Today, organizations face new risks as consumers, employees, partners, and investors demand more corporate accountability, sustainability, and transparency. Stakeholders want to know how businesses affect the environment, how they treat their customers, employees, and communities, and if they do their business ethically.
Those environmental, socioeconomic, and governance risk factors that affect an organization's operating performance and financial situation are known as Environmental, Social, and Governance (ESG) risks. Although ESG factors are pretty diverse, they have one thing in common: they can significantly affect an organization’s profitability and sustainability.
A company that ignores these risks might lose investors, stakeholders, and customer support. But ESG matters aren’t created equal, and their relevance varies by organization, sector, and industry. This means every company must be on the lookout for ESG risks.
Bloomberg’s insights report that ESG investments are expected to reach $50 trillion by 2025. Thus, not calculating and reducing ESG risks might be a costly venture.
Understanding ESG Risk: Primer
Again, ESG risk stands for environmental, social, and governance risks. Environmental, social, and governance risk factors may cause a bad reputation, including harming a company economically or greenwashing. ESG risk factors are crucial in the business world as many organizations transition towards becoming sustainable. That’s because ESG risks can help a company manage its investments. This allows for the board of directors to stay cognizant of their own ESG risks, and for customers and future employees to seek out new organizations that follow their own environmentally ethical values.
Basically, ESG risks are environmental, social, and governance variables that affect a company’s management and financial success. ESG risk factors are relevant to businesses of all sizes and are fundamental to any company's economic success. Thus, many businesses strive to enforce an ESG plan to manage their ESG risks and safeguard the quality and success of their business.
Implementing comprehensive ESG risk management can help organizations identify and manage potential hazards associated with social, environmental, and governance risk factors. By assessing these risks, organizations can make educated decisions that safeguard their reputation and boost their long-term financial sustainability.
Also, ESG risk management enables businesses to stay ahead of regulatory requirements. As governments increasingly focus on sustainable practices globally, strong ESG policies can help companies avoid penalties or fines for non-compliance.
Further, enforcing ESG risk assessment and management can boost stakeholder relationships. Investors are increasingly interested in working with socially and environmentally responsible organizations. By demonstrating a dedication to managing ESG risks, organizations can attract more sustainable investing and ultimately improve their valuations.
Assessing ESG Risk Factors
ESG risks fall into three groups. Here are the most common risk factors for every group.
These refer to how an organization affects the environment. The environmental risk factors include variables like:
- Water usage
- Carbon footprint
- Water disposal
- Impact on biodiversity
- Greenhouse gas emissions
Environmental risk management encompasses adhering to environmental rules and regulations. Not doing so could result in hefty penalties and lawsuits. For instance, in 2012, AIREKO’s demolitions exposed over 450 people to asbestos fibers. The company was fined $1.5 million and an additional $172,020 to cover victims’ medical examinations.
These risks are diverse and subjective. Common social risk factors include:
- Workplace safety conditions
- Wage equality
- Human rights violations
- vendor/supplier practices
- Data privacy
- Diversity, inclusion, and equity
Social risk factors affect customer loyalty and brand reputation. For example, in a study conducted in 2021, 83% of consumers said they would base their support on how a company treated its employees during the pandemic.
When managing social dynamics, organizations should focus on these critical areas:
- Ensure the workplace conditions encourage employees’ health and safety.
- Ensure suppliers meet their ESG policies.
- Ensure the company doesn’t take unethical advantage of its employees and customers.
Governance risk variables refer to how an organization operates, including its governing standards. Examples include:
- ESG disclosures
- Transparent communication
- Corruption and Fraud Prevention
- Diversity and board structure
- Executive compensation
- Organization ethics and integrity
Organizations that underestimate the impact of governance risks often face hefty fines for their mistakes. For instance, in 2015, Volkswagen admitted to fabricating emission tests. This ESG scandal cost the global car manufacturer billions in penalties, fines, financial settlements, and buyback costs.
Thus, organizations must consider industry-specific compliance rules and the board’s role when overseeing their risk management standards. In addition, your organization’s governance risk management must encourage transparency and deter illegal conduct.
