Recasting the risk/return ratio at the time of ESG

Integrating non-financial criteria into the assessment of corporate strategies and investment policies is becoming a market standard.

These criteria are obviously essential for strategies that integrate social and environmental impacts into their very design: through the development of impact investment, of course, but also in the listed sector as part of SRI policies and labels, and related approaches. But they also have to be taken into account in the analysis of any company and any investment, whether in the listed sector or in private equity.

It is high time to update the reading of the risk/return trade-off at a time when ESG – environmental, social and governance – criteria are becoming increasingly important.

Recent acquisitions of agencies specializing in non-financial rating, climate risk estimation or big data processing that meet ESG criteria and financial performance illustrate it. As does the multiplication of dedicated funds and the shift of an increasingly significant proportion of existing institutional investment vehicles to Green, SRI (Socially Responsible Investment) or similar labels.

What these examples demonstrate is the redesign of the risk/return trade-off in the assessment and definition of corporate financial analysis. This recast is directly linked with the redefinition of the role of corporations in society, and in particular of the impact of its activities in the social and environmental fields.

Indeed, the long-standing debate on the role and responsibility of companies regarding the general interest seems to be finally leaning towards abandoning profit alone as the ultimate objective of companies, as demonstrated once again by the letter signed by 200 CEOs of major American companies on the redefinition of the role of business in society.

And this is reflected both in risk management and financial performance.

A profound change in risk management policies

First, the risk assessment is fundamentally changed by the realization of the importance of ESG criteria. Logically, risk management policies are therefore increasingly integrating environmental, social and governance issues.

The risks related to these subjects are mainly of three types:

1. Regulatory risk

The laws and regulations in place impose a duty of vigilance on companies throughout their supply chain: law on the duty of vigilance in France, or Modern Slavery Act in the United Kingdom, for example. It is highly likely that these regulatory constraints will be extended and that other countries will adopt legislation that will be at least comparable, if not similar.

Numerous large companies have modified their organizations to take this into account, but there is still a long way to go. For companies that do not take these changes into account, the risk is not only to face punctual charges (fines, lawsuits, etc.). The possibility of market access will simply become more and more difficult for companies that do not play the collective game.

On their side, investors have changed their practices and integrate ESG risks in their definition, even if the regulatory angle related to the duty(ies) of vigilance is still insufficiently integrated to date in the definition of many allocation policies. In this context, it is logical to expect that the impact of these regulatory changes will increase in the coming years.

2. Risk of having to deal with social and/or environmental crisis

Societal expectations are more and more demanding for companies: responsibility for climate change, organization of value chains that respect a form of equity, etc. Thus, the image of a company or organization increasingly depends on the in-depth integration of its values and the resulting responsibilities into its business model – whether for its customers, teams or partners.

In this context, “tax avoidance” practices or unreasonable environmental risk taking policies, for example, involve risks of crisis leading to potential financial cost and degraded positioning, or even disqualification for certain actors, partners, or employees.

3. Risk of changes in business models (Transition risk)

Whether it is for environmental, social or societal issues, current organizational choices must anticipate future developments in ESG.

For example, regarding the climate emergency, it is likely that the cost to our societies of the emission of greenhouse gases associated with economic activities will be taken into account in a radically different and probably exponential way in 10 or 15 years. It will for reasons of market context (peak oil, etc.) or changes in market expectations themselves, requiring exemplarity in carbon sobriety for example. Companies that have not challenged their business models in time to take into account this “transition risk” and have not transformed themselves accordingly will be in serious difficulty. Another example is that if the producers of a raw material, especially the younger generations, are discouraged by economic conditions made difficult by an imbalance in the distribution of value, an industry could ultimately find itself without access to these raw materials. Whereas these commodities can be essential elements for the proper functioning of companies in this industry even though they represent only a modest part of their cost structure.

Companies that have not incorporated these elements will thus increasingly be categorized as comprising discriminatory risks. Let us bet, for example, that issuers of bonds in this category will experience difficulties comparable to those high-yield bond issuers are currently encountering: not only an increase in the cost of their financing, but above all a restriction on the universe of subscribers, a significant proportion of them having investment policies that essentially involve the subscription of investment grade bonds. Thus, the integration of climate risk is already a major challenge: but it will be even more so when regulators on banking institutions in particular will impose global warming effects in determining reference economic scenarios and running stress tests.

Long-term performance improvement

Not only are risk management policies profoundly disrupted by the integration of so-called non-financial risks, but the correlation between the consideration of environmental and social aspects and financial performance has been demonstrated many times (see studies led by George Serafeim, for example). This is not only an improvement in risk management but also an improvement in overall performance: better performance for controlled volatility.

This is no surprise.

Admittedly, this can undeniably generate additional constraints that may seem at first sight like a brake. But the fact that a company takes ESG criteria into account shows that it is open to changes in the expectations of societies, and therefore of customers. It also demonstrates that it reflects on long-term development conditions and accepts its responsibilities, all of which generate sustainability and performance.

– Climate change, impact on biodiversity or public health, reduction of social inequalities are all subjects that are largely covered by the Sustainable Development Goals. They correspond to the deepest expectations of our societies. Their consideration at a time when they were not so clearly expressed shows an openness and attention to societal changes: thus, orienting oneself according to financial performance but also to the environmental and social impact has the effect of adapting more precisely to the changes in our societies

– In an economic world that has been largely marked by a short-term vision of performance, whether at the level of public policies or corporate strategies, the integration of non-financial impacts (which are only non-financial for a time, just as an aside) generated by activities is also a way to reintegrate a long-term vision into investment policies and business development strategies

– Finally, in the organization of companies’ value chains, whether in their social policies or in the distribution of their added value among their employees, business partners and shareholders, the search for a form of balance makes it possible to perpetuate business models, in particular by retaining employees and partners, which entails improved comfort and security in operations.

In conclusion, the assessment and integration of ESG criteria, particularly environmental and social criteria, into investment policies and corporate strategies fundamentally changes deeply and in many ways the risk/return trade-off, which remains an essential criterion for any investment decision making.

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20+ years of experience in investment & asset management.
Raphael Hara works on relationships between finance and sustainability, in particular through the development and management of impact investment funds and projects.

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