Why Companies Must Manage Environmental, Social and Governance Risks

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Wharton's Witold Henisz, Katherine Klein and Sherryl Kuhlman discuss how ESG risks impact companies' bottom lines.

Companies are increasingly scrutinized on how they manage environmental, social and governance (ESG) risks. These could be external risks such as land disputes with indigenous groups, or internal factors such as how well they take care of their employees. Research by Wharton management professor Witold Henisz shows that ESG risks do affect a company’s bottom line. He shared some of his findings on the Dollars and Change show on Wharton Business Radio, which airs on SiriusXM channel 132. He spoke with Wharton management professor Katherine Klein, who is vice dean of the Wharton Social Impact Initiative (WSII), and Sherryl Kuhlman, its managing director. (This interview is included in a special report by Knowledge@Wharton and WSII titled, “Innovative Business Approaches to Social Impact.”)

Following is an edited transcript of the conversation.

Katherine Klein: How would you describe the focus of your work? Is it sustainable investing? Is it ESG investing? Is it ESG metrics? What’s captivating your interest in your research right now?

Witold Henisz: I’m focused on this exciting space which is evolving rapidly where firms are dealing with non-traditional risks — risks that emanate from the social sector and from the external stakeholders around them, whether they be community leaders, NGOs, or government officials who are upset or concerned about pollution, human rights and social rights. And that is translating into material risks for companies.

I’m not looking at it solely from a social perspective, or solely from [from the standpoint of] social welfare. I’m trying to say that when stakeholders are upset or outraged, and they protest or sue a company and demand regulatory action, that’s material risk that the company needs to deal with. The companies that deal with it better can deliver superior, sustainable returns.

Sherryl Kuhlman: Let’s get more concrete. Help our listeners think about, “That’s a real risk for that company,” or “I don’t think highly of this company when I hear that they’re doing X.” Is this Uber?

Henisz: You can look at the new economy and Uber. I started looking at the older industries — the gold mines, the oil fields. How much is ExxonMobil worth today? If you’re trying to value that company, you start with the value of its reserves. But what’s the price of oil going to be in 10 or 20 years? How are carbon fuels going to compare to solar, wind or others?

In order to value the future of Exxon you need to understand whether we’re going to have a carbon tax, what our climate change policy is going to be, and what a two-degree solution looks like. (Climate scientists have for two decades called for a global warming cap of two degrees Celsius above pre-industrial levels; a United Nations panel recently lowered the target to 1.5 degrees Celsius). ExxonMobil has a duty to disclose that to its shareholders. That’s one example.

“When stakeholders are upset or outraged, and they protest or sue a company and demand regulatory action, that’s material risk that the company needs to deal with.”

Kuhlman: And do they?

Henisz: There’s a lot of pressure on them to do so. That’s the first place you’re starting to see this integration, where what used to be thought of as an ESG risk is now all of the sudden being pressured to be in the annual report, and not just in the sustainability report. ExxonMobil is not one of the leaders in that space, but they’re certainly under pressure to disclose and reveal the sensitivity of their forecasts to different climate change policies.

Kuhlman: You began by talking about stakeholders who are putting pressure on companies, and stakeholders who are protesting them, but that’s not as clear to me in the ExxonMobil example. Are there other examples?

Henisz: In the ExxonMobil case, many people are pushing for some sort of a carbon tax, and policies to address climate change. A simpler example is that of a gold mine in Romania sitting on a couple of million ounces of gold where the development of the mine has been wrapped up in corruption scandals, and concerns around the use of cyanide. The government has been reluctant to move forward with the environmental permitting of the mine. It’s been sitting fallow for 15 years since the first development project. This could have been a $10 billion project in the heart of the European Union.

Klein: These are compelling examples of why corporations need to be attentive to these social environmental risks, and their implications for the financial performance and growth of these companies. Do we need research on this? That sounds like a no-brainer.

Henisz: In the research that I’m working on right now, we’re trying to get inside the relationship that I was describing. There’s been a burst of activity. [It goes beyond] looking at how environment, social and governance factors affect stock prices: Is there an alpha? How much do [investors have] to give up in terms of returns or can we reduce the volatility of returns?

But if you think about who takes a long-term perspective, looking 10 to 20 years out, it’s been the creditors. There has been a surge of interest looking at bonds and loans, and trying to see if better management of environment, social and governance risk factors affects loan spreads, credit spreads, or credit default swap spreads.

There has been this implicit argument that it is because of things like lawsuits, regulatory actions and strikes [that cause] volatility of earnings, which affect [a company’s] ability to pay back the loans, that creditors should be concerned. But there hadn’t actually been any empirical research on it. … There is data that shows that credit default swap spreads, credit spreads and loan spreads actually do correlate with the ESG risks.

Kuhlman: What do these terms mean?

