Certified Environmental Social and Governance Analyst (CESGA) EFFAS Practice Test

What does the "free rider problem" refer to in the context of ESG strategies?

1. Best-in-class screening

2. Engagement and proxy voting

3. Impact investing

4. Value-based screening

The correct answer is: Engagement and proxy voting

The "free rider problem" in the context of ESG strategies refers to the situation where some investors benefit from the efforts of others to improve corporate behavior without contributing to those efforts themselves. This often occurs in the realm of engagement and proxy voting. When shareholders actively engage with companies to encourage better ESG practices or participate in proxy voting to influence corporate governance, they often face the challenge of free riders who do not partake in these efforts but still gain from the outcomes, such as improved sustainability practices or enhanced corporate value. The essence of the free rider problem highlights the importance of collective action in influencing corporate behavior. When a sizable number of investors engage with a company, they can drive significant changes that benefit all stakeholders, including those investors who do not engage. By focusing on engagement and proxy voting, organizations can work towards creating a more responsible corporate environment, but must contend with the fact that some may choose not to participate while still enjoying the benefits of those who do. Other options like best-in-class screening, impact investing, and value-based screening revolve around selecting investments based on certain ethical criteria or potential impacts rather than direct engagement in corporate governance. These strategies typically do not directly illustrate the dynamics of free riders in the same way that engagement and proxy voting do, as they