Many companies are coming to realize that an effective environmental, social, and governance (ESG) strategy supports better financial performance and long-term business success. As a result, efforts to define and manage ESG issues are rising ever higher on corporate executives’ priority list.
Including ESG concerns in your strategy and risk management program, however, is easier said than done. Keep reading to learn more about ESG risk management and how you can integrate ESG risks into your enterprise risk management framework.
What is ESG Risk Management?
ESG risk management addresses numerous operational criteria that go beyond standard business and financial risks that every company faces. An ESG risk management program allows an organization to develop a business model that is tailored to manage various environmental, social, and governance risks.
The ESG program’s environmental aspect includes climate change, reducing emissions, and supply chain sustainability. Social criteria examine how the business manages labor relations, diversity, and inclusion. Governance deals with leadership, internal controls, and ethics to promote greater accountability and transparency.
The Need for ESG Risk Management
The clamor for ESG risk management has been growing for years, and especially since the outbreak of the Covid-19 pandemic. ESG issues matter more than ever to investors, customers, stakeholders, employees, communities, and regulators.
Strong ESG performance can lead to greater access to capital, talent, and business opportunities. For these reasons, it’s critical for today’s organizations to focus on integrating ESG management into their overall risk management framework.
What Risks Can ESG Risk Management Help With?
An ESG-informed methodology can help companies identify, manage, and mitigate many crucial risks, including:
- Climate risk
- Greenhouse gas emissions
- Carbon footprint
- Water, soil, and air pollution
- Waste and waste management
- Use of toxic chemicals
- Effect of operations on biodiversity
In other words, environmental factors measure how well the organization performs as a steward of the natural resources it consumes and the waste it creates.
- Diversity, equity, and inclusion (DE&I)
- Inequalities in the workplace
- Employee relations
- Employee health and safety (H&S)
- Employee working conditions
- Human rights
All these social factors are increasingly scrutinized by shareholders, stakeholders, regulators, and potential investors. Companies must also pay more attention to social justice, systemic racism, and implicit bias in the workplace.
- Board diversity and structure
- Political contributions
- Executive pay
- Operational policies and standards
- Controls for corruption and ethics
- Tax avoidance
- Shareholder rights
- Board management of regulatory, legal, and reputational risks
Corporate governance factors determine how an organization governs itself, manages operations, and controls financial practices. It also includes whether its decision-making is transparent, inclusive, and ethical.
What Are the Benefits of ESG Risk Management?
ESG risk management is not necessarily cheap, but the costs of inaction can be even higher. Incorporating ESG risk management into your business plan has many benefits, including:
In 2020 the world endured 22 separate billion-dollar disaster events (the most on record), which in total cost organizations $1.875 trillion. In the first half of 2021 alone, disasters inflicted $42 billion in losses.
Further back, oil giant BP landed in a massive scandal in 2010 when it failed to manage its environmental risks and suffered the infamous Deepwater Horizon disaster – where more than 130 million gallons of oil spilled into the Gulf of Mexico. This huge oil spill led to the loss of 11 lives and cost BP a whopping $65 billion in fines and cleanup.
Poor ESG practices also landed German automaker Volkswagen in an emissions scandal. In the late 2010s and into this year, the company paid out $33.3 billion in fines, settlements, and buyback costs as part of “Dieselgate,” where U.S. environmental regulators found discrepancies between laboratory results and actual emissions in real-world driving.
These damages and costs might have been avoided if the companies had adequately understood the risk environment and made concerted risk mitigation efforts.
Improve Regulatory Compliance
Poor ESG risk management can also affect a company’s regulatory posture since more and more regulators now ask for ESG data and reporting.
For instance, in the European Union, the Sustainable Finance Disclosure Regulation (SFDR) has introduced sustainability disclosure requirements and incentives for companies to provide complete ESG data. IIn the United States, the Securities and Exchange Commission (SEC), Federal Reserve, and other regulators are also updating their reporting requirements regarding the risks and costs related to climate change.
