Why ESG Risk Management Will Be More Important After COVID-19

Firms show their true colours in a crisis. Boards and senior executives are either prepared or unprepared. They can quickly assemble an appropriate response, or resort to replaying their Global Financial Crisis playbook. ESG risk was reaching its peak at Davos in January just two months ago. Still, some of the firms who were lauding their progress on managing ESG risk had gone back on how they said they’d conduct themselves before the quarter even finished.

The speed of the spread of COVID-19 and the widespread economic fallout around the world makes comparisons to the GFC and even the Great Depression unsuitable. This situation is far worse because of the sudden lockdowns and loss of revenue, leading to mass layoffs around the world. On the other side of this bridge, ESG risk management will be even more critical.

Why would that be the case? Well, think about the Royal Commission into financial services that highlighted enormous conduct issues. Then observe the dilemma that the banks find themselves in – they know they have to be responsible corporate citizens, but their loan books are facing an awful lot of uncertainty right now.

The central bank and regulators are supporting them for now. Still, there are so many different stakeholders to manage it will be a difficult task to get the balance right in such a highly uncertain situation. And what about the insurers? How do they do right by their customers in this scenario? It’s doubtful they could afford to waive pandemic exclusions on business interruption insurance, for example.

What about the superannuation funds and their trustees? Are their operating models – relying on 3rd party administrators and systems for core administration capabilities – able to respond fast to a massive regulatory shift with early access to super? When they thought about responsible investment principles, how rigorous was their assessment of their own DR/BCP capability, and what risk mitigation around handoffs between the funds and their administrators exists?

This crisis will also test asset manager operating models that heavily rely on outsourcing critical functions to 3rd parties. A lot of these particular concerns fall under the governance risks area. The need for independent governance and strong accountability of management to the board will be paramount when company boards are conducting post-pandemic reviews.

An ESG risk post-pandemic review will need to cover:

  • The timeline of the firm’s response
  • Environmental risks
  • Social risks
  • Governance risks
  • An assessment of stakeholder perceptions before, during and after the pandemic
  • A remediation programme of work to uplift any areas of weakness before the next crisis strikes

Boards and senior executives operate under resource constraints. Thinking carefully about all of the projects that a firm is currently undertaking and cancelling some to free up pandemic response resources is a natural response. However, the business needs to be ready for the other side of the bridge. ESG risk uplift projects will become quite pressing if any controversies occur during the crisis.

The lessons of the global financial crisis include the reality that community expectations drive your firm’s social license to operate. Quite simply, pure shareholder value decisions or creditor protection decisions that negatively impact other stakeholders are unlikely to go unnoticed by the public and the media. This fact means that even during the high-pressure environment of crisis decision making, senior executives need to challenge and consider a broad range of stakeholders interests. The heavily regulated environment firms are operating in mean that keeping regulators and politicians happy is perhaps more critical than keeping shareholders happy. We are now capitalism-adjacent.

ESG risk management is an extension of risk management in general. Most of the ESG risks will sit on a risk register already and have mitigants in place. There may be uplift projects already in flight. The mistake will be cancelling any of them if you want to be able to operate with the confidence of stakeholders on the other side of the bridge.

Simplifying your operating model and focusing on delivering the right outcomes to stakeholders as part of the business-as-usual cadence of your firm will help reduce ESG risk. Of course, if revenue has gone to nothing, then the most responsible decision for many boards will be to wind down the business and radically reduce its product and service offering to reflect its new reality.

Being responsible in a crisis like COVID-19 doesn’t mean martyring your balance sheet with no hope of reaching the other side of the bridge. It does mean doing the right thing by your employees, your customers, your suppliers, your stakeholders and the broader community.

A key consideration for boards and senior executives during this time is what your responsible operating model looks like after this crisis. A standard target operating model programme that does not incorporate ESG risk reduction into the design and implementation of the TOM won’t deliver the outcomes you need to differentiate your firm from its competitors on the other side of the bridge.

COVID-19 And ESG Risk Management

ESG risk hasn’t disappeared because of the COVID-19 pandemic. Unfortunately, some firms have reverted to their Global Financial Crisis playbook and accidentally opened up a swathe of avenues for criticism. Environmental, social, and governance risks are particularly acute in a crisis.

Many firms have done a fantastic job of looking after their stakeholders during this crisis. Unfortunately, others have not been behaving as the good corporate citizens that exist in their marketing and their annual report commentary.

The rise of ESG issues over the past decade was reaching its crescendo at the World Economic Forum in Davos just two months ago. There is no reason why firms who care about these issues will revert to old habits if they have embraced managing these risks inside their business in line with community expectations.

If anything, this current crisis will heighten the level of scrutiny on everything a company does. Every press release, every employment decision, every change to a product or service – they will all be under the microscope.  

The level of panic and fear in the community around COVID-19 and its health and economic fallout means that boards and senior executives need to think carefully about how their actions will be perceived and interpreted by the community.

Environment Risk

Environment risks include climate change, the natural environment, pollution, waste, and environmental opportunities for firms to create a positive impact on environmental outcomes.

Because of the COVID-19 pandemic, and the rise of working from home, there is a massive opportunity for firms to reconsider their office space footprint. If remote working is the new normal, customers can still receive value.

Firms can use a different mix of activities that rely less on office space, such as video calling. A lower office space footprint will reduce the firm’s overall environmental footprint as long as business travel remains cancelled or not possible.

New ways of working across a firm’s end-to-end value chain will need to consider what other firms in your value chain are doing at the same time to reduce their environmental footprint.  

Social Risk

Social risks include the wellbeing and development of workers, health & safety, supply chain issues, product design, controversies and positive social impact initiatives.

