Free Practice Questions for CFA Institute Sustainable-Investing Exam

A lower ESG risk profile suggestsbetter risk management and potentially greater resiliencecompared to peers. This canreduce the risk premiumdemanded by investors andincrease the fair value P/E ratio. In practical terms, investors may be willing to pay more (higher P/E multiple) for the earnings of a company perceived to be less exposed to ESG-related risks.

Statement 1 isincorrectbecauseinvestor engagement prioritizes long-term value creation, not just short-term gains.

Statement 2 iscorrect:lobbying through industry groupsor collective engagement initiatives is a recognized and effective method for investors to influence systemic ESG risks or sector-level improvements.

According to the CICERO Shades of Green taxonomy—which is referenced in the CFA Sustainable Investing materials—bonds that support short‑term or limited environmental improvements (such as one‑off energy efficiency upgrades) are categorized underLight Green. This classification reflects that while they offer transitional or near‑term benefits, they do not deliver comprehensive, long-lasting climate resilience solutions.

One of the challenges in quantitative ESG investing is thatESG scores and ratings often overlap or correlate with traditional risk factorslikevalue and momentum. This makes it more difficult toisolate the unique impact of ESGin statistical models, leading to potential “double counting” or confounding of factors. While data quality (options A and B) is also a concern, it’s thefactor correlationthat most directly impacts the reliability of ESG-based quantitative models.

Fixed income (Option B) is the most sensitive to climate-related transition risk because:

Bondholders have limited upside potential but full downside risk—meaning climate policy changes, carbon pricing, and regulatory shifts can significantly affect credit risk and yield spreads.

Stranded asset risk affects sectors like coal, oil & gas, leading to downgrades in corporate and sovereign bonds.

Option A (Equity) also faces transition risks but tends to be more adaptable, as companies can pivot strategies.

Option C (Alternative investments) (e.g., real estate, infrastructure) are less liquid but not as directly affected by short-term policy changes.

Climate Action 100+ is a global investor initiative aimed at engaging with the world’s largest corporate emitters to curb greenhouse gas emissions and improve governance on climate-related issues. (ESGTextBook[PallasCatFin], Chapter 3, Page 153)

A fund that invests in the best ESG performers across industries uses both positive screening to select companies with strong ESG performance and norms-based screening to ensure they meet international norms and standards. (ESGTextBook[PallasCatFin], Chapter 7, Page 325)

An Emissions Trading System (ETS), also known as a cap-and-trade system, is designed to control and reduce greenhouse gas (GHG) emissions by setting a total emissions cap and allowing participants to trade allowances.

How it works:

A government or regulator sets a cap on total emissions.

Companies receive or buy carbon allowances (permits to emit a certain amount of CO₂).

Companies can trade allowances—if they emit less, they can sell excess permits; if they emit more, they must buy additional permits.

Key examples:

EU Emissions Trading System (EU ETS) (largest globally)

California Cap-and-Trade Program

China’s National Carbon Market (launched in 2021)

Why not A or B?

A is incorrect because an ETS does not directly set a price on carbon—it allows the market to determine the price based on supply and demand.

B is incorrect because an ETS does not involve direct investment in renewable energy (that would be carbon offset programs).

Greenwashing—misleading claims about a company's environmental efforts—directly leads to a loss of consumer trust (Option C).

Consumers become skeptical of sustainability claims, leading to brand damage and reduced sales.

Companies caught greenwashing (e.g., Volkswagen Dieselgate, H&M’s false sustainability claims) suffer reputational and financial losses.

Option A (Labor strikes) can occur due to ESG issues, but greenwashing itself does not directly trigger strikes.

Option B (Greater regulation) is a secondary consequence, but the direct impact is consumer trust erosion.

Weitzman’s Dismal Theorem (Option C) argues that:

Extreme climate risks cannot be properly captured by traditional cost-benefit analysis.

High-impact, low-probability climate events (e.g., runaway warming, tipping points) mean economic models underestimate catastrophic risks.

Option A (Low discount rate for moral reasons) is incorrect because Weitzman focused on uncertainty, not ethics.

Option B (Economic value for biodiversity) is relevant but not the core of the dismal theorem.

The scorecard technique relies on company disclosures to assess ESG risks, as these disclosures provide direct information about a company’s practices and performance in relation to ESG criteria. (ESGTextBook[PallasCatFin], Chapter 7, Page 364)

Passive investors, unlike active investors, do not frequently trade securities but instead hold investments that track an index. Their engagement strategy is typically broad and issue-based rather than firm-specific.

Passive investors, such as large asset managers (e.g., BlackRock, Vanguard, and State Street), generally begin engagement by identifying sector-wide ESG risks or opportunities that may affect long-term value.

They then engage with companies within the sector to improve transparency and governance on these issues, often using proxy voting and public statements to drive change.

This differs from active investors, who may focus on underperformers or specific management discussions.

Quantitative ESG analysis involves numerical, measurable data that can be compared across companies and time periods.

Why A (Issuer-reported carbon emissions) is correct:

Carbon emissions data (Scope 1, 2, and 3) is measurable and numeric, often reported in metric tons of CO₂ equivalent (MTCO₂e).

This data can be used in financial models to assess climate risk.

Why not B or C?

B (Executive compensation policies) are qualitative, as linking pay to ESG goals involves policy assessments rather than hard data.

C (Investments and policies credibility) involves subjective judgment rather than numerical data.

Companies integrating ESG into operations enhance efficiency through improved resource management, governance, and stakeholder engagement.

Why A (Efficiency) is correct:

ESG initiatives lead to cost savings, innovation, and better risk management.

Example: Energy-efficient supply chains reduce waste and increase productivity.

Why not B or C?

B (State intervention) is incorrect—proactive ESG efforts often reduce regulatory risks.

C (Negative externalities) is incorrect—effective ESG integration minimizes externalities, not increases them.

The carbon offset market allows companies and individuals to purchase carbon credits to compensate for their emissions.

Why C (voluntary and regulated aspects) is correct:

Regulated markets: Compliance-based (e.g., EU Emissions Trading System, California Cap-and-Trade Program).

Voluntary markets: Used by companies seeking to offset their carbon footprints (e.g., via Verra, Gold Standard projects).

Why not A or B?

A (Very transparent) is incorrect—voluntary carbon markets often lack transparency and face greenwashing risks.

B (Rigorous scientific process) is partly true but varies widely between high-quality and low-quality offsets.