How can ESG factors help investors navigate the year ahead?

Key points 

• From a red-hot jobs market to the increasing incidence of heatwaves, hurricanes and other extreme weather events, ESG factors are more significant to the key risks facing the economy and company bottom lines
• In assessing ESG – or environmental, social and governance factors, to give its full title – investors should look to see if companies have climate transition plans in place and that they are able to pivot towards operating in a low-carbon economy
• The best and brightest talent is increasingly drawn to companies that are run ethically and sustainably – as well as those that treat their workforce well – and those that don’t may struggle to attract and retain staff in the future (a potential red flag for investors)
• Investors should always view ESG factors as business-critical – and incorporate ESG reporting alongside financial factors into the core investment decision-making process

Many key global issues for 2023 may be already known, but as investors’ experience of 2022 demonstrated, new challenges can rapidly emerge. Underlying many of the current issues and potential risks is a common theme: sustainability. Here we review how investors can use sustainability to better identify risks and opportunities in their portfolios. 

After 2022 saw an energy crisis, sky-high inflation and soaring interest rates, investors are probably relieved to start this year with minimal volatility and positive market momentum. However, you may be wondering how persistent these challenges will be and scanning the horizon for new issues. 

So, what are the main risks that might push your portfolio off-course? Alternatively, where can investors look to spot opportunities that others may have missed?

"Wholly new and eerily familiar" risks

The World Economic Forum’s (WEF) Global Risk report, published in January, highlights the global risks that business leaders foresee currently, as well as over short and longer time-periods¹.  

While predicting the future is notoriously difficult, understanding widely held views can still be valuable when considering market sentiment and how companies are adapting to shifts in the world. 

In collating the views of over 1,000 experts, the WEF report suggests that widely held views on the chief risks facing businesses are “wholly new and eerily familiar”. While current risks, around issues such as food, energy and security, may be historically familiar, they have manifested in new ways.  Indeed, if there is an overarching factor connecting the current iteration of these risks, then it might be “sustainability” (see table). 

During 2023, the top-ranked issues appear to repeat last year’s flashpoints — energy supply crisis, cost-of-living squeeze, high inflation, food supply crisis and cybersecurity attacks. Across each of the five issues, underlying sustainability factors affect them all.  

Extending the assessment horizon by just one year, results in half of the ten severest risks being environmental in nature. Looking at a ten-year horizon, and five becomes six, with “Biodiversity loss and ecosystem collapse” entering the top ten. Moreover, the top four overall risks are environmental. 

To account for these risks, investors can look to understand and incorporate the relevant sustainability factors into their investment processes, specifically the environmental, social, and governance (ESG) dimensions that affect company performance. 

To illustrate further, we consider one key ESG risk that companies will likely face this year. While these risks are not exhaustive, and their financial materiality varies by industry, they demonstrate how including ESG factors into your investment process can inform security selection decisions in 2023.

Top 10 perceived risks facing investors

In the following table, survey respondents were asked: Please estimate the likely impact (severity) of the following risks in 2023 and over a two-year and ten-year period.

Assess company readiness for the impact of climate change

The physical impact of climate change is already becoming more visible and pronounced, not least via extreme weather events. In 2023, investors should arguably be looking more deeply at the climate risks facing countries and companies, as well as how prepared their portfolio holdings are to meet them.  

With climate change, the frequency and intensity of extreme weather, such as heatwaves, droughts and floods, have intensified. Last year, the top ten extreme weather events each caused at least $3 billion worth of damage². Beyond the immediate economic and humanitarian devastation, such weather incidents can damage infrastructure and disrupt supply chains, upping potential financial losses for companies and investors.

Companies that do not adapt to this new reality will be at a significant disadvantage in the long run. Risk-aware investors should examine if investee companies have climate transition plans and take a view on if they are sufficient to guard against both the immediate physical risks and the longer-term transition risks.  

Observe how companies treat their workforce

Companies face a divergent set of challenges when managing their staff this year — employee expectations in a post-pandemic, high-inflation world versus slowing growth or potential for recession.  

The economic slowdown has already seen some companies, especially in the technology sector, reduce staff numbers. Leaving aside the immediate financial need for this, the way such cuts are implemented can affect a company’s reputation and share price performance. Firms that manage such employment issues poorly may be marked down by consumers and avoided by jobseekers. 

At the same time, several groups of “key workers” are seeking higher wages at a time of the worst cost-of-living squeeze in decades, as rising inflation eats into the value of wages.  

Last year’s “great resignation” seen in many developed countries is arguably shifting to a “great reshuffle”. Companies known for having a poor culture or dubious labour practices around wage disparities, and employee benefits in general, will likely struggle more to attract and retain staff. Furthermore, those organisations seen as contributing to social inequality may face increased labour action, public scrutiny and pressure from activists. All of this could hurt companies’ financials.

Investors should be assessing company culture and leadership style, as well as more detailed aspects of social and labour practices, as part of judging their attractiveness as investments. 

Look for a steady hand on the governance tiller

The strength of an organisation’s corporate governance can underpin how smoothly management pilots their company in the current tough macro waters. 

Companies with poorer corporate governance practices may be more likely to suffer financial losses through ineffective or slow management oversight. As managers come under greater pressure to “make their numbers”, a lack of accountability and transparency can lead to more financial fraud, insider trading, and other unethical practices. 

In selecting investments, investors should look for companies with strong corporate governance practices, such as diverse and active boards, effective oversight, and clear communication with stakeholders.  

Using sustainability for better investment decision-making

While ESG factors primarily provide data on how a company operates, and not on its goods and services, by evaluating the ESG practices of current or potential holdings, investors may be able to rest easier knowing they did all they could to make fully-informed investment decisions.  

In fact, the most recent Investing for Global Impact report shows that more than seven in ten (72%) “traditional” investors responded to say they now assess ESG factors for their portfolios, up from 60% last year³.

At the same time, investors should look at investment opportunities as well as risks. Ventures with products or services that address sustainability issues have potential for strong growth. For example, clean energy companies enabling the world to transition away from fossil fuels to reach global climate goals, as we reviewed in The case for investing in clean energy, in our Outlook 2023.  

Sustainability is becoming more important for governments, consumers, and companies alike. As such, investors should view sustainability as a critical issue for every current or potential holding, especially when seeking to navigate the rebalancing act that is 2023.