61_PDFsam_365_PDFsam_CFA Institute - 2022 - CFA Certificate in ESG Investing. Curriculum 2023.pdf

© CFA Institute. For candidate use only. Not for distribution. Fixed Income, Credit Rating Agencies, and ESG Credit Scoring Good ESG risk management not only affects asset prices but can also fundamentally protect people’s lives. For instance, no one was injured in the 2013 landslide at a Rio Tinto...

© CFA Institute. For candidate use only. Not for distribution. Fixed Income, Credit Rating Agencies, and ESG Credit Scoring Good ESG risk management not only affects asset prices but can also fundamentally protect people’s lives. For instance, no one was injured in the 2013 landslide at a Rio Tinto mine in Utah. Rio Tinto’s laser scanning system sent early warning signals, enabling a prompt evacuation of the site. However, the 2019 Vale dam failure in Brazil cost many lives. Continuing Evolution for Credit and ESG Since PRI Releases Practice in the area of credit and ESG has evolved in the past few years. By 2020, CRAs were in a different place than when the first observations were made by the PRI in 2016–2017, which was when the PRI’s Statement on ESG in Credit Risk and Ratings29 and its report on CRAs were both released. The PRI statement was designed to commit CRAs and fixed-income investors to incorporate ESG into credit ratings and analysis in a systematic and transparent way. As of May 2022, the statement remains open for investors and CRAs to sign. Global and Regional Credit Rating Agencies There are global and regional CRAs. Historically, ESG analysis was not typically considered by CRAs. But this has changed in recent years. A major evolutionary step was taken by S&P (a global CRA) when it rolled out ESG as part of its credit assessments in 2019. The World Bank also launched its Sovereign ESG database in late 2019. In addition, the IMF launched its Climate Change Indicators Dashboard in April 2021. Surveys from investors suggest that the G factor remains more important to credit investors than E and S. Credit investors argue that this is because downside risk (as in bankruptcy risk and therefore the chance of losing a credit investor’s entire capital) is more important than any upside or opportunity risk. Arguably, opportunity is more important to equity investors. Upside is limited for most credit investors, but downside risk from bankruptcy will hurt returns. Credit investors view fraud prevention and governance as important factors in protecting from downside risk (negative credit events). As G is directly related to preventing downside risk, its direct relevance is easier to trace for credit investors. Many of the challenges are similar to equity ESG ratings. These challenges include: ► the lack of transparency ► inconsistent or changing methodologies ► the use of estimated data ► the lack of comparability through time and between providers and companies The following also give some specific fixed income challenges (see also case studies and discussion of sovereign and fixed income expressions of ESG elsewhere in this chapter): ► time horizon (e.g., three-month paper or 50-year bonds), ► lack of proxy vote, ► different levels of management engagement, and ► unique qualities of sovereign credit. 29 PRI, Statement on ESG in Credit Risk and Ratings (2020). www​.unpri​.org/​credit​-ratings/​statement​ -on​-esg​-in​-credit​-risk​-and​-ratings​-available​-in​-different​-languages/​77​.article. 425 426 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration Corporate Credit Risk Assessments When assessing credit risk, pre-2016 CRAs typically did not attempt to capture the environmental, ethical, or social impact of a bond issue.30 For example, CRAs may have somewhat ignored environmental damage measurements (e.g., CO2 emissions of a company) or environmental opportunities. Before 2016, when analyzing a carbon-intense company, CRAs might have typically focused on other material impacts, including financial, regulatory, and legal factors, that could affect the company’s credit profile. As of 2020, though, many CRAs look at a range of ESG factors (and judge materiality). They judge the company’s response to ESG risks and “ESG events” and link that response to potential financial and balance sheet or cash flow considerations, such as the ability to meet debt obligations. In addition, during 2018–2019, Moody’s and S&P developed further ESG evaluation systems, which continue to evolve today. Typically, CRAs assess the predictability and certainty of an issuer’s ability to generate future cash flow to meet its debt obligations. To this end, they look at whether companies can sell their assets to cover obligations (and certain assets might be impaired through ESG concerns, such as coal assets). The levels of litigation risk are often analyzed as well, including environmental litigation, employment litigation, and human rights violations (e.g., modern slavery laws). To that degree, ESG risk, which comes to litigation, has always been incorporated into CRA analysis. On the quantitative side, CRA analysis focuses on the issuer’s overall bankruptcy risk, the strength of its balance sheet, and how it compares to other issuers. Using standard credit ratio analysis, CRAs might test the following: ► how ESG factors affect an issuer’s ability to convert assets into cash (profitability and cash flow analysis) ► the impact that changing yields—due to an ESG event—could have on the cost of capital, depending on the share of debt used in the issuer’s capital structure (interest coverage ratio and capital structure analysis) ► the extent to which ESG-related costs affect an issuer’s ability to generate profits and add to refinancing risks ► how well an issuer’s management uses the assets under its control to generate sales and profit (efficiency ratios) In summary, a CRA rating is typically ► based on analytical judgment (both quantitative and qualitative), using all the information deemed material by the analysts; ► forward looking, with a varying time horizon; ► composed of dynamic and relative measures; and ► a statement of the relative likelihood of default. An interested fixed-income investor may conduct different materiality assessments or judgments to a CRA (see case studies). This is considered true of equity ESG ratings by many investors as well. Indeed, credit investors typically use the information provided by credit ratings to help them price, trade, and assess the credit risk of fixed-income securities and to determine whether these are suitable investments, but ratings are not the only input. 