CFA ESG Investing Study Notes, Study notes of Finance

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Summary Notes by Brainie

Version: 2022. 3

Chapter 1 – Introduction

• Triple bottom line: People (social), Planet (environmental), Profit (financial) aims to communicate more clearly with stakeholders on value created when social & environmental factors are systematically accounted
• Types of responsible investments o Conventional (limited to no scope for ESG) o Sustainable and responsible investing (ESG Investing) ▪ SRI; socially responsible investment (incl. faith based/shariah, etc.) ▪ Best-in-Class ▪ Sustainable ▪ Thematic / Green o Social impact investing (Social & impact investing) ▪ Social – bottom of pyramid (target people in poverty) ▪ Impact (not necessarily market return expectations) o Philanthropy (only social impact focused)
• Fiduciary duty o Freshfield reports states ESG investing is in line with fiduciary duty
• Economic perspective o Stockholm Resilience Centre ▪ 9 Planetary boundaries o doughnut economy (planetary + social boundaries)
• Financial materiality o Consider additional risk due to ESG integration ▪ Reduced cost / increased efficiency ▪ Reduced risk of fines and state interventions - McKinsey calculated that typically a third of corporate profits are at risk from state intervention (not only fines). Sectors at risk: pharma/autos/banking/technology ▪ Reduce negative externalities (Prof. Arthur Pigou, 1920 + later William Nordhaus was awarded Nobel Prize on externality of climate change) - Internalization through market-based, regulatory or voluntary instruments. ▪ Improved ability to benefit from sustainable megatrends
• Challenges in integrating ESG o Prior to investing: ▪ Fear may negatively impact returns ▪ Fiduciary duty prevents from integration ▪ Investment consultants or advisors not supportive o Once decision has been made ▪ Lack of understanding how to build an investment mandate / unclear needs of asset owners with regards to ESG ▪ Impression that significant resources are needed (human/tech/financial) ▪ Gap between marketing and actually delivering - Data availability - Modelling: Incorporate ESG into valuation – often a qualitative input that is used alongside traditional measures (P/E, discount rates)

▪ Kigali Amendment of the Montreal Protocol 20 16: phase out manufacturing of hydrofluorocarbons (HFCs) = ocean depleting chemicals ▪ IMO = International Maritime Organization, 20 20 = introduced a cap on sulphur content in oil (ship oil) ▪ CORSIA = Carbon Offsetting and Reduction Scheme for International Aviation. Paris only covers domestic flights, this covers international flights

• Reporting Initiatives o Global Reporting Initiative (GRI) ▪ Provides guidance on disclosure across environmental, social, economical factors for ALL stakeholders (not only investors). Standard for UNGC o Value Reporting Foundation (VRF) ▪ Merger of SASB & IIRC ▪ Provide investors and corporates with a comprehensive corporate reporting framework across the full range of enterprise value drivers and standards
• Other: Carbon Disclosure Project (CDP), Climate Disclosure Standards Board (CDSB), Corporate Reporting Dialogue (CRD), International Business Council ESG Disclosure Framework (EDF of IBC), Asia Investor Group on Climate Change (AIGCC), Global Impact Investing Network (GIIN), Global Sustainable Investment Alliance (GSIA), International Corporate Governance Network (ICGN),
• Task Force on Climate Related Financial Disclosure (TCFD) o Paris agreement target of staying below 2 degrees with ambition of staying below 1.5 degrees. Urges companies to disclose on ▪ Governance around climate related risks & opportunities ▪ Strategy: actual and potential impact of climate related risks & opportunities on organisational business, strategy & financial planning ▪ Risk management: processes, assess and manage climate related risk ▪ Metrics & targets used to assess and manage climate related risks & opportunities o Recommends these disclosures as part of mainstream financial filings
• EU Sustainable Finance Disclosure Regulation (SFDR) (Article: 6,8,9) o Improve comparability of sustainability characteristics of investment funds by standardizing sustainability disclosure o A building block of Sustainable Finance Action Plan o All financial participants in EU economic area o On firm level and product level o PAIs (principal adverse impacts): negative effects from an investment on sustainable factors o Under SFDR 9 – one must abide by the DNSH principle (sustainable use and protection of water and marine resources, transition to a circular economy, waste prevention, pollution prevention, protection of healthy ecosystems). Notes:

