When considering the factors that could impact a company’s long-term sustainability in addition to traditional company risk exposures, there are a number of “ESG” risk factors that an analyst should consider to get a full picture of the company’s long-term risks. These so-called ESG factors are:
- Environmental risk: e.g. greenhouse gas emissions that may cause climate change
- Social risk: labor rights or occupational safety
- Governance risk: the effectiveness of a company’s governance structure
On this page, we discuss each of these risks in more detail.
Legislative and regulatory risk
First, there is the regulatory risk. This is the risk that new laws or regulations will negatively impact a firm’s profitability or business model. Examples of this kind of risk include new standards that restrict automotive emissions: any manufacturer that fails to meet these standards will suffer a negative impact on sales.
It is important to consider legislative and regulatory risk when analyzing investments since a company that has invested in cleaner or safer technologies is less likely to suffer from new legislation than their competitors that have not invested in new technologies.
Second, there is legal risk. It refers to the potential for lawsuits resulting from management’s failure to adequately address one of the ESG factors. Such lawsuits could originate from employees, shareholders, or the government. The potential value of such judgements could have a material impact on a company.
To evaluate the level of legal risk that a specific firm is exposed to, an analyst should evaluate the company’s regulatory filings, such as form 10-K, which requires companies to disclose possible legal risk exposures. Additionally, an analyst should consider the industry in which the firm operates, as well as its specific operations, in order to evaluate the magnitude of legal risk exposure.
Third, there is reputational risk. This risk is increasingly important as investors come to see this factor as a major source of risk and thus an important input in valuation. Companies with management that have been seen in the past to show insufficient regard for ESG issues will be valued at a lower market value compared to companies that manage these risk exposures suitably.
Operational risk refers to the possibility that a firm will be forced to modify an operation, or shut it down altogether due to the impact of ESG factors.
The last risk is financial risk. Financial risk is simply the risk that the ESG risk factors will result in a monetary cost to the firm or shareholders. Because of this potential financial cost, analysts should be sure to examine all possible sources of ESG risk when analyzing a company and include these potential risk impacts in the valuation.
We discussed the major risks that follow from companies’ exposure to potential ESG risks.