Environmental, Social and Governance (ESG) and Climate Risk Investing – You must be kidding me?!

“As if there weren’t enough jargons and complex terms to remember for an investor, you are telling me I need to now know about ESG and Climate Risk – You must be kidding me!!” – These are the exact words (with a couple of expletives, that I cannot quote here) – a senior fund administrator from a large investment firm uttered when we were presenting about environment aware financial risk management.

For some of the old-fashioned investors, who grew up in the “Wild Wild Wall Street” days, this still seems a bit farfetched. But you know what, anything that can make more money, intelligently in the long term is a good idea for all investors, investment managers, banks and consultants like me. So, hear me out – I may help you make your next big profitable move, be it investing, divesting, or selling a new idea.

Warren Buffett wrote: “Today our world is changing faster than ever before: economic, geopolitical, and environmental challenges abound. However, taking shortcuts is not the pathway to achieving sustainable competitive advantage, nor is it an avenue toward satisfying customers. In times such as these, a company must invest in the key ingredients of profitability, people, communities, and environment.”. I, for one, listen when this legend speaks.

What does it mean?

ESG? – The textbooks define it as a “a set of criteria used to assess the sustainability and ethical impact of investments in companies or organizations. Environmental factors evaluate a company’s impact on the environment, such as its carbon footprint, resource usage, and efforts towards sustainability. Social factors consider a company’s treatment of employees, diversity and inclusion practices, community relations, and involvement in socially responsible initiatives. Governance factors focus on the organization’s leadership, transparency, accountability, and adherence to ethical business practices.”

ESG criteria help investors make informed decisions by considering not only financial performance but also the broader impact and responsibilities of the entities they invest in. This is also one quickly becoming one of the parameters on which Investment Companies, Banks and HNI clients want their investments to be routed towards for a sustainable long-term benefit. Companies that prioritize strong ESG practices are often seen as more forward-thinking, resilient, and better positioned for long-term success in an increasingly sentient and interconnected global economy.

So making a profit while doing good is an idea we all can benefit from. But to take it to the next level, as larger banks and investment firms bring in these criteria as a deciding factor on some of their investments, guess what’s going to happen to the companies that adhere to the ESG standards? They are going to grow in value and profits. Making these companies great investments in the longer term.

 

How Do I know?

Base our investment on ESG factors you ask? Well, while some major investment firms have made it mandatory to check ESG scores while investing and consider Climate Risk as a part of their Global Investment Portfolio Risk Assessment Criteria; others use it as a tertiary decision driver.

Most rating agencies today including Bloomberg, Dow Jones, Thomson Reuters and MSCI provide ESG Scores for publicly traded companies, though a standardization in the scores and its global applicability is something that the governing bodies including FDIC (Federal Deposit Insurance Corporation) in the USA and ESMA (European Securities Markets Association) In EU are working towards. A major step in this direction is the European Union Markets in Financial Instruments Directive II (EU MiFID II) Regulation requiring financial firms to incorporate sustainability preferences into their advisory and portfolio management processes since 2022. So in case you are planning to also invest in European markets, now you have to know ESG scores of every company you plan to invest in!

ESG criteria help investors make informed decisions by considering not only financial performance but also the broader impact and responsibilities of the entities they invest in. This is also one quickly becoming one of the parameters on which Investment Companies, Banks and HNI clients want their investments to be routed towards for a sustainable long-term benefit. Companies that prioritize strong ESG practices are often seen as more forward-thinking, resilient, and better positioned for long-term success in an increasingly sentient and interconnected global economy. Whilst ESG factors are more wholesome and elaborately modelled, it is important to recognize that Climate Change accounts for only one of the ten ESG key themes as set out by the MSCI [ENVIRONMENTAL – Climate Change, Natural Resources, Pollution and Waste, Environmental Opportunities; SOCIAL – Human Capital, Product Liability, Stakeholder Opposition, Social Opportunities; GOVERNANCE – Corporate Governance, Corporate Behavior] but plays a significantly important role from a financial risk management perspective.

How does it impact me?

I can assure you, it’s going to impact you if you are an Investor, or a Bank or a Financial Consultant. ESG and Climate Risk aware investments are going to be tracked, appreciated and in some cases mandated over the next few years as financial risk reforms and directives like MIFID II become mainstream and while this is the more technical reason, I will also attempt to answer it more directly.

Its fairly clear that as an Investor, good long-term investments is a basic, tried and trusted strategy. ESG investing will focus resources on scrips whose underlying companies that follow positive environmental, social, and governance principles. More and more investors are expected to align their portfolios with ESG-compliant outfits and providers, making it an area of growth with positive effects on society and the environment. And more demand means rising prices of stocks and hence more profits.

Banks and Organizations have also started to address a growing number of critical drivers concerning ESG. This new international and national legislation and regulation and the voluntary disclosure approach led by the Task Force for Climate-Related Disclosures (TCFD) in addition to Increasing public concerns and pressure from lobby groups, activists, regulators and investors.

A significant chunk of investment is already being made in the Banking and Financial Services industry, especially in the risk management area that addresses the ESG and Climate Risk related strategies and disclosures. This is an opportunity for consulting firms and individuals to build and hone expertise in the area and field for more regulation and hence more transformation driven work in core and tertiary capacities.

All and all, ESG and Climate Risk is going to impact all of us, one way or the other. Whether we take the opportunity, take cognizance and make the most of it is up to us as an individual, an organization and a community as a whole.

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