How to Assess Environmental, Social, and Governance (ESG) Risks

In recent years, ESG (environmental, social, and governance) risks have received increased attention from investors due to the growing awareness of the impact these issues can have on their investments. Regulators are also increasingly requiring companies to disclose them in annual reports. Investors who want to assess ESG risks should develop a framework for evaluating their potential impacts on company performance, which will vary depending on the industry that they invest in.

Assessing ESG can be a challenge because it requires a different approach to traditional financial analysis. ESG issues can be diffuse and complex, whereas the financial risk is normally located in clearly measurable positions such as earnings, capital expenditure, or currency exposures.

In this article, we are going to look at what are ESG risks and how to assess them, and the key considerations that you should keep in mind when measuring ESG risks.

What are ESG risks

ESG risks refer to the impact of an organization's activities and business operations on environmental, social, and governance (ESG) factors such as political stability, human rights, labor practices, corruption, or bribery.

For example. A company may suffer from ESG problems due to

• The inferior quality of its products; poor management; inadequate corporate governance
• Bribery or corruption of employees, suppliers, distributors, and customers
• Unsafe working conditions in its factories; deforestation brought about by the company's paper pulp mills

Such issues could have a direct impact on financial performance if they damage company reputation with current or prospective customers, affect the working conditions of the company's workforce, trigger high legal fees to defend against lawsuits, or lead to an expensive remedial program that impacts the company's net earnings.

However, ESG issues might not be immediately apparent and their impact on financial performance could take considerable time (for example, deforestation and its effects).

How to assess ESG risks

The assessment of ESG risks is a complex process that requires an integrated, systematic approach. Questions to consider include

• What are the ESG risks that might pose a risk to my investment?
• What are the principles I want my investments to follow in respect of ESGs issues? How am I going to monitor these risks?
• How can I measure their impact on company performance, and how large could they be?
• How will they impact my investment?

The process of ESG risk analysis should be integrated into the application of fundamental analysis and technical analysis.

The first thing to do is build awareness about the company's ESG issues; this can be achieved either by visiting its manufacturing site, attending annual meetings and investor forums or conducting extensive internet research (for example, NGOs' websites).

You can focus on ESG issues that are more relevant to your investment by identifying the company's products and customers ahead of time. For example, if you are investing in a paper pulp mill, deforestation is likely to be an important ESG issue for you. You can then devote more time to investigate this area further.

Identify the company's major ESG issues, starting with the worst case. This will help you get a clearer idea of what are the risks it faces in this area.

Start with disclosing information about its ESG risks by reading through the relevant sections in annual reports. You can take things further by visiting company websites or subscribing to services that monitor ESG issues, or by attending its annual general meeting (AGM) to ask questions.

You can calculate the company's exposure to these risks by estimating net earnings per share, revenue, cash flow from operations, gross margin, and capital expenditure in each year

These figures will help you get a sense of how large an impact ESG issues could have on the company's financial performance.

Key considerations

You can calculate the company's exposure to ESG risks by estimating net earnings per share, revenue, cash flow from operations, gross margin, and capital expenditure in each year.

These figures will help you get a sense of how large an impact ESG issues could have on the company's financial performance.

ESG risks that affect profitability are the best candidates for further analysis.

You can assess the impact of ESG risks on company performance by carrying out a sensitivity analysis, which is where you stress-test the effect of these risks on your investment.

Figures that are likely to be most sensitive to an ESG issue include net earnings per share, revenue, gross margin, and capital expenditure.

For example, if you are assessing the impact of ESG risks on an oil company's net earnings per share, look for its exposure to government regulations about greenhouse gas emissions or safety standards.

Conclusion

ESG risks are difficult to predict, but you can start by identifying the major ESG issues that matter to your investment. You should then carry out a thorough assessment of their potential impact on company performance. Finally, use sensitivity analysis techniques (stress testing) to assess the magnitude of this risk and how it might change in different scenarios.

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