Expanding the Lens of ESG Investments

Incorporating ESG into Risk Management and the Consequences of Its Neglect

By: Rhea Sequeira

Critics of sustainable investments have long centered their arguments on the link between ESG ratings and alpha generation, which are as yet unproven. However, if ESG performance makes up one side of the coin, then the benefits of these investments, when integrated into a risk management framework, is the flipside. While these exposures are difficult to quantify in traditional risk models – and their catalysts difficult to time – they still require adequate consideration due to their potential to transition into material risks, both financial and operational, over time. ESG investment alternatives have been rapidly proliferating, predominantly as a result of investor objectives moving toward a more focus on values and the ability of these assets to mitigate portfolio risks. Even as researchers and analysts work to establish a clear link between ESG factors and alpha, opportunities remain on the horizon while the industry matures and awaits the development of a standardized, quantifiable metric for accurate ESG ratings and assessment. This article aims to look beyond mere performance objectives, we also seek tounderstand the long-term benefits from investments in ESG factors, in order to appropriately integrate them into existing risk management frameworks, as well as recognize the opportunities and implications of neglecting them.

____________

Understanding the Risks & Implications of Neglect

While the ESG factors are vastly disparate in nature, they share critical characteristics: timing the impacts can be unpredictable and capturing and quantifying these impacts within traditional risk models can present an even bigger challenge. However, pushing firms to consider the negative externalities of unsustainable operations can drive businesses to instead, consider value creation strategies, with the best interests of long-term shareholders in mind.

Governance factors tend to be of the highest priority to long-term shareholders, given their severe direct impact on firm operations. Failure to implement a robust corporate culture and a lack of oversight can lead to litigation, as well as severe reputational damages. Though not as implicit, environmental,and social risksare also growing – and while some firms might neglect these risks in the short-term, the long-term effects are expected to create significant material risks: financial, governance, operational, regulatory, and conduct risks, to name a few. Hence, when sustainability exposures are not well-accounted for, they can hurt a firm’s reputation, create litigation expenses, and increase regulatory barriers – all of which will forcibly increase conventional exposures to firms.

In light of the dramatic shift in stakeholder preferences to social responsibility and sustainable ideals, consumers and legislators, have advocated for greater inclusion of sustainability factors within a firm’s operational framework to mitigate significant economic exposures, which affect firm value both directly and indirectly. With profit still the main objective of most, critics of ESG performance have argued that sustainability efforts fail to generate any material benefits to shareholders. This notion has led many investors to shy away from sustainably focused funds. However, slowly but surely, this has all begun to change, as the expanding dataset starts to portray an entirely different story.

____________

Reviewing the Data

Historically, there has been no clear link between firms’ rankings on ESG metrics and outperformance. This could be attributed to the fact that the impacts of unsustainable businesses, historically, have been low and predominantly firm-specific in nature. A Morningstar quantitative research report published earlier this year focused on firms around the world using  Sustainalytics ESG Risk Ratings, supports this notion,  showing there is no economically significant differences in performance between ESG leaders and laggards. Both leaders and laggards also exhibited similar volatility and downside risk, and while some differences arose across markets, these could be attributable primarily to chance.[1]

A paper published by AQR Capital Management in 2017 attributes the lower prices of stocks ranked poorly on ESG factors to compensation for the added risk, with a promise of greater expected returns than their well-ranked counterparts. While well-rated ESG equities are superior in terms of their sustainable virtues, their tendency to generate higher P/E ratios makes them more expensive, creating a challenge for value investors in the ESG space. An essential finding of the Morningstar report was that investors, specifically in North America, tend to pay a premium for better ESG equities. While the data assessed within this study cites little evidence of ESG risk management’s abilities to enhance performance with well-rated equity holdings, there are still significant benefits to portfolio managers that arise with these high-priced investments.[2]

The AQR study focused primarily on the correlation between MSCI ESG Ranks and total risk, stock-specific risk, and beta: “Stocks with the worst ESG exposures saw total and stock-specific volatility up to 10-15% higher, and betas up to 3% higher, than stocks with the best ESG exposures.” The study also found that ESG scores may help predict changes in risk estimates using a traditional risk model. Despite the only slight increase in risk, when controlling for contemporaneous risk model estimates, the study found that poor ESG integration largely predicts increased future statistical risks – thus implying that ratings can capture expected risks in the long-run, even if the impacts may take a while to emerge.