Chapter 2 – The ESG Market

• History o Brundtland Report “Our common Future” published in 19 87. Foundation for Rio Summit in 1992 o Pax World Fund during Vietnam war 1971 (SRI) o Sullivan Principles – Apartheid late 70s (engage, disinvest)
• Modern responsible investment o ’02 Sarbanes-Oxley Act (post Enron) o Freshfields Report (key message: ESG in line with fiduciary duty)
• Pension Funds o Fiduciary duty: pension fund trustees could face legal risk from financial losses by climate change or insufficiently covering climate risk
• Asset managers o Key challenges to integrate ESG ▪ lack of clear signals from asset owners that they are interested in ESG (clear investment mandates help) ▪ very narrow interpretation of investment objectives on which consultants and advisors base their advice to owners ▪ resource challenges
• Policy makers o Regional differences ▪ North America – policies remain voluntary = comply or explain, however shift is expected from comply OR explain to comply AND explain; voluntary to mandatory; policy to implementation and reporting ▪ US – ERISA (Employee Retirement Income Security Act) - ’94 Clinton Administration = all things equal - ’08 Bush admin = discourage ESG integration - ’15 Obama = encourage ESG integration - ’20 Trump = discourage ESG integration ▪ EU Green Deal = climate neutral by 2050 – as part of the EU taxonomy was created ▪ EU Taxonomy Regulation (voluntary green bond standard and voluntary low-carbon benchmark) – framework that states conditions for an economic activity to be considered environmental/sustainable = destroy greenwashing - 3 elements: Substantially contribute to at least 1 + do no significant harm to other 5 + comply with min. safeguards (MNE, UNGP) - Groundwork for SFDR & NFDR (see below) o Climate change mitigation o Climate change adaption o Sustainable use and protection of water and marine resources o Transition to a circular economy o Pollution prevention and control o Protection and restoration of biodiversity and ecosystem ▪ NFRD = non-financial reporting directive

Chapter 3 – Environmental Factors

• 9 planetary boundaries o Ocean acidification o Chemical pollution o Nitrogen & phosphorus leading o Freshwater withdrawals / use o Land conversion o Biodiversity loss o Air pollution o Ozone layer depletion o Climate change
• Responding to climate change o Climate change mitigation – reducing & stabilizing levels of GHG emission into atmosphere = slow down the process ▪ Reduce GHG emission ▪ Enhance GHG storage (forest, oceans, etc) ▪ “Buy time for the planet to be able to adapt” - continue in a sustainable manner ▪ Paris agreement = below 2 degrees, aim at 1.5 global warming o Climate change adaption – adapt to climate change taking place & increase resilience ▪ Building flood defences ▪ Planning for scarce water resources ▪ Protecting coastlines against sea-level rise ▪ Develop clean cooling system o Jevons paradox: relative improvements in efficiency are offset by higher consumption.
• Blue economy = sustainable usage of ocean and marine resources
• Circular economy o Design out waste and pollution o Keep products and materials in use o Regenerate natural systems
• Systematic risks to financial system: physical and transitional risks o Physical: storms, floods, etc. o Transition risk ▪ Policy risk = policy makers ▪ Legal risk = lawsuits claiming damages from entities (e.g PG&E) ▪ Technology risks = low carbon innovation disruption industries
• Supply chain transparency and traceability o Scope 1 – core operations o Scope 2 – purchased energy o Scope 3 – whole supply chain. GHG emissions from supply chain are estimated to be on average 5x as high as those from direct operations o Deforestation commitment o NGOs help with measurement frameworks ▪ The sustainability Consortium (TSC), WWF, SASB, etc. ▪ Forest (FSC), Marine (MSC), Roundtable for Sustainable Palm Oil, Fairtrade Labelling Organizations (FLO)

