Quantitative Methods for ESG Finance

A quantitative analyst’s introduction to the theory and practice of ESG finance

In Quantitative Methods for ESG Finance, accomplished risk and ESG experts Dr. Cyril Shmatov and Cino Robin Castelli deliver an incisive and essential introduction to the quantitative basis of ESG finance from a quantitative analyst’s perspective. The book combines the theoretical and mathematical bases underlying risk factor investing and risk management with accessible discussions of ESG applications.

The authors explore the increasing availability of non-traditional data sources for quantitative analysts and describe the quantitative/statistical techniques they’ll need to make practical use of these data. The book also offers:

• A particular emphasis on climate change and climate risks, both due to its increasing general importance and accelerating regulatory change in the space
• Practical code examples in a Python Jupyter notebook that use publicly available data to demonstrate the techniques discussed in the book
• Expansive discussions of risk factor investing, portfolio construction, ESG scoring, new ESG-driven financial products, and new financial risk management applications, particularly those making use of the proliferation of “alternative data”, both text and images

A must-read guide for quantitative analysts, investment managers, financial risk managers, investment bankers, and other finance professionals with an interest in ESG-driven investing, Quantitative Methods for ESG Finance will also earn a place on the bookshelves of graduate students of business and finance.

Foreword vii

Introduction and Book Overview 1

1. Overview 1

2. Why ESG Finance? 2

3. Why Quantitative Methods? 2

4. Target Audience and Timing of This Book 2

5. Book Outline 3

1 Introduction to ESG Finance 5

1.1 Preface: ESG Is Not a Niche Strategy Anymore 5

1.2 Introduction and Definitions 7

1.3 ESG Investment Performance 21

1.4 Sustainability and Sustainable Finance 25

2 Factor Investing and Smart Beta 39

2.1 Index Construction Basics 39

2.2 Smart Beta Indexes 40

2.3 Risk Factor Investing 48

2.4 Fama- MacBeth Regressions 50

2.5 Expanding the Risk Factor Universe 53

3 ESG Ratings 55

3.1 Introduction 55

3.2 Overview of ESG Rating Methodologies 57

3.3 Regression Trees as an Alternative Scoring Technique 61

3.4 Random Forest 69

4 Alternative Data 75

4.1 What Are Alternative Data and Their ESG Applications? 75

4.2 How to Validate an ESG Data Provider 81

4.3 Processing Satellite Data 83

5 Alternative Text Data 105

5.1 Alternative Text Data on ESG 105

5.2 Corporate ESG Reports 108

5.3 Topic Modeling 114

5.4 Latent Dirichlet Allocation 118

5.5 Outlier Topics 126

6 Introduction to Agent- Based Modeling for ESG Finance 129

6.1 Preface 129

6.2 Use of Agent- Based Models in Other Fields and Their Applicability to ESG Finance 131

6.3 Use of ABMs in the ESG Field 132

6.4 General Overview of ABMs 133

6.5 General Operating Principles of ABMs 136

6.6 Example of the PartE Framework Applied to an ESG Scenario 136

6.7 Why We Should Look Closely at ABMs 138

6.8 Challenges in the Use of ABMs 139

6.9 Example: Buildup of a Population Model ABM 140

6.10 In- Depth Review: ABMs in Academic and Regulatory Publications 154

7 Climate Risk: Macro Perspective 165

7.1 Climate Change: Background Information and Definitions 165

7.2 Regulatory Response to Climate Change 185

7.3 Climate Change Modeling 191

7.4 Carbon Risk and Carbon Pricing 199

7.5 Climate Risk in Investment Practice 202

8 Stress Testing for Banks 207

8.1 Stress Testing as a Risk Management Tool 207

8.2 Macroeconomic Stress Scenarios for Climate Risk 213

8.3 Climate Loss Modeling 220

8.4 Climate Stress Testing Exercise 223

8.5 Concluding Notes 224

Index 227

CYRIL SHMATOV, PHD is Head of Enterprise Stress Testing (Managing Director) at Citigroup and Adjunct Associate Professor of Industrial Engineering and Operations Research at Columbia University. An area of particular interest for Cyril is ESG (Environmental, Social and Corporate Governance) Finance, including the management of financial risks associated with Climate Change and the quantitative analysis techniques that make such management possible. Cyril’s recent research focuses on leveraging alternative data for Climate Risk quantification and management, including its practical aspects from a financial institution’s perspective. Cyril holds a PhD in Applied Mathematics from Columbia University.

