Free CFA Institute Sustainable-Investing Practice Exam with Questions & Answers | Set: 7

A company's water management efforts are both a credit strength and an ESG strength (Option C) because:

Credit strength: A stable water supply reduces operational risks, improving financial resilience.

ESG strength: Water sustainability aligns with environmental responsibility, reducing risks of regulatory fines or reputational damage.

Option A (Credit strength only) ignores the environmental and social benefits.

Option B (ESG strength only) overlooks the financial stability aspect.

TheESG Performance and Attributionsection of the OTM clarifies that measuring ESG impact on returns involves quantitative decomposition, often using theBrinson modeland multi-factor risk frameworks. It explains:

“ESG performance attribution can bedecomposed using Brinson and risk factor methodologies, identifying how ESG tilts, exclusions, or integration decisions contributed to active returns.”

This allows analysts to isolate the effects of ESG scoring, factor exposure (e.g., quality, size, value), and sector allocation. However, the manual also cautions that attribution is complex infixed income, due to duration, credit quality, and issuer heterogeneity, making option A incorrect. Commercial tools (option B) support but do not fully automate this analysis.

Thus, optionCcorrectly reflects both the methodology and practical application as described.

????Reference:2021-Final-Book.pdf, Chapter 9 — Investment Mandates, Portfolio Analytics, and Client Reporting (ESG Performance Attribution section).

The Official Training Manual cautions that short sample periods limit robust conclusions for ESG index back-tests: “Although the short times (August 2009 to April 2016) limit the ability to make a strong performance claim across multiple economic cycles….” This highlights thedifficulty of back-testing performance across multiple market cyclesrather than implying a standardized methodology across ESG indices.

The manual also shows a widerange of ESG index methodologies(e.g., FTSE Russell, S&P/DJSI) rather than a single standard, further contradicting option A.

The OTM provides several examples ofsocial factor materiality, particularly labor practices and consumer perception. It notes:

“Companies facing controversies overworking conditions or labor rights violationscan experiencereputational damage and consumer boycottsleading to animmediate fall in sales revenueand market share.”

While costs or liabilities may arise later, thedirect and measurable impactof a boycott is on revenue — the firm’s top line. The manual cites real-world examples (e.g., apparel and retail industries) showing that adverse public reactions directly depress revenues before longer-term financial or legal implications materialize.

Hence, the verified answer isC, as it most accurately captures the primary financial effect of a consumer boycott.

????Reference:2021-Final-Book.pdf, Chapter 4 — Social Factors (Material Impacts of Social Issues section).

One of the main challenges incollective engagementis ensuring compliance with legal and regulatory boundaries, particularly rules around"acting in concert"ormarket abuse regulations. Investors working together risk being seen as trying to influence control over a company, which can triggerregulatory scrutinyor require disclosures.

“Many investors see such market abuse rules as limiting their ability to carry out collective engagement effectively.”

Organizations like theInvestor Forumin the UK have created frameworks to facilitate engagement without breaching these regulations, underscoring the seriousness of this issue.

The OTM explains theKyoto Protocolas a foundational global climate agreement under the UNFCCC framework. It states:

“The Kyoto Protocol (1997) legally binds developed countries tolimit and reduce their greenhouse gas emissions in accordance with individual country targets, representing the first implementation mechanism under the UNFCCC.”

Option C refers instead to theParis Agreement (2015), which succeeded Kyoto and introduced the “well below 2°C” goal. Option A describes portfolio-level commitments, not the obligations of Kyoto signatories.

Hence, the verified and historically accurate answer isB, which directly matches the Protocol’s text.

????Reference:2021-Final-Book.pdf, Chapter 3 — Environmental Factors (Climate Frameworks and International Agreements section).

The manual distinguishes firm-specific (idiosyncratic) risk from systematic (market/sector) risk: “Risk also appears as either idiosyncratic or systematic risk:▶Idiosyncratic risk describes firm- or stock-specific risk.”

It also notes sector-wide environmental risks “may affect the discount rate used,” showing that systematic (sector/market) risks can be reflected in the discount rate.

For company-specific assessments, the manual’s DCF case study explains the team “prefers DCF and explicit model scenarios for sales, margins and asset turns … rather than an adjustment to a discount rate … for a company specific assessment.”