30 PRI, Shifting Perceptions: ESG, Credit Risk and Ratings (2017). www​.unpri​.org/​credit​-ratings. © CFA Institute. For candidate use only. Not for distribution. Fixed Income, Credit Rating Agencies, and ESG Credit Scoring A combination of investor research, analysis and judgment determines the suitability of a bond investment based on a range of factors, of which credit ratings may be one. Other factors may include proprietary indicators and recommendations by security analysts. It is notable that not all credit will have a rating. With that said, credit ratings have an important role in the credit risk assessment of a bond issue and are typically used to define and limit investment mandates set by a wide range of institutional investors. Many investors in investment grade credit have limited or no ability to invest in high-yield speculative-grade credit, for example. Certain Fixed-Income Investors Use QESGs Certain fixed-income investors use quantitative ESG scores (QESGs) – not to be confused with what investors often mean by quantitative investing (see the section titled “The Different Approaches to Integrating ESG”) – in their fixed income assessments. These QESGs might be based on quantitative data (such as carbon intensity) or be judgments based on data and/or policy (e.g. policy or commitment to align business model to science-based targets). Not all investors use the term and different investors may be referring to different proprietary systems when referring to QESGs. Green Bonds Considered a Different Class of Credit Green bonds (bonds financing green projects) or bonds assessed to meet B-corp criteria are sometimes considered a different class of credit. Once certain ESG or sustainability criteria are met, a green bond’s credit risk is often assessed in the same manner as a standard credit. Typically, a green bond is a fixed-income instrument tied to projects that create an environmental benefit. Issuers use proceeds for a variety of activities aimed at contributing to climate change mitigation, adaptation, or some other environmental benefit, such as conservation or pollution control. Examples include projects associated with renewable energy, public transportation, energy-efficient buildings and manufacturing processes, agricultural land management, waste management, and water management. Often a green bond has some form of verification or assurance from a third-party organization. This organization ensures that the financing meets the criteria set out in the bond, though the covenants related to this will vary by different bonds. Debate continues as to what makes a bond “green” because no global consensus exists on the types of capital projects that fit within the scope of green bonds. There are, however, several frameworks, which may start to standardize with the publication of the EU Green Taxonomy and with the EU Green Bond Standard potentially evolving in 2021.31 Note that B-corporation certification is a private certification issued to for-profit companies by B Lab, a global nonprofit organization that verifies social and environmental performance, public transparency, and legal accountability to balance profit and purpose. 31 European Commission, European Green Bond Standard (2021). https://​ec​.europa​.eu/​info/​business​ -economy​-euro/​banking​-and​-finance/​sustainable​-finance/​eu​-green​-bond​-standard​_en. 427 428 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration Sovereign Credit Risk Assessment A country’s competitiveness, growth and potential growth, governance, and political stability are all important ingredients of prosperity. There are many ESG factors to possibly take into account, including the availability and management of: ► resources (including population trends, human capital, education and health), ► emerging technologies, and ► government regulations and policies. Beyond this though, a CRA is typically most interested in a government’s ability to generate enough revenues to repay its financial debt obligations. Each CRA uses a different framework when assessing sovereign debt, but typically looks at some form of: 1. economic growth; and 2. governance. The ways that E and S factors transmit to economic growth and potential can also be indirect, and the way CRAs assess this is still evolving. The G factor is a more obvious and direct assessment, which has been analyzed historically. On G, each major CRA has a different framework to assess it, so in that sense, this replicates some of the difficulties around equity stock ESG ratings. Also see discussion in the case studies. ESG and Credit Ratings: Discussion over Relationship The link between ESG ratings and credit ratings is still hotly debated among investors. Proponents might point to a Barclays’ study (see Chapter 8) looking at a high ESG portfolio versus a low ESG portfolio using two different ESG datasets (MSCI and Sustainalytics). © CFA Institute. For candidate use only. Not for distribution. Fixed Income, Credit Rating Agencies, and ESG Credit Scoring Exhibit 11: Investment-Grade Bond Portfolio Performance (High ESG over Low ESG) Cumulate performance % of a high-ESG portfolio over a low-ESG portfolio using MSCI ESG data33 5.5 US Investment Grade Europe Investment Grade 4.5 4.0 US Investment Grade 3.5 Europe Investment Grade 3.0 2.5 3.5 2.0 2.5 1.5 1.0 1.5 0.5 0.5 –0.5 Cumulate performance % of a high-ESG portfolio over a low-ESG portfolio using Sustainalytics ESG data 34 0.0 -09 an-10 an-11 an-12 an-13 an-14 an-15 an-16 an-17 J J J J J J J J Jan –0.5 -09 an-10 an-11 an-12 an-13 an-14 an-15 an-16 an-17 J J J J J J