ESG as a Risk Management Tool

Investors may employ sustainable investment strategies for a variety of reasons, including personal preference or a desire to align financial assets with their values.

But sustainable investment strategies also may help investors address a wider range of risks, including pre-financial indicators that may have financially material impacts on the companies in their portfolio. In fact, portfolio managers have been utilizing environmental, social and governance (ESG) risk factors for many years, partly to try to avoid corporate controversies.

Changes in the world — including climate risk, a renewed focus on human rights, cyber security and biodiversity loss — have heightened investors’ awareness of pre-financial risks present in investment portfolios and products.

According to the World Economic Form 2023 Global Risk Report, if the top ten global risks were to occur over the short and long term there would be a negative impact of a significant proportion on global GDP, population or natural resources. Notably, as shown in the chart below, 50% of the top ten risks over the next two years are environmental and the top four risks over the next decade are also linked to environmental risks such as failure to mitigate climate change, natural disasters and extreme weather events.

To help investors understand how prepared companies are to withstand the implications of climate risk, the Securities and Exchange Commission (SEC) proposed regulation for companies to report on climate-related financial disclosures providing investors with “consistent, comparable, and decision-useful information for making investment decisions”. Increasingly, investors want to know how they can minimize their portfolio exposure to ESG risks.

Understanding ESG Risks to Businesses

Many practitioners of sustainable investing seek to mitigate a wide range of risks that have the potential to have negative financial impacts on their investment portfolios. The array of environmental, social and governance (ESG)-related risks may include:

• Direct impacts to business infrastructure, such as those caused by natural disasters, supply chain disruptions or inadequate data security
• Investor disfavor when companies fail to adapt to new realities, such as increased scrutiny of privacy practices
• Regulatory and policy risks as laws evolve to address environmental issues such as climate change and biodiversity; social issues such as human rights, worker safety and diversity; and governance matters such as board composition, auditing and international operations
• Litigation related to environmental, social or governance matters
• Reputation or brand damage due to public perceptions of a poor record on environmental or social issues
• Financial mismanagement, from lack of proper controls to outright fraud
• Loss of talent and other problems related to human capital

How Managers of Sustainable Investment Strategies Seek to Mitigate Risk

Managers of sustainable investment strategies may engage in a range of approaches to attempt to understand, measure and ultimately reduce their exposure to ESG risks. These approaches include:

Exclusion: Opting to avoid investing in companies in specific business lines or companies with significant controversies around ESG issues.

Integration: Incorporating an analysis of environmental, social and governance issues in the investment process.

Thematic investing: Investing in broad ESG themes, such as clean technologies.

Stewardship: Utilizing investors influence to maximize long-term value. By engaging in robust dialogues, investors encourage companies to act proactively on ESG risks and may leverage proxy voting to promote change.

The range of approaches allows investors to incorporate ESG considerations into their portfolio — reflecting their preferences and priorities in managing ESG risk.

Sustainable Investing and Performance

Many investors who seek to adopt a sustainable investing approach may be hesitant, as performance is a key concern.  However, our portfolio research finds no evidence of underperformance or outperformance when incorporating ESG criteria into an investment strategy. This is good news for investors with ESG preferences, as they are more likely to stay the course acknowledging there is no significant difference in performance over the long-term.

Managing ESG Risks

Risks come in various forms and understanding them is central to investing and helping investors to make more informed investment decisions. Today, investors are utilizing ESG data and reporting tools to evaluate their portfolio’s exposure to ESG risks. We collaborate with clients by leveraging sophisticated tools to help them align their portfolios with both their financial and ESG goals.

Talk to your advisor if you are interested in exploring whether sustainable investment approaches might help you mitigate additional dimensions of ESG risks.