ESG & Sustainable Investing: Complete Beginner's Guide

Module 2: The "E" - Environmental Factors

Learning Objectives

By the end of this module, you will be able to:

• Understand the key environmental issues that affect investment value
• Distinguish between physical and transition climate risks
• Interpret carbon emissions data (Scope 1, 2, and 3)
• Identify which sectors face the greatest environmental risks and opportunities
• Analyze how environmental factors have created or destroyed shareholder value
• Evaluate a company's environmental performance using key metrics

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2.1 Why Environmental Factors Matter to Investors

The Financial Impact of Environmental Issues

When you hear "environmental investing," you might think of saving polar bears or protecting rainforests. While those goals matter to many people, investors care about environmental factors for a more fundamental reason: they directly affect profits, risks, and long-term company survival.

Consider these real-world examples:

Pacific Gas & Electric (PG&E): California's largest utility filed for bankruptcy in 2019 after its equipment sparked wildfires that killed dozens and caused over $30 billion in liabilities. Environmental risks—aging infrastructure in increasingly dry conditions—wiped out shareholder value built over a century.

Volkswagen: The 2015 "Dieselgate" scandal, where VW deliberately cheated on emissions tests, cost the company over $30 billion in fines, recalls, and legal settlements. The stock price crashed, and the brand's reputation suffered lasting damage.

Coal Companies: Since 2010, dozens of coal companies have gone bankrupt as the energy transition accelerated. Investors who ignored environmental trends lost billions as cleaner, cheaper alternatives rendered coal economically unviable in many markets.

Tesla: Conversely, Tesla became the world's most valuable automaker by capitalizing on the shift toward electric vehicles. Investors who recognized this environmental transition early were rewarded handsomely.

The pattern is clear: environmental factors aren't externalities—they're core business risks and opportunities that directly impact the bottom line.

The Two Types of Climate Risk

As an investor, you need to understand two distinct categories of environmental risk:

Physical Risks: Direct damage from environmental changes

• Extreme weather destroying facilities, disrupting supply chains
• Sea-level rise threatening coastal assets
• Droughts affecting agriculture and water-dependent industries
• Wildfires damaging infrastructure
• Heat waves reducing labor productivity

Transition Risks: Economic impacts from shifting to a low-carbon economy

• Regulatory changes (carbon taxes, emissions caps)
• Technological disruption (renewables replacing fossil fuels)
• Market shifts (consumer preference for sustainable products)
• Reputational damage from being seen as polluting
• Stranded assets (fossil fuel reserves that become worthless)

Smart investors assess both. A coastal real estate investment faces physical risks. An oil company faces transition risks. Some companies face both.

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2.2 Climate Change: The Investor's Perspective

Understanding the Science (Briefly)

You don't need to be a climate scientist to invest with environmental awareness, but understanding the basics helps:

The Core Issue: Human activities, primarily burning fossil fuels, release greenhouse gases (especially CO₂) that trap heat in the atmosphere. This causes global temperatures to rise, which triggers cascading effects: melting ice, rising seas, changing weather patterns, more extreme events.

The Timeline: Global temperatures have already risen approximately 1.2°C above pre-industrial levels. Without major intervention, we're on track for 2.5-3°C+ of warming by 2100. International agreements aim to limit warming to 1.5-2°C.

Why Investors Care: The transition to limit warming will reshape the global economy. Trillions in assets must be redirected. Entire industries will grow or shrink. Companies adapting will thrive; those ignoring reality will struggle.

The Paris Agreement and Net Zero

Paris Agreement (2015): Nearly every country committed to limiting global warming to well below 2°C, ideally 1.5°C. This created clear policy direction that investors can't ignore.

Net Zero Commitments: Over 5,000 companies and 1,000+ cities have committed to reaching "net zero" emissions by 2050 or sooner. Net zero means balancing emissions produced with emissions removed from the atmosphere.

For investors, these commitments create predictability. Whether through choice or regulation, the global economy is transitioning away from fossil fuels toward cleaner energy. The question isn't if, but how fast.