The natural response of many firms has been to immediately furlough workers to reduce costs. If revenue has gone to zero, then cutting costs is obvious. However, some firms have made responsible decisions – paid sick leave for staff needing to self-isolate due to COVID-19, paying wages where they can for the duration of a lockdown, and continuing to pay health insurance premiums.

Some firms are even partnering with organisations in other industries needing lots of staff quickly to offer opportunities to their furloughed workers. Health and safety actions are even more critical during this time. The provision of PPE is essential – if it can’t occur, then boards and senior executives should think very carefully about whether it is responsible to open at all without providing this to staff.

The way that some firms have chosen to treat staff is already causing controversy. On the other side of the bridge, they will face unfair dismissal claims and litigation from suppliers treated poorly. Other firms have endeavoured to pay their invoices faster and settle trade creditors and contractors where possible before closing their operations temporarily.

Governance Risk

Governance risks include corporate governance issues such as board composition, executive remuneration, shareholding composition and accounting standards used in financial reporting. Organisational behaviour issues such as tax policy, ethics, anti-competitive actions and financial stability are risks here.

Sharing the pain is a smart decision many boards and senior executives have already taken. Pay cuts and no bonuses are the bare minimum act of corporate social responsibility if you are standing down thousands of employees.

Firm-wide pay cuts to protect jobs instead of redundancies can also work here. How many boards have turned over completely since the GFC? For most, this will be their first major crisis and letting senior managers deal with the crisis and focusing on governance as opposed to micro-managing will be a challenge for some.

Board composition needs to be a blend of different experience and perspectives – how many will have thought through the productivity implications for their workforce if school kids are at home during this crisis? Managers being genuine about workplace flexibility where possible will be a differentiator on the other side of the bridge.

Executive remuneration in the coming years will be even more sensitive than after the Global Financial Crisis. You see, many people never thought anything changed after the GFC. If Australia is facing its highest levels of unemployment since the Great Depression, even the at-risk potential numbers when it comes to executive remuneration could be a target for regulators.

Considerations For Boards And Senior Executives

Boards and senior executives will be under a lot of pressure right now. Many have invoked their business continuity plan or had to manage crises non-stop since this pandemic escalated in severity worldwide. A key consideration at the back of your mind is how stakeholders will perceive the firm’s actions during this crisis.

Are you doing the right thing by your employees? Are you doing the right thing by your customers? Are you doing the right thing by your suppliers and key partners? Are you doing the right thing by your community? In the age of social media, there will be real-time feedback on the appropriateness of your actions. In the age of continuous disclosure, your share price will be gyrating each day based on traders assessment of whether you have this situation under reasonable control where you can.

A lot of fluff is written about values and corporate social responsibility. A crisis is where firms that live what they believe and stay true to their word get to demonstrate to the world their integrity. Customers, employees, shareholders, stakeholders and the community at large will recognise that and reward it on the other side of the bridge.

Why Firms Will Bring Forward Operating Model Changes Because Of COVID-19

The pace of the COVID-19 collapse in economic activity has been incredible to witness. Many sectors have faced complete decline to zero of their revenue. Many firms were prepared for a crisis and will be dusting off their crisis transformation plans. Having invoked their business continuity plan, many will realise that they don’t need as many resources as they thought they did to run their business.

A firms ability to respond to a crisis depends on its leadership and its willingness to make radical changes to its operating model. Many firms will have found that underinvestment in technology in recent years has not set them up to succeed over the coming months and years. Their employees will be making working from home up as they go, introducing enormous cybersecurity risks into their operating model outside of the organisation’s standard risk management framework.

Other firms will have found that their healthy attitudes towards working from home have made this crisis a smooth transition for their workforce. They may generally be in professional service type industries with the margins to make investments in this or in the public sector where such expenditures are mandatory.

A firms culture before the crisis will determine what things look like for them on the other side of the bridge. It will also help drive whether they make it through the COVID-19 pandemic at all. High performing organisations generally embrace flexibility and openness to change. For some firms, this crisis will be the end of them because they can’t respond fast enough to near-daily requirements to make hard decisions.

However, a crisis is also an opportunity. And many firms will be dusting off their crisis playbooks and implementing cost-saving plans that may have been too difficult due to internal politics to execute over the past few years in an environment of rising profits and revenues.

The other side of the bridge, as many politicians refer to it, will be very different because of the psychological impact of simultaneous health and economic crises. This change means that firms will need to carefully review their products and services and make hard calls about what their customers will be willing and able to buy.

Already, a shift away from premium brands to store brands has emptied the shelves of basics around the world. If this continues, a wave of small businesses selling organic this-or-that will hit the wall within months. Anything luxury will only survive if it can sell at scale to those still earning good incomes on the other side.

Firms will need to simplify their products and services and demonstrate real value-for-money. Sales will be more difficult, particularly in business-to-business environments if all of the sales calls are going to be via video conferencing for the next year. That is if a prospective customer is even interested in taking a sales call unless there is a critical need.

A keen focus on simplifying operations wherever possible, embracing automation and eliminating any discretionary spending will deliver savings. But achieving cost savings isn’t the end of the story. Reducing process complexity, reducing system and application complexity and making hard calls to eliminate entire product or service lines will be needed to drive real change in your operating model through this crisis.

One of the downsides of this crisis is that as each firm tightens its belt, economic activity shrinks more. When they stand down or make staff redundant, the impact on lives is immense. It’s not like a typical recession which generally stems from one or two sectors wider. This COVID-19 disaster is an economy-wide sudden stop in economic activity. Doing the right thing by your customers, your employees, your suppliers, and your community were how many firms marketed themselves in recent years with the increasing focus on ESG issues. Many have failed the crisis test within weeks when you look at how some have responded.