J J Jan Source: Barclays (2018).32 The case for sustainable bond investing strengthens, but critics would point out the flaws of correlational studies as well as the short 2009–18 time period. Critics further point out that the factor attributions post-2008/2009 (the financial crisis), and some ESG ratings correlate with quality factors (though not all). Portfolio managers are developing more sophisticated approaches beyond simple ESG tilts. Chapter 8 illustrates some of the ratings distribution features developed by a fixed-income specialist asset manager within its portfolio ESG evaluation framework. The framework uses third-party ESG data but combines the data to produce proprietary ESG metrics for that firm, including a fundamental, absolute-oriented ESG rating and a relative investment ESG score. The internal investment teams can see an ESG risk from the single-issuer level to the portfolio level, which is a value added part of the process. The impact can be seen in the credit default swap (CDS) market as well as on a single-issuer basis, such as with Volkswagen and emissions testing.33 This would be an argument for the impact an ESG event can have on CDS. However, the timing of subsequent CDSs does not perfectly correspond to when all the information was first released. The lag in timing might suggest inefficient markets or the lagged delays that market participants have in assessing material ESG information into CDS prices. The research on ESG and credit is historically less well developed than in equity, but interest continues to grow and techniques are developing, with CRAs recently embedding ESG into their processes. There is some evidence that ESG ratings and 32 Barclays, The Case for Sustainable Bond Investing Strengthens (2018), Sustainalytics data based on the firm’s legacy ESG ratings. www​.investmentbank​.barclays​.com/​content/​dam/​barclaysmicrosites/​ ibpublic/​documents/​our​-insights/​ESG2/​BarclaysIB​-ImpactSeries4​-ESG​-in​-credit​-5MB​.pdf. 33 Multiple sources (including Volkswagen AG), as detailed in P.A. Griffin and D.H. Lont, “Game Changer? The Impact of the VW Emission Cheating Scandal on the Co-Integration of Large Automakers’ Securities” (2016). http://​ssrn​.com/​abstract​=​2838949. 429 430 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration CDSs may have a relationship. Still, the overall principles of gathering ESG data or ratings, assessing material ESG factors, and then embedding them into asset assessment and valuation hold. Potential Bias in Ratings ESG ratings in the credit area could suffer bias as is seen in other asset classes. Three key types of bias are typically encountered: 1. Company size bias, where larger companies might obtain higher ratings because of the ability to dedicate more resources to nonfinancial disclosures. 2. Geographical bias, where a geographical bias exists toward companies in regions with high reporting requirements or some other cultural factor (e.g., higher unionization in Europe). 3. Industry and sector bias, where rating providers oversimplify industry weighting and company alignment. Bias can potentially also be seen in how certain industries (e.g., technology) are assessed in comparison to other industries, or through the lens of other factor labels, such as “growth” or “value.” Key Facts © CFA Institute. For candidate use only. Not for distribution. KEY FACTS 1. Investors integrate ESG techniques to improve investment returns, lower investment risk, meet client needs, and comply with regulatory requirements. 2. A multitude of approaches can be used to integrate ESG analysis into a firm’s investment process. Many approaches can be combined, and some are more suitable to specific asset classes and risks. 3. Quantitative and qualitative approaches can be used at all stages of the investment process, from idea and research generation to asset valuation and portfolio construction. 4. Materiality assessment is an important ESG technique because investors typically distinguish between important, material ESG factors and less important, nonmaterial ESG factors. Nonmaterial factors are considered to not affect investment considerations. 5. Primary ESG data come from direct sources. Secondary ESG information has been transformed or assessed. Investors can use both types of ESG sources in their analysis. ESG data, like all data, need to be interpreted in the correct contexts. 6. ESG rating agencies use a mix of ESG information and proprietary assessments to give ESG ratings to stocks and credits. Current ESG rating agencies have variable correlation between their ESG ratings because of methodological differences. 7. CRAs are increasingly using ESG factors, particularly G, in their credit assessments. This has developed and is expected to continue to develop quickly. 8. Investment consultants and asset owners will use ESG assessment to judge investment managers and as part of their decision criteria. 9. Index providers use ESG factors in establishing ESG indexes. These can be thematic or general. 10. Investors use a range of ESG ratings and techniques, both internally generated and sourced from third parties, to enhance their investment valuation and decision processes. 11. ESG tools and integration techniques continue to develop at a fast pace because of investor and end-customer demand. Conclusion There are many techniques for ESG integration across asset classes, though most investors are aligned in seeking to maximize risk-adjusted returns in using these ESG tools. While certain tools are asset-class specific, the overall framework of identifying material ESG factors and then embedding them in valuation and assessment remains similar. As of 2021, the field remains dynamic, as it has been over recent years, and expert techniques and tools for analysis continue to evolve. 