The voice of risk: how to avoid ESG missteps by Carl Densem

the voice of risk: how to avoid ESG missteps

by Carl Densem

As risk managers, we are in the room to think ahead and often at crosscurrents to the consensus. If the business is determined to follow a new strategy, we are there to ask what dangers it might pose and how they could be mitigated, avoided, or protected against. Our job is to short-circuit the consequences of ill-advised actions.

Economic, Social and Governance (ESG) is no different. ESG is a prominent concern for global investors (79% consider it an important factor in investment decision-making1), who are escalating demands for action and transparency from corporations. Companies are responding feverishly with long-term carbon-cutting goals, sustainability efforts, and eyeing community pushes that will prove their seriousness. All of this is outside, as of today, a unifying and clear framework for materiality, how meaningful data are shared and progress measured.

Risk managers on all sides should be aware of this dynamic. While ESG has the potential to reap rewards, this depends on how carefully plans are rolled out. Risk has its place in clarifying terms, asking the uncomfortable questions, and provoking thought on what could go wrong.

background

ESG is nothing new, having been through more transformations than Madonna. An early form of ESG began in the 1960s, before the Queen of Pop even hit adolescence, as “socially responsible” investing2 and today is enjoying its latest revolution.

ESG, as a conceptual basket, comprises ethical ideas about how corporations should behave regarding their non-financial responsibilities. The basket has dropped some outdated ideas and picked up glitzier ones over the years. Critically, in this appearance, ESG is more focused on longevity. As an OECD paper on ESG investing puts it, there is “growing momentum for corporations and financial institutions to move away from short-term perspectives of risks and returns.” 3

By their nature, ESG factors are complex and range in time horizon from the immediate to generational, out to existential (climate, for example). This presents a great analytical challenge to those attempting to integrate factors into valuation and business models. More so, they can be fairly abstract, escaping simple and agreed-upon descriptions.

Question 1: As a risk manager, it is important to start with basics: “How do we define ESG?”

Question 2: The next question is: “How does ESG fit with our larger strategy and competition?”

With something as pervasive as ESG’s recent comeback, it should be no surprise interpretations vary. This will be made clear in a moment by surveys, but just think about your local pharmacy or grocery store. We find consumer products trending toward conscientious causes: ‘buy local’, cruelty- and toxin-free, vegan and organic, meat substitutes, and even ice cream with a political message4 .

The dots connect from this new array of products directly to ESG and how companies are rebranding themselves to investors. But with such variety comes a pitfall if ESG is left undefined. On one hand, trying to be everything to everyone leaves companies open to the market’s whim and on the other, it might appear nonchalant or dismissive to ignore ESG. It may even be the case that companies are pursuing ‘ESG goals’ without knowing it and need to adapt their approach to the zeitgeist.

A “not-insignificant minority” of global financial professionals polled by the CFA Institute and PRI5 thought ESG was a negative screen, a way of excluding investable assets like heavy-emitting coal producers (based on [E] environmental impact) or cigarette manufacturers (on [S] social grounds). Most respondents considered it only a tool and the paper went so far as to say ESG investing would fade away in favor of ESG analysis. This makes sense when you consider the wide variety of investment approaches, from arbitrage to short-selling, where screening out candidates goes against the investment mandate.

The we is critical in Question 1, how we define ESG should be different from our competitors but it should not stop there.

Using ESG to constrain the investable universe and, implicitly, pigeon-hole strategy could severely impact financial performance. While this may not be the intent, adherence to new limits could push performance objectives out of reach – something which should be open to management discussion and debate. This is not starkly different to investors being forced down the credit curve, into riskier issuers, to maintain yield and meet financial objectives. Yes, doing so risks credit loss events and reputational risk, but if the trade-off is clear then risk limits can be calibrated along the way.

A company which pivots to ESG as an overriding concern might accept losses or slippage on other goals to satisfy a Board worried about reputational risk. This should be kept in mind though: failed companies contribute nothing to ESG goals and having goals but not acting in accordance with them is a far bigger risk. The balancing act is tricky with far-reaching effects.

Most investors are acutely aware of the potential conflict between ESG and their fiduciary duty. According to PwC’s investor survey, 81% were “either unwilling to accept any reduction on returns or would accept only a drop of 1 percentage point or less.” 1 in 20 investors were willing to give up 3 percentage points or more in rebalancing.

Question 3: ESG is defined and fits our strategy, the question now is: “Are ESG goals resilient and do we have a plan for misses?”

With companies following in the UN’s footsteps by espousing 2030 goals (and even 2050 ones), it is reasonable to expect some fluctuation along the way. As risk managers, we are aware of how poor longterm plans pan out – even plotting our own retirement is notoriously difficult – and should advocate for tolerances and contingency plans. Some ESG goals cannot be set in stone, acknowledging this sets more reasonable expectations on everyone and take the emphasis off misses as mistakes. Tabletops, scenario analysis and other well-worn risk policies, infrastructure and tools will be invaluable in shaping achievable goals.

The greatest opportunity with ESG, if taken seriously, is the chance to look decades into the future, beyond immediate competitive pressures and the market’s short-sightedness. If taken up, it should lead to capital investment and self-regulation that supports both investors and other stakeholders, both the environment and communities. The intent is good but that is only part of the puzzle, ESG could use the voice of risk to guide its future.

conclusion

references

1. Chalmers, James et al. “The economic realities of ESG.” PwC, March 3, 2022, https://www.pwc.com/ gx/en/services/audit-assurance/corporate-reporting/esg-investor-survey.html 2. “The Evolution of ESG Investing.” MSCI, March 3, 2022, https://www.msci.com/esg-101-what-is-esg/ evolution-of-esg-investing#:~:text=The%20practice%20of%20ESG%20investing,the%20South%20

African%20apartheid%20regime 3. “ESG Investing: Practices, Progress and Challenges.” OECD, March 5, 2022, https://www.oecd.org/ finance/ESG-Investing-Practices-Progress-Challenges.pdf 4. “Issues We Care About.” Ben & Jerry’s, March 5, 2022, https://www.benjerry.com/values/issues-wecare-about

5. “ESG Integration in Canada.” CFA Institute, March 3, 2022, https://www.cfainstitute.org/-/media/documents/article/position-paper/cfa-esg-integration-canadaweb-3pp.pdf

author

Carl Densem

Carl Densem has a decade of risk management experience under his belt since graduating from Oklahoma State University’s master’s in quantitative finance program in 2012. He spent four years in asset management before immigrating to Vancouver (Canada) and joining Central 1 Credit Union. There he helped establish several missing pieces from the risk function, including model risk management, and led integrated risk reporting. He is now Risk Manager with Community Savings Credit Union and lives in Halifax, Nova Scotia.