Environmental, social, and governance (ESG) related risks are becoming more relevant to the ability of entities to exist and thrive. As the landscape of risks continuously changes, it is imperative for entities to have a strong ERM system in place to ensure that strategy and business objectives remain aligned with risk appetite.
ESG issues are generally defined as follows:
Environmental Issues: Include broad aggregate matters such as pollution, deforestation, and climate change. ESG values include positive efforts contributing to environmental protection.
Social Issues: Include such legal and social matters as occupational health and safety, customer relations, employee relations, and human rights. ESG values include positive efforts contributing to socially responsible behavior and outcomes.
Governance Issues: Include proactive board membership and succession planning, promoting fair compensation, promoting diversity and inclusion, establishing strong data security, preventing bribery and fraud, preventing culturally and politically insensitive remarks, and preventing discrimination. ESG values include positive efforts within an entity’s governance to produce sustainable outcomes.
Application of ERM to ESG-Related Risks
1. Governance and Culture for ESG-Related Risks
This component of the ERM framework focuses on the oversight and culture of an entity and how that is applied to the entity's approach to risk management. For ESG-related risks, it is important that management is aware and understands applicable ESG-related risks. This awareness can be created by obtaining a deeper understanding of mandatory and voluntary ESG compliance requirements, ensuring that information related to ESG risks is shared in a collaborative manner throughout the organization, and considering individuals with ESG- related skills and knowledge during the hiring and talent management process.
2. Strategy and Objective-Setting for ESG-Related Risks
This component of the ERM framework includes understanding the business context of an entity and setting the strategy and business objectives in a manner that aligns the entity's risk appetite with its goal of creating value. When applying to ESG-related risks, management must consider the impact of the strategy and business objectives on nature and society and ensure that these impacts are considered in the short, medium and long term. An entity must build upon the foundational knowledge discussed in the previous component and begin to gain a deeper understanding of the potential impacts through an analysis of existing and emerging ESG-related risks.
3. Performance for ESG-Related Risks
The performance component includes identifying, assessing, prioritizing, and responding to risks. Examples of ERM risks that are linked to ESG risk often include reputational, operational, credit, market, compliance, and liquidity risks.
Identification: Entities may use many different approaches for identifying ESG-related risks, including megatrend analysis, SWOT analysis, impacts and dependency mapping, and stakeholder engagement. A stakeholder workshop may include discussions in which risk events are identified, likelihood and impact of events are reviewed, root causes of the event are identified, and prevention and detection approaches are evaluated for potential effectiveness. Ensuring collaboration between risk management and sustainability practitioners is key to the proper identification of ESG-related risks.
Assessment and Prioritization: It is necessary to appropriately assess and prioritize risks to ensure that the entity's response is appropriate given the nature and severity of the risk. Leveraging ESG expertise is important to ensure that risk severity is appropriately assessed and communicated to management in a way that they understand.
Response: Responding to identified risks is critical to an effective ERM framework, An entity considers the source of the risk, the cost and benefit of responses, and the overall risk appetite. A through understanding of the short, medium and long-term impacts of ESG- related risks is important to ensure an appropriate response.
4. Review and Revision for ESG-Related Risks
Ongoing review and revision of the risk management approaches are an important component of ensuring that the approaches remain effective. For ESG-related risks entities must continuously assess internal and external changes to ensure risks are appropriately identified and prioritized and seek improvements to ESG-related risk responses.
5. Information, Communication and Reporting for ESG-Related Risks
The key objective of the ERM framework related to effective communication and reporting is that management and other stakeholders remain informed of risks so they are able to make informed decisions. Reporting may be to internal or external stakeholders and may be mandatory or voluntary. Because ESG issues can be complex, it is critical that data reported is accurate.
Examples of climate-related report disclosures may include:
a. Oversight and governance of climate-related risks.
b. Whether processes for identifying, assessing, and managing climate-related risks are integrated into overall risk management systems or processes.
c. Plans to reduce climate-related risks.
d. Specific climate-related metrics for financial statement disclosure (eg. Audited assertions regarding the impact of climate change on financial statement line items).
e. Disclosures of greenhouse gas (GHG) emissions metrics.
f. Climate-related targets or goals.
Disclaimer: The above analysis is based on publicly available policy information and does not constitute specific investment advice. Investors should make decisions in light of their own financial situation, risk tolerance, and professional advisory.
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