Impact investment is growing rapidly. Why? What are the developments? And how is this sector driving the transition to a sustainable and inclusive society? In 6 articles we highlight the developments, opportunities and risks of Purpose & Impact investment. This is the second article, by Martin de Jong and Anne Rademaker.
While most organizations focus on the negative effects of risks (such as revenue declines), now is the time to seize the opportunities these risks can provide. There is growing interest from investors who want to understand how organizations identify and respond to ESG-related risks. However, existing risk assessment tools may not be set up to ensure proper assessment and consequently management of ESG risks. For example, the traditional “probability” and “impact” criteria do not allow for more important aspects such as speed or resilience. We believe that risk mitigation should be quantified, monetized and analyzed with a 10-year time frame to truly understand the value of a risk and turn a risk into an opportunity.
The ultimate balance of risks and opportunities
Risk management is hot and gaining prominence in boardrooms. According to COSO’s Enterprise Risk Management, a risk is “the possibility that events will occur and affect the achievement of strategy and business objectives.” This includes both negative effects (e.g., revenue reductions) and positive effects (meaning opportunities). Most public and private parties face an evolving landscape of environmental, social and governance (“ESG”) related risks and have limited time to explore and seize potential opportunities around them. While there is no universal definition of ESG-related risks (and they are often referred to as sustainability, non-financial or extra-financial risks), it is well known that these risks can affect the profitability, success and even survival of companies. For example, physical risks arising from climate change are likely to cause unprecedented disruptions to supply chains across sectors. And as COVID-19 shows, short-term social (health) risks likely to have a disruptive effect on society and many businesses. We believe companies need to start preparing and managing these risks in a structured way to protect both revenue and reputation. This approach fits with investors’ growing awareness that ESG factors can be linked to a company’s long-term performance.
Investor interest in ESG-related risks
There is growing interest from investors who want to understand how organizations identify and respond to ESG-related risks. The largest passive investors worldwide, including BlackRock (with USD$6.3 trillion in assets under management), State Street Global Advisors (USD$2.8 trillion) and the Government Pension Fund of Japan (USD$1.4 trillion), have embraced objective and ESG considerations in their investment and risk management practices. Responsible investing has evolved from a primarily exclusionary approach to one focused on identifying companies that can effectively manage ESG risks and opportunities.
Managing the cost of ESG risk mitigation, as well as seizing some opportunities around it, is something that is currently being effectively implemented by Heineken. Although water covers 70% of our planet, only 3% is fresh water, of which 1% is accessible. A growing population, economic development and climate change are making fresh water scarce in many parts of the world. On top of that, beer is 95% water, and good beer requires high-quality water. Heineken has incorporated management of this external risk into their own Every Drop Strategy and currently they are not only reducing water consumption in their breweries, they are investing time and money in activities such as reforestation, landscape restoration, desalination and water harvesting and working closely with other water users to protect vital river basins.
These assessments and outcomes in the form of heatmaps provide insights, but generally offer three main drawbacks:
- Probability is often defined in the short term (3 to 5 years), which limits companies’ strategic decisions in terms of long-term value creation and related investment decisions.
- It usually does not allow criteria other than “probability” and “impact,” such as speed or resilience, to be included in the discussion of risk assessment.
- In general, ESG risks are new to risk managers and often have an external component. Therefore, we see ESG risks not included in the heatmap or rated low.
We believe that risk mitigation should be quantified, monetized and analyzed with a minimum time frame of 10 years to truly understand the value of a risk and the potential to turn a risk into an opportunity. In fact, an impact valuation across the entire risk management chain can add significant value here. In the Heineken example, the risk heat map shows a dependency on an externality such as water availability. Consequently, a board decision was born to move from mitigation to long-term opportunity. Profit or loss calculations are no longer calculated only from an economic perspective, but also from a social and environmental perspective to capture the full impact. More on this in article 6 of this series.
This article was published at: https://www.duurzaam-beleggen.nl/blog/impact-investing-the-ultimate-balance-of-risks-and-opportunities/