___________

Highlighting the Opportunities

While data on ESG integration and performance has been growing over time, there is still much work to be done to create ESG assessment metrics that are suitable for all firms, irrespective of industry and geographic characteristics. Making assumptions over a long-term horizon is challenging with existing data, primarily through traditional statistical risk models. “If stocks share common ESG risks, which the market is yet to appreciate fully, firms with low ESG scores could be undervalued and priced to offer market-beating returns,” a more recent Morningstar research report notes.[3] Therefore, as some firms remain inappropriately underrated, opportunities arise, allowing investors to de-risk portfolios, while still benefiting from the higher expected returns. This, however, can only be expected to last until markets recognize ESG risks systematically, thereby transitioning these stocks to a higher price with lower expected values. 

A shift towards ESG leaders would lower their cost of capital and facilitate growth for socially responsible firms, thereby encouraging more market participants to adopt sustainability best practices. Once top-level management can fully appreciate these advantages, the transition into sustainable policies and procedures should begin with robust integration of ESG principles into the enterprise risk management framework – for which there are several existing tools for guidance.

____________

Leveraging the Tools Available

The Committee of Sponsoring Organizations of the Treadway Commission (COSO), in partnership with the World Business Council for Sustainable Development (WBCSD), has developed a detailed methodology to implement sustainability through an enterprise risk management lens. The methodology defines risk as “the possibility that events will occur and affect the achievement of strategy and business objectives.”[4] The guidance produced by COSO and WBCSD aims to assist firms in understanding the full spectrum of ESG risks, in order to effectively manage and disclose them.

While each step of the framework remains crucial to the robust implementation of ESG policies and procedures, the ability to identify deviations from principles in place, and make corrections accordingly, remains of utmost importance to ESG risk management’s success. The unique impacts and dependencies of ESG-related exposures across industries make it difficult to quantify, predict, and mitigate these risks, especially within an everchanging exposure environment. Therefore, consistently adapting policies and procedures to fit the evolving risk landscape reinforces the framework and allows firms to “widen the moat.” Through adept execution of the sixth stage in COSO’s ERM framework, the risk management structure is strengthened, allowing firms to be prepared to deal with potentially severe exposures, whenever they may arise. A clear example of this has been observed most recently, during the global pandemic.

Social and governance factors began to take center stage amid the outbreak of COVID-19. Despite the volatility and shifts in investor expectations and risk tolerance, the market has observed better performance across sustainable products globally on a risk-adjusted basis.[5]

One explanation could be the negative screens performed to reduce exposure to ecological “sin stocks.” The most common of these exclusions is the fossil fuel supply chain, which, amid depressed oil prices and sharply curtailed air travel, sheltered most sustainability-focused portfolios during these tumultuous times. Researchers agree: Claudia Coppenolle, co-founder and CEO of the IMP+ACT Alliance, which developed the IMP+ACT Classification System (ICS), told Finextra Research, “Even though outperformance of sustainable funds during the pandemic might have occurred due to divestment from heavily hit sectors, there are increasing studies and datasets that start to evidence that sustainable funds match or exceed the performance of conventional funds over the long run.”[6]

____________

Conclusory Remarks

In the wake of the pandemic, many have found predicting the “unknown unknowns” to be a serious challenge – but for a few, here lies the opportunity. Companies are now observing the results of intentional investments and devoting significant efforts and resources towards research and analysis, as they attempt to monetize sustainable risks and gain an edge over their competitors. ESG investments largely promote long-term shareholder interests and should therefore be placed at the forefront, since outperformance in the short-term may be fleeting. A Donnelley Financial Solutions white paper quotes the wise words of WBCSD President and CEO Peter Bakker: “When companies have a better grasp of their risks, they can make better business decisions.”[7] Once top management begins to perceive the severe material financial implications of sustainability risks in operations, firms will start to take accountability for the bigger picture – moving towards value creation and away from short-term profit maximization goals.