431 432 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration FURTHER READING Reports and standards concerning ESG practice CFA Institute 2017. Global Perceptions of Environmental, Social, and Governance Issues in Investing​.www​.cfainstitute​.org/​en/​research/​survey​-reports/​esg​-survey​-2017. CFA Institute and PRI 2018. Guidance and Case Studies for ESG Integration: Equities and Fixed Income​.www​.cfainstitute​.org/​-/​media/​documents/​survey/​guidance​-case​-studies​-esg​ -integration​.ashx. CFA Institute and the Principles for Responsible Investment 2018. ESG Integration in the Americas: Markets, Practices, and Data. www​.cfainstitute​.org/​en/​research/​survey​-reports/​ esg​-integration​-americas​-survey​-report. Financial Reporting Council 2020. UK Stewardship Code​.www​.frc​.org​.uk/​investors/​uk​ -stewardship​-code. Financial Services Agency 2017. Principles for Responsible Institutional Investors “Japan’s Stewardship Code.” www​.fsa​.go​.jp/​en/​laws​_regulations/​pc​_stewardship​.html. Generation Investment Management 2019. Generation Philosophy​.www​.generationim​.com/​ generation​-philosophy/​. Global Asset Management R. B. C. 2019. RBC Global Equity.http://​global​.rbcgam​.com/​global​ -equities/​default​.fs. PRI 2016. Credit Risk and Ratings Initiative​.www​.unpri​.org/​credit​-ratings. Tuan, M. T. 2008. Measuring and/or Estimating Social Value Creation: Insights into Eight Integrated Cost Approaches. https://​docs​.gatesfoundation​.org/​Documents/​wwl​-report​ -measuring​-estimating​-social​-value​-creation​.pdf. 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. Books and Articles Chatterji, A., D. I. Levine, M. W. Toffel. 2009. “How Well Do Social Ratings Actually Measure Corporate Social Responsibility?” Journal of Economics & Management Strategy18 (1): 125–69. https://​ssrn​.com/​abstract​=​139470410​.1111/​j​.1530​-9134​.2009​.00210​.x Edmans, A. 2011. “Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices.” Journal of Financial Economics101 (3): 621–40. https://​ssrn​.com/​abstract​=​ 98573510​.1016/​j​.jfineco​.2011​.03​.021 Flammer, C. 2013. “Does Corporate Social Responsibility Lead to Superior Financial Performance? A Regression Discontinuity Approach.” Journal of Economic Literature27. https://​ssrn​.com/​abstract​=​2146282 Haskel, J., S. Westlake. 2017. Capitalism Without Capital: The Rise of the Intangible Economy. Princeton University Press. 10.2307/j.ctvc77hhj Khan, M., G. Serafeim, A. Yoon. 2016. “Corporate Sustainability: First Evidence on Materiality.” Accounting Review91 (6): 1697–724. https://​ssrn​.com/​abstract​=​257591210​.2308/​accr​ -51383 Krosinsky, C. 2018. “The Failure of Fund Sustainability Ratings.” Medium.com. https://​medium​ .com/​@​cary​_krosinsky/​the​-failure​-of​-fund​-sustainability​-ratings​-bea95c0b370f. OECD 2017. Responsible Business Conduct for Institutional Investors: Key Considerations for Due Diligence Under the OECD Guidelines for Multinational Enterprises.https://​ mneguidelines​.oecd​.org/​RBC​-for​-Institutional​-Investors​.pdf. PRI 2014. A GP’s Guide to Integrating ESG Factors in Private Equity​.www​.unpri​.org/​private​ -equity/​a​-gps​-guide​-to​-integrating​-esg​-factors​-in​-private​-equity/​91​.article. Appendix © CFA Institute. For candidate use only. Not for distribution. APPENDIX This appendix provides further information on Sustainalytics and its ESG products as well as MSCI Research. This content will not be assessed. It is provided to give more insight into two major rating providers’ methodology but does not suggest that these are the only ways in which ESG ratings can be performed. Sustainalytics and Its ESG Products ► Sustainalytics is an ESG and corporate governance research and rating provider. As of 2018, it was considered a top-three provider of ESG ratings, and in 2020, it was acquired by Morningstar. It has strategic partnerships with: ► Morningstar; ► Glass Lewis (proxy adviser); ► STOXX (index provider); and ► since 2018, FTSE Russell (index provider). It has several products ranging from compliance and screening, index research, portfolio analysis, carbon and country risk research to ESG integration research. The Sustainalytics’ ESG Risk Rating The Sustainalytics’ ESG Risk Rating measures the degree to which a company’s economic value is at risk driven by ESG factors or, more technically speaking, the magnitude of a company’s unmanaged ESG risks. The rating system gives points for specific risk factors. Each point of risk is equivalent, no matter which company or issue it applies to. Points will add up across issues to create overall scores, which are then rated. The rating sorts companies into five risk categories: 1. Negligible 2. Low 3. Medium 4. High 5. Severe These risk categories are absolute, meaning that a “high” risk assessment reflects a comparable degree of unmanaged ESG risk across the research universe, whether it refers to an agriculture company, a utility, or any other type of company. According to Sustainalytics, an issue is considered “material” within the ESG Risk Rating if its presence or absence in financial reporting is likely to influence the decisions made by a reasonable investor. To be considered “relevant” in the risk rating, the issue must have a potentially substantial impact on the economic value of a company and, hence, the financial risk and return profile of an investor investing in the company. Distinguishing the ESG Risk Rating’s use of materiality as a concept from narrower legal or accounting-focused definitions is important Not every issue Sustainalytics considers “material” in the rating is legally required to be disclosed in company reporting. Some issues are “material” from an ESG perspective, even if the financial consequences are not fully measurable today. 