Environmental, Social, and Governance (ESG) Considerations in Investment Analysis
Refresher reading access
Introduction
Environmental, social, and governance (ESG) considerations are increasingly being integrated into investment analysis. Evaluating how ESG factors potentially affect a company may provide analysts with a broader perspective on the risks and investment opportunities of a company’s securities. Although corporate governance has long been recognized as having a significant impact on a company’s long-term performance, investors have become increasingly concerned with environmental and social factors and how companies manage their resources and risk exposures that relate to such factors. Mismanagement of these resources has led to a number of high-profile corporate events that have negatively affected security prices. Increasingly stringent regulatory environments, potentially finite supplies of natural resources, and global trends toward energy conservation and waste reduction have led many investors to place greater emphasis on the management of environmental risks. Similarly, such issues as worker health and safety policies, community impact, and marketing practices have increased the visibility of how a company manages its social capital.
This reading provides an overview of ESG considerations in investment analysis. Section 2 provides an overview of the global variations in corporate ownership structures, as well as how these ownership structures may affect corporate governance outcomes. In Section 3, we discuss company-specific factors that should be considered when evaluating corporate governance in the investment process. Section 4 discusses the identification of ESG-related risks and opportunities that are relevant to security analysis. Section 5 demonstrates the evaluation of ESG-related risks and opportunities through several examples. The reading concludes with a summary of the key points discussed.
Learning Outcomes
- describe global variations in ownership structures and the possible effects of these variations on corporate governance policies and practices;
- evaluate the effectiveness of a company’s corporate governance policies and practices;
- describe how ESG-related risk exposures and investment opportunities may be identified and evaluated;
- evaluate ESG risk exposures and investment opportunities related to a company.
Summary
Shareholder ownership structures are commonly classified as dispersed, concentrated, or a hybrid of the two.
- Dispersed ownership reflects the existence of many shareholders, none of which, either individually or collectively, has the ability to exercise control over the corporation. Concentrated corporate ownership reflects an individual shareholder or a group (controlling shareholders) with the ability to exercise control over the corporation.
- Controlling shareholders may be either majority shareholders or minority shareholders.
- Horizontal ownership involves companies with mutual business interests that have cross-holding share arrangements with each other. Vertical (or pyramid) ownership involves a company or group that has a controlling interest in two or more holding companies, which in turn have controlling interests in various operating companies.
- Dual-class (or multiple-class) shares grant one or more share classes superior or even sole voting rights while other share classes have inferior or no voting rights.
- Types of influential owners include banks, families, sovereign governments, institutional investors, group companies, private equity firms, foreign investors, managers, and board directors.
- A corporation’s board of directors is typically structured as either one tier or two tier. A one-tier board consists of a single board of directors, composed of executive (internal) and non-executive (external) directors. A two-tier board consists of a supervisory board that oversees a management board.
- CEO duality exists when the chief executive officer also serves as chairperson of the board.
- A primary challenge of integrating ESG factors into investment analysis is identifying and obtaining information that is relevant, comparable, and decision-useful.
- ESG information and metrics are inconsistently reported by companies, and such disclosure is voluntary, which provides additional challenges for analysts.
- In an ESG context, materiality typically refers to ESG-related issues that are expected to affect a company’s operations or financial performance and the valuation of its securities.
- Corporate governance considerations, such as the structure of the board of directors, tend to be reasonably consistent across most companies. In contrast, environmental and social considerations often differ greatly.
- Analysts typically use three main sources of information to identify a company’s (or industry’s) ESG factors: (1) proprietary research, (2) ratings and analysis from ESG data providers, or (3) research from not-for-profit industry organizations and initiatives.
- In equity analysis, ESG integration is used to both identify potential opportunities and mitigate downside risk, whereas in fixed-income analysis, ESG integration is generally focused on mitigating downside risk.
- A typical starting point for ESG integration is the identification of material qualitative and quantitative ESG factors that pertain to a company or its industry.
1.25 PL Credit
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