Leveraging The Relationship Between ESG and Business Risk
@ the IERP® Global Conference, October 2022
Environmental, social and governance (ESG) risks have become more prevalent over the last decade; these are now viewed as business risks that could make or break a company. A strong ESG proposition can create value, and managing ESG risks through enterprise risk management (ERM) processes and activities is an effective means of raising ESG awareness throughout the organisation. It is thus important for companies to understand ERM principles and work out ways of linking them to ESG risks, while realising their unique risk profiles and circumstances.
“Some businesses feel that ESG risks are either immaterial, or will not have a significant impact on them,” said presenter Eqhwan Mokhzanee Muhammad, CEO, Ambank Islamic Berhad. “That’s the traditional view of ESG risks, where the whole purpose of the commercial existence of entities is to make money. That’s not wrong but recent evidence has shown that this traditional view may not hold water.” His presentation covered five areas: the traditional view of ESG risks; recent evidence that debunked the traditional view; linking ESG and business risks; key takeaways; and next steps. Climate change, he said, was an example of an environmental risk.
The ‘Social’ part includes labour practices, and matters related to fraud, Occupational Safety & Health (OSH) issues and corruption, for instance. While the primary objective of a business is to make a profit, businesses need to recognise that there are ESG risks today that make it necessary to go beyond the traditional notion of only maximising shareholder value. However, due to the prevalence of traditional thinking, there is reluctance even among larger corporations to integrate ESG aspirations into their strategy. “If you are a business, and all you do is make profits, and you don’t care if your business hurts the environment, surely that isn’t right,” Eqhwan said.
“When you affect the environment, and you get fined, surely that affects your business,” he added, pointing out that companies are already showing the results of ignoring ESG, as in the case of a palm oil giant which saw a significant loss of 8% of its revenue due to environmental degradation. “Prosperity and profitability are intrinsically linked to the long-term prosperity of the environment and society in which we serve.” Also, if customers are impacted because of ESG risks, there is a possibility that the financials of the organisation are not up to the mark, causing ineffectiveness and inefficiency, and affecting profitability and cash flow.
As ESG risks can be expected to impact the business, there is a need to take them into account when strategising for sustainability; there are many factors, including politics, to consider. Therefore, an ERM framework is a viable option as it is capable of identifying risks, responsibilities and responses; and be applied where monitoring and reporting are required. ESG risks are linked to business risks such as sales, costs, financing, order activity, manpower and operations, among others. Transmission channels are examples of how ESG risks translate into business risk. “If you have high greenhouse gas emissions, for instance, it may adversely impact your ability to get loans or financing,” Eqhwan said.
Greenhouse gas emissions (GHGs) are now seriously considered by banks, he added, stressing that this is because it is an imminent regulatory requirement. In about two or three years’ time, banks will need to disclose the GHG emissions of their customers. Labour and OSH issues also matter. If organisations do not treat their employees well, staff turnover will be high. If OSH issues are not taken seriously, accidents will happen. High staff turnover and poor labour practices will result in low productivity and manpower. There will not be enough talent to run the business. Additionally, the company will be subject to the full force of the law if deemed to be party to corruption in any way.
This in turn will lead to reduced trust among stakeholders. “It is important to look at business-specific considerations and identify the potential ESG risks specific to the business,” he advised. “Identify and assess how these ESG risks can be transmitted to your business risks through sales, costs, operations, manpower, productivity, reputation etc. Once you have identified the ESG risks, and assessed the impact of these risks on the business, you can start establishing risk controls such as governance, policy, setting targets, having an OSH committee, undertaking CSR programmes, welfare policy, and establishing the tone from the top, among other things.”
He emphasised that adopting the ERM framework was about identifying ESG risks, understanding and assessing the transmission channels, understanding how these channels could lead to business risk, and from there, establishing the appropriate risks and controls. Eqhwan’s presentation also covered the current direction of banks in Malaysia in relation to ESG risks. The focus of this, he said, was primarily on loan financing and investments but banks were also considering deposits and fundraising. Banks have set an exclusionist policy and will not give loans involving weapons, that violate habitats and wildlife, impact UNESCO heritage sites, involve child or forced labour, or adult-related materials.
Additionally, businesses which are involved in all these, or coal-related operations, will not be able to access new or continuing financing facilities. However, there were exceptions. “We are mindful of the need for coal in the national interest, and weapons for the country’s defence or strategy,” he said. Banks look at borrowers’ ability to repay their loans when making an assessment using traditional factors like financials, track records and character. They then come up with a formula for a risk model: the credit risk grid. “ESG risk and climate change risk overlay this assessment,” he explained, adding that some banks do ESG risk while others don’t.
How is the customer impacted? Customers need to pass the credit test first, then look at ESG risk, he said. Low ESG assessments will get them access to the facilities they need but if they have medium or high assessments, they will be required to come up with a mitigation plan. There may be concern, of course, if these assessments will have an impact on long-term pricing, tenure and collateral but Eqhwan said that this was normally not the case. “Customers just need to get used to these checks,” he said, adding that after loans were disbursed, they would be closely monitored to ensure their commitments to the bank were met.
Some banks have started ‘tagging’ loans, i.e., overlaying them with the ESG risk grid to identify the risk the customer poses to the environment and society for not following standards, as well as to assess climate change classification and the impact the customer has on climate change. “A lot of institutional shareholders have come up with their own ESG frameworks, which expects investing companies to look at ESG risks,” he said. It should be noted that the impact of environment and society on the bank does come with risks as well as opportunities. Banks are looking at supporting their business customers through transition; it is about nurturing them and helping them. “We want to be sure that we do not inadvertently stop providing credit to businesses that need it,” he said.
But he stressed that an ESG proposition was still necessary and that it did not concern risks exclusively. Because the priority of some customers was to survive, it has become a matter of how ESG risk is managed. “From one dimension, it is about a defensive approach – do it because it may impact the organisation,” he said. “You have to safeguard your business, reputation and people, but see it as an opportunity, depending on documentation or how much investment you need for green transitioning.” Emphasising again that ESG risk was not immaterial, he stressed that it will impact businesses in the long term; they should therefore start thinking seriously about sustainability.
“Sustainability is not net zero or CSR,” he said. “ESG is a framework to help you become a sustainable organisation – but what is a sustainable organisation?Sustainability means the ability to meet current requirements without compromising the ability of future generations to meet theirs. You are actually trying to sustain your own existence and profitability. Being a sustainable organisation means sustaining your own long-term relevance by considering the long-term needs of stakeholders. Identify the ESG risks, identify the transmission channel, then look at the impact on the business. You can take an offensive or defensive strategy – whichever will provide the most value.”