• Carbon pricing o Emission trading system (ETS) ▪ Excess emissions need to be offset via purchase of permits ▪ Too restrictive framework may offshore emissions = carbon leakage o Carbon taxation ▪ Direct price on GHG
• Carbon foot printing is one of the most common ways, applies the international accounting tool of GHG protocol standards.
• Corporate project finance o Shadow carbon pricing (apply a theoretical rate to project) o Energy / water / waste measures
• Asset Managers o Net Zero Initiative = zero emissions by 2050 or sooner
• Analysing environmental risks o Weighted carbon emissions / 1m sales (recommended by TCFD)
• Green Bonds o Shades of Green by CICERO (dark/medium/light-green/brown) o Transition bonds = high emission companies to fund reduction in GHG
• Blue Economy Ocean Framework by EU & World Bank – step into international ocean governance
• Natural capital: stock of natural assets, incl. geology, soil, water, all living things o NCP focuses on food & beverage, apparel and forest products Notes:

• Product liability - Consumer protection o Businesses being found liable when court finds design flaws o Manufacturing defects o Failure to warn consumer of potential dangers
• Identifying material social factors for investors o Consider geography and industry o Materiality or risk assessment o Quality of management o Ratio analysis & financial modelling ▪ Health & safety issues ▪ Human capital mgmt. or supply chain mgmt. issues ▪ Local protests ▪ Poor working conditions o Adjust discount rate to account for any issues Notes:

Chapter 5 – Governance Factors Definition: Corporate governance is the process by which a company is managed and overseen. It also includes developing an appropriate culture. Among the 3 ESG factors, the one that has the clearest link to financial performance

• More difficult for large and complex companies
• In practice corporate governance comes down to 2 A’s o Accountability: for decision-making and consequences o Alignment : agency problem (e.g. executive pay, bonus & LT KPIs)
• Board: Diversity (background, experience, gender) and independence key to avoid group think. Should be strong to challenge mgmt., understand business (bad example: Theranos)
• Corporate Governance Codes o Origin ’92 Cadbury Committee (comply or explain) post Caparo & Polly Peck scandals o Greenbury ’97 executive-pay (long-term schemes, e.g. >3 years) o Enron: Sarbanes-Oxley ’02 & ’03 Ahold & Parmalat scandal gave a push in Europe o ’10 Dodd-Frank (Wall Street Reform) o ’12 & ’15 Olympus & Toshiba gave push in Japan due to huge hidden losses o Board structures ▪ Single tier (dominated by executives (JP), combined chair & CEO (US, FR) ▪ Two-tier (non-executive & mgmt. boards; DE, NL) o US only country without a formal code (due to corporate law at state level) ▪ Most: comply OR explain ▪ NL – apply or explain ▪ Australia – if not, why not?
• Shareholder engagement and minority shareholder alignment o Related-party transactions (e.g. transactions that benefit majority shareholder) ▪ 5% of company asset/profits/capital additional disclosure (Class 2; UK rule) ▪ 25% of company assets, (..), shareholder vote needed to approve the deal (Class 1 transaction: UK rule) o Pre-emption rights = shareholders can maintain % position (rights issue, ex US) ▪ As rights-issues are cumbersome, so companies seek authority at AGMs for 5-10% placements non-pre-emptively (soft-pre-emptive offering to existing shareholders) o Dual-class shares = less accountability to other shareholders due to limited say ▪ US council for institutional investors, recognize can bring stability but should be abandoned after year 7 (include a sunset clause)
• UK corporate governance code o Board leadership and company purpose o Division of responsibilities o Composition, succession and evaluation o Audit, risk and internal control o Remuneration o Board of Directors: Nominations, Audit & Remuneration Committee

Chapter 6 – Engagement and Stewardship Stewardship: active & involved owners (vote & engage) (Steward: guardian of home); Walker report Engagement: put into effect stewardship in line with PRI principle 2