Henisz: [Spreads are] the amount that you have to pay above some baseline interest rate….. For a riskier project, you have to pay a higher interest rate. The amount you pay goes up if you’re not very good on ESG. Credit default swap spreads are financial derivatives whose prices are correlated with the likelihood that a bond will default. So you see credit default swap spreads — or essentially the insurance on a bond — also moving with these ESG risks.

But people hadn’t zeroed in on why that’s happening or what are the mechanisms. What we did was pull information from Bloomberg terminals on what are called credit events. These are material events which could impact the payback of a bond, like lawsuits, regulatory actions and strikes. We found striking increases for firms that are not managing their social risks well.

[That is particularly so] in a project where we’re looking at the risk of managing indigenous land claims — or major projects that are close to indigenous populations. The Dakota Access Pipeline is a great example in the U.S. Many of these large oil fields or pipeline projects are close to lands that are claimed by indigenous groups in Latin America, Asia and Africa.

“What used to be thought of as an ESG risk is now all of the sudden … in the annual report, and not just in the sustainability report.”

That proximity generates a real need to manage your stakeholder relations — to work with stakeholders, to come to an understanding of how you are going to share the benefits. If you don’t do that well, they’re going to be protesting, filing injunctions and demanding investigations. We show that these events are 50% to 160% more likely for projects that are proximate to indigenous land claims. That correlation is even higher or stronger for firms that aren’t rated well on environment, social and governance factors.

Klein: If I’m a company that is working in this area and I’m not managing these relationships with indigenous populations well, does my company have a greater likelihood of ending up having to pay more for the loans, and for the long-term investments that we are getting?

Henisz: They are [likely to pay more]. Our research tries to get at why [that is the case]. Why are the creditors suspicious? What is it that they’re worried about? Well, they’re worried that there’s going to be a regulatory action, which is going to lead to a delay by a year of the construction of the pipeline, which means a year before there’s any revenue. There’s a greater likelihood of a lawsuit, which is going to claim they’re violating, maybe, formal land claims or they’re violating civil rights or human rights. Or there’s a strike. We’re showing why.

Other scholars have shown that creditors are charging more [when such ESG risks exist]. There’s been a burst of activity in the accounting literature exploring that correlation. But the explanation for where should you look and where are the variances that are causing those loans to be less likely to be paid back or to be riskier, is what we’re digging into.

Kuhlman: Are corporations able to mitigate those risks? Some of it is external, such as regulatory [actions]. There’s the relationships with stakeholders where clearly they can take some action. How much can they control and mitigate?

Henisz: That’s what I teach in my course here at Wharton on corporate diplomacy. There’s a lot that companies can do. You start by knowing who your stakeholders are. You do due diligence on how to build the pipeline, where is the gas, and what’s the price of gas. But have you actually mapped your stakeholders? Do you know where the indigenous land claims are? Have you mapped the issues they care about? Have you looked at the issues of education, development, poverty? What are the social stresses on that population?

Have you thought about it not as a philanthropic activity, and not as something that you do because you’re nice or because you’ve got some extra money? That’s the wrong attitude. This pipeline isn’t going to get built if you haven’t addressed the indigenous issues, if you don’t have the relationships, if you don’t have their support, and if you haven’t won their hearts and minds.

You have to think about the project overall — building the pipeline, financing it, the cost of gas, and the cost of winning the hearts and minds altogether. And that may mean shifting your operational plan, or shifting your financial plan. You have to take it from a more holistic, enterprise risk management perspective.

“The amount you pay goes up if you’re not very good on ESG.”

How do you know you’re actually doing that? Someone on the board should be looking at your stakeholder map. Someone should be looking at your stakeholder management system, and at your enterprise risk management system. It should be validated by auditors. It should be externally audited. The people who are staffing your stakeholder and risk management functions shouldn’t just be specialists or consultants who pop in and out; they should be part of the senior management rotation.

You want to get into the C-suite? You should have gone through external affairs. You should have gone through community engagement. That should just be part of the process. And everybody’s compensation and promotion should be influenced by how well their company and their unit is working with external stakeholders.

Klein: What questions should companies be asking to understand who their stakeholders are?

Henisz: It’s easy to think that the stakeholders are inside the value chain — suppliers, buyers, workers. Companies do a pretty good job of [managing] that. But it’s the external stakeholders that are harder. There are three easy questions to ask. It’s not a priority or a ranking; they are just three questions that will help you fill out the roster.

The first one is, “Who’s directly affected by what I’m doing?” Who’s richer or poorer, sicker or healthier, or who faces a direct impact based on my organization’s activity? The next tier is, “Who’s directly affected by my suppliers’ or buyers’ activity?” Sometimes you’re targeted not because of what you’re doing, but because of something your supplier or your buyer is doing and you’re just a convenient target to influence them.

