Chapter 7 Flashcards
(76 cards)
1
Q
Give examples of qualitative ESG analysis:
A
- The presence and quality of issuer reporting on ESG-related topics, such as employee engagement, pay equity, accident and safety, management and board diversity, and carbon emission
- The presence and credibility of investments, policies, and commitments to ESG-related goals, such as a net-zero commitment and a board-level committee on sustainability.
- Executive compensation policies linked to progress on ESG-related goals.
- Company culture, including the “tone at the top” from management and the board, and whether progress on ESG issues is a priority
- Companies’ products and services and their broad effect on society and the nonhuman world, which may be subjective but highly relevant
2
Q
Give an examples of an indicator of qualtiv of issuer reporting
A
- An issuer’s use of a broadly accepted reporting framework e.g. International Sustainability Standards Board (ISSB).
2. If ESG reporting is audited
3
Q
What discretion and judgment is needed for qauntitative ESG analysis?
A
- Choice of which data to examine
- Materiality
- Weights relative to other data
- Points of reference - selection of peers for comparison
4
Q
Give examples of Quantitative ESG Analysis
A
- Analyzing issuer-reported and third-party ESG-related measures and metrics, such as carbon emissions, employee turnover, percentage of board members who are independent, and board and management diversity - assess against expectation, peers and commitments
- Aggregating ESG data into an ESG score, which is then considered as a factor in an asset allocation or security selection model (alongside other factors, such as value, size, momentum, growth, and volatility).
- Using ESG data for position sizing in a portfolio
- Tilting toward certain ESG factors in index-based strategies: e.g. Japanese Government Pension Investment Fund (GPIF) created gender-tilted versions of broad market indexes.
5. Thematic funds might assess alignment with priority themes that are ESG related (e.g., climate, gender) - By material opportunity mapping process or using ESG data to adjust weights
5
Q
What does ESG data typically include?
A
- A mix of a third-party and internal proprietary data
- come from large datasets of securities, rather than individual issuers, though some firms will create their own proprietary scores from individual company assessment.
6
Q
When is QESG used and when is blended approach?
A
- QESG: more systematic investment strategies including index-based strategies
- Blended: fundamental analyses particularly focused on security selection within a concentrated portfolio.
- Blended: where data is scarce or where intangible non-quant concerns require experience and judgement
7
Q
Give some examples of Al in ESG investing
A
- Quickly measuring companies’ ESG performance and risk using incidents reported across many sources online
- Efficiently interpreting satellite imagery with machine learning to assess issuers’ carbon footprints, impact on the natural environment (e.g. deforestation), and use of proceeds from green bonds.
- Helping to close data gaps in issuer disclosures e.g. a model that estimates issuer’s Scope 3 carbon emissions
8
Q
How do investors bring qualitative and quantitative analyses together?
A
- Scorecard: turns qualitative judgements into quantitative scores
- Adjusting financial model inputs (e.g., revenue, profitability, capital expenditures, discount rate, valuation multiples) based on an assessment of the company’s ESG risk factors
9
Q
Besides analyzing issuer-reported and third-party ESG reports and metrics, what other tools do investors use in ESG analysis?
A
- Red flag indicators
- Company questionnaires and management interviews
- Checks with outside experts
- Watch lists
10
Q
What are red flag indicators?
.
A
- Securities with high ESG risks are flagged and investigated further or excluded.
11
Q
What are company questionnaires and management interviews?
A
- if the detail insufficient, the investor might ask the company for specific data.
- Or investors might have a predefined list of standard ESG data they ask for.
- These questionnaires are also used in parallel with regular company meetings
12
Q
What are watch lists?
A
- These lists might include securities with high ESG risk added to a watchlist for monitoring
- securities with high ESG opportunities that are put on a watchlist for possible investment.
13
Q
What are some challenges in ESG integration?
A
- ESG disclosures by issuers
- Subjective nature of ESG analysis and decision making
- Cultural challenges and biases within investment management firms
14
Q
How many countries and regions have ESG disclosure mandates?
A
- 35
- Australia, China, South Africa, and the United Kingdom.
15
Q
What are the ESG reporting frameworks being developed?
A
- EFRAG : EU
2. ISSB: Global
16
Q
What did the IFRS Foundation achieve in its first two decades?
