Free Practice Questions for CFA Institute Sustainable-Investing Exam

Monitoring allows investors to gather information on company performance and capital allocation. While engagement may lead to changes in company behavior or improvements in corporate governance, monitoring focuses on analyzing and optimizing capital efficiency.ESG Reference: Chapter 6, Page 297 - Engagement and Stewardship in the ESG textbook.

Best-in-class funds most likely target a higher ESG rating than that of a corresponding index.

Best-in-Class Approach: This strategy involves selecting companies that have the highest ESG ratings within their sectors or industries, compared to their peers. The goal is to outperform the average ESG performance of the corresponding index.

Higher ESG Standards: Best-in-class funds aim to include top performers in ESG criteria, thereby achieving a portfolio that scores better on ESG metrics than the broader market index.

Selective Inclusion: These funds do not necessarily include only companies considered responsible investments (B) or use a common set of ESG criteria across all sectors (C). Instead, they focus on relative performance within each sector to ensure high ESG standards.

CFA ESG Investing References:

The CFA Institute’s guidance on ESG investment strategies discusses the best-in-class approach as one that aims to surpass the ESG performance of benchmark indices by selecting the top ESG performers within each sector​​​​.

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Scope 3 carbon emissions, which include indirect emissions from the entire value chain (e.g., suppliers and customers), are accounted for under both the UK Task Force on Climate-related Financial Disclosures (TCFD) and the European Union’s Sustainable Finance Disclosure Regulation (SFDR). These frameworks guide companies in reporting and managing all relevant emissions, beyond direct operations.ESG Reference: Chapter 3, Page 133 - Environmental Factors in the ESG textbook.

Europe has the largest proportion of sustainable investing relative to total managed assets. The region has been a leader in ESG integration due to strong regulatory frameworks, such as the European Union's Sustainable Finance Disclosure Regulation (SFDR), and increasing investordemand for sustainable products.ESG Reference: Chapter 2, Page 58 - The ESG Market in the ESG textbook.

Step 1: ESG Philosophy in Investment Mandates

An ESG philosophy embedded within an investment mandate means integrating ESG factors into the overall investment strategy, influencing both short-term (tactical) and long-term (strategic) decisions.

Step 2: Tactical vs. Strategic Asset Allocation

Tactical Asset Allocation: Short-term adjustments to the asset mix based on market conditions.

Strategic Asset Allocation: Long-term asset mix decisions based on the investor's objectives, risk tolerance, and time horizon.

Step 3: Verification with ESG Investing References

Embedding ESG philosophy within an investment mandate affects both tactical and strategic asset allocations, ensuring ESG factors are considered in all investment decisions: "Integrating ESG considerations into investment mandates ensures that both tactical and strategic asset allocation decisions align with sustainability goals"​​​​.

Conclusion: ESG philosophy can be embedded within an investment mandate to determine both the asset owner's tactical and strategic asset allocations.

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Financial materiality in the context of climate change encompasses both the impacts of a company on the climate and the climate-related impacts on a company.

Double Materiality: This concept involves assessing how a company’s operations affect the climate (inside-out perspective) and how climate change affects the company's financial performance (outside-in perspective).

Regulatory Frameworks: Many sustainability reporting frameworks, such as the Global Reporting Initiative (GRI) and the Task Force on Climate-related Financial Disclosures (TCFD), emphasize the importance of understanding both dimensions of climate impact.

Risk and Opportunity Assessment: Considering both perspectives provides a comprehensive view of a company's exposure to climate risks and opportunities, which is crucial for informed decision-making and long-term sustainability.

CFA ESG Investing References:

The CFA Institute’s ESG Disclosure Standards highlight the importance of double materiality in evaluating ESG factors. By considering both the impacts of the company on the climate and the climate-related impacts on the company, investors can better understand and manage ESG risks and opportunities​​​​.

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Traditional ESG Providers: These include established entities such as credit-rating agencies that have long been involved in providing financial data and have integrated ESG factors into their traditional credit rating processes.

Role of Credit-Rating Agencies: They assess the creditworthiness of issuers, including sovereign, corporate, and municipal issuers, and increasingly incorporate ESG factors into their ratings to reflect potential risks and opportunities.

Nontraditional Providers: These include newer, often technology-driven firms focusing solely on ESG data, sometimes using alternative data sources and innovative methodologies.

CFA ESG Investing References:

The CFA Institute’s materials on ESG integration recognize credit-rating agencies as traditional ESG data providers because they have expanded their analysis to include ESG factors alongside traditional financial metrics​​​​.

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ESG engagement is a two-way dialogue to share perspectives between investors and investees.

Engagement Definition: ESG engagement involves active communication between investors (e.g., asset managers, shareholders) and investees (e.g., companies) to discuss ESG issues and improve sustainability practices.

