How to Manage ESG Investor Risk (2024)

How to Manage ESG Investor Risk

Today, most companies have committed to managing and improving their environmental, social, and governance (ESG) risk profile to meet growing scrutiny and due diligence from investors, banks, regulators, and customers. In an era of climate change, global conflict, economic uncertainty, and social inequality, ESG has become one of the most important trends in capital allocation, risk management, and corporate value creation.

What is ESG Investment Risk?

ESG investor risk refers to potential financial losses or negative impacts that can result from investing in companies, assets, or industries that do not align with environmental, social, and governance (ESG) principles and market trends. This can include risks such as reputational damage, corporate governance failings, regulatory changes, climate risk, and shifts in consumer demand toward more sustainable products and services.

While ESG focuses on "non-financial" performance indicators compared to classic investor metrics like profit and earnings-per-share, ESG issues increasingly have material, financial impact on a company's access to capital, operating costs, and long-term competitive standing. ESG criteria give investors a holistic risk lens to evaluate a business or investment's key ESG-related risks.

ESG analyst scores and investment ratings are designed to capture and reflect an investment's ESG risk profile.

Why is ESG Risk Management Important to Investors?

ESG risk is important to investors because it lets them assess information about a company's performance in areas that matter for overall investor returns, but may not be included in a company's traditional financial reporting or an asset's capital profile, such as environmental impact, worker human rights and safety, and governance effectiveness. Investors use ESG data to assess the sustainability and long-term performance of a company or other investment, as well as identify areas where they can potentially reduce risk.

Exxon Mobil, Meta (Facebook), Twitter, Tesla, WeWork, Theranos, Volkswagen, Wells Fargo, and FTX are all cautionary, recent examples of companies whose share price and investor returns have been significantly influenced by ESG risk factors.

The Different Types and Categories of ESG Risk

For companies and other investments, there are five primary types of ESG investor risk:

1. Reputational risk: Companies that fail to properly manage their ESG risks may face negative public perception and reputational damage, leading to loss of customer trust and loyalty. When a company lacks robust ESG controls, actions, and disclosures, it's often viewed as not being "forward-looking" or "risk-conscious", which can hurt public brand perception and investment value.

2. Direct ESG financial risk: ESG risks can have significant financial implications for companies. For example, failure to properly manage environmental risks may result in regulatory fines or costly lawsuits. Labor violations, product recalls, or supply chain shortages can lead to lost sales, revenue, and customers.

3. Economic transition risk: Climate and biodiversity risk are both critical ESG focus themes today for companies, investors, and governments. As the world adapts to the impacts of climate change and transitions to a lower-carbon economy, assets and organizations that fail to adapt face long-term devaluation risk. Fossil fuel companies and assets, as well as companies that ignore important strategic trends like circular economy will be at a fundamental competitive and access-to-capital disadvantage long-term unless they adapt immediately. By comparison, companies that effectively manage their ESG risks will gain a competitive advantage over their peers and attract investors who prioritize ESG performance.

4. Legal and regulatory risk: Companies and investors that fail to properly manage their ESG risks may face legal action and penalties from regulators or other stakeholders. In the United States, the SEC (Securities and Exchange Commission) announced a plan in March 2022 called "The Enhancement and Standardization of Climate-Related Disclosures for Investors." The SEC's new climate disclosure framework will introduce mandatory climate risk reporting requirements for registered companies. In Europe, the Corporate Sustainability Reporting Directive (CSRD) is an upcoming set of EU sustainability reporting rules designed to make corporate sustainability reporting more standardized like financial accounting and reporting. Other countries and stock exchange operators, including Australia, Canada, Singapore, and the United Kingdom are also broadening climate risk rules for large companies, ESG investment funds, and financial institutions.

5. Acute physical risk: Many companies and assets are also exposed to acute physical risk, both directly and in their supply chains. For example, an insurance company might insure property near the ocean in a region where climate change is scientifically proven to increase storms and raise sea levels. Since climate change increases the risk those homes or buildings suffer weather damage, climate change creates material financial risk for that business which needs to be managed. A company that sources crops and food ingredients from a region prone to draughts, heat waves, or flooding due to climate change is also exposed to ESG risk.

In total, Fortune 500 companies carry an estimated $2 trillion+ in financial risk from climate impacts alone, based on outside-in analysis and company ESG reporting. The overall ESG risk exposure of the global economy is even larger.

ESG investment risk is also very company and asset-specific. Some companies have high ESG investor risk due to factors like their industry (examples: fossil fuel, mining, fast fashion), geographic location(s), corporate leadership and governance, business practices, or other areas. It's important for investors to perform their own materiality research and due diligence when assessing a company's ESG risk.

An Example of Company ESG Investment Risk: Coca-Cola

Since Coca-Cola is a globally-recognized drinks brand, we'll use them as a quick ESG investment risk case study example. Analysis of Coca-Cola's ESG risks might highlight:

Social consumer sustainability risk: As a leading producer of sugary beverages, Coca-Cola has faced criticism for contributing to global obesity and health issues. The company has made efforts to offer healthier beverage options, but these efforts may not be enough to address consumer purchasing shifts and growing concerns about the negative impact of sugary drinks on public health.

Water use and scarcity risk: Coca-Cola has faced criticism for its water usage and management practices, particularly in regions where water scarcity is an issue. The company has committed to improving its water stewardship, but water remains a material risk that Coca-Cola's operations may contribute to water depletion, environmental damage, and biodiversity loss.