The overall simplification of an operating model can’t happen in a vacuum. Due to the complexity of contractual arrangements and service models between 3rd parties that are a crucial part of many operating models, working with key partners and suppliers through this crisis will be essential. Engaging early with key suppliers and being open about changes to get to the other side is far better than surprising them with sudden cancellations. They have employees and families to look after too.

What is emerging from the scale of this health crisis is that many businesses will make the rational decision to close their doors utterly independent of any policy response from the government. Rash and sudden choices will occur. Firms that could use the JobKeeper payment won’t even apply because the owner has already given up.

Firms will bring forward operating model changes because of COVID-19, and the impact on workers on the other side of the bridge will be immense. Higher levels of automation will particularly hurt the lower-skilled, but its impact will reach high skilled workers over time. No one is safe from the Great Depression playbook.

In Australia, there are many turning to government support for the first time in their life. They may previously have looked down on welfare recipients, but now find themselves with no other choice. One thing that firms will need to monitor is attitudes towards unionisation and general strikes over working conditions through this crisis.

If they don’t care for their workers, particularly the lower-paid ones on the shop floor, they may have industrial relations issues on the other side of the bridge. There will also be legal consequences arising from some of the actions of small businesses. Fair Work will have a lot of work to do, and the Job Keeper payments will provide an ongoing stream of audit and investigation work for the ATO to chase down.

The benefit for the firms that adapt fast and simplify their operating models as quickly as possible is that they will emerge in a stronger competitive position once this is over. If they can reduce fixed costs and simplify processes, then they extend their time horizon to stay in business.

One interesting thing to remember is that landlords are businesses too. In essence, both commercial and residential landlords will have to renegotiate their previously guaranteed fixed revenue streams because commercial reality has completely changed in less than a month. The banks will end up being the primary beneficiaries even after a wave of credit losses once the six-month repayment holiday window is over. Hopefully, there’s a vaccine by then, if not, then dark times are on the horizon.

The Shutdown Decision And Permanent COVID-19 Job Losses

The shutdown decision is a fundamental economic principle. A firm should continue to operate if it can generate sufficient revenue to cover its variable costs. A firm should shut down if it didn’t make at least enough revenue to meet its variable costs. Because of government restrictions put in place to reduce the spread of COVID-19, whole swathes of the economy need to shutdown.

Many politicians are talking about the bridge to the other side. Unfortunately, many businesses have already decided to shut down. Some did not even engage with the possible support avenues because they knew there was no chance the bank would lend them more money or their landlord cut them some slack on their lease obligations.  

The evidence of this is in the enormous unemployment claim numbers around the world. The queues outside social security offices are happening even in countries where a wage subsidy policy now exists because of COVID-19. I don’t think the blame game is helpful at this point, but some empathy with people who are the collateral damage from the public health actions exists.

The public health crisis itself is playing out differently in each country. It’s not clear yet what the real impact of COVID-19 will be – modelling is uncertain, and each country will have its factors that either make their outcomes worse or better. It is silly to think that the only problem here is the health crisis. The social consequences of a 2nd Great Depression due to the sudden stop of economic activity will be just as awful for the world.

A simple thought experiment can help us understand the likely decisions of business owners. If revenue has gone to zero, for an unknown period, there are several ways to pay costs that are still being incurred by the business. It can use its cash reserves, borrow more from the bank, raise more equity from shareholders or use government support packages.

Every business owner will know what their break-even point is. They will also be acutely aware of their ability to support the business. If they have a year’s worth of bills in the business cheque account, this isn’t an issue for them. They will be fine, assuming there is a resumption of regular economic activity on the other side of the bridge.

However, if they are already running a low cash balance or using debt to meet operating expenses, they will not be able to proceed with zero revenue for longer than a month or two. Putting businesses into hibernation doesn’t work because every contractual arrangement they have entered into has to be put into hibernation on reasonable terms at the same time.

The recent drop in asset prices due to uncertainty around COVID-19 impacts and already recognised economic losses such as travel and hospitality shutting down, mean that the fair value of any small business is lower. There are unlikely to be any buyers at present. Incurring too much debt through a crisis impairs the value of the company on the other side.

This reality is affecting large businesses too. Unlike the public sector, a private company can hit “hard limits” of what is possible. Resource constraints exist,  their bank will tell them they can’t borrow more, and the government will restrict their operations. Their employees may choose to quit instead of coming into work and being put at risk. Their landlord will refuse to cut a deal on rent.

This health crisis is a society-wide coordination problem. Without the government imposing a lockdown on all, the decentralised decision-making of many actors leads to businesses putting people at risk because other companies in their industry are still operating, so they feel like they have to as well.  It’s crazy.

One of the issues with specific bailouts is that at this stage of the collapse, it’s likely putting good money after bad. Equity owners and debt owners receive a risk premium to incur risk. If every time a crisis occurs, they get bailed out, with no consequences, the people don’t like it.

The irony is that if people thought the response of populism to the Global Financial Crisis and its fallout was terrible, just wait until the second wave of populism and nationalism arrives after a global pandemic accelerated by the free movement of people and goods across borders.

It will be even worse when banks and large corporations get bailouts when at the same time, many households can’t access welfare. The losses will be borne by those who are unable to negotiate their bailouts with their creditors and landlords because they don’t owe them enough. Because of the uncertainty, many businesses will merely shut down because their balance sheets can’t sustain six months of no revenue.

The government is trying its best under considerable uncertainty. The lesson of this particular crisis so far is that looking to the government for financial support in an emergency is a dangerous path to take. On the other side of the bridge, expect a lot of debt aversion and laser focus on lean operating models where only the critical expenditures to deliver value to customers happen.

