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ESG Investing Is About Long-Term Risk Management (Part 1)

Sustainable investing isn't just about values, it's about managing risks that affect all investors.

Alex Bryan 20 August, 2020 | 13:53

The market is good at evaluating and pricing systemic risks that are regular and easy to quantify--the "known unknown." These include things like changes in the business cycle or interest rates. But as the coronavirus pandemic has shown, the market doesn't do as well with risks that are difficult to predict or quantify--the "unknown unknowns." The environmental, social, and governance risks most firms face fall somewhere in the middle of this spectrum.

There are clear examples in which firms' failure to manage ESG risks has hurt the value of their stocks. Most of these issues have been firm-specific, so they have tended to have little impact on well-diversified portfolios. But there's a good chance that may change over the long term, as companies face greater scrutiny from consumers, investors, and governments alike over their ESG practices.

Climate change and evolving social expectations are difficult to fully diversify away, and their impact will likely grow over time. While these changes could directly increase the cost of doing business, their impact could also be felt indirectly as regulations tighten and consumer preferences shift.

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About Author

Alex Bryan  is the Director of Passive Fund Research with Morningstar.

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