This should have been the first blog post of this series but eagerness to got the better of me. So now let’s start at where it all begins.
What is Risk?
To paraphrase financial literature, risk typically refers to uncertainty and the probably of incurring unexpected losses (losses beyond what has been anticipated and priced in). Risk is associated with volatility, which may threaten financial returns.
Risk management is process of managing uncertainty and mitigating risk. It is a structured process that involves the identification of the sources of risk, analysis of risk factors, and implementing risk controls and mitigation. IMHO risk management is as much a science as it is an art. Risk managers typically employ the following risk mitigation strategy: Avoid, Transfer, Mitigate, Keep.
Integrating ESG in Risk Management
IMO in its current state and form, ESG is best used as for risk management. Current ESG ratings represent a company’s exposure to environmental, social and governance risks either through the involvement in controversial activities or misconduct by its employees, and its ability to manage such risks. While there is a rapidly increasing interest in using ESG data to measure impact of a company’s activities and products, impact ratings are still in their infancy and have ways to go before they can be integrated in a meaningful way in financial valuations.
ESG factors can be considered in all levels of the risk mitigation framework:
Avoid: Avoid companies with a high exposure to ESG risks. Companies that rely on just one business line or asset with ongoing ESG-related issues have a high likelihood of experiencing an event that could materially impact its operations in a one to three-year time frame. IMHO screening out single asset extractive companies is a prudent approach as a single blow could know these companies down. Moreover, avoid companies that have an inherently unethical business model. These are firms that are likely to face regulatory scrutiny.
Transfer: Risk transfer can be done through securitization where pools of loans are packaged and sold off to investors by banks. Investors of these securities make money from the cash flows of the underlying assets. Risk transfer, however, does not absolve banks of any responsibility to investors. The pool of underlying assets of a security must be diversified so as to reduce the risk of a credit event, which will force a payout by the bank.
Mitigate: Risk mitigation can be the inform of diversification. As mentioned above, diversification of loan or investment portfolios mitigate the risk of one loan or one investment pulling down the bank or the asset manager. In an investment portfolio for example, asset managers can underweight issuers with a high exposure to ESG risks, or those with no ESG program, or those with a track record of involvement in ESG issues.
Keep: A company may decide to take on risk if the reward for doing so exceeds the disadvantages. A bank may still offer a loan to a company with poor ESG performance or an asset manager may still overweight it because the financial benefits simply exceed the risk. Perhaps the risks associated with such a company are long-term and are already priced in. Or the risks have a low probability of materializing. Nonetheless, deciding on taking on risk should be complemented by a risk transfer or risk mitigation approach and an exit strategy.
A key challenge to integrating ESG into risk management is quantification. Risk management as a discipline has quantitative foundations and risk is typically measured in numeric terms (i.e. standard deviation). Quantifying environmental risks for example is not as straightforward as measuring interest rate risk. There are no established models to quantify such risks, much less risks such as social unrest and corrupt leadership. However, the absence of a standard quantification model is also not a reason to drop ESG integration in risk assessment. Applying ESG concepts in risk assessment enriches any RM approach and ensures that all facets of risk are considered in decision making.