Quantifying ESG Risk: Metrics and Ratings
ESG ratings and metrics measure an organization's vulnerability to social, environmental, and governance risk factors. ESG risks concerning issues like workplace safety, board independence, and energy efficiency-- have significant economic consequences. Investors and suppliers who use ESG metrics and ratings to complement financial analysis gain a more comprehensive overview of an organization’s long-term potential.
The Morgan Stanley Capital International (MSCI) ESG score is a commonly used ESG score system. MSCI scores approximately 8,5000 organizations and over 680,000 equity securities and fixed income globally, including ESG funds.
The basis of the MSCI ESG rating system is a fundamental issue framework that quantifies risks across ten categories of social, environmental, and governance.
MSCI’s primary environmental issues include natural capital, climate change, environmental opportunities, and waste and pollution. Social score matters are categorized into four groups: product liability, human capital, social opportunities, and stakeholder opposition.
Further, the MSCI ESG rating system divides governance into two key categories: corporate behavior and corporate governance.
MSCI ESG score translates the numerical scores into ESG ratings. ESG ratings range from AAA to CCC. Top-ranking companies have AAA and AA scores.
A good ESG score means an organization manages its environmental, governance, and social risks better than its peers. While a poor ESG score means the organization has a higher vulnerability to ESG risks. Further, a good ESG rating can be a competitive edge for organizations. It can help attract sustainability-focused investors and consumers, showing an organization is dedicated to managing social, environmental, and governance risks.
ESG reporting, coupled with ESG ratings, helps investors and suppliers understand an organization’s long-term threats and priorities it may face in the future.
Third-party companies, known as EDG rating agencies, create ESG scoring systems. Each ESG rating agency has a unique set of criteria and methodology for assessing companies. Some ESG rating agencies like MSCI classify organizations as leaders, average, or laggards, while others use a 0-100.
The Financial Implications of ESG Risk
Although ESG reporting and data collection is the first step of an organization’s ESG journey, it doesn’t by itself result in financial improvement. McKinsey reports that strong ESG performance positively correlates with reduced downside risks and higher equity returns. Further, an analysis of more than 1,000 studies conducted between 2015 and 2020 shows that strong corporate management of ESG risks correlates to improved return on assets, return on equity, operational efficiency, stock price, and risk management. That makes a case for why moving ESG risk reporting into performance improvement and risk management can generate massive returns for organizations.
Here are more examples of performance improvement and ESG risk management can result in improved financial performance:
- Greenhouse gas emissions: Prioritizing assets to decarbonize depending on the potential for business disruption and emissions intensity can improve company revenue.
- Green products: Manufacture greener products and invest in lowering the carbon footprint of your existing portfolio to increase company revenue. According to McKinsey, over 70% of consumers are ready to spend more to buy green products.
- Operational risk: Establishing robust risk management systems that reduce incidents and facilitate a healthier workforce can help minimize operations downtime and boost productivity.
- Governance programs: Creating robust governance systems can help reduce regulatory and legal non-compliance, ensuring effective decision-making, ethical behavior, and compliance with rules and regulations. That protects your organization from facing hefty fines, penalties, lawsuits, and financial settlements, increasing company revenue.
Businesses that proactively integrate ESG risk factors into their business strategies will benefit from increased financial performance because they’re better positioned to reduce costs, manage risks, and capitalize on new market opportunities.
Effective ESG Risk Mitigation Strategies
ESG risk management plays a critical role in establishing sustainable supply chains. By efficiently managing ESG risks, companies can proactively address sustainability challenges, positively impacting the environment and society.
To proactively address ESG risks, you can implement a robust ESG risk mitigation program by:
- Conducting ESG risk assessments: Conduct thorough assessments of your organization’s supply chain and operations to discover potential ESG risks and opportunities. Engage with experts to collect data, perform stakeholder interviews, and examine existing policies and practices. Leveraging technology can speed up the assessment process and determine the possibility and potential impact of identified ESG risks.
- Remediate ESG risks and create execution plans: After conducting the ESG assessments, develop and execute strategies to address the identified risks and opportunities within an agreed timeframe. Prioritize mitigation measures based on the likelihood and potential of each ESG risk. For example, suppose you prioritize environmental risks connected to carbon emissions. In that case, your execution plan might include taking measures to reduce energy consumption, investing in carbon offset projects, or increasing renewable energy usage.
