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Do financial services firms only monitor the tip of the iceberg?

Many investors are unable to conduct due diligence. Here's what can be done about it.

Are financial services sector firms overlooking issues that undercut return on investment? Do the usual due diligence processes capture all relevant credit and market risks? Or are analysts assessing only what can be easily seen — the proverbial tip of the iceberg?

The reality is that many investors conduct only due diligence on the "tip of the iceberg" — as few financial services firms have robust processes for assessing environmental, social and governance (ESG) factors. 

This lack of robust ESG insight is significant, given that including ESG risk can enhance ROI, as a growing number of studies have documented. For example, a 2012 Deutsche Bank Group report stated that in 100 academic studies, "ESG factors are correlated with superior risk adjusted returns at a securities level."

A 2014 analysis of 190 studies — conducted by the University of Oxford and Arabesque Partners — found that 88 percent showed that "companies with robust sustainability practices demonstrate better operational performance."

In light of this research that links ROI with ESG factors — along with the fiduciary duty that requires factoring in all that could affect ROI — the time is now for financial services sector firms to invest in rigorous ESG analysis. 

Fortunately, many institutions have operational or financial flexibility that allows for managing ESG risks, so that these factors will not affect their credit quality materially. And pathways forward, in terms of how financial analysts can assess ESG factors, are clearer than before. 

For example, in terms of environmental issues (the "E"), the business risks of climate change are increasingly clear for particular sectors and even companies, such as in reports from: the Risky Business Project; BSR (PDF); Carbon Tracker; the Carbon Disclosure Project (CDP) and CERES, among others. Specifically, coal assets (fired power plants and mines) are singled out for high greenhouse gas emissions. Therefore, a growing number of analyses advise avoiding financial support, given the likelihood that these investments will become "stranded assets," likely to increasingly be seen by shareholders and regulators as unburnable carbon (PDF) (as laid out by Bill McKibben in 2012 in Rolling Stone and being acted on by divestment of institutions worth $2.6 trillion). 

In addition to climate-related issues, biodiversity loss and deforestation are also becoming more business relevant and risky — as they negatively affect natural capital, upon which business relies. Brand and regulatory risk increasingly loom in the months and years ahead on these issues, with growing likelihood of ROI-related implications for investments linked to biodiversity loss and deforestation. 

In response to these and numerous other ESG concerns, savvy institutions integrate into due diligence the data from the Integrated Biodiversity Assessment Tool (IBAT) as well as the WRI’s Global Forest Watch — as both are easily accessible online. Banks with cutting edge ESG review processes also consider biodiversity and ecosystem services (BES) impact assessments and mitigation plans, as the International Finance Corporation does based on its own Performance Standards (PS 6 (PDF)). More detailed quantitative KPIs related to natural capital also can be drawn from the Cross-Sector Biodiversity Initiative (CSBI) guidelines and natural capital accounting (NCA) approaches (such as the Natural Capital Protocol; the environmental profit & loss [EP&L] approach; Total Impact Measurement and Management [TIMM], TruCost and TrueValue [PDF]).

Leading financial institutions also can pinpoint geographies where assets are likely to be at risk of water stress, particularly where water demand outstrips water supply (insights on water risk from the World Resources Institute’s [WRI] Aqueduct Tool, the CDP’s Water Disclosure reports or CEO Water Mandate’s Water Stewardship Tool). 

Simply put, the best financial institutions in the world assess the ecosystem malfunction risk in ESG due diligence processes that are structured with quantification of financial risks and opportunities, based on robust guidance tools and data. 

As the most advanced institutions assess these environmental issues systematically and in-depth (as well as other social and governance issues, related to ESG), the financial services sector leaders recognize that ESG analyses provide a way to see what is beneath the tip of the iceberg (which is a company’s Balance Sheet and P&L).

The question is not whether ESG is relevant to investors and ROI — a growing number of robust, credible studies have shown that ESG is linked to improved ROI. And there is no longer a question about where to find rigorous and reliable environmental data on companies or assets. 

The only remaining question is whether and how financial services firms draw upon ESG insight and innovate internal decision processes. 

ROI and fiduciary responsibility is at stake as a minimum. 

More broadly, the transition to a low-carbon economy is also at stake — as full consideration of ESG factors points analysts in that direction quite clearly. And addressing climate change is the challenge for which the current generation of financial institutions will be remembered or slandered. 

The leading firms are already acting to align ESG with analysis, investment decisions and sound future decisions. It is time for all financial services companies to engage and invest in ESG analyses as a factor in investment decisions.

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