ESG Exam 2 Definitions

Agency costs

The costs associated with managers making self-serving decisions, often through incentive alignment or closer oversight.

Beta

A measurement of the price volatility of a stock or asset relative to the market as a whole; used as a proxy for risk in valuation.

Book value

Represented in financial metrics (as P/B) to compare a firm's market price to its accounting value.

Business model

A key factor in ESG ratings and SASB standards that describes how a company creates value and its exposure to external risks.

Business resilience

A topic assessed through environment metrics that measures a company's adaptive capacity and ability to respond to climate shifts.

CAPM (Capital Asset Pricing Model)

A finance model describing the relationship between systematic risk and expected return, establishing a linear relationship for required return on assets.

Capex (Capital expenditures)

Investments in physical assets; categorized as a measure with expected dynamic effects on future cash flows.

Corporate governance

The system of rules, practices, and processes by which a firm is directed and controlled to balance the interests of stakeholders.

Cost of debt

A component of WACC representing the interest rate a company pays on its borrowed funds.

Cost of equity

The return investors require for bearing the risk of a company's equity; robust ESG practices typically lead to a lower cost of equity.

Discount rate

Expressed as WACC or cost of equity, it is used to determine the present value of future cash flows based on associated risks.

Discounted Cash Flow (DCF)

A valuation model that estimates the present value of future cash flows to determine a company's total value.

EBIT / EBITDA

Financial metrics (Earnings Before Interest and Tax / Earnings Before Interest, Tax, Depreciation, and Amortization) used to evaluate core operating performance in valuation models.

Economic Value Added (EVA)

Created when a firm earns more on its capital (ROIC) than its cost of capital (WACC).

EVA margin

(Economic Value Added) A performance metric calculated as (ROIC−WACC)×IC/Sales.

Employee productivity

One of the five ways ESG creates value; it increases as a result of better social practices and engagement.

Free Cash Flow (FCF)

The cash a company generates after accounting for operating expenses and capital expenditures; the basis for DCF valuation.

Operating costs

Future expenses adjusted in investment models to account for ESG-related efficiencies in energy and waste.

Operating margin

A profitability ratio that can be improved by reducing ESG-related costs.

Return on invested capital (ROIC)

A measure of how effectively a company uses its capital; higher ROIC relative to WACC drives economic value.

Terminal growth rate

The rate at which a company's cash flows are expected to grow indefinitely beyond the explicit projection period.

Terminal value

The estimated value of a company’s expected Free Cash Flows beyond the explicit projected period of a financial model.

Top-line growth

Value creation facilitated by ESG through better access to markets and improved consumer demand.

WACC (Weighted Average Cost of Capital)

A weighted average of a firm’s cost of debt and equity financing, used as a discount rate to determine intrinsic value.

ESG Frameworks and Metrics

Activity-based metrics

Metrics that capture the management systems, processes, and activities companies use to manage potential and actual ESG impacts.

Anti-corruption policies

Policies evaluated under Governance to ensure ethical conduct and accountability.

Business environment metrics

Relate to a company’s exposure to external factors in its operating environment, such as stranded assets or water stress.

Business ethics

Governance standards focusing on bribery, corruption, and the ethical conduct of the board and management.

Carbon offsets

Assumptions within net-zero targets involving the use of credits to balance a company's emissions.

DEI (Diversity, Equity, and Inclusion)

Monitored through workforce metrics; diversity refers to human attributes and backgrounds, while inclusion is the state of feeling respected and safe.

Dynamic metrics

Metrics that capture the progress and evolution of ESG performance over time, such as reduction targets or pathways.

Energy efficiency

An environmental issue focused on reducing consumption, often resulting in lower operating costs.

ESG Integration

The explicit and systematic inclusion of ESG factors into investment analysis and decisions.

ESG metrics

Standardized numerical or descriptive measurements used to evaluate the effectiveness of a company’s ESG policies.

ESG ratings

Assessments from agencies (like MSCI or Sustainalytics) that help stakeholders evaluate the sustainability and ethical practices of businesses.

Gap filling

An issue in data quality caused by missing observations and estimated data using opaque methods.

Human rights

A social pillar factor focusing on community relations and the prevention of labor violations. Fundamental rights inherent to all human beings, including the right to life, liberty, and freedom from slavery.

Input-based metrics

Metrics focusing on company efforts (policies and activities) rather than outcomes; they constitute 68% of ESG metrics.

