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CFA Level II Exam · Environmental, Social, and Governance (ESG) Considerations in Investment Analysis

ESG Investment Approaches for CFA Level II

Updated 7 October 2026 · Fact-checked

ESG investment approaches are the methods investors use to put environmental, social and governance views into portfolios. The main ones are negative screening, positive or best-in-class screening, norms-based screening, thematic investing, impact investing, ESG integration and engagement. To answer exam questions, match the vignette's goal and method to the correct definition.

Understand ESG Investment Approaches

An ESG investment approach is a rule or process for using ESG information when you pick securities or manage a portfolio. Different approaches answer different questions. Some answer "what do I refuse to own?" Others answer "what do I want to own?" or "does ESG change my valuation?"

Negative (exclusionary) screening removes sectors, companies or practices from the universe. Examples are tobacco, weapons or thermal coal. Positive or best-in-class screening keeps or overweights companies with the best ESG scores relative to peers, often within each sector. It can hold an oil company, if that company ranks best among oil companies. Norms-based screening excludes issuers that breach international norms or standards, such as labour or human rights conventions.

Thematic investing picks securities exposed to a specific ESG-related theme, such as clean energy, water or gender diversity. The theme drives selection, not an overall ESG score. Impact investing targets measurable, positive social or environmental outcomes alongside a financial return. The key features are intent and measurement of the outcome. Impact funds are often in private markets, but not only there.

ESG integration means including material ESG factors in the normal analysis: forecasts, valuation, credit assessment and risk. It does not exclude anything by itself. It changes inputs such as cash flows, discount rates or credit views. Engagement or active ownership uses voting and dialogue with company management to change behaviour.

Approaches are often combined. A fund might exclude coal, integrate ESG into valuation and then engage with holdings. In a vignette, look for the action the manager takes. Excluding is screening. Tilting to a theme is thematic. Targeting measured outcomes is impact. Adjusting forecasts or valuation is integration.

Key formulas to remember

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.

How to solve ESG Investment Approaches questions

Use this method for any question that asks you to identify, compare or apply an ESG approach in an item set.

  1. 1Read the question first, then find the manager's stated objective in the vignette.
  2. 2Find the action taken: excluding, ranking against peers, choosing a theme, measuring outcomes, or changing forecasts and valuation.
  3. 3Match the action to the definition: exclusion is negative screening; peer ranking is best-in-class; a specific theme is thematic; intended measurable outcomes is impact; ESG in the analysis is integration.
  4. 4Check whether norms or international standards are the basis for exclusion. If so, it is norms-based screening.
  5. 5Consider portfolio effects the question asks about: sector bias, tracking error, diversification, return expectations.
  6. 6Check for combinations. If several approaches are used, answer for the approach the question names.
  7. 7Eliminate options that overstate, such as claiming an approach guarantees higher returns or removes all ESG risk.

Quickest way: One-word trigger method

When to use it: When time is short and the question asks you to name or distinguish an approach.

  1. Exclude = negative screening.
  2. Rank vs peers = best-in-class.
  3. Specific theme = thematic.
  4. Measured outcomes = impact.
  5. Changes to forecasts or valuation = integration.
  6. Voting or dialogue = engagement.

Common mistakes in ESG Investment Approaches

  • Calling best-in-class a form of exclusion of whole sectors.

    Both are screens, so they get blended together.

    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.

    Both sound purpose-driven, such as a clean energy fund.

    Fix: Thematic is about exposure to a theme. Impact requires intent to create and measure outcomes.

  • Saying ESG integration excludes poor ESG companies.

    Students link ESG with avoidance.

    Fix: Integration adjusts analysis and valuation for material ESG factors. A company can still be held if the price compensates for the risk.

  • Assuming screening has no effect on portfolio risk.

    Screens are seen as ethical choices only.

    Fix: Exclusions shrink the universe and can create sector bias and higher tracking error against the benchmark. Best-in-class limits this.

  • Claiming an approach guarantees higher returns.

    Marketing language leaks into answers.

    Fix: Choose answers that state effects conditionally. ESG approaches change exposures and risks; outperformance is not assured.

  • Ignoring that approaches can be combined.

    Students look for a single label.

    Fix: Identify each action in the vignette and label it separately. Then answer for the approach the question asks about.

Worked examples

Example 1

Vignette: A global equity fund removes all companies earning more than a set share of revenue from thermal coal and tobacco. Among the remaining firms in each sector, it overweights those in the top quartile of ESG ratings versus peers. Analysts also lower the long-term growth forecast for a utility facing likely carbon pricing. Q1: Which approaches does the fund use? Q2: Which action is ESG integration?

Show the solution
  1. Removing coal and tobacco firms on a revenue test is negative screening.
  2. Overweighting top-quartile firms within each sector versus peers is best-in-class.
  3. Lowering a growth forecast for expected carbon pricing changes the valuation input. That is ESG integration.
  4. So the fund combines all three.

Answer: Q1: negative screening, best-in-class and ESG integration. Q2: lowering the utility's growth forecast for expected carbon pricing.

Example 2

Vignette: Fund A buys listed shares of solar, wind and battery companies. Fund B lends to affordable housing projects and reports the number of homes built and tenants housed each year, targeting a modest market-rate return. Q1: Classify each fund. Q2: Which is more likely to report measured outcomes as a core objective?

Show the solution
  1. Fund A selects securities by exposure to a clean energy theme. That is thematic investing.
  2. Fund B intends a social outcome, measures it (homes built, tenants housed) and seeks a financial return. That is impact investing.
  3. Measured outcomes as a core objective is the defining feature of impact investing, so Fund B.

Answer: Q1: Fund A is thematic; Fund B is impact. Q2: Fund B.

Exam tips

  • 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.
  • Avoid answer options that promise higher returns or remove all risk.
  • With no penalty for wrong answers, always answer; eliminate absolutes first.

ESG Investment Approaches in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

ESG Investment Approaches: frequently asked questions

What is the difference between negative screening and best-in-class?

Negative screening excludes sectors, companies or practices by rule. Best-in-class ranks issuers against peers and selects or overweights the leaders, often within every sector. Best-in-class can therefore hold companies in controversial sectors.

How is ESG integration different from thematic and impact investing?

ESG integration puts material ESG factors into normal analysis and valuation across the portfolio. Thematic investing targets a specific theme such as water or clean energy. Impact investing aims for intended, measurable social or environmental outcomes.

Do ESG approaches change portfolio construction?

Yes. Screens reduce the investable universe and can create sector tilts and tracking error versus a benchmark. Integration changes expected returns and risk estimates security by security. Thematic funds can be concentrated.

Can a fund use more than one approach?

Yes, and many do. A fund may exclude some sectors, rank the rest, integrate ESG into valuation and engage with holdings. In the exam, answer for the approach the question names.