Is COVID19 the end of ESG and the beginning of existential risk management?

ESG and mainstream finance: Both students are failing the test, but one of them actually claimed to have studied

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Only in finance can a product lose 24% of its value and be celebrated as success. Since traditional benchmarks have lost more than ESG funds since the beginning of the year, ESG is feted by some as a success, a “refuge”. One commentator even suggested that their performance makes them “all-weather investments”. Posts to that effect on LinkedIn and other platforms abound. ESG is outperforming during the crisis! We need ESG now more than ever!

A more honest assessment would perhaps yield a different conclusion. The overwhelming majority of so-called ESG funds – like mainstream funds – are suffering dramatic losses due to the crisis. What’s worse, at least in theory, ESG funds are explicitly designed to manage these types of risks. Both students are failing the test, but one of them actually claimed to have studied for it. What was the point of ESG if not to prepare us for these types of events?

The rude fact is that, on the whole, ESG risk management frameworks did not prepare us for the inevitability of the pandemic. They did not help investors and banks anticipate the crisis, nor how to navigate it. The pandemic is a failure of mainstream risk management frameworks. Sadly, it is also a failure of ESG risk management frameworks.

Some of this criticism is unfair. After all, ESG isn’t designed to prepare us for these types of events. ESG works within the confines of various norms – environmental norms, social norms, governance norms, and the regulatory environment enforcing them. It seeks to identify risks that materialise when those norms get violated, or risks when those norms and the regulatory environment around them change. They try to prepare investors where companies get a reputational hit due to labour rights violations, where their governance creates risks of fraud and deceit, where their business model may eventually be regulated away.

The challenge is that a global pandemic doesn’t operate within those norms. Like climate change, antibiotic resistance, the breakdown of social order, nuclear conflict, and other massive environmental and technological events, pandemics belong to a class of risks that may be called “existential” – threatening global economic welfare, the resilience of societies, the common good, and financial markets.

ESG wasn’t built to manage and navigate this class of risks. The current crisis is evidence to that effect. While good governance and lower business cycle exposures due to sector allocation choices have helped ESG funds outperform, ultimately, they sit on the same rollercoaster carriage as mainstream benchmarks, if only a few seats back. As many ESG funds track benchmark indexes, this is by design. Criticising ESG for this is criticising it for a job well done. They are supposed to have low tracking error; outperformance is nice, but not by too much please, lest you deviate too much from the market.

In that spirit, my criticism in the first two paragraphs may be misplaced. ESG funds didn’t actually study for the tests either. And it’s still better to lose just two shirts, not three or four. ESG is more often than not a strategy to invest in companies with quality governance and systems that help them be resilient and considerate of the world around them. Even if that doesn’t equate to preparing for pandemics, it undoubtedly helps.

Saying that however, the question remains. If not ESG funds, then who is studying for the test – who is preparing us for this crisis? And who is preparing us for the next one?

As we assess the carnage of this crisis, it may be time for an entirely new concept. We may in the future look back on the next decade as one of “existential risks” – the ramp up of climate change, new technologies threatening privacy and society, another pandemic, increased geopolitical tension, higher antibiotic resistance, and unknown unknowns. As investors and society navigate this decade, it does not appear that ESG risk management is really designed to prepare us for this.

As a result, we face two options. Either ESG graduates to capture existential risk management. Or a new set of tools, concepts and approaches is needed, one that we may for now call “existential risk management”. Whatever the path, a number of questions are still unanswered. How can financial institutions truly contribute to reducing existential risks – especially in a context in which they may become unhedgeable for any individual portfolio? What exactly are these existential risks, how material may they be, and who are the canaries in the coal mine that can warn us before they materialise? How smart is it to prepare for these risks rather than hope for a government bailout? What is the point of resilience in the face of potential mass destruction, how preventable and “manageable” is such destruction really?  And finally, from the perspective of supervisors and policymakers, where do we put the needle between investing in resilience and spare capacity – for example, through “rainy day funds” for companies – and profits now? How can we address moral hazard? And in finance, what are optimal capital requirements in the decade of existential risks?

A few areas of action already appear on the agenda. First, investing in long-term equity and credit research can strengthen risk management systems in the face of these risks. Second, building better early warning systems can ensure mitigation actions are taken early. Third, a review of insurance frameworks and mandated “corporate rainy day funds” of companies are likely to reduce the public cost when risks materialise. Fourth, many risks are in reality not “force majeure” but directly driven by decisions we take collectively today. Climate change comes to mind, but the same can be said for pandemics, antibiotic resistance, etc. 

Mainstream investing wasn’t prepared for this crisis. The sad truth is that ESG frameworks weren’t either. The hope is that perhaps with new concepts of existential risk management, we can and will do better next time.

Jakob Thomä is the Managing Director of the 2° Investing Initiative