Delivering Enterprise Value: The Case for Sustainability and Risk Management Integration
The evaluation of sustainability practices and risk management belong together. Here is why: combined, they deliver enhanced enterprise value – across sectors, across geographies and across regulatory regimes.
The integration of sustainability dimensions within a company’s risk function has not yet received the attention it deserves by corporate observers. Most likely, it is due to the fact that it challenges the ultimate mandate of traditional enterprise risk management (ERM) frameworks, namely, to minimize (or transfer) the residual risk of the business. By “residual risk” we mean the amount of aggregate risk exposure that does not respond outright to standard mitigation practices. It also typically emerges as a by product of a company’s evolving business model. In that context, credit, market or interest rate risks are well analyzed and observable real time while non-traditional risks such as sustainability are harder to consistently quantify. Yet, they create significant residual risk potential for an organization.
While harder to consistently quantify, sustainability dimensions introduce significant residual risk potential for an organization along with a novel list of business opportunities.
Sustainability risks have direct impact on enterprise value in the form of reputational risk, brand equity erosion, employee retention, customer satisfaction, not to mention the economic burden of legal proceedings to clear competitive market behaviors and instances of alleged corporate complacency over socio-environmental remediation. Recent headlines provide tangible evidence of the near-term effects of sustainability risks left unattended. Bankruptcy of once reputable utility operators, health and safety concerns in the metals and mining sector, and mounting data privacy issues affecting technology and telecommunication providers have reopened the question regarding risk controls. Are these a matter of board-level oversight of management? Are they part of a broader assurance program?
The good news is that mitigation of sustainability risks brings a novel list of business opportunities to the marketplace. A number of incumbents as well as more agile innovators have refocused their business development efforts on turning key non-financial risks into opportunities for new business through the lens of their R&D/innovation function. To name just a few, the case of agritech employing green chemistry and eliminating hazardous waste in the chemicals sector; traditional aerospace and defense warfare solutions now transferable for law enforcement and border control to enhance customer security, and automotive component manufacturers moving swiftly to fill in their customer needs for electrification and autonomous driving. The use of alternative data is key to compare and contrast the rich evidence available through surveys, textual and verbal search, and aerial mapping of consumer behaviors. On the other hand, visualization techniques, which have been widely used in the medical field, are likely to serve as transferable use cases across sectors.
How to ensure residual risks and opportunities that stem from sustainability are captured across the organization? A materiality assessment is an essential starting point. The past several years have seen the adoption of a materiality approach to the discussion of non-traditional risk dimensions by public companies operating in the US and overseas. Specifically, corporations today are better versed at mapping strategic business issues associated with economic, social and environmental considerations through a 2-dimensional matrix. On one axis, they assess the significance of such emerging issues to their finances and operations, while on the other axis, they map the relevance to a broader range of stakeholders: society overall. The further the issue at hand is on the axes, the higher its relevance to the company, to society, or both. According to a recent study of 600 listed companies by global sustainability think-tank Ceres titled “Turning Point”, approximately 32% of the participants carried out materiality assessments in 2017 vs. only 7% in 2014. While materiality disclosures bring deeper corporate transparency, they also introduce the need for “progress tracking” against those areas which are deemed of the highest relevance to the corporation as well as to its stakeholders. Unfortunately, as of 2017 less than 6% of respondents actively discuss the effect of these assessments on strategic planning by management or by their statutory boards. At the same time, mention of non-financial risks in shareholder proposals has become more frequent and focused on outcomes. By providing a roadmap for prioritization of business risks and enterprise value creation through new product development, materiality matrices are well positioned to drive the next generation of governance tools.
Enterprise risk dashboards that address both operational setting and business model evolution through the added lens of sustainability are key to the development of the next generation of governance tools.
What is most likely to drive the successful integration of traditional ERM frameworks and sustainability risks?
The following checklist has proven effective in distilling the information already available through materiality matrices and aligning it with established internal risk controls across industries. It also addressed the necessary strategic business planning and regulatory oversight that follow integration. To be an eligible candidate for risk integration, a non-financial issue would have the following characteristics:
1) affects operations directly in terms of its ability to deliver tangible enterprise value such as business growth and customer satisfaction
2) affects the company’s ability to retain its license to operate either by jeopardizing existing customer relationships, investor engagement or regulatory concerns
3) affects the evolution of the broader sector as a disruptor of the sector’s organic growth (either as a key competitive advantage or as a threat of the existing innovation effort)
Traditionally, integration of risk management practices focuses on combining elements of (1)and (2). Sustainability risks factor in business model changes because of broader industry-level effects as highlighted in (3). They also drive competitive forces to a company’s strategic advantage by defining outright the high-leverage points of the business. By leading with a sustainability risk culture that prioritizes the alignment of risk mitigation efforts with an organization’s drivers of profitability, ERM practices are likely to move away from a residual risk mindset into that of direct enhancers of enterprise value.
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