As regulatory and stakeholder issues heighten around environmental, social and governance factors, companies must now oversee the associated risks more strategically. Unfortunately, ESG issues are sensitive to public choices, rely on future scenario-based materiality and require longer time horizons. Thus, the challenge in quantifying ESG risks has prompted companies to adopt different risk management procedures.

Since ESG risks can turn to sizable negative impacts throughout a company’s value chain if not appropriately managed, companies are now engaging through effective scenario planning and building a well-crafted strategic fit with other business operations while diligently adapting to frequent regulatory changes.

Rare, yet more impactful physical risks

Climate change is a huge environmental risk, and it is interlinked with other environmental issues. The Task Force on Climate-Related Financial Disclosures categorizes physical climate change risks into two groups: acute and chronic. For example, disasters caused by extreme weather events are acute risks that could disrupt a company’s ordinary logistics. The dryness that causes forests to become more combustible and prone to electric utility-linked wildland fires is an example of chronic risks increasing worldwide.

In 2019, California’s Pacific Gas & Electric nearly went bankrupt after four trees hit the power lines and a massive wildfire destroyed the entire town of Paradise. PG&E eventually exited bankruptcy, but experts mark PG&E’s case as a recordable climate change fiasco. Such failures would have mattered less or brought no damage years back, but California forests had become much more combustible due to climate change. South Korea experienced a similar wildfire in 2019 in Goseong, Gangwon Province. Due to this disaster, the Korea Electric Power Corp. is still under investigation for not properly managing an extra-high-voltage wire that fell due to high winds, causing damage to some 2,000 buildings.

Physical climate change disasters are increasing and they can bring out many different negative externalities. Life, operational, legal and reputational risks will be immense if specific safety measurements such as the safety power shutoff programs are not monitored and regularly checked.

Transition risks during the ‘greening’ process

The 192 countries that cause 96 percent of global greenhouse gas emissions submitted Nationally Determined Contributions in accordance with the Paris Agreement by 2020. The United Nations Framework Convention on Climate Change Adaptation Committee recently requested synthesis reports from these countries to check their progress. While physical climate change risks like wildfire may be industry-specific, most companies will face some degree of risk as they are forced to shift to low-carbon business schemes. For instance, one type of transition risk may be the financial risk when companies make investment decisions in renewable energy.

The Task Force on Climate-Related Financial Disclosures systemized the risks during transition periods into four groups: regulatory/legal, technology, market and reputation risks. What companies should do is oversee all four risk types throughout their value chains. For example, market risks include the material price, uncertain market signals during procurement and logistics, as well as changing customer preferences when commercializing eco-friendly products and services. Reputational risks have also become more critical as stakeholder activism exerts greater influence on board decisions than before. Overall, ESG risks interfere with the nonfinancial risks of other involved parties such as credit institutions and investment firms.

Initially, energy companies will be subject to most of the transition risks due to the growing pressure to make sure their energy consumption and production abide by green standards. Reports show that two-thirds of the world’s fossil fuel reserves must close down to meet the Paris Agreement targets. Automotive, shipbuilding and construction sectors consuming raw materials like steel and cement should also carefully benchmark and implement transition risk management.

The recent 76th UN General Assembly detailed the progress and topics of the 2030 Agenda for Sustainable Development. The agenda highlights the implementations for sustainable consumption and production, concerns for the present and future generations, desertification, biological diversity and coastal zone management. The upcoming UN Climate Change Conference’s Convention of the Parties 15 will discuss the development of biodiversity footprint and measurement standards. The largest international conference since the Paris Agreement will be the COP26 summit, which runs Oct. 31 through Nov. 12. It will focus on achieving net-zero to advance climate change issues and guide companies on managing transition risks.

New risks will continue to emerge, and they will derive from legal and compliance conflicts. These regulatory risks will soon lead to other risk types if not managed in due time. The unique trait of ESG risk is its interconnected and expansive scale of impact throughout the value chain. Therefore, companies should track and assess risk drivers and transmission channels such as increased cost of compliance or lower profitability. Then materialize the financial and nonfinancial impacts such as supply chain or talent acquisition risks. Companies must diligently oversee all risk types and implement an ESG management scheme that is strategically fit yet differentiated from the previous risk management.

Lee Yeon-woo
Lee Yeon-woo is an expert adviser at the Korean law firm Bae, Kim & Lee. -- Ed.