ESG Excels for Risk Assessment

Investors value corporate disclosures when they exceed their legal reporting obligations. These give context to how a company operates and thinks about governance and risk management. Long-term investors including BlackRock and Vanguard increasingly expect their portfolio companies to improve transparency on how they undertake stakeholder engagement, manage near-term, and plan for the future.

Investors increasingly use corporate disclosure data as a proxy for a company’s long-term health. How capable are they to adapt in volatile market conditions? How resilient might they be in a business environment that is experiencing increasing disruption? Their overall performance will determine how exposed a long-term investor chooses to be to their stock.

“Profits are in no way inconsistent with purpose –
in fact, profits and purpose are inextricably linked…”

Larry Fink, Annual CEO Letter, BlackRock, 2019

The executive leadership teams of publicly traded companies value having thoughtful, long-term investors as their primary shareholders. These investors provide support to a business as it navigates new competitive challenges and manages emerging risk. CEOs in Europe and North America are responding to investor demand for greater transparency by implementing Environment, Social and Governance (ESG) strategies and then reporting their results.

To implement the ESG process, a company starts by eliciting feedback from a broad range of internal and external stakeholder engagement. This supports better risk identification and new opportunity identification. The new knowledge and insights help to establish internal goals and key performance indicators, which in turn influence the strategic planning and risk management processes. For the ESG process to create real intrinsic value, it should be embedded into existing corporate functions, rather than creating new committees and job titles.

Why Does ESG Matter to Investors?

“The objective of engagement at PIMCO is to influence change, improve returns, and reduce risks for our clients.”

PIMCO, 2018

The ESG process creates a regular disclosure framework: essentially a list of criteria that a company may wish to disclose on (e.g., health and safety policies, charitable giving, lawsuits). Investors value the ESG framework as a disclosure tool. It provides them with insight into how a business thinks about risk and manages internal processes (e.g., considerations made when appointing new board members).

Long-term asset managers can score a company by weighting disclosures against their own internal matrix. Debt fund manager PIMCO runs more than $1 trillion in corporate and government debt. The weighting it applies to ESG varies depending on the sector. For example, commercial banking is highly dependent on good internal governance and risk reporting. PIMCO prioritizes key governance issues such as internal business culture and the volume and severity of legal and regulatory settlements to rate a company (governance accounts for 60% of a commercial bank’s overall ESG score).

How Companies Are Rewarded

If ESG is really about the long-term management of companies in alignment with investors, stakeholders, and customers, then how do well-run companies get rewarded?

According to recent UBS research, companies that scored highly on ESG factors generated above-average returns between 2014 to 2017. ESG outperformance may have been driven by increased demand for best-in-class companies, which in turn bolsters share price.

How Does ESG Affect the Cost of Capital?

Research by Barclays Bank recently demonstrated that companies with high ESG disclosure scores are rewarded by investors with lower borrowing costs when compared against peers and spread over Treasury bonds. Put simply, this gives companies a long-term competitive advantage.

That is why 78% of the S&P 500 report annually on corporate responsibility (Harvard, 2018).