ESG Considerations for Investors | CFA Level I Corporate Issuers
Welcome back to our study notes on ESG considerations for investors. In this lesson, we’ll introduce ESG, explore the factors involved, and discuss common approaches to implement ESG investing. So, let’s dive in!
An Introduction to ESG
ESG stands for Environmental, Social, and Governance. These three themes measure the sustainability and ethical impact of an investment in a company. We’ve covered corporate governance in past lessons, so let’s focus on environmental and social aspects.
ESG investing, also known as sustainable or responsible investing, involves considering ESG factors when identifying companies to invest in. The goal is to invest in companies that efficiently manage their environmental, human capital, and financial resources to generate attractive long-term profitability.
Keep in mind that ESG investing is sometimes referred to as socially responsible investing, which can also mean ethical or moral investing. This might involve excluding companies like casinos, tobacco, and weapons producers.
Fiduciary Responsibility and ESG
Conflicts may arise with ESG investing when a portfolio manager has a fiduciary responsibility to clients. Constructing a portfolio based on ESG factors at the expense of investor returns could technically violate the manager’s fiduciary duty. However, the U.S. Department of Labor recently addressed this potential conflict, stating it is not a violation. Specifically, when two investments have the same relevant financial characteristics, using ESG factors to choose one over the other is not a violation of fiduciary duty.
Examining ESG Factors
Here are some general environmental and social factors that are often considered material in investment analysis:
Environmental factors include:
- Natural resource management
- Pollution prevention
- Water conservation
- Energy efficiency
- Existence of carbon assets
- Adherence to environmental safety and regulatory standards
Social factors typically involve:
- Human rights and welfare concerns in the workplace
- Staff development
- Employee diversity
- Impact of the business on the community
These factors can affect a firm’s staff turnover, employee morale, and reputation, which can impact profitability and competitiveness. Keep in mind that there is no universal set of factors applicable to all companies, as the materiality of ESG factors often differs among sectors.
Approaches to Integrate ESG Factors
Let’s examine some common approaches to integrate ESG factors into the portfolio management process:
Negative screening (exclusionary screening): Exclude companies based on specific ESG factors, e.g., excluding certain mining, oil extraction, transport, and tobacco companies due to poor track records on corruption and human rights practices.
Positive screening: Identify companies with positive ESG practices using ESG ranking or scoring approaches.
Best-in-class approach: Identify companies within each industry group with the best ESG practices, maintaining sector weightings comparable to a benchmark index.
ESG integration (ESG incorporation): Integrate ESG factors into traditional security and industry analysis, focusing on identifying risks and opportunities arising from ESG factors.
Thematic investing: Focus on investing in specific sectors or themes based on economic or social trends, e.g., sustainable energy sources or clean water resources.
Impact investing: Achieve targeted social or environmental objectives along with measurable financial returns. Investments can be made in specific companies or projects, such as venture capital investments in companies focused on increasing sustainability or providing environmental improvements.
An example of impact investing is the purchase of climate bonds by investors who want to advance low-carbon initiatives. Climate bonds, such as green bonds, are issued to finance projects that fight climate change, like the development of infrastructure and alternative energy projects.
Congratulations! You’ve made it through our lesson on corporate governance and ESG considerations for investors. The course will become more quantitative in the next topic on capital budgeting. Take a break, attempt the quiz, and we’ll see you in the next lesson!