ESG risks that you can’t afford: Avoid business impact 

In today’s corporate landscape, Environmental, Social, and Governance (ESG) compliance can determine an organization’s success or failure. Understanding ESG risks and how to mitigate them is crucial.

What is ESG risk?

ESG risks are potential negative consequences of the three core pillars:

1. Environmental: A company’s environmental impact, including its carbon footprint, resource use, and emissions.
2. Social: How organizations engage with employees, communities, and other stakeholders.
3. Governance: The management of an organization. Governance includes ethical practices, fair pay, and board diversity.

Mismanagement of ESG risk can have financial, reputational, and legal implications. Regulatory bodies enforce ESG standards. These authorities can impose fines on entities that fail to comply with regulations. U.S. regulatory agencies include the Environmental Protection Agency (EPA) and the Securities and Exchange Commission (SEC).

Top ESG risks that you can’t afford

Each of the three components of ESG has unique risks. The type of risk may depend on the industry. For example, in the energy sector, environmental risk can relate to gas emissions, while the manufacturing sector must consider resource use.

Here are some top risks to avoid in each ESG pillar:

Environmental risks

Organizations must monitor their environmental impact or risk noncompliance, fines, or legal implications. The following are examples of environmental risks:

• Pollution: Industries such as energy or manufacturing can pollute the air, water, and soil.
• Natural resource depletion: Corporations that overuse natural resources to the point of depletion, such as deforestation.
• Greenhouse gas emissions: Excessive emissions can pollute the surrounding area and contribute to climate change.
• Business disruption: A lack of preparation for weather-related or natural disasters can interrupt operations.
• Climate change: An organization’s environmental strategy can help or hinder the effects of climate change. 

Social risks

How businesses operate impacts different stakeholders, from staff to local communities. Common social risks include:

• Human rights violations, such as exploiting workers through forced or child labor. 
• Manufacturing products that are misleading or pose safety risks.
• Unequal or unfair pay, unsafe working conditions, or unreasonable hours.
• Failing to engage with communities in a fair and ethical way. 
• Data breaches and noncompliance with regulations due to insufficient protections.

Governance risks

Governance refers to internal policies and controls. Improper business practices can harm an organization’s finances, reputation, and customer trust. Governance risks may mean:

• Unethical business practices: Fraud, corruption, and bribery are examples of unethical practices.
• Dishonesty: An organization may lack transparency around internal policies or financial performance.
• Conflicts of interest: Examples of conflict of interest risks include parties making business decisions based on bias or vested interests, such as hiring a vendor because of a personal relationship with a shareholder. 
• Board diversity: A lack of board diversity can result in groupthink where board members make decisions without proper evaluation to conform with the majority.

Examples of ESG mismanagement

ESG presents organizations with both threats and opportunities. Done right, it can strengthen business resilience and increase profits. Done wrong, it can cause irreparable damage. 

Here are three famous examples of ESG management failures:

1. Volkswagen: Environmental risk

For years, Volkswagen (VW) marketed itself as an eco-friendly car company. It claimed to use “Clean Diesel” to power its cars, positioning itself as an alternative to hybrid and electric vehicles. 

Unknown to the public, VW installed software in its cars to detect emissions testing. While their vehicles were passing emissions tests, the truth was different. Cars were pumping out more than 40x of the legally permitted emissions levels. These high emission levels jeopardized the health and safety of both customers and the public.

Dubbed “Dieselgate,” the 2015 emissions revelation sent ripples throughout the business world. VW incurred a greenwashing fine of over $30 billion, the largest to date. It also had to pay billions in damages to customers and dealers. Some lawsuits, including one against the CEO in Germany, settled for close to $350 million. 

“We have totally screwed up,” said VW of America CEO Michael Horn. VW’s chief executive, Martin Winterkorn, said his company had “broken the trust of our customers and the public.” Winterkorn resigned as a direct result of the scandal. 

2. Enron: Financial risk

One of the most infamous examples of ESG failures is former energy giant Enron. In 15 months, it went from a $70 billion market capitalization to bankrupt. 

Analysts noticed some questionable accounting in the organization’s annual reporting. The SEC found unusual accounting practices that inflated profits and hid significant losses.

Enron presented a facade of stable and consistent cash flow, but the truth differed. The company forecasted profits for projects that did not generate revenue. Where revenue was less than forecast, Enron handed the asset over to an off-book entity. The entity pressured the auditing firm Arthur Andersen to ignore any accounting irregularities. 

In December 2001, Enron filed for bankruptcy. The company couldn’t survive plummeting share prices and a $40 billion shareholder lawsuit. Arthur Andersen collapsed due to its involvement. As a result, in 2002, the government passed the Sarbanes-Oxley Act to prevent corporate fraud and ensure accurate financial reporting.

3. Wells Fargo: Governance risk

In 2016, financial institution Wells Fargo found itself in an account fraud scandal. Employees under pressure from unrealistic sales targets and incentives turned to fraud. They created millions of fraudulent bank and credit card accounts without customer consent. The bank’s customers suffered fees and damaged credit scores as a result.

Once uncovered, the scandal cost Wells Fargo over $3 billion in settlements and fines. The damage to the organization’s reputation resulted in lost customer trust. Market value plummeted and several senior executives resigned. 

The case emphasized the need for ethical governance and control. The bank was subject to regulatory action, including restricting asset growth. This restriction was still in place at the time of publishing. 

Some may argue that ESG risks are not cause for concern. However, the continuing pace of the ESG conversation indicates otherwise. Unpreparedness or ignoring risks can lead businesses to significant legal vulnerabilities and financial consequences. 

Why is ESG risk bad for business?

1. Reputation and brand damage: Ethical and sustainable practices demonstrate your company’s commitment to responsible conduct. Failure to commit to these goals can damage reputation, brand value, and customer trust.
2. Financial implications: Strong ESG performance attracts a broader range of investors. Investor interest in sustainable and responsible investing continues to grow. ESG mismanagement can restrict capital access and increase borrowing costs.
3. Regulatory and legal risks: Proactive ESG management helps companies comply with evolving regulations. Ignoring or mismanaging ESG can result in noncompliance, legal issues, and reputational damage.  
4. Stagnation and competitive disadvantage: Sustainable practices drive innovation in environmentally friendly technologies, materials, and processes. Today’s consumer seeks out sustainable and socially conscious products or services. Therefore, businesses that display environmental and social responsibility gain a competitive edge. 
5. Employee dissatisfaction: Companies that prioritize ESG goals are often more attractive to potential talent. Employees who work for a company that shares their values are more engaged and motivated.

Tips for ESG compliance

Understanding the requirements set by regulatory agencies is the first step to compliance. The following tips can improve your organization’s change of ESG compliance:

1. Conduct an ESG risk analysis: Identify gaps in environmental, social, and governance reporting gaps. 
2. Create an ESG strategy: Use the risk analysis results to inform a strategy. List specific ESG objectives with a plan to achieve each goal. This roadmap should align with ESG reporting requirements. 
3. Stay updated on standards: ESQ regulations change often. Keeping ahead of evolving standards ensures your organization remains compliant. 
4. Manage ESG data: Collecting and maintaining data is vital to ESG compliance. The type of data depends on the industry. For example, organizations may need to record emissions, labor practices, or board diversity.

Stay ESG compliant with Agiloft

The era of ESG is here and with it comes opportunities and risks. Businesses must review ESG legal frameworks to understand their implications and risks. Now is the time to assess those risks and determine what you need to protect your organization.

To learn how to mitigate these risks and ensure ESG compliance with CLM, check out our ESG Playbook here.