How ESG Has Evolved into Risk Management and How You Can Prepare

With roots in corporate social responsibility (CSR) and the environmental movement, ESG (environmental, social, governance) is now a complex undertaking that not only takes into account an organization’s impact on society and the environment but also identifies the risks posed by climate change and evolving attitudes toward environmental, social, and governance-related issues.

Read on to learn how companies can start to integrate risk management into ESG and align ESG risk with corporate decision-making.

The Evolution of ESG

Since the term ESG was first coined in a 2005 report commissioned by United Nations Secretary-General, it has been a guide for organizations to better integrate environmental, social, and governance issues in asset management, securities brokerage services, and associated research functions.

Over the years, ESG has transformed from a nice-to-have to a must-have. Now, stakeholders and investors demand greater transparency in the operations of businesses around the world, and regulatory bodies introduce frameworks and standards for disclosure.

But where ESG initially measured a company’s environmental and social impact, it now also includes identifying and managing climate, social, and governance-related risks a company faces.

Risk Management in the ESG Era

The top five global threats identified in the World Economic Forum’s 2022 Global Risks Report are unanimously climate-related. As worldwide attention shifts to climate issues, there is growing consensus that climate risk is a business risk.

In recent times, mainly due to the work of the Task Force on Climate-Related Financial Disclosures (TCFD), it has become widely accepted that climate-related impacts on a company can be material and require disclosure. Taking this idea one step further, the concept of double materiality outlines that an organization’s impact on the climate or the environment can also be material. Additionally, climate-related impacts extend beyond the environment to people, resulting in the increasing convergence of the “E” and the “S” of ESG.

ESG Risks

Managed poorly, ESG issues can potentially cause legal, financial or reputational damage. ESG risks fall into three pillars, and each organization will face issues specific to its industry and operations.

• Environmental risks can include concerns related to the global transition toward a greener future, such as climate change impact mitigation and adaptation strategies, as well as the physical risks posed by a changing climate, such as drought, natural disasters, and agricultural disruption
• Social risks can include working and safety conditions and respect for human rights, diversity, equity, and inclusion efforts
• Governance risks cover concerns such as anti-bribery and corruption practices and compliance with relevant laws and regulations

ESG Scandals

As ESG becomes a major concern of consumers and stakeholders, more examples of bad practices are surfacing, and the brands involved are coming under fire. Controversies such as Volkswagen’s emissions scandal and BP’s Deepwater Horizon oil spill serve as warnings for brands not yet taking ESG risk assessments and management seriously. There has also been a spike in the number of companies being slapped with greenwashing fines.

External Risk

Scandals and controversies about environmental or social impact aren’t the only ESG risks an organization can face; growing risks from external environmental factors are equally prevalent. For example, a fashion brand relying on water-heavy fibers, such as cotton, from drought-prone areas can face short supplies if a drought impacts crop growth. Even a future price on carbon could spell disaster for firms that aren’t yet accounting for their carbon emissions. An HBR article by Eccles and Mulliken suggested that a $100/ton price on carbon would cost ExxonMobil $11 billion annually: $3 billion more than its average annual revenue.

Disclosure and Compliance Risk

Based on recent global climate commitments, ESG disclosure requirements around the world are likely to become more rigorous, and companies will be required to invest significantly in data collection and reporting and should expect to be scrutinized more heavily by a wide range of stakeholders. Disclosure failures or inaccuracies could also lead to legal and financial liability; in 2023, effective data collection and reporting accuracy should be a key focus area for firms.

Missed Opportunities

Even if a company has yet to experience the consequences of ESG risks, failing to identify, disclose, and address these threats adequately can lead to missing out on key business and investment opportunities. As more institutional investors capitalize on ESG investing, these key risk assessments will be integrated into the heart of due diligence and investment screening procedures.

Aligning ESG with Environmental Resources Management

As organizations become more sophisticated in their ESG data collection and reporting, risk management becomes a vital part of their ESG strategies. Companies must first identify ESG risks material to their operations, and then work to prevent or mitigate the potential impact of these threats through adequate planning and management.

In turn, ESG risk factors can and should be integrated into a company’s corporate decision-making and enterprise risk management (ERM). Smart organizations are looking to not just address risk as part of ESG, but to fully align their existing risk management frameworks and decisions with ESG strategies. Doing so can unlock the true power of ESG, transforming it from a fringe consideration (often at odds with other corporate goals) into the heart of a company’s corporate strategy.

Identifying Material ESG Risks

To determine material issues, companies can start with an all-encompassing list of ESG issues. Organizations should consider the impact these issues could have on each of its activities, products, services, and relationships and their potential effect on employees, local communities, investors, customers, and the environment.

Once identified, these issues can be ranked by priority to pinpoint the key areas the organization should report on. These material issues should be assessed based on their influence on stakeholder decisions as well as the economic, environmental, and social impacts. Prior to gathering information to report, it is essential to ensure that the key aspects identified provide a comprehensive overall view of the organization’s ESG performance and impacts — is each topic relevant and material to the company, and is nothing obvious missing? Once reports are published, review material topics to incorporate stakeholder feedback.

Materiality Assessments

Materiality assessments are a helpful exercise for determining which ESG risks apply to a company’s operations and what is important to its internal and external stakeholders. Understanding how economic, social, and environmental impacts are perceived along the entire value chain requires extensive stakeholder engagement and data gathering.

Materiality assessments should also examine what these ESG risks and opportunities look like in the future and enable organizations to make projections. The insights gained from these interactions and research can help you capture a business’s non-financial impacts, prioritize which impacts to focus on, and guide strategic thinking and communication.

Understanding what is important to stakeholders is not a one-time activity. Since materiality is dynamic in nature, assessments should be repeated frequently (ideally, every year or every few years) to track changes in stakeholder priorities and sentiment.

ESG Risk Management is Good for Business

The verdict is clear: ESG risk management is not just a compliance activity — it’s good for business. Rather than protest the cost of ESG, organizations must consider the cost of inaction, and what ignoring red flags and bad practices can cost in the long run.