ESG Analysis, Valuation and Integration Flashcards
(31 cards)
Reasons for Integrating ESG
- Meeting fiduciary duty
- Meeting clients demand
- Lowering investment risk or increasing returns
- Giving professionals more tools
- Lowering reputational risks on firm level
- Improve quality of engagement or stewardship
Qualitative ESG analysis vs. Quantitative & active vs. passive
Qualitative ESG analysis
• Used for company specific, fundamental analysis or stock-picking
• Analyse ESG data to get opinion
• Combine opinion with financial analysis by linking ESG risk to different value drivers such as cost
• Integrate opinion in a quantified water into financial models
Quantitative ESG analysis
• ESG analysis used in quat models to attract investment opportunities
• ESG score added to quant model
• Used to screen or adjust valuations
Qualitative vs Quantitative analysis
• Quant
o Systematic investing – heavy mathematical modelling, computing power
o Build and backtested
o Can use ESG integration – difficult as time series usually shorter
• Qual
o Human judgement
o But machine learning can use sentiment
Active vs. Passive
• Human discretionary (active) vs. algorithm (passive)
• Between active and passive is factor strategies (momentum)
Elements of ESG analysis
- Red flag indicators: High ESG risk are flagged and investigated e.g. no board independence
- Questionnaires and management interviews: if insufficient detail available, investor may ask for specific data
- Checks with outside experts: Investor interview key industry leaders or stakeholders such as customers, suppliers or regulators
- Watch list: ESG risks or opportunities – look for stock price entry levels or ESG events
- Internal ESG research: Proprietary techniques and data sources such as scenario analysis or materiality frameworks
- External ESG research: sell-side or 3rd party, materiality framework
- ESG agenda items: at investment committee or CIO meeting, ensures scrutiny at higher levels
Elements of ESG integration
- Adjusting forecasts
- Adjusting valuation model or multiple
- Adjusting credit risk
- Managing risk and exposure levels
- ESG factor tilts
- ESG momentum tilts
- ESG controversies
Differences between company and security analysis
• Stocks and bonds different properties to companies such as stock beta or volatility
• Company could have competitive advantages
• ESG different for example for businesses
o E: natural capital
o S: corporate culture
o G: Management structure
Three ESG assessment stages
- Research
- Valuation
- Portfolio construction and investment decisions
R&I: Gathering Information and Materiality assessments
- Gather ESG data from multiple sources
- Company reports, 3rd party research and primary research
- Materiality: which factors are likely to impact company’s financial performance
- Two ways: ESG issues considered that are financially material to company or ethical/impact investor who focus on most critical regardless of financial integration
R&I: Tangible vs. Intangible factors using IIRC framework
- Financial capital: pool of funds for goods or services, obtained through financing or generated through operations
- Manufactured capital: manufactured physical objects that are available for buildings, equipment and infrastructure
- Intellectual capital: organisational, knowledge based intangibles such as IP or patents
- Human capital: Peoples competencies – ability to understand organisation’s strategy or engage with governance framework
- Social and relationship capital: relations between communities, stakeholders and other networks such as sshared norms, stakeholder relationships
- Natural capital: All renewable and non-renewable environmental resources and processes that provide goods or services that support the past such as air, water, land
R&I: Generating Ideas
- Positive (seek high G), Negative (avoid low G) or momentum (seek rising G)
- Themes: clean water or energy services
- Checklists – ‘red flag’
- Hurdle based on what may be priced into asset
- Quantitative: carbon intensity relative to index
- Qualitative: Experience of management team
R&I: Scorecards
I. Identify company or sector specific ESG items
II. Breakdown issues into indicators
III. Determine scoring system based on best practive
IV. Assess company and give score
V. Calculate aggregated score at issue level, dimension level and total score level
VI. Benchmark against industry average
R&I: Materiality assessments and risk mapping
- Looking for ESG issues that are specific to a company or sector
- No common agreement around standards for sectors
- For example water stress for mining
- Framework maps provided by SASB
R&I: ESG risk mapping methodologies