Purpose: The goal is to influence company behavior, enhance ESG performance, and align business practices with sustainable investment objectives. This dialogue allows both parties to share perspectives, address concerns, and work towards common goals.

Two-Way Communication: Effective ESG engagement requires open and ongoing communication, ensuring that both investors and investees contribute to the conversation and decision-making process.

CFA ESG Investing References:

The CFA Institute’s guidance on ESG engagement highlights the importance of two-way dialogue between investors and investees to foster better ESG practices and drive positive change in corporate behavior​​​​.

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In contrast to active investors, passive investors are most likely to start their engagement process by writing a letter to all the companies impacted by a certain ESG issue.

Passive Investment Approach: Passive investors, such as those managing index funds, typically hold a wide array of companies within their portfolios. Direct engagement with each company individually can be resource-intensive.

Broad Engagement Strategy: Writing a letter to all companies affected by a specific ESG issue allows passive investors to address concerns across their entire portfolio efficiently. This approach ensures that all relevant companies are informed of the investor's expectations and concerns regarding the ESG issue.

Active Investors: In contrast, active investors may prioritize direct discussions with senior management and the board (A) or focus on specific underperforming companies (C) for more targeted engagement.

CFA ESG Investing References:

The CFA Institute’s resources on engagement strategies for investors distinguish between the broad, systematic engagement methods used by passive investors and the more targeted, intensive approaches favored by active investors. This helps ensure effective ESG integration across different investment styles​​​​.

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When portfolio managers upload their portfolios onto third-party ESG data provider online platforms, most of these platforms are capable of producing a measure of the portfolio's relative carbon exposure.

Carbon Exposure Measurement: ESG data platforms typically offer tools to measure the carbon footprint of a portfolio, providing insights into the portfolio’s exposure to carbon-intensive companies.

ESG Metrics: These platforms use company-level data on greenhouse gas emissions and other related metrics to calculate and compare the carbon exposure of different portfolios relative to benchmarks or peer groups.

Risk and Controversy Scores: While platforms may offer some insights into controversies or risk scores, these are often estimates and not exact calculations. The primary focus is usually on relative exposure measures like carbon intensity.

CFA ESG Investing References:

The CFA Institute’s guidance on ESG data providers highlights the importance of carbon exposure metrics as a key component of portfolio analysis, enabling managers to understand and manage their environmental impact​​​​.

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A discretionary ESG investment strategy is characterized by active selection, where the portfolio manager uses bottom-up analysis complemented with ESG factors to make decisions about individual investments. This strategy often leads to a concentrated portfolio because of the selective nature of investment choices. Discretionary ESG strategies differ from index-based or systematic approaches, which are more passive and structured.ESG Reference: Chapter 8, Page 94 - ESG Integrated Portfolio Construction & Management in the ESG textbook.

The Stockholm Resilience Centre has identified several planetary boundaries that have already been crossed due to human activity. These boundaries define the safe operating space for humanity, and crossing them increases the risk of triggering large-scale environmental changes. Examples include biodiversity loss and biochemical flows.ESG Reference: Chapter 3, Page 166 - Environmental Factors in the ESG textbook.

Creating ESG scorecards for private companies presents unique challenges compared to public companies:

Less information is available in the public domain (A): Private companies are not required to disclose as much information as public companies, which are subject to regulatory requirements for transparency and reporting. This lack of publicly available data makes it more difficult to assess and create comprehensive ESG scorecards for private companies.

Rating agencies are more critical of private companies (B): While rating agencies might have stringent criteria, the primary challenge is the availability of data rather than the critical nature of the rating agencies.

Management is more unwilling to disclose commercially sensitive information (C): While management's unwillingness to disclose information can be a factor, the fundamental issue is the overall lower level of mandatory disclosure for private companies. Public companies have established reporting standards and are legally obligated to provide certain information, making the data more readily accessible.

Therefore, the main reason why creating private company scorecards is challenging is due to the limited availability of information in the public domain, making it difficult to gather comprehensive ESG data.

CICERO’s “Shades of Green” methodology classifies bonds based on their environmental impact. A bond that supports transition activities which do not lock in emissions, but contribute to a gradual transition to low-carbon operations, is considered "Light Green." This designation indicates that while the activities are beneficial, they may not yet be fully aligned with a low-carbon future.ESG Reference: Chapter 7, Page 123 - ESG Analysis, Valuation & Integration in the ESG textbook.

ESG factors affecting balance sheet strength, such as environmental liabilities or governance risks, are particularly material to corporate bond investors. These factors influence a company's ability to meet its debt obligations and, therefore, affect credit risk.ESG Reference: Chapter 7, Page 362 - ESG Analysis, Valuation & Integration in the ESG textbook.