Environmental, Social and Governance (ESG) Risks
As planet earth retreated into phase one lockdown last year, the global consulting firm Bain, very presciently pronounced “Covid-19 was a dress rehearsal for climate change”. While this remains true and will be an enduring headline, 2020 will also be remembered as the year that the Environmental, Social and Governance (or ESG) agenda took center stage in boardrooms and businesses around the world.
ESG is a broad and complex topic and covers a multitude of areas but one of the most material, real and urgent aspects of ESG is risk management and specifically, identifying, managing and mitigating these risks.
ESG risks explained
ESG risks examples
aspects include how a business performs as a steward of our natural environment, and includes:
Climate Change & GHG Emissions |
Water Security |
Waste |
Pollution |
Deforestation |
Loss of Biodiversity |
aspects consider how a company treats people, and includes:
Inequalities |
Diversity & Inclusion |
Employee Relations |
Health & Safety |
Working Conditions |
addresses how a corporation governs and polices itself, and includes:
Executive Remuneration |
Board Diversity and Structure |
Donations and Political Lobbying |
Bribery and Corruption |
Policies & Standards |
Why ESG risks are important
Similar to other business risks, it is important to understand the nature of these risks, to identify them, to quantify them, and thereafter manage and mitigate them. Unlike most other risk types, certain aspects of ESG risks are emerging with unique characteristics. For example, climate-related risks tend to have little, relevant historical data associated with them and tend to be non-linear in nature.
And although the overall cost in adaptation and mitigation runs into trillions of dollars, it is still well below the cost of doing nothing. For those risks we can insure, we have seen a significant increase in insured losses over recent years, which in turn leads to increased insurance costs.
Insurance costs from climate-related events have increased significantly in recent years
The National Oceanic and Atmospheric Administration (NOAA) very clearly summarizes the alarming increase in billion-dollar events in the USA and, I believe, suggests a clear direction of travel
“2020 sets the new annual record of 22 events - shattering the previous annual record of 16 events that occurred in 2011 and 2017. 2020 is the sixth consecutive year (2015-2020) in which 10 or more billion-dollar weather and climate disaster events have impacted the United States. Over the last 41 years (1980-2020), the years with 10 or more separate billion-dollar disaster events include 1998, 2008, 2011-2013, and 2015-2020.”
Source: NOAA National Centers for Environmental Information (NCEI) U.S. Billion-Dollar Weather and Climate Disasters (2021). https://www.ncdc.noaa.gov/billions/, DOI: 10.25921/stkw-7w73
And when ESG risks materialize, they can be very costly…
Some examples include:
In April 2010, BP’s oil rig Deepwater Horizon exploded in the Gulf of Mexico, creating an environmental disaster and significantly impacting biodiversity. The total bill topped an estimated $65 billion between fines and cleanup costs.
During 2011, severe flooding in Thailand disrupted automotive and technology supply chain networks. The World Bank estimated $46.5 billion in economic damages and losses due to this flooding.
In 2014, drinking water in Flint, MI, was found with dangerous levels of lead, resulting in estimated costs of up to $1.5 billion. The State of Michigan agreed to pay $600 Million in settlement.
PG&E, facing up to $30 billion in liabilities for its roles in several fires, filed for Chapter 11 bankruptcy protection in early 2019.
Poor governance resulted in millions of Volkswagen (VW) cars recalled after the company admitted to falsifying emissions tests. As of mid-2020, the scandal had cost VW $33.3 billion in fines, penalties, financial settlements, and buyback costs.
…. and they can be interconnected, raising social issues and impacting reputations in addition to causing financial stress
Although three distinct areas, we often see interconnectedness and interdependence across the E, S and G.
- When the Covid-19 pandemic struck in the USA, in many cases, the poorest communities were the hardest hit, thus causing further hardship.