- Risk mapped to specific theme or factor (usually material)
- Also means mapping portfolio to specific ESG risk to identify which sectors contribute most to profile
- Also can be for material opportunity such as transition to renewable energy
R&I: Quantitative, Systematic and thematic approaches to integrated ESG analysis
• Quantitative:
o Third party database (000s of companies)
o Integrate ESG with other factors such as value, size, momentum or growth
• Systematic:
o Derive correlations to understand how ESG factors might impact financial performance
o Passive and index: rules based indices with tilt towards ESG factors
• Thematic:
o Invest in priority theme
o Climate or gender
Val: Valuation and company integrated assessment stage
- Forecasted financials
- Valuation model variables such as WACC
- Valuation multiples
- Internal credit assessments
- Assumptions on models
Val: Model adjustments based on ESG assesssments
- DCF: Weak policies: Increase WACC
- Explicit profit and loss sales, margin adjustment: Employee satisfaction could lead to higher sales growth, less litigation, higher margins
- Valuation ratio adjustments with ESG integration: premium/discount the multiple
- Complement traditional analysis: business drivers, longer cash flow, higher customer satisfaction, higher carbon taxes
Active ownership as ESG techniques
- Using engagement the investment team can get commitments
* These can be used to inform traditional analysis
Val: Company disclosure on ESG topic
- Companies have variable disclosure and reporting isnt compulsory
- No disclosure doesn’t mean poor performance (smaller or cultural differences)
- Difficulty to efficient market but source of risk-adjusted return for skilled investor
- Ask questions around why the company is not reporting and estimate size of scope emissions
- Call company and engage
Des: Private Markets, Real Estate and Infrastructure
- Global Real Estate Sustainability Benchmark (GRESB) – KPIs, environmental data and efficiency, reduction targets, data validation and assurance
- Depends on GRESB engagement
- Private equity – lack of public transparency, established reporting standards, regulatory oversight and public market expectations
Des: Fixed Income and differences to equity
- Bond differ by quality, duration, schedule, seniority, currencies, collateral and time horizon
- ESG typically not as material for company to pay debt
- Sovereign debt is difficult as G factors are obvious but don’t have the same impact as on equites
- Municipal credit: corruption levels, reporting, overall transparency – looking for inclusive communities
Challenges to ESG integration
- Disclosure and data related challenges: Consistency, scarcity, incompleteness, unaudited
- Compatibilities: between ESG ratings agencies, different accounting standards, geographies and cultures, jargon terms
- Materiality and judgement: inconsistent, difficult and uncertain
- ESG integration across asset classes: different strategies integrate ESG using different techniques
Investment Firm culture challenges
- Additional resources needed
- Lots of investment professionals don’t use ESG data
- Only recently become part of curriculum at universities
Criticisms of ESG integration
- Too inclusive of poor companies: ESG mutual funds usually hold investments in bad actors
- Dubious assessment criteria: Too subjective and are narrow, materiality assessments are considered flawed
- Quality of data: Often unaudited, complicated ability to verify, compare and standardise information
- Lack of emphasis on long term improvements: if screen for performance first then exclude high ESG practices that will be implemented in long term
ESG integration databases and software
- Direct information: surveys, company communications, reports, presentations
- Indirectly: news articles, third-party reports
- Types: Traditional (SRI industry), Non-traditional (credit agencies), AI (NLP)
- Techniques: raw data, backwards looking based on reported data, ratings from internet, aggregators of data
- Considerations for selection of provider: length of history, number of companies, languages used, stability of methodology, regularity of updates
Types of mutual fund and fund manager ratings
- Morningstar sustainability ratings: 20,000 mutual funds with score of 1 to 5 using sustainalytics – holdings based approach
- Real Impact tracker: deep dive into due diligence – will assess culture, philosophy, process impact and public policy efforts
- Mercer’s point system: 4-point ESG score – ESG factors featured in teams’ decision making process, build ESG factors into valuation metrics, willingness to collaborate with other investors
