A deeper understanding of environmental, social and governance issues will allow you to make better-informed investment decisions

It is not always possible to quantify the impact of qualitative factors, but attempting this is part of investment analysis. This is what sits at the heart of incorporating environmental, social and governance factors (ESG) into mainstream investment management. Today, it is very difficult to obtain information and analysis of sufficient quality and depth to measure the impact of ESG issues on the value of companies. However, you don't have to be an expert to know that these factors can form risks and opportunities.

What is ESG? These are factors to assess the opportunities and risks that apply to a company whether ‘sin' stocks, blue chips or others. Changes in social thinking and socially responsible investment (SRI) have fuelled interest in ESG factors. Their application makes good risk management sense in investment analysis.

At the CFA Institute we have framed ESG risks and opportunities as, legislative and regulatory; legal; reputational and operational.

First, take changes in legislation. The introduction of EU legislation to reduce carbon emissions has reached all areas of commerce. Carbon credits, fuel taxation, investment in alternative energy, and new building regulations have had both direct and indirect effects on European business Investors should therefore consider if legislative changes will help or hinder a corporate strategy and find out whether the company has conducted analysis on the risk or opportunities available. Shareholders need to understand that they are at risk from changes in legislation, or that regulations could affect a company's business model, cash flows, even its very survival.

Whether a company has broken the law, or, more importantly, is accused of breaking the law, is another major consideration for investors. The litigious environment varies from country to country and it is probably at its greatest in the US. Hence large companies usually have several legal actions in process at any one time. Fortunately, companies recognise that they have obligations to inform shareholders of legal action. In the developed markets the level of disclosure is relatively better though the extent of potential liability, cash flow impact, is often greyly defined as a gaming ploy during the legal process. It is due to this very uncertainty that the investor must evaluate the market's pricing of litigious liability and compare it with their analysis.

As with the legislative and regulatory factors, analysts need to conduct the same style of analysis for legal factors. They need to estimate the size of the problem, talk to the company, satisfy themselves that the management has made a thorough and realistic assessment of the situation and check that this assessment has been effectively communicated to the market.

 A more subjective factor to assess is reputation. What price do you value the brand and therefore by default the company itself? This is a question colleagues and investors no doubt wanted to put to Gerald Ratner, CEO of UK jewellery retailer Ratners, following his speech to the Institute of Directors in the early 1990s with his now infamous comments: "We also do cut-glass sherry decanters complete with six glasses on a silver-plated tray that your butler can serve you drinks on, all for £4.95. People say: ‘How can you sell this for such a low price?' I say, because it's total crap."

Reputational risk is about maintaining the trust of customers, and reputational failure is the consequence that affects customer behaviour and thereby the bottom line. In parallel with this is the corporate relationship with shareholders. If shareholders don't trust management, it could raise the cost of capital, even close the door on new finance.

Société Générale had its reputation damaged in January 2008 by its €5bn loss at the hands of an employee. Similarly, when Credit Suisse dropped UK retailer Safeway, one of its corporate broking clients, in the middle of a deal in order to advise KKR on a possible bid in 2003, the corporate broker's reputation remained tarnished for many years. Companies that are attentive to reputational risk issues prevent them from happening or respond effectively when things go wrong.

The branded apparel business periodically becomes embroiled with child labour and sweatshop issues. In 2001 Nike became involved in several child labour scandals, with the discovery that children as young as 10 were making footballs, shoes and clothing in Pakistan and Cambodia. Though discontent rumbles on from various human rights groups, Nike saved its reputation by admitting its mistake, putting stronger procedures in place to prevent the problem occurring again. However, Nike also admits that it cannot guarantee enforcement of these standards 100% of the time. Several campaigns against child labour have been taken up by anti-globalisation and anti-sweatshop groups, such as the United Students Against Sweatshops. Despite these campaigns, Nike's annual revenues have increased from $6.4bn (€5bn)in 1996 to nearly $17bn in 2007.

In between robust reputational risk management and its absence is ‘greenwash', the term used to describe ESG style public relations stunts that have no substance. Recently a high-profile airline became the first to demonstrate the inclusion of bio-fuels in its jet kerosene, and, to demonstrate the fact, it flew one of its jumbo jets from London to Amsterdam on the additive. Unfortunately, this occurred around the recent peak in basic food prices. The predominant news story was that many in the third world were finding it even harder to feed themselves because of the first world's competitive demands of bio-fuels. Hence, this exercise in socially responsible initiative became tainted as greenwash, and backfired.

The message is that investors need to understand how reputation failure can affect a company's business, and discover how seriously a company evaluates and manages its reputational risks.

Finally, operational, is rather an important ‘catch-all' risk. Take, for example, the impact of changing weather patterns on wine growing or the holiday trade. Both have created operational opportunities and challenges, with new wines being grown commercially in southern England for the first time. The recent succession of dismal European summers combined with cheap air travel has fuelled short-haul foreign holidays to the adverse affect of holidays at home. Similarly, the smoking ban in the UK has made pub visits pleasanter but has dramatically depressed trade, forcing many pubs to close.

The investor evaluates operational risk by looking at the company's sources of cash and associated costs. As with the other factors, a similar checklist risk analysis applies. Common to all factors is that a well-managed company appreciates the risks of doing business, has thoroughly researched the issues, and adapted the business model to mitigate the risk or put plans in place to manage risk events as they occur. Without such information, it might be worth reaching for the sell ticket.

In conclusion, one of the most challenging issues investors face when attempting to evaluate ESG issues is in finding the relevant information. Because of ESG's newness in the investment process, there is a lack of uniform ESG disclosure standards. In turn, this means a lack of comparable data on metrics and information. A better understanding of ESG issues will allow you to make better investment decisions, which is commensurate with our goal to raise professional standards.

The CFA Institute Centre's has produced a free ESG educational guide to help investors convert non-financial information into tangible value. A number of different organisations and regulators are in the early stages of addressing the problem of the lack of information by working to standardising certain ESG reporting frameworks for issues like carbon emissions that touch a number of industries.

However, for now it can be difficult for investors to find the type of information they need. A skilled investor will often need to interpret different types of information that is often not provided in a standardised format. That investor will then have to evaluate the risks and assign a probability of the event occurring, to adjust the present value of a stock for ESG factors. Given the newness of ESG factors for consideration, coupled with a lack of uniform ESG disclosure standards and comparable data, this makes understanding the risks and opportunities open to investors challenging.

However, one thing is for sure and that is ESG will not be a passing fashion and will embed itself as an integral part of mainstream analysis.

The CFA Institute Centre's ESG guide is available to download from cfapubs.org

Charles Cronin is head of CFA Institute Centre for Financial Market Integrity (EMEA)