Chapter 7: ESG Analysis, Valuation and Integration Flashcards
What are investors objectives to integrate ESG into investment process?
or
Which factors incentivize investors to integrate ESG?
- Meeting requirements of FIDUCIARY duties or regulations
- Meeting CLIENT or BENEFICIARIES’ demands
- Lowering investment RISK
- Increasing investment RETURNS-> seeking higher alpha
- Giving investment analysts more TOOLS and TECHNIQUES to use in analysis
- Improve QUALITY OF ENGAGEMENT & STEWARDSHIP activities
- Lowering REPUTATIONAL RISK
What is qualitative ESG analysis?
- Used in investment process that is based on company-specific research, fundamental analysis and stock-picking
○ Investment teams analyze ESG data to form their opinion on the ability of the firm to manage certain ESG issues
○ They combine their opinion with financial analysis by linking specific aspects of the company’s ESG risk management strategy to different value drivers (e.g. costs, revenue etc) - Analysts and portfolio managers then seek to integrate their opinion in a quantified way in their financial model by adjusting assumptions such as growth, margins or costs of capital
What is quantitative ESG analysis?
- Likely to be used in investment process that uses quantitative models to identify attractive investment opportunities
- ESG data is typically aggregated into ESG factor (score) which is added to a quantitative model
- Score could be used to screen or to adjust valuations
What is a fundamental active investment strategy?
- Human judgement is used
- Will tend to use ESG techniques that have both qualitative and quantitative elements
- Not typically considered quantitative investment
What are beta or factor investment strategies?
- Investment class that is often viewed as sitting between fundamental active and passive index tracking
What is meant with active or passive investment?
- How human discretionary or computer algorithm based an investment strategy is
What are elements of ESG analysis?
- Red flag indicators - Securities with high ESG risk flagged to be examined or excluded
- Company questionnaires and management interviews - Checks with outside experts
- Watch lists
- Internal ESG research
- External ESG research
- ESG agenda items at investment committee
- Chief Information Officer (CIO) level meetings
What are elements of internal ESG research?
○ Proprietary ESG research and anlaysis is performed; output can be provided in SCORES, RANKINGS or REPORTS;
Research could consist of:
○ Materiality frameworks
○ ESG-integrated research notes
○ Research dashboards
○ SWOT analysis
○ Scenario analysis
- Relative rankings
What are elements of external ESG research?
○ Sell-side research, ESG specialists or third-party data provider
- Materiality frameworks
What are ELEMENTS of ESG INTEGRATION into investment?
- Adjusting FINANCIAL FORECASTS - for example revenue,
operating costs, capital expenditure - Adjusting VALUATION MODELS or multitudes - for
instance discount rates, ratios - Adjusting CREDIT RISK and DURATION
- Managing RISKS- by limiting exposure, scenario
analysis, value-at-risk models - ESG FACTOR tilts
- ESG MOMENTUM tilts
- STRATEGIC asset allocation
- TACTICAL asset allocation
- ESG CONTROVERSIES and POSITIVE ESG EVENTS
What are the elements of the ESG INTEGRATION FRAMEWORK?
RSP:
- RESEARCH stage - Red flag indicators, watch lists, materiality framework, company survey, voting, SWOT analysis etc
- SECURITY level - Financial forecast, valuation modelling, credit risk etc, relative ranking
- PORTFOLIO level - Asset allocation, tilting, scenario analysis, Value-at risk analysis, weighting, ESG profile
What are differences in company and business analysis and security analysis?
A COMPANY or BUSINESS assessment typically examines fundamental properties of a business:
○ Natural capital (G)
○ Corporate culture or supplier analysis (S)
- Management structure (G)
Stocks and bonds can have properties that companies don’t have, like stock beta or volatility
- Debate whether ESG components that are robust quantitative stock or bond factors
What is materiality assessment?
○ Assessment to identify ESG issues that are likely to have an impact on the company’s performance
○ Measured in terms of likelihood and impact
- Evidence that non-material factors don’t have financial impact
- Distinguished from some exclusionary investment strategies that also consider non-material factors
- Investors who see ESG analysis and integration as a way to enhance investment process are likely to focus on ESG issues that are financially material
- Investors that are interested in the positive and negative impact of companies will focus also on non-material factors
What goes into generating ideas as part of the research and generation stage?
○ Can be helped with a valuation screen
○ Considering ESG megatrends
○ Checklist and Red flags can be used to narrow the investable universe
○ Negative materiality assessment may lead to decision that investment fails hurdle
- Assessment can be quantitative (CO2) or qualitative (management)
Why and how can you develop a scorecard for ESG risk and opportunities?
WHY develop a scorecard?
- Needs to be developed if there is no third party information available that helps with assessment
- Converts qualitative judgment of a factor into a quantative score
- ESG analysis can be quant or qual.. or hybrid. Scorecard is example of hybrid.
I B D A C B - IBD ACB
How to develop scorecard?
1. Identify sector or company specific items
- Breakdown issues into number or indicator
- Determine scoring system based on what is good or bad practice
- Assess a company
- Calculate aggregate scores at issue level etc
- Benchmark
What is risk mapping and how is it used in materiality assessment?
- Individual company or sector has its risk mapped to a specific theme or factors that is judged material
- SASB has developed materiality maps for sectors with material factors for different sectors
○ Risk mapping could also mean mapping a portfolio or investible universe against a specific risk to identify which sectors or companies contribute the most to this particular risk profile
- Mapping can also be done for material opportunities and risks and can be scored to combine scorecard and mapping technique
What is the quantitative aproach to integrated ESG analysis?