Carbon Pricing: Making Pollution Expensive

Many governments are implementing carbon pricing—putting a cost on CO₂ emissions through taxes or cap-and-trade systems:

• European Union: World's largest carbon market, with prices rising significantly
• Canada: Federal carbon tax increasing annually
• China: Launched the world's largest emissions trading system in 2021
• Dozens More: Countries and regions implementing various carbon pricing schemes

Why This Matters: Carbon pricing directly affects company costs. High-emission businesses face rising expenses; low-emission competitors gain advantage. As carbon prices rise globally, this effect intensifies.

Investors who understand which companies have high carbon exposure can anticipate margin compression and competitive disadvantage.

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2.3 Key Environmental Metrics: What to Measure

Carbon Emissions: Scope 1, 2, and 3

Understanding carbon emissions is essential for environmental analysis. Emissions are categorized into three "scopes":

Scope 1: Direct Emissions Greenhouse gases released directly by the company's operations:

• Fuel burned in company-owned vehicles and facilities
• Industrial processes that release emissions
• On-site manufacturing emissions

Example: A delivery company's truck fleet burning diesel fuel.

Scope 2: Indirect Energy Emissions Emissions from generating the electricity and heat the company purchases:

• Electricity bought from the grid
• Purchased steam or heating
• Purchased cooling

Example: A tech company's emissions from running its data centers on grid electricity.

Scope 3: Value Chain Emissions All other indirect emissions from the company's value chain:

• Upstream: Raw materials, business travel, employee commuting, purchased goods
• Downstream: Product use, product disposal, franchises, investments

Example: An oil company's Scope 3 includes emissions when customers burn the gasoline they sold.

Why All Three Scopes Matter

For Many Companies, Scope 3 Dwarfs Scopes 1 and 2

Consider these examples:

• Apple: Scope 3 represents about 75% of total emissions (mostly manufacturing by suppliers)
• Oil Companies: Scope 3 can be 90%+ of total emissions (mostly customer use of products)
• Airlines: Scope 1 dominates (direct jet fuel burning), but Scope 3 includes aircraft manufacturing

Companies increasingly report all three scopes, though Scope 3 measurement remains challenging due to data complexity across entire value chains.

Investment Implication: Don't just look at a company's direct emissions. A tech company might have low Scopes 1 and 2 but massive Scope 3 from manufacturing. Comprehensive analysis requires understanding the full carbon footprint.

Other Key Environmental Metrics

Water Usage and Stress

• Total water withdrawn and consumed
• Water recycled or reused
• Operations in water-stressed regions
• Water pollution incidents

Most Critical For: Agriculture, beverages, textiles, mining, semiconductors

Waste Management

• Total waste generated
• Percentage recycled vs. landfilled
• Hazardous waste handling
• Circular economy initiatives

Most Critical For: Manufacturing, consumer goods, food & beverage, electronics

Energy Efficiency and Renewable Energy

• Total energy consumption
• Percentage from renewable sources
• Energy intensity (energy per unit of production)
• Renewable energy investments

Most Critical For: Energy-intensive industries, utilities, manufacturing

Biodiversity and Land Use

• Operations in protected areas
• Deforestation impacts
• Species protection efforts
• Land rehabilitation

Most Critical For: Agriculture, forestry, mining, real estate development

Air and Water Pollution

• Air pollutant emissions (NOx, SOx, particulates)
• Water pollutant discharge
• Toxic chemical releases
• Environmental violations and fines

Most Critical For: Manufacturing, chemicals, oil & gas, utilities

How to Find This Data

Companies disclose environmental metrics through:

• Annual Sustainability Reports: Dedicated environmental disclosures
• Integrated Reports: Financial and sustainability data combined
• CDP Disclosures: Companies report to CDP (formerly Carbon Disclosure Project)
• Regulatory Filings: Some jurisdictions require environmental disclosure
• ESG Rating Agencies: Compile and standardize data from multiple sources

We'll cover how to access and interpret these sources in Module 5.

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2.4 Sector Analysis: Where Environmental Factors Matter Most

Not all industries face equal environmental risks and opportunities. Understanding sector differences helps you focus analysis where it matters most.

