Environmental, Social, and Governance Dr Yifan Zhou Environmental, Social, and Governance • Shareholder vs. Stakeholder Theory • ESG (environmental, social, and governance) considerations • ESG considerations in investment analysis Environmental, Social, and Governance Shareholder vs. Stakeholder Theory “In the traditional corporate governance framework, shareholders elect a board of directors, which in turn hires managers to serve the interests of shareholders.” Environmental, Social, and Governance Shareholder vs. Stakeholder Theory Good idea? Environmental, Social, and Governance Shareholder vs. Stakeholder Theory Environmental, Social, and Governance Shareholder vs. Stakeholder Theory Environmental, Social, and Governance Shareholder vs. Stakeholder Theory Stakeholder theory argue that corporate governance should consider the interests of all stakeholders, not just shareholders. Gives more prominence to ESG (environmental, social, and governance) considerations as objective for board of directors and management. Stakeholder groups Employees: seek fair remuneration, good working conditions, access to promotions, career development opportunities, training, job security, and a safe and healthy work enviro nment. Stakeholder groups Employee Mechanisms: Labor Laws Unions seek to influence certain matters affecting employees Represented on the board of directors or su pervisory boards (e.g., Germany, Austria, and Luxembourg) Stakeholder groups Suppliers: have an interest in the com pany’s long-term stability. Stakeholder groups Customers: may desire ongoing support, pr oduct guarantees, and after-sale service. Customer and Supplier Mechanisms ➢ Contracts ➢ Social media has become a powerful tool Stakeholder groups Governments: seek to protect the interests of the general public and ensure well-being of their nations’ econo mies. Government Mechanisms Regulations or Corporate Governance Codes Company laws or tock exchange listing requirements (e.g., Chile, India) Environmental, Social, and Governance Shareholder vs. Stakeholder Theory ESG considerations have become increasingly Why ESG? Environmental, Social, and Governance Shareholder vs. Stakeholder Theory ESG considerations have become increasingly • The risks of poor corporate governance have long been understood by analysts and shareholders. • In contrast, considering environmental and social factors has been slower to take hold. Environmental, Social, and Governance Shareholder vs. Stakeholder Theory ESG considerations have become increasingly ESG issues are having more material financial impacts on a company’s fair value. Environmental, Social, and Governance ESG considerations have become increasingly Many investors have suffered substantial losses due to mismanagement of ESG issues ➢ environmental disasters ➢ social controversies ➢ governance deficiencies Environmental, Social, and Governance ESG considerations have become increasingly The greater number of younger investors are increasingly demanding that their inherited wealth or their pension contributions be managed using investment strategies that systematically consider material ESG risks. ESG Considerations in Investment Analysis Environmental factors Material environmental effects can arise from strategic or operational decisions based on in adequate governance processes or errors in judgment. ESG Considerations in Investment Analysis Environmental factors In 2019, the collapse of Dam I of the Córrego do Feijão Min e in Brumadinho, Brazil, resulted in the spillage of millions of tons of nontoxic mud. Two hundred seventy lives were los t, and the nearby Paraopeba River was contaminated. The mine was owned and operated by Vale, multinational Br azilian mining corporation. ESG Considerations in Investment Analysis Environmental factors Brazil Dam Collapse: 12M litres of mining waste slams into town https://www.youtube.com/watch?v=9Fn3tSDuXvs Brazil dam collapse: Murder charges filed by prosecutors https://www.bbc.co.uk/news/world-latin-america-51192741 ESG Considerations in Investment Analysis Social factors considered in ESG implementation to the management of a business’s human capital ✓ human rights ✓ welfare concerns in the workplace ✓ product development ✓ community impact ESG Considerations in Investment Analysis Social factors considered in ESG implementation to the management of a business’s human capital ✓ human rights ✓ welfare concerns in the workplace ✓ product development ✓ community impact ESG Considerations in Investment Analysis Social factors ✓ staff turnover ✓ worker health ✓ training and safety ✓ employee morale ✓ ethics policies ✓ employee diversity Effect on the company’s competitive advantage ESG Considerations in Investment Analysis Social factors and company’s competitive advantage ✓ employee productivity ✓ lower employee turnover ✓ reduced litigation potential ➢ minimizing social risks ➢ lower a company’s costs ➢ reduce its reputational risk ESG Considerations in Investment Analysis Examples of Environmental Factors • • • • • • • Climate change and carbon emissions Air and water pollution Biodiversity Deforestation Energy efficiency Waste management Water scarcity ESG Considerations in Investment Analysis Examples of Social Factors • • • • • • • • Human rights Labor standards Data security and privacy Occupational health and safety Customer satisfaction and product responsibility Treatment of workers Equity and diversity Community relations and charitable activities ESG Considerations in Investment Analysis Examples of Governance Factors • • • • • • • Bribery and corruption Shareholder rights Board composition (independence and diversity) Audit committee structure Executive compensation Lobbying and political contributions Whistleblower schemes ESG Considerations in Investment Analysis Evaluating ESG-related risks and opportunities? • From a risk/reward perspective, use of qualitative and quantitative ESG factors are different. • equity and fixed-income (debt) analysis ESG Considerations in Investment Analysis Evaluating ESG-related risks and opportunities? • For