A
- Harmonized financial reporting standards globally through IFRS Accounting Standards -
IASB
17
Q
What are the ISSB standards based on?
A
- Recommendations from the Task Force on Climate-Related Financial Disclosures (TCFD) and materials from Climate Disclosure Standards Board CDSB, SASB, and International Integrated Reporting Council IIRC.
18
Q
Describe IFRS S2:
A
- sets out disclosure of material information about climate-related risks and opportunities, incorporating TCFD recommendations and climate-related industry-based requirements of the SASB Standards.
- It requires disclosure of material information about physical risks, transition risks, and climate-related opportunities.
- Sets requirements for disclosures around transition planning, climate resilience, and Scope 1, 2, and 3 emissions in accordance with the GG Protocol.
19
Q
What are the 4 primary concerns of critics about the precision, validity and reliability of ESG investment strategies
A
- Too inclusive of poorly performing companies e.g. oil and gas should do exclusionary
- Subjective assessment criteria SO should have manager aligned to own criteria
- Quality of data SO corroborate with multiple sources
- Scepticism of return benefits
20
Q
Describe why critics have ‘Skepticism of return benefits.’ of ESG investment:
A
- Some believe the time horizon for assessing ESG factors is too short and point to time periods during which sectors that tend to be excluded (e.g., tobacco, energy, defense) outperform.
- Second, increased crowding into more ESG-friendly sectors (e.g., technology, health care) increases valuations, reducing those sectors’ expected returns while increasing it for others, which presents a challenge for realizing robust financial returns.
- Third, there are complications surrounding performance attribution of ESG factors and financial performance that make any such claims questionable
21
Q
What are the Investment Process Stages?
A
- Idea generation
- Materiality Assessments and Information Gathering
- Forecasting and Valuation
- Investment Decision and Post-monitoring
22
Q
How are companies excluded at the idea generation stage?
A
- Checklists might red flag companies and be used to narrow the investable universe
- Threshold for corporate governance or unacceptable ESG score can exclude
- Assessment may be quant as well (carbon intensity etc)
23
Q
What frameworks provide guidance on which ESG issues are most material?
A
- Materiality maps by SASB (now ISSB)
- But investment professionals often develop their own view on what is most material
24
Q
What are manageable risks?
A
- the risk of employee safety, which can be managed through modern capital equipment and safety procedures
- data security and privacy: with security software, hardware, and employee training.
- Manageable, however, does not mean the risk can be eliminated.
25
What are two types of unmanaged risks
1. unmanageable risks, which are inherent in the business model and cannot be addressed by company initiatives E.g carbon emissions at airlines
2. The management gap, which represents risks that could be managed but aren't
26
What are scorecards?
1. Translate qualitative judgement into numerical scores
2. Common form of assessment especially when 3rd party research or scores are not available
3. Score companies on risk factor from 0 to 5
27
What are challenges of creating private company scorecards?
1. Rating agency score is less likely to be available and less info about it is in public domain
28
What are the summary steps involved in developing a scorecard?
1. Identify sector- or company-specific ESG items.
2. Break down issues into a number of indicators (e.g., policy, measures, disclosure).
3. Determine a scoring system based on what good/best practice looks like for each indicator/issue.
4. Assess a company, and give it a score.
5. Calculate aggregated scores at the issuer level, dimension level (ESG level), or total score level (depending on the relative weight of each issue).
6. Benchmark the company's performance against industry averages or its peer group.
29
What is a major challenge for company disclosure of ESG information?
1. companies have variable disclosure policies and reporting practices, and mandatory ESG disclosure is not universal across jurisdictions.
2. Although "material factors affecting financials" is an intuitive idea, management has wide discretion.
3. Over disclosure of nonmaterial ESG info has been problem
4. Sometimes companies discontinue publication or avoid publication in years where indicators are poor - but in some countries has legal consequences
5. Smaller companies with fewer resources face cost constraints of reporting
6. Geographical differences: manager might decide certain info is of limited importance to investors or commercially sensitive
7. Info might be available to other stakeholders but not investors
8. ESG disclosures might be unaudited, incomplete or incomparable between companies
30
Why does duration of company disclosures matter?
1. Consistency and reliability of a firms reporting are important.
2. may influence how analysts rate companies (e.g., in a scorecard approach) or adjust their valuation models
31
What are the questions analysts might want to ask firms regarding disclosures if only disclosed scope 1?
