This blog series explores ways where environmental, social and governance (ESG) factors can be incorporated in different areas of risk assessment.
Last week I wrote about the possibility of integrating ESG into market risk analysis. This post continues along the thread of market risk but this time exploring the integration of ESG in measuring market risk.
Financial institutions typically measure market risk using Value at Risk (VaR). VaR measures the maximum loss that can be expected from a certain time period (from 1 to 10 days) at a given confidence level. VaR is widely used because it provides decision-makers one number that is the best representation of enterprise-wide risk and allows them to determine how much capital to allocate for risk.
VaR maybe explained as an absolute amount (i.e. $1 million), or a percentage of market value (i.e. 3.5% of portfolio). A VaR of $1 million at 99% confidence level means the company may lose at least $1 million in one out of the next 100 days.
To calculate VaR, risk factors need to be identified. Risks to portfolios are dependent on the factors that drive volatility of a specific instrument or a portfolio. Can ESG risk factors be explicitly integrated in, say, a bond portfolio or an options portfolio? One can argue that ESG risk factors are implicitly integrated through interest rate risk and currency rates. But perhaps there is room for explicitly incorporating political risks and large scale social risks for example, and see how it impacts VaR results. A sudden escalation of government instability may trigger significant volatility risks that may increase the probability of losses to exceed the VaR threshold at a certain confidence level.
The 2007 financial crisis demonstrated the inadequacy of VaR to anticipate extreme events. Hence, regulators started requiring banks to conduct stress-testing, and this is done by applying extreme but probable scenarios to risk models to determine the maximum loss a financial institution may incur should the scenario materializes. The subjective component of stress-testing allows the inclusion of ESG factors that are difficult of quantify.
Scenario building identifies risk factors (i.e. interest rates, equity prices, current rates, etc.) to a portfolio, a business or an enterprise and tests the impact of a scenario on those risk factors. It would be interesting to stress test a corporate bond for a sudden and severe escalation of a percolating labor issue. Similarly, it would be interesting to see the results if a sovereign bond portfolio is stress-tested for extreme environmental degradation.
Thoughts on ESG and Market Risk
I believe there is room for ESG to be integrated in market risk analysis and the measure of market risk. Although the highly quantitative nature of market risk analysis makes integration a challenge with ESG in its current form. For ESG factors to be effectively integrated into market risk, they need to be quantified, or quantitative proxies need to be used. Still, scenario building for stress-testing offers an opportunity for testing out ESG integration.