualification within the investment universe, based either on the full universe or sector by sector. This information serves as a first screen to create a list of SRI-qualified companies. SRI ranking can be used in combination with best-in-class investment, thematic funds, high-conviction funds, or quantitative investment strategies. Best-in-Class Investment Best-in-class investment (also known as “positive screening”) involves selecting only the companies that overcome a defined ranking hurdle, established using ESG criteria within each sector or industry. ► Typically, companies are scored on a variety of factors that are weighted according to the sector. ► The portfolio is then assembled from the list of qualified companies. Bear in mind, though, that not all best-in-class funds are considered “responsible investments.” Due to its all-sector approach, best-in-class investment is commonly used in investment strategies that try to maintain certain characteristics of an index. In these cases, security selection seeks to maintain regional and sectorial diversification along with a similar profile to the benchmark or target market-cap index while targeting companies with higher ESG ratings. As an example, the MSCI World SRI Index, which is designed to represent the performance of companies with high ESG ratings and uses a best-in-class selection approach to target the top 25% companies in each sector, has characteristics similar but not identical to those of the MSCI World Index. Sustainable Investment Sustainable investment refers to the selection of assets that contribute in some way to a sustainable economy—that is, an asset that minimizes natural and social resource depletion. ► It is a broad term, with a wide range of interpretations that may be used for the consideration of typical ESG issues. ► It may include best-in-class and/or ESG integration, which considers how ESG issues impact a security’s risk and return profile.  © CFA Institute. For candidate use only. Not for distribution. 18 Chapter 1 Introduction to ESG Investing ► It is further used to describe the prioritization of the selection of compa- nies with positive impact or companies that will benefit from sustainable macro-trends. The term “sustainable investment” can also be used to mean a strategy that screens out activities considered contrary to long-term environmental and social sustainability, such as mining or burning coal or exploring for oil in the Arctic regions. Thematic Investment The thematic investment approach in an ESG context is often based on needs arising from environmental or social challenges. Two common investment themes focus on (1) access to low-carbon energy and (2) access to and efficient use of water. Global economic development has raised the demand for energy at the same time as increasing greenhouse gas emissions are negatively affecting the Earth’s climate. Similarly, rising global living standards and industrial needs have created greater demand for water and electricity and the need to prevent drought or increase access to clean drinking water in certain regions of the world. While these themes are based on trends related to environmental issues (refer to the following subsection), social issues—such as access to affordable health care and nutrition, especially in the poorest countries in the world—are also of great interest to thematic investors (refer to the subsequent “Social Investment” subsection. Bear in mind, though, that not all thematic funds are considered to be responsible investments or best-in-class. Becoming such a fund depends not only on the theme of the fund but also on the ESG characteristics of the investee companies. Green Investment Green investment refers to allocating capital to assets that mitigate ► climate change, ► biodiversity loss, ► resource inefficiency, and ► other environmental challenges. These can include ► low-carbon power generation and vehicles, ► smart grids, ► energy efficiency, ► pollution control, ► recycling, ► waste management and waste of energy, and ► other technologies and processes that contribute to solving particular envi- ronmental problems. Green investment can thus be considered a broad subcategory of thematic invest- ing and/or impact investing. Green bonds, a type of fixed-income instrument that is specifically earmarked to raise money for climate and environmental projects, are commonly used in green investing. Further details on green investing and green bonds can be found in Chapter 3. Social Investment Social investment refers to allocating capital to assets that address social challenges. These can be products that address the bottom of the pyramid (BOP). “BOP” refers to the poorest two-thirds of the economic human pyramid, a group of more than four  © CFA Institute. For candidate use only. Not for distribution. Types of Responsible Investment 19 billion people living in poverty. More broadly, BOP refers to a market-based model of economic development that seeks to simultaneously alleviate poverty while providing growth and profits for businesses serving these communities. Examples include ► micro-finance and micro-insurance, ► access to basic telecommunication, ► access to improved nutrition and health care, and ► access to (clean) energy. Social investing can also include social impact bonds, which are a mechanism to contract with the public sector. This sector pays for better social outcomes in certain services and passes on part of the savings achieved to investors. Impact Investment Impact investing refers to investments made with the specific intent of generating positive, measurable social or environmental impact alongside a financial