Getting Serious About ESG Risks

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environmental social and governance risks esg

Until recently, a company’s environmental, social and governance (ESG) approach was not considered a major concern for investors. But today, that perception has changed, with many stakeholders now realizing that these issues are critical to a company’s financial performance.

The increased focus on ESG has not been due to specific laws or regulations mandating a new level of disclosure, but rather a broader understanding of the reputational and financial impact of handling these issues poorly. Pressure from investors and the public has also spurred leaders to address the effect issues like climate change can have on the business and what they are doing to mitigate potential problems.

“ESG is now considered by investors to pose major financial risks,” said Kristen B. Sullivan, CPA, partner and leader of Deloitte & Touche’s sustainability services. “A decade ago, companies were under increasing pressure to provide information around their responsibility for impacting the environment. Now, this has evolved rapidly and dramatically to include the environment’s impact on their business, as well as the risks of social and governance issues.”

Pressured by large institutional investors and shareholders alike, many companies are being compelled to manage their ESG risks and disclose these activities in their 10-K and 10-Q financial reports. These risks run a wide gamut, including climate change, board gender composition, workplace culture, human rights, anti-bribery and anti-corruption efforts, data privacy, and, for some kinds of businesses, timely issues like gun violence and the opioid crisis.

“Investors perceive these issues as material to corporate performance, and they’re demanding disclosures to help them gauge the likelihood of a financial performance impact,” Sullivan said. “A systematic, integrated and intentional cross-enterprise approach is needed to normalize the evaluation of ESG risks and opportunities.”

A Narrative Unfolds

Unlike the more tangible operational risks that affect an organization’s performance, ESG was long considered a modest if not minor financial risk exposure. Consequently, little was done to assess the loss potential.

The increased emphasis on ESG has required some risk professionals to make adjustments to their risk management strategies. Unlike the more tangible operational risks that affect an organization’s performance, ESG was long considered a modest if not minor financial risk exposure. Consequently, little was done to assess the loss potential. But as the realities of climate change set in, businesses started to realize that reducing their carbon footprint was good for both the planet and the bottom line. Green companies adhering to sustainability principles became a preferred investment for private equity, hedge funds and institutional investors.

At the time, most companies had not evaluated the impact of climate change on their operations. Once they undertook these assessments, the risks became clearer. As large oil companies like Exxon, Occidental and PPL Corp. passed resolutions to disclose the risks that climate change posed to the business in their financial statements, companies in other industry sectors were pressured to do the same.

More recently, social and governance issues like workplace culture, executive behavior and data privacy have had an increasing material impact on corporate performance, affecting company reputations. Large institutional investors took notice. Larry Fink, CEO of BlackRock, the world’s largest asset management firm, was one of the first business leaders to acknowledge these changes, writing in his annual letter to investors in 2017 that a company’s ability to manage ESG matters was directly related to its sustainable long-term growth. Fink concluded his letter by stating that BlackRock would increasingly integrate ESG into its investment process.

Assembling an enterprise response to ESG disclosure demands is now falling to risk professionals like Jana Utter, vice president of enterprise risk management at Centene Corporation, a publicly traded managed care intermediary. A few years ago, Utter said, “I did some research and began to realize there was a movement out there picking up momentum, and we needed to get on top of it fast.”

She subsequently reached out to Centene’s investors relations leader, who said that the organization received a letter from FTSE Russell4Good, a stock market index that had begun to list public companies with strong ESG disclosures and mitigations. She learned that Centene was rated for ESG by Fidelity, which handles the company’s 401k retirement account, but no information was provided as to how Fidelity came to its conclusions. Utter conjectured that asset management firms had developed an algorithm that scoured the internet to piece together information on a company’s ESG approach. “At that moment, I realized we needed to take control of this narrative,” she said.

Taking Stock

Investors hate surprises, especially ones that dominate news cycles with negative attention. As that risk increases, they are demanding information about what companies’ exposures to ESG issues are and what they are doing about them.

