Pricing ESG risk (or not)
Risks associated with the environmental, social and governance profile of a business are not quantified in a standardised way across the investment industry. Partly because they can’t be - they are hard to measure. In turn this means that Environmental Social and Governance (ESG) risks specifically can’t be fully priced in. Reducing risks in a portfolio should mean lower return. However, an active, dynamic and forward looking approach to responsible investing means that this does not have to be the case. If ESG risks and returns are not fully “in the price” then ESG investors can outperform by doing the research and putting the assessment of ESG risks on a par with more traditional risk factors like credit, interest rate and business cycle risk. As well as doing well for the planet and its people, responsible investors will end up being exposed to the best performing assets as ESG related risks and opportunities become more materialised – and priced – over time.
Whether choosing a “Responsible Investment” strategy involves giving up potential financial return is a question that many investors and commentators still ask. It pre-supposes that there is some linear trade-off between good environmental, social and governance credentials and higher financial returns. Of course, my colleagues and I at AXA Investment Managers would completely disagree with that supposition. Over the long-term, we believe the best performing assets will be the ones that have more sustainable business models. Sustainability means reducing risks that could become material drags on financial performance. It also means a focus on businesses that grow in areas that either do not create negative environmental and social impact or contribute to positive environmental and social outcomes.
Return and risk
There are plenty of non-financial reasons to invest in businesses that have a limited negative impact on the planet and its people or are able to contribute to a cleaner environment, more sustainable use of natural resources, and more equal societal outcomes. But we believe there are also very compelling financial reasons. It’s all about risks and opportunities, as it is with investing full stop. It is a basic principle that for any investment, expected returns should compensate for the risks attached to those returns – credit, inflation risk, business cycle risk, earnings risk, legal risks, and so on. A rule of thumb is that the higher the perceived riskiness of returns the higher the yield the investor needs to compensate. That is why high yield bonds can have a prospective return that is higher than government bonds. In efficient markets, market returns should reflect those risks and allow investors to make rational decisions about asset allocation as a result. Investors try to assess how these risks are priced through time – there is a lot of literature, for example, on trying to estimate the equity risk premium and what level of additional prospective return from equities compensates for all the embedded risks (quality of earnings, management and position in the business cycle). Active investment strategies are based on the assumption that markets are not totally efficient, and distortions can occur that allow for deviations of prospective returns from an assets’ risk profile. The government bond market in many countries is distorted by central bank asset purchases and today’s prospective returns do not compensate for the risks (inflation, higher rates, government deficit funding) – hence the bias over recent years to be underweight government bonds.
Can we price it?
It is interesting to contemplate whether ESG risks are priced in or whether higher risk premiums on low scoring ESG assets merely reflect the overall quality and riskiness of the business or sector. My feeling is that risks are not priced in, for the following reasons. First, analysis of companies from an ESG standpoint is still a relatively new line of work and there have not been enough risk events to properly identify signals, triggers and responses. Secondly, there is a lack of standardisation across the industry as far as ESG analysis goes. Investors use various datasets, there is a lack of uniformity on the weights given to certain factors, and many of the ESG risks are difficult to measure. Third, it is hard to quantify the materiality of many ESG risks. In some areas it is easy – a carbon emitting business in Europe facing a financial cost for doing so if it needs to purchase carbon credits. That is a clear, measurable and material risk factor that can be incorporated into financial modelling. However, not all ESG risks are that clear. When looking at the emissions we can make a judgement that businesses might be at risk of incurring a carbon tax in the future, or be subject to tighter regulation that increases costs, or may fall behind in terms of investing in new technology that allows its business to transition to a lower carbon future. These are clear risks that need to be taken into account by investors but modelling their impact on future financials is difficult. In the sphere of social factors, it is even tougher to quantify risks. Qualitatively we can identify where a business may run into legal problems, where its brand might become tarnished by human rights issues in its manufactured goods supply chains, or where its activities have negative social impacts on communities – but putting a probability on them materially impacting revenue or credit risk is not easy. The risks are multiple in the field of ESG and there is no right or wrong way to rank them, weight them or apply some metric to them that feeds into an observable risk premium in the price.
What we can observe is, perhaps, the most obvious pricing differentials that might be related to ESG factors. As an example, take the energy sector. In the ICE/Bank of America Merrill Lynch (BofAML) global corporate bond index, the energy sector has a weight of 8%. It currently has a yield to worst of 2.20% compared to an overall yield on the index of 1.7% (or 1.5% excluding energy). It shows energy corporate bonds have a higher yield than non-energy bonds. The problem is they always have and that may be more to do with the cyclicality of earnings and the highly leveraged nature of much of the sector. Maybe there has always been some residual carbon risk premium as well, but I can’t prove that. This is even more extreme in the high yield market, where the universe of assets embeds more risks and therefore pays higher prospective returns. The US high yield energy sector currently yields 5.13% compared to a market index yield of 4.20% (estimated ex-energy yield of 3.5%). The significant yield premium on energy high yield bonds really became material following 2014 when US shale oil and gas output began to accelerate and issuance from oil developers increased. Again, higher yields reflect a risker business but there could be some intrinsic carbon risk or broader environmental premium in the yield historically and today.
