Hurricane Katrina, the mortgage meltdown, the BP Deepwater Horizon tragedy, uprisings in the Middle East, Fukushima--it's hard not to notice a pattern of escalating risk. One not accounted for by the mere volatility in stock or bond prices that has come to represent the underpinnings of how investors assess risk. How do you quantify these? And are they really Black Swans? After all, most of these crises were predictable-if investors had bothered to gather the right data and incorporate it into their analyses.
In the first module of its new RI Essentials on-line course that teaches responsible investment to analysts and wealth managers worldwide, for example, the Australia-based RI Academy points out that the Occupational Safety & Health Authority had issued 760 egregious willful citations to BP between June 2007 and March 2009 across its five refineries in the US-compared to one egregious willful citation issued across the other 145 refineries in the US.
Jonathan Naimon, who runs Light Green Advisors, an environmentally responsible investment fund based in Seattle, complained about BP's safety record-five years ago. Ditto Nick Robins, head of the HSBC Climate Change Center for Excellence, who two years ago-a year before Deep Horizon-said that since sustainable investors talk to different people both outside the company (NGOs, regulators, etc.) and inside the firm, this offers them a huge potential competitive advantage over the mainstream. Without operational safety, he said, oil and gas firms can be forced to close down operations. "How many mainstream investors are asking BP about their safety record?" he said. "Most investors have a very siloed approach. Data points become very much the black box of financial data. But they know little about how that data was derived."
Welcome to a new world, where understanding environmental, social and governance (ESG) issues and how they relate to a particular company's operations is no longer the sole domain of ethically-inspired do-gooders. This should be no surprise. NYU Stern Business School accounting guru Baruch Lev has pointed out that items on the balance sheet (or the traditional accounting of bricks and mortar and even financial capital) represent less than 20% of the value of the average company. That means a whopping 80% of the value of the average company is not reflected in the financial statements. That's because most wealth these days is created by knowledge, organizational relationships, reputation, brand and other intangibles.
In his book, Investing in a Sustainable World, Inflection Point Capital Management Chairman Matthew Kiernan argues that the most salient intangible is management. Yet while Wall Street has repeated the "management, management, management" mantra for decades, it has no rigorous way to assess it. That's where ESG issues come in. "Environmental and social issues are, and will remain, among the toughest, most complex management challenges of the next 20 years," he says.
Louise O'Holloran, executive director of the Responsible Investment Association of Australasia, which runs RI Academy, agrees. "We now live in a world [characterized] by the interconnectivity of these issues, intense feedback loops, and the increasing velocity of potential negative outcomes," she says. "The more we experience these problems, the more we need to understand they are not isolated events."
Incorporating ESG issues into financial analysis has been recognized worldwide as a fiduciary obligation of asset managers. But O'Holloran says that such considerations also apply to financial advisors and wealth managers who are shifting from a product focus to fee-for-service. "Fee for service is more quality focused," she says. "Implicit in that is the ownership of risk management, and that means taking into account ESG issues from a risk perspective even before you ask your client whether he or she would like to be more proactive in these areas from a sustainability perspective."
Of course, it's hard to expect people to understand all of these issues unless, as she puts it, they are "absolutely political/social/science/history/philosophy buffs." Which is why, backed by a $2.5 million grant from the Australian government, RI Academy has developed two on-line courses: one for analysts and asset managers (RI Essentials) and the other for financial advisors and wealth managers (RI for Wealth Managers)-- the latter available this summer. Although the RI Academy is based in Australia, the online courses (which, unlike traditional courses and print textbooks, can be altered quickly) have been designed for the global marketplace but incorporate different regulations and products for different countries like the US where applicable. Whereas the two courses draw on similar case studies, they are quite different.
RI Essentials helps analysts understand ESG issues through the lens of financial modeling and shows how these issues can be taken from what seems an abstract world into the bottom line. The case studies include a detailed explanation of how various valuation methods, ratios and multiples can be used to bring ESG issues into various parts of discounted cash flow or ratio work. Trucost PLC, the UK-based environmental research firm known for its carbon footprint analyses of companies, various mutual funds and indices, wrote the carbon liability lesson. SAM, the pioneer of sustainable investing based in Switzerland, developed the enhanced financial analytics lesson. But most of the work is an amalgam of various independent analysts and does not subscribe to any one company's methodology. Says O'Holloran: "The purpose is to provide a foundation that organizations can innovate from, not a prescription."
While RI for Wealth Managers includes some of the work in the Essentials course, O'Holloran says most advisors don't want or need financial modeling. This course, rather, helps advisors learn what ESG issues drive their clients, how to tap into their needs, and how to conduct professional conversations about it. "I prefer to segment the market in a nuanced way, rather than say this is ethical investment, that's sustainable investment and that's ESG integration," she says. "If you sit back in the chair of the advisor, there are so many more shades than that. And if you find your client is incredibly well-informed, at least you are not out of your depth."
-Ellie Winninghoff
She can be reached at: [email protected].