ESG Integration in Investment Management: Myths and Realities

The number of public companies reporting ESG information grew from fewer than 20 in the early 1990s to 8,500 by 2014. Moreover, by the end of 2014, over 1,400 institutional investors that manage some $60 trillion in assets had signed the UN Principles for Responsible Investment (UNPRI). Nevertheless, companies with high ESG “scores” have continued to be viewed by mainstream investors as unlikely to produce competitive shareholder returns, in part because of the findings of older studies showing low returns from the social responsibility investing of the 1990s. But studies of more recent periods suggest that companies with significant ESG programs have actually outperformed their competitors in a number of important ways. The authors’ aim in this article is to set the record straight on the financial performance of sustainable investing while also correcting a number of other widespread misconceptions about this rapidly growing set of principles and methods: Myth Number 1: ESG programs reduce returns on capital and long‐run shareholder value. Reality: Companies committed to ESG are finding competitive advantages in product, labor, and capital markets; and portfolios that have integrated “material” ESG metrics have provided average returns to their investors that are superior to those of conventional portfolios, while exhibiting lower risk. Myth Number 2: ESG is already well integrated into mainstream investment management. Reality: The UNPRI signatories have committed themselves only to adhering to a set of principles for responsible investment, a standard that falls well short of integrating ESG considerations into their investment decisions. Myth Number 3: Companies cannot influence the kind of shareholders who buy their shares, and corporate managers must often sacrifice sustainability goals to meet the quarterly earnings targets of increasingly short‐term‐oriented investors. Reality: Companies that pursue major sustainability initiatives, and publicize them in integrated reports and other communications with investors, have also generally succeeded in attracting disproportionate numbers of longer‐term shareholders. Myth Number 4: ESG data for fundamental analysis is scarce and unreliable. Reality: Thanks to the efforts of reporting and investor organizations such as SASB and Ceres, and of CDP data providers like Bloomberg and MSCI, much more “value‐relevant” ESG data on companies has become available in the past ten years. Myth Number 5: ESG adds value almost entirely by limiting risks. Reality: Along with lower risk and a lower cost of capital, companies with high ESG scores have also experienced increases in operating efficiency and expansions into new markets. Myth Number 6: Consideration of ESG factors might create a conflict with fiduciary duty for some investors. Reality: Many ESG factors have been shown to have positive correlations with corporate financial performance and value, prompting ERISA in 2015 to reverse its earlier instructions to pension funds about the legitimacy of taking account of “non‐financial” considerations when investing in companies.     

Market Interest in Nonfinancial Information

During the past two decades, more and more companies have volunteered to provide “corporate social responsibility” or “sustainability” reports that include information about their environmental, social, and governance (ESG) policies and performance. Such reporting has come about largely in response to demands by a wide range of stakeholders for information about how the company's operations are affecting society in a number of different ways. But do investors really care about companies' ESG performance and policies? Using data from Bloomberg, the authors provide the first broadly based empirical evidence of investors' interest in ESG data. More specifically, the authors show how interest in the top 20 ESG metrics varies with geographical location (European vs. American), asset class (fixed income vs. equity), and firm type. At the aggregate market level, there is greater interest in environmental and governance information than in “social” information. U.S. investors are more interested than their European counterparts in governance and less interested in environmental information. Equity investors are interested in a wider range of nonfinancial information than are fixed income investors. And whereas sell‐side analysts are primarily interested in greenhouse gas emissions, money managers tend to focus on a broader set of metrics. Similarly, pension funds and hedge funds have shown interest in more nonfinancial metrics than insurance companies. The authors' bottom line: Companies need to recognize the growing market interest in nonfinancial information and ensure that they are providing it according to the specific information needs of market users.     

