This blog post is a part of a series of entries to explore the application of ESG concepts and principles into aspects of Risk Management.
Basel II defines operational risk as “the risk of loss resulting from inadequate or failed processes, people and systems or from external events.” Operational risk management is the prevention, control and mitigation of a loss event, or an incident that triggers a financial loss for the company.
A loss event may have direct or indirect impacts on the business. Direct impacts include a drop in income, drop in share price, or decline in the value of the company’s assets and liabilities. Indirect impacts include reputational damage, opportunity costs or “event spin-offs”, which causes losses in other functions of the firm.
ESG and Operational Failures
ESG encompasses all aspects of a business, it is not limited to environmental sustainability. ESG includes the conduct of ethical business, employee health and safety, the production of high quality and safe products, maintaining a sustainable supply chain, and safeguarding of privacy and online security for employees and customers, among others. The failure to manage ESG factors in a company’s operations can generate both direct and indirect impact on a business.
Recent high profile cases demonstrate that the relevance of ESG to operational risk. Volkswagen’s manipulation of carbon emissions tests in the US led to an unprecedented guilty plea and a $4.3 billion fine , and became the poster boy for deceiving regulators and customers. Wells Fargo lost institutional and new retail clients after creating unauthorized customers accounts last year. The 2014 hack on Yahoo, revealed in 2016, prompted Verizon to review its impending acquisition of the web company. All these events triggered ESG rating downgrades for the companies involved.
ESG issues can be used as key risk indicators and key risk drivers.
As risk indicators: For example, companies can use the number of whistleblower complaints as a key risk indicator. An increasing trend in whistleblower complaints could indicate a growing incidence of unethical activity in the company. A retail company can use media or NGO reporting on their suppliers as a risk indicator to monitor the stability and sustainability of their supply chains. An increase in NGO criticism of a supplier could indicate serious problems in that supplier, which could disrupt the flow of raw supply or manufactured goods into the retailer.
As risk drivers: Using the same examples above, whistleblower complaints on unethical behavor may be driven by the company’s incentive system or outdated ethical policies and protocols. NGO criticism of a supplier may be driven by the retail company’s supply chain management. The retailer may not be conducting adequate due diligence of and training for supplier companies.
Operational risk is an area of risk where ESG factors can be applied naturally, if a company recognizes their importance to the business.