CINO ROBIN CASTELLI is Director at Citi, Business Unit Manager for Enterprise Risk Management, the area that covers, amongst other topics, Climate Risk. Prior to this position, Robin was the Chief Strategy Officer for Quantitative Risk and Stress Testing, the division of Risk tasked with developing all the quantitative models used for Market Risk, Counterparty Risk, Credit and Obligor Risk Analytics, Risk Capital Analytics, and Stress Testing. Robin is also co-founder and former Executive VP for Business Development at MacroUSA, in the field of Unmanned Ground Vehicles, and prior to that, co-founder, CEO and president of Macroswiss SA. Robin holds a Bachelor’s Degree and a Master’s Degree in Molecular Biology, summa cum laude, from Università degli Studi di Milano-Bicocca, with an evolutionary biology thesis on “Chromosomal rearrangements as speciation mechanisms.”

In Quantitative Methods for ESG Finance, distinguished risk and finance experts Dr. Cyril Shmatov and Cino Robin Castelli deliver a startlingly insightful combination of the theoretical and quantitative bases underlying risk factor investing and risk management with ESG applications. Written from the quantitative analyst’s perspective, this book discusses both investment management (buy-side) and investment banking (sell-side) applications. It also offers explanations of the proliferation of newly available, “alternative” data sources available to analysts and the quantitative techniques necessary to process them.

The authors pay particular attention to climate risk because of its increasing general importance. They offer an overview of recent quantitative advances and the evolving regulatory landscape in the climate risk space, as well as an in-depth discussion of the financial impact assessment of various climate risk-driven scenarios.

In every chapter, theoretical discussions are accompanied by functional code snippets and walkthroughs of a Python Jupyter notebook containing publicly available data and demonstrating practical examples that apply the techniques introduced in the book.

Investment managers will be particularly interested in the authors’ exposition of risk factor investing, portfolio and index construction, and ESG scoring, while bankers will likely focus on the discussion of a newly emerging class of ESG-driven financial products and new financial risk management applications, many of which are driven by new financial regulations.

An indispensable resource for finance professionals—including investment managers and investment bankers—and researchers, Quantitative Methods for ESG Finance will also earn a place in the libraries of graduate students of business and finance seeking a one-stop reference for the latest quantitative applications in ESG finance.

PRAISE FOR QUANTITATIVE METHODS FOR ESG FINANCE

“A timely and practical book that explains how to effectively adopt and incorporate ESG risk measurement and management, an issue currently facing both the investment and the issuer (corporate) communities. The topics covered will have broader applicability to financial intermediaries and regulatory agencies as well. This comprehensive work fills a vital gap on the quantitative side of ESG finance, where there is a growing critical need to harness the proliferation of newly available alternative data sources and for the associated quantitative techniques required to process and analyze this data.”

—BRADFORD HU, Chief Risk Officer, Executive Vice President, State Street

“In what is a fairly nascent and rapidly evolving field, Shmatov and Castelli provide to finance practitioners a much-needed comprehensive reference of fundamental and technical aspects of ESG risk measurement and management.”

—NICOLAS FRIES, CRO, Investment Risk, BNY Mellon

“Up-to-the minute, no-nonsense and uncommonly rigorous for its field.”

— RICHARD ROBB, Professor of Professional Practice in International and Public Affairs, Columbia University

“Everyone talks about investing with ESG criteria, but there is a lot of confusion as to what exactly that means. This book is essential for understanding what an ESG strategy is and how you can get it right. Useful for both common investors and professionals, and also for supervisory authorities.”

— MARIA TERESA COMETTO, Journalist, Author, contributor to Investment & Pensions Europe and Corriere della Sera