fixed-income analysis ➢ generally focused on mitigating downside risk ESG Considerations in Investment Analysis Evaluating ESG-related risks and opportunities? • For equity analysis, to identify ➢ potential opportunities ➢ mitigate downside risk ESG Considerations in Investment Analysis Evaluating ESG-related risks and opportunities? • Forecasting financial metrics and ratios • Adjusting valuation model variables (discount rate) • Sensitivity and/or scenario analysis. ESG Considerations in Investment Analysis For example, a hotel company’s excessive employee turnover is increased (employee, social factors) • Forecasting the operating costs? ESG Considerations in Investment Analysis For example, a hotel company’s excessive employee turnover is increased, (employee, social factors) ✓ lost productivity ✓ reduced customer satisfaction ✓ increased expenses for employee searches, temporary workers, and training programs • Then the higher operating costs ESG Considerations in Investment Analysis For example, an analyst may include the effect of law suits on the credit ratios, cash flow, or liquidity of company. ESG Considerations in Investment Analysis Debt investment: coal company faces long-term risk from potential asset write-downs — that is, for ✓ assets that are obsolete ✓ no longer economically viable ✓ changes in regulatory /government policy ✓ shifts in demand ESG Considerations in Investment Analysis For the valuation of the coal company: Which would be more negatively affected？ 10-year maturity notes or 1-year maturity one? ESG Considerations in Investment Analysis Debt investment: effect on credit spreads of debt obligations may differ depending on maturity. For the valuation of the coal company: The 10-year maturity notes would be considerably more negatively affected than its 1-year maturity one. ESG Considerations in Investment Analysis Environmental, social, and governance investment approaches： Responsible investing is the broadest (umbrella) term used in ESG investing coverage. ✓ incorporates ESG factors into investment decisions ✓ avoiding negative environmental or social consequences on assets value ESG Considerations in Investment Analysis ESG investment approaches： Sustainable investing selects assets and companies based on their perceived ability to deliver value by advancing economic, environmental, and social sustainability. ✓ seeks to promote positive ESG practices that may enhance returns. ESG Considerations in Investment Analysis ESG investment approaches： Socially responsible investing (SRI) incorporates environmental and social factors into the investment decision-making process: ✓ selecting investments with favorable profiles or attributes based on the investor’s social, moral,or faith-based beliefs. ESG Considerations in Investment Analysis ESG investment approaches： ESG investing ranges from being value-based to values-based. Value-based investingincorporate material ESG considerations and traditional financial metrics into investment analysis while mitigating risk. ESG Considerations in Investment Analysis ESG investment approaches： ESG investing ranges from being value-based to values-based. Values-based investing is to select investments that express, or align with, the moral or faith-based beliefs of an investor. ESG Considerations in Investment Analysis ESG investment approaches： Negative screening excludes certain sectors, companies, or practices from investment using criteria based on the investor’s values, ethics, or preferences. Example? ESG Considerations in Investment Analysis ESG investment approaches： Negative screening Companies underperforming globally accepted standards in areas such as human rights or environmental management. Companies producing controversial products such as weapons or tobacco can also be excluded as part of a negative screening approach. ESG Considerations in Investment Analysis ESG investment approaches： Positive screening includes certain sectors, companies, or practices for investment using criteria based on the investor’s values, ethics, or preferences. ✓ selecting investments with favorable profiles or attributes based on the investor’s social, moral, faith-based beliefs. ESG Considerations in Investment Analysis ESG investment approaches： Positive screening includes certain sectors, companies, or practices for investment using criteria based on the investor’s values, ethics, or preferences. ✓ typically implemented using an ESG ranking or scoring methodology ESG Considerations in Investment Analysis ESG investment approaches： ESG integration entails the systematic consideration of material ESG factors in asset allocation, security selection, and portfolio construction decisions to achieve the product’s or portfolio’s stated investment objectives. ESG Considerations in Investment Analysis ESG investment approaches： Thematic investing: investing in assets related to ESG factors or themes, such as clean energy, green technology, sustainable agriculture, gender diversity, and affordable housing.. ✓ based on needs arising from economic or social trends ESG Considerations in Investment Analysis ESG investment approaches： Engagement/active ownership uses shareholder/bondholder rights and mechanisms to influence corporate behavior through direct corporate engagement ESG Considerations in Investment Analysis ESG investment approaches： Engagement/active ownership uses shareholder/bondholder rights and mechanisms to influence corporate behavior through direct corporate engagement ESG Considerations in Investment Analysis ESG investment approaches： Impact investing is investing “with the intention to generate positive, measurable social and environmental impact alongside a financial return,” ✓ investing in products or services that help achieve one (or more) of the 17 Sustainable Development Goals (SDGs) launched by the United Nations in 2015, such as SDG 6: Clean Water….. Environmental, Social, and Governance • Shareholder vs. Stakeholder Theory • ESG (environmental, social, and governance) considerations • ESG considerations in investment analysis