Labor risk: Coca-Cola has been criticized for its labor practices in developing countries, where it has been accused of poor working conditions, low wages, and mistreatment of workers. The company has committed to improving its labor practices, but there is a risk that these efforts may not be sufficient.

Human rights risk: Coca-Cola has faced criticism for its operations in countries with poor human rights records, where it has been accused of contributing to human rights abuses and supporting governments that violate human rights. The company has committed to improving its human rights practices, but there is a risk that these efforts may not be sufficient to address these concerns.

Supply chain risk: Coca-Cola has a complex and global supply chain, which raises concerns about the company's ability to monitor and manage its suppliers. The company has committed to improving its supply chain practices, but there is a risk that these efforts may not be sufficient to address concerns about labor practices, environmental impacts, and other sourcing issues.

Regulatory risk: As more governments, ranging from California to the European Union aim to reduce plastic waste, Coca-Cola faces increasing accountability for its role in contributing to plastic waste and pollution. Coca-Cola has made commitments to reduce its plastic waste, but there are risks these efforts are insufficient compared to the organization's overall waste footprint and environmental impacts.

When deciding whether or not to invest in Coca-Cola's stock or buy its debt, ESG investors will evaluate and assess these different risks and their short-term and long-term impacts on Coca-Cola's business performance and competititiveness.

An Example of ESG Investor Risk Management: UPS

Sound, strategic ESG risk management can serve as an effective hedge against climate-related and other ESG financial risks. For example, UPS made an equity investment in UK electric van manufacturer Arrival, with plans to purchase 10,000 vehicles from the company. UPS's CFO estimates that if the world's largest cities become more congested and polluted, governments will increasingly look to reduce traffic and car emissions through congestion charges and vehicle restrictions. If UPS delivery vehicles can't access a city (or have to pay high fees to do so if they run on fossil fuels), the financial risks to UPS's business could be much higher than the costs of buying EVs.

By proactively investing in electric vehicles in key markets, UPS is actively managing and mitigating its long-term climate risks.

How to Reduce and Manage ESG Investor Risk

There are several steps that a company can take to reduce its ESG investment risk:

1. Conduct a thorough ESG materiality and risk assessment: This involves researching and evaluating the potential environmental, social, and governance (ESG) risks associated with the company's operations, products, and services. This assessment can help identify potential ESG risks and help the company take action to mitigate them. For more on ESG materiality, please read our guide here. Or feel free to contact us directly for materiality help or questions.
2. Develop an ESG risk management plan: This plan should outline the steps the company will take to manage and reduce its ESG risks. This can include implementing new ESG policies, initiatives, and procedures, investing in new technologies, divesting from high-risk ESG investments, or engaging with stakeholder groups to better understand and address ESG concerns.
3. Engage with stakeholders and investors: Actively listen to and engage with your company's key ESG stakeholders, including customers, employees, and investors, to better understand their concerns and priorities. This can help a company identify and address potential ESG risks and improve its overall ESG performance. Investor perspective on ESG risk is particularly important. We always recommend engaging investors during your materiality assessment, even if you're a private company. If your company is publicly-listed, review your top institutional shareholders. What are their ESG portfolio criteria and methodology? Are there any dedicated ESG strategy funds? What ESG issues are they focused on? Many larger institutional investors and fund managers like BlackRock, State Street, Fidelity, Vanguard and others post public information on their websites about their ESG criteria, voting approaches, and investment expectations. Be sure to review and familiarize yourself with that information.
4. Invest in sustainability initiatives: Invest in projects and initiatives related to renewable energy, reducing waste and emissions, and implementing more sustainable business practices. These initiatives can help the company reduce its ESG risk profile and improve its overall sustainability performance and perception.
5. Monitor and report on ESG performance: This involves regularly tracking and reporting on the company's ESG performance, including its progress in reducing ESG risks and improving sustainability. This can help the company identify areas for improvement and take action to reduce its ESG risks over time.

ESG risk management is a firm-wide, cross-disciplinary approach that starts from the top. It's critical that a company's board and C-suite are engaged in evaluating, assessing, and managing ESG risks, as well as allocating resources toward addressing them.

Why ESG Risk Management Matters for Every Company

Compared to quarterly earnings cycles and short-term decision-making, ESG is a longer-term lens on risks, opportunities, and value creation. But ESG also carries near-term, immediate consequences, particularly for companies who fail to consider and address material ESG considerations.

In particular, ineffective ESG creates investor risks across areas like:

In many ways, ESG performance has become a proxy for responsible management quality, brand reputation, and macroeconomic risk management. A well-run company that cares about its people, customers, and the environment will logically be more resilient over time and outperform its peers who don't.

The Importance of ESG in Perspective + Next Steps

While ESG risk management may feel like a complex, vauge obligation, dozens of case studies demonstrate that strong, thoughtful, and strategic ESG risk management and governance are competitive business advantages that deliver positive ROI. Many companies start ESG work due to compliance and investor reporting pressures, only to find that as their ESG investments, maturity, and capabilities evolve, their company realizes significant cross-company benefits and efficiencies.

Every company's ESG roadmap is different - and ESG risk management is a long-term, strategic journey for boards and management teams. Nonetheless, the benefits of strong ESG performance on brand reputation, employee talent attraction and retention, culture, operational efficiency, risk management, and access to capital are not only numerous - many are quantifiable. And, as always, if we can help your organization understand or improve your ESG risk management, please be in touch.