- In July 2020 a report in the UK revealed widespread labour abuse in Leicester’s garment sector, including wage theft, poor working conditions and a high Covid-19 risk. The report stated that Boohoo orders account for at least 75% of work in the city’s garment manufacturing sector and called on the company to provide greater transparency on its supply chains so the practices of its suppliers could be scrutinised. Following the allegations, Boohoo announced an independent review into working conditions in its UK supply chains. Boohoo claimed the initial findings of the review did not reveal garment workers being paid below the minimum wage. However, investors, dissatisfied with Boohoo’s review, dropped the fast fashion Brand. Aberdeen Standard Investments sold the majority of its shares in the fast fashion retailer, contributing to the £1bn fall in Boohoo’s market value in a single week. The investor’s decision followed a move by several prominent retailers to remove Boohoo clothing from sale.
- In many parts of the world, loss of biodiversity caused by increased ocean temperatures can impact fish stocks which in turn impacts livelihoods and economic wellbeing in fishing communities.
- In late 2018, severe drought conditions impacting water levels on the Rhine river significantly disrupted supply chains, forcing chemical giant BASF to cut production due to a lack of transportation and thereafter lowered its yearly profit forecast after a slowdown in the third quarter partly from the extra costs incurred.
ESG risks impact the global financial system and impact business
Central banks and financial regulators around the world recognize that climate change is a source of risk to the stability of the global financial system. They also agree that the pricing of climate-related risk with its specific challenges (including lack of relevant historical information, nonlinear nature and long-term characteristics), is a challenge for corporations, financial institutions and the financial markets. Accordingly, there is a need for better data as well as new disclosures to better understand, and manage these climate-related risks.
As transverse risks, climate-related risks will manifest themselves through recognized risk channels or risk types. Risk frameworks have been developed to help organizations approach their climate-related risk assessment and disclosure requirements, the most widely used and recognized, and most likely to be adopted as the global standard, is from the Task Force on Climate-related Financial Disclosure (TCFD, 2017). TCFD presents its framework across the four areas of Governance, Strategy, Risk Management, and Metrics and Targets
Organizations can be exposed to Physical or Transition risks. Physical risks are those related to the physical impacts of climate change. Transition risks are risks related to the transition to a lower-carbon economy. The nature, type and examples of these risks are set out below. When organizations consider the range of ESG risks in a structured matter, they can determine the categorizations of these risks as shown in the following table:
Transition Risks
Type | Examples |
Policy & Legal |
|
Technology |
|
Market |
|
Reputation |
|
Physical Risks
Type | Examples |
Acute |
|
Chronic |
|
Given the transverse nature of ESG, and specifically, climate-related risks, it is critical that they be considered in the context of and as part of the underlying business, and not as a risk, a challenge or a project to be handled separately. And so, the governance of these risks, their reflection in the business strategy and the ongoing management and reporting of them as outlined in the TCFD framework becomes critically important.
Opportunities from undertaking a risk assessment
While a thorough climate-risk assessment will put you on a firm footing in identifying the universe of risks your business is exposed to, it is equally important that this exercise considers the value that ESG opportunities can bring. These include increased revenue and top-line growth, operating expense reduction, reduced regulatory intervention and legal costs, and higher levels of employee engagement and productivity.
Opportunities
Type | Examples |
Resource Efficiency & Cost Savings |
|
Energy sourcing (from low emission energy sources) |
|
Development of new products and services |
|
Markets |
|
Building resilience into the supply chain |
|
Meanwhile, on the global political stage, focus on climate change continues to intensify with the G7 Finance Ministers just last week laying solid foundations to support mandatory climate-related risk reporting and paving the way for more exciting proclamations from the G7.
And with the G7 Summit in search of a more prosperous and sustainable future, focus is shifting to the impact that the global corporate community can have on achieving that goal, something that will be reinforced in the run-up to COP 26 later this year.
There’s a lot for businesses to consider and be aware of whether they are embarking on or continuing a review of their ESG guidelines, procedures, recommendations and targets.
