It was whilst buying safety lights for my bike that I was reminded to do the second blog in this series. As I bought the lights, I thought about what it would be like to buy bicycle lights that produced some sort of disco effect, thereby getting more for one’s buck. Somehow, this then reminded me of the management of risks related to ESG issues in businesses. From having worked with organisations to reduce their ESG risks, I know that they then often start to reap rewards from the risk management processes themselves, getting more value then they originally bargained for. An analogy of bicycle safety with added entertainment, or perhaps I have been thinking about the sustainability business case too much?

Well, anyway… in the first blog in this series, I discussed the increasing demand by investors for ESG information on the companies they invest in, and some of the places they are gathering this information from. But why do investors gather this ESG information and how do they factor this data into their investment decisions? In more technical terms: what are the financial implications of ESG data and when are these factors sufficiently significant, or ‘material’, for an investor to take their money elsewhere?

A recent article in The Guardian quoted Neil Brown, SRI fund manager at Alliance Trust, saying, “successful investment requires an accurate analysis of risk and reward”[1]. I for one couldn’t agree more. We have witnessed from events globally that not accounting for ESG factors is in fact a misrepresentation of the real costs and impacts for businesses. As Steve Waygood from Aviva Investors stated at a talk attended by my colleague, climate change is the worst example of market failure. He also noted that in 89% of cases clients will have some sort of ESG related query. So things are changing.

ESG risks and rewards in a nutshell

A risk by any other name is still a risk. ESG issues generate risks. Many businesses are already incorporating some of these into their risk registers  –they link to reputational, contractual, operational, regulatory and resource cost risks. Rewards from managing these risks effectively include enhanced relationships with stakeholders, reduced resource costs, attracting new business and investment and enhanced working procedures.

Investment trends are changing with average holding periods increasing and investors looking at longer term, stable return investments. This usually co-incides with those companies that are managing there risks efficiently and effectively, with no hidden shocks.

Let’s start with a short-term risk that can be significant: natural resource costs. This is particularly the case in those sectors in which a natural resource constitutes an essential input to the business or use amounts to a comparatively high percentage of total costs.. Wholesale energy prices are increasing every year, water reserves are fast-shrinking, and timber and certain minerals are becoming harder to source and becoming subject to more stringent regulation.. Simply by implementing a series of energy saving programmes companies save significant sums of money. Take the DuPont energy optimization scheme, for instance. Also, the Carbon Action investor-led initative[2] found that carbon reduction activities are delivering an average Return On Investment of 33% or a payback in 3 years.

Reputational risk: a hidden risk. This risk can be split into two; a one-off event and stakeholder requirements. An example for the first is the ‘happy eggs’ saga. Do you know if your company has a risk down its supply chain relating to human rights infringements? People dismiss this risk by pointing to Primark, who were linked to the Bangladesh factory fire and collapse disaster and yet their profits and share price still went up. However, although this didn’t stop some customers shopping at Primark, what about others? By how much more would Primark’s share price and profits have increased if that hadn’t happened? Moreover, Primark has now given in to signing the ‘Bangladesh Fire and Building Safety Agreement’ and is now offering to pay compensation to the injured workers and families of those killed[3]. How does patching it all up compare to the cost of the risk management steps they could have taken? Not to mention bearing moral responsibility over the irrevocable damage caused.

Then there are employees, customers and investors who may have certain expectations or requirements of the companies they work for, buy from and invest in. These stakeholders are starting to assess ESG criteria in their job expectations, procurement processes and investment criteria respectively. Companies with higher brand risk are also learning from incidents such as the Primark one and starting to work down their supply chains to ensure that their suppliers comply with ESG codes and standards. This could therefore translate into significant contractual risk as well.

By engaging with these stakeholders on their requirements, organisations can understand their stakeholder expectations and start to focus on improving performance in those particular areas and enhancing their reputation with stakeholders.

How do investors enforce their requirements?

So investors want this information to analyse the potential for risk and reward. What happens if they think that companies are not sufficiently disclosing significant risks from ESG issues? They turn to disclosure programmes, direct information requests, proxy votes, resolutions, legal action or complaints to regulators. Even worse, they might just take their investment elsewhere. More on this next time.