1. What is the size of the company
2. How well do the company's disclosures compare to those of its competitors?
3. Does the business model suggest scopes 2 and 3 would be a material matter?
4. How long has the company been disclosing and has management made other commitments to future disclosure?
5. Does the presence of a narrative and strategy (and strength or weakness) improve an analyst's view on disclosure? - is it aligned with best practice guidance e.g. IASB's IFRS practice statement on management commentary
32
What could a follow up to initial questions be to company who only disclosed scope 1 factors?
1. could ask the company for an explanation of the data's absence and its view on materiality and then judge its willingness to engage or commit to publishing the data.
2. Or the analyst could estimate the data using comparable company data (e.g., a larger one compromising the data on materiality competitor's ratio of Scope 1 to Scope 2 and 3 GHG emissions) or find a third-party data source
33
What are challenges of ESG investing in emerging markets?
1. Limited data - less disclosure and fewer available ESG ratings means benchmarking ESG
performance is more challenging in emerging markets due to less data and greater variability between companies and countries
2. Potential EG risks such as weaker regulations, governance and infrastructure
3. Cultural complexities: methods from developed markets may not as easily apply - concern for ESG ratings that take a global approach which can disproportionately punish emerging market companies
34
What happens after research and risk/materiality assessment?
1. Valuing the issuer and its equity
2. Investors integrate the impact of material ESG factors into their financial statement forecasts and/or other valuation inputs such as multiples or discount rates
35
What is a DCF analysis?
1. A financial valuation method used to estimate the value of an investment based on its expected future cash flows
2. Analysts project the compnay's future cash flows over a specific period e.g. 5 years
3. These projections are based on various factors such as revenue growth, expenses etc
4. The projected cash flows are then discounted back to their present value using a discount rate
5. The discount rate reflects the risk and opportunity cost of investment
6. After the forecasted period, analysts estimate the terminal value which represents the value of the company's cash flows beyond the forecast period - using perpetual growht rate
36
If a company faces significant environmental regulations or litigation what happens in DCF analysis?
1. Future cash flow could become impaired
2. Investor would factor in the potential costs of these risks in cash flow projections, lowering company's valuation in discounted cash flow analysis
37
Besides adjustment to discrete cash flow projections how can material ESG factors be taken into account?
1. Adjust the discount rate (required rate of return or cost of capital)
2. Adjust terminal growth assumption
38
What is the discount rate?
1. The opportunity cost used to discount future cash flows
2. frequently a weighted average of the required rates of return of debt and equity investors, and generally reflects the risk profile of the investment.
39
What is the terminal growth rate?
1. the perpetual rate that a company's cash flow is assumed to grow by after the discrete forecasting period
2. (e.g., after the next 5 or 10 years of individual forecasts, an analyst assumes cash flows grow by 2% forever)
3. it reflects the company's long-term, sustainable growth prospects.
40
Why does it matter if the factors are company specific or sector-wide?
1. Company specific are not typically included in discount rate even though may affect growth rate
2. Sector/market-wide ESG risks manifest in growth and discount rate
41
What does a higher discount rate lead to?
1. A lower estimate of intrinsic value
2. Care must be taken when adjusting the discount rate for ESG risks that are believed to be either sector-wide or market-wide in nature
42
What does the size of the discount rate or terminal growth rate adjustment depend on?
1. How significant ESG factor
2. How well ESG factor is managed
3. Typical ranges for the discount rate and terminal growth rate
43
Why do analysts need to be careful of double counting?
1. When reducing projected cash flows AND increasing the discount rate in the DC analysis for same risk factor
2. While this might be appropriate in a situation involving a sector-wide or market-wide risk where an analyst judges not only that the expected value of future cash flows has decreased. but also that the uncertainty (i.e., volatility) around that expected value has increased, it might otherwise be overly punitive.
44
How might an analyst incorporate climate change policy risk for oil and gas producer inot DCF analysis
1. Reduce revenue projections based on government policies that subsidize alternative, renewable energy sources and electric alternatives for transportation. The forecasts might factor in various scenarios for the pace and impacts of the policy.
2. Increase the discount rate to account for the increased sector-wide volatility in future cash flows stemming from unpredictable climate policy shifts.
