What is ESG Risk: Meaning, and Examples

There is a shadow with every light, the same with the contemporarily rising ethical ESG sector. It has grown exponentially crucial for businesses and investors alike. ESG is now the new metric to judge any business. In a highly competitive corporate world, the traditional financial metrics of turnover are losing relevance to attract long-term investments. Lets explore what is ESG risk with meaning and examples.

Being in such a pivotal position, ESG is becoming prone to several risks that can affect the global financial system. Let us find out some of the many.

What is ESG Risk?

ESG risk is the negative impact on a company’s financial performance and goodwill due to environmental, social, and governance factors. There are various sources of the inception of these risks such as regulatory changes, supply chain disruptions, stakeholder activism, or failure to address societal expectations.

Types of ESG Risks

ESG risks are the risks that happen to the environmental, social, and governance sectors. These are caused by businesses due to the lack of ESG measures and being irresponsible and unethical.

Environmental Risks

1. Climate change and deranged ecosystems due to business operations.
2. Pollution.
3. Resource depletion, deforestation, and loss of biodiversity.
4. Environmental disasters are caused by a lack of regulatory measures, supply chain disruptions, and physical asset damage.

Social Risks

1. Violating Human rights and Labour Law to increase profits.
2. Company miscommunication can offend communities, thereby damaging community relations.
3. Compromised product quality can raise safety concerns. This can cause legal liabilities, sabotaging the brand image and reputation.
4. Failing to live up to employee morale, and consumer trust.

Governance Risks

1. Lack of representation in the board of directors.
2. Unsatisfactory executive compensation.
3. Corruption, bribery, and accounting fraud.
4. Loss of investor trust, regulatory scrutiny, and stakeholder activism will deplete the business sustainability.

What are The Benefits of Implementing a Plan to Mitigate ESG Risks?

There are several benefits of implementing a well-structured plan to mitigate ESG risks, such as:

1. Enhanced goodwill and brand image.
2. Reduced chances of regulatory and legal liabilities.
3. Improved stakeholder relationships.
4. Increased operational efficiency and fostered interpersonal trust.
5. Welcoming new markets and opportunities due to a good track record.
6. Sustainable financial performance and investor confidence for long-term ROI

What Is ESG Risk Score?

An ESG risk score measures the business sustainability based on industry, geographical location, and business practices.

It is an essential marker for stakeholders to determine whether to be a part of the business or not. 

The risk score is determined by considering a company’s —

• ESG performance
• Risk profiling
• Prior Investment Decisions
• Risk management strategies.

ESG Risks Impact the Global Financial System and Impact Business

ESG practices have a domino effect, if one fails, the rest falters. Every individual company indirectly serves a higher purpose, as they are part of the whole — the global financial system.

ESG risks can cause global economic harm, here’s how.

Reputation Earthquake

When consumer trust dominos falls, it makes the whole market quiver. Skepticism has speed — it can seep from a company to a whole industry like fire.

Then, a brand isn’t at stake, a whole industry is. With industries being intertwined in this globalized economy, others will feel the tremor too.

Greenwashing the Sin

Any product marked ‘eco-friendly’ instantly gets a huge price markup! Well, this feature is often grossly exploited. The consumers and investors deserve authenticity, not adulteration in the name of environmental friendliness. 

Climate Change (The Real One)

Climate change that is caused by industrial malpractices can yo-yo back to do severe damage to businesses like —

• Disrupting logistics
• Increasing insurance costs
• Destabilizing share prices

4 Real Examples of ESG Risks

The world has faced fatal ESG risks and repercussions several times, here are some incidents that got featured on the news.

1. Climate Change Risk

In 1984, the famous Bhopal Gas Tragedy happened at the Union Carbide India Limited (UCIL) pesticide plant due to a chemical accident. The world calls it the “world’s worst industrial disaster”, and it was caused due to inadequacy of maintenance and management.

The Pacific Gas and Electric (PG&E) in California faced charges as their inadequate infrastructure led to wildfires.

Similarly, in 2015, heavy rainfall flooded Chennai. Why? Rapid urbanization that ignored environmental concerns ended up with improper drainage systems in the city of Chennai, leading to stagnation and life-threatening flooding.

2. Labour Practices Risk

A recent BBC article claimed the violation of India’s Factories Act* with the overworked Indian factory workers who are being exploited to manufacture for international brands like Marks & Spencer, Tesco, Sainsbury’s, and Ralph Lauren.

*The Indian Factories Act states that no worker should exceed more than 48 hours a week (or 60 hours with overtime); maximum of 9 hours of working per day.

The collapse of the Rana Plaza (Bangladesh, 2013) killed 1100 garment workers. The workers were alleged child laborers. Such workplace accidents and exploitation can trigger consumer boycotts, and result in legal action. The NIKE Sweatshop controversy regarding poor working conditions in the 1990s also led to a massive consumer boycott. 

3. Board Diversity Risk

Goldman Sachs faced brutal scrutiny in 2020 to which their lack of gender diversity at the directorial level was exposed. The company’s governance practices were at stake which had the potential to affect their long-term business performance and shareholder value.

4. Data Privacy Risk

With the META group ruling the social media platforms, there are several data breaches and user security threats that surface. One such is the Cambridge Analytica Scandal — probably the biggest data privacy scandal, where the personal data of millions of users had been harvested without their consent by Cambridge Analytica, a political consulting firm. This dropped Facebook’s share price significantly and to date, users look at META with a hint of scepticism.

Conclusion

ESG risk management is no more a choice but rather a burning necessity. The globalized market is as interconnected as the internet itself. With risk management involved, the sustainable and ethically humanitarian intent behind ESG efforts gets strengthened. 

For business sustainability, factors like reputation, brand image, long-term value creation, goodwill, operational transparency, ESG practices, and an ethical eco-friendly cause are more important than financial turnovers.

FAQ’s on What is ESG Risk:

What is high ESG risk? 

High ESG risk in a business is its high exposure to environmental, social, or governance issues that can hamper its financial performance and brand image.

What does ESG low risk mean? 

ESG low risk indicates companies follow standard ESG protocols. These resilient businesses pose a low threat to the environment, society, or governance.

What is ESG physical risk? 

ESG physical risk affects the stakeholders directly and physically. Such as climate change, natural disasters, and resource scarcity on business operations, assets, and supply chains.

How is ESG risk calculated? 

ESG risk is calculated using various qualitative and quantitative metrics, including ESG scores, industry benchmarks, risk assessments, and scenario analysis, to evaluate a company’s exposure to ESG-related risks and opportunities.

Partham Barot is an ACCA-certified professional. showcasing his expertise in finance and accountancy. he’s revolutionising education by focusing on practical, real-world skills. Partham’s achievements underscore his commitment to elevating educational standards and empowering the next generation of professionals.

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