ESG Environmental Risks Overview

This is the first in a series of articles introducing the three components of ESG: Environmental Risk, Social Risk, and Governance Risk. 

Environmental, social, and governance (ESG) risk has become a significant consideration in risk management and a major concern for board members and other governance teams. ESG risk management addresses a company’s exposure to risks relating to commitments on environmental issues and sustainability, support for community welfare and social equity, and corporate governance. As stakeholders increasingly prioritize good corporate citizenship, environmental, social, and governance risk management has become a critical business goal, placing it directly within the scope of risk and audit professionals. Connecting ESG issues with operational objectives, business strategy, and organizational risk assessment will be challenging without clear guidance. Why Are Environmental Risks a Priority Now?

Over the past few years, news reports of environmental issues have been a daily occurrence. Environmental issues like unprecedented heatwaves, wildfires, hurricanes, and blizzards are impacting our lives, and according to a recent UN report, the impact will continue to worsen due largely to human-caused emissions. Artificial ecological disasters also worsen natural events. A toxic chemical containment pond was recently breached in Florida, and officials pumped millions of gallons of wastewater into the Gulf of Mexico. Not long after, a gas spill in a different part of the Gulf led to terrifying images of the water on fire. In the same body of water, a red tide (an overgrowth of red algae) exacerbated by the previously mentioned chemical runoff killed thousands of fish, sea turtles, dolphins, and manatees.

Environmental risks have only exacerbated corporate risks due to the interconnectedness between business operations and the natural world. As global concerns about climate change, resource depletion, and environmental degradation escalate, companies are recognizing that their operations and supply chains can impact, and be impacted by, the state of the environment. Changes in corporate sustainability strategy and corporate social responsibility plans have been evolving alongside the growing crisis. Regulatory changes, physical impacts like extreme weather events, and shifts in consumer preferences towards sustainable practices are among the factors contributing to the elevation of environmental risks to corporate risks. Additionally, investors and stakeholders increasingly consider a company’s environmental performance as a key factor in decision-making, making effective environmental risk management crucial for maintaining reputation, avoiding legal issues, and ensuring long-term resilience in an era where sustainability is integral to business success.

Is There a Financial Impact on Environmental Risk?

According to the US Federal Reserve, the effects of climate change “can result in direct financial risks, prompting a reassessment of asset values, changing the cost or availability of credit, or affecting the timing or reliability of cash flows. They can also create risks to economic activity, which can themselves create or amplify financial risks.” 

Businesses are devastated by natural events that are caused or worsened by climate change, and in the meantime, they bear the burden of increased insurance costs. For example, a Reuters article explains that wildfires in the US in 2020 “cost insurers a staggering $7 billion to $13 billion,” which is linked to climate change. They go on to explain “Ten years ago, this was a non-issue for (insurance firms). Now they’re saying ‘This is an extraordinary increase in our risk portfolio.’” The intertwining of environmental and financial factors underscores the urgency for businesses to proactively address and manage environmental risks to safeguard their long-term economic resilience – not only for them but for local communities and the resulting social impact a failed business can have. 

Other financial risks associated with climate change and environmental impact include regulatory penalties and compliance costs, supply chain disruptions, reputational risks, and energy and materials price volatility, and loss of investors. The regulatory and governance world is rapidly adapting to a new corporate status quo of emissions reporting schemes, ESG management, and climate goals. Compliance with new regulations can cost thousands of dollars – largely due to the time and resources it requires to undertake a greenhouse gas emissions accounting project or produce an ESG report. Supply chain disruptions, now more often due to extreme weather events, can cause production delays or increased costs for the same or alternative materials. This break in production can cost serious revenue for all parties in the value chain. Brand reputation is more important than ever; consumers can “vote with their dollars” and identify companies that share their values. Negative brand perception can lead to reduced market share and even a stock price devaluation. Energy prices and raw materials are subject to market volatility, and the volatility is only increasing. This can pose difficulties for financial planning and asset management, as well as ensuring consistent product/service offerings. 

