Learning Module 2: Environmental, Social, and Governance (ESG) Considerations in Investment Analysis

Learning Module 2 Environmental, Social, and Governance (ESG) Considerations in Investment Analysis EXAMPLE 1 Conflicts between Shareholders and Managers 1. The managers of Company A, a widely held conglomerate, collectively own approximately 30% of the outstanding shares. No other shareholder owns more than a 1% share. Each ownership share has equivalent voting rights. Describe the potential conflict between the shareholders and managers of Company A given its ownership structure and voting rights. Solution: Company A has dispersed ownership and dispersed voting power. In this ownership structure, shareholders do not appear to have the ability to con- trol or monitor managers, that is, there are weak shareholders and strong managers. In this case, a risk exists that managers may seek to use company resources to prioritize their own interests rather than to maximize share- holder value. This type of conflict is known as the principal-agent problem. EXAMPLE 2 Evaluating the Board of Directors 1. A junior analyst is analyzing the board of directors of Style, a fictional global clothing retailer based in Italy. Style was founded by the Donato family and is publicly traded. Style's 11-member board of directors has a chairperson who is not the CEO and two independent directors. Among the six non-independent directors, the Donato family accounts for four of them. All these family members have served on the board for at least 20 years. The gender and age characteristics of the board are both diverse, with women representing five of the board's directors-including its chair. Leila Donato-and the directors ranging in age from 35 to 75 years old. Describe considerations that the junior analyst would use in evaluating the effectiveness of Style's board of directors. Solution: The CEO and chairperson roles are separate for Style (no CEO duality), which can be considered a sign of effective corporate governance. In addi tion, the board appears to be diverse in terms of age and gender, which is typically considered a positive attribute. Conversely, board independence appears to be substandard: Only two board directors are independent, whereas four Donato family members, including the chairperson (Leila Donato), are board members. The tenure of the family board members is also likely to be considered a negative attribute (it far exceeds the typical 10 years) GREEN BONDS Green bonds are bonds in which the proceeds are designated by issuers to fund a specific project or portfolio of projects that have environmental or climate benefits. The first green bond, the Climate Awareness Bond, was issued by the European Investment Bank in 2007. Issuers have the primary decision for labeling their bonds "green." This decision is made in close cooperation with the lead underwriter. At a minimum level, issuers provide detail to the investors about the green eligibility criteria for the use of proceeds, in line with the Green Bond Principles (discussed in the next paragraph). Issuers are responsible for providing investors with details on the criteria used to classify the bonds as green and how the bond's proceeds are used. In some cases, issuers may commission independent reviews of the green criteria to provide investors with greater transparency. Issuers of green bonds typically incur additional costs related to the monitoring and reporting of the use of the bond's proceeds. However, these issuers may benefit from a more diversified investor base and potentially a new-issue premium if demand is strong. The Green Bond Principles, a set of voluntary standards to guide issuers in the determina- tion of labeling a bond as green, were developed in 2014 by a consortium of investment banks. Ongoing monitoring and further development of the Green Bond Principles is the responsibility of the International Capital Market Association, a global securities self-regulatory organization. As the green bond market has evolved, index providers, credit rating agencies, and the not-for-profit Climate Bonds Initiative have developed their own methodologies or standards to assess labeled green bonds. In addition, the European Commission is exploring the feasibility of imposing specific criteria that must be met for a bond to be labeled green. Green bonds typically resemble an issuer's conventional bonds, with the exception that the bond proceeds are earmarked for green projects. Green bonds normally have the same credit ratings and bondholder recourse as conventional bonds of the same issuer (all else being equal). In addition to conventional or "plain vanilla" corporate bonds, other types of green bonds include project bonds, mortgage-backed and asset-backed securities, and municipal bonds. For example, the state of California's $300 million general obligation 