return (which differentiates it from philanthropy). It is a relatively smaller segment of the broader responsible investing market. Impact investing is usually associated with direct investments, such as in private debt, private equity, and real estate. However, in recent years, there is increasing demand from investors on impact investing products in public markets. Impact investments can be made in both emerging and developed markets. They provide capital to address the world’s most pressing challenges. An example is investing in products or services that help achieve one (or more) of the 17 Sustainable Development Goals (SDGs) launched by the United Nations in 2015, such as the following: ► “SDG 6: Clean Water and Sanitation—Ensure availability and sustainable management of water and sanitation for all” ► “SDG 11: Sustainable Cities and Communities—Make cities and human settlements inclusive, safe, resilient and sustainable”1 Measurement and tracking of the agreed-upon impact generally lie at the heart of the investment proposition. Impact investors have diverse financial return expectations. Some intentionally invest for below-market-rate returns in line with their strategic objectives. Others pursue market-competitive and market-beating returns, sometimes required by fidu- ciary responsibility. The Global Impact Investing Network (GIIN) estimated the size of the global impact investing market to be US$502 billion; its 2019 annual survey indicated that 66% of investors in impact investing pursue competitive, market-rate returns (Mudaliar, Bass, Dithrich, and Nova 2019). Ethical (or Values-Driven) and Faith-Based Investment Ethical and faith-based investment refers to investing in line with certain principles, often using negative screening to avoid investing in companies whose products and services are deemed morally objectionable by the investor or certain religions, interna- tional declarations, conventions, or voluntary agreements. Typical exclusions include: ► tobacco, ► alcohol, ► pornography, ► weapons, and  © CFA Institute. For candidate use only. Not for distribution. 20 Chapter 1 Introduction to ESG Investing ► significant breach of agreements, such as the Universal Declaration of Human Rights or the International Labour Organization’s Declaration on Fundamental Principles and Rights at Work. From religious individuals to large religious organizations, faith-based investors have a history of shareholder activism to improve the conduct of investee companies. Another popular strategy is portfolio building with a focus on screening out the neg- ative; in other words, avoiding “sin stocks” or other assets at odds with their beliefs. Next, we cover a few examples of faith-based negative screening. Christian Investors wishing to put their money to work in a manner consistent with Christian values seek to avoid, in addition to the activities listed previously, investing in firms that ► facilitate abortion, contraceptives, or embryonic stem-cell research or ► are involved in the production and sale of weapons. They often favor firms that support human rights, environmental responsibility, and fair employment practices via the support of labor unions. Shari’a In general terms, investors seeking to follow Islamic religious principles have restric- tions around the following: ► investment in firms that profit from alcohol, pornography, or gambling; ► investment in companies that pay interest; ► investments that pay interest; ► liaisons with firms that earn a substantial part of their revenue from inter- est; or ► investment in pork-related businesses. Exhibit 4 shows negative screening strategies for various types of funds. Exhibit 4: Negative Screening Strategies Negative Screening Christian Funds Islamic Funds SRI Funds Alcohol X X X Gambling X X X Tobacco X X Pornography X X Pork products X Interest-based X financial services High leverage X companies Anti-family X entertainment Marriage lifestyle X Abortion X Human rights X X Workers’ rights X X Bioethics X  © CFA Institute. For candidate use only. Not for distribution. Types of Responsible Investment 21 Negative Screening Christian Funds Islamic Funds SRI Funds Weapons X X X Source: Adapted from Inspire Investing (2019). Shareholder Engagement Shareholder engagement reflects active ownership by investors in which the investor seeks to influence a corporation’s decisions on ESG matters, either through dialogue with corporate officers or votes at a shareholder assembly (in the case of equity). It is seen as complementary to the previously mentioned approaches to responsible investment to encourage companies to act in the best interest of stakeholders. Its efficacy usually depends on ► the scale of ownership (of the individual investor or the collective initiative), ► the quality of the engagement dialogue and method used, and ► whether the company has been informed by the investor that divestment is a possible sanction. For further details on the process of engagement, see Chapter 6. ESG investing also recognizes that the generation of long-term sustainable returns is dependent on stable, well-functioning and well-governed social, environmental and economic systems. This is the so-called triple bottom line coined by business writer John Elkington. However, since its inception, the concept of TBL evolved from a holistic approach to sustainability and further into an accounting tool to narrowly manage trade-offs. Therefore, Elkington (2018) “recalled” the term in a Harvard Business Review article. Ultimately, ESG investing recognizes the dynamic interrelationship between social, environmental, and governance issues and investment. It acknowledges