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ESG Risk: Why Do We Need a Risk Metric Based on Environmental, Social and Governance factors?

To hear about ESG risk, we reached out to Paolo Capelli, Head of Risk Management at Etica - an asset management company which offers socially responsible investment funds.

Posted: 28th April 2020 by
Paolo Capelli
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In a context that has seen rapid growth in the offer of sustainable and responsible funds in recent years, Etica stands out for having made this approach its exclusive approach as far back as the year 2000. Integrating ESG criteria into investment decisions is an important element for society in creating value over the long term, both financial value, i.e. with returns adjusted for risk, and non-financial value, i.e. value for the community and the environment.

Numerous studies have shown that the returns of sustainable and responsible funds are in line with traditional returns, and sometimes even higher, particularly in periods of greater market volatility. ESG (Environmental, Social and Governance) analysis of securities allows for more comprehensive control of risks and helps to select the most sustainable companies in the long term. Investing in companies that ignore ESG issues can, in the long term, turn out to be an unfortunate choice in terms of performance.

According to 2019 data from the World Economic Forum, which monitors the main global risks by type, over the past 10 years, there has been a transition from predominately economic risks in 2009-2010 to an ever greater frequency of environmental and social risks, particularly since 2017. Not only have these risks become more common, but they have also become more significant given the extent of the damage they can cause. The most recent report published by the WEF at the beginning of 2020 shows that, for the first time ever, the top five global risks in terms of probability are all environmental.

Investing in companies that ignore ESG issues can, in the long term, turn out to be an unfortunate choice in terms of performance.

Precisely from a risk perspective, Etica has innovated the relevant studies, structuring a new risk metric, the ESG Risk, which measures ex-ante the actual impact of critical elements arising from factors related to ESG concerns that could have an adverse effect on the performance of the securities in which a fund invests.

The starting point for the elaboration of ESG Risk is the concept of entropy which, in statistics, represents the measure of disorder. This parameter comes into play because it is suitable for analysing the portfolio in relation to a characteristic of the securities that are fundamental for Etica - ESG relevance expressed through the score associated with each company or government security in the issuer analysis phase. The first step is to look at the six classes of ESG scores into which securities are divided and to take into account how issues are distributed, and then to calculate how much “disorder” there is in the ESG scores in the different configurations of the six possible cases. This is the first measure of risk.

Analysis of the results has shown that the riskiest portfolios financially are also the most “disorderly” compared to the ESG score.

The importance of this metric is also confirmed by robust evidence showing a close connection between financial risk, represented by undiversified VaR (one of the possible measurements of a potential loss of an investment position within a given time frame) and non-financial risk, represented by ESG Risk, for all asset classes and all sectors and countries. That is, a fund with a higher VaR also has a greater ESG Risk and a fund with a limited ESG Risk is characterised by a modest VaR.

In addition, by estimating the financial loss of the equity portfolio, through a stress analysis and via VaR (Value at Risk), if we consider only ESG risk factors, we can estimate that the risk of the ESG component alone generally amounts to between 5 and 15% of the overall risk. We regard this as a very significant result.

The importance of considering ESG variables in the analysis and valuation of a portfolio is also clear in the context of a new type of efficient frontier linking the portfolio’s return to its overall risk which we call “holistic” and which includes both traditional financial variables and non-financial (ESG) variables.

 

The chart on the left shows a “traditional” efficient frontier, as we are accustomed to considering it, namely portfolios sorted according to their reward-to-volatility ratio. The chart on the right shows a new efficient frontier, which has the vector risk module on its X-axis, i.e. our holistic view of risk Rv (which considers the VaR, the Relative VaR with respect to Etica's Investable Universe and the ESG Risk).

 

The result of the comparison is remarkable because, on the one hand, it highlights how the efficient frontier remains broadly valid in the shape and trend of the curve, but on the other hand, it tells us that also considering ESG Risk (and RelVaR) modifies the shape of the frontier to such an extent that, if ignored, the expected reward would be overestimated for like risk, and could potentially lead to unwelcome surprises.

The result of all our analyses paves the way for integrating ESG variables into the all-inclusive investment risk calculation, something that Etica has been conducting for all its funds for about 5 years.

More recently, Etica developed further analyses of ESG Risk and its potential, presenting them at the twelfth International Conference on Risk Management, held in Milan in June 2019. The joint study by Paolo Capelli, Risk Manager at Etica, Federica Ielasi, University of Florence, and Angeloantonio Russo, LUM Jean Monnet University, demonstrated that the ESG Risk metric helps to optimise portfolio diversification and improve the financial volatility estimate, especially in the medium-to-long term. Let's take a closer look at these two key results.

Empirical evidence shows that certain typical analysis factors within the process for selecting issuers, such as the company's market value, its governance characteristics and the country risk (in terms of control of corruption and regulatory quality), have a strong influence on the ESG Risk metric. Some examples to provide clarification.

A lower ESG Risk is more likely to be found when:

  • companies have a higher market value than their competitors;
  • companies have large dimensions, diverse expertise in decision-making and precise methodologies for handling complex decisions. These companies are the most willing to invest in innovative, long-term, sustainability-oriented strategies;
  • companies are globalised and digitalised, capable of developing competitiveness beyond borders and demonstrating good management of international relationships.

Thus, ESG Risk helps managers in portfolio analysis, reducing the inherent entropy (disorder) and optimising the portfolio’s internal diversification.

Analysis of the results has shown that the riskiest portfolios financially are also the most “disorderly” compared to the ESG score.

The second relevant implication of this study relates to the power of the ESG Risk metric to mitigate and reduce the unexpected volatility of a portfolio over the medium to long term.

As previously indicated, sustainable and responsible strategies with long-term objectives should consider ESG Risk analysis in order to obtain financial, as well as social and environmental returns. Traditional financial ratings do not show the same tendency to mitigate the relationship between ex-ante financial risk and the ex-post volatility of a portfolio in the short or medium term.

Therefore, investors who establish their own investment strategy without considering ESG Risk run the risk of losing control of the volatility of their portfolios, as well as making their investments more vulnerable, particularly during economic downturns.

The results of this study, therefore, make an interesting contribution both to financial theory and practice, particularly in relation to asset management. In addition to traditional financial risks, it is increasingly important to consider and manage risks arising from ESG factors that often translate into significant economic risks.

Anyone deciding to invest by incorporating aspects related to ESG issues into the financial analysis can then rely on competitive advantage in long-term risk management since calculation of the ESG Risk provides a holistic view of the total risk of their investment, which is synonymous with greater transparency and awareness.

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