Free CFA Institute Sustainable-Investing Practice Exam with Questions & Answers | Set: 3

Transition risk—linked toclimate policy changes, regulatory crackdowns, and shifts in demand—poses thehighest risk to common shareholdersbecause they areresidual claimantsin the capital structure. Debtholders and preference shareholders havepriority in claims, so common shareholders absorb most of the financial impact if the coal-powered utility faces declining demand or increased regulatory costs.

The CFA Institute confirms thatESG indices have been developed for both equity and fixed income asset classes, providing investors with performance and risk data. While the specific criteria and weightings of these indices can vary widely (so option A is incorrect), and comprehensive back-testing across multiple cycles is often limited (option C is also not uniformly true), these indices do consistently extend acrossboth equities and bondsto enable portfolio-level ESG integration and benchmark comparisons.

Thecarbon budgetdefines themaximum cumulative amount of CO₂ emissionsallowed tolimit global warming to a specific temperature threshold, such as 1.5 °C or 2 °C above pre-industrial levels. CFA materials emphasize that this budget is afinite global allocationof emissions that can be emitted while still maintaining areasonable chanceof staying within these warming limits. It is distinct from reaching net zero at a specific date (A) or the broader planetary boundary concept (B), although it relates to climate stability within those boundaries.

According to theGHG Protocol and CFA ESG materials,sulphur hexafluoride (SF₆)has aglobal warming potential (GWP) thousands of times higherthan carbon dioxide (CO₂). Methane (A) is also significantly higher than CO₂ but much lower than SF₆. SF₆’s warming potential makes it acritical but lesser-known targetin climate risk assessments.

ESG rating agencies collect data from abroad range of sources, including public documents from nonprofits, regulatory filings, and expert analysis. They do not restrict themselves to audited disclosures only, nor do they exclude commonly used inputs such as CDP data—so statement B is correct.

Impact investingexplicitly aims to achievemeasurable social or environmental outcomesandgenerate afinancial return(not necessarily market-beating, but at least risk-adjusted and sustainable). CFA materials define this as adual objective: positive, measurable impact andadequate financial performance—not purely one or the other.

ESG disclosure rulesare increasingly enforced by bothstock exchanges(listing rules, ESG reporting frameworks) andsecurity regulators(mandatory sustainability disclosure standards like the EU SFDR and CSRD). CFA materials emphasize that this dual regulatory approach is becoming more common to ensure comprehensive sustainability transparency.

CFA sustainable investing materials explain that after settingupper and lower boundsfor ESG constraints (like carbon intensity or ESG scores), optimization can be carried out either:

On an absolute basis: minimizing absolute risk/return outcomes while meeting ESG limits, or

On a benchmark-relative basis: minimizing tracking error to a benchmark while meeting ESG constraints.Thus, ESG constraints do notrequireeither approach—theypermitboth.

The official CFA Institute guidance states that the foundational step in developing any ESG investment mandate is to "clarify client needs and set them out in a clear statement of ESG investment beliefs." This clear statement forms the basis of the mandate. From this strong foundation, the ESG strategy can be tailored and implemented in ways that ensure alignment among the investor’s values, the investment process, and overall ESG objectives. It is therefore identified as the essential first step in the mandate's design.

When a company holds significant cash, investors generallyprefer a balanced capital structure—meaning a mix ofequity and debt—becausesome debtcanimprove the company’s return on equityandenhance capital efficiency. A company with significant cash and no debt may be seen as underutilizing capital, which could be more productively allocated to growth initiatives or returning value to shareholders.

Forced laboris expresslyprohibitedby theILO’s core labor standards. The fundamental conventions promote labor rights such as:

Elimination of forced labor(prohibition)

Freedom of association and collective bargaining

Equal remuneration and non-discriminationThus, while companies should support collective bargaining and equal remuneration,forced labor should not be supported—it is a violation of core labor standards.

Strong governanceis foundational for effectively addressingenvironmental and social riskswithin a company, as highlighted in CFA’s ESG materials. Good governance practices create structures and accountability mechanisms that improve oversight of E&S issues. Statement B is incorrect because direct board involvement in private equity doesn’t eliminate governance risks entirely. Statement C is misleading because negative governance signals actuallyreduce confidencein future earnings, not increase it.

Stewardship teams that evolved from governance practices generally start engagement bycommunicating with investor relations teams—the designated point of contact—and thenescalate discussions to senior executives or board membersif concerns persist or intensify. This phased escalation reflectstypical engagement protocolsand stewardship codes outlined by CFA.

Asset owners must ensure clarity of purpose: portfolio managers shouldestablish a clear rationale for ESG assessment, such as value creation, risk reduction, or client alignment. This rationale forms the policy's basis. Selective disclosure (option B) may breach transparency principles, and segregating ESG risk from overall risk management (option C) is generally discouraged. Instead, ESG risk should be integrated holistically with traditional financial risk into the overall risk framework.

EU regulation aims to strengthen audit independence bylimiting the range of non-audit servicesthat an audit firm can provide to its audit clients. This ensures that external auditors remain objective and do not haveconflicting commercial interests. Mandatory tendering and rotation also exist (five and ten years), but thecore focusof independence requirements is restricting non-audit services to reduce potential conflicts of interest.