ESG-Related Risks and Opportunities

Investors get a wider picture of industry and company analysis when integrating ESG considerations in the investment process. The effects of ESG factors on the company’s valuation—and financial statements—can be evaluated and inform investment decisions.

ESG Integration

A good starting point for ESG integration is identifying which ESG factors affect a company or industry. An analyst can identify these factors using forecasts and historical data relating to the company and make the necessary adjustments to the company’s financial statements. For example, capital expenditures, operating margins, earnings, operating costs, and revenues are ESG-related adjustments made in a company’s cash flow and income statements.

On the balance sheet, ESG-related adjustments take the form of estimates of impaired assets. Equity and valuation ESG-related adjustments include terminal value or cost of capital using the discount rate. For bonds, the issuer’s credit or CDS is adjusted to reflect the effects of ESG considerations.

Green bonds are fixed-income instruments earmarked to raise funds for specific projects that benefit the climate and the environment. All factors held constant, green bonds have the same credit ratings as conventional bonds of the same issuer. In addition, the analysis and valuation of conventional bonds and green bonds are the same except for using the proceeds.

Greenwashing is the risk that the green bond’s proceeds will not benefit climate or environmental projects. This will result in an investor who paid a premium for the green bond to pay more for the bond or hold a bond that does not satisfy its environmental or climate objective.

Question

Reagent, a beverage manufacturer, has been under heavy criticism from environmental activist groups over its use of the community lake water for manufacturing. The activists argue that the company has reduced water levels and releases harmful substances into the lake, risking the extinction of endangered fish species. Reagent’s CEO has hired a consultant to help the company address the ESG issue. The consultant advised the company to issue a green bond that would finance the digging of water wells to access the underground water and a treatment plant for wastewater.

Which one is most likely an advantage of taking up the consultant’s advice to Reagent?

1. Reagent will get a lower cost of capital to finance their project.
2. Reagent will incur additional costs relating to the monitoring and reporting of the use of the bonds proceed.
3. Reagent’s green bonds will be less liquidity.

Solution

The correct answer is A.

Reagent will get a low cost of capital due to the green bond premium.

B is incorrect.  This is a disadvantage of using a green bond to finance environmental projects.

C is incorrect. This is also a disadvantage of the green bond.

Reading 19: Environmental, Social, and Governance (ESG) Considerations in Investment Analysis

LOS 19 (d) Evaluate ESG risk exposures and investment opportunities related to a company.