High Environmental Impact Sectors

Energy (Oil, Gas, Coal)

• Primary Concerns: Massive carbon emissions, transition risk, stranded assets, spills and disasters
• Investor Considerations: Is the company investing in renewables? How vulnerable to carbon pricing? What's the long-term demand outlook?
• Opportunity: Renewable energy companies, energy transition leaders

Utilities

• Primary Concerns: Electricity generation emissions, grid infrastructure resilience, renewable transition speed
• Investor Considerations: Renewable energy percentage? Grid modernization investments? Regulatory support?
• Opportunity: Utilities leading clean energy transition can gain competitive advantage

Transportation (Airlines, Shipping, Automotive)

• Primary Concerns: Fuel consumption, emissions regulations, electrification pressure
• Investor Considerations: Electric vehicle strategy? Fuel efficiency improvements? Alternative fuel investments?
• Opportunity: EV manufacturers, sustainable aviation fuel, efficient logistics

Materials and Mining

• Primary Concerns: Energy-intensive processes, water use, land degradation, tailings disasters
• Investor Considerations: Renewable energy adoption? Water recycling? Mine rehabilitation?
• Opportunity: Materials for clean energy (lithium, copper, rare earths)

Agriculture and Food

• Primary Concerns: Deforestation, water use, methane emissions, soil degradation
• Investor Considerations: Sustainable farming practices? Supply chain traceability? Climate adaptation?
• Opportunity: Sustainable agriculture, plant-based proteins, precision farming

Real Estate and Construction

• Primary Concerns: Building emissions, water use, physical climate risks to assets
• Investor Considerations: Green building certifications? Energy efficiency? Climate resilience?
• Opportunity: Green buildings command premium rents and valuations

Chemicals

• Primary Concerns: Hazardous substances, air and water pollution, waste management
• Investor Considerations: Chemical safety record? Circular economy initiatives? Clean production?
• Opportunity: Green chemistry, sustainable materials, recycling technologies

Moderate Environmental Impact Sectors

Technology and Telecommunications

• Primary Concerns: Data center energy consumption, electronic waste
• Lower Risk: Generally cleaner operations than heavy industry
• Investor Considerations: Renewable energy commitments? E-waste recycling programs?
• Opportunity: Companies enabling environmental solutions (clean tech, efficiency software)

Finance

• Primary Concerns: Financed emissions (carbon footprint of lending and investment portfolios)
• Investor Considerations: Climate risk in loan books? Fossil fuel financing policies? Green finance offerings?
• Opportunity: Green bonds, sustainable investment products, climate risk analytics

Retail and Consumer Goods

• Primary Concerns: Supply chain emissions, packaging waste, product lifecycle
• Investor Considerations: Sustainable sourcing? Packaging reduction? Product recyclability?
• Opportunity: Circular economy business models, sustainable products commanding premiums

Lower Environmental Impact Sectors

Healthcare and Pharmaceuticals

• Primary Concerns: Medical waste, chemical use (moderate relative to other industries)
• Less Material: Environmental factors less central to competitive positioning
• Note: Still worth monitoring, but Social and Governance factors typically matter more

Professional Services

• Primary Concerns: Office energy use, business travel (relatively minor)
• Less Material: Primarily office-based operations with limited environmental footprint
• Note: Environmental factors rarely drive material financial impacts

The Materiality Concept

Here's a crucial principle: Not all environmental issues matter equally for all companies.

Environmental factors are "financially material" when they significantly affect a company's financial performance or value. The Sustainability Accounting Standards Board (SASB) has identified which environmental issues are material for each industry.

Example of Materiality:

• Carbon emissions are highly material for airlines (major cost and regulatory risk)
• Carbon emissions are less material for software companies (smaller footprint, less exposure)

This doesn't mean software companies should ignore their carbon footprint—but investors analyzing software stocks should focus more on data privacy, talent retention, and product innovation (more material factors) than carbon emissions.

Investment Implication: Focus your environmental analysis on sectors and issues where environmental factors materially affect financial outcomes. Don't waste time on immaterial factors.

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2.5 Real-World Case Studies

Case Study 1: BP's Deepwater Horizon Disaster

What Happened: In 2010, BP's Deepwater Horizon oil rig exploded in the Gulf of Mexico, killing 11 workers and causing the largest marine oil spill in history. Nearly 5 million barrels of oil leaked over 87 days.

Environmental Impact: Devastating damage to marine ecosystems, coastal wetlands, and wildlife. Beaches and fishing grounds closed. Effects persisted for years.

