Many investments are assessed through a Risk Management Framework to determine their suitability for investors. This refers to the risk a particular equity or investment vehicle might have is derived from its balance sheets, potential regulatory and legal liabilities, as well as its leaders.
In recent years, investors and equity firms now consider more than just traditional factors when it comes to risk management. Environmental, social, and governance (ESG) driven considerations have become crucial facets in many Risk Management Frameworks today.
What is Risk Management and how does ESG fit into the picture?
One of the core pillars of a Risk Management Framework is Risk Measurement. Investors do their due diligence and weigh aforementioned factors as part of the risk profile against projected profits and expected values of return on investments.
While it used to just be the numbers that pointed investors in the right direction, ESG criteria and considerations now provide another viewpoint for risk measurement as well. If we consider risk measurement to be a giant pros and cons list, investments with ESG driven policies chalk up a huge point in the pros column for investors.
Here are some ways ESG criteria can be incorporated into Risk Management Frameworks:
Environmental Risks
Part of the ESG factors that investors consider when assessing a Risk Management Framework nclude the environmental policies and risk a particular investment might carry. For example, industrial manufacturing projects or refineries which tend to have a larger carbon footprint due to operations might be seen as having a riskier investment profile.
An investor should take note of this and understand the risks that come with long-term carbon emissions – both financially and practically. Considering environmental and sustainability factors can have long-term ramifications too. Carbon taxes, imposed by many countries working towards decarbonisation and a carbon-neutral goal, will ultimately hurt the bottom line of respective entities with large carbon footprints.
Furthermore, prolonged carbon emissions that speed up climate change will inevitably propagate a vicious cycle in which a damaged environment and threatened biodiversity impacts quality of life. Such behaviour is not sustainable and continuous use of resources will lead to scarcity or even public criticism from environmentally-minded activists.
For investors looking towards how to manage environmental risks, consider investments that work towards managing and eliminating their carbon emissions, while enforcing policies and internal reporting structures to ensure that carbon goals are adhered to. Whether its a department charged with oversight on green behaviour internally, or spearheading green initiatives within the company, these are all positive signs that an investment is working towards strong environmental goals.
Social Factors
The next cornerstone of ESG policies lie in social factors and how a particular organisation or investment works towards its success. In the current day and age, social factors such as diversity, equality, and inclusion (DEI) play a big part in ESG criteria. In the context of diversity, the key is on ensuring genuine and non-tokenising diversity not only within the rank and file but also across leadership and the board of directors.
Additionally, sustainable employment and fair treatment of employees is yet another consideration investors must have when it comes to assessing risks pertaining to ESG. Non-exploitation of employees and providing them with fair wage and benefits goes a long way in retaining a strong workforce. The boons of ethical employment policies translate to lower turnover and higher possibilities for internal promotions, thereby reinforcing culture.
The challenge that these organisations are faced with involves accurately reporting and assessing DEI progress. Unlike environmental factors which can be measured with statistics and data, social inclusion in the realm of ESG is a little more intangible. Still, considering issues such as employee treatment and labour relations in a Risk Management Framework can help investors assess the overall social impact of an entity.
Corporate Governance
The final tenet of ESG lies in the form of governance. In this case, both corporate governance and governance in relation to bigger entities such as regulatory boards and national laws. In the case of the former, it is key that companies are transparent about decision-making processes and are able to communicate that to all employees. There should be no doubt in how decisions were made, and the logic behind them must be available to all stakeholders.
Along the same lines, compensation structures for C-Suite employees should also be made open and transparent to prevent any misunderstanding or hostility between management and employees. All this is to say that corporate governance policies directed at clear open communication are big pros when it comes to assessing risk and measuring an investment’s potential liability with the Risk Management Framework.
On a macro scale, investors should be informed as to whether a company is in full compliance with the regulatory standards and requirements, especially if it is a multinational company dealing with different regions of business at one time. Legal liabilities can often put a damper on potential growth and hurt the bottom line of companies, which in turn negatively affects investments and funds directed towards respective companies. Assessing these in addition to traditional fiscal measures helps investors better understand the scope of risk they might be taking on when it comes to capital injection and expected returns.
Although a relatively new school of thought, ESG risk management adds new methods for investors and equity firms alike to properly assess the potential returns and risks they might undertake with a variety of investment vehicles. These data points should help investors wisely select portfolio options in the future.
