Businesses face new risks as investors, consumers, employees and partners demand greater corporate accountability, transparency and sustainability. Stakeholders want to know how organizations are affecting the environment, how they treat their employees, clients and communities, and if they conduct their business ethically.
These environmental, socioeconomic and governance variables, which are likely to affect the financial situation or operating performance of a company, are collectively referred to as ESG (Environmental, Social, Governance) risks. While ESG variables are diverse, they all have one thing in common: they can have a significant impact on a company’s long-term sustainability and profitability.
A business that overlooks these risks could potentially incur large financial penalties and also lose investors, customers and stakeholder support. However, not all ESG issues are created equal, and their relative relevance varies by company, industry and sector. This means each organization must identify, manage and reduce its unique material ESG risks.
Why do ESG risks matter?
ESG risks exist outside of a standard financial audit, yet they are just as important to a company. Every business, regardless of size or industry, faces a variety of ESG concerns, some of which can result in financial or reputational harm.
Negative ESG situations are becoming more costly and harmful. The Bank of America (BofA) Global Research team recently estimated more than $600 billion of market cap for S&P 500 companies has been lost to “ESG controversies” in the last seven years alone. Examples include:
Pacific Gas & Electric recently agreed to pay more than $55 million to avoid criminal prosecution for two major wildfires started by aging Northern California power lines belonging to the company.
Poor governance resulted in the recall of millions of Volkswagen cars after the company admitted to falsifying emissions tests. This has cost VW $35 billion in fines, penalties, financial settlements and buyback costs.
While medium and smaller businesses may not be subjected to the same level of stakeholder scrutiny or regulatory requirements as larger corporations, they’re nonetheless vulnerable to ESG incidents. More important, smaller businesses may not be able to recover without the help of major investors.
If not addressed swiftly and appropriately, ESG controversies can have massive negative impacts on company performance and survival. And while the cost of adaptation and mitigation can be trillions of dollars, it is still a bargain when compared to the cost of doing nothing. As a result, it’s critical for businesses to recognize and mitigate the various types of risks that pose a threat to their company.
Types of environmental risk
Environmental risks have become a main focus for investors and consumers as attention on climate change, greenhouse gas (GHG) emissions, resource usage and biodiversity protection has increased. Environmental risk refers to how an organization affects the environment and includes things such as:
Climate change impact
Water security and usage
Waste prevention and recycling
Pollution prevention control
Protection of healthy ecosystems
Impact on biodiversity
Protection of marine resources
Transition to a circular economy
Environmental management practices
Energy- and resource-intensive companies must be particularly aware of environmental risks and regulations in order to develop strategies for long-term, sustainable growth.
Types of social risk
Social risks range from employee treatment to boycotts to labor violations to product recalls. These issues are diverse, qualitative and often affect all company stakeholders simultaneously, from workers and customers to suppliers and local communities. Maintaining healthy, positive, fair and ethical relationships with these stakeholders is critical to the long-term success of a company, especially if that business’ success relies on public trust. Types of social risk include:
Diversity, equity and inclusion
Working and safety conditions
Respect for human rights
Training and workforce development
Ethical supplier/vendor labor practices
Social issues tend to have an impact on all company stakeholders. A firm’s ability to avoid damaging its relationships and reputation can be important for ensuring long-term competitive advantages.
Types of governance risk
While most investors have a sense of good governance practices, there’s no one-size-fits-all approach. It can be difficult to identify where and how best practices might affect business performance. Types of governance risk include:
Companies must navigate industry-specific compliance and regulations, consider the role of the board of directors when overseeing risk management policies, develop sound risk management systems and internal controls, determine what disclosures need to be made to the public and investors, and provide guidance for sound decision-making and effective resource allocation.
Physical and transition risks
Organizations can also be exposed to what are known as physical and transition risks.
Physical risks are those related to the physical impacts of climate change. These include acute risks such as increased frequency and severity of extreme weather events such as wildfires, floods and hurricanes. Chronic risk events happen over time and include changes in weather patterns, temperature increases and rising sea levels.
Transition risks arise specifically from the transition to a lower-carbon economy. These considerations include increased cost of raw materials, increased costs due to supply chain changes or disruption, introduction of carbon taxes and increased pricing of GHG emissions, expanding emissions reporting requirements, exposure to lawsuits and the cost of lower emissions technology.
Because of the complex, interconnected nature of all ESG risks, impacts can be wide-reaching, making ongoing risk management and reporting critically important.
Managing ESG risks
Climate change is a major risk that has the potential to destabilize the global financial system. As a result, better data and new disclosures are required to better identify and manage these risks.
ESG frameworks have been established to assist firms in assessing and disclosing their susceptibility to a range of ESG risks. There are many ESG frameworks, but some of the most widely recognized include the recommendations from the Value Reporting Foundation’s SASB Standards, the Global Reporting Initiative (GRI) and the Task Force on Climate-related Financial Disclosures (TCFD).
ESG frameworks assist businesses in moving away from compliance-driven mindsets and toward proactive risk reduction strategies. Some general risk management guidelines to keep in mind include ensuring:
Companies can successfully identify and assess ESG risks
Upper management takes responsibility for ESG integration and risk mitigation
Companies have the appropriate skills, knowledge and expertise to manage risks
There is compliance with and preparation for regulations
ESG risks are considered when establishing, implementing and maintaining reporting practices
Proper ESG risk mitigation makes for less volatile companies and strengthens investor confidence. Companies are rewarded with access to credit and debt markets, positive brand equity, reinvestments and sustainable, long-term growth.
ESG data is critical to helping companies engage in effective risk management and allows organizations to plan for compliance, improve voluntary disclosures and create risk mitigation roadmaps to preemptively address threats.