There is no one single definition for sustainability risks but most experts agree on two facts: sustainability risks aren’t simple to address and the scarcity and reliability of data to assess them are a common issue.
According to the SFDR (sustainable finance disclosure regulation), “Sustainability risk means an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment.”
The recent increased emphasis on sustainability is making it necessary for some risk professionals to make adjustments to risk management strategies.
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And that’s good news.
Unlike the more tangible operational risks that affect an organisation’s performance, sustainability was long considered a modest— if not minor— financial risk exposure.
Consequently, little was done to assess the loss potential.
But climate change went from whispers in scientific groups to a resounding echo that radiated into every single sphere of our lives. And sustainability gained ground and continues to do so on the same path.
Materiality is— if not the main, one of the most—critical elements to identify business risks and impacts while a business is setting up its sustainability strategy. In this article we dig deeply into it.
Climate change is shifting the paradigm regarding sustainability risks
As climate change effects became more noticeable, businesses started to realise that striving for the reduction of their carbon footprint was good for both the planet and the bottom line.
It took a long time for a large number of companies to evaluate how their operations were influencing climate change. Surprisingly, the move was driven by large oil companies like Exxon, Occidental and PPL Corp who began to pass resolutions to disclose in their financial statements the risks that climate change posed to the business.
Large institutional investors took notice. Larry Fink, CEO of BlackRock, the world’s largest asset management firm, was one of the first business leaders to acknowledge these changes, writing in his annual letter to investors in 2017 that “a company’s ability to manage sustainability matters was directly related to its sustainable long-term growth”.
At this time, businesses adhering to sustainability principles have become a preferred investment target for private equity, hedge funds and institutional investors.
But the climate consideration isn’t the only factor influencing the increasing bet on sustainability. The ongoing situation and the crisis that COVID-19 has caused, is showing us that social and governance issues such as workplace culture and well-being, executives’ behaviour and data privacy are having an increasing material impact on corporate performance, affecting company reputation as well.
And among the risks, the ones linked to sustainability are impacting reputation, customer loyalty and financial performance.
When incidents related to pollution, customer and employee safety, ethics and management oversight have such dramatic impacts on market prices, it becomes clear that sustainability risks are business issues and that their near-term market impacts reflect anticipated long-term effects on cash flows and associated risks.
However, low-probability, high-impact events have demonstrated that sustainability is not purely a long-term risk. For instance, there is the case of the recent floods that occurred in central Europe and other parts of the world. These regions weren’t at imminent risk of this sort of natural disaster.
Sustainability risks and the holistic approach
All the evidence points to the importance for businesses to have a long-term global plan for sustainability rather than a well-written plan in place that may be narrow in scope and vision.
Unfortunately, there is still a disconnect between traditional risks and sustainability risks, mainly because identifying, assessing and responding to the latter is still challenging. Sustainability risk needs to be prioritised and looked at in a holistic way, rather than just being considered a separate entity. At the end of the day, all risks are interconnected.
The fact that we’re still in the middle of a major pandemic should not make us forget that the ecological and economic impactof global warming also take lives in large numbers.
According to the Global Humanitarian Forum, climate change is responsible for 300,000 deaths a year and experts expect these figures to double again over the next 20 years, heralding the worst humanitarian crisis in human history.
The pandemic has forced investors and financial institutions to look at the “social” component from a broader perspective and make it an integral part of their risk management frameworks and investment strategies.
While the health, economic and social crises are generating untold strain on governments, businesses and individuals, it is also giving birth to greater scrutiny on the social impact of corporate activity and on investors. All these challenges prove to us that environmental risks can not be seen without their social component and vice versa.
Materiality and stakeholders’ assessment as key tools
Often, we see that investors, asset managers and business in general forget some key steps before tackling their sustainability risks. Performing both a materiality and stakeholders’ assessment is undoubtedly one of the first key steps.
Both are interconnected and don’t work without each other.
In the sustainability realm, materiality assessments are arguably the most important reporting aspect. Indeed, they are essentially the backbone of sustainable reporting, consisting of factors that directly impact the organisation or its stakeholders, depending on the methodology used.
According to the Global Reporting Initiative (GRI), materiality is topics that have direct or indirect impact on an organisation’s ability to create, preserve, or erode economic, environmental, and social value for itself, its stakeholders, and society at large.
The NFRD (Non-Financial Reporting Directive)—which will likely become the CSRD (Corporate Sustainability Reporting Directive)—and the GRI (Global Reporting Initiative) will even integrate the concept of the double materiality. This means that businesses shouldn’t only disclose how sustainability issues may impact them, but also how they affect the wider society and the environment.
Sustainability risks through materiality
You can definitely identify and assess the sustainability risks your business is exposed to, as well as the organisation’s social and environmental impacts through materiality. Consider the most relevant risks and opportunities all along the global value chain and processes. The last piece of the process is, precisely, the reporting exercise and the communication-related actions that will unfold.
It’s important for businesses and private market actors operating in a given industry to know which sustainability factors are most likely to materially impact their financial condition or operating performance, their portfolios, their products, their stakeholders and the society at large.
A materiality assessment will determine your ability to correctly evaluate risks and impacts and respond to them following a business’ values, mission, and long-term objectives.
At the end of the day, how an organisation responds to the identified sustainability risks and impacts will determine how effectively it preserves and creates value over the long term.
Sustainability risks as part of the traditional risk management system
The growing importance of sustainability risks brings both challenges and opportunities.
While the world continues to face the COVID-19 pandemic effects, there are other risks, sometimes more pervasive and that have been running for a longer time, that remain in the business agenda. Among them, systematic sustainability risks, and physical, transitional and reputational risks.
Moving forward, focusing on incorporating sustainability risks within existing organisational procedures, systems and controls is what both businesses and asset managers want to do to ensure these risks are considered in investment and risk management processes.
Rather than being seen as a separate type of risk, sustainability risks should be integrated into the traditional risk management system.
The disconnect between traditional and sustainability risks mainly depends on the investment strategy. The latter are usually treated, evaluated and considered over a longer period. By all possible means, we should reconcile the strategy around traditional and sustainability risks, even if they are harder to assess, integrate and quantify.
Issues around data access and processing have also arisen since they still can’t be effectively quantified and compared.
This issue of quantification mainly depends on the fact that the right tools for capital markets aren’t yet available.
The collaborative approach to assessing sustainability risks
We acknowledge that assessing traditional and sustainability risks over time takes a collaborative approach within organisations as well as risk exposure.
Identifying and prioritising a sustainable risk as soon as possible is key. In fact, when evaluating sustainability-related risks, onset speed and vulnerability may be important considerations when determining which response is the most appropriate.
We should remain confident that instruments for the sustainability risks management for private markets will emerge and help to solve these challenges.
Sustainability-related risks and opportunities require useful material data covering many areas and aspects, a vision over the short, medium and long term, and an integrated strategy.
To make a long story short, and in conclusion, sustainability risks need to be incorporated into mainstream finance.
Integrating a sustainability framework into a risk management system can have exceptional results for the wellbeing of the economy and the environment. Finance is good at pricing and measuring traditional risks, but there is an uncertainty when it comes to environmental and social issues. Sustainable risk management and scenario analysis can help with those uncertainties.
In traditional finance, the shareholder’s value is maximised by having a balanced and optimal financial return and risk combination.
Addressing our sustainability risks through materiality assessments will definitely benefit not only planet Earth, but your stakeholders and your reputation as well.
At the end of the day, how an organisation responds to the identified sustainability risks and impacts will determine how effectively it preserves and creates value over the long term.