433 434 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration The ESG Risk Rating’s emphasis on materiality incorporates an additional dimension—the exposure dimension. It reflects the extent to which a company is exposed to material ESG risks identified at the industry level and affects the overall rating score for a company as well as its rating score for each material ESG issue. ESG issue risk exposure is estimated at the sub-industry level and further adjusted at the individual company level. The ESG Risk Rating’s second dimension is management. ESG management can be considered a set of company commitments and actions that demonstrate how a company approaches and handles an ESG issue through policies, programs, quantitative performance. and involvement in controversies, as well as its management of corporate governance. Sustainalytics considers management in the ESG Risk Rating because company commitments and actions provide signals about whether companies are managing ESG risks. Unmanaged Risk: How Sustainalytics Arrives at the Scores The ESG Risk Rating scoring system for a company is best thought of as occurring in three stages on the issue level: 1. the starting point is exposure, 2. the next stage is management, and 3. the final stage is calculating unmanaged risk, using the concept of risk decomposition. The final ESG Risk Rating score is a measure of unmanaged risk. This is defined as material ESG risk that has not been managed by a company. As noted in the subsection titled “Materiality Assessments and Risk Mapping”, it includes two types of risk: 1. Unmanageable risk, which cannot be addressed by company initiatives 2. The management gap, which represents risks that could be managed by a company through suitable initiatives but which may not yet be managed The share of risk that is manageable versus the share of risk that is unmanageable on a material ESG issue is predefined at a sub-industry level by a manageable risk factor. Every material ESG issue has an issue manageable risk factor (MRF), ranging from 30% (indicating that a high level of the issue risk is unmanageable) to 100% (indicating that the issue risk is considered fully manageable). Calculating the Final Unmanaged Risk Score The assessment of unmanaged risk (the final ESG Risk Rating score) requires three steps: 1. Assess the share of the overall exposure of companies and compare to a material ESG issue in a given sub-industry that can be managed by a company (manageable risk assessment). 2. At the company level, the degree to which a company has managed the manageable risk portion of its overall exposure, with regard to an issue being calculated based on the management assessment (overall management score assessment). 3. Finally, the unmanaged risk score is calculated by subtracting managed risks from a company’s overall exposure score in relation to a material ESG issue (final unmanaged risk score calculation). © CFA Institute. For candidate use only. Not for distribution. Appendix Exhibit 12 shows how the companies Sustainalytics has used for testing and validation are allocated across the five ESG risk categories that were defined for the ESG Risk Rating. Exhibit 12: Allocation of Companies Across ESG Risk Categories (January 2020) Software Company Risk Score 12.6 1000 894 900 Number of Companies 885 767 800 Oil and Gas Company 700 590 600 Risk Score 59.9 500 400 327 296 300 185 200 100 0 Risk Score Risk Category 44 2 0–5 5–10 Negligible 10–15 15–20 Low 20–25 25–30 30–35 Medium 35–40 40–45 High 99 91 45–50 >50 Severe Car Manufacturer Risk Score 28.7 Source: Sustainalytics (2020).34 Further details on how research looks at materiality, governance, and idiosyncratic issues can be found in Further Reading. MSCI ESG Research According to the MSCI ESG Rating, ESG risks and opportunities are posed by large-scale trends (e.g., climate change, resource scarcity, or demographic shifts) and the nature of the company’s operations. The MSCI considers a risk or an opportunity to be material to industry as follows: ► A risk is material to an industry when companies in a given industry are likely to incur substantial costs in connection with it (e.g., a regulatory ban on a key chemical input). ► An opportunity is material to an industry when companies in a given industry could likely capitalize on it for profit (e.g., opportunities in clean technology for the LED lighting industry). Note that this definition of “materiality” is different from that of Sustainalytics but is still a judgment (and might differ from other investors’ judgments). MSCI assesses material risks and opportunities for each industry through a quantitative model that compares ranges and average values in each industry for externalized impacts (e.g., carbon intensity, water intensity, and injury rates). Exceptions are 34 Sustainalytics, Our Solutions (2019). www​.sustainalytics​.com/​our​-solutions. 435 436 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration Chapter 7 allowed for companies with diversified business models or that are facing controversies, or based on industry rules. Once identified, these “key issues” are assigned to each industry and company. Exhibit 13 summarizes the MSCI ESG hierarchy (note the overlaps with, but also differences from, the SASB mapping seen in Exhibit 6. Exhibit 13: MSCI ESG Hierarchy 3 Pillars 10 Themes Environment 37 ESG Key Issues Emissions Climate change Financing environmental impact Product carbon footprint Climate change vulnerability Water stress Natural resources Biodiversity and land use Raw material sourcing Toxic emissions and waste Pollution and waste Packaging material and waste Electronic waste Opportunities in clean tech Opportunities Opportunities in green building Opportunities in renewable energy Social Labor management Human capital Health and safety Human capital development Supply chain labor standards Product safety and quality Chemical safety Product liability Financial product safety Privacy and data security Responsible investment Health and demographic risk Stakeholder opposition Controversial sourcing Access to communications Social opportunities Access to finance Access to health care Opportunities in nutrition and health Appendix © CFA Institute. For candidate use only. Not for distribution. 