April 2, 2019

Sustainability isn’t New, it’s the New Face of Risk

Madelyn Antoncic, PhD

Since I joined the Sustainability Accounting Standards Board (SASB) Foundation in February as chief executive officer, I’ve become happily swept up in a whirlwind of activity—new faces, fresh challenges, and no shortage of good questions in search of better answers. It’s been invigorating and I’m thrilled to be here.

It has also reminded me how quickly time can disappear when I’m engaged in work that stokes my passions. So, before another week passes, I think it’s important to share some of my thoughts about sustainability, how and why it’s important to capital markets, and what I believe SASB can contribute to the future of finance.

The way I see it—which I’ll unpack in more detail below—sustainability is simply a 21st century extension of traditional risk management. As an emerging arm of an established practice, it is therefore ripe for rigorous interrogation through novel applications of existing approaches, such as scenario analysis and stress tests, as well as through the development of new, next-generation techniques. However, as I’ve learned at various stages of my career—for example, when developing innovative climate-related risk mitigation plans for countries at the World Bank—robust risk assessment is impossible without reliable data. This is why—among many other reasons—I’m eager to bring my experience to bear on global capital markets via the SASB Foundation.

SASB provides tools which can help companies to identify opportunities in their strategic planning as well as to identify business-critical aspects of the emerging and evolving set of material environmental, social, and governance (ESG) risks, which include the potential for significant tail-risk events. And by identifying ESG risks, companies can inform their thinking on managing and mitigating those ESG risks. In turn, by reporting the “key risk indicators” identified by SASB, investors can use this decision-useful information to allocate capital to the most efficient users of that capital. Together, this group of increasingly risk-aware market participants can foster economic growth that is both sustained and sustainable.

In this context—and as anyone who has closely followed my career can tell you—this new role at the SASB Foundation is a natural extension of the work I’ve been doing for decades. Let me explain further.

The Evolution of Risk

I’m a markets person. I have built a career studying and managing risk, value creation, and economic policy and I’ve used this experience and expertise to drive innovation in financial markets with the aim of promoting broad, inclusive economic growth.

The emergence of ESG factors as key signals of risk and return is the latest evolutionary development on the very same continuum of risk management that I’ve been engaged in over my entire career. Since the 1980s, our understanding of risk has become more nuanced—beginning with fundamental credit risk and adding new layers of market, model, operational, reputational, and cybersecurity risk, for example—and it will continue to do so. ESG is simply the next step forward.

This recognition has driven much of my work in recent years. During my time as Vice President and Treasurer of the World Bank, for example, we executed the largest weather and energy derivative the market has ever seen to help a country that is hydropower-dependent mitigate the risk of droughts and high energy prices. We developed catastrophic risk structures to help member countries mitigate and transfer risks related to the extreme weather events exacerbated by climate change. And we used our convening power and international influence to advocate for global standards for issuers of green bonds, a market which the World Bank and the European Investment Bank developed and helped kick-start. These efforts were not focused on driving either economic growth or social outcomes—they were engineered to achieve both.

Drilling Down

However, it’s also important to recognise that macroeconomic risks such as global warming are often associated with underlying microeconomic drivers. Where individual actors, such as companies and their investors, may struggle to get traction on an unwieldy megatrend like climate change, they can far more readily manage their energy efficiency if they’re a manufacturer, their business continuity planning if they’re in health care, or their product design if they’re an automaker.

In such cases, mismanagement of what would traditionally have been considered “non-financial” risks and opportunities can have clear, direct, and significant financial impacts for both companies and their investors. In other words, “non-financial” risks become financial risks just as in traditional risk management we have seen market risk can become counterparty credit risk which can become liquidity risk which ultimately and quickly can become, as we have seen before, fatal for a company.

In the broader sustainability landscape, mismanagement of these “non-financial” risks is why, at least in part, a large consumer goods company recently made a staggering $15 billion write-down as consumer preferences shift toward healthier, more natural alternatives to packaged foods. It is, in part, why a social media giant’s increasingly shaky stock price took one of the largest single-day hits in history (about $120 billion in market cap) as the company’s data privacy foibles piled up. It explains, in part, why, in the wake of a prominent commercial bank’s governance failures, the company’s stock price dropped during a year when its industry rivals gained between 33-46 percent on a wave of optimism buoyed by the promise of tax cuts and regulatory reform. And it is why, in part, one of the largest utilities in the U.S. lost roughly two-thirds of its market value, saw its credit downgraded to junk status, and filed for bankruptcy after equipment failures resulted in a series of wildfires. Each one of these is an example of losses relating to risk exposures for which SASB provides tangible metrics along its five key risk dimensions: Business Model & Innovation, Social Capital, Human Capital, Governance, and the Environment, respectively.

