Clearing the air: Is ESG the same as sustainability?

The first step towards taking the mystery out of ESG (Environmental, Social and Governance) is to understand that it is not simply another way of saying “Sustainability.”

This common misunderstanding has been around since the United Nations Global Compact coined the phrase “ESG” in its 2004 report “Who Cares Wins” and it was discussed further in the U.N.’s Principles for Responsible Investing two years later. That was a time when the concept of investment stewardship was just gaining ground, with the idea that companies which addressed environmental, social and corporate governance issues would likely be the ones who could not only reach sustainability goals but would also gain awareness on how to protect themselves from risks related to those issues, leading to better long-term financial returns.

Since then, as attention to ESG issues has grown, risk managers and their organizations have grappled with how best to implement the frameworks to address them. That has led to some confusion.

ESG and sustainability: understanding the difference

While ESG is often conflated with sustainability, it has, in fact, become a specific reporting and risk/return-led strategy. It is a subset of sustainability and, sustainability risk is a much broader concept than the tighter definition of ‘ESG risk’, although many use this term in a looser way too.

As ESG has entered the mainstream, it has attracted detractors as well as supporters, often due to different interpretations of what the underlying concept actually represents. It has become a highly politicized issue in some countries, with the claim that it is simply ‘woke behaviour’ and not sufficiently focused on the fiduciary responsibility of delivering investment returns. But, as others have pointed out, ESG in investing is not about changing the world, it’s about understanding the long-term risks of investing in companies and other financial assets. In short as Ron O’Hanley, The CEO of State Street recently put it, it’s ‘a matter of value, not values.'

As sustainability discussions evolved, especially in Europe while the EU sustainable finance disclosure regime was developed, the concept of “double materiality” gained currency, to describe different aspects of sustainability risks. It considers, not only external financially material sustainability impacts, like climate change, on a company, but also the impacts of a company on the climate – or any other dimension of sustainability. “Inside-out” impacts and risks that come from a company’s effect on the world have led to sustainability strategies focus on this aspect. Sometimes evolving from corporate social responsibility responses, aiming to minimize the company’s negative impact or maximize positive sustainability impacts. Typically aligned to broader goals and commitments on topics such as human rights, labour, environment and anti-corruption embedded in the principles of the UN Global Compact.

On the other hand, there are “outside-in” risks that arise when a changing world affects an enterprise in ways such as physical climate risks (floods, windstorms, or wildfires) or transition climate risks (changes of technology and regulations) that may increase the likelihood of direct negative consequences to the bottom line and to a company’s business model. In addition to environmental risks, outside-in risks can also arise from the company’s response to societal issues such as changes in working practices (the “gig-economy”, or hybrid working) that affect employee risks, or how technology creates ethical challenges, e.g. AI creating ethical dilemmas and risks in the use of customer data.

From a narrower investment context, it is also important to understand the governance issues of investee companies as that often has a strong link with long-term share-holder value. The focus of the “G” of ESG for several years has been on leadership accountability, in particular executive remuneration (aligning remuneration with investors’ interests) and the separation of CEO and chairman roles (to avoid concentration of executive power). This illustrates the challenge of applying the ESG framework to a broader sustainability risk context, where company governance issues are sometimes only a small part of the overall sustainability risk landscape, especially when ESG factors are typically applied in aggregate.

As the CRO Forum points out in its report, “Mind the Sustainability Gap,” risks commonly thought of as sustainability risks – and in the minds of many, ESG risks - are in fact risk drivers. Climate risk, for example, is a driver of many other risks in an enterprise risk management (ERM) framework, including financial, operational, business and strategic risks. For a risk manager, this is a useful concept because it clarifies that a separate risk management framework isn’t necessary – you only need to understand how these ‘sustainability themes’ affect core risks already being addressed in an ERM framework.

Looking long-term and beyond the organization

Climate change risk is also a good example of a sustainability risk that has the characteristics of an emerging risk. A risk that is new or developing rapidly, is often long-term in nature and, because of a lack of data, has a high degree of uncertainty in terms of how quickly it may evolve, its potential impact and the likelihood it may occur.

These long-term sustainability risks need to be tracked and managed using techniques such as scenario-based climate risk assessment as recommended by the Taskforce for Climate related Financial Disclosures (TCFD). This is in contrast to climate-related risks that are manifesting today, such as floods and wildfires which are managed using natural catastrophe models based on historical claims and exposure data.

The important consequence for risk managers of understanding time-horizons is that emerging and current sustainability risks have different processes and tools to identify, assess, mitigate and monitor the risks.

In the long-term, “outside-in” sustainability risks need to be managed using horizon-scanning risk identification tools such as an emerging risk radar to determine what sustainability risks may develop, their potential impact on an organisation and the time frame over which they could materialise. Identifying a sort-of risk gestation period enables companies to mitigate risks before they manifest themselves. In the commercial insurance space this may include wording changes, changes in underwriting acceptance criteria or developing new insurable risk propositions that help customers manage emerging sustainability risks. In other sectors, risk managers may choose to take a precautionary approach, such as tracking employee or customer health impacts from new technologies, products or services, before a product liability claim materialises.

Risk management’s role

Risk managers at companies that are starting to develop ESG and sustainability risk management strategies should help top management understand how the key sustainability issues affect the organization and create both risk and opportunities. The first steps are often with the top management or the Board of Directors, helping them understand the double materiality perspective of sustainability risks. It is important to consider what is relevant to the organisation’s business model, the impacts on stakeholders and which issues the company can influence or be impacted by.

There is no one-size-fits-all approach. Every company will have a different view of sustainability that depends largely on the type of business it conducts. The head of sustainability is usually tasked with determining which sustainability issues are relevant to the company and the risk manager will work closely with this leader and senior management to help understand the risks that are associated with sustainability issues, whether they are long- or short-term, inside-out or outside-in.

Among the questions risk managers should be asking: What are the risks associated with efforts to meet sustainability goals, which ESG risks are material and are they being addressed? Is the company subject to greenwashing risks if they are unable to fulfil sustainability promises? How are societal and other conditions changing outside the organization in ways that could affect operations? How are current risks, such as flooding or other natural disasters, affecting the value chain and supply chain?

It is important that risk managers do not lose sight of the distinctions and overlaps between ESG and sustainability, recognizing that what are often thought of as sustainability risks are actually drivers and amplifiers of other risks within their companies. An understanding of how a suite of sustainability risk metrics, including ESG in investments, can be developed, will help risk managers track progress of sustainability strategies and smooth the path to a comprehensive sustainability risk management approach.

Originally published in Commercial Risk on June 21, 2023