Five key ESG risk considerations investors care about

The importance of ESG (Environmental, Social, Governance) continues to grow and has become a key area of focus for a range of stakeholders, particularly investors as they acknowledge that environmental and social issues present some of the decade's most difficult challenges.

The ESG movement has changed the way large investors, and the companies they hold in their portfolios, view the risks associated with traditional business models and the potential for sustainable future value creation. By considering ESG factors, investors gain a more holistic view of the companies they back, which can help mitigate risk and identify opportunities for growth and improvement.

What's driving the change?

Investors have become increasingly interested in ESG issues over the past five years. Recent estimates say there are more than $330 billion in assets managed by ESG funds, and additional ESG funds are anticipated to be established in 2022. According to the Harvard Business Review, this heightened focus has been driven by some specific factors.

Investment firm size
The investment industry is extremely concentrated, with the top 15 asset managers holding 56.7% of externally managed assets. Large investment firms are no longer able to mitigate system-level risks using modern portfolio theory due to their size. This means that firms that handle trillions of dollars have no protection against the global economy and, in other words, have become too large to allow the world to collapse.

Financial returns
A Harvard Business School study discovered that businesses that established organizational systems to monitor, manage, and communicate performance on ESG concerns in the early 1990s outperformed a carefully matched control group over the next 18 years. Many different studies have discovered positive links between strong financial performance and solid performance on relevant ESG issues.

Growing demand
Asset owners no longer need to be persuaded of the importance of sustainable investing and are pressing asset managers for sustainable investing strategies more frequently. Due to this growing demand for ESG investment solutions, several asset management companies are scrambling to put together new options.

Evolving view of fiduciary duty
Many continue to assume that sustainable investing implies giving up some financial gain and many investors have neglected ESG considerations out of concern that they will negatively affect bottom-line returns. However, more recent judicial judgments and regulatory directives make it clear that failing to take ESG considerations into account is a breach of fiduciary duty. Although the United States has been hesitant to adopt this new thinking, other nations including Canada, the United Kingdom, and Sweden are moving to reinterpret the fiduciary obligation idea to include sustainability.

Top-down adoption
Senior investment business executives are also influencing ESG trends by requiring analysts and portfolio managers to conduct ESG evaluations as part of their main financial responsibilities. BlackRock, the largest asset manager in the world with $6.1 trillion in assets under management, has elevated itself to the position of ESG leadership by integrating ESG into financial analyses. Long a proponent of sustainable investing, the company's CEO, Larry Fink, has strived to fully integrate ESG considerations into the firm's investment strategy over several years.

Five ESG risks that matter to investors

The reasons investors care about ESG in their investment can be broadly classified into four categories: financial, competitive, strategic, and perception. Overall, investors consider ESG investments safer and more stable bets. Here are five of the top risks that matter to investors:

1. Asset devaluation & long-term risk

Climate risk is a critical ESG focus today. Potential infrastructure and property losses due to climate change are already affecting organizations' long-term financial sustainability. Many investors examine a company's preparation assessment and capacity to forecast and respond to a variety of climate threats when evaluating its ESG profile. As companies embark on risk assessments, there are three primary types of risk to consider:

• Transition risk refers to the climate policies and laws shifting the global economy away from fossil fuels. Policy and regulatory risks, technological risks, market risks, reputational hazards, and legal risks are all part of transition risks that can impact the portfolio. These risks are intertwined, and they're often on investors' minds as they try to negotiate a more aggressive low-carbon agenda that might have capital and operational implications for their assets.
• Litigation risk surrounding CO2 emissions. Companies that generate and emit more CO2 than others are more liable to class-action lawsuits and other legal issues that hold them responsible for contributing to global warming.
• Physical risks, such as extreme weather and record temperatures, are now recognized as events that can be predicted and factored into financial planning. Droughts, floods, excessive precipitation, and wildfires are all examples of acute threats. Rising temperatures, the spread of tropical pests, illnesses in temperate zones, and an accelerated loss of biodiversity are all examples of chronic concerns. Investors are exposed to both idiosyncratic and systemic risks as a result of acute and chronic threats.

Beyond these three primary risks, investors also consider the costs incurred due to the political instability and conflicts that climate change may engender and supply chains that can become impacted by extreme weather occurrences.

2. Social & governance risk events

ESG social factors can range from employee treatment to boycotts to labor violations to product recalls. These issues are diverse, qualitative, and can often impact all company stakeholders at once, from workers and customers to suppliers and local communities, and disrupt portfolio stability. The ability to maintain healthy, positive, fair, and ethical relationships with these stakeholders is critical to the success of a company, especially if the success of that business relies on public trust.

Geopolitical events and labor issues also fall under the social category in ESG investing and conflicts like these can prevent companies from producing or distributing their products. For example, the recent drone attack on an oil refinery in Saudi Arabia temporarily halted roughly 5% of worldwide oil production.

While most investors have a sense of good governance practices, it’s not a “one-size-fits-all” approach. It can be difficult to identify where and how best practices might have an impact on business performance. While most investors have a sense of good governance practices, it is difficult to identify where and how best practices might have an impact on business performance. Types of governance risk can include:

• Company integrity & ethics
• Anticompetitive behavior & practices
• ESG regulation compliance (including emerging regulations)
• ESG disclosures
• Transparent communications
• Grievance procedures and systems
• Corruption/fraud prevention
• Executive remuneration
• Board structure & diversity
• Bribery & corruption
• Policies & standards
• Tax compliance

Investors must understand the compliance and regulations that apply to the industry in which the portfolio company operates, take into account the role of the Board of Directors in overseeing sustainability risk management policies, check that internal controls and risk management systems are in place, sift through company disclosures, and make sure that company leadership is making wise decisions and allocating resources efficiently.

