This blog series explores ways where environmental, social and governance (ESG) factors can be incorporated in different areas of risk assessment.
TL;DR: ESG risk factors, while implicitly considered in traditional market risk analysis, can be a valuable input to long-term market risk assessment.
What is market risk?
Stated simply, it is the risk of financial losses faced by companies or investors from trading activities. Market risk is also known as systemic risk in that it cannot be diversified but can be hedged. Market risk can take the following forms:
- Equity risks : The risk of losses from a drop in share prices.
- Interest rate risk: The risk of losses from a change in interest rates.
- Commodity risk: The risk of losses from changes in commodity prices.
- Currency risk : The risk of losses from changes in foreign exchange rates.
What are ESG factors?
ESG refers to environmental, social and governance impacts arising from a company’s value chain, which may end up affecting the company’s bottom line. For purposes of this blog post, we will focus on the negative ESG impacts of a company’s activities and “social” will also include political risk factors. ESG risk assessments are increasingly being used to complement traditional financial analysis although ESG integration methodologies vary depending on the investor.
ESG and market risk
ESG factors are implicitly considered in market risk analysis, although it is not explicitly referred to as ESG. For example, interest rate risk is determined by a number of macro-economic and socio-political factors. Government stability is a key political factor considered in macro-economic analysis and this requires an analysis of the quality of leadership and other inflationary pressures. Currency risk is similarly analyzed by looking into economic fundamentals, which also include issues that may negatively impact economic indicators.
Market risk is measured in days (maximum of 10 days as required by regulators) hence, it is a short-term analysis by nature. Therefore, ESG factors that are relevant in short-term market risk analysis are those that have escalated to a level so severe that it results in market volatility. This could mean an escalation of a lingering political crisis in the form of for example, large scale protests, political violence, or a military coup.
But ESG factors can play a more relevant role in longer term market risk projections. Weak governance, weak protection of labor rights and human rights, corruption, environmental degradation, could destabilize a country raising currency and interest rate risks. Evidence suggests that labor issues in South Africa, which triggered numerous strikes over the last 30 years, impacted share prices in the Johannesburg Stock Exchange. The negative market reactions to periods of labor strikes in South Africa demonstrate that a labor issues can become a systemic risk that cannot be diversified away.
Some current global situations are worth integrating into a one-year market risk projection:
- Unpredictability of the Trump administration in the US.
- Growing nationalist sentiments in continental Europe.
- The human rights impacts of the anti-drug campaign in the Philippines.
- Corruption scandal in South Korea.
Next time, ESG and VaR and Scenario-Building.