The current operating model for many businesses has grown over time to include a lot of unnecessary expenditure. There will be a focus on crucial value streams – what is the bare minimum required to deliver an excellent experience for customers? Product and service catalogues will need to be simplified. Entire categories will disappear because they will seem frivolous in more austere times.

Many firms are already replaying their GFC playbook. This playbook means cancelling projects, standing down staff, offboarding contractors and consultants, and eliminating discretionary spending wherever they can.

Unfortunately, this is the last thing the economy needs. When businesses tighten their belts, the drop in demand from public health restrictions accelerates further. The carnage from further reductions in economic activity will be just as awful as the health crisis happening in the hospitals.

A pandemic of this nature is going to change our way of life for decades to come. The health and economic scarring will be worse than the Great Depression because other than those directly impacted by the GFC, many in the developed countries have not known adversity on this scale their entire lives.

Hopefully, random acts of kindness and humanitarian response from governments to help their people in crisis can prevent a complete collapse of social order. This COVID-19 pandemic is a crisis on many fronts, and the worse the health crisis becomes, the worse everything else becomes. The other side of the bridge mightn’t be one we want to cross in the end.

The Industry Composition Changes From COVID-19 Fallout

The industry composition changes from the COVID-19 fallout will be enormous. The firms with the most robust operating models that deliver value without people needing to leave their homes will emerge in a dominant position. The firms that rely on in-person service delivery will struggle to rebuild their revenue once social distancing becomes a new way of life. The impact on households will be dark as many stores closing now will never reopen.

The rapid spread of COVID-19 and the accompanying public health restrictions have caused millions of job losses globally. The speed of the economic collapse of the entire industry sectors of tourism, air travel, retail, hospitality and personal services is unprecedented. Different countries have responded with varying policy responses to slow the spread of the virus.

Some have focused on the banks and business. Others have focused on jobs and wage subsidies. Some have tried to balance a mixture of support across the economy. This human tragedy is a real-time policy experiment across countries where everyone can see the different outcomes of different ideological belief systems.

We are dealing with both a health and an economic crisis. It is juvenile to ignore that there are tradeoffs governments are making, whether we agree with them or not. There is some modelling behind their decisions to move from one level of restrictions to a higher level. One of the things politicians are responsible for is making the calls based on the advice they receive. That’s part of what modern Westminister democracy entails – outsourcing political judgment to politicians, supported by the public service.

One concerning aspect of the policy response so far is that the crisis has highlighted the weaknesses of many existing business models. Typically, a recession would lead to those businesses closing down as part of the normal business cycle of creative destruction. In this case, a rapid collapse in economic activity in some cases because of government decisions means that many businesses are closing well ahead of where they would have failed in the next economic downturn.

The rational response of many boards and senior executives has been to lobby the government to secure an industry-specific support or bailout package. Small businesses don’t have that option. The support offered to banks to extend lending terms or provide low-interest bridging finance for an indeterminate period looks good at first blush but doesn’t pass the real-world test.

The reason why many businesses won’t take on additional debt in a time of high uncertainty is that if their revenue has gone to zero, they are still incurring fixed costs. They will try and reduce as many of those fixed costs as possible, and may not have the cash to be able to top up wages for a wage subsidy or even let people take annual leave or sick leave for a month.

Hence, many layoffs and redundancies have happened already irrespective of whatever policy response the government has deployed. The likely announcement of a wage subsidy in Australia today is too late for all the people already lining up at Centrelink. In New Zealand, every second day, MBIE announces little tweaks to the wage subsidy in perhaps the best example of iterative policy implementation in the country’s history.

When it comes to identifying industry composition changes from COVID-19, strong balance sheets are a crucial factor. In the hospitality sector, a clearout of small businesses is likely, leaving many countries with national chains and franchises the last ones standing on the other side of the bridge. Unless retail landlords give rent holidays, lots of cafes, bars and restaurants will have no choice but to close down. Given that very few own their premises, the prospects for independently owned hospitality operators is bleak.

Because of the uncertainty of the COVID-19 pandemic, it’s unlikely many small business owners will take on more debt other than out of pure desperation. If you trace back the impact of zero revenue and work backwards to who loses, generally it is property owners and the banks. Their tenants may default, and their borrowers may default. This reality is how a health crisis becomes a financial crisis.

There are now three crises – health, economic, financial. All three are interlinked, but the primary focus of many governments has been the economic and financial crisis. The health crisis has had far less government money directed to it. There will be real-world consequences from this approach.

For example, the purchase of residential mortgage-backed securities by the central bank is a significant change in the expected behaviour of a central bank. If the central bank is becoming the entity holding the credit risk hot potato, what is the point of the banking sector? What was the justification of the enormous investment in higher regulatory standards since the Global Financial Crisis if a stress event of 1 month changes everything?

The US Federal Reserve mainly spent a decade doing and then trying to rewind quantitative easing. Now it is going full speed on quantitative easing again. How can you price risk responsibly in such an environment? There are enormous problems that will stem from the panicked responses to this crisis. Those who most need a bailout don’t have a hope of getting nearly as much as they may require through no fault of their own.

The impact of COVID-19 on the retail sector is another one to watch. With physical retail stores closed, and staff stood down, how likely is it that firms will reopen them on the other side of the bridge? Already, retail in Australia was struggling. Many firms will use this crisis as an opportunity to accelerate plans to reduce store numbers and increase online shopping share of their revenue.

Some will use the crisis to close underperforming brands or chains and exit onerous lease obligations wherever they can. The face of retail will never be the same again. The impact on major landlords such as shopping centres will be grave. In the USA, commercial mortgage-backed securities could be in deep trouble. How many rent payments will they receive on April 1? Many retail chains there have told their landlords they would not pay the rent for the duration of this crisis.

