“If you gaze into the abyss, the abyss gazes back into you”
It is always fun to have something apocalyptic with which to start an article on ESG. The area, from a financial data perspective, is so new and so multi-dimensional, and so largely informed by opinion rather than actual facts that is quite possible for many different ESG data companies to say many different things about, possibly, non-ESG, companies at exactly the same. However, some sort of, well not redemption, but assistance is at hand. As Mike Tyson helpfully pointed out, “Everyone has a plan until they get punched in the face”. In this case, everyone can have an opinion until they get data, and in the case of ESG data, that will start arriving in significant amounts in the second half of 2021 and the first half of 2022. At which point the various opinions will have to be compared to the data, and more importantly, the opinions will have to start to become consistent with data. At which point inevitably, large amounts of overly-complicated maths will be used to imply ratings globally. But whether you use linear regression or multi-layer deep learning, no amount of analysis is turning a tobacco company into a medical company. Opinion will start to converge to an effectively agreed definition of reality.
At which point, an investor or a regulator is going to worry about the ESG riskiness of portfolios. You can already see it starting in the Standard Tables for Disclosure in ESMA 30-379-471 (Final Report: Advice on Article 8 of the Taxonomy Regulation). Funds will be required to determine taxonomy related percentage exposures of the portfolios. And where there is a measurement, limits can be applied and these limits will need to be monitored. And if you are close to an applied limit, a sensible risk manager will want to know the likelihood of breaching that limit, based on the evolution of the portfolio, or on the evolution of the taxonomy data, or both. In that way we have swiftly moved from a Gross Exposure type ESG score to a Value at Risk (VaR) score. Taxonomy VaR or T-VaR for short. However, the T might as well stand for Trouble (with a capital T) as the Taxonomy characteristics can change over time. It is if a portfolio that held pharmaceuticals at the beginning of a year saw them slowly morph into Industrials by the end of the year, but you have to monitor and limit your Pharma and Industrial exposure. Disconcerting. Of course, if you are now monitoring T-VaRs you will need to carry out stress tests and as we are in a joined-up world, the application of ESG constraints to Liquidity Reverse Stress Tests (LRST) will also have to be considered.
The above scenario is only a single possible version of the future and potentially a quite painful one if proper preparation has not been carried out. The reality is that ESG does not appear to be going away. Legislators and therefore regulators appear to be very keen to keep moving on this front. In addition, anyone who has observed the stellar growth of funds that claim to have an ESG component will understand that investors appear more than happy to allocate according to an ethical approach. Furthermore, they are inevitably going to be a higher proportion of investors in the future than they are today. I honestly cannot recall a time when both regulators and investors are pushing the industry to move hard in a given direction. At the same time. As a result, whatever we think the impact will be, it will inevitably be greater. The version of ESG risk management that I have outlined above may not be accurate, but be in absolutely no doubt that some version will be implemented and that version will be fully integrated into an overall risk management process. And I am afraid that no amount of quoting “Nature, Scale and Complexity” is working as a “get out of jail free card” to avoid carrying it out in the first place. This is because ESG risk management is Complex, by Nature, at any Scale.
