4 Features of the Modern ESG Landscape Risk Managers Should Keep on Their Radar
We begin our brief narrative where the Wall Street Journal ended its coverage late last month: “Investors want to make money while feeling they are contributing to a more sustainable and fair world. Given the demand, firms are rushing to classify their investment offers as ESG-friendly, sometimes stretching the definition, or making overblown claims.”
“The definition of what ESG or responsible investment truly is has been up for debate ever since it was created,” a portfolio manager told the Financial Times, injecting professional sang-froid into an investigation of the asset management unit of Deutsche Bank, DWS, by regulators in Germany and the U.S. for alleged “greenwashing.”
One could blame poor data for the pickle DWS and many other asset managers are in. A survey by BlackRock of 425 institutional investors found that poor quality or availability of ESG data and analytics represent the biggest obstacle to sustainable investing. Or, one could blame the overall conceptual ESG framework, characterized by a Securities and Exchange commissioner (SEC) as “labelling based on incomplete information, public shaming, and shunning wrapped in moral rhetoric preached with cold-hearted, self-righteous oblivion to the consequences, which ultimately fall on real people.”
Cue the risk manager, with a package of reputation risk management strategies and financially sophisticated reputation insurances, including a recently announced new product – ESG Insurance – to protect corporate directors.
This article directly addresses the fundamental challenge implied by the ESG movement which is to consider both the interests of stakeholders in environmental stewardship, social justice, and dutiful governance and the interest of shareholders in maximum sustainable returns. Let’s unpack the features of this risk management narrative.
Feature 1: The value in ESG resides not in the babble of data and analytics but rather in the expectations of stakeholders for corporate environmental stewardship, social justice, dutiful governance, and superior equity returns. This expectation is “reputation.” The things that put this reputational value at risk are “reputational hazards.” The phenomena that create reputational impairments are “perils.” And the overall threat to cash flows is “reputation risk.”
Feature 2: Institutional investors and bond raters both appreciate that reputation risk management in the context of ESG phenomena is vital to equity returns and bond default risk. BlackRock, for example, issued new proxy voting guidelines asking for details on how companies have considered the interests of diverse stakeholder groups in their decision making – a key step in implementing reputation risk controls.
The guidelines also explore other aspects of the enterprise risk management apparatus, asking for evidence that firms have appropriate due diligence and board oversight processes in place. Environmental, social and governance (ESG) risks were cited as a material credit consideration in 85% of Moody’s Investors Service’s 8,700-plus rating actions for private-sector debt issuers in 2020, up from 32% in 2019. Meeting the expectations of institutional investors and bond raters is a path to a “reputation premium.”
Feature 3: Risk managers are ideally positioned to build a compelling case of reputational stewardship through an enterprise-wide management and governance process authenticated by a sophisticated insurance story that will appeal to capital market cognoscenti. The essential reputation risk management story involves a cross-silo reputation leadership team that implements reputation risk controls. The risk manager chairs this enterprise-wide team.
Our checklist for controls requires each stakeholder-centric silo to generate qualitative and quantitative intelligence on their stakeholders’ expectations, corporate capabilities, costs of adaptation, costs of disappointment, and the means to frame this stakeholder intelligence in the context of external events as well as historical trends. Other controls include communication strategies that are simple, credible and convincing, enabling stakeholders to understand, appreciate, and value the materiality of a functional enterprise reputation risk management apparatus.
The insurance story is clear and compelling. There is an implicit authority to numbers.
Reputation insurance captives and parametric insurance products convey to financially sophisticated stakeholders a more expansive understanding of the nature of reputation risk, and a comprehensive qualitative and quantitative hazard-focused mitigation of the perils.
ESG Insurance, covering “strategic managerial and governance actions signaling corporate values” that may arise in the context of an ESG crisis, combined with reputation insurance for the enterprise, sends a compelling message to financially sophisticated stakeholders.
Feature 4: Risk managers should be mindful of traps and pitfalls. First, they should not lose control of risk management to marketing executives or compliance counsel who lack the broad understanding necessary of the possible risks and liabilities facing the enterprise as a whole.
There is clearly a need for counsel to support the effort and help boards preempt securities and derivative litigation with the work product of the reputation leadership team and its controls. And there is a need for marketing to help promote effective risk management, risk financing, and risk transfer to external audiences so the firm can realize the sought after “reputation premium.” But both of these are adjuncts to the central matter of managing risks with controls.
On the other hand, a major pitfall is for risk management to fail to distribute the workload. Risk departments are not large. Risk managers should “chair” the integration process, but execution requires the leadership team comprising internal “owners” of different stakeholders.
Regulatory investigations into DWS are unlikely to be a one-off, concludes the Financial Times. Risk managers can help their firms steer clear of the stramash around ESG metrics and earn a “reputation premium” by speaking directly to all stakeholders in the language they understand. &