The market is good at evaluating and pricing systemic risks that are regular and easy to quantify--the "known unknown." These include things like changes in the business cycle or interest rates. But as the coronavirus pandemic has shown, the market doesn't do as well with risks that are difficult to predict or quantify--the "unknown unknowns." The environmental, social, and governance risks most firms face fall somewhere in the middle of this spectrum.
There are clear examples in which firms' failure to manage ESG risks has hurt the value of their stocks. Most of these issues have been firm-specific, so they have tended to have little impact on well-diversified portfolios. But there's a good chance that may change over the long term, as companies face greater scrutiny from consumers, investors, and governments alike over their ESG practices.
Climate change and evolving social expectations are difficult to fully diversify away, and their impact will likely grow over time. While these changes could directly increase the cost of doing business, their impact could also be felt indirectly as regulations tighten and consumer preferences shift.
Historically, there hasn't been a clear link drawn between firms' ESG characteristics and performance. So, enhancing returns shouldn't be the primary motivator for ESG investing. However, that also means that an ESG mandate doesn't necessarily hurt returns. ESG investing can be an effective way for investors to align their portfolios with their values. But ESG isn't just about values, it's about long-term risk management that affects all investors.
ESG Risks
It may seem odd to group environmental, social, and governance risks together. While they appear to have little in common, they are all issues that affect firms' long-term value and are hard to quantify.
There is little dispute that strong corporate governance is in the best interest of long-term shareholders. It promotes accountability and long-term focus by providing transparency and a clear link between long-term value creation and compensation.
Corporate governance failures often result when firms prioritize quarterly results over the interests of long-term investors and lack appropriate risk oversight. For example, Wells Fargo (WFC) pressured bank employees to meet aggressive sales quotas, tying compensation to those targets, which led to the creation of millions of fraudulent accounts. When the scandal came to light, it ended up costing the company more than US$2 billion in settlements and fines, as well as the trust of many clients.
Environmental and social risks may seem more remote than governance risks, but they are growing for many firms. For example, climate change could directly increase costs for insurers. Warmer oceans increase the risk of more frequent and intense hurricanes, increasing potential property damage. Litigation arising from environmental damage, like the BP oil spill, and damage to brand equity are also direct costs that environmental issues can create.
However, the indirect impact that environmental issues have on business will likely be much greater, as consumer preferences shift toward more environmentally friendly products (like electric vehicles) and firms. Less environmentally friendly companies may also be subject to greater regulatory risk, including higher taxes and fees imposed on emissions.
Social risks cover a broader range of issues, including data security, product safety, workplace safety, diversity, compensation, and benefits. Like environmental risks, damage to brand equity, litigation, and the threat of regulatory changes can increase costs for firms that aren't managing these risks well.
The opportunity cost of failing to take care of employees is one of the biggest risks here. Human capital is increasingly becoming many firms' most valuable asset, as intellectual property and services continue to grow in importance. Companies that offer safer workplaces and better compensation can better attract and retain talent and often get better productivity from their workers.
As these examples illustrate, ESG risk management often aligns with long-term shareholder interests. However, not all firms give these issues the attention they deserve, likely because doing so may conflict with short-term profit maximization and the long-term benefits are hard to quantify
In part 2 of the article, we will continue explore whether ESG risks is linked to performance.
