Study Session 12: Corporate Finance (1)
Study Session 11: Corporate Finance (2)

Describe how environmental, social, and governance factors may be used in investment analysis

At one end, value-based investing adds ESG consideration on top of traditional security analysis, while on the other hand, values-based investing screen/filter companies based an investor’s values/beliefs. In between these exist the specific implementations of ESG such as: 

  • Negative screening (also called exclusionary screening or norms-based screening) excludes companies which do not meet the ethical/ESG standards of an investor.
  • Positive screening, typically implemented using ESG scoring approach, selects investments if they have minimum required ESG scores. Best-in-class screening selects investments with the best ESG score in each sector weighted in accordance with some benchmark.
  • Full integration, explicit inclusion of ESG factors into traditional security analysis.
  • Overlay/portfolio tilt involves use of certain strategies to achieve particular ESG characteristics for a portfolio. Risk factor/risk premium investing includes ESG information in determination of systematic risk. 
  • Thematic investing focuses on investing in a specific sector or theme such as energy efficiency.
  • Engagement/active ownership attempts to achieve targeted social/environmental objectives along with measurable financial return, often through active/direct investment. Examples include green finance, green bonds, etc.

Catalysts for ESG growth include (a) significant losses incurred by some companies due to their ESG lapses, such as BP Plc for environmental concerns due to Deepwater Horizon, Walmart for HR policies, Volkswagen for unlawful emissions; and (b) focus of long-term institutional investors, called universal owners, on long-term sustainable growth due to their seemingly perpetual time horizon.

There has been a significant growth in assets under management (AUM) dedicated to consideration of ESG factors. Different organizations such as Global Sustainable Investing Alliance (GSIA) collect information about assets subject to ESG consideration. There is also an increased focus on additional ESG disclosure, for example Global Reporting Initiative (GRI) prepares a sustainability reporting framework, Sustainability Accounting Standards Board (SASB) prepares sustainability accounting standards.

ESG factors in investment analysis

Not all ESG considerations are equally important for all companies. For example, environmental factors such as emissions and water usage are more significant for utilities or mining companies, yet inconsequential for financial institutions.

Environmental factors include natural resource management, pollution prevention, water conservation, energy efficiency and reduced emissions, the existence of carbon assets, and adherence to environmental safety and regulatory standards. Stranded assets, carbon-intensive assets which are no longer economically viable, are of particular concern for energy companies because if not managed properly they may result in huge liabilities for energy companies. However, such an assessment is not easy because it is difficult to assess political and regulatory risks. 

Social factors relate to worker rights, human rights, welfare concerns in the workplace, and community impact. Quality of human capital can affect a company’s competitive advantage because it affects employee turnover, training, safety, diversity, etc. Further, lower social risks mean lower costs, higher productivity and lower reputational risk.

Governance factors have long been recognized in investment analysis. Many performance indicators can help evaluate risks arising from governance issues such as ownership structure, board independence and composition, and compensation. 

But there is a question, whether the consideration of ESG factors is consistent with fiduciary duty, such as in the case of pension funds. For example, whether a pension fund should accept lower return in fulfilling its ESG consideration while it is required by law to protect the interest of pension fund participants. However, recent court judgements have upheld that certain ESG factors do not violate fiduciary duty, such as addition of ESG factors in investment policy statements, integration of ESG in determining risk and return, and in the case of investments which are economically equivalent, using ESG considerations should be the determining factor.