To understand this impact of ESG issues, consider the example of Facebook. Following a string of data privacy scandals, including revelations that the social media giant had allowed research firm Cambridge Analytica to access users’ personal data without their permission, 26% of all users—including 44% of those between the ages of 18 and 29—deleted the Facebook app from their phones, according to a September 2018 survey by Pew Research Center. By that point, the company’s stock had already fallen more than 20% since January and some ESG-focused investment funds had decided to drop Facebook shares from their holdings.

Investors hate surprises, especially ones that dominate news cycles with negative attention. As that risk increases, they are demanding information about what companies’ exposures to ESG issues are and what they are doing about them. “Investors now give these risks the same attention they give traditional financial and operational metrics,” said Courteney Keatinge, director of ESG research at proxy advisory firm Glass Lewis & Co.

Large institutional investors like BlackRock, Vanguard and State Street Global Advisors (SSGA)—which together hold the stocks of 40% of publicly traded companies in the United States—have elevated ESG as a major financial performance exposure. The firms recently posted their shareholder voting decisions in advance of companies’ annual meetings for 2019, wanting to know specifically about what companies are doing to address priorities like climate change risks and employing more women in senior executive positions and on boards of directors.

Companies that take these demands seriously can do well by doing good. For example, Levi Strauss & Co. CEO Chip Bergh drew favorable attention by taking a stand in support of measures to end gun violence. When Nike featured former NFL quarterback Colin Kaepernick in advertisements, supporting him for his protests against racism and police brutality, the company’s stock reached an all-time high.

CEOs now increasingly speak up on polarizing social and governance issues that would have silenced their peers in the past. For example, Tim Cook of Apple, Jamie Dimon of JPMorgan Chase and Brian Moynihan of Bank of America publicly denounced the Trump administration’s immigration policies last August. A few months later, more than 50 companies including Apple, Amazon and Facebook signed a letter calling on President Trump to not roll back transgender rights.

For the most part, investors see value in such decisions, with some taking more direct action to advocate for social change as well. In 2017, for example, SSGA placed a bronze statue of a young girl staring down Wall Street’s famous charging bull statue in New York’s Financial District. While the “Fearless Girl” statue was initially conceived as a way to market an index fund of gender-diverse companies, it has also helped the investment firm raise awareness about the importance of gender diversity on corporate boards. SSGA called on the thousands of companies in its investment portfolio to increase the number of women on their corporate boards, announcing that it would be willing to use its proxy voting power if companies failed to act. The movement has since gained steam and, since the statue’s debut, SSGA reported that more than 420 companies worldwide have added a female director to their previously all-male boards.

SSGA is not alone in considering board gender composition to be material to a company’s long-term financial performance. According to a 2018 EY survey of 60 institutional investors collectively representing $32 trillion in assets under management, 82% consider this issue a management priority warranting disclosure, while 52% percent also want companies to disclose their workforce diversity and inclusion actions.

Long-standing issues like climate change also continue to concern investors. Nearly eight in ten (79%) respondents to the EY survey believe climate change is a significant business risk, with just under half (48%) stating that enhanced reporting of these risks is now a priority.

The reputational damage of not taking action on something that is material to a company’s long-term performance is substantial.

Companies can no longer sweep these issues under the rug. “The reputational damage of not taking action on something that is material to a company’s long-term performance is substantial,” said Suzanne Christensen, treasurer and head of investor relations and risk at independent investment management firm Invesco. “In the past, concerns centered mostly on sustainability issues. Now, the focus is equally on governance of such issues as board gender composition and workforce diversity and inclusion more broadly. For instance, we’re getting lots of investor questions around our culture and whether we’re perpetuating behaviors that may pose long-term risk.”