A great thesis topic for a budding Ph.D. would be to analyse what the outcomes might have been had the boards and senior management of these companies employed industry-specific risk indicators. Certainly, this information would have revealed new risk exposures. As a result, it also likely would have informed strategic planning and risk mitigation efforts—especially if reported to investors. When companies that built their brands over years or even decades choose to manage it over quarters, value can vanish overnight.

I’ve spent much of my career leveraging the power of financial markets to help the global economy absorb and transfer risk, including through hedging instruments such as the derivatives we developed at the World Bank. With the SASB Foundation, I’m simply zooming in to a more granular level, where I can work with the users and providers of financial capital to more effectively mitigate and control those risks—before they unduly impact markets—by managing performance.

The SASB Solution

Corporate sustainability initiatives are nothing new, but SASB’s approach is unique. It is the only organisation in the sustainability space that provides a complete analytical framework and robust ESG standards and metrics across a wide spectrum of industries and a full suite of material risk dimensions—all designed to facilitate more effective communication between companies and investors, creditors, and even insurance underwriters who are exposed to issuers’ contingent liability tail-risk. In short, it provides practical tools that capital market participants can deploy where the rubber meets the road.

Companies can integrate the SASB issues and associated key risk indicators into their strategic planning, risk oversight, performance management, and—of course—public reporting. The standards enable corporations to more effectively measure and manage and inform their ability to mitigate, or where appropriate, eliminate these material ESG-related risk exposures, thereby creating enhanced financial performance. This includes not only their own, internal risks, but those throughout the value chain, as every company is both a supplier and consumer of resources with considerable influence in both directions. In such an environment, even idiosyncratic, company-level risks can spread.

Similarly, the risk and return profiles of investors’ holdings cannot be easily isolated. At the World Bank, it was essential to think systemically about risk as global economies became increasingly interconnected and, indeed, interdependent. In the age of “fiduciary capitalism,” today’s investors face similar challenges, with broad, diversified, long-term portfolios that represent a slice of the entire economy. For these “universal owners,” one company’s externalities can impact others in the portfolio, adversely affecting not only those specific investments but overall market return. For example, water systems that are contaminated by a mining operation can negatively impact a range of industries in the food, beverage, and consumer goods sectors, putting a drag on growth that ripples through the economy—and the portfolio.

The SASB standards provide investors with the framework and metrics needed to identify inefficiently priced, residual ESG risks embedded in their portfolios, analyse related performance across peer corporations, and allocate financial capital to its highest and best use. Research has shown that by selecting or overweighting companies with a strategic approach to material sustainability factors, investors can add alpha. It also suggests that by demanding transparency around these issues, they can drive a race to the top and reduce overall market risk, creating a rising tide that lifts all boats.

After all, efficient capital markets are a necessary precondition for sustained, equitable economic development. And assessing and reporting risk is just a first step. Effective risk management requires follow-through to mitigate and hedge that risk.

Creating Shared Value

Which brings us to the road ahead. Today, only about a quarter of firms [1] report having a fully integrated enterprise risk management framework of any kind—never mind one that incorporates sustainability factors. This is not just an opportunity for SASB; it’s an opportunity to develop the infrastructure that can support a more robust and resilient global economy.

I believe when risks materialize from the bottom up, their solutions should, as well. I view SASB as a market-driven solution that will help companies not only develop awareness and understanding of financially material sustainability risks and opportunities, but also establish effective risk responses to create sustainable, long-term value for themselves, their shareholders, and society at large.

With a background in economic research and 30 years applying quantitative analyses in various aspects of business and the capital markets, I have always found it invaluable—even essential—to ensure risk-based strategies are rooted in robust, data-driven models that not only support forward-looking projections but can also be validated through back-testing. In this regard, given the intellectual rigor and technical research that underpins SASB’s standard-setting work, my new role is a continuation of my longstanding efforts to use financial innovation to enhance the management of risks—whether they are systemic, systematic, or specific.

With the SASB standards recently codified and ready for use by companies and investors, the time is right for markets to envision and aggressively pursue a future in which broad economic prosperity is no longer held back by outmoded, zero-sum thinking. As a practitioner of the “dismal science,” the marriage of sustainability and finance continues to fill me with optimism for both.

[1] RIMS 2017 ERM Survey

Madelyn Antoncic, PhD, is former CEO of SASB. She also serves as a member of the Board of Directors of S&P Global Ratings and Fin Tech Acquisition Corp III and serves on the Board of Overseers of Weill Cornell Medicine. Formerly, she has held a variety of leadership roles with global financial institutions in both the private and public sectors, including the World Bank, Goldman Sachs, and Lehman Brothers.