Environmental Factors
This domain tests whether you can translate environmental issues into financial risk and opportunity: climate (physical and transition), natural capital, pollution and waste. The exam expects correct use of GHG scopes, scenario analysis and the TCFD structure.
Climate risk splits in two
Physical risk is acute (flood, wildfire, storm) or chronic (temperature, sea-level, water stress). Transition risk arises from policy, technology, litigation and market sentiment shifts. Both hit cash flows, assets and the cost of capital. Stranded assets are those written down early because of the transition - fossil reserves, carbon-intensive plants.
Emissions accounting
The GHG Protocol defines Scope 1 (direct combustion), Scope 2 (purchased electricity/heat) and Scope 3 (value-chain: purchased goods, use of sold products, business travel, investments). For most sectors Scope 3 dominates, so a low Scope 1 footprint says little about climate exposure. Financed emissions attribute investee emissions to a lender or investor.
TCFD's four pillars
Governance, Strategy (including scenario analysis), Risk Management, and Metrics and Targets. Typical scenarios: orderly transition (early policy action), disorderly (late, abrupt), and hot house (failure to act).
Natural capital and other issues
Water stress, biodiversity loss and deforestation (TNFD framework), pollution and waste, circular economy, resource depletion. Regulation includes emissions trading schemes, efficiency standards, extended producer responsibility and permitting.
Worked example
A cement producer emits 800,000 tCO2e of Scope 1 per year under an ETS at $40/t, with free allowances covering 60%. Cost = 800,000 × 40% × $40 = $12.8m per year. Capitalised at a 5× EBITDA multiple, that is roughly $64m of value at risk. Raising the assumed carbon price to $80 doubles it. The reasoning shows a policy factor converted into a valuation channel - cost line, then multiple - rather than a qualitative comment.
Traps that cost marks
Treating Scope 3 as optional or additive without noting double counting between companies; reading low Scope 1 as low climate risk; confusing physical with transition risk; assuming all environmental factors are climate factors; ignoring water and biodiversity in sectors such as utilities and food.