Together, these extracts support that company-specific (idiosyncratic) ESG risk is not well suited to be embedded in the discount rate, whereas sector- or market-wide risks are.

When ESG is integrated into portfolio optimization, it does not typically follow a fixed or rigid process for individual securities. Instead, portfolios areorganized based on the ESG characteristics of individual securities, which are then used to construct an efficient portfolio under aspecific ESG optimization approach. This may include aligning portfolios with particular sustainability goals, managing ESG-related risks, or maximizing ESG scores within acceptable levels of risk and return.

“Much of the research focuses on the correlation between a particular ESG criterion and individual securities… ESG integration should not be seen as detrimental to the risk–return dynamic of portfolio optimisation. Rather, it should be understood as simply another factor that potentially may enhance the risk and return profile.”

This approach leverages ESG as anadditional factor in the optimizationprocess, not merely as a constraint.

The manual explains the trade-off explicitly: “Reducing (or outright divesting) portfolio concentration to highly carbon-intensive investments in the energy sector will decrease exposure to long-term transition risk. However this decision may in turn reduce the portfolio income yieldas the energy sector is generally associated with an above market cashflow profile and dividend income stream….”

TheSASB Materiality MapidentifiesGHG emissionsas amaterial issuein sectors where operations havehigh environmental impact, particularlyextractives and minerals processing. These industries include oil, gas, mining, and related heavy industrial activities.

“SASB indicates that greenhouse gas (GHG) emissions are considered material in more than half the industries within the extractives and minerals processing sector.”

Healthcare and technology sectors are less carbon-intensive in comparison.

Step 1:Calculate Company A's carbon intensity:

Step 2:Portfolio weight of Company A:

Step 3:Weighted average carbon intensity:

Start-upstypically haveless mature risk management frameworks, including around ESG and supply chain due diligence. However, they often possessgreater agilityandstrategic flexibility, which enables them torespond fasterto market disruptions and innovations compared to larger incumbents.

“Young companies… may lack the robust systems to manage social risks such as labor practices, but they may be more nimble in responding to new business models or technologies introduced by competitors.”

Therefore, the combination ofweaker ESG systemsandgreater responsiveness to disruptionmakes option C the most accurate.

Credit rating agencies analyze how ESG risks and opportunities affect a company’screditworthiness, which is directly linked to itscost of capital. The CFA UK ESG Investing Training Manual explains that ESG factors can materially affect an issuer's ability to meet financial obligations and thus alter the perceived credit risk. This risk perception translates into the rate at which the company can borrow — its cost of capital.

"Credit rating agencies incorporate ESG into their analysis by assessing how environmental, social, and governance factors might influence the issuer’s ability and willingness to meet financial obligations. For example, material environmental risks could impact a firm’s future cash flows, which would in turn influence its cost of capital."

There is no indication in the CFA UK ESG curriculum that ESG credit scoring is used to test for credit default swaps or green bond eligibility directly. These instruments may reflect ESG risks indirectly, but they are not the focus of ESG credit scoring.

When companies integrate ESG into their operations, they are more likely to enhanceoperational efficiency. This happens through better resource management (e.g., energy and water use), streamlined processes, reduced regulatory risks, and improved stakeholder relationships. The ESG manual states:

“ESG integration in business practices often leads to reduced costs and improved efficiency due to reduced waste, optimized energy use, better supply chain management, and employee satisfaction.”

This integration also supports long-term value creation by aligning operations with sustainability trends, rather than increasing externalities or requiring state intervention.

The OTM distinguishes betweenprimaryandsecondarysources of ESG data. It explains:

“Company communications—including annual reports, sustainability reports, filings, and press releases—are the principal sources of primary ESG information used in data collection.”

This data is then aggregated, normalized, and analyzed by ESG tool providers. While news articles and third-party reports serve as supplementary inputs or controversy screens, they arenot direct sourcesof raw ESG data for formal reporting.

The manual underscores that reliability depends on the transparency and accuracy of company disclosures, which form the foundation for ESG assessment frameworks and rating systems.

Therefore,option Cis correct, aligning directly with the definition of primary ESG data collection.

????Reference:2021-Final-Book.pdf, Chapter 7 — ESG Analysis, Valuation, and Integration (Primary vs. Secondary Data Sources section).