Introduction: 2nd Generation ESG is Coming
The first incarnation of ESG has been around for a while and in recent years has become mainstream. As with all evolutions, we see a demand from investors, industrial firms, financial firms, regulators, policymakers and other stakeholders for further development and rigour in ESG, something that may usefully be referred to as “2nd generation ESG tooling”.
It is this 2nd generation of tooling that Quant Foundry (QF) is now focussed on delivering. In many respects, QF is now seeing a trend towards the alignment and integration of the wider spectrum of ESG, Climate Risk and Sustainability. As these disciplines coalesce, we are moving towards a comprehensive suite of rigorous, quantitative models and frameworks that form the foundations that enable enterprises to deliver robustly and consistently on their overall strategy.
Some History
In 2019, Quant Foundry (QF) was asked by Refinitiv to look at their suite of ESG risk factors. The objective was to find a subset that would present a level of causality that an investor can link to alpha. Undeterred, the QF Labs division attempted to uncover the Holy Grail of ESG indices that is purely objective. The project did not get very far, and so QF Labs placed the idea on the shelf of good intentions.
QF Labs concentrated their attention on their climate change offering that modelled the impact on the corporate balance sheet due to climate change risks. The solution simulated how a corporate response to changes in demand to achieve net carbon neutral by 2050.
The subsequent model called QF4CM and the collaboration with Imperial College has created an analytical framework based on a core risk axiom, as follows.
Risk management fulfils a rigorous process when it completes four phases of: Identify; Measure; Monitor; and, Control. A four-step approach contrasts to ESG, which follows the two-step approach of: Score; and, Filter.
The starting gun for climate change comes from international bodies such as IPCC that identify the risk of global temperatures increasing (see citation below). The scientists have made a direct link between, for example, a two-degree scenario with an allowance of CO2 emission through the burning of fossil fuels.
Government policy enters the fray and declares net-zero carbon by 2050 which augments the metric with a target and timeframe for adoption. The government can now monitor progress of the mitigation against target each year and apply control through carbon tax or fines. Identify, Measure, Monitor, Control.
The same four-part risk process migrates down to the corporate level. Climate risk specialists have highlighted new risk factors for corporates such as migration and physical risk to capture the impact that climate change (and the response of governments) will have on corporates.
The QF4CM model translates these new risk factors into equity and credit impact scenarios that feed a financial firm’s stress capability. Capital measures such as CRD4, ORSA, Solvency 2 and Liquidity (see footnote) are now in scope for climate-related scenarios that feed into all firms governance and strategic thinking.
Firm’s senior management such as the CRO is now considering making a statement on their firm’s risk appetite for climate change that moves beyond a declaration of which sector they are exiting. Risk appetite for climate change can follow standard aggregation procedures used by credit and market risk where each investment contributes to an overall figure.
Risk appetite can limit the portfolio’s green-brown mix (measured accurately using their revenue streams and by adopting robust taxonomies to correctly classify such measures) by looking at every company and their network of suppliers and buyers. The bottom-up and network approach provides a more sophisticated but complementary suite of metrics compared to excluding investments based on sometimes subjective scores as used in first-generation ESG.
The other benefit of using scientific and neutral metrics in ESG is to enable internal funding transfer from those that have a high brown-green mix to those that have a higher mix of green. A nudge approach could cajole company targets and their deal teams to alter the cost of investment to projects that contribute to the smooth transition to a low carbon future
The risk framework built by QF for carbon is available for roll-out to other areas of Environment that follow a similar route of:-
- Identifying the risk (air pollution, use of plastics, soil erosion
- Creating a measurable metric (NO2 particles, the weight of plastics in the seas, nutrients)
- Passing government policy that drives the scale and timeframe for mitigation
All of the environmental roads above lead to measuring the impact of corporates and how senior management step up to the challenge. Through migrating their offering to comply with a new policy and managing the inevitable increase in costs. The response approach is precisely what the QF4CM does for climate change.
The QF4CM is addressing the issue of the impact of climate change on sovereigns. QF4CM with a well known physical risk provider that measures the physical element of climate change due to the increase in severity and frequency of droughts and flooding.
The key element for any sovereign is their resilience to adversity that is largely based on freedom factors such as ownership, business, labour, monetary, trade and financial. In short, how a sovereign is governed is a critical factor in measuring their propensity for rating downgrade and default as a consequence of a catastrophic event.
QF is now making the causality linkage between Environmental-related migration, physical and litigation to the Governmental elements of ESG. The capacity for a corporate to have the right level of governance to execute a migration strategy differentiates the leaders from the laggards.
The view from QF is that the Score-and-Filter paradigm for ESG has highlighted the need for far more invasive information so that investors can reflect the values and activities of a company to their personal values.
QF also believe that thanks to the evolution of the analytics around climate change, ESG can benefit from a more neutral and sophisticated suite of analytics.
The next suite of ESG analytics leverages off the metrics used in Environmental and deploys causality routines to link the potential outcomes with the resilience of the individual c-suites and that of wider networks such as sectors and sovereigns.
The new framework has recently evolved by QF to bring in a new risk factor based on the disruption and economic damage that epidemics and lockdowns unleash on the supply-demand dynamics around each company and sovereign.
https://www.eiopa.europa.eu/content/eiopa-financial-stability-report-june-2019_en