ESG risk: Definition and best practices to mitigate it

Environmental, Social, and Governance (ESG) risks are increasingly central to corporate strategy as companies face growing pressures from stakeholders, regulators, and consumers. A systematic review by Saini et al. (2023) highlighted that firms with poor ESG management often experience higher financial costs, while socially responsible companies benefit from lower capital costs due to their reduced risk profiles. 

Moreover, businesses failing to address ESG concerns can face financial losses ranging from 6% to 20% of revenue, mainly due to supply chain disruptions, as seen in a study by IBM. This underscores the growing financial implications of neglecting ESG considerations, which can directly affect a company’s bottom line. 

Poorly managed ESG risks jeopardise a business’s sustainability, long-term financial health, and market position. This article will explore ESG risk, its implications, and the best practices companies can adopt to mitigate these risks.

What is ESG risk?

ESG risk encompasses the potential dangers that businesses face in relation to environmental, social, and governance factors. These can affect a company’s operations, reputation, and financial performance. Each component presents distinct challenges, and failure to address them adequately can have severe consequences, including loss of investor trust, legal penalties, and operational disruptions.

The most critical aspect of managing ESG risk is first identifying these risks. Without proper identification, companies cannot effectively assess or mitigate potential impacts. Once risks are identified and quantified, businesses can implement tools to manage and minimise their effects.

Environmental risks

Environmental risks involve climate change, resource depletion, pollution, and biodiversity loss. For businesses, these risks can manifest as regulatory penalties for non-compliance with environmental standards, increased operational costs due to resource scarcity, or disruptions caused by climate-related events such as floods or hurricanes. 

Companies that are slow to adopt sustainable practices may also lose out on customers who are increasingly favouring eco-conscious brands, leading to revenue decline and reduced market competitiveness.

Social risks

Social risks pertain to how a company manages its relationships with employees, communities, and consumers. Poor labour conditions, human rights violations, or neglecting employee health and safety can result in labour strikes, legal action, and a damaged reputation. 

This translates into losing customer trust and potentially lowering sales as consumers increasingly hold businesses accountable for their social impact. Failing to meet social expectations can make attracting and retaining talent difficult.

Governance risks

Governance risks arise from inadequate corporate governance practices, including corruption, lack of transparency, and poor decision-making. These risks often result in legal actions, financial mismanagement, and erosion of stakeholder confidence. Companies with weak governance may also find it harder to secure investments, as investors seek transparency and accountability in the companies they support.

Failure to integrate robust ESG strategies may hinder a business’s ability to compete in a market where consumers and investors are increasingly ESG-conscious.

Understanding ESG risks through examples.

Several high-profile cases highlight the possible far-reaching consequences of poor ESG risk management for companies. These examples offer valuable lessons for businesses on proactively addressing ESG risks to avoid financial, legal, and reputational damage.

The explosion of the Deepwater Horizon oil rig in the Gulf of Mexico led to one of the worst environmental disasters in history. BP faced fines of $20.8 billion, the largest corporate environmental settlement ever, and a total financial cost exceeding $60 billion, including cleanup, legal penalties, and compensation claims. The spill caused enormous damage to marine ecosystems, coastal economies, and BP’s reputation, demonstrating how mismanaging environmental risks can lead to catastrophic financial and operational impacts.

In the 1990s, Nike faced a backlash over allegations of child labour and unsafe working conditions in its supply chain. Public boycotts and negative media coverage tarnished its brand image, severely impacting consumer trust and investor confidence. This forced Nike to invest in improving its labour practices, increasing transparency, and implementing more robust supply chain oversight. This case illustrates the financial and reputational risks companies face when they fail to manage social factors like labour rights and community relations. 

Volkswagen’s deliberate manipulation of emissions tests for its diesel vehicles led to heavy fines, legal challenges, and a loss of consumer trust. The company’s governance failures resulted in a financial cost exceeding $30 billion, showing how poor decision-making and a lack of ethical oversight can damage a company’s financial health and reputation.

While these are pretty extreme cases, ESG risks can arise in everyday business operations. 

For example, a company failing to address workplace safety could face costly lawsuits or operational disruptions from employee strikes. Similarly, missing environmental compliance deadlines or ignoring diversity initiatives could lead to fines, reputational harm, and strained stakeholder relationships. Even for smaller companies, these issues can negatively impact profitability and customer trust, making ESG risk management essential at all levels of business.

ESG risk assessment methods

Assessing ESG risks is crucial for a company’s long-term success. Companies must adopt a comprehensive approach that integrates qualitative and quantitative assessment methods to identify potential vulnerabilities.

Qualitative approaches

These involve interviews, policy reviews, and stakeholder feedback assessments. Companies thoroughly analyse internal policies, governance structures, and stakeholder expectations to gauge potential risks. Understanding the concerns of employees, customers, and investors helps companies anticipate challenges and align their ESG strategies with stakeholder expectations.        

Quantitative approaches

Quantitative assessments utilise ESG data, scoring models, and metrics to evaluate a company’s performance in areas like carbon emissions and diversity statistics. These metrics help businesses track progress and compare their performance against industry benchmarks.

For example, carbon footprint calculations provide critical insights into environmental risk exposure, while diversity statistics highlight potential social risk areas. 

