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Squeamish About ESG? Consider It a Risk

Or, how to explain ‘ESG’ to ‘Both sides’ without saying ‘ESG’.

Ian Tam, CFA 6 December, 2022 | 2:03AM
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The comet-like appearance of the term “ESG (environmental, social, governance) Investing” is unfortunately surrounded by a halo of confusion. This confusion, alongside the heavily politicized views-and also some controversies around the very concept of ESG-coupled with allegations of false advertising, a.k.a. “greenwashing”, may have left a bad taste in the mouths of some investors. At the very least, some investors may be driven to inaction because of the uncertainty around what ESG is, or even why it matters.

Let’s cut through the noise for a moment.

It All Boils Down to Risk

People invest to see their money grow. It is generally understood that by taking on some risk, investors will see their assets grow over time, which will help them reach a financial goal (like retirement or saving for a child’s education).

There are many sources of risk. For example,

  • Liquidity risk crystalizes when we realize that we can’t sell an investment for the price we want in a timely manner.
  • Foreign exchange risk hits us when we sell an investment in US dollars, but due to currency exchange fluctuations, our gains are erased by the time we convert our money back to Canadian dollars.
  • Credit risk is realized when a bond issuer fails to make a coupon payment to bond holders, greatly depreciating the value of the bond.

What’s common amongst all types of risk is that, if realized, they negatively affect investor outcomes. Here’s the thing – risk isn’t always realized, or sometimes can take a long time to be realized. This doesn’t mean that we shouldn’t pay attention to risk before entering an investment position.

It would be silly to buy an investment without some assurance that we’re able to sell it when we need to. It would be crazy to buy a USD stock without considering the foreign exchange rate. Finally, it would be ludicrous to lend money (i.e. buy a bond) without understanding the borrower’s ability to repay that debt.

Why Paying Attention to Risk Is Important

At the heart of the topic at hand is also the concept of risk. Naming aside, these are risks that have material financial impacts on a company’s bottom line but aren’t made evident in traditional financial statements.

For example, a manufacturing company that has their workforce go on strike due to labor disputes will ultimately disrupt production, affecting investors. A company with poor business ethics (like those accused of price fixing) will ultimately feel the backlash of regulators and lawmakers, which detracts from company performance.

In the wake of fluctuating fuel prices, and ongoing mandates from governments to reduce carbon emissions, companies that don’t have tangible contingencies to curb their reliance on fossil fuels will either have to pay high prices for fuel or will have to deal with government intervention – neither of which is favorable to an investor’s bottom line.

The key point here is that no one knows whether these backlashes on companies will happen or when they will happen, only that they might happen. This is the paradox that is risk. And make no mistake, ESG risk is a type of risk.

ESG Risk is a Type of Risk

From the perspective of the profit-seeking conservative investor, it makes no difference whether you care to make the planet a better place for its people. Understanding and analyzing risk is a prudent endeavor before buying any investment. Looking at ESG risks adds an additional lens that adds further insights to your investment. 

For reference, here’s a link that explains Morningstar’s “globe” ratings, which are a portfolio-level measure of ESG risk. 

This article does not constitute financial advice. Investors are always encouraged to conduct their own research before buying or selling any investment.

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About Author

Ian Tam, CFA  Investment Specialist at Morningstar Canada. 

 

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