Identifying ESG-Related Risks and Opportunities

When integrating ESG factors into investment analysis, the major challenge is identifying and obtaining information that is relevant and useful. Another challenge is the inconsistency of ESG metrics and information. ESG-related disclosures are voluntary for many companies.

Materiality and Investment Horizon

In the context of ESG, materiality refers to ESG-related problems that are likely to affect a company’s operations, security valuation, and financial performance. Hence an omission of crucial financial reporting information is considered material if it changes the user’s decision.

When deciding which ESG factors to consider in their analysis, analysts should consider their investment horizon. Long-term ESG issues may have a negligible impact on the valuation of securities if the firm or client the analyst works for has a short-term investment horizon.

Relevant ESG-Related Factors

While corporate governance considerations across companies are similar, the environmental and social considerations differ. Therefore, analysts must first determine the relevant factors that affect a company’s industry before identifying its specific ESG opportunities and risks. Once the ESG-related factors relevant to the company’s industry have been identified, the analysts can identify applicable quantitative and qualitative data using the proprietary method approach, ESG data providers, and not-for-profit industry organizations and initiatives.

With the proprietary method approach, analysts will use their firm’s tools or judgment to identify ESG information by researching industry associations, environmental groups, and news reports.

ESG data providers are another method of identifying ESG factors. This involves the use of data from ESG data vendors such as Sustainalytics. The analysts’ information is presented in individual ESG analyses, scores, and ranking for each company in the vendor’s universe.

The final approach in identifying ESG factors is not-for-profit industry organizations and initiatives that provide data on ESG issues. They include the Global Reporting Initiative.

Equity vs. Fixed Income Security Analysis

The use of ESG integration will differ for debt and equity analysis. In fixed income analysis, ESG is used to alleviate downside risk, while for equity analysis, the ESG integration alleviates downside risk and finds potential opportunities.

ESG integration also differs between fixed income and equity regarding valuation. ESG-related factors are often overanalyzed while doing equity security analysis. Credit analysis, relative credit ranking, forecasting financial ratios, and internal credit assessment are all used to integrate ESG factors.

Question

Delware Inc. is a company that operates in the manufacturing sector. It has been using coal to power its engines since its inception. The company has a long-term investment horizon; however, there has been new legislation in the company’s jurisdiction that has banned the use of coal for more environmentally friendly energy sources.

What is the most likely long-term effect of such regulation?

1. The company’s profitability will increase if they continue using coal after the ban.
2. The company’s profitability will reduce in the future.
3. The company fixed asset valuation will remain unchanged.

Solution

The correct answer is B.

Due to the ban on coal as an energy source, the company has no choice but to buy new equipment and change its entire operations, which is capital intensive.

A is incorrect. The company’s profitability will reduce due to large capital expenditure to comply with the new laws. There may also be hefty fines associated with non-compliance and bad publicity that affects the company’s revenue.

C is incorrect.  The company’s fixed asset valuation will increase as it will have new equipment to replace the old engines.

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

LOS 19 (c) Describe how ESG-related risk exposures and investment opportunities may be identified and evaluated.