2014 green bond issue is backed by the state's General Fund, just as California's other general obligation bonds are. Because only the use of proceeds differs, the analysis and valuation of green bonds are essentially the same as those of conventional bonds. Some green bonds, however, may command a premium, or tighter credit spread, versus comparable conventional bonds because of market demand. One unique risk of green bonds is greenwashing, which is the risk that the bond's proceeds are not actually used for a beneficial environmental or climate-related project. Greenwashing can result in an investor overpaying for a bond (if the investor paid a premium for the bond's green feature) or holding a bond that does not satisfy a prescribed environmental or climate investment mandate. Liquidity risk may also be a consideration for green bonds, given that they are often purchased by buy-and-hold investors. EXAMPLE 3 ESG Integration-Environmental Factors (Beverage Company) 1. Based in the United States, Frizzle Drinks (Frizzle) is a fictitious non-alcoholic beverage company that ranks among the largest in the world. Frizzle operates in both developed and emerging markets, including countries where water is scarce. Frizzle is a significant user of water in its operations. Given that water is a key ingredient in Frizzle's beverages, the continued availability of water is critical to the company's manufacturing process. Because of its extensive use of water, Frizzle faces ongoing regula tory scrutiny for pollution and effects on climate change. Ultimately, how Frizzle conserves and manages its water usage has implications for product pricing and company/brand reputation. Sam Smith, CFA, is analyzing the effects of environmental factors on Friz- zle's financial statements. Based on his research, Smith considers "water intensity" to be a key ESG metric for the beverage industry. Water intensity is defined as the ratio of total liters of water used per one liter of a beverage product. Exhibit 6 illustrates the trend of Frizzle's water intensity ratio from 2009 to 2021, as well as the consensus forecast ratio for the subsequent four years. Frizzle has steadily decreased its water usage over the past several years. From 2009 to 2021, its water intensity ratio declined by 27%. By the end of 2025(F), the company aims to reduce its water intensity by another 13%. Exhibit 6: Water Intensity Ratio (in liters) Note: (F) indicates forecast year. Exhibit 7 compares the year-over-year change in Frizzle's water intensity ratio with that of its peer group over the past three years. To facilitate com- parison among companies of varying sizes, Smith normalized the reported water intensity ratios by calculating the water intensity ratio per $1 million of revenue. Exhibit 7 illustrates that Frizzle's water intensity has decreased considerably relative to its peers over the past few years, particularly in the last reported year, 2021. Exhibit 7: Water Intensity Ratio Change per 51 Million of Revenue Next, Smith analyzes the effects of Erizzle's water intensity on its overall financial performance and compares it with the adjusted financial perfor mance of its peers. As one example, Smith adjusts Frizzle's operating costs to account for the improved effects of water intensity (ie., reduced usage). For the first projected year, 2022, Smith expects that Frizzle's cost of goods sold as a percentage of revenues (before any ESG adjustment) will be 40% and its peer group average will be 42%. For the same forecast period, Smith assumes that Frizzle's reduction in water intensity will result in a 1% reduc tion in its cost of goods sold/revenues, whereas the peer group average will remain the same. Exhibit 8 demonstrates this improvement in cast of goods sold/revenues on both an absolute and a relative basis. By extension, Exhibit 9 shows the absolute and relative improvement in Frizzle's gross margin (sales minus cost of goods sold) percentage Exhibit 8: Cost of Goods Sold as a Percentage of Revenue Exhibit 9: Gross Margin In the last step of the integration analysis, Smith incorporates Frizzle's adjusted financial performance in valuing Frizzle's stock, bonds, and, if applicable, CDSs. In this example, Smith judges that Frizzle's lower cost of goods sold from the adjustment would resalt in higher forecast earnings and, all else being equal, a theoretically higher fair value for Frizzle's stock. With respect to Frizzle's bonds and CDSs, Frizzle's operating cash flow would improve through a lower cost of goods sold. When assessing the credit spreads of Frizzle's bonds and/or CDSs, Smith will analyze whether the lower relative ESG risk is already reflected in current spread levels and adjust accordingly. EXAMPLE 4 ESG Integration-Social Factors (Pharmaceutical Company) 1. Well Pharma (Well) is a fictitious European pharmaceutical company that manufactures