What is ESG and Why It's Important for Risk Management

ESG is changing the business world as stakeholders increasingly expect companies to make their operations more sustainable. There are good reasons to meet those expectations, but before starting out, it’s important to understand what ESG is and what it means for your company. In this blog post, we’ll look at basic ESG concepts, ESG scores and ratings, and why companies of all sizes need ESG risk management.

ESG Explained

Broadly, the term ESG refers to the examination of a company’s environmental, social, and governance practices, their impacts, and the company’s progress against benchmarks. An ESG program is a form of risk management. A wide range of stakeholders — from investors, lenders, and government agencies, to communities, customers, employees, and others — is looking at corporate ESG performance. For example, investors and lenders may rely on ESG data, including ESG scores or ratings, to assess a firm's risk exposure as well as its possible future financial performance. Communities and customers may want to know about a company’s environmental and social practices to inform their advocacy and purchasing decisions.

The Rise of ESG as a Framework for Sustainable Business

ESG gained the world’s attention following the 2005 UN-sponsored report, Who Cares Wins: Connecting Financial Markets to a Changing World. The report argued that embedding ESG considerations into capital markets would lead to better societal outcomes. The UN subsequently developed the (PRI) to be the standard for a sustainable global financial system. Since 2006, the number of signatories to the PRI has grown from 63 with US$6.5 trillion assets under management (AUM) to over 3,800 signatories with US$121 trillion AUM.ⁱ

CSR and ESG – Compatible, but Not the Same

Many firms already have corporate social responsibility (CSR) programs, which differ from ESG programs in specific ways. CSR initiatives are voluntary and tend to focus on improving a company’s relationships with external constituencies. For example, CSR managers might oversee corporate philanthropy or partnerships with community groups. ESG programs are generally implemented as a broader corporate strategy to address investor or regulatory demands. ESG practice involves fairly rigorous measuring and reporting on environmental, social, and corporate governance activities to understand the risks and impacts.

ESG Scores – The Topic on Every CEO’s Mind

With this new focus on ESG practice and reporting, decision-makers need to analyze immense amounts of specialized data. Adding to the challenge, ESG reporting is not yet standardized. This is where ESG scores and risk ratings are useful. An ESG rating and the information used to calculate the score provide investors and executives with tools to evaluate a company's ESG performance and risk management.

ESG ratings providers use available data to produce a company’s ESG score or risk rating. Each provider uses a different method to rate companies, so what is considered a good score can vary. Sustainalytics’ ESG Risk Rating aims to show how exposed a company is to a set of material ESG risks and how well it manages those risks. A low risk rating suggests risk is being managed effectively. A high risk rating indicates significant gaps in ESG risk management.

ESG Risk Management is Regular Risk Management

No matter the size of your company, your industry, or your ESG score, integrating ESG factors into corporate decision-making is good risk management. Every company faces a variety of ESG-related issues and some of them have the potential to be material and cause financial or reputational damage. Moreover, any company that neglects environmental, social, and governance issues is at increased risk of experiencing an ESG-related incidentⁱⁱ or controversy. In other words, ESG risk is regular business risk and ESG risk management should be part of a company’s standard risk reduction practices. Indeed, most companies are managing some of these risks even in the absence of a formally defined ESG program.

The Cost of Inaction

It’s important to build on existing risk management practices because negative ESG incidents are increasingly damaging and costly. Research has found companies that experienced high to severe ESG incidents lost 6% of their market capitalization on average. Consumer staples and utilities are at greatest risk of declining market value from ESG-related controversies.ⁱⁱⁱ This average hides the potentially disastrous effects of ESG controversies. For example, in 2015, pharmaceuticals company Valeant, once the most valuable on the Toronto Stock Exchange, lost 90% of its market value amid accounting and pricing scandals.^iv On the other hand, companies that implement effective ESG practices are less likely to face harmful controversies and are better able to respond when such incidents do occur.

Medium and smaller firms may not face the same stakeholder scrutiny or regulatory requirements, but the risk from ESG incidents applies to them as well — and can be much more damaging.  Without the backing of major investors, smaller companies may not be able to recover from harmful events. In short, ESG risk is material risk, and failing to address it promptly and appropriately can lead to a range of damaging consequences.

Managing ESG Risk Is Great for Everyone

While ESG may seem like a trendy new buzzword, your company has likely been managing some environmental, social, and corporate governance risks for years. The difference today is the urgency of the calls to address these issues — and the approach. Companies are under more pressure than ever to set clear targets to reduce risks, measure their progress effectively, and report in a transparent manner.

The great news is that managing ESG risk doesn’t have to be a burden and there are lots of services to turn to for help. The benefits of action far outweigh the costs of inaction, particularly for medium-sized companies, which can scarcely afford to experience a major ESG controversy. Many companies have already found that implementing an ESG program offers the rare opportunity to be good corporate citizens, while also doing what’s good for business. With this knowledge, companies can confidently get started addressing ESG risks.

Download our latest ebook to learn what every company needs to know to get started with ESG.

 

 

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Sources

ⁱ Principles for Responsible Investment (2021), “About the PRI,” PRI, accessed (14.02.2022) at: https://www.unpri.org/about-us/about-the-pri

ⁱⁱ Incidents refer to company activities that generate undesirable social or environmental effects.

ⁱⁱⁱ Morrow, D., Vezér, M., Apostol, A., Vosburg, K. (2017), “Understanding ESG Incidents: Key Lessons for Investors,” Sustainalytics, accessed (14.02.2022) at: https://connect.sustainalytics.com/understanding-esg-incidents-key-lessons-for-investors

^iv Goulet, J. (2017), “Potential ESG Risks in the US Health Care Industry,” Sustainalytics, accessed (23.02.2022) at: https://www.sustainalytics.com/esg-research/resource/investors-esg-blog/potential-esg-risks-in-the-us-health-care-industry