Risks Associated with ESG Investing
Investment managers agree that Environmental, Social and Governance (ESG) criteria affect shareholder value both in the short- and long-term. ESG criteria affect both company risk and return.
In this article we highlight each of the ESG related risks faced by companies with practical examples.
The listed companies that investors invest in are faced by risks relating to Environmental, Social and Governance (ESG) issues. If these risks are not identified the companies might be exposed to risks that could affect the profitability of the company adversely.
ESG risks fall in these main categories:
- Regulatory Risk (Industry-specific risk)
- Physical Risk (Industry-specific risk)
- Business Risk (Company-specific risk)
- Legal risks
- Reputational risks
- Competitive risks
Regulatory Risk (Industry-specific risk)
Efforts by governments at the international, national and regional levels to regulate Environmental, Social and Governance (ESG) issues will have direct financial and legal implications for industries and companies in breach of such regulations.
- Environmental regulation
An example of environmental regulation is the imminent South African Carbon Tax. The South African Carbon Tax is set to commence on 1 January 2015. This tax sends a clear signal to companies regarding the government’s commitment to a low-carbon economy as set out in the National Development Plan. This tax is aimed at lowering the carbon dioxide emissions (hereafter referred to as carbon emissions) from companies. Large emitters might be able to reduce their liability created by the carbon tax by ensuring energy is used efficiently. On-site renewable energy generation and reducing waste streams are some of the possible actions to be taken.
The EU, Australia, China and South Korea are already implementing some form of carbon pricing scheme which indicates that the South African carbon tax issue is not going to go away.
There are only two years left before the carbon tax is to commence. South African companies should consider the impact on their operations and identify ways to mitigate the risk and manage costs arising from the carbon tax. Failing to do so might result in increased costs as well as pressure from government through litigation and regulation.
The following sectors are most likely to face significant regulatory risk due to their high carbon emissions namely electric power, manufacturing, oil and gas, and transportation. Examples of companies in these sectors include Eskom, AECI, PPC, Sasol, Super Group.
An example of social regulation is the Occupational Health and Safety Act which came into effect during 1993 which falls under the Department of Labour. This Act governs the basic requirements for the well-being of employees such as dangerous work equipment, exposure to electricity and other hazardous work surfaces, exposure to biological agents, proper ventilation, psychological factors and emergency evacuation procedures. Non-compliance could result in serious financial and legal risk.
Sectors that face significant regulatory risk on social regulation include the mining and agricultural industries. Examples of companies in these sectors include Angloplats, Highveld Steel, Harmony, Lonmin, Afgri, Rainbow Chicken.
The Report on Governance Principles for South Africa (King III) was released on 1 September 2009, with an effective date of 1 March 2010. The King III report provides a guide to best practise corporate governance within an organisation and requires the statutory financial information and sustainability information to be integrated in the “integrated report”. An integrated report should be prepared annually. The integrated report should have sufficient information to record how the company has positively and negatively affected the economic life of the community in which it operated during the year under review. The report should also contain forward-looking information on how the board believes it can enhance the positive aspects and negate the negative aspects that affect the economic life of the community in which it operates, in the future.
Although voluntary, the Johannesburg Securities Exchange (JSE) has requested listed companies to comply with the King Report’s recommendations or to explain their level of non-compliance. All sectors are therefore exposed to regulatory risk from corporate governance issues.
An example of how a regulatory risk can escalate into a legal risk is the corporate governance scandal of the Enron Corporation that was revealed in October 2001. This scandal eventually lead to the bankruptcy of Enron, criminal charges and jail sentences to the executives and the auditing company, Arthur Andersen, losing its license and reputation in the industry.
Physical Risk (Industry-specific risk)
Some sectors and companies will face direct consequences from the physical impacts of climate change, including droughts, floods, storms and rising sea levels. Sectors such as agriculture, fisheries, forestry, health care, insurance, real estate, tourism and water may be particularly exposed because of their dependence on the physical environment.
Examples of companies in these sectors include Oceana, Grindrod, York Timbers, Sappi, Adcock Ingram, Santam, Growthpoint, City Lodge Hotels.