3. Access to information

A key problem in the ESG investment world is scant regulations governing what ESG measures and risks companies must disclose and the patchy, inconsistent nature of ESG communications. As investors increasingly incorporate ESG data into their investment decision-making processes, they often cite the inability to meet limited partner (LP) requests for ESG information as a key concern.

Reliable, factual, consistent data gives investors the opportunity to track progress and gather the critical information they need for peer comparison and risk mitigation. Using financial data, industry benchmarking, and artificial intelligence can help companies capture vast amounts of structured and unstructured data. All of this data can be used to report on ESG performance improvements and provide assurance to investors.

Investors want to foresee what LPs will request ahead of time. Being ready for those requests before they happen can give investment firms a competitive edge over general partners. This need for meaningful ESG data and clear information on sustainable practices is forcing companies to demonstrate their outcomes better.

4. Perception

Investments that lack a robust ESG program are viewed as not being "progressive" or "risk-conscious", which can hurt perceptions and impact investment value. Companies that consider ESG issues enhance value creation, according to McKinsey. Higher stock returns are correlated, both from a tilt and momentum viewpoint, with a solid ESG strategy. Lesser loan and credit default swap spreads and higher credit ratings are only two examples of how better ESG performance is associated with improved perceptions and lower negative risk. McKinsey found strong ESG propositions:

• Help portfolio companies tap new markets and expand into existing ones by building trust that awards them the access, approvals, and licenses that afford fresh opportunities for growth.
• Enable companies to achieve greater strategic freedom by easing regulatory pressure, reducing companies’ risk of adverse government action, and engendering government support.
• Help companies attract and retain quality employees, enhance employee motivation by instilling a sense of purpose, and increase productivity overall. Why is this important? Employee satisfaction is positively correlated with shareholder returns.

5. Regulatory risks

In Gartner's 2021 Emerging Risks Monitor Report, the regulatory risk associated with ESG disclosures quickly climbed to the second-top concern. According to a poll of 153 senior executives, enterprises are faced with both significant risks and opportunities as a result of ESG regulatory requirements.

With continued climate-related disasters and variable weather patterns, tighter regulations around GHG emissions, rising demand for renewable and sustainable energy, biodiversity and supply chain ethics issues, and growing concern over social and governance issues, 2022 is expected to see an even greater demand for ESG disclosures.

Executives have long been concerned about investor pressure on ESG disclosures, but established legal frameworks are only now starting to take effect in some jurisdictions. In April of this year, the Securities and Exchange Commission (SEC) voted 3-to-1 to support a proposed rule requiring firms to disclose their climate risks as well as data on greenhouse gas emissions (GHG) in annual SEC filings.

Many companies currently release information about their GHG emissions. The Governance & Accountability Institute (G&A) reported that roughly 92% of the S&P 500 companies already publish a sustainability report. However, the new proposal will require companies to track, manage, and plan their environmental data and view transition risk in a more structured, systematic way.

Companies and funds alike must prepare for impending mandates by implementing ESG strategies and frameworks from the top down. Those ESG efforts should begin by cross-functionally mapping out ESG strategies and risks while working to capture data on relevant, material ESG metrics.

The way forward: ESG reporting & data

Despite the forces propelling ESG investing forward, there are still barriers to overcome. Currently, most sustainability reporting by corporations is not useful to investors because it is intended for other stakeholders, such as NGOs.

ESG frameworks have been established to assist firms in assessing and disclosing their susceptibility to a broad range of ESG risks. There are multiple frameworks to choose from, but some of the most widely used and recognized are the Value Reporting Foundation’s SASB Standards, the Global Reporting Initiative (GRI), and the Task Force on Climate-related Financial Disclosures (TCFD).

Businesses can transition from a compliance-driven perspective to the proactive risk reduction measures that investors are seeking with the aid of ESG frameworks. It’s important to ensure:

• The company can successfully identify and assess ESG risks
• Upper management takes responsibility for the integration and mitigation of ESG risks
• The company has the appropriate skills, knowledge, and expertise to manage risks
• There is compliance with and preparation for regulations
• ESG risks are taken into account when establishing, implementing, and maintaining internal and external reporting

Proper risk mitigation makes for less volatile companies and provides greater confidence for investors. These companies are rewarded through access to credit and debt markets, positive brand equity, reinvestments, and sustainable, long-term growth.

ESG data is also critical to helping companies engage in effective risk management and allows organizations to plan for compliance objectives, improve voluntary disclosures, and create risk mitigation strategies & roadmaps to help address threats before they happen.

ESG materiality assessments

With investors inquiring more and more frequently about what your company is doing in regard to responsible investment, how you treat employees and vendors, your dedication to sustainability initiatives, and other activities that fall under the ESG umbrella, it’s important to have answers to these questions.

An ESG materiality assessment empowers you to easily report on your current state and outline future initiatives while taking into consideration your business goals and risks. Download our guide to creating and extracting the maximum strategic value from an ESG materiality assessment.

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Sambhram Patel

In his role as a Senior Solutions Architect, Sam manages portfolio-wide projects for reporting frameworks such as GRESB, CDP, and the S&P CSA for multiple clients. Additionally, he helps drive asset-level sustainability by supporting projects such as LEED, ENERGY STAR, Fitwel, and utility benchmarking.

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