that ► social, environmental, and governance issues may impact the risk, volatility, and long-term return of securities (as well as markets) and ► investments can have both a positive and a negative impact on society and the environment. Corporate Social Responsibility The concept of ESG investing is closely related to the concept of corporate sustain- ability. Corporate sustainability is an approach aiming to create long-term stakeholder value through the implementation of a business strategy that focuses on the ethical, social, environmental, cultural, and economic dimensions of doing business (Ashrafi, Acciaro, Walker, Magnan, and Adams 2019. Related to this approach, corporate social responsibility (CSR) is a broad business concept that describes a company’s commitment to conducting its business in an ethical way. Throughout the 20th century and until recently, many companies implemented CSR by contributing to society through philan- thropy. While such philanthropy may indeed have a positive impact on communities, modern understanding of CSR recognizes that a principles-based behavior approach can play a strategic role in a firm’s business model, which led to the theory of TBL. The TBL accounting theory expands the traditional accounting framework focused only on profit to include two other performance areas: the social and environmental impacts of a company. These three bottom lines are often referred to as the three Ps: 1. people, 2. planet, and 3. profit.  © CFA Institute. For candidate use only. Not for distribution. 22 Chapter 1 Introduction to ESG Investing While the term and concept are useful to know, including for historical reasons, they have been replaced in the industry with a broader framework of sustainability that is not restricted to accounting. Effective management of the company’s sustainability can ► reaffirm the company’s license to operate in the eyes of governments and civil society, ► increase efficiency, ► attend to increasing regulatory requirements, ► reduce the probability of fines, ► improve employee satisfaction and productivity, and ► drive innovation and introduce new product lines. ESG investing recognizes these benefits and aims to consider them in the context of security/asset selection and portfolio construction. There are many organizations and institutions contributing to the further explo- ration of interactions between society, environment, governance, and investment. This curriculum focuses on how professionals in the investment industry can better understand, assess, and integrate ESG issues when conducting stock selection, carrying out portfolio construction, and engaging with companies. 4 MACRO-LEVEL DEBATE ON ESG INCORPORATION 1.1.3 describe the benefits and challenges of incorporating ESG in decision making, and the linkages between responsible investment and financial system stability There is a range of beliefs about the purpose and value, both to investors and to society more broadly, of integrating ESG considerations into investment decisions. Some of the main reasons for integrating ESG factors are detailed in this section. It starts with an overview of some important perspectives in the debate on integrating ESG considerations, financial materiality, and challenges in integrating ESG issues and finishes with integration and financial performance. Macro-Level Debate on Integrating ESG Considerations This subsection describes various perspectives from which, over the years, the debate on the purpose and value of integrating ESG factors has been held. These include perspectives of risk, fiduciary duty, economics, impact and ethics, client demand, and regulation. Risk Perspective Evidence of the risks current megatrends carry is illustrated by “The Global Risks Report 2020” (World Economic Forum 2020), which for many years has highlighted the growing likelihood and impact of extreme weather events and the failure to address climate change. Note that Exhibit 5 highlights how risks related to the environment have been significantly increasing in importance in recent years while classic economic risks have disappeared from the top five risks.. Among all global risks, climate now tops the agenda.  © CFA Institute. For candidate use only. Not for distribution. Macro-Level Debate on ESG Incorporation 23 Exhibit 5: Top Global Risks Likelihood Impact 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 Economic Environmental Geopolitical Asset bubble Biodiversity loss Global governance failure Critical infrastructure failure Climate action failure Interstate conflict Deflation Extreme weather National governance failure Energy price shock Human-made environmental State collapse Financial failure disaster Terrorist attacks Fiscal crises Natural disasters Weapons of mass destruction Illicit trade Unemployment Unmanageable inflation Societal Technological Failure of urban planning Adverse technological advances Food crises Cyberattacks Infectious diseases Data fraud or theft Involuntary migration Information infrastructure breakdown Social instability Water crises Source: World Economic Forum (2020). Recognizing the change in profile of key risks to the economy, in 2015, Mark Carney, then governor of the Bank of England and chairman of the Financial Stability Board (the international body set up by the G20 to monitor risks to the financial system), referred to this challenge in a speech that became a cornerstone for the integration of climate change to financial regulators: Climate change is the tragedy of the horizon. We don’t need an army of actuaries to tell us that the catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors—imposing a cost on future generations that the current generation has no direct incentive to fix.... The horizon for monetary policy extends out to two to three years. For financial stability it is a bit longer, but typically only to the outer boundaries of the credit cycle—about a decade. In other words, once climate change becomes a defining issue for financial stability, it may already be too late. (Carney 2015)  © CFA Institute. For candidate use only. Not for distribution. 