- Quantitative factor investors typically integrate ESG factors alongside other factors
- ESG data is included in investment process and could result in upward or downward adjustment of the weights of securities
What approaches to integrated ESG analysis exists?
QST
- Quantitative
- Systematic
- Thematic
What is the systematic appraoch to integrated ESG analysis?
- Systematic approach - attempts to derive correlations to understand how ESG factors impact financial performance
- Passive index - tilting toward ESG, integration of ESG mandate
What is the thematic approach to integrated ESG analysis?
- Assess alignment with priority themes
What factors can change when integrating ESG assessment into valuation?
OR
After research stage & any relevant risk & materiality mapping, what might practitioners adjust with respect to assessing impact of material financial and ESG factors on corporate and investment performance of a company??
○ Forecasted financials
○ Valuation-model variables, such as cost of capital, terminal growth rates in discounted cash flow analysis
- Valuation multiples
○ Forecasted financial ratios
○ Internal credit assessment
- Assumptions in qualitative and quantitative models
CAN’T blanketly adjust return expectation
How can weak or strong ESG complement traditional financial analysis?
Increase or decrease sales margin
Increase or decrease long term cash flow
Increase or decrease intrinsic value
Increase or decrease share price
- SALES MARGIN
- LONG-TERM CASH FLOW
- INTRINSIC VALUE
- SHARE PRICE
What does a high carbon intensity mean for financial analysis?
- Increased risk from carbon tax
- Increased costs or debt from new projects
- Increased balance sheet risk of default on debt
- Change in debt rating
- Lower value of corporate debt
What does weak governance mean for financial analysis?
- Increased risk of negative capital allocation
- Lower future cash flows or difficulty to do IPO
- Lower valuation or increase risk of bankruptcy risk
What are challenges related to ESG disclosure in investment analysis?
- Lack of disclosure could be good indicator of POOR MANAGEMENT
- Poor disclosure is a sign of market inefficiency - could be a source of superior risk-adjusted returns
Why does integration of ESG into bonds differ from equities?
- Equity securities tend not to have issues like credit quality, duration, currency etc, therefore bonds require different integration techniques
- Fixed income investors will often see similar principles in materiality and ESG frameworks, but adapt them
- Opportunity side of ESG may be less relevant for bond investors as the impact of ESG on the ability of a company to pay back its debt obligation are most important
- ESG analysis needs to integrate into credit risk analysis and investment decision
What are the main challenges for ESG integration in investment analysis and decision?
DCMI or DMCI..
- Disclosure and data-related challenges (consistency, scarcity, incompleteness, audited data)
- Comparability (ESG ratings, accounting standards, geographies, culturers, terminology)
- Materiality and judgement challenges (difficult, uncertain, inconsistent)
- ESG Integration across assets (different assets require different strategies)
What are the main criticisms against ESG integration?
TDQP or PTQD or QDPT QuiDProTo
- Too inclusive of poor companies - ESG mutual funds and ETFs often hold investment in companies acknolwedged as ‘bad actors’ in one or more of the ESG spaces
- Dubious assessment criteria - Criteria used for selecting ESG factors are too subjective and can reflect narrow or conflicting ideological or political viewpoints. Non-material factors or socio-political factors might be overemphasized. Materiality assessments might be considered flawed.
- Quality of data - Information used for selecting ESG factors often comes unaudited or unassured from companies themselves. Complicates ability to verify, compare and standardize the info.
- Potential lack of emphasis on long-term improvements - Some financial advisors screen investments first for performance and then for ESG factors. This intial emphasis on performance can exclude companies with high ESG practices that focus on longer-term performance
What could high-correlation between ESG rating mean?
- Could lead to group think - > Credit agencies in 2008
- Could also mean higher credibility and more consistent message
What are potential consequences of lack of correlation between ESG ratings?
- This means that information that investors receive is noisy
- ESG performance is less likely to be reflected in corporate stock or bonds prices, because investors struggle to agree which are the leaders and which are the laggards
- Divergence in ESG ratings also hampers companies ambition to improve ESG performance
- Difference in ratings also poses challenges for empirical research
What are different ESG rating techniques?
- Raw or partially transformed data
- Ratings based on backward looking reported data
- Ratings or information based on internet, third-party and web-reported data
- Aggregators of data or ratings
What should be considered when choosing an ESG rating provider?
- Number of companies covered
- Length of history of dataset
- Language
- Stability of methodology
- Regulatory of updates
What are the limitations of mutual fund manager ratings?
○ Different methodologies (some focus on investment
process, other on holdings)
○ Use of data sources and rating providers
○ Unaudited and limited data sources
○ Time resources to make comparison
- Non-transparent and non-comparable ways ratings are made
What are different types of COMPANY ESG ASSESSMENT and rating approaches?
FODANO
a. Fundamental including risk, business model, policies
and preparedness
b. Operational including carbon impact, water stress and capital managemnet
c. Disclosure-based
d. Algorithm-based
e. News-based
f. Opportunities
In Sustainalytics rating methodology, what does high-risk imply?
- High-risk reflect comparable degree of unmanaged risk
In Sustainalytics rating methodology, what does materiality address?
- Materiality depends on if presence or absence in financial reporting is likely to influence investor decisions
In Sustainalytics rating methodology, what does exposure mean?
-The extent to which a company is exposed to a material risk at the sub-industry level and adjusted at the individual level
