ESG is a relatively new but powerful idea. However, to avoid misunderstandings, it is time to engage more thoughtfully on how it is used by investors and regulators.  

The effective analysis and management of risk has never been more important for investors seeking to make strong, long-term, risk-adjusted returns. Although the days of the ‘robber barons’ are behind us, governance failures such Enron, and the global financial crisis of 2007–09 are still raw in the memory. 

Over the past decade, ESG has emerged as a powerful force in investment thinking: not only are many asset owners requiring their managers to take ESG factors into account, but financial market regulators are minded to make this mandatory.

Is this healthy? There are certainly compelling reasons for those managing money to continually improve what they do, and ESG thinking raises issues and ideas that are new for many. However, as an incomplete framework without robust definitions, ESG is at best an indicator of where improvements could be made rather than a foundation for new thinking.

Our archive suggests that ‘ESG’ was born in 2004, when analysts focusing on governance issues met their peers interested in triple-bottom-line investing, which involves assessing the environmental and social issues around investing in addition to financial benefits. The conflation of these workstreams led to ESG, a composite that spoke to both how companies are run as well as two external factors seen by most from an ethical perspective. It remained in the background until after the global financial crisis, when it became a lodestone for what had gone wrong.

Despite its creators’ worthy objectives to challenge thinking, ESG is not a foundation of investment management. Specifically, environmental and social issues are just two of the many external factors facing companies. A more compelling framework would map all internal and external issues affecting corporates.

Three-step process

At its core, investment management is a three-step process. Asset owners should first set their investment beliefs – the principles that guide their search for profits. Second, they should seek opportunities; third they should analyse and manage risk. We think of ESG as a reminder to do a better job in each area – for example, to broaden the dialogue with stakeholders about investment beliefs; for instance, that the investment portfolio should contribute to protecting the environment in which plan beneficiaries may retire. Equally, ESG can be a prompt to look more broadly for investment opportunities linked to medium term market trends. 

But let’s look at how ESG can improve risk analysis, which often falls short, particularly in three areas.

First, a lack of structure: after 70 years of accident investigation, pilots take a systematic approach to checking their plane and plans before leaving the gate. In contrast, investors typically fail to structure their approach to analysing risk. Initial public offering (IPO) prospectuses typically publish extensive, unstructured lists of risks generated by lawyers mandated to help their clients avoid criticism, an approach that can lead to mistakes or omissions: the IPO prospectus of Coal India published in 2010 listed 35 pages of risks but failed to refer to climate change.

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Second, a narrow approach to identifying risks: there are many instances of sudden, unexpected events destroying value. One such example would be the Deepwater Horizon disaster in 2010, when an ESG approach may have seen a pattern of health and safety failures in BP’s record. Nevertheless, many investors seem to lack imagination when identifying risk, for example, weather-related disruption to supply chains and taxes on sugar designed to combat obesity, which impact not just sugar suppliers but a wide range of food processors. 

Third, a short-term bias: there is plenty of evidence that market prices fail to identify or assess risks adequately, particularly those that could destroy substantial value over time. From January 2011 to end-2015, North American energy stocks in the MSCI World index fell 10.4% (in dollar terms), while North American coal and consumable fuels stocks dropped 84%. Investors in 2011 appear to have assigned an absurdly low probability that shale gas prices and air pollution regulations would substantially reduce the demand for and price of coal.  

ESG thinking can open up a broader and longer-term perspective. The success of ESG in catalysing a richer dialogue on risk has been highly beneficial for investors. Yet there are significant drawbacks in taking the framework well beyond its design limits. I am particularly concerned that regulators are starting to refer to it in formal guidance for market practitioners. In 2016 the US Department of Labor (DoL) stated that investors could consider ESG factors without violating their fiduciary duty.  

In April 2018, prompted by a new administration, the DoL changed its mind, saying investments based on ESG issues are not always a “prudent choice” and such factors should not “too readily” be considered. Without a robust, compelling definition and with origins (to some degree) in the world of ethics, it was easy for elected officials to see ESG as politically slanted.  

In the UK, it is troubling that The Pensions Regulator (TPR) has requested that trustees consider ESG factors as a way of combatting complacency, and that the “consideration” may become enshrined in law. It would be preferable to see regulators remind us that current requirements for risk management should lead to broad-based analysis and a long-term perspective. 

Useful tool, wrong task?

So how can the industry avoid the dangers of applying this useful tool to the wrong task? First, ESG should be fully incorporated into mainstream investment processes as a proxy for ‘smarter thinking’, particularly taking a longer-term, broader view.  

Second, materiality is vital: investment analysis is complex, so analysts should focus on what’s important and not waste their time producing tick-box reviews of every conceivable risk issue.  

Finally, and probably most importantly, regulators should not make it an explicit requirement in market standards, but rather require that regulated firms and persons take a comprehensive view of risk, using ESG analysis/factors if appropriate. In this context, ESG is not a straitjacket and there should be room for interpretation. 

Investors are facing uncertain times and we will need all possible help to achieve our objectives. In this context, ESG is an excellent tool:  let’s add it to the investment toolbox but remember to use it wisely.

Ian Simm is CEO and founder of Impax Asset Management