Level 1 CFA® Exam:
ESG Considerations & Approaches
ESG stands for environmental, social, and governance. While the corporate governance aspects are widely understood and considered in investment analysis, the environmental and social issues still seem to be of secondary importance to many investors and analysts. This is, however, changing.
In this lesson, you’ll find out why ESG considerations should be taken seriously and why we should evaluate the environmental and social factors just as we assess the company’s ownership structure, management compensation, or board independence before we decide to invest.
Although it is not easy to identify which environmental and social factors may impact the company, it cannot be denied that they affect the company’s financial performance. More and more investors – often young ones – want to consider ESG risks and make aware decisions. So, it seems that ESG is the future of finance and investment. Companies need to be aware that their operations have a real effect on climate change, air pollution, and society. Investors – on the other hand – should invest their capital with a broader perspective in mind.
In the past, ESG factors were considered hard to define and measure but recently their quantifiability has increased. Also, ESG used to be treated by companies as negative externalities. Now, awareness has been enhanced and more positive approaches are promoted.
NOTE: Although ESG stands for environmental, social, and governance, in this lesson we use the ESG abbreviation to refer to the environmental and social factors mainly. The corporate governance part is covered in the previous ESG lesson.
Here is why environmental and social factors should be considered in investment analysis:
- scarcity of natural resources,
- climate change,
- global economic and demographic trends,
- societal evolution.
ESG factor is considered material when the factor is believed to influence the company’s long-term business model. Factors that affect one company/sector may not affect other companies/sectors.
We can distinguish between material environmental and social factors.
Here are some definitions of ESG-aware investing. These are the new trends that are more and more widely accepted and implemented in the investment decision-making process.
Responsible investing (RI) – when investment decisions take ESG considerations into account to avoid negative environmental and social consequences while trying to minimize risk and protect the value of assets
Sustainable investing (SI) – when investment decisions are made to promote ESG practices that are believed to increase returns; the company’s ability to ensure economic, environmental, and social sustainability is taken into account
Socially responsible investing (SRI) – when investment decisions are based on the alignment of the company’s profile with the investor’s beliefs
ESG investing can be value-based or values-based:
Value-based ESG investing combines material ESG considerations and traditional financial metrics while minimizing risk
Values-based ESG investing is based on the investor’s beliefs (social, moral, or faith-based).
Currently, we distinguish 6 investment approaches that take into account ESG considerations. These include:
- Negative screening
- Positive screening
- ESG integration
- Thematic investing
- Engagement/active ownership
- Impact investing
Negative screening is about excluding from analysis those companies or sectors that disregard ESG aspects
Positive (best-in-class) screening is done to include companies that can manage ESG aspects well compared to their peers; it uses positive criteria such as the investor’s values, ethics, etc.
- ESG stands for environmental, social, and governance.
- ESG factors affect the company’s financial performance. Also, more and more investors – often young ones – want to consider ESG risks and make aware decisions.
- Reasons for ESG implementation include scarcity of natural resources, climate change, global economic and demographic trends, as well as societal evolution.
- ESG factor is considered material when the factor is believed to influence the company’s long-term business model. Factors that affect one company/sector may not affect other companies/sectors.
- Taking care of environmental and social factors reduces the company’s legal and reputational risks.
- ESG investing can be value-based or values-based.
- We distinguish 6 ESG investment approaches such as negative screening, positive screening, ESG integration, thematic investing, engagement/active ownership, and impact investing.