By Mxolisi Siwundla
When you enrol for a Finance 101 course at university, one of the first lessons you are taught is the valuation of assets. The theorem goes; the value of any asset is the present value of its future cash flows. For some assets, determining this value is much easier than for others.
For example, a bond’s future cash flows are determinable from the day it is issued, and is made up of the principal (i.e., repayment of loan) and coupons (i.e., interest) paid by the borrower/issuer. For other assets, like equity, determining future cash flows is not as straightforward because when you buy shares in a company, you don’t have as much certainty about the future flow of the returns. Owning a company (whether in whole or as a listed share) does not guarantee you a return. For companies, returns are made up of dividends and the appreciation in the value of the company over time, and both these items can be zero.
As you would have noticed, the fundamental difference between equity and bonds is the level of uncertainty on the investment, with bonds generally being a safer asset than equity. However, because of this higher risk in equity, investors typically expect a higher return than for bond assets.
The one risk all asset classes face is the long-term sustainability of the issuer, that is; their ability to survive well into the future and continue to meet their commitments to investors.
An existential risk affecting all regions of the world is climate change. If left unchecked, it threatens the viability of all businesses in all industries. In fact, according to the UN, climate change has a disproportionate impact on developing countries. Speaking at the 2022 installment of the World Economic Forum meetings, Chinese President Xi Jinping remarked that growing the economy at the cost of environmental degradation is like draining a pond to get fish.
Another major risk is if a company has poor governance structures and a lack of adequate financial controls in place to detect and prevent governance failures (e.g. fraudulent activities) within its operations. Again, these failures can impact a company’s ability to meet future commitments to investors. The scandals/corruption uncovered at Steinhoff, Tongaat Hulett and Wildcard in Germany, are examples of how things can go monumentally wrong when the right checks and balances are not in place.
Collectively, these risks can be summarised by the term “ESG”. In essence, while ESG is relatively new in financial markets, the idea is not. Providers of capital have always cared deeply about mitigating risk, and ESG is just a convenient way to summarise a set of common risks into an easy to understand phrase.
More and more, our ability to understand environmental and social impacts on assets and the growing importance of these factors to all stakeholders, allows investors to better price this risk and place an appropriate premium on it.
According to the Chartered Governance Institute of Southern Africa (CGISA), eight in 10 global investors and analysts say that how a company manages ESG risks and opportunities is a significant factor in their investment decision making process. Issuers (whether countries or companies) who do not adequately manage these ESG factors are seen as riskier, and so investors will either demand a higher return or stop providing funding altogether.
We are already seeing these growing shifts around the world. In South Africa, the JSE has recently published guidance papers on sustainability and climate change disclosure. This aligns with the most influential global frameworks that are being increasingly adopted by other stock exchanges. In investment management, inflows into ESG/sustainability focused funds have increased rapidly over the last few years and funding a green recovery from the COVID-19 pandemic (under the banner of Building Back Better) is top of mind for governments around the world.
The rise of ESG is good for investors, financial markets, society and the global economy. This trend is here to stay!
Mxolisi Siwundla, FRM, is a finance professional.