How to respond to the increased risk posed by ESG issues

Businesses in all sectors are increasingly facing regulatory and stakeholder scrutiny and pressure to address existing and emerging environmental, social and governance (ESG) issues.

For businesses, the main areas of focus from an ESG risk perspective should be corporate reputation and directors’ and officers’ liability.

Value of corporate reputation

A brand’s reputation is a valuable intangible asset that should be consistently protected and nurtured by the management team, as it is a way to communicate important information to stakeholders about the organisation’s identity, what it is and what it stands for, as well as how it is distinct from competition. A strong positive reputation results in a stronger competitive advantage, better performance on the stock market and enhanced financial performance.

However, reputation is a socially built phenomenon that could either enhance or destroy the financial and/or brand value of a business and the business’ character needs to be in line with the shifting expectations. Any impact on customers’ loyalty and trust can affect a business’ performance and desirability to the main stakeholders. Consequences can include loss of income, reduced customer base, and an inability to retain or attract talent.

ESG and reputational risk

Meeting the business’s ESG objectives results in several short-term achievements, such as inclusion in ESG-focused investment funds, positive media coverage and customer approval. However, since these objectives are often highly publicised, over-promising may lead to disastrous reputational damages, especially if a strong reputational risk management programme is not adapted. A disconnect between the plan and its roll-out may also trigger lawsuits by activist investors.

The risk exposure is arguably shifting faster and is generally higher in end-consumer facing operations. The report “Consumer Products and Retail: How sustainability is fundamentally changing consumer preferences (opens a new window)” from CapGemini, finds that sustainability has risen up the customer’s agenda: 79% of consumers are changing their purchase preferences based on social responsibility, inclusiveness, or environmental impact. Moreover, COVID-19 has increased consumer awareness and commitment to buying sustainably: 67% of consumers said that they will be more cautious about the scarcity of natural resources due to the COVID-19 crisis, and 65% said that they will be more mindful about the impact of their overall consumption in the “new normal.”

Reputational risk management

Due to the acceleration and amplification of bad news through the media, an urgent and coordinated response is critical, as reputational damage is inflicted faster and deeper than ever before. Businesses must acknowledge that meeting stakeholder expectations is not enough to safeguard corporate reputation. Inaccurate reporting by the media or unfair attacks from special interest groups may significantly damage a business’s reputation, consequently hindering stakeholder perceptions.

Unlike other loss events and perils, reputational harm is triggered by incidents that are difficult to predict and hard to quantify or characterise. Hence, a proactive risk management approach is required, as it safeguards businesses across their reputation life cycle. As discussed in KPMG’s “Safeguarding Reputation: Are you prepared to protect your organisation? (opens a new window)” report, the actions and decisions of an organisation are the main determinants of survival if an adverse event was to materialise.

Recommendations:

  1. Proactive horizon scanning: Considering the rapidly changing consumer perceptions regarding sustainability development and practices, as well as the changing regulatory landscape and ESG reporting standards.

  2. Building resilience: Improving reporting and communication, both internally and externally, narrows the reputation-reality gaps, which drives value creation for shareholders.

  3. Creating a culture of responsibility: Emphasizing the accountability of all employees and staff, as well as allocating clear and defined responsibilities in building resiliency across the various functional areas.

  4. Training at all levels: Regularly train all employees, from executives to associates, to better manage and deal with situations that could give rise to reputational harm, especially instances of negative media exposures.

  5. Understanding the impact of every stakeholder group on the organisation’s success and operations.

Failing to detect signs of changing stakeholder beliefs and expectations, or denying their validity, is management oversight, which can have significant repercussions and consequences on the overall business and even trigger shareholder lawsuits.

D&O exposures

Companies that have been caught in the crosshairs of advocacy groups, employees, and shareholders have been subject to litigation and campaigns focused on ousting executives, or else targeting director remuneration. Businesses also face regulatory interventions and investigations into supply chains, environmental impact, and disclosures related to social and climate issues.

Increased attention on ESG has meant insurers are taking a more guarded approach to D&O policies, seeking more information on a company’s current and future strategies in terms of environment, social, and governance issues.

Questions D&O insurers may ask businesses:

  • Do you have a carbon neutral strategy and how is it communicated?

Many companies have already begun adapting to the “green economy” with initiatives that target improved sustainability and clear targets for carbon emission reductions. Being able to show a clear intent to achieve carbon reduction targets in a clear time frame will demonstrate a clear environmental initiative. The way companies promote these initiatives will also assist in making them more attractive. Transparency regarding environmental disclosures is essential, with the minimum being an inclusion of sustainability and climate strategies in a company’s annual report. Beyond this, companies with dedicated sustainability reports, clear, forward-looking strategies to tackle environmental issues within it, and other shareholder disclosure material will all help in demonstrating good environmental and social management.

  • Is the board and management responsible for ESG issues?

The ESG-driven impact on D&O insurance is largely down to reputational risk, tied to concerns over negative events a company may face. Consequently, businesses should demonstrate an actively engaged board with clear oversight of a business’ ESG strategy, pre-emptively addressing major supply chain, labour, or environmental issues. Having a dedicated ESG officer as part of a management team is a common move to address this. The position demonstrates a company’s willingness to improve ESG standards within itself and provides a clear point of contact for ESG- related strategy progression, along with providing a board a clear liaison for ESG activity. Another route businesses can consider is basing remuneration and other compensation on ESG targets.

  • Are there clear commitments to diversity and human rights?

Insurers are looking beyond environmental concerns in D&O coverage now, as concerns of reputational risk to a company are affected by racial and gender issues, while scandals concerning labour practices have demonstrated the impact they can have on businesses. It is therefore essential that companies take these factors into account when communicating with stakeholders and the wider market – early transparency and communication over the possible implications a company’s finances may face regarding fines, lawsuits, or investigations into facets of the business which tap into social standards. Again, clarity and transparency are the tools for the job. Food and drink businesses are perhaps more clear cut in this sense, with oversight of international and domestic suppliers working conditions an essential point for clarity. Insurers will want to know how often reviews of suppliers and working conditions of domestic and international factories are, along with clarity in the company’s ethical stance on modern slavery. Diversity initiatives focusing on representation of women and people of colour on the board and in management will also be seen as green flags to insurers, while wider social initiatives focused on community projects assist in tapping into a company’s social prowess.

  • How do you monitor supply chains for good ESG practice?

Businesses that use domestic or foreign supply chains will also benefit from monitoring and auditing these facilities to ensure ESG-friendly will be cost-beneficial to businesses in the long- term. Essentially, companies will want to ensure that the supply chains they partner with do not possess any major red flags, be that regarding climate or social components. Carrying out annual in-person assessments of factories should be a minimum for companies with partnering supply chains. Visits to sites will allow companies to gauge the working conditions of supply chains, while businesses should also investigate the working culture of supply chains and the regions they operate in to ensure workers are not being subjected to human rights violations. Companies should also consider the environmental impact supply chains have. Ideally, companies will have already sought to optimise the supply journey for minimal carbon footprint impact, with a minimum move being an audit of suppliers’ climate impact, and targets for them both to move towards minimising this.

Having an engaged relationship with supply chains will keep companies in good stead when it comes time to renew D&O policies. Insurers which see companies taking a proactive approach to their partners will be more confident in knowing a business is not a possible liability due to external factors of its supply chains. For further information, please contact:

Michael Lea, Head of Management Liability

M: +44 (0)7584 884479

E: michael.lea@lockton.com

Matt Humphries, Head of Crisis Management (SVP)

T: +44 (0) 20 7933 2044

E:matthew.humphries@lockton.com