Investors, including institutional investors, are becoming more conscious of how ESG risks, and more specifically environmental risks, can impact the bottom line, and ultimately, their investment decisions. With rising insurance costs, supply chain disruption, low-carbon transition costs and risks, regulatory risks, and a heightened awareness of reputational damage, there is a growing concern about investor returns. This has spurred the growth of ESG investing, otherwise known as socially responsible investing (SRI), sustainable investing, and impact investing, in which investors seek out companies who proactively manage their environmental and other ESG risks, and have third-party verification, like Morningstar, to add credibility to their risk management strategy and results through ESG ratings and ESG scores. Companies can also utilize frameworks for sustainability reporting, such as the Sustainability Accounting Standards Board (SASB) and MSCI, to increase their visibility in managing their carbon footprint and risk portfolio. 

What Is the Responsibility of Risk Management Professionals Regarding Environmental Risks?

Risk management professionals must ensure corporate objectives related to environmental commitments are met. Many organizations are making environmental commitments, like net-zero, or joining movements like The Climate Pledge. Once this kind of action is committed as a strategic objective, our responsibility is to evaluate the control environment to ensure these commitments happen. From a reputational risk perspective, failure to follow through will result in bad press, loss of customers, loss of investors, and damage to capital market dominance. Even worse, failure to hold up our commitments will create an even more significant impact on environmental issues and related financial risks in the long term. In essence, risk management professionals are charged with turning lofty goals and promises into actionable strategies. They are responsible for the resilience and long-term responsible growth of organizations. 

How Do You Start Assessing Environmental Risks?

To help you get started, use these six questions to assess the current situation for your organization’s environmental commitments:

1. Does your company have existing environmental commitments, targets, or goals?
   1. Identify and document any current commitments. This could include targets or objectives related to:
      1. Carbon emissions 
      2. Renewable energy portfolio
      3. Biodiversity, deforestation, and ecosystem damage
      4. Supply chain resiliency and human rights issues
      5. Water usage
      6. Waste management
2. Have the commitments been incorporated into the strategic objectives?
   1. These environmental commitments and goals need to be aligned with the company’s overall mission, vision, values, and strategy. Integration will ensure environmental risks are woven into strategic decision-making, and not being left behind or sacrificed. 
3. What monitoring programs or committees have been formed related to environmental commitments? 
   1.  Identifying internal teams or technology platforms to understand the structure behind these initiatives and to identify key contacts that can work cross-departmentally to communicate value and needs can progress these goals further and more efficiently.
4. How is the monitoring program actively assessing metrics and measuring risks to achieving these commitments?
   1. Understand the KPIs and ESG data your team is utilizing to progress towards these goals. This can include both quantitative and qualitative measurements which provide a more holistic view of environmental performance. 
5. What controls are in place to mitigate risks?
   1. Identify various policies, procedures, software providers, employee education, and others that are designed to prevent, mitigate, or manage risks within the organization. Begin assessing their effectiveness moving forward, and identify any gaps in control mechanisms. 
6. How is progress toward those environmental commitments reported to the board, shareholders, and other stakeholders?
   1. Evaluate the frequency of reporting, reporting mechanisms, and transparency and align this with stakeholder feedback. Effective communication will build trust and rapport with stakeholders, and honor shareholder rights, which will positively feed back into the reporting process. 

Using these questions to facilitate the conversation with the CEO, other senior management and board members will provide an excellent starting point in evaluating your organization’s current response to environmental risk and resulting social factors, and what ESG criteria is most material. The insights you gain from the conversations will enable you to assess whether environmental concerns are truly embedded into the strategic objectives, or if these are performative and misaligned in nature. Answering this question will reveal either commitment to a cause or a pending regulatory or financial risk. 

How Can We Overcome Top ESG Program Challenges?

Leading organizations have found their biggest challenges with managing an effective ESG program relate to:

• having one system of record to track all ESG initiatives & claims.
• evidence collection to substantiate the organization’s progress towards those public claims.
• selecting the appropriate framework(s) to map against.
• consolidating results for ESG reporting purposes, whether into stand-alone ESG reports or as part of their broader Annual reporting.

Whether you’re looking to start or accelerate your ESG journey, implementing connected ESG software can help your organization get on the right footing going forward in preparation for potential future requirements.