- Track and monitor ESG performance: Regularly track and monitor ESG performance based on relevant ESG metrics, like human rights best practices, emissions, and labor practices. Leverage technology to gather and analyze data efficiently. Engage with investors and suppliers to boost performance based on insights gained.
- Cooperate with suppliers: Team up with suppliers to improve their ESG sustainability and performance. Develop clear ESG standards and goals, offering necessary support and education to help suppliers meet those goals and standards. Provide ESG training to boost labor practices, environmental management, and governance best practices. Further, incentivize your suppliers by offering bonuses or long-term contracts for attaining specific ESG scores or standards.
By following the four steps, companies can proactively address ESG risks, promote social responsibility strategies, and drive sustainability throughout the supply chain. The use of technology and cooperation with suppliers play fundamental roles in effective ESG risk mitigation and achieving positive ESG outcomes.
Here’s a case study of a company that has implemented an effective ESG risk mitigation strategy.
Company Y: A global technology giant recognized the value of incorporating ESG risk mitigation into its operations. It implemented an ESG risk mitigation program to ensure sustainability and improve its reputation as a responsible corporate firm. By carrying out in-depth risk assessments of its supply chain partners’ adherence to sustainable practices, the company was able to identify potential ESG risks and mitigate them effectively. This systemic approach helped reduce operational disruptions and improved the company's resilience.
Transparency and Reporting: Building Trust
As ESG risks continue to gain importance in investment decision-making, the need for accurate reporting and transparency in ESG practices is paramount. Stakeholders, investors, and the general public increasingly demand greater accountability and transparency from businesses regarding their ESG performance.
Transparency is the clear and accurate disclosure of data related to an organization’s ESG performance. Transparent ESG reporting allows stakeholders and investors to evaluate an organization’s impact on society, the environment, and corporate governance. This improves trust and credibility, and it ultimately facilitates educated decision-making.
Here are reasons why transparency and accurate reporting are crucial in ESG risk management:
- Trust and credibility: Transparent and accountable ESG reporting helps businesses improve trust and build strong relationships with employees, investors, customers, and other stakeholders. It shows a business’s dedication to responsible and sustainable business practices and offers evidence of its ESG performance. That can improve an organization’s reputation and attract sustainable investment, customers, and talent who value ESG considerations.
- Stakeholder engagement: Transparent and accurate ESG reporting promotes meaningful engagement with stakeholders, like customers, investors, suppliers, communities, and employees. This allows organizations to communicate their ESG goals, challenges, and progress and collect stakeholder feedback. That engagement can help businesses uncover areas of improvement, build strong relationships, and address stakeholder concerns based on mutual understanding and trust.
- Educated decision-making: Transparency and open ESG reporting help investors make educated decisions based on a business’s ESG performance. It helps them to analyze an organization’s risks and opportunities related to ESG risk factors and align their investments with their sustainability objectives and values. Also, transparent reporting helps investors determine businesses that efficiently manage ESG risks and are well-placed for long-term success.
Transparency and accurate reporting of ESG risks are vital in ESG risk management as they help organizations build trust, make educated decisions, drive continuous improvement, and engage stakeholders. Organizations that are transparent and accountable in their ESG practices are well-placed to manage ESG risks, create long-term value, and capitalize on ESG opportunities. By prioritizing transparency and accurate reporting of ESG risks, businesses can demonstrate their dedication to responsible corporate citizenship and sustainability, contributing to a more inclusive and sustainable future for all stakeholders.
Conclusion: ESG Risk
Proper ESG risk management makes for less violated businesses and improves investor confidence. It also rewards businesses with positive brand equity, access to credit and debt markets, sustainable, long-term growth, and reinvestments.
ESG metrics and ratings are vital in helping organizations engage in efficient risk management and allow companies to improve voluntary disclosures, plan for compliance, and develop risk mitigation programs to proactively address risks.
When conducting an ESG risk assessment or any other risk assessment, the experienced team at RiskRecon by Mastercard can help. We can help you quickly identify, analyze, and mitigate ESG and cybersecurity risks facing your company. For more, request a demo here.