ESG RISKS AS A NON-FINANCIAL FACTOR IN INVESTMENT STRATEGIES

 

 

 

 

 

 

 

 The ESG Risks

From Cape Town’s dwindling water supply to intensifying droughts witnessed across different african countries (as we can see in Cunene, Angola), the effects of climate change are now very real and have both economic and social impacts that are and will be felt by african populations.

Consequently, it has become essential to adapt and prepare our societies and the economies to respond and recover from its effects, making it necessary for us to provide a greater attention to ESG related issues and how they may relate with the investment environment at a global, continental and at a national scale.

The Environmental, Social and Governance (ESG) criteria are a set of standards for a company’s operations that socially conscious investors use to screen potential investments that seek positive returns and long-term impact on society, which are also known as sustainable investments.

Environmental criteria consider how a company performs as a steward of nature. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. Governance deals with a company’s leadership, executive pay, audits, internal controls and shareholder rights.

Therefore, ESG investing looks at “extra-financial” or non-financial factors and the ESG investment analysis, encompasses those aspects of an issuer’s operations which may materially influence its ability to meet its financial obligations in the long term.

These ESG related risks (and opportunities) will vary by country, industry, as well as by characteristics specific to an issuer such as size and geographical footprint and they can be broken down in the following way:

• Environment or Environmental risk: it may include a company’s energy use, waste, pollution, natural resource conservation, and treatment of animals. The criteria can equally be used in evaluating any environmental risks a company might face and how the company is managing those risks.

 This, for example, might constitute a ‘stranded assets’ risk for oil & gas companies, whose activity has a significant direct impact on the environment;

• Social risk: this relates to issues of inequality, inclusiveness, labour relations, investment in human capital and communities.

This can then manifest as the interconnection of human rights and supply chains, where investors require security of supply risk for retailers sourcing from suppliers operating in unethical and illegal working conditions;

• Governance risk: and this implies analyzing management structures, employee relations and executive remuneration in both public and private institutions, since these play a fundamental role in ensuring the inclusion of social and environmental considerations in the decision-making process.

Here, transparency and integrity are key aspects and this can be translated in the lack of appropriate board oversight and decision making structures which undermine investor confidence in management.

Bearing this in mind, supplementing traditional financial analysis by reviewing ESG related management practices and performance is, therefore, a prudent strategy, particularly in a world where initiatives such as the European Green Deal (EGD) are enforced.

 

ESG Factors as a part of the Investment Decision Process

This can be achieved (on a broader approach) by resorting to an ESG Integration Investment Strategy. As it is done today, ESG integration describes an approach where material ESG risk factors are considered as part of the broader investment process.

But Such an approach does not necessarily mean that portfolios will automatically exclude issuers from investment purely on ESG grounds.

Its purpose is to ensure that investors are aware of, and taking informed investments decisions with knowledge of key ESG risks.

In this way, ESG factors become an input into the investment process, but they are not necessarily the key determinant in the final investment decision making process, which ultimately reflects the view of an investment’s risk or return.

But with the implementation and enforcement of any broad ranging economic and social reform program (as it is with the EGD in the EU, for example), there is a possibility that this will change and ESG factors will have a greater weight in final investment decisions for investments targeting any space where such rules are enforced.

And this is critical, both for the investors and the invested, because Poorly managed ESG risks can lead to inefficiencies, operational disruption, litigation and reputational damage, which may ultimately impact an issuer’s ability to meet their financial responsibilities.

So, to ensure that ESG risk is efficiently managed and this is prevented, some strategies can be employed:

• Top-down macro-level ESG analysis: which consists in analysing and evaluating trends and development at a global/regional/country level in terms of the political, legal and regulatory, environmental and social megatrends shaping the operating environment of governments and economic development, and which set the stage for corporate activities;

• Bottom-up micro level ESG issuer analysis: here, there is a greater focus at the corporate level, and it involves conducting a fundamental analysis and evaluation of ESG management and performance trends and developments for a given industry;

• Product Based ESG Negative Screening: and here the investors conduct a screening process based, and centered on excluding corporate issuer’s involvement in the production any goods or services that may breach the ESG parameters as it would be the case if investors found out that a company produced clothes by resorting to child labor, for example;

• Financial Covenants: through contractual clauses, the investor can impose that certain activities will or will not be carried out or that certain thresholds will be met.

 In this case specifically, these covenants could establish that complying with certain levels of carbon emission or not entering into an agreement with third parties that are suspected of operating in unethical or illegal working conditions could trigger this covenants (this, of course, entails specific due diligence duties on the part of the invested party).

 

Preparing for a “Brave New World” (?)

Although african countries may be among those who have least contributed to the climate crisis, according to a 2011 report of the African Development Bank (AfDB), they stand to be amongst the regions worst-affected by the climate crisis, what also makes them particularly vulnerable to climate change induced poverty, given that they have the highest initial number of people living in poverty and may very well face the steepest projected increases in agricultural prices caused by expected yield losses, at least according to the World Bank projections.

For the worst effects of climate change to be mitigated (internal climate changes migrants, reduced availability of natural resources and of land where agriculture can be developed, what might fuel new conflicts across the continent), a shift towards climate-informed development seems to be necessary in order to ensure that new projects are adaptable to (and do not exacerbate) climate conditions, and to reduce people’s vulnerability to the impact of climate change.

And in the case of Angola, it is particularly important that both public and private investment begin to consider the importance of these factors so that projects that are being funded now are not born already obsolete and don’t have to be changed in order to be in conformity with the new climate, social and (corporate) governance challenges which would not only make them more expensive, but would also make the country more vulnerable to the transformations that are expected to occur in the global arena in the coming decades.

 

Author: Elvis Barros 

Bibliography:

Environmental, Social and Governance Issues in Investing: A Guide for Investment Professionals, CFA Institute, 2015.

ESG in Equity Analysis and Credit Analysis, CFA Institute, 2018.

Groundswell: Preparing for Internal Climate Migration, World Bank Group, 2018.

Raising the Heat: Exploring Climate-Consciousness in Africa Private Equity, AVCA, 2020.

Shock Waves: Managing the Impacts of Climate Change on Poverty, World Bank Group, 2016.

The Cost of Adaptation to Climate Change in Africa, AfDB, 2011.