Financial Impact:

• Over $65 billion in cleanup costs, fines, and legal settlements
• Stock price dropped 50% in weeks
• Dividend suspended
• Reputation severely damaged
• Criminal charges against the company

Investor Lesson: Environmental disasters create catastrophic financial consequences. Investors should assess:

• Company safety culture and track record
• Operations in high-risk environments
• Quality of risk management systems
• Emergency preparedness

Poor environmental risk management isn't just bad for the planet—it can destroy shareholder value overnight.

Case Study 2: Orsted's Transformation

The Story: Orsted (formerly DONG Energy) was one of Europe's most coal-intensive energy companies. Recognizing the energy transition's inevitability, management made a bold decision in the early 2010s to completely transform the business.

The Transition:

• Sold oil and gas businesses
• Divested coal-fired power plants
• Invested massively in offshore wind energy
• Became the world's largest offshore wind developer

Results:

• Carbon emissions reduced by 87% from 2006-2020
• Stock price increased over 400% from transformation start through 2021
• Became one of the world's most valuable renewable energy companies
• Named the most sustainable energy company globally multiple times

Investor Lesson: Companies that proactively adapt to environmental transitions can create enormous value. The early recognition of inevitable change—transitioning before being forced—allowed Orsted to lead rather than follow.

Investors who identified this transition early were rewarded handsomely. Those who stayed in pure coal companies saw investments decline or disappear.

Case Study 3: The California Utility Crisis

Background: California's major utilities faced mounting wildfire risks due to aging infrastructure and climate change creating hotter, drier conditions.

What Happened:

• PG&E: Equipment sparked multiple deadly wildfires. Declared bankruptcy in 2019 with $30+ billion in liabilities. Shareholders nearly wiped out.
• Edison International: Also faced wildfire liability but avoided bankruptcy through better risk management and settlement strategies. Stock still fell sharply.

Environmental Factor: Climate change increased wildfire risk (physical climate risk), but companies' responses to this risk varied dramatically.

Investor Lesson: Physical climate risks are real and quantifiable. Within the same sector facing identical environmental threats, company-specific risk management quality makes the difference between survival and bankruptcy.

Investors should assess:

• How seriously does management take climate adaptation?
• Are companies investing in resilience?
• What's the liability exposure if risks materialize?

Case Study 4: Beyond Meat's Rise and Reality Check

The Opportunity: Growing awareness of livestock's environmental impact (greenhouse gases, land use, water consumption) created demand for plant-based meat alternatives.

The Rise: Beyond Meat went public in 2019 with massive investor enthusiasm. Stock soared 800%+ in months as investors bet on the plant-based revolution.

The Reality Check: By 2023, stock had crashed over 90% from peaks as:

• Growth disappointed expectations
• Competition intensified
• Consumer adoption slower than anticipated
• Company struggled with profitability

Investor Lesson: Environmental themes create real opportunities, but investment success requires more than just a good sustainability story. Fundamental business analysis still matters:

• Is the market actually growing as fast as expected?
• Can the company execute operationally?
• What's the competitive landscape?
• Is the valuation justified by realistic projections?

Environmental opportunities are real, but they don't eliminate the need for sound investment analysis.

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2.6 Evaluating Environmental Performance

A Framework for Analysis

When evaluating a company's environmental performance, work through these questions systematically:

Step 1: Materiality Assessment

• Which environmental factors are financially material for this company's industry?
• Where should I focus my analysis?

Step 2: Performance Metrics

• What are the company's key environmental metrics (emissions, water, waste, etc.)?
• How do these compare to industry peers?
• Are metrics improving or worsening over time?

Step 3: Targets and Commitments

• Has the company set environmental targets (emissions reductions, renewable energy, etc.)?
• Are targets ambitious and science-based?
• Is the company on track to meet targets?

Step 4: Risk Exposure

• What physical climate risks does the company face (floods, droughts, extreme weather)?
• What transition risks (regulation, technology disruption, market shifts)?
• How vulnerable is the business model to environmental changes?

Step 5: Adaptation and Innovation

• How is the company adapting to environmental challenges?
• Is it investing in cleaner technologies or processes?
• Are environmental initiatives creating competitive advantage?

