Free CFA Institute Sustainable-Investing Practice Exam with Questions & Answers | Set: 12

When undertaking an ESG assessment of a private equity deal, ESG screening and due diligence are most likely to take place during the deal sourcing phase. Here’s why:

Initial Evaluation: ESG screening at the deal sourcing stage allows investors to evaluate potential investments against their ESG criteria before committing significant resources. This helps in identifying any red flags or areas of concern early in the process.

Risk Management: Conducting ESG due diligence early helps in managing risks associated with environmental, social, and governance issues. By understanding these risks upfront, investors can make more informed decisions and potentially avoid costly issues later.

Integration into Investment Strategy: ESG considerations integrated during deal sourcing ensure that these factors are part of the overall investment strategy and decision-making process. This alignment is crucial for achieving long-term sustainable returns.

Regulatory Compliance and Reputation: Early ESG assessments help in ensuring compliance with relevant regulations and standards, and in protecting the investor’s reputation by avoiding investments in companies with poor ESG practices.

The Paris Agreement has the long-term goal to keep the increase in global average temperature to well below 2°C (3.6°F) above pre-industrial levels.

Global Climate Accord: The Paris Agreement, adopted in 2015 under the UN Framework Convention on Climate Change (UNFCCC), aims to strengthen the global response to climate change by keeping the temperature rise well below 2°C above pre-industrial levels, and to pursue efforts to limit the temperature increase to 1.5°C.

Long-term Goals: The agreement sets long-term goals to guide countries in reducing greenhouse gas emissions, enhancing adaptation efforts, and ensuring that finance flows support low-emission and climate-resilient development.

Commitments and Contributions: Countries are required to submit nationally determined contributions (NDCs) outlining their plans to reduce emissions and adapt to climate impacts. These contributions are to be updated every five years with increasing ambition.

When a company reduces water usage and increases the use of more expensive resources due to more stringent regulations, this directly impacts its operating expenditure (OPEX). Here's a detailed breakdown:

Regulatory Compliance:

As regulations become stricter, companies often need to adopt new technologies or practices that may be more costly. This increase in cost is directly related to the day-to-day operations of the company, affecting operating expenditures.

For example, implementing water-saving technologies or switching to sustainable raw materials that are more expensive than traditional ones will raise the ongoing costs associated with production​​.

Impact on Revenues:

While reducing water usage and adhering to stricter regulations can have long-term benefits for the company, such as improved sustainability ratings and possibly higher market valuation, these changes do not typically have an immediate direct impact on revenues. Revenues are more directly influenced by sales and market demand​​.

Impact on Provisions:

Provisions are set aside for future liabilities or losses, such as environmental remediation costs or legal disputes. While stricter regulations might eventually lead to increased provisions, the immediate impact of switching to more expensive resources affects operating expenditure first​​.

CFA ESG Investing References:

The CFA ESG Investing curriculum highlights the importance of understanding how regulatory changes can affect various aspects of a company's financials. Operating expenditure is often highlighted as the most immediately impacted area when companies adapt their operations to comply with new environmental standards​​.

Wastewater treatment facilities are highly capital intensive to develop. The development of these facilities involves significant upfront investments in infrastructure, technology, and construction.

Infrastructure Costs: Building a wastewater treatment facility requires substantial investment in infrastructure, including pipelines, treatment plants, and equipment. These costs can be very high due to the scale and complexity of the systems needed to treat wastewater effectively.

Technology and Equipment: The technology and equipment used in wastewater treatment, such as filtration systems, chemical treatment processes, and monitoring tools, are expensive to acquire and install. Advanced technologies that improve efficiency and reduce environmental impact further increase costs.

Regulatory Compliance: Ensuring that the facility meets regulatory standards and environmental guidelines adds to the capital costs. Compliance with regulations often necessitates additional investments in specialized equipment and processes.

The Principles for Sustainable Insurance (PSI) were established by the United Nations Environment Programme Finance Initiative (UNEP FI). Here’s a detailed explanation:

UNEP FI and PSI: The United Nations Environment Programme Finance Initiative (UNEP FI) launched the Principles for Sustainable Insurance in 2012. The PSI aims to promote sustainability within the insurance industry by encouraging insurers to integrate environmental, social, and governance (ESG) factors into their business strategies and operations.

Objectives of PSI: The PSI provides a global framework for the insurance industry to address ESG risks and opportunities. It helps insurers improve risk management and decision-making processes, enhance their reputation, and contribute to sustainable development.

Not the Other Options:

Climate Disclosure Standards Board (CDSB): The CDSB is an international consortium of business and environmental NGOs. It was not established by UNEP FI but aims to provide a framework for companies to report environmental information with the same rigor as financial information.

Global Sustainable Investment Alliance (GSIA): The GSIA is a collaboration of the world's largest sustainable investment membership organizations. It was also not established by UNEP FI but works to deepen the impact and visibility of sustainable investment organizations.