3 Pillars 10 Themes 437 37 ESG Key Issues Board Governance Pay Corporate governance Ownership Accounting Business ethics Anti-competitive practices Corporate behavior Tax transparency Corruption and instability Financial system instability Source: MSCI (2019).35 Final MSCI ESG Ratings are derived by the weighted averages of the key issue scores. These scores are aggregated, and companies’ scores are normalized by their industries. After any overrides are factored in, each company’s final industry-adjusted score corresponds to a rating between the best (AAA) and the worst (CCC). These assessments of company performance are not absolute but are explicitly intended to be relative to the standards and performance of a company’s industry peers. MSCI ESG Risk Score MSCI argues that to understand whether a company is adequately managing a key ESG risk, it is essential to understand both: ► what management strategies it has employed (i.e. risk management); and ► how exposed it is to the risk (i.e. risk exposure). The MSCI ESG Ratings model attempts to measure both of these. For MSCI to score a company highly on a key issue, the management needs to be judged commensurate with the level of exposure: ► a company with high exposure must also have very strong management, but ► a company with limited exposure can have a more modest approach. The risk exposure and management scores are combined so that a higher level of exposure requires a higher level of demonstrated management capability in order to achieve the same overall key issue score. Key issue scores are also on a 0 to 10 scale, where 0 is very poor and 10 is very good. MSCI ESG Opportunity Score The assessment of MSCI ESG opportunities works similarly to risks, but the model for combining exposure and management differs: ► exposure indicates the relevance of the opportunity to a given company based on its current business and geographic segments, and ► management indicates the company’s capacity to take advantage of the opportunity. 35 MSCI, MSCI ESG Ratings Methodology: Executive Summary, September 2019 (2019). www​.msci​ .com/​documents/​1296102/​14524248/​MSCI+​ESG+​Ratings+​Methodology+​-+​Exec+​Summary+​2019​.pdf. 438 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration Where exposure is limited, the key issue score is constrained toward the middle of the 0 to 10 range, while high exposure allows for both higher and lower scores. MSCI Controversy Assessment MSCI ESG Ratings also reviews controversies, which may indicate structural problems with a company’s risk-management capabilities. As noted earlier in this chapter, a controversy case is defined as an instance, or ongoing situation, in which company operations or products allegedly have a negative environmental, social or governance impact. EXAMPLE 6 Controversy Cases The ESG rating model is applied to two controversy cases: 1. A case that is deemed by an analyst to indicate structural problems 2. A case that is deemed to be an indicator of recent performance, but that does not offer clear signals of future material risk The rating system finds that Case 1 poses future material risks for the company and therefore triggers a larger deduction from the key issue score than Case 2. MSCI Data Sources These data sources that MSCI ESG Ratings use are similar to what Sustainalytics and other in-house teams might use, including the following: ► macro data at the segment or geographic level from academic, government, and NGO datasets ► company disclosure (e.g., annual report filings, sustainability report, proxy report, or annual general meeting results) MSCI Final Letter Rating Summary To arrive at a final letter rating, the weighted average key issue score is normalized by industry. The range of scores for each industry is established annually by taking a rolling three-year average of the top and bottom scores among the MSCI ACWI Index constituents; the values are set at the 97.5th and 2.5th percentile. Using these ranges, the weighted average key issue score is converted to an industry-adjusted score from 0 to 10, where 0 is worst and 10 is best. The industry-adjusted score corresponds to a rating between best (AAA) and worst (CCC). MSCI ESG Research MSCI is historically most well-known for its market index products, but it also provides ESG and corporate governance research and ratings, a index and fund research. As of 2018, it was considered a top-three provider of ESG ratings. Like Sustainalytics, it has several products ranging from compliance and screening, index research, portfolio analysis, and carbon risk research to ESG integration research. MSCI has the intellectual property from legacy companies KLD, Innovest, IRRC, and GMI (Governance Metrics International) Ratings. © CFA Institute. For candidate use only. Not for distribution. Self Practice and Self Assessment SELF PRACTICE AND SELF ASSESSMENT 1. Which of the following is an objective for integrating ESG into an investment process? Lowering: a. reputational risk. b. quality of engagement activities. c. risk-adjusted investment returns. 2. Tools of ESG analysis include: a. ESG factor tilts. b. red flag indicators. c. ESG momentum tilts. 3. Elements of ESG integration include: a. watch lists. b. scenario analysis. c. ESG momentum tilts. 4. The typical stages of an integrated ESG assessment are: a. research, valuation, and portfolio construction. b. materiality assessment, risk mapping, and valuation. c. materiality assessment, risk mapping, and portfolio construction. 5. ESG risk mapping refers to: a. positive or best-in-class screening. b. testing a portfolio against different climate scenarios. c. identifying the ESG issues that are likely to have an impact on the company’s financial performance 6. Weak governance identified in a private company mostly likely leads to higher: a. valuation. b. future cash flows. c. risk of negative capital allocation decisions. 7. High carbon intensity of a project most likely leads to lower: a. valuation. b. cost of debt. c. risk of default on debt. 8. Which of the following is an example of an ESG-integrated valuation adjustment? Upward adjustment in: a. sales growth due to high employee engagement. b. valuation due to weak governance of a company. c. cost of debt for new project financing with low carbon intensity. 