The Need for Sector‐Specific Materiality and Sustainability Reporting Standards

The market continues to show growing interest in how well companies are performing across a broad range of environmental, social, and governance (ESG) dimensions. Partly as a result, the companies themselves are paying more attention to these performance dimensions, how they contribute to financial performance, and how to evaluate tradeoffs that arise. One of the greatest challenges facing both investors and companies in using ESG performance information is the absence of standards. Another challenge is knowing which of the many ESG dimensions are most material for a company in terms of creating value for shareholders and stakeholders over the long term. The authors argue that materiality and reporting standards must be developed on a sector‐by‐sector basis, and that failure to do so will result in inconsistent and even misleading disclosures. The authors illustrate this with the case of climate change. The SEC has already issued interpretive guidance on climate change disclosures, making it quite clear that existing regulations require companies to report on material effects of climate change, from both an upside and downside perspective. Based on an analysis of 10K filings in six industries, the authors show that, even within a given industry, there is substantial variation in reporting among companies that ranges from no disclosure, to boilerplate disclosure, industry‐specific interpretation, and the use of quantitative metrics. After providing further detail on this by looking at the airline and utilities industries, the authors conclude by offering a methodology for defining material ESG issues on a sector‐by‐sector basis that could provide the basis for developing key performance indicators.     

Innovation in Stock Exchanges: Driving ESG Disclosure and Performance

Stock exchanges are in a unique position to promote ESG transparency and leverage their institutional capacity to build more sustainable capital markets. To facilitate the quick uptake of material ESG disclosure and raise the quality and comparability of the data, the Athens Stock Exchange has created ESG guidelines for listed companies that will be published in the summer of 2019. One important feature of the guidelines is their degree of sectoral specificity and emphasis on materiality. The guidelines and supporting metrics they propose are based on reporting practices endorsed by international sustainability standards like the SASB's industry standards. This materiality‐oriented approach will help issuers focus on the sustainability value drivers inherent in their business, and so ensure that corporate ESG disclosures satisfy the demand of investors for comparable quantitative and accounting metrics that help companies communicate their commitment to long‐term value creation.     

A CEO's Playbook for Creating Long‐Term Value: Ten Essential Resource Allocation Practices

A former CEO of a large and successful public company teams up with a former chief investment strategist and a well‐known academic to suggest ten practices for public companies intent on creating long‐run value:

1. Establish long‐term value creation as the company's governing objective.
2. Ensure that annual plans are consistent with the company's long‐term strategic plan.
3. Understand the expectations embedded in today's stock price.
4. Conduct a “premortem”—and so gain a solid understanding of what can go wrong—before making any large capital allocation decisions.
5. Incorporate the “outside view” in the strategic planning process.
6. Reallocate capital to its highest‐valued use, selling corporate assets that are worth more to or in the hands of others.
7. Prioritize strategies rather than individual projects.
8. Avoid public commitments, such as earnings guidance, that can compromise a company's capital allocation flexibility.
9. Apply best private equity practices to public companies.
10. CEOs should work closely with their boards of directors to set clear expectations for creating long‐term value.

These practices, as the authors note in closing, “are meant to provide a starting point for public companies in carrying out their mission of creating long‐run value—and in a way that earns the respect, if not the admiration and support, of all its important stakeholders.”     