Materiality

A filter to identify which ESG issues actually matter for a company or industry to prevent "drowning" in irrelevant data (financial & double - financial & impact)

MSCI

An ESG rating agency that uses a scale of AAA-CCC to evaluate management of financially material ESG risks relative to peers.

Net zero

The state where the amount of greenhouse gas emitted equals the amount removed from the atmosphere.

Output-based metrics

Metrics associated with the actual outputs of business activities, such as salaries, GHG emissions, or turnover rates.

Policy-based metrics

A subset of input metrics covering aspirational aspects like corporate strategies, net-zero commitments, or codes of conduct.

Product stewardship

An approach holding businesses responsible for the end-of-life management of their products or packaging.

Qualitative ESG metrics

Non-numerical data used to provide descriptive insights into aspects of performance that are difficult to measure with numbers.

Quantitative ESG metrics

Numerical metrics that reflect performance measurements and can be directly compared, such as GHG emissions.

Sustainalytics

An ESG rating agency owned by Morningstar that provides risk scores (0–50) focusing on unmanaged ESG risk exposure.

Biases and Cognitive Terms

Anchoring bias

The tendency to rely too heavily on the very first piece of information learned or received early in a process.

Availability heuristic

Placing greater value on information that comes to mind quickly, often leading to overestimating the probability of recent events.

Cognitive bias

A systematic error in thinking that occurs when processing and interpreting information, often caused by the brain's attempt to simplify processing.

Confirmation bias

Favoring information that conforms to existing beliefs and discounting evidence that does not.

Dunning-Kruger effect

When individuals believe they are smarter and more capable than they truly are.

Endowment effect

The tendency for individuals to over-value items that they possess.

Experiential vagueness

A psychological characteristic of sustainability challenges where impacts are difficult to perceive directly because they evolve slowly.

Fast thinking (System 1)

The brain’s fast, automatic, intuitive, and emotional approach to decision-making.

Framing

The concept that how the exact same situation is presented can lead to dramatically different consequences.

Groupthink

A corporate-level bias where team cohesion may lead to poor decision-making and amplified risks.

Halo effect

When an overall impression of a person or brand influences how specific traits or qualities are perceived.

Herding behavior

Following the actions of competitors and peers to avoid risks or appear "safe".

Hindsight bias

The tendency, after an outcome is known, to believe one "knew it all along".

Hyperbolic discounting

A bias where people disproportionately prefer immediate rewards over larger future ones, creating time-inconsistent preferences.

Loss aversion

The tendency to perceive losses as more psychologically impactful than gains of the same value.

Misinformation effect

The tendency for post-event information to interfere with the memory of the original event.

Normalcy bias

The tendency to underestimate the likelihood of a disaster and believe things will continue functioning "normally".

Optimism bias

The belief that one is less likely to suffer misfortune and more likely to succeed than peers.

Overconfidence bias

Being supremely confident in one's own abilities or models despite evidence of bubbles or risks.

Self-serving bias

Blaming external forces for failures while taking personal credit for successes.

Slow thinking (System 2)

The mind’s slower, analytical mode where reason and logic dominate.

Sunk cost fallacy

The bias of continuing an investment in a failing course of action because of past costs already incurred.

Tunnel vision

A tendency under pressure to overfocus on a specific goal and ignore all other context.

Investing and Risk Strategies

Best-in-class screening

A positive screening approach involving the selection of only those companies that meet a defined ESG score threshold.

Greenhushing

When companies underreport or hide their sustainability activities to avoid public backlash.

Greenwashing

The act of misleading or deceiving information receivers regarding ESG performance or reporting.

Greenwishing

Unintentional greenwashing where a company hopes to meet commitments but lacks the means to do so.

Impact investing

Investing in assets intended to generate a measurable positive social or environmental impact alongside financial returns.

Information asymmetry

A problem where agents (managers) have superior information about a company compared to principals (shareholders).

Litigation risk

The risk of financial impact due to legal interventions or failure to manage ESG performance.

Negative screening

The exclusion of certain companies or sectors from an investment universe due to poor ESG performance.

Positive screening

Identifying and including assets that meet desired ESG-related criteria.

Regulatory risk

Potential financial exposure from changes in legislation or compliance requirements.

Reputational risk

The risk that negative public perception regarding a firm's ESG impact will reduce its value or ability to attract talent.

Thematic ESG investing

Investing in assets involved in a specific ESG-related theme, such as renewable energy.