9. Which of the following is a criticism of ESG integration? a. Rapid advances in ESG integration techniques b. ESG screening emphasizes longer-term performance 439 440 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration c. ESG investment strategy being too inclusive of poor companies 10. Which of the following best describes the relationship between ESG and credit ratings? a. ESG and credit ratings are positively correlated. b. The link between ESG ratings and credit ratings is still hotly debated among credit investors. c. Surveys from credit investors suggest that S factor remains more important than E and G factors. The following information relates to questions 11-25 Self Assessment Questions These questions are provided only to enable you to test your understanding of the chapter content. They are not indicative of the types and standard of questions you may see in the examination. The Self-Assessment questions do not include an explanation of the correct answer. 11. Qualitative ESG analysis is likely to be used in investment processes that are based on: a. company-specific research. b. fundamental analysis. c. stock picking. d. all of the above. 12. Qualitative analysts and portfolio managers seek to integrate their qualitative investment opinion by incorporating: a. negative screening. b. quantitative adjustments to financial models and valuations. c. qualitative measures only. d. none of the above. 13. Elements of ESG integration include: a. ESG factor tilts. b. red flag indicators. c. company questionnaires and management interviews. d. watch lists. 14. Which of these statements is not true? a. The ESG integration framework is not meant to illustrate the perfect ESG-integrated investment process. b. The ESG integration techniques of one firm are not necessarily the right techniques for all firms. c. There is a consensus amongst firms on which techniques to use to identify and assess ESG factors d. Every firm is unique and will use a selection of the techniques referenced in the ESG Integration Framework. 15. In relation to materiality assessment, which of the following is correct? a. The materiality assessment is typically contained in the valuation stage. © CFA Institute. For candidate use only. Not for distribution. Self Practice and Self Assessment b. Materiality is measured in terms of likelihood and magnitude of impact on a company’s financial performance. c. Evidence that non-material factors impact financials, valuations, and company business models. d. Ethical or impact investors judge material factors affecting social, environmental, and maximum financial returns. 16. Which of the following best represents the chronological order for ESG scorecard development? a. Approach a) Step 1 Determine a scoring system based on what good or best practice looks like for each indicator or issue. Step 2 Assess a company and give it a score. Step 3 Identify sector- or company-specific ESG items. Step 4 Benchmark the company's performance against industry averages or peer group. Step 5 Calculate aggregated scores at issue level, dimension level, or total score level. Step 6 Break down issues into a number of indicators. b. Approach b) Step 1 Determine a scoring system based on what good or best practice looks like for each indicator or issue. Step 2 Break down issues into a number of indicators. Step 3 Assess a company and give it a score. Step 4 Identify sector- or company-specific ESG items. Step 5 Calculate aggregated scores at issue level, dimension level, or total score level. Step 6 Benchmark the company's performance against industry averages or peer group. c. Approach c) Step 1 Identify sector- or company-specific ESG items. Step 2 Break down issues into a number of indicators. Step 3 Determine a scoring system based on what good or best practice looks like for each indicator or issue. Step 4 Assess a company and give it a score. Step 5 Calculate aggregated scores at issue level, dimension level, or total score level. Step 6 Benchmark the company's performance against industry averages or peer group. d. Approach d) Step 1 Identify sector- or company-specific ESG items. Step 2 Assess a company and give it a score. Step 3 Break down issues into a number of indicators. Step 4 Determine a scoring system based on what good or best practice looks like for each indicator or issue. 441 442 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration Step 5 Calculate aggregated scores at issue level, dimension level, or total score level. Step 6 Benchmark the company's performance against industry averages or peer group. 17. Which of these is not an ESG-integrated valuation technique? a. Adjusting sales growth assumptions due to weak employee engagement scores b. Adjusting cost of capital due to poor governance ratings c. Adjusting cash flows due to cash tax adjustments d. Changing fair value price/earnings (PE) ratio due to strong sustainability scores 18. An analyst assesses a company as below average on ESG metrics. All other matters being equal, she is most likely to: a. give a PE premium to the stock. b. increase the company’s cost of capital. c. increase the terminal growth rate assumption in a DCF model. d. reduce the risk of default in her forecast models. 19. This question relates to the case study focusing on the beverages company. Which of the following are examples of material environmental factors that should be considered? a. Talent retention, recruitment strategy. b. Water efficiency, greenhouse gas emissions (GHG). c. Supplier code-of-conduct protocols, product mix. d. Human rights strategy, anti-bribery policy. 20. The aims and objectives for integrating ESG into an investment process may include: a. Meeting requirements under Principles for Responsible Investment (PRI) regulations. b. Increasing reputational risk at a firm and investment level. c. Meeting internal audit demands. d. Improving the quality of engagement and stewardship activities, and increasing investment returns. 21. Disclosure and data-related challenges for ESG integration include: a. data consistency. b. data scarcity. c. data incompleteness and lack of audited data. d. all of the above. 