The transformation of our society that is called for by the UN Sustainable Development Goals is bold. Moving towards a circular economy where both production and consumption are sustainable is a crucial target to achieve by 2030. The ever-increasing expectations of the community on how private firms help make these outcomes are one of the ESG risk factors boards and senior executives need to manage.
Many firms can change their current operating model to improve energy efficiency, reduce environmental impact, reduce adverse social effects, and still deliver strong economic returns to shareholders. Understanding the breadth of your current operating model and continuing to drill down into the people, processes and technology across your entire value chain is a crucial part of understanding and managing these ESG risks appropriately.
The current consumption footprint of the global population is vastly unequal between countries. If developing countries consume at the average rate of developed countries, by 2050, we may need the equivalent of 3 planets to produce the level of natural resources required. It’s not explicit what assumptions around increasing technological efficiency sit around that number, but it is still a concern.
There are still boards and senior executives whose mindset has not adjusted to how they will need to change their business to make a positive impact on solving these societal issues. Making changes to your operating model to help address these issues and reduce ESG risks isn’t about veering out of the lane of private enterprise into politics – it’s about responding appropriately to changing community expectations around what a business has to do to maintain its social license to operate.
The Royal Commission into financial services in Australia provided a wakeup call to the financial services industry but was not that much of a surprise to many consumers. Many feel as if, after speaking to the hand for many years, the social risks inherent in many of the products that the banks, insurers and wealth providers sold, were exposed in case study after case study.
When you realise that the terms of reference were heavily restricted and that there are not only these risks around acting in the best interest of customers that need to be managed appropriately by doing the right thing by your customers, but there are many other environmental, social and governance risks that must be equally managed or removed from operating models in the financial services industry alone, the scope of the challenge for Australian business becomes apparent.
Boards and senior leaders need to revisit their social purpose – why does their business exist? When they have figured that out, there is a clear need to design their business strategy in line with responsible and ethical principles. The subsequent design and implementation of a new responsible operating model to deliver the outcomes to customers, shareholders, and the broader community of stakeholders, could be one of the defining make-or-break moments for your business in the coming decade.
It is amusing to read the “head-in-the-sand” commentary that is still coming out on climate change and ESG risk. Responsible investing isn’t going away, and if your firm participates in the capital markets, your cost of capital could be increased substantially over time if significant ESG risks are not remediated substantively.
One of the trends in corporate governance since the Global Financial Crisis has been a strong focus on risk management – have a risk appetite statement, have a risk management framework, implement a three lines of defence model, have robust internal and external audit, and have the board and senior executives sincerely across the details of the risks the business is running. The response so far of many large corporates indicates that the “risk bureaucracy” response to increasing regulatory demands means that ESG risk may be “press release managed” by many firms.
This approach may suffice in the short-run. However, institutional investors such as super funds, sovereign wealth funds, and pension funds are becoming even more demanding on these issues. It won’t be long until extensive operational due diligence on suppliers and customers up-and-down your value chain will be a standard part of their questioning.
The plethora of ESG ratings, disclosure, and evaluation approaches aren’t helping matters. So how do boards assure themselves that their firm is positioned ahead of the curve on these issues? Thinking deeply about what “ever-increasing” community expectations mean for your firm and the products and services it sells is a useful exercise. Increasingly, it means that outcomes for customers that would be outrageous from your perspective or even against your interpretation of contract law could soon be the default new expectation for that product line.
As an extreme thought example, the “slippery slope” outcomes from a heightened focus on ESG risk could see enormous changes in product design that need to be thought about today to enable your firm to maintain its product and service catalogue in the face of ever-increasing demands from stakeholders who you may never have imagined would have a voice in your boardroom or management committee.
The previous bare minimum of sustainability reporting is now having climate-related risk financial disclosures added to the checklist. The catchup required by firms is analogous to that on AML/CTF risk which many buried their heads in the sand on until they saw that the penalties for non-compliance had teeth. I predict that over the next decade, large financial services firms that currently have to balance technology investments in customer experience against risk & compliance will face a third stream of required investments in ESG related projects that will cost some tens of millions of dollars a year.
From a business strategy perspective, turning the cost of managing ESG risk on its head and asking the question: “can our operating model be simplified to remove or reduce ESG risk by design”? will be a differentiator from your competitors. The rise of B Corporations is merely the start of this. Increasingly, entire value chains will be sustainability-focused, and revenue growth will not be possible if you can’t meet the vendor selection criteria that will exhaustively interrogate your business on its ability to comply and attest compliance around an ever-increasing number of ESG risks.
Boards and senior executives will need to consider the breadth of their operating model carefully. To manage ESG risk appropriately, bringing previously outsourced capabilities in-house may be required. Some firms could face having to redesign their entire production capability as it stands today because they have no chance of meeting institutional investor expectations under their current operating model. This change will present enormous opportunities for disruptors in capital-intensive industries.