“Non‐Financial” Is a Misnomer,but Doesn't Have to Be a Missed Opportunity

With enterprise values now representing increasing multiples of companies' net book assets, investors are clearly looking beyond financial reporting for enhanced insights and understanding of when and how companies are adding value. This shift includes growing attention to environmental, social, and governance (ESG) information. Although ESG data presents its own unique challenges, dismissing it as “non‐financial” can be misleading. When explicitly linked to a company's long‐term value creation strategy, ESG information can serve as a valuable input to more farsighted financial analysis. Market‐driven initiatives, notably that of the Sustainability Accounting Standards Board (SASB), aim to standardize a subset of business‐critical, industry‐specific sustainability data for investors. Research indicates such approaches can generate positive outcomes not only for providers of financial capital, but for their portfolio companies and markets in general. In illustrating these concepts, the authors explore ESG impacts in three sectors and industries, while examining how access to consistent, comparable, reliable sustainability information in those sectors can augment an analysis of traditional business fundamentals. One example focuses on water management in the Oil & Gas Exploration & Production industry, a major environmental issue where geographic considerations can shed light on company‐specific exposures to cost increases, production disruptions, increased CapEx and R&D spending, as well as the potential for asset write‐downs. In the Food & Beverage sector, health and nutrition concerns are shown to be changing consumer preferences, triggering regulatory action, and reshaping companies' product portfolios—with significant implications for the companies' brand values and ability to compete for market share. Finally, in Aerospace & Defense, lapses in business ethics such as bribery of government officials present a governance challenge that comes with the risk of value‐destroying fines and penalties and, even more significant, associated reductions in revenues.     

How to Integrate ESG into Investment Decision‐Making: Results of a Global Survey of Institutional Investors

The authors review the findings of their global survey of 582 institutional investors that were either practicing or planning to practice some degree of integration of environmental, social, and governance (ESG) factors into their investment decision‐making process. The investors were evenly split between asset owners and asset managers, equity and fixed income, and across the three regions of the Americas, Asia Pacific, Europe, Middle East, and Africa. The survey explored reasons for ESG investing; the barriers to such investing and investor approaches to overcoming them; and the time frames used for making investment decisions, evaluating the performance of managers, and awarding compensation. The authors report finding that the commonly perceived barriers to ESG integration—the belief that ESG integration requires sacrificing returns, that fiduciary duty prevents one from doing so, and unrealistically short‐term expectations for ESG to deliver outperformance—were not as great as commonly believed. The biggest barrier is the lack of high quality data about the performance of companies on their material ESG factors—a scarcity that the authors attribute to the lack of standards for measuring ESG performance and the lack of ESG performance data reported by companies. The results were very similar between asset owners and asset managers, equity and fixed income, and across regions. However, the investment horizons of asset owners were notably longer than those of asset managers, and the same was true of equity vs. fixed income investors. Investors in the Americas were more patient about time frames for seeing outperformance from ESG, while those in Asia Pacific were the least patient. There were also differences across regions in how to overcome the barriers to ESG integration.     

Private Equity: Accomplishments and Challenges

The authors provide an overview of the main accomplishments of private equity since the emergence of leveraged buyouts in the 1980s, and of the challenges now facing the industry—challenges that have been encountered before during three major growth waves and two full boom‐and‐bust cycles. In so doing, the authors review a large and growing body of academic studies responding to questions like these:

• (1) How have PE buyout companies performed relative to their public counterparts? And to the extent there have been improvements in operating performance and productivity gains, how have such gains been achieved? What role have PE firms played in this process?
• (2) Especially in light of the large fees and profit shares paid to the PE firms, or GPs, and the significant “control” premiums over market paid to the selling companies, how have the returns to the LPs that provide the bulk of the funding for PE funds compared to the returns earned by the shareholders of comparable public companies?
• (3) Apart from the high fees earned by its GPs, why is PE so controversial? Beyond their effects on productivity and benefits for investors, what are the employment and other social effects of buyouts and PE?
• (4) What are the prospects for future PE returns to their LPs, especially in light of the volume of capital commitments and high purchase multiples that were being paid, at least until the onset of the COVID pandemic? And what role, if any, should PE activity be expected to play in the recovery from the pandemic?

