Sustainability has become a major factor affecting businesses around the world. Through the three dimensions of the Environmental, Social and Governance framework, sustainability has been incorporated into the business activity of many companies and has become an important factor affecting financial decisions. In this context, ESG risks can have a significant impact on the long-term financial performance and reputation of companies.
ESG risks: a definition
The EU Regulation 2088/2019 on sustainability‐related disclosures in the financial services sector gives a definition of sustainability risks which states as follows:
“An environmental, social or governance event, or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment arising from an adverse sustainability impact.”
As environmental and social concerns have become increasingly important to stakeholders, including investors, ESG risks have emerged as a critical consideration for businesses.
An article published by Deloitte, based on the analysis of ESG risk factors and the reference regulation (Regulation on disclosure and EU Taxonomy) outlines three main domains of ESG risks:
Environment:
- Climate change
- Sustainable use and protection of water and marine resources
- Transition to a circular economy
- Waste prevention and recycling
- Pollution prevention control and protection of healthy ecosystems
Social:
- Equality
- Social cohesion
- Social integration
- Labour relations
Governance:
- Sound management structures
- Employee relations
- Remuneration of relevant staff
- Tax compliance
“Sustainability Risk may impact other risk domains, including Governance Risk (e.g. does the integration of Sustainability Risk have the required senior management oversight) Operational Risk (e.g. impacts of environmental events on operations), Regulatory Risk (e.g. compliance with the amended UCITS and AIFMD directives) and Conduct Risk (e.g. misrepresenting the carbon footprint of an investment product to attract greater investment).”
An important characteristic of ESG factors is its interdependency, meaning that a failure to manage one can lead to risks in another. For example, environmental risks such as climate change or water security can create social risks by disrupting communities and causing climatic migrations; governance risks such as corruption can lead to environmental risks by encouraging the exploitation of natural resources. This characteristic makes it necessary to consider holistically ESG risks in order to ensure effective management of their impacts on society and the environment.
Financial and Strategic implications of ESG risks
Business
As the consequences of climate change and other environmental and social phenomena start to manifest with a higher frequency, the necessity to evaluate and assess ESG risks has become impellent.
The U.S. NOAA has estimated that just in the United States since 1980 there have been 341 weather and climate disaster with a total cost of 2.475 trillion $. The increased rate of occurrence of environmental disasters in the late years has shown how relevant the matter is going to be in the next years, as the rate is going to continue to rise. These events may be generated by companies as in the case of BP’s Deepwater Horizon, which exploded in the Gulf of Mexico generating an environmental disaster with a tremendous impact on biodiversity. The incident caused a total cost estimate of 65 billion $. This case proves that ESG risks can impact a company's license to operate.
Governments, regulators, and civil society groups are increasingly scrutinizing companies' environmental and social impact, and those that fail to address ESG risks may face legal or reputational consequences, resulting in a loss of business opportunities, partnerships and customer loyalty.
Financial System
As climate change has become a risk to the stability of the financial system, regulators and central banks are developing frameworks in order to assess ESG risks in businesses. According to a report by the Global Sustainable Investment Alliance, global sustainable investment assets reached $35.3 trillion in 2020, up 15% from 2018. This trend is expected to continue as investors increasingly recognize the importance of ESG factors in driving long-term financial performance.
The recognition of the importance of sustainability in financial investments has fostered the birth of ESG rating frameworks, which systematically analyze and measure the environmental, social and governance aspects of a company, issuer, fund or country.
It summarizes information by assigning a score based on compliance with international sustainability guidelines, environmental impact, adherence to social values and corporate governance, and the level of risk a company faces regarding these factors.
Examples of such ratings are MSCI ESG Ratings, Sustainalytics, Standard Ethics, Refinitiv and Bloomberg.
ESG risks management
Given the importance of ESG risks, companies must take a proactive approach to manage them. This involves identifying and assessing ESG risks, developing strategies to mitigate them and reporting on their ESG performance.
Some key steps companies can take to manage ESG risks include:
- Conducting a materiality assessment to identify the most significant ESG risks and opportunities facing the business.
- Integrating ESG factors into the company's overall strategy
- Engaging with stakeholders, including investors, customers, employees and local communities to understand their expectations and concerns.
- Developing policies and procedures to address ESG risks, such as environmental management systems, human rights policies and anti-corruption policies.
- Reporting on the company's ESG performance, including progress towards goals and targets, providing transparent and accurate information to stakeholders.
By managing environmental, social and governance risks, companies can mitigate financial and reputational risks, attract and retain investors, maintain their license to operate and create value for all stakeholders. As the importance of ESG factors continues to grow, companies that fail to address ESG risks may be left behind.