22. Which of the following is NOT used by a fixed-income practitioner when evaluating ESG aspects? a. Bankruptcy risk b. Proxy voting c. Negative credit events d. Time horizons © CFA Institute. For candidate use only. Not for distribution. Self Practice and Self Assessment 23. Which of the following best represents factors least considered by CRAs? a. Bankruptcy risk, standard credit ratio analysis, litigation risk b. Bankruptcy risk, litigation risk, human capital risk c. Environmental risk, religious or ethical risk d. Environmental risk, standard credit ratio analysis, governance risk 24. Which of the following factors is generally considered the most important when evaluating ESG considerations around sovereign debt? a. Environmental factors b. Social factors c. Governance factors d. Human capital factors 25. Which of the following statements best describes a green bond? a. Bonds that finance green projects b. Bonds that meet certain ratings criteria c. Bonds that get the green light based on governance guidelines d. Bonds that are evergreen and roll on for a specified duration 443 444 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration SOLUTIONS 1. A is correct. An investment firm might have several different aims and objectives for integrating ESG into an investment process. These can include the following: ► 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 ► lowering reputational risk at a firm level and investment level 2. B is correct. Regardless of the ESG analysis classification as qualitative or quantitative, there are many types of tools used by investors. These tools of ESG analysis may include: ► red flag indicators ► company questionnaires and management interviews ► checks with outside experts ► watch lists ► internal ESG research ► external ESG research 3. C is correct. The elements of ESG integration include the following: ► adjusting forecast financials ► adjusting valuation models or multiples ► adjusting credit risk and duration ► managing risk ► ESG factor tilts ► ESG momentum tilts ► strategic asset allocation ► tactical asset allocation ► ESG controversies and positive ESG events 4. A is correct. Firms and investment teams might not have ESG factors embedded in their philosophy but still use ESG techniques within investment processes. These can run alongside a financial analysis or have integrated aspects to the analysis. The typical stages of an integrated ESG investment are ► a research stage, ► a valuation stage, and ► a portfolio construction stage, which leads to investment decisions. 5. B is correct. Risk mapping means mapping a portfolio or investable universe against a specific ESG risk (e.g., climate risk or water-related risks). Examples of risk-mapping methodologies include carbon footprinting or testing portfolios against different climate scenarios. Solutions © CFA Institute. For candidate use only. Not for distribution. 6. C is correct. Weak governance identified in a private company (proved by board with poor skills, not independent, non-diversified thinking): ► increased risk of negative capital allocation decisions ► lower future cash flows or difficulty in initial public offering (IPO) to capital markets ► lower valuation or increased bankruptcy risk 7. A is correct. The judgment of an E factor, such as exposure to carbon, leads to analysis on the risk to debt pricing. It complements a traditional take on default risk. High carbon intensity: ► increased risk from carbon taxes ► increased cost of debt for new project financing ► higher taxes ► increased balance sheet risk of default on debt ► change in debt rating ► lower value of corporate debt 8. A is correct. Practitioners assess the impact of material financial and ESG factors on the corporate and investment performance of a company and make adjustments to: ► forecasted financials ► valuation-model variables (e.g., cost of capital or terminal growth rates in DCF analysis) ► valuation multiples ► forecasted financial ratios ► internal credit assessments ► assumptions in qualitative or quantitative models Rather than changing model discount assumptions, explicit sales or margin assumptions may also be adjusted. For example, an analysis of a company’s strong management of its employees (as assessed by employee engagement or satisfaction metrics) leads to an assessment of strong future customer satisfaction, which in turn leads to sales forecasts five years out being raised to above the industry average to account for this strong social factor score. 9. C is correct. One of the most common criticisms of ESG investing is the difficulty for investors to correctly identify, and appropriately weigh, ESG factors in investment selection. Critics express concerns about the precision, validity, and reliability of ESG investment strategies. One concern is of ESG mutual funds and exchange-traded holding investments in companies that may be acknowledged as “bad actors” in one or more of the ESG spaces. 10. B is correct. The ways that E and S factors transmit to economic growth and potential can also be indirect, and the way CRAs assess this is still evolving. The G factor is a more obvious and direct assessment, which has been analyzed historically. The link between ESG ratings and credit ratings is still hotly debated among investors. Proponents might point to a Barclays’ study looking at a high ESG portfolio versus a low ESG portfolio using two different ESG datasets (MSCI and Sustainalytics). The case for sustainable bond investing strengthens, but critics would point out the flaws of correlational studies as well as the short 2009–18 time period. Critics further point out that the factor attributions post-2008/2009 445 446 Chapter 7 © CFA Institute. For candidate use only. Not for distribution. ESG Analysis, Valuation, and Integration (the financial crisis) and some ESG ratings correlate with quality factors (though not all). 11. D is correct. 12. B is correct. 13. A is correct. 14. C is correct. 15. B is correct. 16. C is correct. 17. C is correct. 18. B is correct. 19. B is correct. 20. D is correct. 21. D is correct. 22. B is correct. 23. C is correct. 24. C is correct. 25. A is correct.