Evaluating ESG Exposures

It is important for a firm’s corporate governance to be effective. Consequences of ineffective corporate governance can include damage to reputation, difficulty competing, low or volatile stock price, higher borrowing costs, and decreased profitability. When a company is not behaving according to stockholders’ wishes, shareholder activism may occur: this is the term for techniques used by shareholders to force management to act in shareholders’ interests.

Board Policies and Practices

A board’s policies and practices determine its effectiveness.

1. Structure of board of directors. When analyzing the board structure, the analyst should focus on whether the board is appropriate in light of its accountability to shareholders and its oversight and representation. CEO duality occurs when the chairperson of the board is also the chief executive officer (CEO). CEO duality raises concerns that the chairperson’s oversight and monitoring responsibilities may not be effectively rendered.

2. Board independence. Ideally, a majority of board members should be independent; independent directors are more likely to prevent management from self serving behavior. It will also lower investor perceptions of risk.

3. Board committees. The number and types of board committees will vary greatly between companies but often include committees related to governance issues such as compensation, nomination, and audit committees, as well as in areas such as risk and compliance.

When analyzing a corporation’s board, an analyst should consider whether the key committees related to financial reporting, management selection, and compensation are sufficiently independent.

4. Skills and experience of board. Ideally, board members will have industry specific experience and skills while also having the broad expertise needed to function efficiently in the board member role. When the company faces specific ESG risks, it is essential that board members have some previous exposure to those kinds of concerns.

Board tenure is another consideration. A board member’s long tenure (say, more than 10 years) can be viewed as either an asset or a liability. A long tenured board member will have strong knowledge of how the firm’s management has been operating, as well as a good understanding of the firm’s business operations.

However, long tenure can make a board member resistant to beneficial change and can cause board members to become too friendly with management, affecting the board members’ independence.

1. Composition of board. It has been observed in recent years that small, diverse boards of directors are generally more effective than large boards made up of members with similar backgrounds. Diversity refers to characteristics such as age, gender, length of tenure, education, culture, and place of birth.

2. Other board evaluation considerations. A board of directors may be evaluated from a number of perspectives, but an evaluation is generally undertaken to appease investors and to ensure that the firm is operating effectively. Typical areas of interest include the board’s structure and committees, the culture of the board, its interaction with management, its effectiveness, and its leadership. Board evaluations can be self evaluations or external reviews (by outsiders).

The audience for a particular evaluation can be investors, regulators, or some other interested party.

Executive Compensation

When the remuneration of a firm’s executives is analyzed, one of the primary concerns is whether this compensation scheme properly aligns management’s incentives with the corporation’s value creation. Metrics such as KPIs (key performance indicators) are useful measures of incentive mechanisms. Clawback policies allow firms to reclaim past compensation if inappropriate conduct comes to light later (e.g., violations of the law, misreported financial statements).

Say on pay rules can give stakeholders the opportunity to vote on executive compensation. The pay differential between the CEO and the firm’s average worker has come under scrutiny in recent years.

Voting Rights of Shareholders

When investing in a company, it is important to be aware of the rights associated with holding various classes of shares. Some firms structure share offerings as a single class with equal voting rights. Alternatively, in a dual class structure, the shares held by the firm’s founders or management have more voting power than those sold to external investors.

Such a structure will disadvantage minority shareholders and sets up a conflict of interest between the two classes of shareholders.

As awareness of ESG related risks has increased over time among stakeholders, the amount of related disclosures has also risen. However, obtaining sufficient quality and quantity of information about ESG concerns is still a challenge for investment analysts. Sources of ESG data can include corporate communications as well as corporate filings.

However, there is no uniformity in such disclosures, and they are usually purely voluntary.

Investment Horizon and Materiality

Analysts should consider the impact of identified ESG factors over time; issues that are likely to have a financial impact on the firm only over the long term may be of little concern for short term investors. Further, the analyst should determine if the impact is material or not. Materiality refers to an impact on the company’s share price, its operations, or other financial aspects.

In general, an investor would consider an ESG factor material if it would affect their investment decisions.

Relevant ESG Factors

Before an analyst starts compiling data related to a specific company’s ESG exposures, the analyst should first work to determine which specific ESG factors are most relevant to that particular industry and firm. Several methods might be used to identify these factors, including ESG data providers, industry organizations, and proprietary methods.

1. ESG data providers. Data is sourced from a vendor of ESG information, such as MSCI, Sustainalytics, or RepRisk. These vendors provide information in the form of rankings, scores, and quantitative analysis.

