Demonstrating the value of incorporating non-financial factors into investment analysis has long been a significant challenge limiting its wider adoption.
Academics have yet to develop a clear consensus as to whether utilising Environmental, Social and Governance (ESG) factors in analysis actually improves performance, either through lower risk or greater returns. Although there does seem to be some gravitation towards a belief that it positively impacts investing.
Approaching the issue from a more pragmatic standpoint we believe that there are three areas where incorporating non-financial factors can add value to investment analysis: downside risk, cost and opportunities.
Extreme events, e.g. water shortages or serious accidents, can have significant impacts on a business’s ability to operate effectively. Consequently, understanding the probability of these events occurring can help to better understand downside risk.
The impact of businesses and the costs that businesses are forced to bear are becoming increasingly linked: as resource prices rise, efficiency becomes increasingly relevant; and costs, which have traditionally been external to businesses, are being internalised through legislation and regulation.
Finally, environmental and social change creates great challenges for business and society, but they also create great opportunities. Businesses and products which attempt to meet the challenges facing society, rather than exacerbating the problems, are likely to hold competitive advantages in the long term.
While there is no easy solution to the problem of how to incorporate ESG factors into investment analysis we believe that there is a strong case demonstrating that there are material factors which impact on business performance, and consequently valuations, and that their incorporation leads to more complete analysis.