In his annual letter to CEOs, BlackRock CEO Larry Fink described the decarbonization of the economy as “the greatest investment opportunity of our lifetime.” He also noted that “we focus on sustainability not because we’re environmentalists, but because we’re capitalists and fiduciaries to our clients.” In other words, ESG’s focus on sustainable economies that serve the interests of diverse stakeholders is a fundamental tenet of capitalism.
However, Fink sounds a note of caution regarding the risks involved in ESG. “It will also leave behind companies that don’t adapt, regardless of what industry they are in,” Fink says. “And just as some companies risk being left behind, so do cities and countries that don’t plan for the future. They risk losing jobs, even as other places gain them.” ESG risk, therefore, presents significant threats in addition to rich opportunities.
When we think about risk, we only know what we know. To paraphrase Donald Rumsfeld, it’s easy to prepare for the known-knowns, but it’s much harder to anticipate the known-unknowns and the unknown-unknowns. The timeframe for ESG risk presents quite a few unknowns that disrupt our traditional risk management models. Some elements of ESG, such as the immediate impacts of climate change in the form of droughts and severe storms, can be seen today. Others, such as the long-term impacts of irreversible climate change on human habitation and industrial production are much harder to predict and require risk scenarios that extend decades into the future, far beyond the normal timeframes we might normally include in a risk mitigation plan.
These risks include physical risks—direct impacts of environmental disruption on economic activities dependent on natural resources or physical infrastructure—and transition risks—those that arise from systemic changes to current business models, such as the costs related to regulatory measures to combat environmental degradation. Physical and transition risks are closely related, since the cost of immediate transition risk will reduce the impact of physical risk later on. Recent economic stress testing by the European Central Bank (ECB) has demonstrated that without an orderly implementation of policies to limit global warming, the costs of threats related to physical risk are likely to spiral out of control over the next several decades.
Mitigating ESG risk in a world of seemingly constant disruption isn’t an easy task, but there is help. Risk frameworks such as the Due Diligence Guidance for Responsible Business Conduct from the Organization for Economic Co-Operation and Development (OECD) and Enterprise Risk Management: Applying Enterprise Risk Management to Environmental, Social and Governance-Related Risks by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), as well as general risk frameworks like ISO 31000:2018, are critical for incorporating risk-based thinking for ESG into your organization’s strategic vision. Innovative technology solutions that combine cloud-based data collection, reporting and artificial intelligence, such as Intelex, ehsAI and Datamaran, are also critical tools for managing the heavy regulatory burden and massive amounts of data required to address ESG risk. Our Insight Report, ESG and the Changing Face of Risk Management, examines the threats and opportunities that ESG risk presents to today’s organizations. It provides insights into the results of economic stress testing, different types of ESG risk, frameworks for ESG risks and digital solutions that can help you navigate and thrive in a world of increasingly frequent disruption.