ESG risk management: Why it’s business-critical
31 March 2021
In the wake of the coronavirus pandemic and the growing global urgency around climate change, organisations worldwide will be forced to place an even greater focus on their ESG risk management practices.
Historically, corporate social responsibility (CSR) was the initiative frequently championed by activist employees and consumers, whereby issues such as carbon footprints and ethical supply chains were scrutinised. Yet for most organisations, this wasn’t considered a core business objective – nor was it officially regulated.
Fast forward to today and it is now ESG that is the hot topic in boardrooms, whilst becoming an increasing requirement for investors, employees and customers alike. As perceptions have changed over time, these stakeholders have come to realise that environmental, social and governance issues are critical to a business’s reputation and financial performance.
We explore what this means for risk managers, and the benefits of organisations prioritising their ESG risks to improve their sustainability in the long-term.
What is ESG?
Environmental, social and governance (ESG) refers to a trio of business standards used by socially conscious investors to screen potential investments.
Investors look at a broad range of behaviours and criteria within each of the three key areas:
- Environmental measures address the way an organisation responds to issues such as climate change, greenhouse gas emissions, water conservation, green products and the treatment of animals. They will also be used to evaluate the environmental risks a company might face and how these risks are being managed. For instance, is it working to reduce its carbon footprint? How is the business utilising renewable energy? Is compliance with government-led environmental regulations being maintained?
- Social benchmarks focus on business relationships and how the organisation meets the challenges of data privacy, health and safety, stakeholder interests, employee treatment and diversity. These help stakeholders understand the answers to questions including: does the business work with suppliers whose values are aligned to its own? Are the company’s working conditions showing high regard for employee welfare? Is the organisation charitable and supporting its local community?
- Governance criteria refer to how businesses deal with transparency in their communications and financial reporting, and how they ensure directors are given an equal opportunity to vote on important issues. It also covers executive compensation, the independence of the board and senior management team, proxy access and stock structures. Finally, governance measures provide assurance that companies are avoiding conflicts of interest when choosing board members and that they are not engaging in illegal activity.
Why is ESG important for organisations to consider?
In recent years, businesses have faced heightened pressures from environmental groups and non-governmental organisations (NGOs) to be more accountable for their actions, as well as having to navigate emerging legislation and initiatives such as the TCFD’s climate-related financial disclosures recommendations and the new Biden administration proposals for reinvigorating ESG policies.
Investor activity is now also reflecting these changes, where interest in sustainable investment has surpassed that of pure financial returns, with a record amount of investors moving into ESG funds in 2019.
There is now a much broader understanding of the reputational and financial impact of ESG issues being handled insufficiently. But it is not just industry bodies and investors who are putting on the pressure.
Consumers too are demanding social and environmental commitments from organisations, wielding their power collectively to drive greater sustainable corporate practices, close gender pay gaps, urge clearer environmental credentials and more.
Employees are yet another influential group, with many individuals wanting to work for organisations with values that align closely with their own priorities. Indeed, businesses that use ESG as a workforce strategy achieve a significant competitive advantage in being able to attract and retain top talent.
Whilst the COVID-19 pandemic could well have derailed the expansion of ESG priorities, conversely, it propelled them to centre stage. 2020 was proof that we can’t always predict what is around the corner, and so a long-term commitment to ESG principles will be more important than ever as organisations begin to recover and build greater resilience.
What should risk managers be aware of?
With an ever-growing emphasis on ESG and a wide gamut of risks to manage, many risk professionals are having to adjust their strategies accordingly to ensure that environmental, social and governance standards are fully integrated into the organisation’s ERM.
Collaboration with key stakeholders will also be essential in helping risk managers to mitigate ESG risks and put forth a strong disclosure strategy. By applying traditional risk fundamentals to ESG risk management, such as putting appropriate controls in place and ensuring accuracy and transparency in all communications, companies will be in a better position to act on their values, respond quickly to threats and prepare for upcoming regulatory intervention.
Organisations who do this will also stand a far better chance of increasing their ESG ratings, which provide a means of measurement for investors requesting insight into a company’s sustainability credentials. Broadly speaking, the higher the ESG metrics score, the more likely a business can withstand long-term risk, embrace innovation and take a forward-looking approach to value creation.
What are the benefits of having a strong ESG proposition and managing ESG risks?
There are a wealth of business benefits to placing greater focus on ESG risk management and building it into the wider risk framework. The top advantages include:
With a clearer view of ESG risks, businesses can better allocate their resources, combat rising operating expenses, improve their employee retention and remain compliant with regulations. These combined can help to create greater efficiencies and cost savings in the long-term, whilst providing a stronger foundation of resilience in the face of future uncertainty. Sustainability is also achieved by recognising opportunity, as those businesses who are forward-looking when it comes to ESG risks often gain the upper hand in a competitive market.
More proactive regulatory compliance
As the demands from stakeholders increase for organisations to be accountable and transparent throughout all business activity, so too do the industry regulations surrounding ESG. Businesses will be expected to report on all ESG issues, therefore if ESG risk management is incorporated as a major part of the ERM strategy, disclosing this information to the relevant governing bodies should be much more straightforward, helping to reduce legal intervention.
It goes without saying that if a business is responsive to mitigating risks that might otherwise impact its bottom line or reputation, then it is in a much better position of being profitable. ESG-conscious organisations are more likely to be considered a safer investment by those exploring sustainable funds. They are also attractive to consumers and top talent, who are becoming increasingly more clued up about the goods and services they buy, and who they work for. This leads to stronger top-line growth and the ability to tap into new markets or expand into existing ones.
More enticing to investors
Further to the previous point, socially conscious investors are now keen to incorporate ESG values such as responding to climate change into their portfolios, in line with the more traditional factors of risk and profitability. The organisations that manage their ESG risks well will be the ones more likely to attract top investors. Not only is ESG investing gaining traction due to generating competitive returns but it also helps investors to feel good about the stocks that they own. Even amid the pandemic, European sustainable funds continued to rise over €20billion in 2020.
Greater employee productivity
We’ve already mentioned an ESG focus as being a cornerstone to attracting and retaining talented employees, yet it can also enhance employee motivation and productivity by instilling a sense of purpose. A commitment to ESG is often seen as an organisation ‘giving back’, which is met with enthusiasm by many employees. Plus, many aspects of ESG risk management directly impacts employee welfare, such as health and safety, working hours and diversity and inclusion – all of which, if done well, can improve the employee experience and lead to greater output.
Organisations must continually work hard to preserve and enhance their reputations with multiple stakeholders across a broad range of issues. ESG issues are no exception, and businesses must be alert to every shift and change in the ESG landscape and the associated risks if they are to maintain a competitive advantage.
Business intelligence tools are crucial to achieving this level of agility, where robust data analytics can enable organisations to weight specific risks and respond appropriately to movements in the environmental, social and governance domain.
Discover how Pentana Risk can automate your ESG risk management practices, whilst helping to improve business resilience and performance. Also, learn how the Civil Aviation Authority (CAA) is using the solution to get more value from its risk data.
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