Better understanding of risk through the integration of ESG criteria

Florian Sommer

Florian Sommer,

Head of Sustainability Research, Union Investment

The capital markets have fundamentally changed in recent years: the stock markets have not escaped the profound impact of digitalisation and globalisation and new business models have triumphed, leaving old companies floundering in their wake. At the same time, but less noticeably, there has been a shift in the way that risk categories are assessed. In the past, if the price of a security suddenly crashed, it was usually for one of two reasons. Either the political or macroeconomic parameters had changed and the issuer was considered a potential loser, or something had gone wrong with the company itself – its sales forecasts were wrong or a hoped-for takeover had failed to materialise.

But traditional fundamental research – with its strong focus on the balance sheet, income statement and cash flow statement – is no longer enough on its own to adequately analyse and control the risks of a company. It needs to be extended to take account of non-financial criteria, also known as sustainability criteria, in order to capture today’s complexity. This extended approach will provide a deeper insight into the specific risk profile of an issuer.

The additional risk categories include litigation, regulatory, reputational and event risks. Examples that have come to light recently include the network of corruption at the Brazilian oil giant Petrobras, the VW emissions scandal and, most recently, the dam breaches at mines owned by the Brazilian iron ore mining company Vale. These risks are at the centre of an extended form of risk management that is very closely linked to the greater integration of traditional financial analysis and sustainability research.

ESG integration: sustainability improves risk management

ESG integration: sustainability improves risk management
Source: Union Investment, as at: 16 May 2019

Problems don’t appear out of the blue

Each of these four risk categories presents a potential threat to the portfolio. Investors who include ESG criteria in their investment process are introducing an additional risk management filter. Problems caused by issues such as CO2 emissions, poor working conditions or inadequate control mechanisms within a company never appear out completely out of the blue. If we look, we can see them coming, and in-depth ESG analysis brings these problems to light at an early stage. Technology risks are another risk category. They include, for example, the risk of companies being unable to adapt their business model when circumstances change. This could be in connection with the change in travel habits – think electric vehicles – or the switch from conventional light bulbs to LEDs. As well as risks, these aspects also create opportunities and it is up to investors to seize them. Investors who have the know-how to assess the risks arising from forthcoming regulation, for example, or from the trend towards electric vehicles will be able to judge which companies and which business models are most likely to flourish in the new environment. This has clear implications for companies’ share price and probability of default, and measurable consequences for investors.

In recent years, risk management considerations have persuaded many investors of the need to apply sustainability filters to their investments. And increasing regulatory pressure is forcing companies to be more transparent. The Corporate Social Responsibility (CSR) Directive, implemented in Germany through the CSR Directive Implementation Act in 2017, requires banks and large corporations to provide information about important non-financial matters in their annual reports. This includes information on environmental protection, social responsibility and treatment of employees, respect for human rights, and anti-corruption and bribery. The directive, which only applies to large companies, benefits investors as the extended disclosure obligations mean they obtain additional information.

EU action plan supported

There has been a lot more action at EU level on matters of environmental, social and corporate governance in recent years. One key measure is the action plan for funding sustainable growth that was put forward by the European Commission in March 2018. The plan is part of the EU’s efforts to create a low-emission, resource-efficient economy. At its heart is the management of capital flows in order to drive the change towards a more sustainable economy. The recommendations should help to achieve the Paris climate goals (COP21) and strengthen the 17 sustainable development goals agreed by the United Nations in 2015 that cover matters such as sustainable growth, sustainable urban development and sustainable consumption.

Sustainability has a regulatory tailwind in Europe - Brussels is pressing ahead with EU action plan
Source: Union Investment: Assessment based on plans of the European Commission and the legislative process in Parliament and the Council, as at: 16 May 2019

The individual measures of the action plan to fund sustainable growth are still being negotiated in Brussels, but it is clear that companies and investors will have to adapt to the action plan – and that is good news. It is currently expected that a number of regulatory measures will be in force from 2020.

New analysis criteria for government bonds too

The need to integrate ESG criteria into the analysis process does not just apply to private issuers. Investment approaches that include sustainability filters are also useful for conventional government bonds. The European sovereign debt crisis was merely the latest reminder of the long-known fact that even countries can default and that bondholders are left to foot the bill when it happens. However, the introduction of the extended concept of risk into the government bond segment presents investors with new challenges. For both regulatory reasons and liquidity management purposes, government bonds remain an indispensable asset class that cannot simply be ignored in asset allocation. But the financial crisis and sovereign debt crisis clearly illustrate that choosing reliable government bonds is by no means a straightforward exercise any more. There is also a growing awareness that traditional and established ratings are no longer unequivocally helpful in this respect. Their reputation has been tarnished as a result of the financial crisis.

Proprietary crisis Radar

To solve this dilemma, new approaches need to be integrated into established valuation models that are used to manage the risks attaching to government bonds. The goal must be a comprehensive and primarily quantitative analysis that follows a consistent logic and does not require country-specific special factors. All factors that could typically lead to a sovereign default have to be taken into account. Based on these considerations, Union Investment has developed a proprietary credit assessment model for government bonds which does not seek to replace standard rating procedures, but rather adds an additional analytical process. This model rests on three pillars. The main pillar, the macroeconomic fundamental rating, assesses a country’s ability to repay its debts based on its economic performance. The second pillar is an analysis of the willingness to pay. Thirdly, the implementation of an early warning system ensures that developing crises are detected and included in the assessment process. The degree of bribery and corruption in countries is an example of a key indicator that may be used. The advantage of this crisis radar is that any adverse trends, which can crop up even in fundamentally high-scoring countries, can form part of the rating and thus allow the potential for default to be identified at an early stage.

Summary

Today’s investment world is very different to that of a decade ago – and the issue of sustainability has moved into the mainstream. Investors who want to effectively monitor and consistently manage the risks in their portfolio can no longer rely on pure, fundamental securities analysis. That much is clear from past events. The future will show that the integration of ESG factors – regardless of regulatory requirements and irrespective of asset class – will continue to gain in relevance and do so in every market phase.

 

Unless otherwise noted, all Information and illustrations are as at 16 May 2019