LM02 Introduction to Corporate Governance and Other ESG Considerations

Part 3

6. ESG Considerations in Investment Analysis

ESG is an acronym for environmental, social and governance issues. The importance of good corporate governance has long been understood by analysts and shareholders. Therefore, the practice of considering governance factors in investment analysis has evolved considerably. However, the practice of considering environmental and social factors in investment analysis has evolved more slowly.

The two main catalysts for growth in ESG investing are:

1. ESG issues are having more financial impacts. Many investors incurred significant losses when the companies they invested in mismanaged ESG issues.
2. A greater number of younger investors are increasingly demanding that their inherited wealth or pension contributions be managed responsibly.

Historically, environmental and social issues, such as climate change, air pollution, and societal impacts of a company’s products and services, have been treated as negative externalities. However, increased stakeholder awareness and strengthening regulations have led to inclusion of environmental and societal costs in the company’s income statement by responsible investors.

Introduction to Environmental and Social Factors

Corporate governance considerations are reasonably consistent across most companies and industries. However, environmental and social considerations differ greatly across industries. For example, environmental and social concerns for the energy sector will be very different from the concerns for the banking sector.

While evaluating ESG factors, analysts first need to evaluate if a factor is material. An ESG factor is considered to be material when that factor is believed to have an impact on a company’s long-term business model.

Some environmental and social factors considered in investment analysis are listed below:

Environmental factors

• Natural resource management.
• Pollution prevention.
• Water conservation.
• Energy efficiency and reduced emissions.
• Existence of carbon assets.
• Compliance with environmental and safety standards.

Social factors

• Human rights and welfare concerns in the workplace
• Data privacy and security
• Access to affordable health care products
• Community impact

Stranded assets: A specific concern among investors of energy companies is the existence of “stranded assets” — carbon-intensive assets that are at risk of no longer being economically viable because of changes in regulation or investor sentiment.

Evaluating ESG-Related Risks and Opportunities

Some examples of ESG factors are presented in Exhibit 7 from the curriculum.

Typically, a smaller set of factors are material for each company depending on the  business segments and geography it operates in.

Equity vs. Fixed-Income Security Analysis

ESG integration refers to the implementation of qualitative and quantitative ESG factors in traditional security and industry analysis. The process of identifying ESG factors is similar for both equity as well as fixed-income analysts. However, ESG integration differs significantly between equities and fixed income with respect to valuation.

Equity analysis: ESG integration is used to both identify potential opportunities and mitigate downside risk. ESG-related factors are often analyzed in the context of forecasting financial metrics and ratios, adjusting valuation model variables (e.g., discount rate), or using sensitivity and/or scenario analysis.

Fixed-income analysis: ESG integration is generally focused on mitigating downside risk. Analysts usually do not focus on potential opportunities. Measures such as relative value, spread, duration, sensitivity/scenario analysis are used.

The credit assessment may vary depending on maturity. For example, some factors may have an impact in the long term but have no impact in the short term. Such factors are not relevant while evaluating short term bonds.

7. Environmental, Social, and Governance Investment Approaches

There is a lack of consensus on ESG related terms used in the investment community. The curriculum defines ESG investing terminology as follows:

Responsible investing is the broadest definition used to describe investment strategies that incorporate ESG factors with the objective of mitigating risk and protecting asset value while avoiding negative environmental or social consequences.

Sustainable investing selects assets and companies based on their perceived ability to deliver value by advancing economic, environmental, and social sustainability.

Socially responsible investing (SRI) incorporates environmental and social factors into the investment decision-making process, selecting those investments and companies with favorable profiles or attributes based on the investor’s social, moral, or faith-based beliefs.

ESG investing can be value-based or values-based.

• The goal of value-based investing is to incorporate important ESG factors and traditional financial metrics into investment analysis while mitigating risk.
• The goal of values-based investing is to choose investments that express or align with an investor’s moral or faith-based beliefs.

ESG Investment Approaches

The six main ESG investment approaches are:

• Negative screening: This involves exclusion of certain sectors or companies or practices from a fund or portfolio on the basis of specific ESG criteria. For example, companies engaged in fossil fuel extraction or garment companies employing child labor.
• Positive screening: Positive screening strategy involves inclusion of certain sectors, companies, or practices in a fund or portfolio on the basis of specific ESG criteria. For instance, these companies may have policies focused on the well-being and safety of its employees, and strive towards protecting employee rights.
• ESG integration: Refers to the practice of including material ESG factors in the investment process. Traditional financial analysis metrics such as cash flow forecasts, credit/default risk forecasts, and/or cost of capital estimates are adjusted to account for the ESG factors.
• Thematic investing: This strategy picks investments based on a theme or single factor, such as energy efficiency or climate change. An increasing trend world over is the increasing demand for energy and water. Companies that provide solutions to these socio-economic problems make for attractive investments.
• Engagement/active ownership: This strategy involves achieving targeted social or environmental objectives along with measurable financial returns by using shareholder power to influence corporate behavior. Examples include: venture capital investing and green bonds.
• Impact investing: Investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return. For example, investments that help achieve one of the United Nations sustainable development goals such as SDG6: Clean Water and Sanitation.

Green finance: It is a responsible investing approach that uses financial instruments to support a green economy. For example, green bonds are bonds where the proceeds are used by the issuer to fund environmental-related projects.

ESG Market Overview

The amount of global assets under management (AUM) dedicated to ESG investments has increased substantially. This has led to increased corporate disclosures of ESG issues, as well as a growing number of firms that collect and analyze ESG data. Also, several organizations have been formed to monitor and advance the mission of sustainable investing.

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