In-class Assignment

FM471
Sustainable Finance and Impact Investing
Instructions:

1. Time available: 120 minutes + 10 minutes reading time. No writing is permitted during
the reading time.

2. If you arrive late, your end time will be the same time as all other students.

3. Answer all questions in the answer booklet provided. If you require additional space,
please request another answer booklet.

4. Please write ONLY your Candidate Number on your assignment (in the provided box
below). Any attempt to identify yourself will result in an automatic fail.

5. If at any point, you feel that anything is unclear, please make any additional assumptions,
state them clearly, and proceed with your answers. No academic questions will be
answered during the ICA.

6. You may use a calculator as prescribed in the examination regulations.

 LSE SAMPLE/FM471 Page 1 of 5

Part A

1) Brown Energy is a publicly traded firm that is considering investing in a coal-

mining project that requires an up-front investment of £100 million today and
will generate £10 million in free cash flow in perpetuity starting one year from
today. The coal-mining project has a CAPM β of 0.75. The risk-free rate is 2%,
and the market risk premium is 8%.

A) Using the CAPM, calculate the NPV of the project. (4 marks)

The CAPM discount rate 𝑟𝑟𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 is 𝑟𝑟𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 �𝑟𝑟���

𝑀𝑀 − 𝑟𝑟𝑓𝑓 � = .02 + 0.75 ∗
𝐹𝐹𝐹𝐹𝐹𝐹𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
(. 08) = 0.08. The project is valued as a perpetuity with 𝑁𝑁𝑁𝑁𝑁𝑁𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = − 𝐼𝐼 =
𝑟𝑟𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
10
− 100 = 25.
.08

B) Assume that markets are informationally efficient and an ESG-adjusted

CAPM holds. Do we expect the cost of capital for Brown Energy’s coal
mining project to be higher or lower than the CAPM discount rate you
used in part A)? (4 marks)

We expect the discount rate to be higher as investors which prefer to hold firms
with better ESG scores will require a higher expected return, all else equal, to
hold a firm with a poor ESG score.

C) Calibrate the magnitude of the difference between Brown Energy’s

CAPM discount rate and ESG-adjusted CAPM discount rate using the
following additional information. The fraction of total market value in
brown stocks is 48.5%. The correlation between projects like the one
Brown Energy is considering and green projects is 0.5. The percentage
of green investors in the economy is 10%. (5 marks)

In lecture, we discussed Berk and van Binsbergen’s (2022) calibration of the

ESG premium. Their formula for the expected brown-minus-green return is
𝛾𝛾
𝐸𝐸[𝑅𝑅𝑏𝑏 − 𝑅𝑅𝑔𝑔 ] ≈ 𝑀𝑀𝑀𝑀𝑀𝑀 × 𝑉𝑉𝐷𝐷 × � � (1 − 𝜌𝜌2 ) where MRP is the market risk
1−𝛾𝛾
premium, 𝑉𝑉𝐷𝐷 is the percentage of value in brown stocks in the economy, 𝛾𝛾 is
the percentage of green investors in the economy, and 𝜌𝜌 is the correlation
between the returns on green stocks and the returns on brown stocks.
Applying their formula gives a brown premium of 0.32% and thus an ESG-
adjusted CAPM discount rate of 8.32%

D) What percentage of green investors would we need for Brown Energy to

consider the project not worth pursuing. Explain the economic intuition
as to why this percentage of investors changes the outcome. (7 marks)

REVISED: Setting the coal mining project to 0 NPV and solving for the discount
𝐹𝐹𝐹𝐹𝐹𝐹𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 10
rate results in 0 = 𝑁𝑁𝑁𝑁𝑁𝑁𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = − 𝐼𝐼 = − 100 or 𝑟𝑟𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 0.1. The
𝑟𝑟𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑟𝑟𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
previous solution sketch assumed that the expected brown-minus-green
spread measured the spread between the CAPM discount rate of the coal-

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 mining project and the ESG-adjusted rate. A more reasonable assumption is
that the CAPM discount rate measured in part A) is in the midpoint of the
expected brown-minus-green premium spread. Since the CAPM discount rate
is 8%, we need a brown premium adjustment to that rate greater than 2%, and,
given the above assumption, a brown-minus-green premium spread greater
𝛾𝛾
than 4%. Thus, . 04 = 𝑀𝑀𝑀𝑀𝑀𝑀 × 𝑉𝑉𝐷𝐷 × � � (1 − 𝜌𝜌2 ). Letting 𝑍𝑍 = .04/(𝑀𝑀𝑀𝑀𝑀𝑀 × 𝑉𝑉𝐷𝐷 ×
1−𝛾𝛾
2 )), 𝑍𝑍
(1 − 𝜌𝜌 𝛾𝛾 > . Therefore, 𝛾𝛾 > 57.89%. Intuitively, as the number of green
1+𝑍𝑍
investors increases, the remaining brown investors must hold a larger amount
of the brown assets which results in a more concentrated holding of brown
assets and poorer diversification. The brown investors require relatively higher
expected returns on brown assets relative to green assets as a consequence.