2. Industry organizations. These not for profit groups can provide information about ESG factors. Examples include the IIRC (International Integrated Reporting Council) and the SASB (Sustainable Accounting Standards Board). These organizations work to promote standardized corporate disclosures of ESG issues.

For example, the SASB seeks to promote consistent accounting standards for sustainability.

3. Proprietary methods. The analyst uses her firm’s tools along with her judgment to gather ESG data from published reports, government organizations, and other sources. ESG data specific to a particular firm can be derived from sources such as 10 K regulatory filings, corporate sustainability reports, and annual reports. While considerations like the board structure may be similar across many companies, ESG factors are likely to vary significantly between industries.

For example, a financial institution may have exposures related to issues of data security, while an energy company is more likely to be exposed to environmental concerns. While various organizations are working toward consistent standards relating to reporting ESG factors, comparability continues to be a challenge for analysts.

Security Analysis: Fixed Income vs. Equity

ESG analysis is applicable both to fixed income and equity securities, and the methods used to identify applicable ESG factors are essentially the same. However, when it comes to valuation of securities, there are differences between the valuation of fixed income and equity instruments in terms of how ESG factors are used.

Fixed Income Analysis

Fixed income analysts usually will focus on ESG factors’ downside risk. For example, an analyst evaluating a company that could be subject to lawsuits might make corresponding adjustments to that firm’s liquidity ratios, cash flow ratios, credit ratios, or credit spreads. The timing of such a lawsuit should be considered: the impact of a potential lawsuit far in the future on short maturity instruments is likely to be minimal.

Similarly, for a company with equipment that is likely to become obsolete (known as a stranded assets issue), it is the value of the firm’s 20 year bonds that should be particularly sensitive to the risk that the equipment will no longer be viable in 20 years.

Equity Analysis

Equity analysts consider both the upside and downside impact of ESG factors when valuing a firm’s stock. For example, the analyst may use a lower discount rate for a company that has implemented new manufacturing practices that are environmentally friendly compared to those of competitors. Conversely, the analyst may increase the projected operating expenses of a firm that is struggling with employee retention.

Green bonds are fixed income instruments used to fund projects related to the environment. Aside from the intended use of the proceeds, these bonds tend to have the same recourse and credit ratings as the issuer’s other bonds. Valuation of these bonds is similar to that of a conventional bond, except that green bonds may command a price premium.

One concern is greenwashing, where a bond’s proceeds are not actually used for the environmental purpose advertised.

ESG considerations are increasingly being taken into account during the investment process. In the following sections, we will consider some examples of how ESG factors can be included in a fixed income or equity valuation.

ESG Integration

ESG factors are generally included in a firm’s valuation by making various adjustments to the company’s financial statements. For example, a company’s projected cash flow statement or income statement may be adjusted in terms of earnings, margins, revenues, costs, capital expenditures, or other items. Adjustments to the balance sheet often take the form of altering the value of assets to reflect impairment.

The credit spread of a fixed income instrument may be adjusted to reflect ESG concerns. Similarly, an adjustment to discount rate or cost of capital may be used to reflect ESG considerations in an equity analysis.

ESG Integration Examples

We illustrate the ESG analytical principles involved using three fictitious companies.

1. Environmental factors. Concerned about wasting water, a soft drink company has been able to lower its water usage in its manufacturing process over the past three years. The corresponding analyst adjustment is to reduce projected cost of goods sold (as a percentage of revenues). This leads to improved gross margin, higher forecasted earnings, and a higher stock price.

This may also lead to a modest improvement in CDS or bond prices, due to slightly improved creditworthiness.

2. Social factors. A drug company has experienced a long string of product recalls, product quality controversies, and fines and warning letters from regulators. To reflect that these negative factors may recur in the future, the analyst makes some adjustments: COGS (a as percentage of revenues) are increased, and projected nonoperating expenses (as a percentage of operating income) related to restructuring are increased as well. Negative valuation impacts for stock and bondholders are also appropriate, especially if the firm’s brand reputation is impaired.

3. Governance factors. Compared to its peers, a bank’s board is found to be lagging in a number of measures: the bank’s chairperson is not independent, the board’s overall independence and diversity is low, board members’ industry experience is low, and a number of board members have long tenures. In addition to these factors, the bank has a higher ratio of nonperforming loans than its peers. To reflect these additional risks, the analyst uses a higher risk premium to value the bank’s stock and also increases the credit spread used to value the bank’s debt.