ESG and Corporate Risk

CEOs are waking to the notion that ESG and risk management are entirely related, and to ignore environment, social, and governance factors may well cause irreparable harm to their organisations as well as to their careers.

ESG risks are more than mere operational risk management. Instead of internal navel-gazing, a mature ESG approach questions not just the impact which external matters have upon the organisation, but it involves questioning the impact of an organisation upon others. Recognition of the imperative for every board accept that society’s demands have changed irrevocably, and to face the problems too, is an absolute. However, with the challenges there are opportunities to achieve startling growth while simultaneously reducing risk.

Who are your ESG Stakeholders?

A well designed and executed ESG programme is one way to reduce risk. Far from the somewhat discredited US-centred approach to ESG which concentrates on ESG investing as if a topic to be viewed in isolation. Rather, your corporate stakeholders range from government through to your employees. Suppliers, local communities, consumer advocacy groups, and journalists too, are curious.

Your social and environmental policies affect everyone, and your corporate governance must be beyond reproach. Put another way, a strong ESG program is about keeping your organisation off the front-pages for undesirable reasons. In this decade, an organisation may face collapse for its inattentiveness.

The Role of ESG Ratings

To understand the growth of ESG reporting, consider that PwC announced they will be recruiting 100,000 ESG consultants over the next five years. While reporting has been largely voluntary, we’re now seeing a determined push by international regulatory bodies to move toward establishing reporting standards.

Nowhere is the regulation of ESG reporting more pronounced than in the EU with the forthcoming CSRD (Corporate Sustainability Reporting Directive). Following closely behind are the UK and the US SEC (Securities and Exchange Commission).

Couple with increased reporting has been the emergence of ESG ratings, again with a significant shift being apparent as European interpretations of the ESG concept move away from a pure investment focus to questioning how an organisation is run. Your ESG rating is a yardstick of your organisation’s honesty, transparency and integrity. It’s more than CSR (Corporate Social Responsibility), not least of all because it extends through to reputational risk and climate risk.

A good ESG rating highlights the ability of a company to better manage its environment, social, and governance risks relative to its peers. A poor ESG rating is the opposite as it indicates that the company has relatively higher unmanaged exposure to ESG risks.

ESG Scores and Risk Mitigation

The best ESG ratings may be interpreted like financial ratings, ranging as they do from CCC – AAA. As ESG PRO emphasises to corporate clients, this is not a pass/fail exercise, but a snapshot of performance which lays the groundwork for an action plan of continuous improvement.

A high ESG score indicates an aggressive effort to mitigate the risk. An example of risk mitigation for carbon emissions would be Microsoft‘s (NASDAQ:MSFT) goal to become carbon-negative by 2030.

A low ESG score is typified by global retail giant, Wal-Mart who’s dismal performance is due in part to investigations into bribery; numerous workplace safety violations in the past two years; failure to endorse international labour policies; and use of sweatshops in the recent.

Surprisingly, pharmaceutical giant, Pfizer, also has a low ESG score. Mostly due to poor global governance, some factors which harm Pfizer include excessive CEO compensation, non-independent audit and compensation committees, and ignoring a majority vote on a shareholder proposal in the past three years.

ESG and Investor Preferences

Investors prefer companies with high ESG ratings because the stocks of highly rated companies tend to outperform, according to a study by Deutsche Bank. Of course, consumers might not be aware of a firm’s ESG rating, but they are aware of its reputation, and they can be quick to distance themselves from unsavoury practises.

The investor community is highly active in this regard, as evidenced by the US where about a quarter of the assets under management, or roughly $12 trillion, are ESG-rated investments.

ESG and Access to Capital

For any corporation, risk management must include planning access to capital. More than 2,000 academic studies have demonstrated a favourable association between ESG scores and financial returns, measured by equity returns, profitability, or valuation multiples.

Capital cost is another factor. A superior ESG score correlates to a 10 percent lower cost of capital, because a solid ESG rating reflects that the risks which might affect your business are controlled.

Using ESG as a Critical Risk Measure

So how can a diligent approach to ESG impact corporate risk? Consider the impact upon a transportation company if bad weather (especially if climate change induced) may cause it to fail in its delivery obligations. Not only are its own business operations impacted, but so to those of its customers.

Greater awareness of ESG and dedicated systems to promote it from within enables businesses to make important decisions on multiple facets of their operations, including efficiency, business continuity and risk mitigation. After all, business continuity planning is central to risk management.

Improved efficiency, sustainability and financial performance offer multiple benefits. Those factors not only resonate with employees, customers and investors, but they also tend to reduce the risk of shareholder litigation, which is a major driver of liability claims against company directors and officers.

A Starting Point for Corporate ESG

Building and maintaining a strong ESG program requires CEOs to lead from the front. If you have found your initiatives have produced little or no benefit, or progress is proving too slow, the team at ESG PRO recommend time is invested into the following:

Understanding exposure. Every organisation has a different exposure relating to environment, social and governance issues. Invest in making detailed risk assessments to understand your specific risk exposure.

Assess your ESG view.  Don’t fall into the trap of focussing on environmental or social: governance is integral to any effective broad business strategy.

Being intentional. Addressing ESG is not about merely replicating what a competitor has achieved. Be deliberate in how you design your ESG plans and set meaningful targets while developing systems for measuring your progress.

Support from the top. A top-down approach is needed to drive ESG. That means the board, senior executive leadership and business unit leaders must create the appropriate governance structure to manage, set and execute your ESG ambitions.

Measuring and reporting.  ESG initiatives demand continuous improvement, with transparency as to what has worked and what has under-delivered. Key metrics, such as carbon emission mitigation, gender and racial diversity, and the level of frequency of disclosures, to name only a few, will enable you to create a baseline for measuring future performance and sharing results.

Beware of Event-driven Litigation

Concluding this article, we must consider how the increased awareness of ESG has coincided with the increased litigation risk that companies face whenever there is an adverse event: so-called “event-driven” litigation. This type of litigation tends to follow a headline that purportedly reveals adverse facts or allegations about a company’s business practices or products.

The combined litigation and settlement costs are substantial, and a key factor in many of the event-driven cases filed to date is that they involved a “material” risk to the company. That is, the adverse event involved an aspect of the company’s business that was “intrinsically critical to the company.”

If the adverse event concerns a “material” risk or a “mission critical” aspect of the company’s business, the directors and officers will struggle to achieve an early dismissal because corporations are generally required manage their material risks proactively.

If ever there was a reason to take ESG seriously, this is it!