CFA ESG Investing References:

According to the CFA Institute, the PSI was developed by UNEP FI to promote the integration of ESG factors in the insurance industry, enhancing the industry's role in sustainable development (CFA Institute, 2020).

The PSI is highlighted as a key initiative under UNEP FI to advance sustainable insurance practices globally​​​​.

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Under the disclosure guide for public equities published by the Pension and Lifetime Savings Association (PLSA), fund managers are expected to report on both ESG integration and stewardship activities. Here's a detailed explanation:

ESG Integration:

Fund managers are required to disclose how they integrate ESG factors into their investment processes. This includes the identification and management of ESG risks and opportunities.

They need to provide examples of material ESG factors identified in their analysis, how these factors influence their investment decisions, and how they monitor ESG risks over time .

Stewardship Activities:

Stewardship activities involve how fund managers engage with companies they invest in to promote sustainable business practices and good governance.

This includes voting at shareholder meetings, engaging in dialogue with company management, and participating in collaborative initiatives aimed at improving ESG standards across the industry .

CFA ESG Investing References:

The CFA Institute’s ESG curriculum emphasizes the dual role of ESG integration and stewardship in sustainable investing. Both aspects are crucial for ensuring that ESG considerations are fully embedded in the investment process and that fund managers actively contribute to improving corporate practices through engagement and voting .

When searching for an asset manager with an ESG approach, it is essential for an institutional asset owner to understand whether the asset manager's strategy aligns with their sustainability objectives. The most appropriate question to ask in the RFP is whether the asset manager aims for positive, measurable ESG outcomes beyond financial returns. This question assesses thecommitment to achieving concrete ESG results, which is a critical factor in evaluating the manager's integration of ESG factors into their investment process. Detailed questions about portfolio holdings or which broad market index the manager tracks are less relevant to assessing the ESG integration​​.

According to the UK Investor Forum, a key success factor for effective engagement is clear leadership with appropriate relationships, skills, and knowledge. Effective engagement requires strong leadership to drive the process and ensure that the engagement is meaningful and productive.

Leadership: Clear leadership is essential to guide the engagement process, set objectives, and ensure that the engagement activities align with the overall strategy and goals of the investors.

Relationships: Effective engagement relies on building and maintaining strong relationships with key stakeholders, including company executives, board members, and other investors. These relationships facilitate open communication and trust.

Skills and Knowledge: Having the appropriate skills and knowledge is crucial for understanding the issues at hand, asking the right questions, and providing valuable insights. This includes knowledge of ESG factors, industry-specific issues, and effective engagement techniques.

Prevalence in the US:

Shareholder resolutions are a prominent feature of the corporate governance landscape in the United States. They allow shareholders to propose changes or raise concerns about a company's policies, practices, and governance.

According to the CFA Institute, the US has a well-established tradition of shareholder activism, with a significant number of resolutions submitted annually on various issues, including ESG matters.

Regulatory Framework:

The regulatory framework in the US, particularly the rules enforced by the Securities and Exchange Commission (SEC), provides shareholders with the right to propose resolutions and ensures that these proposals are included in the company’s proxy materials if they meet certain criteria.

The CFA Institute notes that the US regulatory environment is conducive to shareholder activism, facilitating the submission and consideration of shareholder resolutions.

Engagement and Influence:

Shareholder resolutions are an important engagement tool for investors in the US, allowing them to influence corporate behavior and advocate for changes in policies related to environmental, social, and governance issues.

The MSCI ESG Ratings Methodology highlights that shareholder resolutions can drive significant changes in company practices, particularly when they garner substantial support from investors.

Comparison with Other Countries:

While shareholder resolutions are also used in other countries such as the UK and Australia, the frequency and impact of these resolutions are more pronounced in the US.

The CFA Institute indicates that the shareholder resolution process in the US is more formalized and widely used compared to other jurisdictions, making it the most common country for the proposal of shareholder resolutions.

Traditional investment analysts most often take into consideration governance factors among the three ESG factors. Governance factors are typically viewed as critical to the operational and financial stability of a company.

Corporate Governance: Governance factors include the structures and processes for the direction and control of companies, such as board composition, executive compensation, audit practices, and shareholder rights. These elements are directly linked to a company's accountability and integrity.

Risk Management: Effective governance practices help mitigate risks related to fraud, mismanagement, and regulatory non-compliance. Analysts focus on governance to ensure that the company is managed in a way that protects shareholders' interests and enhances long-term value.

Performance Indicators: Strong governance is often correlated with better financial performance and reduced volatility. Companies with robust governance structures are perceived as more reliable and are thus more attractive to traditional investment analysts.

Norms-based screening is the largest investment strategy in Europe. This approach involves screening investments against specific social, environmental, and governance criteria based on international norms and standards. Europe has a strong regulatory and cultural emphasis on responsible investing, which is reflected in the widespread adoption of norms-based screening​​.

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Equity investors are primarily focused on future growth opportunities, as they are investing in the potential appreciation of a company's stock price over time. ESG factors that relate to future growth opportunities are particularly relevant to equity investors because these factors can significantly influence a company's long-term profitability and valuation.

