The reasons investors care about ESG in their investment can be broadly classified into four categories: financial, competitive, strategic, and perception. Overall, investors consider ESG investments safer and more stable bets. Here are five of the top risks that matter to investors:
Climate risk is a critical ESG focus today. Potential infrastructure and property losses due to climate change are already affecting organizations' long-term financial sustainability. Many investors examine a company's preparation and capacity to forecast and respond to a variety of climate threats when evaluating its ESG profile. As companies embark on risk assessments, there are three primary types of risk to consider:
a) Transition risk refers to the climate policies and laws shifting the global economy away from fossil fuels. Policy and regulatory risks, technological risks, market risks, reputational hazards, and legal risks are all part of transition risks that can impact the portfolio. These risks are intertwined, and they're often on investors' minds as they try to negotiate a more aggressive low-carbon agenda that might have capital and operational implications for their assets.
b) Litigation risk . Companies that generate and emit more CO2 than others are more liable to class-action lawsuits and other legal issues that hold them responsible for contributing to global warming.
c) Physical risks, such as extreme weather and record temperatures, are now recognized as events that can be predicted and factored into financial planning. Droughts, floods, excessive precipitation, and wildfires are all examples of acute threats. Rising temperatures, the spread of tropical pests, illnesses in temperate zones, and an accelerated loss of biodiversity are all examples of chronic concerns. Investors are exposed to both idiosyncratic and systemic risks as a result of acute and chronic threats.
Beyond these three primary risks, investors also consider the costs incurred due to the political instability and conflicts that climate change may engender and supply chains that can become impacted by extreme weather occurrences.
ESG social factors can range from employee treatment to boycotts to labor violations to product recalls. These issues are diverse, qualitative, and can often impact all company stakeholders at once, from workers and customers to suppliers and local communities, and disrupt portfolio stability. The ability to maintain healthy, positive, fair, and ethical relationships with these stakeholders is critical to the success of a company, especially if the success of that business relies on public trust.
Geopolitical events and labor issues also fall under the social category in ESG investing and conflicts like these can prevent companies from producing or distributing their products. For example, Ukraine-Russia war.
While most investors have a sense of good governance practices, it’s not a “one-size-fits-all” approach. It can be difficult to identify where and how best practices might have an impact on business performance. While most investors have a sense of good governance practices, it is difficult to identify where and how best practices might have an impact on business performance. Types of governance risk can include:
Investors must understand the compliance and regulations that apply to the industry in which the portfolio company operates, take into account the role of the Board of Directors in overseeing sustainability risk management policies, check that internal controls and risk management systems are in place, sift through company disclosures, and make sure that company leadership is making wise decisions and allocating resources efficiently.
Reliable, factual, consistent data gives investors the opportunity to track progress and gather the critical information they need for peer comparison and risk mitigation. Using financial data, industry benchmarking, and artificial intelligence can help companies capture vast amounts of structured and unstructured data. All of this data can be used to report on ESG performance improvements and provide assurance to investors. This need for meaningful ESG data and clear information on sustainable practices is forcing companies to demonstrate their outcomes better.
Investments that lack a robust ESG program are viewed as not being "progressive" or "risk-conscious", which can hurt perceptions and impact investment value. Companies that consider ESG issues enhance value creation, according to McKinsey. McKinsey found strong ESG propositions:
In Gartner's 2021 Emerging Risks Monitor Report, the regulatory risk associated with ESG disclosures quickly climbed to the second-top concern. According to a poll of 153 senior executives, enterprises are faced with both significant risks and opportunities as a result of ESG regulatory requirements.
With continued climate-related disasters and variable weather patterns, tighter regulations around GHG emissions, rising demand for renewable and sustainable energy, biodiversity and supply chain ethics issues, and growing concern over social and governance issues, 2022 is expected to see an even greater demand for ESG disclosures.
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