45
What is Base Case (before adjustments)?
1. After-tax amounts that can be distributed to investors
2. Revenue - cash uses for operations and reinvestment
46
What is a valuation multiple?
1. a financial metric used to assess the value of a company relative to a specific financial performance measure.
2. It helps investors compare companies within the same industry or sector.
3. sug Price-to-Earnings ratio, Price-to-sales Ratio etc
47
If comparing companies on a relative basis (to other companies in same sector), what may be adjusted?
1. Valuation multiples e.g. P/E
2. , the company has lower employee turnover and high scores on employee satisfaction surveys. The investor thinks these factors will lead to better customer retention and revenue growth.
3. So company should trade at a premium - higher valuation multiple
48
How do bonds differ from equities?
1. A wider range of issuers besides those that issue equity (e.g., governments, nonprofits, special-purpose entities)
2. Seniority in the capital structure
3. Finite maturity/term structure
4. Interest and principal payments are promised on prespecified future dates
5. Instruments with embedded options and/or credit enhancements, such as collateral
49
What do studies suggest about ESG bond investment and what is criticism of studies?
1. Better performance of high-ESG portfolio vs low-ESG portfolio
2. Only over 9 year period
3. ESG ratings correlate with quality and other factors, so it is unclear what portion, if any, of the observed performance is attributable to ESG factors.
50
How are some portfolio managers advancing ESG evaluation beyond simple ESG tilts?
1. By developing proprietary ESG frameworks that combine third-party data into custom metrics,
2. Provide both absolute and relative ESG scores
3. Allow risk analysis from single issuer to full portfolio levels, adding depth and value to the investment process—especially in fixed income.
51
What is a CDS SPREAD?
1. Credit default swap- financial contract that acts like insurance against a company or government defaulting on its debt.
2. Higher CDS spread = higher perceived credit risk (investors think the borrower is more likely to default)
3. Lower CDS spread = lower risk
52
What ESG factors have sovereign debt investors started to integrate?
1. Climate risk
2. Freedom of expression
3. Education levels
4. Corruption
5. Long integrated: Political risk and governance factors
53
What are challenges for soveriegn debt investors?
1. Greater subjectivity than in corporate sector
2. Limited disclosures
54
What has been developed to help sovereign debt investors assess climate risk?
1. Assessing Climate Related Opportunities and Risks (ASCOR)
2. whose methodology was released at the end of 2023, along with the first 25 pilot country assessments
3. help with developing net-zero portfolio solutions.
55
what are issuer structural features that may offset or reduce an esg risk?
1. Taxation authority to service debt (can raise taxes to pay debt)
2. Monopoly over selected products or services - gives reliable revenue
3. Debt monetisation - when a government prints money (via the central bank) to pay off its debt or finance a deficit. It increases the money supply.
4. External support
5. Diversity of economic activity as a risk mitigant
56
Describe taxation authority to service debt for corporate, US Muni and sovereign issuers
1. Corporate: No
2. US Muni: Depends on security; general obligation bonds are typically full faith and credit, which can include taxing power
3. Sovereign: Yes
57
Describe 'Monopoly over selected products or services' for corporate, US Muni and sovereign issuers
1. Corporate: Occasionally
2. US Muni: Often
3. Sovereign: often
58
Describe 'debt monetisation' for corporate, US Muni and sovereign issuers
1. Corporate: no
2. US Muni: Deficit financing is rare dude to balanced budget requirements
3. Sovereign: Yes
59
Describe 'External support' for corporate, US Muni and sovereign issuers
1. Corporate: Potentially from a parent company or government subsidies
2. US Muni: Borrowers may have access to other state or federal support, depending on the jurisdiction
3. Sovereign: No, aside from bilateral or multilateral debt relief
60
Describe 'Diversity of economic activity as a risk mitigant' for corporate, US Muni and sovereign issuers
1. Corporate: Depends on size, product offering, breadth of revenue streams
2. US Muni: Depends on issuer economic characteristics, breadth of revenue and purpose of financing
3. Sovereign: Depends on issuer economic diversification and taxable base
61
Describe 'managing ESG issues' features to consider for issuers
1. Availability of ESG data
2. Investors screening issuers for ESG reasons
3. Degree of investor engagement with issuer
4. Able to move geographic location