The third one is the trickiest, where it really gets most broad, [which] is: Who just cares about what I do? … Anyone who has an axe to grind in your space can suddenly target you. That’s where a lot of the NGOs and the social activists will come in, because they’re more broadly concerned around something like human rights and the environment, and you’re having an impact on that. They’re not directly affected by you, they’re not materially affected, they’re not sicker or healthier, but they just care about pollution or they care about water and you’re doing something that affects water and so you become a target.

… We have to recognize that there’s a longer-term set of relationships we have with both internal and external stakeholders. We want our workers to stay. We want them to be productive. We want them to innovate. We also want our community members and the governments and civil society outside the fence to be working with us and cooperating with us in the longer term. … It’s often the same companies who treat their workers better who take the same logic and say, “Well, why don’t we have better relations with the community? Why don’t we have better relations with these civil society organizations?”

Klein: Sherryl, as we talk about relationships with the larger community … there are a lot of conversations around anchor institutions. If an anchor institution takes its role seriously, are they doing what Wit [Henisz] is describing?

Kuhlman: The point about anchor institutions is that these are things that aren’t going to move.… They’re very much tied to the community in a variety of ways. This has increasingly created some sense about how we work with our community so that it improves, but that also our relationship improves.

“When we just focus on the short term, and on what minimizes costs today, we’re often creating the basis for anger and backlash maybe next year or maybe five years from now.”

Henisz: There’s a great new book that’s coming out, by Myles Shaver at the University of Minnesota. He looks at the broader set of companies — Minneapolis has an enormous density of Fortune 500 headquarter companies.

All of them have had a long-term, forward-looking orientation towards how they manage their relationships with the community. And they haven’t been as focused on quick tax breaks and these little transactional things that you often see. They’ve really thought about, how do we make this a great place for families, make people come here for the universities, make people want to come here and want to stay here?

… The logic that we’re talking about goes from your workers to the community around you to the regional government, and to the national government. It’s thinking about how everything is interconnected, and how our relationship as a company with that entire sociopolitical ecosystem is important for our long-term returns.

When we just focus on the short term, and on what minimizes costs today, we’re often creating the basis for anger and backlash maybe next year or maybe five years from now. But if we look out into the long term and we don’t incorporate that, and if our financial models miss those connections, we’re not going to be a company that will be around in the long term.

Kuhlman: We’ve had several guests who’ve talked about companies doing a little bit more around advocacy, taking a political stance, like Nike. (Nike’s recent ad campaign featured Colin Kaepernick, a controversial former San Francisco 49ers quarterback who protested racial injustice by refusing to stand when the national anthem is played.)

Henisz: That’s a great example. When there are issues like immigration, racial tensions or trade policy, where so many companies have a stake in the policy outcome, I think there’s a responsibility of companies to engage on some of these issues. I think you’re seeing that. Nike is appealing to a younger, urban demographic. I think it [fits] with its image.

People expect CEOs and companies to weigh in on some of these social challenges. It’s a delicate question. You go back to [Merck CEO] Ken Frazier’s decision to leave the president’s [American Manufacturing] Council early on in the Trump presidency. Some of these issues are so large and so material that companies do have a responsibility to act and speak about what they value and what their stakeholders are concerned about.

“That’s the ultimate goal — to make this a management tool so you know where you’re performing better or worse.”

Klein: In some of these cases, there may be a tension that the CEOs have to reconcile between a short-term response and a long-term response.

Henisz: Sure. People were burning the Nike shoes. But they were also buying them. There was a surge of interest. CEOs shouldn’t do this based on a personal whim. When they’re acting out on these advocacy issues, they have to make clear when they’re speaking for the company. The Nike [ad] was a powerful one where the company felt that its stakeholders identified with a whole host of [issues about] injustice and other challenges.

Klein: You’ve been very interested in investment practices. How good is the data that we have on companies, on these different dimensions?

Henisz: There’s a really stinging Wall Street Journal article that looks at a number of different ESG ratings providers, and at some companies [they rate]. There’s almost no correlation across them. It’s really frightening.… If you look at bond ratings, S&P’s, Moody’s and Fitch are correlated between 90% and 95%. ESG ratings are correlated between 5% and 50%. There’s a lot of noise. And so we have to be careful when we’re using them.

But we’re starting to see new data providers that are using not just information that the company provides in their sustainability reports or in response to surveys, but are using artificial intelligence, natural language parsing to surf the web, the news media, government regulatory filings, and social media to try and map what stakeholders are saying about companies to environment, social and governance risk factors.

… There is still a long way to go in terms of providing enough reliability … and enough precision to guide both creditor and equity investors and managers. That’s the ultimate goal — to make this a management tool so you know where you’re performing better or worse.

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Why Companies Must Manage Environmental, Social and Governance Risks. Knowledge@Wharton (2018, October 17). Retrieved from http://knowledge.wharton.upenn.edu/article/companies-need-manage-environmental-social-governance-risks/

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accessed November 14, 2018. http://knowledge.wharton.upenn.edu/article/companies-need-manage-environmental-social-governance-risks/


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