     

ESG for All? The Impact of ESG Screening on Return,Risk, and Diversification

A large body of research has documented a positive relationship between different measures of sustainability—such as indicators of employee satisfaction and effective corporate governance—and corporate financial performance. Nevertheless, many investors still struggle to quantify the value of ESG to investment performance. To address this issue, the authors tested the effects of using different ESG filters on an investable universe that serves as the starting point for a fund manager. In this way, they attempted to determine the extent to which ESG data can add value to any investment approach, regardless of preferences towards sustainable investing. The authors report “an unequivocally positive” contribution to risk‐adjusted returns when using a 10% best‐in‐class ESG screening approach (one that effectively removes companies with the lowest 10% of ESG rankings), both on a global and a developed markets universe. More specifically, as a result of such screening, both the global and developed markets portfolios show higher returns, lower (tail) risk, and no significant reduction of diversification potential despite the reduction in the number of companies. Use of a 25% screening filter was also found to add value, especially by reducing tail risks, but with a larger deviation from the unscreened universe. Overall, then, the authors’ finding is that the incorporation of ESG information contributes to better decision‐making in every investment approach, with the optimal configuration depending on a fund manager's preferences and willingness to deviate from an unscreened benchmark.     

ESG as a Value‐Creation Tool for Active Investors: A Profile of Inherent Group

A growing number of investment managers claim to integrate environmental, social, and governance considerations into their investment strategy and processes, but few have described how they do so in depth. Even fewer reinforce the importance of sustainability within their own firms by becoming a certified ‘B Corporation.’ This article offers a rare, inside look at how one such value‐oriented manager uses ESG as a tool for differentiated investment sourcing, underwriting, and corporate engagement with the aim of achieving superior risk‐adjusted returns. One of the main arguments of the article—and a key principle of the firm's investment approach—is that ESG, as applied to both corporate strategy and operations, is an important factor in determining a company's cost of capital. The authors present specific examples of their investment process at work, highlighting how active engagement with management on ESG issues can catalyze progress that becomes valued by the capital markets.     

Are Performance Shares Shareholder Friendly?

Performance shares, or PSUs, have become the largest element of pay for top executives in corporate America. Their spread was ignited by institutional investors looking for more “shareholder‐friendly” equity awards—as opposed to restricted stock and stock options, which have been characterized as “non‐performance” equity. Although that characterization has been challenged by many directors and compensation professionals, proxy advisers like Institutional Shareholder Services have continued to insist that the majority of stock be granted based on performance, compelling public companies to conform to that standard. With over a decade of experience with PSUs, the evidence is in regarding their net effect:

• PSUs greatly complicate long‐term incentives. Pay disclosures are dominated by discussion of PSUs, including metrics, goals, performance and vesting, and any differences in one grant year versus the next over three overlapping periods.
• PSUs may be contributing to the increase in pay. Companies issuing a significant portion of their long‐term incentives in the form of PSUs have been granting about 35% more in value than companies granting only restricted stock and stock options.
• Shareholders don't appear to be getting anything for that added complexity and cost. S&P 500 companies using PSUs have underperformed their sector peers, and companies using solely “non‐performance” equity have significantly outperformed their sector peers, and in every single year over the last decade.

Given these findings on PSUs, it is time for institutional investors and their proxy advisors to reconsider their view of these vehicles as “shareholder‐friendly,” and rethink their unqualified promotion of their use by the companies they invest in.     

Sustainability and Capital Markets—Are We There Yet?

The High Meadows Institute issued a report in 2016 called ‘Charting the Future of Capital Markets’ that surveyed the mainstream capital market ecosystem by soliciting the views and practices of its key stakeholders around the issue of long‐term value creation. In this follow‐up report, the authors report that much has changed during the past three years. The role of investors in proactively shaping corporate practices is gaining more attention as ESG issues and responsible investment have become mainstream concerns, as new responsible investment regulations and frameworks have been implemented, and as shifting demographics continue to pressure capital market participants and stakeholders to change their practices. At the same time, the report notes significant remaining challenges. The lack of a standard industry definition and framework for ESG data and reporting on ESG continues to be a significant impediment, as does the shortage of qualified ESG analysts and infrastructure to support true ESG integration. Surveys also suggest most corporate boards have yet to recognize the full significance of ESG integration or its value to the firm.     

