Reducing Risk Through Ethical Investment
The value added by ethical business and ethical investment in reducing risk is explored in “Good business sense? Why ethical companies often outperform” published in The Guardian Labs (21st October, 2020). The article suggests that ethical concerns can reflect a business leader’s attitude to long-term risk – particularly their ability to view social and environmental risks as financial risks. It maintains that the global economic fallout this year from the Covid-19 pandemic has demonstrated just how interconnected social and financial risks can be.
The article includes views from UK based founder of SRI Services Julia Dreblow who observes that “Many investors have regarded strong environmental, social and governance (ESG) practices to be proxies for good management”. Dreblow maintains that “Ethical behaviours do not guarantee corporate success, and the performance of shares is notoriously complex. But what is very clear is that poor ESG practices are risky and regularly bite investors.”
Put another way, when companies disregard ethical and social considerations, they are often also turning a blind eye to real world business risks. For example, a tobacco company could have its product restricted or even banned, while carmakers that drag their heels on emissions targets can find themselves caught by tightening regulations. Likewise, a fashion company that is revealed to have used child labour in its supply chain may face a damaging customer boycott.
John Fleetwood, director of responsible and sustainable investing at Square Mile, an investment research business, believes companies with a good record on ESG will continue to benefit from long-term tailwinds and avoid long-term headwinds: “If you look at a 20-year view, that’s the way the world is going. It’s having to focus more on sustainability issues, and [sustainable] products will be more in demand both from legislation, from government and a [consumer] need for these things. A clear example is the move towards electric cars (EVs). That’s going to happen … You’re investing in the winners.”
Academic and industry research has previously highlighted that taking account of ESG factors can also reduce risk. For example, in a Swiss Finance Institute Research paper, academics Krueger and Gibson (2018) conclude that portfolios with high sustainability scores display higher risk-adjusted performance.
While Credit Suisse (2015) found that integrating ESG factors can enhance portfolio performance through both lower exposure to negative risks related to ESG factors and higher exposure to related opportunities. In addition, Credit Suisse found that ESG ratings are a possible lead indicator of management quality.
In their paper ‘A Quantitative Perspective in How ESG can Enhance your Portfolio”, JP Morgan (2016) maintain that ESG offers investors a measurement system to manage reputational and operational risk that companies face, which may impact their long-term profitability. They conclude that ESG can enhance your portfolio by reducing volatility and limiting drawdowns.
The NZ Sustainable Finance Forum, an initiative that Rodger is part of, observes that: “There is growing awareness that sustainability is a key driver of long-term economic and financial value creation, or destruction, at the macro and micro level. Degradation of social and environmental systems, and the transition to a sustainable economy, creates material business and investment risks and opportunities. Understanding and managing these risks and opportunities is now seen as central to the discharge of governance, fiduciary and stewardship duties.”