24 Chapter 1 Introduction to ESG Investing In line with Carney, in his annual letter to chief executives in 2020, Larry Fink, the CEO of BlackRock, stated that the investment firm would step up its consider- ation of climate change in its investment considerations because it was reshaping the world’s financial system (Fink 2020). Concretely, in a parallel letter to its clients, BlackRock (2020) committed to divesting from companies that generate more than 25% of their revenues from coal production for its actively managed portfolios and required reporting from investee companies on their climate-related risks and plans for operating under the goals of the Paris Agreement to limit global warming to less than 2°C (3.6°F). Blackrock’s implementation of the commitment has been ques- tioned: In January 2021 it still held US$85 billion in coal equities, and in 2022, it told a British parliamentary committee that it will not stop investing in coal, oil, and gas. Nonetheless, as the largest asset manager in the world, were BlackRock to deliver on its commitment, it would represent a new paradigm in the investment industry in the mainstream integration of material ESG factors. Prudent investors are engaging with companies to ask them to disclose not only what they are emitting today but also how they plan to achieve their transition to the net-zero world of the future. There is value in being able to spot winners and losers in a rapidly changing risk landscape. Investors that are attempting to take advantage of this usually operate with a longer time frame than the quarterly or one-year time horizon typical for many investors, with the objective of understanding emerging risks and new demands so that they can convert these into above-market performance. While more than one-third (34%) of the world’s largest companies are now committed to being aligned with the Paris Agreement (i.e., committing to being “net-zero” emitters), a study estimated that nearly all (93%) will fail to achieve their goals if they do not at least double the pace of emission reduction by 2030 (Accenture 2022). Lack of ambi- tion and leadership, challenges to secure quality data, and the need to balance carbon reduction with business and social impacts of the transition are all key challenges to companies delivering on their climate-related commitments. According to the report, growing energy price inflation and supply insecurity is pushing commitments even further out of reach. For more details on the benefits and challenges of companies aligning to net zero, refer to Chapter 3. CASE STUDIES Water Depletion Due to Climate Change Companies are already experiencing risks in their manufacturing due to water depletion, which has been aggravated by acute impacts of climate change. Water has largely been considered a free raw material and therefore is used inefficiently, but many companies are now experiencing the higher costs of using the resource, as well as suffering an increasing frequency of extreme weather events. Pacific Gas and Electric Company (PG&E), a listed US utility, was driven to bankruptcy proceedings due to wildfire liabilities (McFall-Johnsen 2019). The company’s equipment led to more than 1,500 fires between 2014 and 2017. As low humidity and strong winds worsen due to climate change, the fire hazard increases. In 2018, a problem with PG&E equipment was deemed to have led to fires that killed at least 85 people, forced about 180,000 to evacuate from their homes, and razed more than 18,800 structures. The Brazilian Aluminium Company (CBA) estimated that the water crisis in the second half of 2021 caused a reduction in its EBITDA of between US$27 million and US$33 million. Hydropower accounts for around 55% of electric- ity generation in Brazil. Water scarcity in the country resulted in shortfalls in hydropower generation, leading to energy shortages and price increases.  © CFA Institute. For candidate use only. Not for distribution. Macro-Level Debate on ESG Incorporation 25 Although CBA generally has the capacity to generate 100% of electricity from its own hydroelectric plants, its reservoirs were also low, requiring it to purchase electricity from the grid at high prices (CBA 2022). In extreme cases, assets can become stranded—in other words, obsolete due to regulatory, environmental, or market constraints. In Peru, for example, social conflict related to disruptions to water supplies has resulted in the indef- inite suspension of US$21.5 billion in mining projects since 2010 (Energy and Mines 2015). There are many ways in which ESG factors can impact a company’s financial results. Nonetheless, identifying those issues that are genuinely material to a sector and company is one of the most active challenges in ESG investment. Each company is unique and faces its own challenges related to its culture, business model, supply chain, and so on. So not only are there substantial differences between sectors, but there are also differences between what is material to individual companies in a sin- gle sector. There are also other factors to consider, such as the growth stage of the company and the geographic location of the operations. For further details on how to assess