Invesco is far from alone in receiving and responding to such investor queries. A November 2018 special report by global communications marketing firm Edelman revealed that 89% percent of investors have changed their voting and engagement policies to be more attentive to ESG. After surveying more than 500 chief investment officers in five countries, the company stated, “ESG focus is now pervasive (and) companies should expect activism from all investors.”

This attention is not likely to dissipate. “Millennials care deeply about a lot of these issues,” explained Michael Gray, manager of ESG research at proxy advisory firm Institutional Shareholders Services. “If a company is deemed to be ignorant of their impact on the lives of millennials, there will be repercussions—people will simply decide not to buy that company’s products or invest in its stock.”

Getting Involved Now

Risk managers can think through the different facets of these risks, put appropriate mitigation and monitoring practices in place, and ensure accuracy and transparency in sending out the right message.

Against this backdrop, corporate risk professionals must partner with senior executive leaders, finance, investor relations and corporate communications to assess and mitigate ESG risks and put forth a robust disclosure strategy. “Risk managers can be instrumental in defining the risk governance and metrics ensuring that ESG is integrated into ERM in accordance with leading standards,” Sullivan said.

According to Christensen, who leads Invesco’s ERM strategy and regularly interacts with proxy advisory firms, external investors and analysts, “Risk managers can think through the different facets of these risks, put appropriate mitigation and monitoring practices in place, and ensure accuracy and transparency in sending out the right message. These are traditional risk management fundamentals, applied to a different space.”

Consistency in approach is crucial. “In some companies, one side of the house may not know what the other side of the house is doing, ESG-wise,” Keatinge said. “Lawyers get involved and muddy up what can and cannot be disclosed. Investor relations then fails to provide corporate communications with clear information on what can be disclosed or not, which affects the presentation of a clear communications strategy. This impasse is a very good place for risk officers to enter the picture to ensure consistent governance and disclosure.”

Risk managers who seize this opportunity have assistance in the form of the final draft of COSO’s ESG guidance document. The draft was released in October 2018 to help risk managers develop internal processes for identifying, assessing and managing ESG risks. The COSO guidance is “an effective tool with excellent case studies—a turning point really,” Sullivan said. “It’s designed to help risk officers integrate ESG into ERM in a very systematic way.”

Measure for Measure

With this information being used so much more by investors and the public in making their investment and buying decisions, credibility and accountability is critical.

An increasing number of resources are available to help improve ESG risk management, such as seminars from the Sustainability Accounting Standards Board, an independent nonprofit that disseminates sustainability standards to public companies to help disclose material ESG information to investors. Keatinge also noted the value of obtaining information from ESG data providers like MSCI and Sustainalytics, which help investors identify and understand a company’s material ESG risks, and provide research to businesses looking to improve ESG oversight and disclosure.

Since public opinion is such a big part of ESG risk management, monitoring consumer sentiment is a smart way to forestall brand damage in the event of a communications gaffe. To that end, artificial intelligence and machine learning tools can help identify negative social media comments before they go viral.

“An algorithm can be created to identify and analyze a series of words or images that may imply that a company is or isn’t socially aware,” said Sapna Nagaraj, director of machine learning and data science at BlackLine, a financial and accounting software automation provider. A company can similarly use artificial intelligence to track a particular sociocultural trend and then compare it to the company’s position on the subject. “The goal here is to ensure a company’s social conscience is in tune with changing public attitudes,” Nagaraj said.

Risk managers cannot ignore the seriousness of identifying, mitigating and reporting material ESG exposures. That is why Utter is partnering with Centene’s investor relations and corporate communications organizations to seize the company’s ESG narrative. “We now have a coordinated front in assessing and disclosing our exposures,” she said.

Other risk managers may find it similarly prudent to examine this growing financial risk. “Companies need to take ownership,” Sullivan said. “If they don’t have a credible story to tell, they won’t be able to control how the market will evaluate them. With this information being used so much more by investors and the public in making their investment and buying decisions, credibility and accountability is critical.”

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