W3: Lecture 7 (only theory) Flashcards
"ESG and Investments" (15 cards)
Socially Responsible Investing vs. Sustainable Investing
Socially Responsible Investing (SRI)
–>An investment strategy that is considered socially responsible, because it invests in companies that have ethical practices.
Sustainable Investing
–>An investment approach that considers environmental, social, and governance (ESG) factors in portfolio selection and management.
Mention parties in ESG Financial Ecosystem
*Asset owners (pension funds, sovereign wealth funds, institutional and retail investors, etc.)
*ESG rating agencies
*ESG associations
*Regulators and international bodies (governments, financial and industry regulators, etc.)
*Issuers (equities, bonds, loans, etc.)
The two main motives behind ESG investing
- VALUE –> Financial motives
*Risk and return trade-off
*Risk management (e.g., climate risk)
*Searching for alpha (low-risk investing) - VALUES–> Societal / Non-Pecuniary Motives
*Ethical or moral values
* Social or environmental impact
* Institutional reputation
* “Warm glow” utility:
Why some investors prefer green assets–>
They value both financial returns and the positive social impact of their portfolio choices.
Investor preferences for sustainable investing in equilibrium: PST study insights
*Firms differ in their “greenness”
*Investors have a different preference for the “green firms”
Key insights:
*Warm glow utility from holding green assets flips the portfolio toward green. –> ESG preference can pull capital toward greener assets despite lower returns.
*Investor may gain utility not just from ”financial” factors, but also from non-financial factors.
In equilibrium:
*Increase in investors with ”sustainability” preferences →increases demand for green
assets →prices go up
(Temporarily higher returns)
*After demand adjustment: Expected returns for green are lower (as investors enjoy holding them and they hedge climate risk).
–>
Sustainable investing produces a positive social impact as firms voluntarily want to become greener by shifting real investment toward green firms.
Key Takeaways:
▶ Preferences for sustainability θ change market outcomes.
▶ Financial performance ̸= total utility.
ESG Strategies
- Exclusion
–>Exclusion policy & negative (worst in-class) screening
The exclusion from a fund or portfolio of certain sectors, companies, or practices based on
specific ESG criteria. - Values
–>Norm-based screening
Screening of investments against minimum standards of business practice based on international norms, e.g., from OECD, UN, or UNICEF.
In the EU, the top excluded criteria are (1) controversial weapons, (2) tobacco, (3) all weapons, (4) gambling, (5) pornography, (6) nuclear energy, (7) alcohol, (8) GMO, and (9) animal testing. - Selection
–>Positive or best in-class screening
Investment in sectors, companies, or projects selected for positive ESG performance relative to industry peers. - Thematic
–>Sustainability-themed investing (ex., green bonds)
Investment in themes or assets specifically related to sustainability, e.g., clean energy, green technology, or sustainable agriculture. - Integration
–>ESG scoring is fully integrated in the portfolio management
The systematic and explicit inclusion by investment managers of environmental, social, and governance factors into financial analysis. - Engagement
–> Voting policy & shareholder activism
The use of shareholder power to influence corporate behavior, including through direct corporate engagement (i.e., communicating with senior management and/or boards of companies), filing or co-filing shareholder proposals, and proxy voting that is guided by comprehensive ESG guidelines. - Impact
–> Impact investing
Targeted investments aimed at solving social or environmental problems, including community investing, where capital is specifically directed to traditionally underserved individuals or communities, as well as financing that is provided to businesses with a clear social or environmental purpose.
Commonly stated rationales for ESG investing
▶ Alignment with morals
▶ Deprive firms of capital
▶ Change behavior
(But many excluded firms have poor investment opportunities; this is why they’re doing poorly. –> Needs to be contingent on behaviour.)
Disadvantages of traditional ESG investing strategies
▶ Considers only one (or a small subset) of factors
▶ Focuses on quantitative, not qualitative ESG measures; good and bad
▶ Ignores strategic context. Certain ESG factors may not be material
▶ Focuses on pie splitting (“do no harm”) rather than pie growing (“actively do good”)
▶ Confuses valuation issues with preference issues
▶ Fails to reward best-in-class companies
▶ Better strategy: tilting away from “bad” industries, but still holding best-in-class firms.
ESG investment funds and their strategies
▶ Mutual funds
▶ ETFs
▶ Mandates & dedicated funds
Involves both alpha and beta management.
Strategies:
▶ Thematic strategies (e.g., water, social, wind energy, climate, plastic, etc.)
▶ ESG-tilted strategies (e.g., exclusion, negative screening, best-in-class, enhanced ESG score, controlled TE, etc.)
▶ Climate strategies (e.g., low carbon, activity exclusions, etc.)
▶ Sustainability-linked securities (e.g., green bonds, social bonds, etc.)
Types of ESG funds:
1. Exclusionary: excluding or underweighting certain sectors, countries, and securities.
2. Inclusionary: investing in sectors or companies with higher ESG ratings than their industry peers or other investment opportunities.
Greenwashing/ESG washing
Activities by a company that are intended to create the perception that it is concerned about the environment, even if its real business actually harms the environment.
Do firms and investors really care about ESG ratings? academic evidence
After Morningstar started publishing ESG ratings, fund flows have increased (+ sustainable funds and - unsustainable)
Traditional ESG ratings measure…
Risk exposure and risk management
“Company’s resilience to financially relevant, industry-specific sustainability risks and opportunities”
–> similar to credit ratings (B, AA, AAA, etc.)
How does ESG scoring system work?
Most ESG scoring systems are based on scoring trees.
Most ESG scoring systems are sector
neutral: best-in-class.
Raw data are normalized in order to
obtain features X1,…,Xm —>
Features X1,…,Xm are aggregated to
obtain sub-scores s1,…,sn —>
Sub-scores s1,…,sn are aggregated to
Obtain the final score.
ESG Ratings vs. Credit Ratings
Credit Ratings
Goal: Measure 1YR P(Default)
▶ Correlation ≥90%
▶ Absolute ratings facilitate comparison
▶ More stable
▶ Accounting standards
ESG Ratings
Goal: Varies, but broadly measures
exposure to and management of industry-specific material ESG risks.
▶ Correlation ≥90%
▶ Absolute ratings facilitate comparison
▶ More stable
▶ Accounting standards
Three main reasons why ESG ratings diverge
- Scope Divergence (38%)
Different topics are included; e.g., one agency includes lobbying, another doesn’t. - Measurement Divergence (56%)
Same topic, but measured differently; e.g., labour practices assessed via turnover vs. lawsuits. - Weight Divergence (6%)
Agencies assign different importance to the same topic; e.g., labour vs. lobbying
Challenges with ESG Ratings
▶ Disagreement among providers: same firm, different scores
▶ Opaque methodologies: hard to compare or replicate, but improving
▶ Potential for greenwashing: ratings based on (self-) reported data
▶ Coverage gaps: Smaller firms may lack data
▶ Mixed bag: What would a relatively high ESG rating with a low E represent?