materiality and what tools are available, refer to Chapters 7 and 8. Fiduciary Duty Perspective For many years, fiduciary duty was considered a barrier to considering ESG factors in investments. In the modern investment system, financial institutions or individ- uals, known as fiduciaries, manage money or other assets on behalf of beneficiaries and investors and have a duty to ensure that they act in their beneficiaries’ interests, rather than serving their own. These best interests are typically defined exclusively in financial terms. The misconception that ESG factors are not financially material has led some investors and regulators to use the concept of fiduciary duty as a reason not to incorporate ESG issues. In 2005, the United Nations Environment Programme Finance Initiative (UNEP FI) commissioned the law firm Freshfields Bruckhaus Deringer to publish a report titled “A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment” (commonly referred to as the Freshfields report). The authors argued that “integrating ESG considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions” (Freshfields Bruckhaus Deringer 2005, p. 13). Despite the conclusions of the report, many investors continue to point to their fiduciary duties and the need to deliver financial returns to their beneficiaries as reasons why they cannot do more in terms of responsible investment. However, an increasing number of academic studies, along with work undertaken on the topic by progressive investment associations, including the UNEP FI and the PRI, have clarified that financially material ESG factors must be incorporated into investment decision making. The Freshfields report (Freshfields Bruckhaus Deringer 2005) and a more recent report published by the PRI (2019) both argue that failing to consider long-term investment value drivers—which include ESG issues—in invest- ment practice is a failure of fiduciary duty. The PRI report concluded that modern fiduciary duties require investors to do the following: ► Incorporate financially material ESG factors into their investment decision making, consistent with the time frame of the obligation. ► Understand and incorporate into their decision making the sustainability preferences of beneficiaries or clients, regardless of whether these prefer- ences are financially material.  © CFA Institute. For candidate use only. Not for distribution. 26 Chapter 1 Introduction to ESG Investing ► Be active owners, encouraging high standards of ESG performance in the companies or other entities in which they are invested. ► Support the stability and resilience of the financial system. ► Disclose their investment approach in a clear and understandable manner, including how preferences are incorporated into the scheme’s investment approach. For further details on fiduciary duty, see Chapter 2. Economic Perspective Another reason for considering ESG issues stems from the recognition that negative megatrends will, over time, create a drag on economic prosperity as basic inputs (such as water, energy, and land) become increasingly scarce and expensive and that the prevalence of health and income inequalities increase instability both within coun- tries and between the “global north and south.” There is an understanding that unless these trends are reversed, economies will be weakened. While this may not have a significant impact on asset managers whose performance is judged by their ability to provide above-market returns, it may considerably affect asset owners, who depend on market returns to pay out pensions and meet their liabilities. As mentioned previously, the Financial Stability Board (FSB) has already identi- fied climate change as a potential systemic risk, which may also be the case for other environmental megatrends The economic implications of these environmental issues (such as climate change, resource scarcity, biodiversity loss, and deforestation) and social challenges (such as poverty, income inequality, and human rights) are increas- ingly being recognized. In fact, the Stockholm Resilience Centre (2015) has identified nine “planetary boundaries” (see Exhibit 6) within which humanity can continue to develop and thrive for generations to come and found that four of them—climate change, loss of biosphere integrity, land-system change, and altered biogeochemical cycles (phospho- rus and nitrogen)—have been crossed. Two of these—climate change and biosphere integrity—are deemed “core boundaries,” for which significant alteration would “drive the Earth system into a new state.”  © CFA Institute. For candidate use only. Not for distribution. Macro-Level Debate on ESG Incorporation 27 Exhibit 6: Stockholm Resilience Centre’s Nine Planetary Boundaries CLIMATE CHANGE FRESHWATER CHANGE Increasing risk Freshwater use Green (Blue water) BIOSPHERE E/MSY water INTEGRITY STRATOSPHERIC OZONE DEPLETION BII erating spac e op e (Not yet quantified) Saf ATMOSPHERIC AEROSOL LAND-SYSTEM LOADING CHANGE (Not yet quantified) NOVEL ENTITIES OCEAN ACIDIFICATION P N BIOGEOCHEMICAL FLOWS Source: Stockholm Resilience Centre (2022). A popular framework that builds on that of planetary boundaries is doughnut eco- nomics, as shown in Exhibit 7. The diagram, developed by economist Kate Raworth, combines planetary boundaries with the complementary concept of social boundaries.  © CFA Institute. For candidate use only. Not for distribution. 28 Chapter 1 Introduction to ESG Investing Exhibit 7: Doughnut Economics Beyond the boundary Boundary not quantified climate change r ye la n ne etio L OG I C A L C EI L I NG ac oc ECO pl id e o ifi oz de c an tio ter food a wa n UN IA L FO DATI O he T gy SO C N SH OO ER er