Phin's theory of 'volatility' as a potential measure of sustainability: An ESG,CAPM oriented Approach
INTRODUCTION
As environmental, social, and governance (ESG) factors continue to gain prominence in the corporate world where risk keeps on evolving, their role as a indirect potential critical measure of sustainability risk should also be recognized, meaning that where ESG is mentioned then sustainability falls a victim also. The concept of ESG started back in the mid-2000, though; the principles behind ESG are decade or centuries old. A 2004 report from the United Nations titled who cares wins carried what is widely considered the first mention of ESG in the modern context. Sustainability risk is an unforeseen situation that affects a company financially and reputation when it fails to effectively address ESG principles. Recently, climate risk which is a “E” category have become the talk of the world. The “S” category which comprises of the relationship between the companies with employees, customers, community among others, sometimes it is treated with contempt which at long last reputation may go down if there is no good relationship that exists. The internal governance (“G” category) of any firm matters a lot, since directors are ones who make policies and come up with business strategies whereby if they fail the company fails, hence sustainability questioned. Volatility is the degree of variation in the price, value, or returns of a financial instrument or asset over a specific period from its mean. Higher volatility indicates instability of prices or value of an asset, while lower volatility shows stable and predictable movements. Away from that, volatility mainly result due to changes in supply and demand. In this case 'volatility' will be defined as per the Capital Asset Pricing Model (CAPM) where 'volatility' as a measure of total risk is divided into specific risk and systematic risk, the assumptions of CAPM holds;
Volatility of returns is a good measure of risk.
The market is efficient (lots of buyers and sellers, perfect information etc)
Investors are rational
Investors are risk-averse
Capital Asset Pricing Model - CAPM
This is the most frequently used models of risk and return in finance, it divides the volatility of let say stock’s price into two parts, the specific risk and the systematic risk. Specific risk can be described using examples:
A company in the business of property development on brownfield sites is exposed to problems such as labour shortages (“S” category), environmental problems(“E” category) and poor project management(“G” category ).
A retailer might face the risk of damage to the company’s reputation if its products are endorsed by a famous personality who becomes the subject of some scandal (“S” category).
Systematic risk would be the risk of being exposed to the economy in general. Many events can affect the market as a whole, such as movements in interest rates, inflation or currency fluctuations.
'Volatility' = Specific risk + Systematic risk
where: Specific risk comprises of risk-free rate and latter is the system risk,
If historical returns are available over a number of periods, we can estimate better and proceed to calculate 'volatility':
Statement of theory:
By set theory and logic law of Syllogism, the theory postulates that volatility implies ESG and latter implies sustainability hence 'volatility' implies sustainability.
The law of Syllogism state that, if A → B and B → C, then A → C. Where, A → B (If A is true, then B is true) and B → C (If B is true, then C is true)
A → B, shows the truth-value of A implies B. Implication is only false when the hypothesis A is true and the conclusion B is false. In all other cases, the implication is true. B→ C shows the truth value of A implies B. A → C, shows the truth value of A implies C, which is what the Law of Syllogism concludes.
Problem Statement:
In the contemporary corporate world, there is a growing emphasis on incorporating Environmental, Social, and Governance (ESG) factors into investment decisions to promote sustainability. However, there are very few existing quantitative methodologies for assessing sustainability risk. This gap raises the need for a comprehensive study on the effectiveness of integrating a Volatility-Linked measure as a potential measure of sustainability risk in the corporate world.
Objectives:
The primary objective of this theory is to investigate and assess the viability of employing a Volatility as an potential innovative metric for measuring sustainability risk in the corporate sector.
1. Proof of the statement of theory:
Let α: volatility implies ESG be true
β: ESG implies sustainability be true
δ: volatility implies sustainability
Proof of truth of sentence α: ESG factors as three categories of demand and supply:
1. Environmental factors
Growing environmental awareness can influence consumer preferences. Consumers may prefer products that are environmentally friendly, leading to an increase in demand for sustainable and Eco-friendly goods.
Natural disasters and environmental events can directly influence demand. For instance, a natural disaster might lead to an increased demand for construction materials and services.
Industries such as agriculture are highly sensitive to climate and weather conditions. Changes in temperature or other climate factors can affect crop yields and influence the supply and demand of agricultural products.
2. Social factors
The level of education in a society can influence consumer awareness and preferences. Educated consumers may be more inclined to make informed choices, affecting demand products.
Public opinions on issues such as operations of a certain firm can affect demand and supply through may be the customer attendance.
3. Governance factors
Government decisions regarding taxation and public spending can influence consumer demand. Changes in income tax rates, for example, can affect disposable income and hence affecting consumer spending.
Actions taken by the central bank to control the money supply and interest rates can influence borrowing costs and, in turn, consumer spending. Lower interest rates may encourage borrowing and spending, while higher rates may have the opposite effect.
Government and firms regulations can affect demand and supply by affecting the price and quality of goods and services.
This shows saying volatility implies ESG it is true, hence proof of truth of sentence α.
Proof of truth of sentence β that ESG implies sustainability is true
ESG standards evaluate sustainability and impact on environmental, social and governance issues as far the corporate world is concerned. Law imposes some of the standards and regulations of the country; others result from stakeholders’ expectations and investors’ pressure due to growing concerns regarding human rights and environmental issues. All this tries to create a sustainable world. This signifies a link between ESG and sustainability hence proof of truth of sentence β.
Proof of truth of sentence δ: 'volatility' implies sustainability
By set theory and logic law of Syllogism, if sentence α is true and it implies sentence β which is true and latter implies sentence δ which is true then, sentence α implies sentence δ.
CONCLUSION
Clearly, by the Syllogism law the statement of theory ('volatility' implies ESG and latter implies sustainability hence 'volatility' implies sustainability) holds. This shows by comprehensively studying 'volatility' of returns, daily customer served on the reception among others, the results can be used to comment partially/fully on the sustainability of that respective firm, hence a potential measure of sustainability.
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