Environmental, Social, and Governance (ESG): Key Considerations and Benefits

In recent times, the importance of considering Environmental, Social, and Governance (ESG) factors in corporate decisions and investment has been acknowledged. As a result, ESG risk management has become a crucial area for companies to fulfil the expectations of their investors and stakeholders. The focus on ESG investing has increased, with ESG assets under management rising to $31.4 trillion in 2018, a 34% growth according to a report by the Global Sustainable Investment Alliance. More investors are expected to recognize the importance of ESG considerations in their investment decisions.

ESG risk management highlights the need for companies to incorporate ESG considerations into their overall business strategy, as failing to do so could result in reputational damage, lost opportunities, and increased regulatory scrutiny.

Stakeholder engagement plays a crucial role in ESG risk management, as companies must be transparent and engage with stakeholders such as investors, customers, employees, and local communities to understand their ESG concerns and expectations. This helps companies identify and prioritize ESG risks while building trust and support for their ESG initiatives.

A survey by the National Association of Corporate Directors in 2020 revealed that 86% of directors believe ESG factors are increasingly vital to their company’s overall risk management strategy. Therefore, it is crucial for companies to integrate ESG considerations into their overall business strategy to avoid reputational damage, missed opportunities, and regulatory scrutiny.

The Initial evolution of ESG

ESG was introduced in a report requested by the UN Secretary-General in 2005, and it has provided a structure for companies to incorporate environmental, social, and governance considerations into their asset management, securities brokerage services, and related research activities.

Over time, ESG has evolved from a desirable feature to an essential one, with stakeholders and investors expecting greater transparency in businesses’ operations worldwide, and regulatory authorities introducing frameworks and standards for disclosure. Initially, ESG focused on measuring a company’s environmental and social impact, but it now includes identifying and managing the climate, social, and governance-related risks that a company may encounter.

ESG risks refer to the possible negative consequences of a company’s operations and activities on the environment, society, and governance. These risks can manifest in various ways, such as environmental harm, human rights violations, and corruption. They can also significantly impact a company’s reputation and financial performance.

As ESG reporting gains importance, decision-makers face the challenge of analyzing large amounts of specialized data. Furthermore, since ESG reporting is not yet standardized, ESG scores and risk ratings provide valuable tools for investors and executives to evaluate a company’s ESG performance and risk management.

ESG rating providers leverage available data to calculate a company’s ESG score or risk rating. Each provider uses a unique approach to rate companies, and thus, what constitutes a good score can vary. Sustainalytics’ ESG Risk Rating aims to demonstrate a company’s exposure to a set of material ESG risks and its ability to manage those risks. A low-risk rating indicates effective risk management, while a high-risk rating suggests significant shortcomings in ESG risk management.

Key Consideration before Implying ESG in risk management

The way in which businesses approach good governance practices can vary, as each business is impacted differently. It is challenging to determine how best practices can affect business performance, and when conducting risk assessments, three main types of risk should be considered.

The first type of risk is transition risk, which is associated with global efforts to shift away from fossil fuels due to climate policies and laws. This type of risk includes policy and regulatory risks, technological risks, market risks, reputational hazards, and legal risks that could impact a company’s portfolio. Investors must consider these interrelated risks when navigating the more aggressive low-carbon agenda that could have implications for their assets.

The second type of risk is litigation risk, which arises from a company’s CO2 emissions. Companies that emit more CO2 than others are more likely to face class-action lawsuits and legal issues holding them accountable for contributing to global warming. Under the social category of ESG investing, falls the geopolitical events and labour issues that can prevent companies from producing or distributing their products. For instance, a drone strike on an oil refinery in Saudi Arabia briefly halted around 5% of global oil production.

Third, physical risks, such as extreme weather and record temperatures, are now recognized as events that can be predicted and factored into financial planning. Droughts, floods, excessive precipitation, and wildfires are acute threats, while rising temperatures, the spread of tropical pests, illnesses in temperate zones, and an accelerated loss of biodiversity are chronic concerns. Acute and chronic threats pose both idiosyncratic and systemic risks to investors.

Apart from the primary risks mentioned above, investors also need to consider the costs incurred due to political instability, conflicts arising from climate change, and supply chains that can be impacted by extreme weather occurrences. Although investors generally understand the importance of good governance practices, it can be challenging to determine how these practices can affect business performance and where they should be implemented. Types of governance risk can include:

Although most investors understand the importance of good governance practices, it can be challenging to determine how and where these practices can impact business performance. Governance risks can manifest in various forms, including:

• Compliance with ESG regulations
• Ethical conduct
• Transparency in communication
• Grievance procedures
• Preventing corruption and fraud
• Executive compensation
• Board structure and diversity
• Anticompetitive behaviour
• Policies and standards
• Tax compliance.

According to Gartner’s 2021 Emerging Risks Monitor Report, ESG regulatory risks have become a major concern for executives, ranking as the second-top concern in a poll of 153 senior executives. The report shows that ESG regulatory requirements present significant risks and opportunities for businesses due to a variety of issues such as climate-related disasters, tighter regulations around GHG emissions, and rising demand for renewable and sustainable energy.

To adhere to the latest regulations, firms and investment funds must adopt ESG strategies and frameworks from their top executives. They should commence by collectively charting out ESG tactics and dangers while collecting information on significant ESG metrics. The new suggestion from the Securities and Exchange Commission (SEC), which necessitates firms to report their climate hazards and greenhouse gas discharges in yearly SEC filings, will make companies maintain, organize, and strategize their ecological data in a more disciplined and organized manner.

While ESG frameworks have been established to help companies assess and disclose their susceptibility to ESG risks, there are still barriers to overcome, and most sustainability reporting is not useful to investors. Some of the most widely used ESG frameworks are the SASB Standards, the GRI, and the TCFD.

iRM’s role in ESG Risk Management

ESG frameworks can help businesses move beyond a compliance-focused approach and adopt proactive risk reduction measures that align with investors’ expectations. iRM offers solutions to help organizations:

• Identify and assess ESG risks effectively
• Ensure senior management takes responsibility for integrating and mitigating ESG risks
• Develop the necessary skills, knowledge, and expertise to manage risks
• Comply with regulations and prepare for new requirements
• Include ESG risks in internal and external reporting

By mitigating risks effectively, companies can achieve greater stability and build investors’ confidence, leading to increased access to credit and debt markets, better brand equity, reinvestments, and sustainable long-term growth. ESG data plays a crucial role in effective risk management, enabling companies to plan for compliance, improve voluntary disclosures, and create risk mitigation strategies to address threats proactively.

An ESG materiality assessment can help companies report on their current state and future initiatives while considering their business goals and risks. With investors increasingly asking about companies’ responsible investment practices, treatment of employees and vendors, sustainability initiatives, and other ESG activities, having answers to these questions is vital.

In summary, ESG risk management is a crucial focus area for companies in today’s rapidly changing business environment. It signals a new era of corporate responsibility, where companies are accountable for the impact of their operations on the environment, society, and governance. Companies that prioritize ESG risks and integrate ESG considerations into their risk management processes are likely to meet their stakeholders’ expectations and succeed in the long run. Book a demo with us by clicking here to know more.