• Engagement can encompass a full range of issues that affect long-term value o Strategy o Capital structure o Operational performance and delivery o Risk management o Pay o Corporate governance o Proper engagement should be tailored and individual, thus time consuming and takes a while (1.5-3yrs) to show its effects o Enhances understanding to corporate approach to sustainability and possible weak rating/score
• Engagement vs. monitoring dialogue: one-way, leads to buy/sell decision vs. engagement is more long-term and two-way
• UK Stewardship Code – 7 principles o Publicly disclose their policy on how they will discharge their stewardship responsibilities o Have a robust policy on managing conflicts of interest in relation to stewardship o Monitor their investee company o Establish clear guidelines when & how they will escalate their activities o Be willing to act collectively where appropriate o Clear policy on voting and disclosure of voting activity o Report periodically on their stewardship and voting activities o = the role of most asset owners (pension funds) is overseeing, challenging and assessing stewardship activities of their service providers o Widely followed around the globe BUT conflict of interest + escalate via collective action often omitted
• UK Stewardship Code Revision - Increase to 12 principles ▪ Former focus on statements of intend changed to investors expected to annually report on their activity + outcome from that activity + concrete examples on what has been delivered to clients & beneficiaries ▪ Principles 1-8 = foundation for stewardship - Principle 4 most difficult = identifying & respond to market-wide and systematic risks - Principal 7-8 integration of ESG factors into investment process ▪ Principle 9 - 12 practical discharge of engagement responsibilities - Principal 9 - 12 cover engagement and voting activities (incl. some voting outcome)
• Engagement Styles o Top-down (passive asset managers) and bottom-up (active asset managers) o Issue-based (passive asset managers) & company focused (active asset managers) ▪ E.g. start with a letter to company to address identified issue and then discuss

o Collaborate with peers where necessary

• Characteristics of Engagement o SF1 – clear and objective o SF2 – material and strategic o SF3 – bespoke o SF4 – effective leadership o SF5 – scale of coalition gathered o SF6 – depth of relationship with company
• Due to wide portfolios and multiple holdings – it is crucial to prioritize 1) company in portfolio most in need of engagement 2) which engagement issues should be prioritized
• Escalation of engagement o Holding additional meetings with mgmt., meet with board or chair o Intervene jointly o Making public statement (ahead of AGM) o Submitting resolutions / speak at AGM ▪ This can often lead to private meetings ahead of AGM o Request meeting / propose board membership o Disinvestment o Escalation might not be the right step if no progress has been made and the objective does not warrant excess activity
• Collective engagement o Opt-in/out per issue o Complementary to individual engagement o Confidentiality o No inside information o No-group, no concert party e.g. seek control of the group o Conflict of interest avoidance
• Voting o Providers: ISS (80% market share) / Glass Lewis
• Corporate fixed income o Focus on low credit quality issuers (limited ability to absorb issues) o Key themes that are material to sector Notes:

• In Fixed Income o Materiality is key as is can impact future repayment of debt. Thus, ESG more a downside/risk mgmt. tool than opportunity. (no upside participation) o Some distinguish between default and creditworthiness impacts (bond vs. credit rating)
• Challenges to ESG integration o Data related challenges (scarcity, consistency, completeness, audited) o Comparability (ESG ratings, accounting and other standards, geographic & cultural differences) ▪ Pro: avoid group think (like credit ratings in ’08) ▪ Con: difficult for corporate how/where to improve, no common standard, hinders global credibility among investors/corporate o Materiality and judgement o Integration challenges (ESG analysts often more junior = lower weight, implications on fundamentals hard to express e.g. on cashflows, growth rates, etc)
• Mutual fund/fund manager ESG assessment o Classical methodology ▪ May be backward looking with holdings-based approach ▪ Does not consider engagement efforts ▪ Limited comparability among rating due to different methodologies o Real Impact Tracker (RIT) ▪ More holistic approach, doing deep dive due diligence ▪ Assess culture, philosophy, process, impact, public policy efforts o Mercer point system (investment consultant)
• Index providers o Often rules-based o Tilt company weightings or exclude entire companies based on ESG score and hurdles o Can be used as benchmark
• Primary vs. secondary data o Primary sourced from company surveys, reports, presentations, news, public documents o Real-time data e.g. using geospatial data to track de-forestation, mining, construction, shipping etc.
• Fixed income / Credit Rating Agencies (CRA) o CRAs start incorporating ESG analysis (G the key factor) o Sovereign credit risk assessment can be influenced by ▪ Resources ▪ Emerging techs ▪ Govt regulations and policies o Typically, CRAs are most interested in a governments ability to generate enough revenues to repay its financial obligations o ES factors can also have indirect impacts, while G can be more easily assessed o Can also have effect on CDS (credit-default-swaps)
• Biases in ratings