Detailed Explanation:

Growth Potential and Future Earnings: Equity investors are interested in companies that demonstrate potential for future growth and increased earnings. ESG factors such as innovation in sustainable technologies, efficient resource management, and positive social impact can drive a company’s growth by opening up new markets, improving operational efficiencies, and enhancing brand reputation.

Risk Mitigation and Long-Term Stability: ESG factors also help equity investors mitigate risks associated with environmental, social, and governance issues. For example, companies with strong environmental practices are less likely to face regulatory fines, and those with robust governance structures are less likely to encounter scandals. This stability is attractive to equity investors looking for sustainable returns.

Valuation and Investor Sentiment: Companies that are proactive in managing ESG factors often enjoy a higher valuation due to positive investor sentiment. Investors are increasingly valuingcompanies that are seen as responsible and forward-thinking. This can lead to a higher stock price as demand for the company’s shares increases.

Regulatory and Market Trends: As regulations around ESG factors become stricter and as consumers become more environmentally and socially conscious, companies that are ahead in ESG practices are likely to benefit. Equity investors look at these trends to anticipate which companies will be market leaders in the future.

CFA ESG Investing References:

According to the CFA Institute’s ESG Investing Guide, “Equity investors are particularly interested in how ESG factors might affect a company’s future earnings and risk profile” (CFA Institute, 2020).

The MSCI ESG Ratings Methodology document highlights that ESG factors are critical in assessing a company’s resilience to long-term financially relevant ESG risks, which directly impacts future growth opportunities and hence, is vital for equity investors​​.

These aspects underscore why ESG factors related to future growth opportunities are most relevant to equity investors, who are keen on capitalizing on both the upside potential and risk management of their investments over the long term.

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The Task Force on Climate-Related Financial Disclosures (TCFD) framework uses the weighted average carbon intensity metric, which calculates carbon intensity based on an issuer's revenue. The formula is as follows: \text{Weighted Average Carbon Intensity} = \sum \left( \frac{\text{Current Value of Investment}}{\text{Current Portfolio Value}} \times \frac{\text{Issuer’s Scope 1 and 2 Emissions}}{\text{Issuer’s Revenue in US$m}} \right) This approach helps investors understand their portfolio's exposure to carbon-intensive companies based on financial performance metrics such as revenue​​.

Among the greenhouse gases (GHGs) listed, fluorinated gases have the longest atmospheric lifetimes. Here's a detailed breakdown:

Methane (CH4):

Methane is a potent greenhouse gas with a significant impact on global warming. However, its atmospheric lifetime is relatively short, approximately 12 years​​.

Carbon Dioxide (CO2):

Carbon dioxide is the most prevalent greenhouse gas emitted by human activities, particularly from the burning of fossil fuels. CO2 can remain in the atmosphere for hundreds to thousands of years, but it is still not the longest-lived compared to fluorinated gases​​​​.

Fluorinated Gases:

Fluorinated gases, such as hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), and sulfur hexafluoride (SF6), are synthetic gases that have extremely long atmospheric lifetimes, often ranging from a few years to thousands of years. For instance, SF6 can remain in the atmosphere for up to 3,200 years​​​​.

These gases are typically used in industrial applications and have a high global warming potential (GWP) due to their longevity and heat-trapping capabilities.

CFA ESG Investing References:

The CFA Institute’s ESG curriculum emphasizes understanding the different types of greenhouse gases, their sources, and their impacts on climate change. The curriculum specifically points out the longevity and high global warming potential of fluorinated gases, which makes them a critical focus in ESG assessments and climate risk evaluations​​​​.

Human rights violations are most likely to occur deep within the supply chain of publicly traded companies. Here's why:

First-tier Suppliers:

First-tier suppliers are those that directly supply products or services to a company. These suppliers are often under greater scrutiny from the company and external stakeholders, including auditors and regulatory bodies. Publicly traded companies typically enforce stricter compliance and monitoring mechanisms at this level​​​​.

Second-tier Suppliers:

Second-tier suppliers supply products or services to the first-tier suppliers. While there is still some level of oversight, the scrutiny diminishes as the layers in the supply chain increase. Human rights violations can occur here, but they are less frequent compared to deeper levels in the supply chain​​​​.

Deep within the Supply Chain:

Suppliers deeper within the supply chain, such as third-tier and beyond, are the least visible and have the least amount of oversight. These suppliers often operate in regions with weaker regulatory frameworks and less stringent enforcement of labor laws. Consequently, they are more prone to human rights violations, including poor working conditions, forced labor, and child labor​​​​.

Companies may not have direct business relationships with these deeper-tier suppliers, making it challenging to enforce ethical practices and human rights standards.

CFA ESG Investing References:

The CFA Institute’s ESG curriculum highlights the importance of supply chain transparency and the risks associated with human rights violations at different levels of the supply chain. The curriculum emphasizes that deeper tiers within the supply chain are often where the mostsignificant human rights risks are found, and it encourages investors to assess and address these risks in their ESG evaluations​​​​.