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Himanshu Gupta • March 31st, 2018.
It is becoming increasingly popular for investors to consider environmental, social and governance (ESG) factors when evaluating investments. These factors are generally thought of as being “non-financial” in nature due to their lack of standardization and treatment in the conventional financial literature. ESG risks include, for example, an asset’s vulnerability to a sea level rise, a company’s decision to abstain from business in states with controversial bathroom laws, or the diversity of a company’s board members.
Dr. Ashby Monk is the Executive and Research Director of the Stanford Global Projects Center and was part of a team that conducted research showing that creating portfolios based upon firms’ carbon-efficiency can generate outperformance between 3.5% and 5.4% per year. I interviewed Dr. Monk to talk about his research and the current state of climate risk assessment in investment management. When asked in general about ESG investing, Dr. Monk made clear that he sees these metrics as necessary in long-term investing.
“I think long-term investing and ESG investing are the same thing. I think ESG factors are long-term risk factors that every long-term investor should be at least considering and including in an investment decision. The big long-term risks of the day are things like population growth, environmental degradation, climate change, the infrastructure crumbling, wealth disparity, all these things that we might think of as ‘hippie risks’ that are ‘non-financial.’ But, the truth is that over a long enough time horizon those ‘non-financial’ risks just become financial risks.“
According to Dr. Monk, investors that are not incorporating climate risk assessment in their asset analysis must be short-term investors only, or long-term investors, those looking at a timespan in the range of five to ten years or longer, that are certain that they have hedged out any exposure to climate risk, a difficult task. He says that the job of long-term investors is specifically to manage risk and generate the highest possible return over time, and over a long time period the risks posed by climate change become a commercial reality. Asked about whether or not short-term investors have good reason to be mindful of climate change, Dr. Monk explained that recent extreme weather patterns, such as Hurricanes Harvey and Maria, may pressure them toward the practice.
“Even short-term investors will begin incorporating ESG considerations if you have a few more dislocations due to climate… If you’re a climate denier, are you so positive that climate change doesn’t exist that you would be willing to not think about it at all in your investment approach?“
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Dr. Monk’s research has shown that utilizing environmental data when designing portfolios is a powerful tool to generate alpha, a financial metric meaning outperformance of the broader market. As he explained when asked about the research, Dr. Monk’s team was able to create a portfolio that generates positive abnormal returns since 2010 using carbon-efficiency data.
“We wrote a paper where we showed in a public market strategy that you can generate outperformance by investing in companies that are efficient with carbon and shorting companies that are inefficient with carbon. If you take this portfolio of one hundred companies and you invest in the top thirty and you short the bottom thirty you get a diversified portfolio. You go long with a hundred bucks and you go short with a hundred bucks so it’s a neutral portfolio and you can generate three to five percent alpha depending on the industry. So, that’s incredible. We’ve just shown that your investments can do better if you think about these environmental considerations.”
With the rise of technologies such as the internet of things, the idea of a network of internet-enabled devices like smartphones and appliances that can exchange and create data, and artificial intelligence (AI), the ability for algorithms run by computers to use data to train themselves absent of human intervention, Dr. Monk sees the financial services industry being turned on its head. These technological advancements enable investors to better implement alternative data, such as the type used to assess climate risk. Dr. Monk described how he sees the internet of things and data science being used to harness a new surge in information, where this information comes from, and their impact on the financial services industry.
“We’re entering this phase which some people call the internet of things. The internet of things is one side of the coin. The other side of that same coin is something we’re calling ‘alternative data’; all these things that are joined by an internet are generating signals, data points, that we can start ingesting and including in investment decisions. We define alternative data as any non-standard data. It could be coming out of a satellite, a mobile phone, a freeway, you name it. That is going to begin to help us measure a bunch of stuff related to these long-term risks. That should, when ingested into a powerful data science platform — even potentially an artificially intelligent platform, help us make inferences about the future of the world and the economy.“
However, Dr. Monk doesn’t see the financial services industry as prepared for the changes that this shift in technology will bring with it. He spoke of a new type of startup emerging which uses these new data sources to create unique “signals,” financial indicators that investors use to assess assets and predict performance. But, the traditional business model for these firms was to start their own fund and to keep the signal to themselves. This model has kept the broader ecosystem from benefitting from the new types of signals being created.
“There’s a bunch of these signal providers that are looking at energy markets and helping investors understand which companies are set up for success in an evolving energy footprint. As these companies emerge and partner with long-term investors the interface between their data and the way investors think will get more seamless. They’re viewing the environment as a lens through which to generate outperformance.“
Dr. Monk sees great change coming in the financial services industry, and as such he sees the key moving forward as preparing for the revolution being brought on by technology.
“Over the next five years the whole financial services industry is going to be transformed by technology and AI and machine learning.“
This will allow the incorporation of climate risk data, as AI systems will consume and utilize any data, traditional or not. Dr. Monk detailed why he doesn’t see the average long-term investor as prepared for this shift, and what those in the industry need to do to keep up.
“We just need to bridge this gap. Many of these long-term investors don’t have their data in a format that would allow a really smart [AI] to go in and say ‘here’s your exposure to climate change.’ My bias is to say that over the next five years the whole financial services industry is going to be transformed by technology and AI and machine learning. But, it doesn’t matter unless you have your data in a format so that it can be accessible, and most plans don’t. So, the hope is that we can get all these plans capturing their data, normalizing it, cleansing it, triaging it and getting it ready to begin to assess ‘are we overexposed or underexposed to climate change in Florida?’ And so that certain tools like this can just be run and you can reposition your portfolio. And it’s in those repositionings that the companies that aren’t investing in climate change will be punished, and the companies that are will be rewarded. That’s the type of signal we need more of.“
By Tyler Johnson. Originally published at sej.stanford.edu.