Environmental, Social, and Governance (ESG) Considerations in Investment Analysis: formula sheet

Key formulas

Environmental factors

E = climate change, emissions, resource use, water, waste, pollution, biodiversity

Issues about a company's effect on, and exposure to, the natural environment.

Social factors

S = labour relations, health and safety, human rights, supply chain, product safety, privacy, community

Issues about how a company treats people inside and outside the firm.

Governance factors

G = board structure, pay, shareholder rights, audit, ownership, ethics and transparency

Issues about how the company is directed and controlled and how it treats shareholders.

Materiality test

Material if the issue can reasonably affect cash flows, risk or valuation for that industry and region

Not every ESG issue is material to every company.

Term distinctions

Responsible investing (broad) ⊃ SRI (exclusion/values), ESG integration (financial analysis), impact investing (measurable outcomes)

Definitions vary in practice, so follow the usage in the vignette.

Negative screening

Investable universe = full universe − excluded sectors, companies or practices

Rule-based exclusion. It does not rank the remaining securities.

Best-in-class (positive screening)

Select or overweight issuers with the highest ESG ratings relative to peers, usually within each sector

Keeps sector weights close to the benchmark, so sector risk is controlled.

ESG integration

Adjusted value = valuation after changing cash flows, growth, discount rate or credit view for material ESG factors

Financial materiality drives the adjustment. No automatic exclusion.

Impact investing test

Intent to create positive outcome + measurable outcome + financial return

If outcomes are not intended and measured, it is not impact investing.

SASB focus

SASB = industry-specific, financially material to investors

Choose SASB when the vignette stresses investor-relevant, sector-specific metrics.

GRI focus

GRI = company's impacts on economy, environment and people

Broad stakeholder audience, impact materiality.

TCFD structure

Governance, Strategy, Risk management, Metrics and targets

Climate-related only. Includes scenario analysis within strategy.

ESG rating divergence

Different indicators + weights + materiality + missing-data methods → different scores

Ratings from different providers are not directly comparable.

Stewardship

Engagement + proxy voting + reporting

Applies to institutional investors under stewardship codes.

DCF firm value

Firm value = Σ FCFFₜ ÷ (1 + WACC)ᵗ + TV ÷ (1 + WACC)ⁿ

ESG risks can change FCFFₜ, the terminal growth rate in TV, or WACC.

Gordon growth terminal value

TVₙ = FCFFₙ₊₁ ÷ (WACC − g) = FCFFₙ × (1 + g) ÷ (WACC − g)

Valid for WACC > g. A lower g or higher WACC lowers TV.

Cost of equity (CAPM)

r = Rf + β × (equity risk premium)

An ESG-driven add-on is a premium on top of this. Use it only if the risk is not already in cash flows.

Relative valuation with ESG adjustment

Value = adjusted multiple × metric

Apply a premium or discount to the peer multiple only with a stated financial reason.

Expected loss for credit

Expected loss = probability of default × loss given default

ESG factors can raise default probability, loss severity, or both.

Probability-weighted cash flow

E(CF) = Σ pᵢ × CFᵢ

Useful for uncertain ESG events such as a possible fine or carbon tax.

Quick revision

• ESG factors matter to investors when they are material to risk, cash flows or value.
• Learn the exact definitions of the terms in the chapter; options often differ by one word.
• Screening excludes or selects securities by set criteria; best-in-class picks the stronger ESG names within a sector.
• Thematic investing targets a specific ESG-related theme, such as clean energy or water.
• Impact investing aims for measurable social or environmental outcomes alongside financial return.
• ESG integration uses ESG information within normal financial analysis.
• Active ownership means engagement and proxy voting to influence company behaviour.
• Weak governance can raise agency problems and lower valuation.
• In valuation, ESG can change forecast cash flows, growth rates and the discount rate.
• In credit analysis, ESG issues can affect default risk, spreads and lender protection.
• Match the approach to the client's stated objective and mandate in the vignette.
• Check whether a question asks for a definition, an approach or an effect on value before choosing.

Common mistakes

• Treating ESG, SRI and sustainable investing as exact synonyms. Fix: Anchor on what the investor actually does. Exclusion on values points to SRI. Using ESG factors in valuation points to integration.
• Assuming all ESG factors are equally material to every company. Fix: Always tie the issue to the industry and its cash flows before judging materiality.
• Calling best-in-class a form of exclusion of whole sectors. Fix: Best-in-class ranks issuers within a sector and can hold controversial sectors. Negative screening removes sectors or companies outright.
• Treating thematic investing as impact investing. Fix: Thematic is about exposure to a theme. Impact requires intent to create and measure outcomes.
• Assuming ESG ratings from two providers should agree. Fix: Remember ESG ratings have no standard method. Differences in indicators, weights and materiality cause divergence.
• Mixing up SASB and GRI. Fix: SASB is industry-specific and investor-focused on financial materiality. GRI covers impacts on stakeholders and society.
• Double counting an ESG risk in both cash flows and the discount rate Fix: Put estimable costs in cash flows. Use a higher discount rate only for residual risk not modelled.
• Treating every ESG issue as material Fix: Ask whether the factor can change cash flows or risk for this industry. If not, leave it out.

Exam tips

• Expect vignettes that mix E, S and G issues and ask you to classify or rank them by materiality for the stated industry.
• Match the investor's action to the term. The stem usually describes what the fund does rather than naming the approach.
• Watch qualifiers such as most likely, least likely and primarily. They change which answer is best.
• Use regional clues in the vignette, such as disclosure rules or ownership structure, to judge governance and reporting differences.
• This topic is quick marks if you stay disciplined, so do not overthink and spend time better used on calculation-heavy sets.
• Underline the manager's action in the vignette. The action, not the fund's name or marketing, decides the approach.
• Expect distinctions: negative screening vs best-in-class, thematic vs impact, and screening vs integration.
• Watch for portfolio-effect questions: exclusions can add tracking error and sector bias, and best-in-class reduces this.