ESG is gaining awareness among investors. To date there are some 120 ESG ETFs with 11 billion USD of assets under management. SRI investing is expanding and currently totals 12 trillion USD in assets. Why might ESG investing be important and useful from an investment perspective, that is discounting the social, ecological and governance aspects of the outcome?
On the environmental front, climate change awareness is important, if nothing else as a factor in risk management. Companies which ignore this aspect are at risk of being unprepared for the implications of climate change. Seasonality changes impact agriculture, transport and consumer behaviour. Increased unpredictability places physical assets and infrastructure at risk. Insurance costs rise and fall with the occurrence of natural disasters. Failure to at least be aware and apprised of climate risk is a gap in the risk management of a business. Sustainability is another important element. The value of industries and companies dependent on diminishing raw materials is sensitive to the expected supply of such scarce resources. This sensitivity can be acute at long horizons where future cash flow assumptions factor into valuations.
On the social front, human rights are not only a moral factor, they are an important risk factor. The health and welfare of local communities, developed or developing, can have important implications for supply chains, and the commercial ecosystem of consumers, employees, and shareholders. Consumer protection is another are of importance. Firms may be tempted to optimize shareholder value at the exclusion of all other stakeholders, but the detriment of the customer is surely self-defeating and a significant risk.
In corporate governance, efficiency and robustness needs to be balanced. The balance of power between the executive and the board has been an area of recent focus. The separation of duties has value in providing checks and balances. Employee relations are equally important as a factor in attracting talent, retaining it and enabling it.
More than all these rather pragmatic and self-serving considerations, businesses clearly do not operate in a vacuum. Their actions and decisions have implications which reach beyond their narrow industries, supply chains and markets. Society and the global economy is an ecosystem which thrives on balance. Imbalances are corrected over time, gradually or suddenly and the greater the imbalance the greater, and often the more sudden the adjustment.
One of the more difficult hurdles that ESG will have to surmount is the misalignment between individual and collective objectives, commonly referred to as the tragedy of the commons, solutions to which are hard to find.
It is important to realize that ESG is not philanthropy, not does it involve sacrificing returns in return for altruistic objectives. In fact, ESG investing is an extension of risk management above and beyond the traditional quantitative metrics such as VaR and volatility, or default and recovery.