Embedding Sustainability Performance and Long‐Term Strategy in the Earnings Call

The practice of disclosing corporate Environmental, Social and Governance performance information continues to evolve, and the frequency of ESG disclosures in investor‐facing discussions, including Investor Day presentations and non‐deal roadshows, continues to grow. But even with these developments, the corporate‐investor dialogue about ESG and long‐term strategy, and their expected effects on long‐run profitability and value, has continued to lag. This seems particularly evident in the quarterly earnings call. In this article, the authors review the work of NYU's Center for Sustainable Business, in collaboration with Chief Executives for Corporate Purpose (CECP), in encouraging companies to work ESG themes and performance into their quarterly earnings calls. After discussing the reasons for the relatively slow progress in this important disclosure venue, including interviews with sell‐side analysts, the authors propose practical approaches that can guide companies, regardless of industry or market cap, in delivering this content in a way that is valuable to both buy‐side and sell‐side equity analysts.     

Does the severity of a client’s negative environmental,social and governance reputation affect audit effort and audit quality?

In recent years, investors have begun to value companies’ reputations through their environmental, social, and governance (ESG) practices. ESG risk can affect business processes and controls and can heighten financial risk and threaten a firm’s survival. This study examines whether and how the severity of media coverage of a firm’s negative ESG issues (tainted ESG reputation) is associated with audit effort and audit quality. I find that auditors manage the higher expected engagement risk conveyed by tainted ESG reputation by applying higher audit effort. Next, I observe that the increased effort is associated with auditors likely detecting and requiring adjustments for material misstatements and that tainted ESG reputation is associated with fewer misstatements (i.e., reduces poor audit quality). The association between tainted ESG reputation and audit quality is driven primarily by increased audit report lag, not by increased audit fees. Further, I find that tainted ESG reputation is positively associated with audit effort and reduces poor audit quality for up to three years. The results also show that the audit effort and audit quality effect vary across the three components of ESG.     

Creating Value at the Intersection of Sourcing,Hedging and Trading

Higher commodity prices, along with higher currency and commodity price volatility, have combined with challenging economic circumstances to make for difficult economics within many industries today. These factors can introduce risk to both top‐line revenue and the cost structure, and wreak havoc on net cash flow and profitability. To the extent that high prices and increasing price volatility continue to be the rule in many global commodity categories, the authors suggest that both sourcing and hedging will soon be (if they are not already) near the top of the strategic agenda for many companies. Many companies now design their hedging programs—and in some cases their sourcing—to achieve the goals of reducing cash flow volatility and optimizing value (as opposed to the more conventional aim of minimizing sourced or manufactured unit cost). And a growing number of corporate managements have expressed interest in an even more systematic approach to risk management. Rising pressure for growth and profitability has led companies with large commodities exposures—both those that are naturally long and those with a natural short—to explore a more strategic role for commodity hedging and trading, as well as the use of innovative risk‐shifting mechanisms for inbound and outbound material flows. This article shows how companies can design their commodity risk management programs to make the greatest use of the expertise and capabilities of four different corporate groups: Purchasing, Treasury, Selling, and Marketing. To that end, the authors presents a five‐step program for creating a company‐wide strategic risk management program:

• ? The first step involves making active design choices about what risks to “own” and what risks to limit based on the company's strategy, core competencies, and relative competitive advantages in owning that risk.
• ? The second step is to establish relevant risk guidelines based on capacity to own risks and, to a lesser extent, risk appetite, with specific hedging targets and benchmarks. This involves defining objectives, priorities, and constraints (for example, protecting liquidity or increasing debt capacity by reducing cash flow volatility).
• ? The third step is to identify and characterize a complete inventory of all exposures—source, size and drivers—and those exposures to be managed. This involves defining, measuring and analyzing all exposures (e.g., commodities, FX, interest rates), with special attention to aggregating, netting, natural offsets, and correlations.
• ? The fourth step involves comparing the suitability of various hedging tools and determining how to incorporate these tools into a systematic program that will achieve stated goals, views, and risk preferences for each exposure.
• ? The fifth and last step is establishing an appropriate risk management operating model, which involves considerations of organizational architecture, management processes, decision rights, information flows, and governance.