E) Assume that the correct calibration of the ESG-adjusted discount rate is

the one studied in part C) but that 51% of Brown Energy’s shareholders
have taken an executive education course on Sustainable Finance and
become green investors. As a consequence, in their utility function,
those investors put a significant weight on the welfare of others affected
by a decision. Could that change in shareholders’ objectives affect
Brown Energy’s decision to invest in the coal mining project? Explain. (5
marks)

As discussed in lecture, shareholders can use their voice to determine which

projects the firm chooses. If the majority of a firm’s shareholders are well-
diversified, and their welfare depends on societal concerns, then those
investors will turn down projects that are positive NPV but reduce social welfare.
In this case, if the coal-mining project reduces societal welfare, these green
investors can engage with Brown Energy and use their voice to stop investment
in the coal-mining project.

2) Discussion Questions

A) Pastor, Stambaugh, and Taylor (2022) (henceforth PST) measure the

greenness of a firm by multiplying MSCI’s environmental pillar score with
MSCI’s environmental pillar weight. The environmental pillar score ranks
firms on 13 environmental issues relate to climate change, natural
resources, pollution and waste, and environmental opportunities. The
pillar score is not industry-adjusted. The environmental pillar weight
measures the importance of environmental issues relative to social and
governance issues and is typically constant across firms in the same
industry. Using their measure, PST show that over the period from
November 2012 to December 2020, green stocks outperformed brown
stocks by a cumulative return of 174%. Does the outperformance that
PST document indicate that the expected return on green stocks is
higher than the expected return on brown stocks going forward? Explain.
(6 marks)

No, not necessarily. In an ESG-adjusted asset-pricing model, taste effects

should result in lower expected returns on green stocks relative to brown

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 stocks. A possible explanation of PST’s findings is that these positive returns
to green-minus-brown bets reflect unexpectedly strong increases in the
environmental concerns of investors, not high expected returns. Indeed, these
high realized returns may instead indicate lower expected returns on green
stocks relative to brown stocks going forward.

B) To stop climate change, countries around the planet must stabilize

greenhouse gas emissions at current levels. True or False? Explain. (4
marks)

False. Even if countries around the planet stabilize emissions at current levels,
the greenhouse gas concentrations will continue to increase within our lifetime
because net removals are much smaller than current emissions.

C) List and describe five conceptual issues with ESG ratings. (5 marks)

The course discussed several broad concerns with current ESG metrics
including both conceptual and methodological. In terms of conceptual
concerns, there were seven issues:
1) Operational vs. Reputational Metrics: Much ESG data focuses on
stakeholder perceptions of companies rather than quantifiable performance
metrics.
2) Forward vs. Backward-looking Metrics: Many ESG metrics look at past
performance rather than future plans and opportunities.
3) Handprints vs. Footprints: Most ESG performance data measures the
impact – or footprint – of just the company in question, but it may be much
more important to know a company’s sustainability handprint (“product
impact”).
4) Upside Opportunities versus Downside Exposure: Most forward-looking
data are risk-focused but overlook metrics on sustainability-derived growth
opportunities including both top-line expansion of sales and bottom-line
profitability.
5) Materiality vs. Immateriality: Data should prioritize those metrics that are
most material to the company and its stakeholders.
6) Narrow focus vs. Broad Frameworks: A careful targeting of a core set of
metrics may be more useful than an extensive framework covering many
factors.
7) Policy Alignment vs. Idiosyncratic Choices: ESG metrics should aim to align
the top-priority ESG issues with policy addressing important externalities of
significant global importance. That alignment should be based on robust,
comparable, and trusted data that facilitate the internalization of
externalities by firms.

D) An investment can be made today to reduce carbon emissions that costs

£5 billion and is expected to avoid environmental damages worth £100
billion occurring 100 years from now. The 100-year risk-free rate is
3%/year and the 100-year equity premium is 5%/year. Discuss two
different justifications and resulting implications for the sign of the beta
of this project. (4 marks)

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 One possibility is that the beta is positive, as temperature increases (and the
resulting environmental damages) occur when the economy is richer. Another
possibility is that the appropriate beta is negative, as emissions abatement
hedges catastrophic macroeconomic risk.

Whether or not the beta is positive or negative is important for whether the
specific investment under consideration is positive or negative NPV. Let’s first
calculate the NPV of this investment using just the risk-free rate, to see if the
risk-adjustment is important. The NPV is 100/(1.03)^100 – 5 = £0.203 billion.
This calculation indicates that the risk adjustment is critical. For example, if the
beta is .01 or higher, the project become negative NPV.

E) List and describe three implicit assumptions of Milton Friedman’s

shareholder capitalism. (6 marks)

The first key assumption in Friedman’s article is that governments are well-
functioning. However, regulation is imperfect, and this fact is a reason why
businesses can have a social responsibility. Regulation is most effective at
addressing measurable issues such as wages and carbon emissions. However,
it’s much harder to regulate qualitative issues such as providing employees with
meaningful work and skill development.

Another key assumption Friedman makes is that a company has no

comparative advantage in carrying out socially responsible actions. $1 spent
on a social initiative by a firm creates the same value as $1 spent by anyone
else. This implicit assumption of Friedman highlights that companies should
only invest in social causes if they have a comparative advantage relative to
others and thus can generate more value in those investments than anyone
else.

Finally, when Friedman argues that profit-focused companies will invest in

stakeholders, Friedman is assuming that they can calculate the impact that
such investments have on profit. In other words, shareholder value can be
maximized instrumentally. Such calculations work for some investments,
including risky ones (i.e., NPV). However, for some projects it may be very
difficult to analyse the project as the firm may have no idea what the appropriate
parameters are. Thus, a firm with explicit stakeholder objectives makes
investments for intrinsic reasons–to deliver value to those stakeholders

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