Access to Investors and Funds
Activist investors, financial institutions, and lenders are also paying more attention to companies’ ESG programs. Many are reassessing their lending and investment strategies to reduce their exposure to companies not focused on environmental protection, carbon neutrality, and sustainability.
Align With Customers
Customers also expect that companies align with their own ethical views. Often, customers will pay a premium to shop from an organization with a good reputation for ESG management.
Protect Reputation and Brand Value
A lack of ESG risk management can damage an organization’s reputation, market value, and revenues. On the other hand, robust ESG risk management can help the company improve public relations and its image with relevant and timely press releases featuring its ESG efforts.
In sum, companies must keep an eye on the various ESG factors, concerns, and risks to minimize financial, regulatory, and reputational damage while protecting brand integrity.
As investors and regulatory bodies demand information on sustainability and social responsibility practices, organizations must track and gather ESG performance data. This data needs to be published in reports based on established reporting standards dictated by the SEC, the European Union, banking regulators, and others.
How to Perform ESG Risk Analysis
Every company will have a different approach to ESG risk, since every company has its own unique set of ESG risks. That said, even though the risks themselves are unique, you can use a traditional risk analysis framework to help you determine what threats are the most critical and how to approach them:
To perform an ESG analysis, you’ll first need to determine what risks you’re facing. It’s likely that your company already has a risk management framework in place, but you may not have accounted for ESG risks within your plan. Bear in mind that these risks not only affect each other, but also any existing threats within your company’s ERM plan. So identifying and documenting your ESG risks is the first step.
Once you’ve created your list of risks, you can further examine them to determine their likelihood and potential impact. Many organizations use heat maps or other visualizations to help them decide which risks are the most severe. A thorough risk assessment will give you an idea of where to allocate your funds and resources moving forward.
In this step, you’ll determine what controls should be in place to protect your company from your identified risks. You should also develop a contingency plan so your business can remain operational should any of the risks occur. The most effective controls will take all possibilities into account, including the ways in which different risks might affect different departments.
Any effective enterprise risk management program will integrate monitoring after their initial framework is devised, and this is particularly true of ESG risks. These kinds of risks change constantly, and your contingency plan will quickly become obsolete if you’re not adapting to new threats as they arise.
How to Integrate ESG Risks Into Your Risk Management Framework
Following a few best practices can simplify integrating ESG risk factors into your overall risk management framework.
Identify the ESG Strategy Based on Organization’s Unique Exposure to Risk
ESG ratings agencies are helpful since they help organizations to understand (often in quantitative terms) where the company stands on material issues. Organizations can easily compare themselves to similar companies in their industry and develop appropriate benchmarks.
These ratings, however, only represent the viewpoints of the respective agencies. Moreover, rating criteria can promote a “checkbox compliance” culture. As a result, it’s essential to develop an ESG strategy tailored to your unique risk exposure and perspective on how best to manage these risks.
Connect ESG Strategy to Business Strategy
Your ESG strategy and business strategy inform and affect each other, so they should always be aligned. ESG integration should be a core part of the vision, mission, and values. Board and management oversight and a thorough materiality assessment are also critical.
Add ESG Risk to the Overall Risk Appetite Statement
All ESG risks should be considered in the overall risk appetite statement. Such considerations will assure that the enterprise risk appetite is adjusted based on all threats (and is, therefore, a holistic reflection of the existing risk posture) instead of just standard financial or business risks.
Put the Right Components in Place
To manage ESG risks as part of the risk management framework, make sure you have all the required components in place, including:
- Risk register
- Risk ownership
- Obligations register
- Key risk indicators (KRIs) and metrics
- Management structures
- Governance structures
- Reporting structures
- Performance monitoring
Manage Risk with ZenRisk
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Schedule a demo today to learn more about how ZenRisk can create an enterprise risk management framework that works for you.