     

Integrating Sustainability Into Capital Markets: Bloomberg LP And ESG's Quantitative Legitimacy

The rise in prominence of environmental, social, and governance data has been driven in large part by a growing interest among investors who seek to gain an edge through the incorporation of such data in their investment decision‐making. There are, however, several significant obstacles to the integration of ESG data into mainstream investing analysis. Perhaps most important, while finance today is a fundamentally quantitative discipline, ESG is often qualitative. Moreover, the ESG data that is available is incomplete and inconsistent, due largely to a reliance on voluntary reporting by individual companies. In short, ESG has not yet earned its quantitative legitimacy in the eyes of the investor community. Nevertheless, recent work in the area of stranded asset values has provided Bloomberg LP, a leading provider of financial data and analytics, an opportunity to “bridge theory and practice” by translating the stranded assets framework into a first‐cut valuation tool designed for mainstream financial analysts. The tool offers a quantitative introduction to an ESG issue that the authors believe will eventually become an important focus of many investment decision‐makers' analysis. While the tool continues to evolve in analytical sophistication, the authors “preview” it here in its early form as one step towards Bloomberg's broader vision of “sustainable finance,” and the company's role in supporting the quantitative maturation of ESG through the twin engines of standardization and disclosure.     

Advancing Sustainability Reporting in Canada: 2019 Report on Progress

This study examines the progress Canada's largest companies are making in their environmental, social, and governance (ESG) disclosures. Given the introduction of the Global Reporting Initiative (GRI) Standards and the United Nations Sustainable Development Goals (UN SDGs) as well as the issuance of the Task Force on Climate‐Related Financial Disclosures (TCFD) recommendations, our research reflects the uptake of these guidance documents by both mature and new reporters. Our analysis suggests that challenges persist—processes and progress often fail to reach investors as they are “lost in translation” when issued through third‐party ESG information providers, and reporters are also pressured to respond to a myriad of requests for information from rating and reporting agencies. Nevertheless, we note that Canada has new reporting sectors that must mature to survive the scrutiny of the markets and also hope that stock markets will respond to the recent announcement by the 181 CEOs of the U.S. Business Roundtable, who committed to lead their companies for the benefit of all stakeholders—customers, employees, suppliers, communities, and shareholders. Overall, we believe that our research will provide food for thought for companies interested in continuous improvement.     

Analysts' Roundtable on Integrating ESG into Investment Decision‐Making

In this third of the three discussions that took place at the SASB 2016 Symposium, practitioners of a broad range of investment approaches—active as well as passive in both equities and fixed‐income—explain how and why they use ESG information when evaluating companies and making their investment decisions. There was general agreement that successful ESG investing depends on integrating ESG factors with the methods and data of traditional “fundamental” financial statement analysis. And in support of this claim, a number of the panelists noted that some of the world's best “business value investors,” including Warren Buffett, have long incorporated environmental, social, and governance considerations into their investment decision‐making. In the analysis of such active fundamental investors, ESG concerns tend to show up as risk factors that can translate into higher costs of capital and lower values. And companies' effectiveness in managing such factors, as ref lected in high ESG scores and rankings, is viewed by many fundamental investors as an indicator of management “quality,” a reliable demonstration of the corporate commitment to investing in the company's future. Moreover, some fixed‐income investors are equally if not more concerned than equity investors about ESG exposures. ESG factors can have pronounced effects on performance by generating “tail risks” that can materialize in both going‐concern and default scenarios. And the rating agencies have long attempted to reflect some of these risks in their analysis, though with mixed success. What is relatively new, however, is the frequency with which fixed income investors are engaging companies on ESG topics. And even large institutional investors with heavily indexed portfolios have become more aggressive in engaging their portfolio companies on ESG issues. Although the traditional ESG filters used by such investors were designed mainly just to screen out tobacco, firearms, and other “sin” shares from equity portfolios, investors' interest in “tilting” their portfolios toward positive sustainability factors, in the form of lowcarbon and gender‐balanced ETFs and other kinds of “smart beta” portfolios, has gained considerable momentum.     

