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101 Concepts for the Level II Exam

Level II Concept 39: Identifying and evaluating ESG-related risks and opportunities


Materiality and investment horizon:

There are several challenges while evaluating ESG information. Companies usually report information and metrics that are inconsistent, making comparisons across companies difficult. Also, ESG disclosures are voluntary. Therefore, different companies may report different levels of information. This again makes comparisons across companies difficult.

While evaluating ESG factors, analysts first need to evaluate if an information is material. Materiality typically refers to ESG related issues that can affect a company’s operation, its financial performance, and the valuation of its securities.

Analysts also consider their investment horizon when deciding which ESG factors to consider in their analysis. Some factors may affect a company’s performance in the short term, whereas other issues may be more long term in nature.

Relevant ESG-related factors:

Analysts typically use three approaches to identify a company’s (or industry’s) ESG factors:

  1. Proprietary research: involves the use of own judgment or their firm’s proprietary tools to identify ESG information.
  2. ESG data providers: involves the use of information supplied by ESG data providers, such as MSCI or Sustainalytics.
  1. Not-for-profit industry organizations and initiatives: involves the consideration of not-for-profit initiatives that provide data and insights on ESG issues.

Equity vs. fixed-income security analysis

  • Equity analysis: ESG integration is used to both identify potential opportunities and mitigate downside risk. Analysts adjust financial model variables such as cost of capital to reflect ESG factors.
  • Fixed-income analysis: ESG integration is generally focused on mitigating downside risk. Analysts usually do not focus on potential opportunities. The credit assessment may vary depending on maturity.

ESG integration

The typical starting point for ESG integration is the identification of material qualitative and quantitative ESG factors that pertain to a company or its industry.

For equities, adjustments related to ESG factors may be made to cost of capital, price multiple, and terminal value.

For bonds, an analyst may adjust an issuer’s credit spread or CDS to reflect anticipated effects from ESG considerations.

Green bonds are bonds in which the proceeds are designated by issuers to fund a specific project or portfolio of projects that have environmental or climate benefits. Such bonds generally trade at a premium over comparable conventional bonds (which implies a lower cost of capital). The risks associated with green bonds are:

  • Greenwashing risk: Risk that the bond’s proceeds are not actually used for a beneficial environmental or climate-related project. To mitigate this risk an investor needs to bear higher monitoring cost.
  • Low liquidity: Relative to conventional bonds, green bonds have low liquidity.