The most challenging impact so far is the people who have already lost work because of this crisis. Recessions are particularly brutal because a proportion of people who become unemployed in downturns never work again.

Many parts of the economy will “bounce back” from this crisis. However, lots of people will lose their lives due to COVID-19 complications, and many will have ongoing issues like lung scarring and respiratory problems. The human cost will be enormous, and the overall human tragedy will be higher if the economic situation keeps accelerating towards a global Great Depression.

We Will Judge Businesses – ESG Risk And COVID-19

The rapidly escalating COVID-19 global pandemic is causing enormous pain for people affected by its spread. The rising death toll and number of cases around the world is growing exponentially, just as experts predicted it would earlier in the year. The different response of many countries is a real-time experiment with people’s lives. There couldn’t be a more tragic way for 2020 to have turned out so far.

We will judge businesses and their response to COVID-19. The good ones are doing what they can to do right by their customers, their employees, their suppliers and their communities. The not-so-good ones are using a public health crisis as a lobbying opportunity for industry-specific bailouts and carveouts that protect executive compensation in a time of mass layoffs. Many boards and senior executives still haven’t learned the lessons from the Global Financial Crisis – your social license to operate can be revoked at any time in this new political climate if you act up.

One of the lessons of the past few weeks is that many well-managed businesses have been able to deal with this crisis as good corporate citizens. They had strong balance sheets, clear business continuity plans invoked, and the right attitude towards their stakeholders. These businesses operated in industries where their margins enable them to invest in preparedness and do the type of work where they can send their staff to work from home with no issue.

Small businesses are in a completely different situation. Already, non-compliance with regulation and community norms is an issue for small businesses. They are likely to be under-capitalised, trading on modest margins in highly competitive industries and aren’t going to have the balance sheet to “get to the other side of the bridge”.

Many small business owners will have looked at proposed support from their bank and wondered how on earth that helps them make lease payments and pay trade creditors. Many will have realised they can’t even last a month without revenue, and the rational course of action is to layoff their staff and close the business down.

Larger businesses not big enough to land a bailout will have moved fast to plan and execute redundancies and stand-downs. This fast decision making is because their cash flow pressures mean they can’t even wait a week because of how fragile their business model is to adverse external shocks.

There is a real-time example in New Zealand: Air New Zealand was able to secure a government loan with associated conditions, still stood down most of its people. Virgin Australia was not able to obtain any support, so is now consulting on closing its entire New Zealand operation.

There are many arguments from both sides – letting businesses close down isn’t the end of the world as long as there are strong social security supports for the people impacted. Because of the speed at which this crisis has developed, the welfare system in many countries is being overwhelmed. Lots of business owners have realised the uncertainty ahead and just pulled the trigger, likely without advice or engaging with any potential support avenues.

We will judge businesses by how they respond to this crisis. Already, some major corporations have shown their true colours and gone back on all of the ESG statements and claims they have made over the past few years. By re-running previous crisis playbooks, they are unlikely to have the goodwill of their stakeholders on the other side of the bridge. It’s already a difficult enough time for the world – doing the right thing is seemingly too hard for many. It’s great to see some businesses stepping up responsibly, they’re the ones who’ll survive.

The Economic Impact of COVID-19 On Australia And New Zealand

The economic impact of the COVID-19 pandemic on Australia and New Zealand is going to be enormous. The governments of both countries have already announced substantial support packages, the central banks are easing monetary policy on a vast scale, and the private sector has begun to make enormous changes in how they do business.

The scale of the impact from a public health perspective is enormous. Everyone apart from essential workers self-isolating is going to happen within weeks. Many experts suggest it should already be in place, and some businesses able to offer working from home have already embraced it. For businesses, this is a massive health and safety issue. Your people should not come into the office unless they have to.

For frontline workers, enormous focus on deep cleaning and provision of appropriate safety equipment is the bare minimum you should be providing. If a business is making no revenue, it needs to cut its costs. It no longer matters if there are contracts involved. Fixed expenses will go down.

The advice from public health officials is always changing. However, the impact of social distancing and self-isolation means that the hospitality and tourism sectors are now over. For the duration of these restrictions industries in deep trouble include aviation, most non-essential retail, and any discretionary or entertainment spending.

What this crisis and the response is highlighting is the fragility of the current economic order. Casual workers, households and small businesses are now the unprepared shock absorbers of risk in the system. The rapid deterioration in asset prices around the world represents a rational reaction to uncertainty over what the present value of those future cash flows is under these economic circumstances.

However, asset prices going up or down doesn’t help households paying bills. The inflexibility of many contracts entered into by businesses or families will accelerate the economic fire we are experiencing. The relevant public health requirement of social distancing flies in the face of economic reality for many households. They simply cannot afford not to work, and their small business cannot afford to operate with $0 in revenue.

There are many ESG risks for firms here. How do they treat their employees? How do they treat their customers? How do they treat their suppliers? Doing the right thing is more important than ever. The behaviour of firms throughout this process will be under the microscope, and any poor decisions will be franchise destroying. All of the goodwill built up inside a brand or reputation can be damaged by making silly decisions like making people come into the office when they can work remotely.

The operating model impacts will be severe. Because of the fragility of many value chains, the reliance on outsourcing, and lack of investment in technology over many years, the inability of some firms to deliver on their contractual commitments after they implement their business continuity plans will become glaringly obvious.

Some companies are doing the right thing: everyone who can work from home already is, flexibility with customers and suppliers, and customers treated properly with credits or waivers offered due to radically changed circumstances.

Some companies are not doing the right thing: lobbying for taxpayer money when there are higher priorities, worrying about their particular industry when this is a societal issue, or treating the parties they have contractual relationships with inflexibly.