drug products for autoimmune diseases and immune disor ders. Over the last five years, Well has had the weakest track record among its peers in terms of product recalls and regulatory warning letters for manufacturing and marketing-related violations. Specifically, the company has been subject to four major drug quality and safety scandals arising from adverse side effects. These scandals have resulted in lost sales, multiple lawsuits, and significant fines. Business disruptions, lawsuits, and fines have reduced revenues and increased costs for the company. As Well's experience shows, product quality is a material social factor for pharmaceutical companies in general. Smith assumes that a drug company's product quality is a combination of the factors shown in Exhibit 10. Exhibit 10: Social Factors-Pharmaceuticals Exhibit 11 shows the number of regulatory warning letters received, as well as product and marketing controversies faced, by Well and several peers. As the graph shows, Well has received significantly more of these letters than its peers have. Exhibit 11: Regulatory Warning Letters and Product Quality Controversies Exhibit 12 demonstrates how the factors listed in Exhibit 10 may affect the financial statements of Well and other pharmaceutical companies. Exhibit 12: Social Factor Effects on Financial Performance Based on these financial effects, Smith adjusts Well's projected revenues, operating expenses, and non operating expenses. The nature of these finan cial statement adjustments will likely differ depending on whether Smith expects these product quality issues to be recurring or non-recurring in nature. Smith assumes that revenues will decrease by 2% over the next year because of existing product quality controversies. For operating expens es, Smith assumes that Well's cost of goods sold relative to revenues will increase by 1.3% to reflect product quality and additional investments in its manufacturing process. Exhibit 13 shows that Well's cost of goods sold as a percentage of revenues is in line with that of its peers, but the additional costs will increase this ratio well above that of the peer group. In addition to operating expenses, Smith forecasts that Well's non-operating expenses, such as restructuring charges, and other non-recurring costs will be an additional 4.5% of operating income. Exhibit 14 shows the current non-operating expense ratio for Well versus its peer group average, as well as the forecast amount Exhibit 13: Cost of Goods Sold as a Percentage of Revenue Exhibit 14: Non-Operating Expenses as a Percentage of Operating Income Smith believes that the valuation implications for Well's stock and bonds could be significant based on its poor product quality and safety track record. Expectations of future poor performance could have a direct im- pact on earnings and cash flow to the detriment of both shareholders and bondholders. In addition, Smith believes there couldEXAMPLE 5 ESG Integration-Governance Factors (Bank Holding Company) 1. Sumiyoshi Banking Group (Sumiyoshi) is a fictitious Japanese bank holding company, with operations in Japan (80% of revenues), the United States, and Southeast Asia. Sumiyoshi's core businesses are commercial banking, leas- ing, securities, and consumer finance. As with most global banks, corporate governance reforms have become increasingly prominent for Sumiyoshi. Smith has prepared Exhibit 15 to show how Sumiyoshi's board of directors compares with the majority of its domestic peer group, on the basis of gov- ernance factors discussed in Section 2 of this reading. be adverse valuation. Implications if investors view Well's brand value and reputation as impaired. Smith notes that Sumiyoshi lags its peers in in several elements of board composition, such as the lack of an independent chairperson, a lower level of board independence and diversity, fewer board members with industry executive experience, and a number of board directors with long tenures. In addition to board composition, Smith uses credit risk as a proxy for a bank's corporate governance risk. In particular, Smith reviews one key banking credit measure-non-performing loans (NPLs). NPLs are loans that are not current in paying the contractual amounts that are due (i.e., interest or principal payments). Smith analyzes Sumiyoshi's credit risk by dividing its NPLs by the amount of its total loans outstanding. Smith estimates that Sumiyoshi's ratio of NPLs to total loans is 50 bps higher than its peer group average, reflecting Sum- iyoshi's comparatively weaker credit/governance risk. To account for the effect of higher credit risk than that of its peers, Smith may increase the risk. premium embedded in his valuation of Sumiyoshi's stock. When valuing Sumiyoshi's corporate bonds, Smith might increase the credit spread rela- tive to peers embedded in the company's outstanding issues.