Lower borrowing costs for green issues
Looking at things the other way around, there is talk of a “greenium” where issuers of green bonds are able to borrow at lower yields than for regular bonds. A green bond, by construction and the way the proceeds are used, eradicates a lot of environmental risks. By being priced at a lower yield, investors are explicitly accepting a lower return for lower risk. On an abstract “risk-return” chart, green bonds would be more to the lower left than conventional bonds that still have ESG risks, even if from the same issuer. The ICE/BofAML green bond index yields 0.76% with an effective duration of 8.14 years, while the global aggregate 7-10 year index yields 1.18% with a duration of 7.62% (also with a higher credit rating on average). Comparing indices is not a like-for-like choice, but there is a clear “greenium” in a market that is explicit in significantly reducing environmental risks. It will be interesting to see how the social bond market develops given that is arguably more difficult to standardise and attach probabilities to the materiality of social risks – although there is a clear regulatory risk with some aspects of social. Philosophically, I would argue that funds raised through a social bond can be put to use to make an impact – related to one of several UN Sustainable Development Goals – which reduces common externalities and thus raises social welfare. That forms part of a “return” on the investment that is not necessarily captured by the yield alone. This is true for green bonds as well, as money raised goes to finance a low carbon transition, providing universal benefits.
Can't rely on market pricing
Taking ESG risks out of a portfolio may reduce prospective returns in the short-term, especially where ESG risk premiums might exist in current pricing. But this also reduces risks to future portfolio performance. If an ESG risk on a higher yielding asset materialises, the investor is likely to suffer losses above and beyond what the additional yield may have offered in return. A regulatory fine, an increase in tax or a rapid shift in demand as a result of a controversy will seriously damage the financials of a business model and re-rate the assets. In turn, the higher cost of capital for the business requires a higher return to be able to compete with lower risk assets. As we get better at assessing ESG risks, then we should be able to compare more accurately the materiality of risks against the current prospective return.
Active and responsible
It is not clear that ESG risks are reflected in risk premiums or that they ever can be. So the argument for active management with ESG analysis entirely embedded in the investment process is overwhelmingly strong. By focussing on ESG factors and having well developed data and methodologies for assessing the riskiness of these factors investors in credit and equity will be able to assess risks in a more holistic way. It could be argued that if excluding ESG risks from a portfolio lowers prospective return, managers might be tempted to increase other risks to compensate (credit, duration, currency or liquidity in a bond portfolio, for example). Yet identifying ESG risks at the security level means this does not have to be the case. Investors can focus on best in class, can assess the value of ESG policies in corporate strategy and can engage with management on how they plan to reduce emissions or have a positive social impact. Investing from an ESG perspective has to be about being forward looking, investing in those companies that are transitioning, that recognise the risks in their own business operations and are willing to reduce those risks over time. The “risk premium” might get reduced but investors will have more sustainable businesses to invest in and performance will be better over the long-term. A low carbon approach today might exclude energy companies. In the short-term that could be detrimental to performance (it has this year in some markets). Yet what happens if the world moves forward on carbon taxes at the COP26 summit this year? That could be very damaging to the performance of the highest emitters. Strategies that exclude energy would perform better financially and, of course, from the perspective of future sustainability.
Reducing risk to making impact
We understand risk in credit and there is a well-established framework of ordinal ranking of credit riskiness, provided by rating agencies with a methodology that is clear. We understand that some equities are riskier given their exposure to the volatility of earnings or because of the dominance of some factor such as beta, momentum or value in the pricing dynamics. We are processing environmental, social and governance risks more than ever and the industry is striving to find the right balance between data, judgemental analysis and engagement. Being an active, sustainability-focussed investor means not just relying on the information in market prices but assessing whether the price matches the risk. The proliferation of ESG investment products runs from the pure risk reduction (exclusion) approach to the active, impact focussed approach where non-financial goals are explicit in the strategy. Across the spectrum, long-term return does not have to be foregone. Indeed, making sustainability part of the financial assessment of an investment will lead, in my opinion, to better long-term performance. It has been noted in some literature that the best ESG companies are the best performers, but this is because they are the best companies. There’s nothing wrong with that. If company management did not take care of how their operating model impacts on the environment and on society, and if it does not have transparency in its supply chain or its management of human capital, then the likelihood is that it will not be one of the “best” companies. In the end, management wants customers to buy its products and investors to provide it with capital and funding. It makes no sense not to take care of ESG if they want to optimise the business model.
In my world of football I am sad to report that my other team – Sheffield Wednesday – was relegated last week to League One (the third tier of the English ladder). They lost out by two points but were already fighting from a weak position having started the season with a points deduction resulting from some off-the field ownership shenanigans. It’s not the first time the club has been down there, and the hope is that it will bounce back, but the story of its management is a sorry one. Unfortunately, that is common place throughout the game today, not just an issue for the six super leaguers. On the field, it’s a happier story with Manchester United who could finish the season with 2nd position and the Europa League trophy (I will ignore the loss to Liverpool). If I were Villareal, I would strive like crazy to get an early goal and then park the bus to frustrate United’s tendency to come back from losing positions. In the end, I hope the reds will be too strong.
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