o Company size o Geographical bias (higher reporting standards in DM vs EM) o Industry and sector bias (oversimplify industrial weightings/company alignment) Notes:

• The Evolution of ESG Integration and its Application to Indices and Benchmarking o Exclusions ▪ Universal - Norms & convention from UN/WHO – controversial arm munitions, nuclear weapons, tobacco etc ▪ Conduct related - Company or country specific – often not a statement against nature of a business. E.g. violations against ILO for example ▪ Faith based - Christian, shariah, etc ▪ Idiosyncratic - Not according to global standard, e.g. whale meat processing
• Applying ESG screening investment strategies within portfolios and across asset classes
• Fixed Income o Mercer ESG ratings in credit – ESG1 to 4 (best-to-worst) o Different maturities lend themselves to a more granular comprehension of ESG issues and their materiality (e.g. short-term maturities likely less impacted by ESG risks) o Despite the development of ESG in fixed income, absence of a universally recognised standard certification system for sustainable bonds should be recognised. ▪ Green bonds, social bonds (e.g. access to services, infrastructure), sustainability bonds (positive social, environmental impact), sustainability linked bonds (SLBs), transition bonds, SDG linked bonds, blue bonds o Sovereign bonds ▪ CRAs start taking into account governance factors - World Bank Governance Indicators: Political stability, voice and accountability, govt effectiveness, rule of law, regulatory quality, control of corruption
• Real Estate o Environmental criteria short term o Impact oriented: social considerations (affordable housing) o Climate and weather risks = earthquakes, volcanic, etc o Integrate ESG to manage (tail) risks ▪ Tail risks are generally long-term in nature and describe a sign change or move by several standard deviations in the risk profile of an asset ▪ Performance attribution to ESG factors not yet commercially existent ▪ Systematic and idiosyncratic risks o Integrate ESG to generate investment returns ▪ Brinson attribution – decomposes performance returns based on a portfolio’s active weights (regional, sector, single equities) ▪ Risk factor attribution (value, growth, etc) o Coverage gaps – up to 25% ▪ Rescale scorable portion of portfolio to 100% ▪ Bayesian interference to coverage ratio, grossing up to 100% probabilistic inference o PR recognises 3 main approaches to screening ▪ Negative (geography, sector, issuer, etc). ▪ Positive (best-in-class)

▪ Norms-based (ILO, OECD MNE, UNGC, Kyoto etc) o Absolute values approach in screening may not provide the context to manage a diversified portfolio while a relative approach may help

• Optimising portfolios for ESG criteria o ESG optimisation via constraints distinguishes itself from exclusionary screening that it does not apply a fixed decision rather organising securities by their individual ESG profile to solve for a specific ESG optimisation at the overall portfolio level (greater constraints = greater risk for tracking error) o Full ESG integration often combines quant & qual approaches to exploit ESG datasets. Counterintuitive, these strategies typically face fewer constraints (no box-ticking, rule-based) than other strategies due to expectations that their own ESG research/ approach is superior to normal process (often leads to lower third-party ESG score). Thus, more concentrated high-conviction portfolio Notes: