Integrating ESG into Risk Management

As published in the ISCA journal June 2022 issue.

MOVING FROM STRATEGY TO EXECUTION

The COVID-19 pandemic has taught us that we are not only connected to one another, we are also interdependent. As we gradually recover from the impact brought on by COVID-19, it is important that countries around the world work together to build a more resilient and sustainable global economy.

The United Nations Climate Change Conference (COP 26), held in October last year, was the first COP to feature a large contingent from the business community, sending the message that businesses have a key role to play in the fight against climate change. Businesses are moving the needle more quickly than governments in this regard, and there is hope that investors will ultimately compel action to implement climate policies.

A PURPOSE-LED APPROACH TO BUSINESS

For many years, the primary purpose of businesses has been profit, scale, and returns. Now, there is growing interest in how they got to where they are today and what they stand for or, simply put, their purpose. Businesses are being more carefully scrutinised by investors and other stakeholders, for their attitudes towards climate change, their sustainability efforts and commitment to the local community, and their investments in future generations. Today, investors care as much about a company’s approach to net zero as they do its business model, and potential employees may decide on joining a company based on its environmental, social and governance (ESG) as well as its diversity, equity and inclusion (DEI) policies.

With the increased demand for accountability, businesses need to be able to quantify and report on their sustainability efforts to measure up to the purpose that they define for their organisation. Increasingly, stakeholders are assessing businesses based on their non-financial impact to ensure that they have a purpose beyond profit – a purpose that also benefits society. Stakeholders are starting to expect high-quality, quantifiable information in areas such as social capital, human capital, and sustainability for strategic decision making.

ESG AS PART OF RISK MANAGEMENT

These ESG considerations are part of risk management. Although no single organisation can predict specific risks, it is critical to prepare for an uncertain or volatile future with threats such as climate change, technological disruption, geopolitical instability, and global supply chain disruptions. To assist organisations with the accurate reporting of information, the International Sustainability Standards Board (ISSB) has been formed to provide guidance on ESG disclosure and on mitigating the risks.

The following are some of the risks facing businesses today:

1) Environmental risk (Climate change)

When it comes to climate change, there are two kinds of risks. The first is physical risk – frequent extreme or unpredictable weather events, environmental degradation such as air, water or land pollution and deforestation are some examples.

Secondly, there are transition risks – financial losses incurred directly or indirectly as a result of the adjustment process towards a low-carbon and environmentally sustainable economy. For instance, businesses that deliver or require carbon-intensive fuels may experience higher costs as regulators seek to increase the price of carbon.

The far-reaching impact of climate change has led many of the world’s largest organisations to report exposure to physical or transition risks, while increasing stakeholder pressure has resulted in disinvestment in some carbon-intensive industries. Already, climate change plays a role in determining a business’ long-term creditworthiness due to potential losses in infrastructure and property. Due to this, the assessment of a business’ environmental profile has gone from being a “good to have” to being a key driver of decision making in terms of long-term strategy.

2) Social risk (Health and safety)

Environment, health and safety (EHS) management is a significant consideration under the social component of ESG concerns. EHS encompasses the health and safety of employees and their surroundings. Public and investor scrutiny of a business’ EHS management has increased since the pandemic – businesses that focused on employee wellbeing were publicly praised, and those that appeared to be putting their employees at unnecessary risks were criticised. This form of public scrutiny regarding EHS practices is likely to continue in the future, and this will have an impact on areas such as compensation claims, policies regarding protective gear at work, and other health and safety concerns specific to industry needs.

In addition, organisations must understand health and safety risks so that they can obtain the appropriate resources, implement the appropriate systems, and monitor performance to effectively control them. Identifying and ranking the risks is critical, and these risks must be communicated to all staff, to reduce the likelihood of an accident.

3) Governance risk

Governance risk refers to an organisation’s ethical and legal management. These include the transparent and accurate reporting of its performance, and its involvement in other ESG initiatives that are deemed important to stakeholders. The Board of Directors and its senior management manage these risks and set the tone and policies for the organisation. They also manage pressure from employees, investors, society, and politicians to influence the organisation’s leadership to take different actions.

Good risk management should include integrating ESG factors into corporate decision making. ESG risks should be treated like regular business risks and addressed as part of a standard risk reduction programme. In fact, most businesses are already managing at least some of these risks, albeit without a formally defined ESG programme.

QUANTIFYING ESG RISKS

How should businesses quantify ESG risks?

Today, valuation professionals are using data to quantify risk and opportunity associated with ESG to help drive capital allocation and decision making. In establishing a framework that includes both financial benefits and values aligned with ESG goals, business leaders can move one step closer to making decisions that create value and benefit the environment.

The following case studies show certain scenarios of how risks can be quantified with data.