Boards and senior executives will need to think very carefully about the impact of their decisions on their communities. Their customers and employees aren’t silly – they know the implications are likely to be negative.

If there are six months of drastically lower economic activity, protecting essential capabilities ability to deliver key value streams on the other side of the slow down is an important consideration. For example, airlines need to preserve some ability to operate domestic flights and cargo freight.

The overall economic impact will be much higher than 10% of GDP. Unemployment will be more than 10% in Australia and New Zealand within months. Underemployment will be even worse because of the number of casuals now out of work and part-time workers who will never get more hours under these circumstances and could also have to take leave without pay to keep their jobs.

The unfortunate economic response from governments so far has been very much about business. This focus underestimates the economic impact of this crisis. The real issue is people being able to pay their bills. If hundreds of thousands of companies go to the wall, asset owners and lenders should be taking a hit. This reality means commercial landlords being flexible with their tenants and banks bending over backwards for their business and institutional customers will be necessary.

The pace of this economic slowdown is so fast that attempts to use fiscal and monetary stimulus during the midst of a public health crisis simply won’t be fast enough. The impact on people’s wellbeing will be devastating.

If you thought that the Great Depression-era generation had unusual attitudes about many things, the scars from the economic side of this crisis alone would last decades. Let alone the enormous changes in societal behaviour that will be required to flatten the curve.

ESG Risk, Technology Risk And Reducing Inequality

One of the UN Sustainable Development Goals is about reducing inequality among and within countries. The UN SDGs are a high-level framework of 17 goals that the world can achieve by 2030. They are useful as a way of understanding your firm’s social impact and identifying how to change your operating model to reduce any adverse effects or enhance any positive ones.

ESG risk and reducing inequality may seem entirely unrelated. However, there are ever-increasing community and employee expectations when it comes to issues such as executive compensation, wage growth, sharing in productivity increases, and managing rising living costs.

The detailed sub-goals of Goal 10 are really about the developing world, and not the relative poverty issues in developed countries. Many countries cannot afford social protection policies and legislation that richer countries can. Some richer countries place high tariffs on goods exported from poorer countries which makes it more difficult for people in these countries to trade their way to higher living standards.

An example of the ESG risk in this space is the cost of migrant remittances. Hundreds of millions globally send billions every year back to relatives in their home country. Often, there are high fees associated with this and many global financial institutions have encountered a lot of issues ensuring AML/CTF compliance in this space.

Goal 10.C is quite sad – reducing the cost of remittances to no more than 3% by 2030 and eliminating remittance channels that cost more than 5% in transaction costs. The rise of startups in developed countries that enable you to send money overseas at wholesale FX rates when poor people are charged enormous premiums is definitely in the social risk category.

Product management and pricing decisions around FX or overseas transfers will be even more complicated over the next decade than they already are. It’s certainly an area that is being disrupted by firms with better technology and customer experience than the banks. People who are moving between developed countries or paying less for their overseas holiday shopping and dining out capture much of this benefit in reduced costs.

When researching this particular UN SDG, the issue of technology startups in developed countries coming up with great ways to solve problems that only work in developed countries became quite clear. Many amazing innovations will only work if you have a passport from an OECD country. There are still enormous increases in transaction monitoring capability required to change negative screening for entire countries that some financial institutions still feel the need to do because their technology is decades behind Silicon Valley.

The strength of the focus on risk and compliance over the past decade has led many boards to authorise investment in their technology platforms. But merely spending hundreds of millions of dollars on technology isn’t necessarily enough.

How many ESG risks are hiding in the legacy technology ecosystems of major financial institutions around the world? A target operating model for a risk function includes more than just the implementation of transaction monitoring software. The people, processes and systems all need to work to clear principles and deliver the right outcomes for a broad group of stakeholders.

The irony of the enormous spend on risk and compliance technology, particularly regarding regulatory and legislative compliance, is that it has provided many large firms with the right model for how they might need to prioritise investment in climate change risk reduction.

The problem for the customer experience is that if you already have a poor customer experience that will cost $X to fix, and now your bank needs to spend a further $X on more risk and compliance programmes of work, then very soon you start running into a point where the duplication of all of these technology investments across different companies becomes redundant.

The role of a board is to provide governance to an organisation, and this includes making tradeoffs between Project 1 and Project 2. The problem is that many of the loudest voices criticising their every move on ESG risk don’t exactly appreciate the concept of constrained resources. For many financial services firms, they will face a point where they need to consider their entire current operating model and seriously rethink their purpose and strategy.

What is the link between this and the central problem of reducing inequality among countries and within them? Well, previously, a firm could make tradeoffs inside its operating model transformation that included plays like outsourcing or radical restructuring. Now, every person with a Twitter account could set off a backlash for something as random as invoice payment times for SMEs.

The reporting on this issue in Australia has been great because nothing could demonstrate more clearly to a board and senior executives that the operational-level decisions inside their operating model are now fair game. ESG risks must now be fully understood and considered at the customer interaction level and the supplier interaction level.

A board that wants to obtain an independent assessment of its ESG risk and current operating model should consider what social license to operate means in the 2020s. A higher proportion of people will increasingly demand more and more of the private sector.

Unlike politicians, CEOs face the market test. Many are already far advanced in changing their firm’s way of doing business to differentiate themselves from competitors. Higher enterprise value is likely to accrue to firms that have low ESG risk relative to other investment opportunities. Protecting access to finance at all should now be a consideration of boards – one serious enough ESG controversy could see lines of credit cut, investment banks no longer willing to work with you on a debt issue, or even suspension from trading on an exchange.

The level of seriousness boards and senior executives have to take these issues is quite clear. They are skating on thin ice in a real-time communication world. Independent assessment of the ESG risks they face and the steps to take to mitigate, reduce, or eliminate them will be a top focus for 2020 and beyond.