Plan A offers a comprehensive carbon management platform that helps businesses measure, report, and reduce emissions. With a decarbonisation-first approach, it combines science-based methods, expert support, and a network of partners to guide companies through their sustainability journey. Businesses can streamline carbon accounting and CSRD reporting, making decarbonisation efforts more impactful and efficient. 

This solution also includes personalised services tailored to each company’s needs, ensuring businesses can achieve their carbon reduction targets while aligning with the latest scientific standards.

Key ESG metrics to track include:

• Carbon emissions (measured in CO₂ equivalents): Helps quantify a company’s environmental impact, revealing how its operations contribute to climate change.
• Energy consumption: This shows how reliant a business is on non-renewable resources, which can present long-term sustainability challenges.
• Workforce diversity: Highlights the company’s commitment to equitable hiring and inclusion, addressing social risk.
• Governance metrics: Such as executive compensation, board independence, and corruption incidents, provide insights into corporate governance practices.

Quantifying these factors allows companies to identify trends, improve decision-making, and set measurable targets for ESG improvements.

Materiality assessment

Materiality assessments help companies prioritise the ESG risks most relevant to their operations. This method involves identifying the issues that have the most significant impact on the company’s financial performance and stakeholder value. By focusing on the most material risks and developing targeted strategies to mitigate potential impacts, companies can allocate resources more effectively. 

Widely used frameworks such as the Global Reporting Initiative (GRI) and Sustainability Accounting Standards Board (SASB) provide structured guidelines for assessing ESG risks. In these assessments, quantitative and qualitative analyses are not separate but integrated, ensuring that numerical data and stakeholder insights combine to understand the risks’ potential impact comprehensively. This combination helps companies gain a more nuanced and accurate view of material risks.

The new European Corporate Sustainability Reporting Directive (CSRD) also emphasises the importance of the double materiality assessment, which examines the impact and financial considerations to identify risks and opportunities linked to ESG factors. These frameworks help companies implement robust reporting and risk management processes that meet regulatory and stakeholder demands.

The link between carbon management and ESG risk

Carbon management is a key factor in mitigating environmental risks under the ESG framework. As regulatory pressure on carbon emissions intensifies, businesses must monitor and reduce their carbon footprints to remain compliant and competitive.

Carbon emissions and regulatory risk

The growing regulatory landscape around carbon emissions, including carbon taxes and cap-and-trade systems, poses a significant financial risk for companies that fail to manage their emissions. Carbon-heavy industries face substantial penalties if they do not comply with ESG and sustainability regulations, directly affecting their bottom line.

Climate change and physical risk 

Climate change-related risks, such as extreme weather events and rising sea levels, can disrupt business operations and supply chains. Companies that contribute to climate change through high carbon emissions increase their exposure to these risks, as their failure to mitigate emissions indirectly heightens the physical risks to their assets, which can, in turn, lead to the following potential consequences:

• Operational downtime;
• Increased costs;
• Long-term damage to physical assets.

By integrating carbon management into their ESG strategies, companies can reduce regulatory risks and improve their resilience against physical climate risks.

Best practices to mitigate ESG risk

To manage and reduce ESG risks effectively, companies can adopt the following best practices: 

• Integrate ESG into corporate strategy: ESG considerations should be embedded into the company’s long-term strategic planning and decision-making processes. This ensures that sustainability becomes a core component of business operations rather than an afterthought.
  
• Transparent ESG reporting: Businesses ensure transparency and accuracy in reporting by regularly disclosing their ESG performance using accepted frameworks like the GRI and SASB. Transparent reporting builds trust with stakeholders and ensures regulatory compliance.‍
• Leverage technology for carbon management: Utilising carbon management software can streamline reporting processes, track emissions, and support decarbonisation efforts. Companies that embrace technology are better equipped to manage their environmental risks and meet sustainability goals.‍
• Stakeholder engagement: Engaging with stakeholders (including investors, employees, and regulators) is essential for aligning ESG initiatives with stakeholder expectations. Regular dialogue ensures that companies stay on track with their ESG commitments and adjust strategies as needed based on feedback.‍
• Strong governance practices: Implementing robust governance measures, such as anti-corruption policies, board diversity, and regular compliance audits, helps companies manage governance risks effectively. Strong governance ensures accountability, reducing the likelihood of corporate scandals.

These practices help mitigate risks and position companies as leaders in sustainability, attracting investors, customers, and talent who prioritise ESG performance. 

Takeaways on ESG risk

The foundation of effective ESG risk management lies in identifying risks, as companies cannot quantify or mitigate what they haven't identified. Once ESG risks are assessed, businesses can take proactive steps to minimise impacts. This is crucial for long-term success, as ESG factors can threaten operations, reputation, and finances, as seen in high-profile cases like BP’s oil spill and Volkswagen’s emissions scandal.

Companies that integrate ESG into their strategies, conduct materiality assessments, and use frameworks like GRI and SASB can mitigate these risks and enhance stakeholder trust.

Businesses can streamline ESG reporting, reduce emissions, and ensure compliance by leveraging carbon management software tools. Proactive ESG management reduces risk and positions companies as sustainability leaders, attracting investors and customers who prioritise responsible practices.

Manage your sustainability journey with our solutions. Book a demo today.