Step 6: Disclosure Quality

• How transparently does the company report environmental data?
• Does disclosure follow recognized frameworks (TCFD, CDP, GRI)?
• Are there gaps or inconsistencies in reporting?

Step 7: Track Record

• Any history of environmental violations, fines, or controversies?
• How does the company respond when problems occur?
• Is there a pattern of improvement or repeated issues?

Red Flags to Watch For

Vague Commitments: "We're committed to sustainability" without specific, measurable targets Declining Metrics: Environmental performance worsening over time Lack of Disclosure: Refusing to report basic environmental data Repeated Violations: Pattern of environmental fines or regulatory issues Misalignment: Lobbying against environmental regulations while claiming to support sustainability No Board Oversight: No board committee or executive responsible for environmental issues Unrealistic Targets: Ambitious promises without credible implementation plans

Green Flags to Look For

Science-Based Targets: Emissions reduction goals aligned with climate science Third-Party Verification: Environmental data audited by independent parties Transparent Reporting: Comprehensive disclosure following recognized standards Improvement Trends: Metrics consistently improving over multi-year periods Capital Allocation: Significant investment in environmental solutions Incentive Alignment: Executive compensation tied to environmental performance Industry Leadership: Being first-mover or setting industry standards Innovation: Developing cleaner products, processes, or business models

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2.7 Environmental Opportunities for Investors

While much of environmental analysis focuses on risks, the transition to a sustainable economy creates massive investment opportunities.

Clean Energy and Electrification

The Opportunity: Global shift from fossil fuels to renewable energy

• Solar and wind power generation
• Energy storage (batteries)
• Electric vehicle manufacturers and charging infrastructure
• Grid modernization and smart grid technology
• Hydrogen and other alternative fuels

Scale: Trillions in investment needed over coming decades

Resource Efficiency and Circular Economy

The Opportunity: Reducing waste and maximizing resource productivity

• Recycling and waste management technology
• Water treatment and efficiency solutions
• Industrial efficiency equipment
• Sustainable packaging
• Product-as-a-service business models

Driver: Rising resource costs and scarcity make efficiency profitable

Sustainable Agriculture and Food

The Opportunity: Feeding growing population sustainably

• Precision agriculture technology
• Sustainable farming practices
• Alternative proteins (plant-based, cultivated)
• Vertical farming and controlled environment agriculture
• Agricultural technology (AgTech)

Driver: Need to reduce agriculture's environmental footprint while increasing output

Green Building and Infrastructure

The Opportunity: Built environment transformation

• Energy-efficient building materials
• Green building certification leaders
• Smart building technology
• Climate-resilient infrastructure
• Sustainable urban development

Driver: Buildings account for ~40% of global energy consumption

Environmental Services and Technology

The Opportunity: Solutions for environmental challenges

• Pollution control and remediation
• Environmental consulting
• Carbon capture and removal technology
• Climate adaptation solutions
• Environmental monitoring and data

Driver: Increasing regulation and corporate commitments create demand

How to Access These Opportunities

Direct Stock Investment: Research and buy individual companies leading environmental solutions

Thematic ETFs: Invest in baskets of clean energy, water, circular economy, or other environmental theme companies

Clean Energy Funds: Mutual funds or ETFs focused on renewable energy sector

Green Bonds: Fixed-income investments funding environmental projects

Infrastructure Funds: Access to large-scale environmental infrastructure projects

Private Equity/Venture Capital: For accredited investors, access to early-stage environmental innovation

Important Note: Environmental themes offer opportunity but require the same rigorous analysis as any investment. Don't let enthusiasm for the theme override fundamental investment discipline.

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2.8 Challenges in Environmental Investing

Data Quality and Availability

The Problem: Environmental data is often:

• Inconsistent across companies
• Self-reported without verification
• Incomplete (especially Scope 3 emissions)
• Not standardized, making comparisons difficult

What This Means: Investors must work harder to verify claims and fill data gaps. Improving, but still imperfect.

Greenwashing

The Problem: Companies exaggerate environmental credentials to attract ESG investors without making substantive changes.