Large transformation projects that have already started may require even larger investments or potentially cancellation and writedowns. The business strategy of a large financial institution is also facing severe risk in an ultra-low interest rate environment. A pandemic related recession could be on the cards in many countries.

When interest rates go down, eventually there is no choice but for net interest margins to go down. The subsequent pressure on high bank operating expense ratios increases ESG risk even further due to the short-term earnings pressure from many shareholders. What a fascinating era!

Sustainable Infrastructure And ESG Risk Management

The UN Sustainable Development Goals are a useful high-level framework for business to use in assessing its negative or positive social impacts. Global partnerships between government, NGOs, and the private sector will be required to achieve them by 2030.

The rise of community expectations around climate change and other ESG risks means that boards and senior executives can no longer function in “press release” mode when it comes to sustainability initiatives.

The management of ESG risk is a crucial part of your risk management framework, and firms need to identify and manage both quantitative and qualitative risks. The excuse that it is difficult to quantify some ESG risks will not cut it with stakeholders over the coming decade.

Institutional and retail investors will increasingly expect rapid and decisive responses to controversies, including the immediate resignation of directors and senior executives. “Riding out” the storm of displeasure will be very difficult given the increasing volume in the media on these issues.

One of the important considerations when thinking about sustainability reporting and the achievement of the UN SDGs by 2030, is that innovation and profitability in the private sector is a crucial success factor.

Many businesses have the opportunity to assess their current operating model, identify where and how they can make a positive social impact, and move towards implementing a responsible operating model that delivers for a full group of stakeholders while still generating an appropriate level of profit.

Goal 9: Build resilient infrastructure, promote sustainable industrialisation and foster innovation

Goal 9 of the UN SDGs is about how essential investments in underlying infrastructure are to enabling sustainable development. Technological efficiency, energy-efficiency, and increased productivity enabled by investments in transport, energy, technology, healthcare, education, and irrigation will all help developed and developing countries alike in improving their standard of living.

A lack of necessary infrastructure in developing countries means that their people are at a clear disadvantage when it comes to ease of access to more markets to sell their products and services. Sustained employment growth will become more realistic for some countries once appropriate infrastructure investments are made and brought online.

Environmentally sound infrastructure development will help achieve other sustainability outcomes while providing lower environmental impacts from infrastructure development. Firms who operate in the infrastructure sector will be able to share their best practices with developing countries to enhance ecological efficiency for new projects.

For firms operating in developed countries, assisting in developing countries and providing technology investments where feasible can help accelerate sustainable development. For example, substantial investment in mobile phone networks in Africa has enabled a wave of entrepreneurship and innovation to take place in previously unconnected communities.

Board and Senior Executive Considerations

Boards and senior executives in other sectors may not think they can have any impact on this particular goal. However, UN SDGs are a broad church of targeted outcomes for a global society. One of the more effective ways that any business can make an impact on these goals indirectly related to your business is through due diligence and standards for your broader value chain.

The first exercise is a current operating model assessment that looks at your present purpose, strategy, and operating model. The outputs of this exercise can be mapped at a high-level to each of the 17 UN SDGs to provide input into the next activity.

The second exercise is mapping the current operating model outputs to each of the UN SDGs and identifying the positive or negative social impacts your business currently has. There may be somewhere there are none, there may be others where some substantial impact is possible.

The third exercise is taking the first two exercises into account and re-examining the purpose of the business. Why do you do what you do? Is your goal relevant in the 2020s? Are you a sunrise or a sunset business?

The fourth exercise is then revisiting the business strategy. Does it help or hinder the achievement of sustainability outcomes? Are there any products or services that need changes or closing down in light of changes in community expectations today or anticipated changes in community expectations tomorrow?

Once the current operating model, mapping exercise, purpose re-examination, and strategy re-examination are complete, a broad group of stakeholders should participate in the development of a responsible operating model.

The current trend in transformation is to speak of the target operating model; however, in the 2020s, it will be necessary to design and implement a responsible operating model. Sustainability outcomes must be incorporated into the design and planning stages of any transformation program. If they aren’t, they won’t be delivered.

One of the changes in thinking about ESG risk is that the business case is about the enterprise value of the business itself. Issues that even five years ago may not have merited a mention in a footnote to a presentation could now present themselves as existential crises for a board of directors.

Over the past decade, the cost of implementing appropriate systems and controls to manage compliance risk has been billions of dollars for the financial services sector. The coming decade will see a further increase in required technology and project expenditure to give boards and regulators assurance that a framework is in place and monitored actively at all levels of a business when it comes to ESG risk.

Other industries have faced similar costs, such as the impact of health & safety legislation on the construction sector. But no one would argue that making sure everyone goes home from a worksite at night is less important than making a profit at any cost. However, 30 years ago, those arguments were undoubtedly being made by some construction sector executives and boards.

Times have changed, and old attitudes towards ESG risk will need to be updated. The current economic environment globally, where the asset markets have boomed, and many companies rebounded from the Global Financial Crisis after brief tests in 2008 and 2009 of their operating model, means that the next downturn will provide an opportunity for deep introspection and consideration of what a responsible operating model needs to look like for a secure strategic position relative to your competitors in the coming decade.

Sustainable Economic Growth And ESG Risk Management

An environment of ever-increasing expectations on corporate leaders to do the right thing when it comes to sustainable business means it’s an issue to be taken seriously from the board-level down. The identification, active management, mitigation, or elimination of ESG risk from your operating model is a vital part of building a sustainable business that makes a positive social impact as well as delivering a profitable business for shareholders.

The UN Sustainable Development Goals provide a useful high-level framework for assessing your firm’s ability to deliver sustainability outcomes and is increasingly used by global firms as the core 17 areas for reporting their sustainability focus in their annual report.