Case study 1

During a risk assessment and review of its supply chain, company A discovers that its supplier has employment practices that fall far below international standards. In light of this, Company A decides to terminate its contract with that supplier. The new supplier has employment practices that comply with international norms, and the price per unit of raw materials from this supplier is 30% higher than the old supplier. As a consequence of terminating its contract with the old supplier, company A expects its costs to increase by 30% and its profit margin to decrease by 30%. The disclosure requirements on the consequences of changing suppliers are not presently required by the current International Financial Reporting Standards (IFRS) standards, but this is being proposed in the exposure draft for the new IFRS S1 and S2 standards.

Case study 2

Company X has a production facility that generates high levels of greenhouse gas (GHG) emissions. The local state government has issued a new regulation, effective 2023, stipulating that any facility that emits more than a certain amount of GHGs will be hit with hefty fines. Company X’s risk assessment identified this as a transition risk, and it decided to close the facility; the restructuring plan was announced to its employees and the public. Affected assets could experience accelerated depreciation as a result of this announcement and an impairment charge could be included in the profit and loss statement if relevant. As the company also disclosed that its restructuring plans may involve job losses and retrenchments, the restructuring liabilities would be recorded if the criteria in the International Accounting Standards (IAS) 37 Provision, Contingent Liabilities, and Contingent Assets were met.

ESG IN PRACTICE – WHO LEADS?

To move from pledge to action, businesses must be functionally set up to respond to, and deal with, ESG-related opportunities, challenges and risks. At a practical level, this requires an operating model that facilitates visibility, accountability and collaboration among departments, across a clear governance structure.

If organisations do not yet allow for a high level of collaboration and interaction among departments and business units, they will have difficulty demonstrating how ESG issues figure in their strategic planning, budgeting, and forecasting processes. Information should flow freely up and down the organisational structure. An effective leader must be able to look into the business and ensure that its public commitments are understood and are being carried out.

A similar flow of information must also come back up from the operational team in the form of risk registers, internal audits, operational plans, and capital commitments that show how well teams are doing. Digital transformation will go some way towards this, as it makes timely and critical information transparent, and readily available. Accessible engagement structures provide a means for key stakeholders to discuss plans and progress over time, which helps to promote more cohesive and responsive approaches.

As with many organisational transformations, ESG will require individuals to change their behaviour. The way people are rewarded will play a significant role in this transformation. To be successful, organisations have to create accountability through individual and functional incentives that are aligned with the ESG agenda.

In the past, sustainability and corporate social responsibility (CSR) agendas were led by a sustainability leader either at the executive level or were reported to a senior decision maker. As ESG gains importance, its implications are greater than ever, encompassing areas such as investor relations, finance, human resources, operations, supply chain, corporate communications, and corporate development. Therefore, identifying the stakeholders within the organisation responsible for leading the various dimensions of ESG strategy is fast becoming a key challenge for most businesses.

Today, many organisations have dedicated teams to look after environmental and safety issues, often with a Chief Sustainability Officer overseeing them. It is, however, essential that operational teams are properly connected to corporate strategies; this fosters the understanding that ESG commitments are non-negotiable, and that the transition from ESG commitments to business or operational processes is clearly outlined. Typically, the sustainability function is well represented at the executive level. For example, a Vice President or Executive Vice President of Sustainability may lead sustainability in large or multinational companies.

However, the Chief Financial Officer (CFO) may also take responsibility for the ESG agenda to be accountable to investors and analysts. CFOs are well suited for this position as they have easy access to several departments such as Finance, Accounting, Operations, Marketing, Human Resources and Research & Development. The CFO can also play a leading role in establishing a transparent infrastructure by designing and implementing sustainability dashboards for information exchange, monitoring, and reporting. CFOs are not just key stakeholders in this area, they are also poised to lead due to their organisational network and indepth understanding of data, processes, and reports. Furthermore, CFOs can align ESG issues with their organisation’s profitability goals. Hence, expanding the role of the CFO to take on sustainability is a core solution for organisations to satisfy internal and external demands as well as ensure long-term success.

VIEWING ESG AS AN OPPORTUNITY

Regardless of how an organisation’s ESG journey began – responding to a reporting requirement or refreshing a top-down strategy – one can expect a comprehensive reappraisal of the operations, activities, and the outcomes across the business. Multiple stakeholders from investors and shareholders to governments, policymakers, employees, suppliers, customers, and society are continuing to push businesses to address ESG challenges and opportunities. The pressure for organisations to address sustainability concerns will only grow.

Even though there is an increasing sense that sustainability risks must be identified and managed, we should not lose sight of the enormous opportunities presented by the scale of sustainability transformation everywhere. Sustainability presents opportunities to identify and grasp new sources of value creation for organisations, and accountancy-trained professionals are best positioned to step up and seize these opportunities.