Examples:

• Highlighting minor green initiatives while core business remains harmful
• Setting distant net-zero targets without credible near-term action
• Marketing products as "sustainable" with minimal basis
• Cherry-picking favorable data while hiding unfavorable metrics

Defense: Critical analysis, third-party verification, comparing claims to actions, examining full value chain impacts. (We'll cover this in detail in Module 8.)

Time Horizon Mismatch

The Problem: Environmental benefits often accrue over decades, but investors frequently focus on quarterly or annual performance.

Example: A company investing heavily in clean technology might see near-term profit pressure but long-term competitive advantage. Short-term investors might sell; long-term investors might buy.

Implication: Environmental investing often requires patience and long-term perspective.

Regulatory Uncertainty

The Problem: Environmental regulations evolve rapidly and vary by jurisdiction. Policy changes create uncertainty.

Example: Carbon pricing expansion would benefit clean companies but remains politically uncertain in many regions.

Approach: Scenario analysis—consider multiple regulatory futures when assessing environmental risks and opportunities.

Valuation Challenges

The Problem: How do you value environmental factors that don't yet appear in traditional financial statements?

Questions:

• What's the NPV of avoided future carbon taxes?
• How much premium should clean companies command?
• What discount should high-emission companies face?

Reality: No consensus yet on precise environmental valuations. Investors must develop their own frameworks.

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Module 2 Summary

Let's consolidate what you've learned about environmental factors:

Financial Materiality: Environmental factors directly affect profits, risks, and company survival. They're not externalities but core investment considerations.

Two Risk Types: Physical risks (direct environmental damage) and transition risks (economic shifts to low-carbon economy) both threaten investments.

Carbon Emissions: Understanding Scope 1, 2, and 3 emissions is essential. Scope 3 often dominates but is hardest to measure.

Sector Variation: Environmental factors matter much more for energy, utilities, transportation, and materials than for services or technology. Focus analysis where it's material.

Real Impact: Case studies show environmental factors can destroy value (PG&E, coal companies) or create it (Orsted, clean energy leaders).

Evaluation Framework: Systematic analysis covering materiality, metrics, targets, risks, adaptation, disclosure, and track record.

Opportunities: The environmental transition creates massive investment opportunities in clean energy, efficiency, sustainable food, green buildings, and environmental solutions.

Challenges: Data quality, greenwashing, time horizons, regulatory uncertainty, and valuation complexity require careful navigation.

You now understand why environmental factors matter to investors, how to measure them, where they matter most, and how to evaluate companies accordingly. This foundation prepares you for analyzing the "S" in ESG—Social factors—which we'll explore in Module 3.

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Module 2 Review Questions

Test your understanding:

1. What's the difference between physical climate risk and transition risk? Give an example of each.

2. Explain Scope 1, 2, and 3 emissions. For an automobile manufacturer, what would each scope include?

3. Which sectors face the highest environmental risks? Which face the lowest? Why?

4. Name three key environmental metrics beyond carbon emissions that investors should monitor.

5. What happened to PG&E and what investor lesson does it illustrate?

6. What environmental red flags should make an investor skeptical of a company?

7. Name three categories of environmental investment opportunities created by the sustainability transition.

8. Why is environmental data often challenging for investors to use?

Reflection Questions:

• How much weight should environmental factors carry in investment decisions for different sectors?
• If you were building a portfolio today, which environmental opportunities seem most compelling and why?

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Practical Exercise: Environmental Analysis

Choose a publicly traded company in an environmentally material sector (energy, utilities, transportation, materials, or food & agriculture).

Research and answer:

1. What are the company's most material environmental risks?
2. What environmental metrics does the company report?
3. Has the company set environmental targets? What are they?
4. How does the company's environmental performance compare to peers?
5. What environmental opportunities or risks do you see for this company over the next 5-10 years?

This exercise builds practical skills in environmental investment analysis.

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Looking Ahead to Module 3

Environmental factors represent just one dimension of ESG. Next, we'll explore the "S"—Social factors.

In Module 3, you'll learn how companies' relationships with employees, customers, suppliers, and communities affect investment value. We'll cover labor practices, diversity and inclusion, human rights, supply chain responsibility, and customer relations.

You'll discover why social factors increasingly drive competitive advantage, how to evaluate social performance, and how social controversies can create or destroy billions in shareholder value.

See you in Module 3!