Portfolio Externalities Analysis

Credit and investment portfolio selection processes often fail to factor in the risks inherent in externalities. These are third-party costs today, but with changes in regulations, they could be 'internalised' and become company costs in future - a form of "regulatory risk". Internalization of externalities could also take the form of "event risk", as it did in the case of BP in the Gulf of Mexico.

Furthermore, many large corporations have environmental externalities - in the form of climate, freshwater, and pollution impacts - that may jeopardize the long term viability of not only their own business model, but of other businesses, their entire sector, or the economy as a whole. Financial institutions and investors alike may thus be subject to not only fluctuations in, but permanent losses in the performance of their portfolios as externalized environmental costs take a toll on companies and sectors.

The UNEP Financial Initiative reported (UNPRI and Trucost, 2010. "Universal Ownership: Why environmental externalities matter to institutional investors") that over 50% of company earnings could be at risk from environmental costs in an equity portfolio weighted according to the MSCI All Country World Index.

More than ever before, the processes of risk recognition and limitation needs an environmental and social dimension built into it to better inform corporate and bank risk management. Such assessments were until recently considered too difficult, but technological and research advances now make them possible. Recent work by Trucost Plc. and others enables sectoral assessments of externalities to be made and benchmarked, sector by sector, against the credit risk portfolios of a Financial Institution. Some of these sectoral externalities can represent significant future risks to sectoral portfolio exposures through potential 'internalization' of these externalities.

GIST Advisory will work with Financial Institutions to assist them in recognizing and responding to the financial risks that corporate externalities pose to them from their Corporate Banking business, which will help Financial Institutions increase long term portfolio profitability and stability.

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