In 2014, a study abroad course in Europe, during my junior year of college, led me to the Autostadt – an attraction in Wolfsburg, Germany that pays homage to Volkswagen’s classic creations, current operations, and future aspirations of a greener tomorrow. Only a year later, I would come to know of “Dieselgate” – a scandal that uncovered that for years, Volkswagen manipulated the software within their vehicles to cheat emissions tests. I was shocked, and even more so, hurt, as an owner of a 2013 VW Beetle at the time. All that I had seen and heard at Autostadt felt like a façade – a cover-up that cost over $500 million and two years to build. It was difficult to believe the lengths to which a company could go, to deceive many millions that visited the center and purchased vehicles. However, the aftermath of the scandal had far more in store for the company – penalties from litigation to the tune of $25 billion and the imprisonment of numerous engineers found at fault. Herein lies the risks of neglecting ESG risks: in the case of Volkswagen, both environmental and governance risks were neglected, and as a result, the firm continues to suffer reputational damages even today, with countless individuals – employees, investors, and various other stakeholders – left feeling duped and disappointed.

This is only one of several such cases which have borne witness to the adverse outcome of ESG neglect. When sustainability factors are overlooked, especially in an increasingly stringent regulatory environment, they have the potential to transition quickly from distant sustainability and transparency risks to severe and unpredictable material impacts when scandals are uncovered. Therefore, it is vital for firms to identify, understand, and prioritize the ESG risks believed to have the utmost direct, substantial impacts to operations within their respective enterprise risk management frameworks. Firms must recognize that the risk landscape is everchanging, and therefore, risk management procedures require constant evolution over time. It is only when these risks are quantified and continually assessed, that they can be somewhat anticipated and managed, creating twofold benefits in the interests of stakeholders as well as firm value.

Contact the Author | Rhea Sequeira, Analyst | Investments & Risk Management

rhea.sequeira@hfr.com

Learn more about HFR Investments at: https://hfr-investments.com/

or reach out to investments@hfr.com    

A downloadable copy of the article may be found here.


[1] Wang, P., & Sargis, M. (2020, February 20). Better Minus Worse – Evaluating ESG Effects on Return and Risk. Retrieved from Morningstar.

[2] Dunn, J., Fitzgibbons, S., & Pomorski, L. (2017). Assessing Risk Through Environmental, Social, and Governance Exposures. AQR Capital Management, LLC, Greenwich, CT.

[3] Bryan, A., CFA (2020, July 14). ESG Investing Is About Long-Term Risk. Retrieved from Morningstar: https://www.morningstar.com/articles/991535/esg-investing-is-about-long-term-risk-management

[4] COSO & WBCSD. (2018, October). Enterprise Risk Management: Applying ERM to environmental, social, and governance-related risks.

[5] “The top performer is BlackRock’s $9.2 billion iShares ESG Aware MSCI USA ETF (ESGU), up 10.1% (excluding reinvested dividends) since the start of the year, compared with the S&P 500’s 6.9% advance. The iShares MSCI KLD 400 Social ETF (DSI) has risen 9.7%, the Xtrackers MSCI USA ESG Leaders Equity ETF (USSG) has gained 7.4%, and the iShares ESG MSCI USA Leaders ETF (SUSL) has climbed 7.1%.” Quinson, T. (2020, September 4). ESG DAILY: The Biggest ETFs Are Outperforming the S&P 500. Retrieved from Bloomberg Law: https://news.bloomberglaw.com/corporate-governance/esg-daily-the-biggest-etfs-are-outperforming-the-s-p-500

[6] Finextra Research. (2020, June 19). Integrating ESG into capital allocation and investment strategy is ‘simply good investing.’ Retrieved from: https://www.finextra.com/newsarticle/36062/integrating-esg-into-capital-allocation-and-investment-strategy-is-simply-good-investing

[7] Donnelley Financial Solutions. (2019) – ESG Risks and Opportunities: Understanding the ESG Landscape. Retrieved from DFINsolutions.com: https://www.dfinsolutions.com/sites/default/files/documents/201903/dfin_gcm_proxy_whitepaper_ESG_risks_and_oppty_2019223.pdf

Expanding the Lens of ESG Investments : By Rhea Sequeira

Leave a Reply