5. Social stakeholders
6. Governing body
62
Describe 'availability of ESG data' for corporate, US Muni and sovereign issuers
1. Corporate: Disclosed by issuers; available through CRAs and third parties; peer comparison difficult
2. US Muni: Disclosed by public sources and issuers (often upon request); available through CRAs and third parties; data can be patchy
3. Sovereign: Disclosed by public sources and issuers (often upon request); available through CRAs and third parties; data can be stable
63
Describe 'Investors screening issuers for ESG reasons' for corporate, US Muni and sovereign issuers
1. Corporate: yes
2. US Muni: sometimes
3. Sovereign: rarely
64
Describe 'investors screening issuers for ESG reasons' for corporate, US Muni and sovereign issuers
1. Corporate: Yes
2. US Muni: Sometimes
3. Sovereign: Rarely
65
Describe 'degree of investor engagement with issuer' for corporate, US Muni and sovereign issuers
1. Corporate: Less common than for shareholders
2. US Muni: Less common than for corporate bondholders and more challenging
3. Sovereign: Less common for corporate bondholders and more challenging
66
Describe 'ability to move geographic location' for corporate, US Muni and sovereign issuers
1. Corporate: yes
2. US Muni: no
3. Sovereign: no
67
Describe 'social stakeholders' for corporate, US Muni and sovereign issuers
1. Corporate: Employees, customers, supply chain
2. US Muni: Local population, taxpayers, employees and the service base
3. Sovereign: National population taxpayers
68
Describe 'governing body' for corporate, US Muni and sovereign issuers
1. Corporate: appointed
2. US Muni: depends on sector as to whether elected or appointed
3. Sovereign: may be elected
69
Summarise which of sovereign, muni and corporate have most tools to manage ESG risks?
1. Sovereigns generally have the most tools to manage ESG risks (taxation, monetization, diversification).
2. Munis have some public powers (like taxation and monopolies) but fewer financial tools.
3. Corporates are the most limited but may benefit from internal diversity or external support.
70
What has the World Bank launched to inform ESG investing in sovereign debt asset classes?
1. Relaunched its Sovereign ESG Data Portal in 2023 (
2. The portal includes 71 ESG indicators ranging from water stress, coastal protection, forest cover loss, heating and cooling degree days, precipitation anomalies, and new data on economic and social rights.
3. It also includes additional indicators that give context to the ESG dimensions, such as the Human Capital Index, inflation, or land surface areas.
4. there are inconsistencies across ESG rating agencies on sovereign ESG scores, even if they share the same underlying data.
71
What does it mean if the yield of a bond rises?
1. Interest rate increases
2. Way to compensate investors for taking on more perceived risk.
72
What might CRAs now test in regard to ESG factors?
1. How ESG factors affect an issuer’s ability to convert assets into cash (profitability and cash flow analysis)
2. The impact that changing yields---due to an ESG event---could have on the cost of capital (interest coverage ratio and capital structure analysis)
3. The extent to which ESG-related costs affect an issuer’s ability to generate profits and add to refinancing risks
4. How well an issuer’s management uses the assets under its control to generate sales and profit (efficiency ratios)
73
What do many investors in investment-grade credit not have the ability to do?
1. invest in high-yield speculative-grade credit
74
What are 3 types of bias seen in ESG ratings?
1. Company size bias, where larger companies might obtain higher ratings because of the ability to dedicate more resources to nonfinancial disclosures: It may also be the case that some ESG rating models may have been built around large firms, and these criteria may not fit as well for smaller firms.
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 levels in Europe)
3. Industry and sector bias, where rating providers oversimplify industry weighting and company alignment
75
What are sustainability-linked bonds?
1. Similar to green bonds.
2. Unlike a green bond, which requires the proceeds to specifically finance environmental-related projects, SLB proceeds are not targeted for a specific purpose but, rather, are issued as general obligation bonds with contractual links to the achievement of sustainability targets by the issuer.
3. Usually, the issuer agrees to pay a higher coupon to investors if it fails to achieve a sustainability-linked target.
4. Relative to green bonds, SLBs allow issuers more flexibility in achieving sustainability targets.
76
Would you increase or decreases a firms cost of capital if ESG risks negatively effect cost of capital?
1. Increase the firm's cost of capital
