The future is uncertain. The central task for investors is to price this uncertainty — to convert it into measurable "risk" — so as to avoid losses and capture gains over time.
To that end, professional investors need to speak more cogently, consistently and collectively on the benefits of integrating environmental, social, and governance factors in the investment process.
ESG skepticism and denialism are pernicious risks.
Recent months have witnessed a rise in skepticism over value of ESG investment strategies. There is now a growing possibility that policymakers will chill investor interest in ESG, writ large. This threatens to weaken the financial market's ability to appropriately price risks.
With regard to pricing risk, the purpose of ESG analysis is to improve security selection with a goal of producing favorable risk-adjusted returns. ESG analysis considers extra-financial factors not included in traditional fundamental security analysis. The goal is not to boycott securities or sectors based on non-financial factors, but to identify overlooked investment risks and opportunities.
ESG data expands the scope of material information available to market participants. Asset owners may place more or less emphasis — a premium or a discount—to certain risks and opportunities: Will a soft drink maker have access to enough clean water to meet future customer demands? Will an energy company thrive in an economy with lower carbon? ESG analysis can promote more efficient capital markets as ESG integration is likely to deepen market liquidity through transparency.
For the rapidly growing number of investors who anticipate that climate or social risks will influence long-term risk-adjusted returns, ESG integration is a necessary piece to the investment decision-making puzzle. Notably, individuals, businesses, governments, endowments, foundations and international institutions already invest based on their own assessments of ESG considerations and sustainability concerns.
In fact, dismissing or ignoring material ESG risks is a pernicious and compounding risk to the markets.
Fortunately, there are ways to mitigate and manage the risks of ESG skepticism and denialism.
First, ESG practitioners should work to protect the integrity of the discipline. Asset managers that sell ESG-infused products should be careful to avoid overreaching to drive revenue growth. Increasingly, ESG assertions must be measurable, substantiated and provable.
Second, the investment community must engage those who are skeptical of ESG or issues of "sustainability" (which can be a fuzzy term). We can increase appreciation for the capacity of ESG analysis to reveal unpriced or mispriced risks. We can elevate understanding of the prudent investor's responsibility to diversify investor portfolios and mitigate outsized losses.
I invite you to join me in creating constructive dialogue that can advance the integrity of ESG analysis and correct misconceptions. ESG integration and investment strategies are necessary tools to help investors price material risks in a changing and uncertain world. If we are fortunate, they will also help us finance a transition to a more sustainable future — but we need the toolbox regardless.
Ognjen Sosa is chief investment officer of Breckinridge Capital Advisors. He is based in Boston. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.
