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ESG as a Risk Management Tool

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Investors may employ sustainable investment strategies for a variety of reasons, including personal preference or a desire to align financial assets with their values.

But sustainable investment strategies also may help investors address a wider range of risks, including pre-financial indicators that may have financially material impacts on the companies in their portfolio. In fact, portfolio managers have been utilizing environmental, social and governance (ESG) risk factors for many years, partly to try to avoid corporate controversies.

Changes in the world — including climate risk, a renewed focus on human rights, cyber security and biodiversity loss — have heightened investors’ awareness of pre-financial risks present in investment portfolios and products.

According to the World Economic Form 2023 Global Risk Report, if the top ten global risks were to occur over the short and long term there would be a negative impact of a significant proportion on global GDP, population or natural resources. Notably, as shown in the chart below, 50% of the top ten risks over the next two years are environmental and the top four risks over the next decade are also linked to environmental risks such as failure to mitigate climate change, natural disasters and extreme weather events.

To help investors understand how prepared companies are to withstand the implications of climate risk, the Securities and Exchange Commission (SEC) proposed regulation for companies to report on climate-related financial disclosures providing investors with “consistent, comparable, and decision-useful information for making investment decisions”. Increasingly, investors want to know how they can minimize their portfolio exposure to ESG risks.

Global risks ranked by severity over the short and long term

Source: World Economic Forum Global Risks Perception Survey 2022-2023

Understanding ESG Risks to Businesses

Many practitioners of sustainable investing seek to mitigate a wide range of risks that have the potential to have negative financial impacts on their investment portfolios. The array of environmental, social and governance (ESG)-related risks may include:

  • Direct impacts to business infrastructure, such as those caused by natural disasters, supply chain disruptions or inadequate data security
  • Investor disfavor when companies fail to adapt to new realities, such as increased scrutiny of privacy practices
  • Regulatory and policy risks as laws evolve to address environmental issues such as climate change and biodiversity; social issues such as human rights, worker safety and diversity; and governance matters such as board composition, auditing and international operations
  • Litigation related to environmental, social or governance matters
  • Reputation or brand damage due to public perceptions of a poor record on environmental or social issues
  • Financial mismanagement, from lack of proper controls to outright fraud
  • Loss of talent and other problems related to human capital

How Managers of Sustainable Investment Strategies Seek to Mitigate Risk

Managers of sustainable investment strategies may engage in a range of approaches to attempt to understand, measure and ultimately reduce their exposure to ESG risks. These approaches include:

Exclusion: Opting to avoid investing in companies in specific business lines or companies with significant controversies around ESG issues.

Integration: Incorporating an analysis of environmental, social and governance issues in the investment process.

Thematic investing: Investing in broad ESG themes, such as clean technologies.

Stewardship: Utilizing investors influence to maximize long-term value. By engaging in robust dialogues, investors encourage companies to act proactively on ESG risks and may leverage proxy voting to promote change.

Spectrum of Sustainable Investing Strategies

The range of approaches allows investors to incorporate ESG considerations into their portfolio — reflecting their preferences and priorities in managing ESG risk.

Sustainable Investing and Performance

Many investors who seek to adopt a sustainable investing approach may be hesitant, as performance is a key concern.  However, our portfolio research finds no evidence of underperformance or outperformance when incorporating ESG criteria into an investment strategy. This is good news for investors with ESG preferences, as they are more likely to stay the course acknowledging there is no significant difference in performance over the long-term.

Managing ESG Risks

Risks come in various forms and understanding them is central to investing and helping investors to make more informed investment decisions. Today, investors are utilizing ESG data and reporting tools to evaluate their portfolio’s exposure to ESG risks. We collaborate with clients by leveraging sophisticated tools to help them align their portfolios with both their financial and ESG goals.

Talk to your advisor if you are interested in exploring whether sustainable investment approaches might help you mitigate additional dimensions of ESG risks.

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Disclosures

This document is a general communication being provided for informational and educational purposes only and is not meant to be taken as investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions or inflation. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed. Northern Trust and its affiliates may have positions in, and may effect transactions in, the markets, contracts and related investments described herein, which positions and transactions may be in addition to, or different from, those taken in connection with the investments described herein.

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