Three Common Misconceptions About Markets (or Why Earnings Smoothing,Guidance, and Concern About Meeting Consensus Estimates are Likely to be Counterproductive)

Although many executives strive for stable earnings growth, finance theory and research have long suggested that the most sophisticated investors aren't especially concerned about “normal” levels of variability in reported earnings. More recent research by the authors and their McKinsey colleagues also suggests that extraordinary efforts to achieve steady growth in earnings per share quarter after quarter aren't worthwhile and may actually hurt the companies that undertake them. While such efforts to smooth earnings involve real costs, the research finds no meaningful relationship between earnings variability and valuation multiples or shareholder returns. Based on these findings, as well as considerable experience in advising companies, the authors offer the following advice to senior executives:

• Managers shouldn't shape their earnings targets or budgets just to meet consensus estimates. Companies that reduce spending on product development, sales and marketing, or other contributors to long‐term growth are sacrificing long‐term performance for the appearance of short‐term strength.
• As the year progresses, managers should likewise avoid costly, shortsighted actions to meet the consensus. Resist the temptation to offer customers end‐of‐year discounts to boost current‐year sales, or to resort to creative accounting with accruals. Investors recognize these for what they are: borrowing from next year's earnings.

Finally, companies should reconsider the practice of quarterly earnings guidance. Instead of providing frequent earnings guidance, companies should design their investor communication policies to help the market to understand their strategy, the underlying value drivers of their business, and the most important risks associated with the business—in short, to understand the long‐term health and value of the enterprise.     

Risk and Regulation in Derivatives (or Why Derivatives Are a Blessing,Not a Curse)

In this article, first published in 1994, the authors aimed to defuse the widespread hysteria about derivatives fueled by media accounts (like Fortune magazine's cover story in the same year) by offering a systematic analysis of the risks to companies, investors, and the entire financial system associated with the operation of the relatively new derivatives markets. Such analysis ended up providing assurances like the following:

• As long as most companies are using derivatives mainly to limit their financial exposures and not to enlarge them in efforts to pad their operating profits, reported losses on derivatives should not be a matter for concern. “Complaining about losses on a swap used to hedge a firm's exposure,” as the authors note, “is like objecting to the costs of a fire insurance policy if the building doesn't burn down.”
• To the extent that companies are using derivatives to hedge—and what evidence we have suggests that most are—the default risk of derivatives has been greatly exaggerated. An interest rate swap used by a B‐rated company to hedge a large exposure to interest rates will generally have significantly less default risk than a AAA‐rated corporate bond issue.
• Thanks to the corporate use of derivatives, much of the impact of economic shocks such as spikes in interest rates or oil prices is being transferred away from the hedging companies to investors and other companies better able to absorb them. And in this fashion, defaults in the economy as a whole, and hence systemic risk, are effectively being reduced, not increased, through the operation of the derivatives markets.

Moreover, the authors warn in closing that the likely effect of then proposed derivatives regulation would be to restrict access to and increase the costs to companies of using derivatives markets. As one example, the excessive capital requirements associated with derivatives facing bank dealers—based on gross rather than net measures of exposure—and which regulators have since proposed extending to nonbank dealers—were expected to have the unintended effect of encouraging dealers to sell precisely the kinds of riskier, leveraged derivatives that Bankers Trust sold Procter & Gamble, and that functioned as Exhibit A in the Fortune article.