You can map the 17 UN SDGs against your current operating model to identify the areas where your firm is making a positive or negative social impact. This exercise could assist in the analysis work before a transformation programme begins, ensuring that the development and deployment of the target operating model incorporate sustainability outcomes.

Ever-increasing community expectations around what businesses are doing to reduce ESG risks and deliver a positive social impact for a full group of stakeholders means that thinking about what a responsible operating model for your business incorporates can help the process of positioning your firm ahead of the curve.

Boards and senior executives might consider assessing their current risk management framework to identify whether the broad array of ESG risks as some choose to define them are present in their existing risk register.

Environmental, social, and governance risks can be much harder to quantify than many financial or operational risks. Firms should develop a defensible framework for estimating the cost of these risks and the severity of their impact on the operations of the business.

The business case for making significant investments into projects that reduce these risks and enhance the enterprise value of your business is clear. Increasingly, firms that do not take these issues seriously or engage in a press-release driven approach will find it difficult or impossible to raise capital.

Institutional investors in 2020 expect well-aligned corporate behaviours and communications on sustainability issues with their preferred responsible investing frameworks than even five years ago. Investor relations and corporate access teams at investment banks will have higher rates of inquiry from stakeholders who may previously never have engaged with them, and that means that the operating model for an investor relations function or corporate sustainability function needs to adapt and improve as part of the core operating model of the business, instead of being tucked away in a small department.

Goal 8: Promote inclusive and sustainable economic growth, employment and decent work for all

Goal 8 is about sustainable growth that cares about people. Eradicating global poverty depends on increasing the quality and compensation levels of workers around the world through raising productivity and sharing some of those gains.

In many developing countries, having a job doesn’t mean that your family is out of poverty. Roughly half of the world’s population lives on less than US$2 a day even with global unemployment around 5.7% according to the UN.

“Sustainable economic growth will require societies to create the conditions that allow people to have quality jobs that stimulate the economy while not harming the environment. Job opportunities and decent working conditions are also required for the whole working age population. There needs to be increased access to financial services to manage incomes, accumulate assets and make productive investments. Increased commitments to trade, banking and agriculture infrastructure will also help increase productivity and reduce unemployment levels in the world’s most impoverished regions.”

Some of the detailed sub-goals associated with Goal 8 include per capita economic growth, higher levels of productivity supported by investment in technology, a focus on high-value-added services, implementation of development-oriented policies, and eradicating forced labour and modern slavery.

8.1 Sustain per capita economic growth in accordance with national circumstances and, in particular, at least 7 per cent gross domestic product growth per annum in the least developed countries

8.2 Achieve higher levels of economic productivity through diversification, technological upgrading and innovation, including through a focus on high-value added and labour-intensive sectors

8.3 Promote development-oriented policies that support productive activities, decent job creation, entrepreneurship, creativity and innovation, and encourage the formalization and growth of micro-, small- and medium-sized enterprises, including through access to financial services

8.4 Improve progressively, through 2030, global resource efficiency in consumption and production and endeavour to decouple economic growth from environmental degradation, in accordance with the 10-year framework of programmes on sustainable consumption and production, with developed countries taking the lead

8.5 By 2030, achieve full and productive employment and decent work for all women and men, including for young people and persons with disabilities, and equal pay for work of equal value

8.6 By 2020, substantially reduce the proportion of youth not in employment, education or training

8.7 Take immediate and effective measures to eradicate forced labour, end modern slavery and human trafficking and secure the prohibition and elimination of the worst forms of child labour, including recruitment and use of child soldiers, and by 2025 end child labour in all its forms

8.8 Protect labour rights and promote safe and secure working environments for all workers, including migrant workers, in particular women migrants, and those in precarious employment

8.9 By 2030, devise and implement policies to promote sustainable tourism that creates jobs and promotes local culture and products

8.10 Strengthen the capacity of domestic financial institutions to encourage and expand access to banking, insurance and financial services for all

8.A: Increase Aid for Trade support for developing countries, in particular least developed countries, including through the Enhanced Integrated Framework for Trade-Related Technical Assistance to Least Developed Countries

8.B: By 2020, develop and operationalize a global strategy for youth employment and implement the Global Jobs Pact of the International Labour Organization


Board and Senior Executive Considerations

Boards and senior leaders will see that, like the other SDGs, there are several areas where any business can make a positive social impact. Procurement processes need to ensure that risks such as forced labour and modern slavery are not in your supply chain.

When you assess your current operating model, the key areas to explore when considering Goal 8 include people and culture processes and policies. If you are in financial services, finding what actions you could take to support the achievement of goal 8.10 would be a key focus. If you are in transportation or travel, exploring sustainable tourism such as going beyond net-zero or carbon neutral and thinking about carbon-negative operating models that create local jobs where you operate your business would be worth consideration.

The use of the UN SDGs as a high-level framework to map your current operating model against the ability of your business to deliver a positive social impact is a useful exercise for businesses. Many leading global firms already incorporate this reporting in their annual reports.

The decade ahead will be necessary for firms as they strategically position themselves to be ahead of their competitors on ESG issues. Moving beyond reporting and engagement to actively choose where your operating model (people, processes and systems) can adjust to improve positive outcomes or reduce adverse consequences will be tables stakes.

Institutional and retail investors are growing their awareness of ESG risks and expectations of the pace at which boards and senior executives will respond decisively if any controversies arise. Waiting it out or sending out a press release won’t cut it. Resignations and ending supplier relationships will become far more frequent and building a responsible operating model with in-built flexibility that can respond if a critical supplier needs to be changed because of an unacceptable level of ESG risk will increasingly mark the leaders in this space distinctly from the laggards.