Incorporating ESG-related Risks and Opportunities into Strategy Formulation and Operations Management
@ the IERP® Global Conference, August 2023
“I am neither a risk practitioner nor a corporate practitioner, so I will have to focus on the strategic landscape of ESG and how it translates into strategy formulation at the operational level,” said speaker Dr Alizan Mahadi, Senior Director (Research), Institute of Strategic & International Studies (ISIS) , as he began his presentation. He focused on the ‘E’ of ESG, the environment being his area of expertise. “There may have been too much focus on this already but this is the most dynamic area in terms of policy decisions because we are in the fastest pace of transition the world has ever seen,” he explained.
His presentation covered an overview of the environment and climate risks; the relevance of strategy formulation; its relevance for operations management; and the way forward, together with concluding thoughts. “Although climate change has always been seen as an intergenerational or long-term issue, the world was already facing it now”, he said, describing it as “global boiling, no more global warming.” Malaysia has not been immune; disastrous floods in 2021 resulted in deaths and RM6.1 billion in damage. Environmental risks have steadily risen to the top of the risk list, and natural disasters are becoming more frequent and intense.
Environmental risks are at the top of the list; natural disasters are becoming more frequent and intense, disrupting farming cycles and affecting the food supply chain and affecting economies. Climate change is also causing large-scale migration as weather events like drought, floods, landslides, earthquakes, and tsunami displace people or cause them to move away. “If the monsoons get worse, internal migration will increase,” Dr Alizan said, adding that responses to physical risks now had to be applied at domestic as well as global levels. This has led to international policies being translated into domestic ones.
Private policies were also being formed in connection with ESG, but ESG was driven primarily by investments, and had nothing to do with governments. “ESG is driven by investments and private policy formation,” he said. “It is a private initiative. Governments can help in capacity-building for ESG but it is being privately driven across the world and is causing ripples. That’s why we are talking about it today.” Shifts in stakeholder sentiment necessitated better ways of measuring ESG, and keeping continuously updated on the latest targets and regulations. There was a need to look into the transition list, follow up closely and understand how it related to specific contexts at individual levels.
There was a lot of pressure for this kind of ESG compliance; not just domestically but from other countries as well. Employees may also pressure their employers to comply. Additionally, it has given rise to the appearance of ‘activist shareholders’ on the boards of companies. While the physical risks and acute impacts of events such as floods, droughts and wildfires undoubtedly affect industry, there was also a real need to look at the transition risks which included changes in terms of policies, regulations, technologies, market and reputation, he said. However, there were also opportunities organisations could leverage on, such as resource efficiency, new energy resources, products, services and markets.
Noting that these were opportunities to increase resilience, he said that they would have a financial impact on organisations, affecting revenue and assessments, for instance. Compliance was another major challenge. “There is a lot that firms must do, to comply with ESG,” he said. “Target-setting, for instance, complying with targets and principles of the UN Global Compact, and with various standards like the GRI accounting, materiality and emissions requirements.” Stringent reporting and good governance are a must; reports need to be published for stakeholders as well. He acknowledged the need to balance the cost of compliance with the actual increase in revenue.
Globally, more than a hundred countries, including Malaysia, have committed to achieving net zero by 2050. Organisations must ask themselves what the implications of achieving net zero are, and how their ESG compliance will affect strategy formulation. Expressing scepticism over the push for compliance, he said that it was basically to level the playing field. “Countries which have net zero pledges and carbon pricing are doing this by ensuring that other countries comply with their regulations,” he said. “There is a real need to assess the risk of countries applying their policies to smaller countries with open economies like Malaysia.”
This approach has also led to the establishment of a ‘Climate Club’ for countries for the harmonisation of emissions. “Those within the Club will have a non-tariff rate,” he pointed out. “Those outside the Club who have not complied with emission reduction will have to deal with the imposition of tariffs – maybe 3% or so – on imports. Members in the Club will have a favoured rate; you are either inside the Club, or outside it. You are either part of the supply chain or outside the supply chain.” There was also a race to be in the Club, he said, because if a country was not in the Club, its access to funds could be limited.
Advocating for every firm to have not a net zero policy but a science-based target that would support the achievement of net zero emissions, he said there was an increasing trend of carbon pricing policies being enacted around the world. Malaysia too was in the process of considering a carbon tax or carbon trade scheme. While World Bank statistics show that 32 national carbon pricing policies are in place globally, those countries which already have a carbon policy are more likely to apply their carbon pricing policy to products and services that enter their countries. Countries which trade with EU countries will have to be part of the EU’s Carbon Border Adjustment Mechanism (CBAM) scheme.
“It starts with carbon-intensive industries like steel, aluminium, cement, fertilisers, electricity etc, and later expands to cover more,” he said, stressing that before talking about the impact of carbon-intensive industries, carbon emissions first needed to be measured. Only then can they be quantified according to accounting principles and regulatory compliance. But Dr Alizan had more important advice. “Sometimes when we talk about ESG, the focus is on reporting only,” he said. “But the landscape is shifting; it’s very dynamic, with closer scrutiny. It’s now not enough to (just) comply with ESG standards – it’s more important to look into firms’ contributions to ESG.”
Investors were now calling for Scope 3 emissions to be accounted for. This, he said, was a game changer because it meant that firms had to account for emissions at supply chain level. “Large corporations and GLCs will have a major task because even accounting for your own emissions is difficult enough,” he cautioned. “Accounting for your supply chain’s emissions will be an incredibly tough task but it is being increasingly talked about at the international level.” A diverse set of stakeholders within ESG – employees, board members, customers, shareholders, investors, government and regulators, public citizens, insurers, media, NGOs, lenders – had to be managed.
The increasing scrutiny on ESG was to avoid the possibility of greenwashing; stakeholders were insisting on consistent, transparent reporting that was sincere and accurate. ESG reports usually cater for investors; they do not cater for a wider range of stakeholders. “There is a need to understand the needs of each stakeholder,” he said. “In terms of operational risk (for example), the main risk when it comes to climate change is the impact of climate change – floods, drought…impacts on dams and food security, coastal erosion, protection of biodiversity etc. Every industry situated along the coast should understand how this will affect their operations.”
However, even with the multitude of ways in which climate change, for instance, can affect a company’s operations, there are opportunities when it comes operationalising ESG, he said. “Energy efficiency, resource efficiency, circular economy – these are some examples of ‘low-hanging fruit’ that firms can benefit from,” he said, when they apply ESG frameworks. He identified board members as a key aspect of ESG success. “Board members have a role to play in strategy formation, policy making, monitoring and supervising, and in terms of accountability,” he said. He also touched on the need to address the ‘known knowns’ and ‘unknown unknowns.’
“In terms of sustainability and environmentally, the known knowns can be measured,” he said. “But there are risks we know that we don’t know about. We don’t know where and when these will hit. These black swans – the unknown unknowns – require emergency response and prevention plans, and contingency reserves to address issues.” To address the uncertainty, the development of skills and competencies must be prioritised as these will enable adaptability, agility and appropriate response to any kind of risk. Here, he said, was where the shift from risk to value creation lay, within the ESG landscape.
Although there was a need to follow global developments where ESG was concerned, the issues connected with it had to be sincerely addressed, and companies had to contribute to ESG in a way that went beyond just complying with regulations. “Looking at it purely from the risk perspective would dilute the value of the opportunities which can be captured or created through the transition to more ESG- or sustainability-compliant measures,” he concluded.