Business Risk (Company-specific risk)
- Legal risks
Companies could face risk from legal action. Similar to the lawsuits faced by the tobacco and asbestos industries, there is a possibility that companies and sectors responsible for large amounts of carbon emissions could be liable for damages associated with the physical effects of climate change such as flooding, severe weather damage and crop failures.
During 1969 Clarence Borel filed the first ever asbestos lawsuit against his employer of over 30 years, Fireboad Paper. In 1973 the lawsuits was decided in favour of the plaintiff and sparked many more lawsuits that completely changed the industry. The EU and Australia has banned all use and extraction of asbestos, while it is still being used in the US and elsewhere.
Lawsuits against tobacco companies began in the 1950s stating that smoking causes lung cancer. The financially powerful tobacco companies fought back and won most of the lawsuits. During the 1980s a second wave of lawsuits claimed that not only was smoking bad for your health, but that the tobacco companies knew it. Again the tobacco companies won most of the lawsuits. However, during the third wave of lawsuits during the 1990s, the tobacco companies weren’t as lucky as information became available that the companies knew about the addictive properties of tobacco. In the year 2000 a Californian jury awarded $51.5 million to a smoker with terminal lung cancer. Tobacco companies now have to add health warnings to all their advertising material and also pay annual taxes due to the additional burden they put on the health care system.
The British Petroleum (BP) is faced with a host of lawsuits after an oil spill at its Macando well in the Gulf of Mexico during July 2010. BP has already pleaded guilty to manslaughter for the 11 employees that died in the incident and paid $4 billion in penalties. The latest lawsuit, which started on 25 February 2013, is in fact a consolidation of hundreds of private lawsuits into one trial and is estimated at a settlement amount of $8.5 billion. This could also mean that BP has to pay billions more (estimated around $17 billion) in Clean Water Act fines.
An example of legal action relating to global warming is when New York Attorney General Eliot Spitzer along with New York City’s counsel and attorneys general from seven other states (Connecticut, New Jersey, Rhode Island, Vermont, California, Iowa and Wisconsin) filed a lawsuit on 21 July 2004 against five energy companies (American Electric Power, Cinergy, The Southern Company, Xcel Energy and the Tennessee Valley Authority) that each company cap its carbon emissions and then reduce them by a specified percentage each year for at least a decade.
The Consumer Protection Act (CPA) came into effect on 1 April 2011. The CPA includes the regulation of goods and services with actual or potential environmental or health impacts. The obligation by companies to provide this information is covered by the CPA.
Companies that do not provide such information freely to consumers might open themselves up for legal risk as consumers become more aware of their rights and demand more from companies.
- Reputational risks
Companies that are viewed negatively with respect to Environmental, Social and Governance (ESG) issues may face backlash from consumers in markets where the public is concerned about ESG.
Examples of how reputational risk can seriously affect profitability of a company is the reputational damage to the audit firm, Arthur Andersen, after the Enron scandal; the reputational damage to Lonmin after the violent strike at the Marikana mine; the reputational damage to BP after the Macando oil spill. There is also a possibility that such reputational risk might spill over to other companies in the same sector if not managed properly.
- Competitive risks
Companies that take positive and proactive measures to mitigate ESG risks may create a competitive advantage for themselves relative to the rest of their sector. These advantages may take the form of lower costs and higher profit margins and/or enhanced reputation and customer loyalty.
Companies such as Woolworths and Nedbank have embraced the challenge and are producing new products that give them a competitive advantage.
Investors might not be directly exposed to ESG risks. However, these risks affect the profitability of companies in which they invest and could therefore indirectly affect an investor’s portfolio return and risk characteristics.
If these risks are not managed pro-actively, it could potentially expose the investor to more risk than anticipated with less than desirable outcomes.
- CERES and the World Resources Institute. December 2004. Questions and Answers for Investors on Climate Risk. (Guide prepared for the Investor Network on Climate Risk).
- The Carbon Trust. March 2005. Brand Value at Risk From Climate Change.
- The Carbon Trust. August 2005. A Climate for change: A trustee’s guide to understanding and addressing climate risk.
- The Carbon Trust. March 2006. Climate Change and shareholder value.