ESG Risks: What They Are and How to Manage Them Best

ESG risks are those arising from environmental, social and governance factors that a company must be able to address and manage.

These risks, in fact, are a combination of threats - but also opportunities if considered in a mirror way - that can have a significant impact on the profitability, reputation and long-term sustainability of a company.

It is no coincidence that ESG reporting has become a fundamental pillar of corporate well-being, thanks to its influence on critical stakeholders.

According to research (from 2021) by the US financial consultancy firm Gartner, 85% of investors consider ESG factors in their due diligence. Employees and customers are also increasingly paying attention to these parameters, with 66% of consumers saying they would pay more for sustainable products.

For listed companies, failure to meet investors’ expectations on ESG criteria could lead to a devaluation of shares and force the company to spend additional time, resources and money to try to regain trust.

As a result, companies today are forced to set ambitious and concrete ESG targets, with an efficient strategy also to address risks related to ESG sectors.

ESG risks, what are they? Meaning

In order to clarify what are the risks associated with ESG, it is necessary to define the three parameters (Environmental, Social, Governance):

• Environmental parameter: it falls under the broad spectrum of the fight against climate change. To achieve the ambitious goals set by the States, the business sector must act responsibly towards the environment. In this context, the data that is analyzed to create the ranking on the sustainability of companies concern, among other things, the management of vital resources (such as water and air), respect for biodiversity, agri-food safety and the containment of carbon dioxide emissions;

• Social parameter: refers to how the business activity has a social impact and therefore on the community. The parameters aim to detect, for example, a company’s compliance with civil rights and labor rights, the maintenance of a labor standard in accordance with the law, compliance with laws relating to child labor and the broader field of social equality;

• Governance parameter: the last parameter concerns the responsibility of corporate governance. This is particularly important because the management of a company - carried out in a correct, fair and transparent manner - gives external observers crucial indications about its corporate identity. Therefore, the wages, the respect for meritocracy and shareholders’ rights, the remuneration of the executive committee and the quality and diversity of the latter end up under observation.

How do these ESG criteria relate to corporate risks? The answer is, in a nutshell, given by this definition:

ESG risk refers to the potential negative consequences that environmental, social and governance issues can have on a company’s capital and earnings. These risks arise from a company’s activities and can affect its reputation, legal standing and operational performance.

Examples of ESG risks include: pollution and waste management issues, poor labor practices and community displacement, unethical behavior or lack of transparency. Each type of risk can impact a company’s reputation, legal standing and operational efficiency.

How to quantify ESG risk

Unlike traditional risk management, ESG risk is more based on qualitative aspects.

In the first case, it is important for companies to understand and above all evaluate what impact a certain event can have and how likely it is to occur; however complex, this operation is possible by using some mathematical models.

An example of this could be an unexpected interruption of the company’s supply chain that forces them to temporarily block their sales, risking losing opportunities or customers.

To prevent this from happening, many companies have a team of people who study these variables to mitigate the risk of this happening and try to avoid complications.

In the ESG field this does not work in the same way: in fact, the impact for the company is mostly reputational, it is therefore not possible to calculate such a risk using the same methods and the same variables.

However, this is far from impossible: those who invest in companies of this type can assess ESG risk through a mix of qualitative and quantitative analyses, which are less precise but still indicative of corporate behavior.

An example of this can be represented by a company that has an excellent track record in its history. Furthermore, today there are specific ESG ratings that evaluate corporate performance according to the three parameters: the higher it is, the greater the ability to manage any risks or to avoid running into threats related to those specific issues.

What is the ESG risk rating and why is it important

The ESG risk score, also known as the ESG risk rating, is a quantitative tool that measures a company’s exposure to environmental, social and governance risks.

The score evaluates the organization’s ability to balance its financial performance with sustainability risks.

Independent firms such as Bloomberg, MSCI, Refinitiv and JUST Capital calculate ESG ratings for different companies.

Each agency has its own way of calculating and scoring, using algorithms and analytics to convert ESG metrics into separate environmental, social and governance scores and then into a single primary rating. Most agencies assign scores on a 100-point scale, with a higher score indicating better ESG risk management.

Why is the score important? It is an integral part of the decision-making process for sustainability-minded investors, allowing them to assess a company’s reputation. This in turn can influence investment decisions, as companies with higher ESG scores are often seen as safer and more responsible investments.

In addition, a good ESG risk score can provide a competitive advantage for companies. It can attract investors and customers who are more sustainability-minded and demonstrate that the company is committed to the responsible management of environmental, social and governance risks.

ESG Risks and Financial Consequences: Examples

To understand how crucial ESG factors have become to business and the success of companies and, therefore, the risks associated with them can negatively impact, we can give some examples.

Asking executives to “do more,” hundreds of Amazon workers protested last year against what they called the company’s lack of progress on climate goals and the decision to return to the office considered unfair. The event is obviously damaging to the giant’s image and profit.

At the same time, there is a reason why employees consistently cite the sportswear company Patagonia as one of the best places to work in the United States. Many of the best business schools study Patagonia’s ESG-focused business model. In 2019, the company had a surprisingly low employee turnover rate of 4%. This translates into a very low risk of failure or negative impact on the business.

As an analysis by Dbrs and Morningstar shows, the ESG-related risks are many and all with knock-on effects on finance and politics. For example, in the environmental field:

• an airline will face increasing social pressure if greenhouse gas emissions from its flights continue to rise;
• a mining company will face cleanup costs or regulatory penalties if it dumps waste into a river;
• the forestry industry that over-exploits old-growth forests will lead to future shortages and price volatility

In the social sector, examples of negative impacts to companies from ESG risks include:

• if workers are unhappy and go on strike, it will impact profits and consumer relations;
• doing business with companies that do not respect fundamental human rights could have a significant impact on the company’s reputation;
• selling defective products and services can result in large fines and negatively impact the value of the company’s franchise

Finally, in the governance sector, these negative mechanisms can be triggered:

• if the company is involved in corruption, it will likely be subject to regulatory sanctions, lawsuits and fines, which could jeopardize the franchise

A 2022 survey by EY found that nearly 70% of companies achieved better-than-expected financial returns due to beneficial climate initiatives.

Furthermore, corporate activities that support the Sustainable Development Goals represent 53% of the revenues of the 500 largest U.S. companies and 49% of the revenues of the 1,200 largest global companies, according to research by S&P Global.

Adopting a proactive ESG strategy and transparently sharing relevant data demonstrates to investors that a company is thinking about the longevity of the business and its reputation.

How to avoid risks

Avoiding risks is never easy, because, especially as investors, they are everywhere. However, it is possible to try to mitigate them, making the possibility of having unpleasant surprises less likely.

If you decide to invest, for example, in ESG funds, it is necessary to study the history of the company well and try to understand its social behavior, preferably avoiding those that show opaque attitudes.

As a customer, if you decide to purchase products with an eye on the importance of ESG issues, you need to know the history of the brand you are dealing with, taking into account how its production impacts the environment, its social behavior and its corporate governance.

However, it is possible that sometimes you realize that you have turned to a unsustainable brand or that it has acquired a terrible track record. In which case, it is sufficient to turn to a brand more aligned with ESG issues.

Original article published on Money.it Italy. Original title: Rischi ESG, cosa sono e come gestirli al meglio