Interconnected risks and the challenge of ESG
Looking at the WEF report through ESG offers some key points to consider
The World Economic Forum (WEF) recently published its Global Risks Report 2023 in advance of the Annual Meeting in Davos. Unsurprisingly, it is full of risks that intersect with ESG. Since ESG represents material risks and opportunities, this shouldn’t be surprising. While “ESG” isn’t mentioned in the report, it provides a great example of how to think about ESG risk while focusing on the interconnected nature of these challenges.
This type of complex thinking and dot-connecting drove me to ESG in the first place, so I found the report fascinating. I think it affords anyone who wants to ‘think a little like an ESG practitioner’ to learn how by observation.
This may be one of my more ‘useful’ newsletters as I guide you through thinking about these trends with corporate ESG in mind. It is a little more academic and commentary-based, but I hope you come away with a new appreciation for how to apply a report like this (or even as you review trend predictions for the New Year).
But first, a note on materiality because it is too good to leave out.
An interesting consideration for materiality hidden in the report
There are several types of materiality that companies should understand, but when talking to companies about ESG, I explain it like this.
Materiality in an ESG context represents items that lead to decision-useful information.
This is a broad definition, so I usually show a materiality matrix to illustrate the point. S&P Global has a pretty good article on materiality matrices, but think about it as a Gartner chart with two axes: the horizontal axis represents business or risk importance, and the vertical axis represents the importance to stakeholders. Usually, this results in simple points on a chart, with those in the top right being critical for the business. For example, here is Microsoft’s (where I work):
Now, WEF considers the global risks it has identified as interconnected, which is how ESG issues should also be considered. This is one reason for the connected acronym. However, I’ve never seen a materiality map that connects the issues. For example, in the matrix above, Responsible product innovation (19) connects with everything in the Governance category, but possibly 2, 3, 5, 7, 8, 12, and 13.
Thinking about material issues in this way helps identify the complexity of their mitigation and can be the difference in impact. Again, turning to the WEF report, they connect the dots on risk to put us in this mindset.
It’s worth noting the legend in the lower left.
Nodes: The size of the dot is how significant the risk is.
Edges: The thickness of the line is how influential the connection is.
As so, today’s risks are connected. For example, check out Figure 2.8 below. In pulling out the connections for Interstate conflict, you can see the relationships and how influential the links are. The Interstate conflict risk (a geopolitical risk) is connected to environmental, societal, and technological risks.
Imagine augmenting your materiality map in this manner. It could open up connections between systems that host risk information for new types of analysis.
Now that we have that covered and hopefully you’re inspired to revisit your company’s materiality matrix, let’s move on. Next, let’s cover the near-term risks WEF has identified in Chapter 1 of the report and consider them through corporate ESG.
The Path to 2025
Section 1.2: The Path to 2025 (starting on page 14) can be confusing if you review the graphics and expect an orderly transition into each prioritized issue. WEF has captured the current crises, like Rising inflation, in Section 1.1 and combined them with the near-term risks for Governments and Businesses through 2025. WEF then turned the top risks into cohesive intersectional topics.
WEF states that “many (risks) expect to play out over the next two years, within the context of the mounting impacts and constraints being imposed by the numerous crisis being felt today.”
In other words, mounting impacts and numerous crises create a confluence like never before.
The ones they’ve created are organized into the following:
Cost-of-living crisis
Economic downturn
Geoeconomic warfare
Climate action hiatus
Societal polarization
Cost-of-living crisis
The Cost-of-living crisis is the first item. This issue emerged even before the pandemic and was undoubtedly exacerbated by it. The global energy and food supply experienced further constraints when Russia invaded Ukraine.
On the surface, this issue looks like a social issue. Consumers feel the pain in their wallets with energy and commodity prices rising, and the most vulnerable become even more so. If you are on Twitter, you probably have seen quite a few viral videos covering grocery store prices and international protests, like this one:
While WEF and many pundits hope this is a short-term risk, other intersections exist with the environment and governance that are worth considering. For example, you can trace the issues in WEF’s graphic above or read the report to see connections to the Natural resource risk. We’re already seeing this with the effects of the avian flu on egg prices.
Extreme weather (E) and its results contribute to this issue through added supply chain pressures, as do other issues like political instability. No matter the cause, as the cost of living increases, people still need commodities and may reprioritize other purchases. This could mean moving away from unnecessary services like streaming or pushing off green household projects like solar panels. If a company doesn’t think about the Cost-of-living crisis beyond the supply chain impacts, it might miss something.
Key ESG point: Considering the impact of risks on stakeholders may help reduce business risk in a world of constant disruptions.
For example, we saw the Cost-of-living crisis impact companies early last year. In February 2022, “streaming services including Amazon Prime, Disney+, HBO Max, Hulu and Netflix” upped their monthly subscription fees (per CBSNews). By April, it was clear that inflation was taking hold, leading to new headlines that proclaimed, “Subscription fatigue, inflation are leading to cancellations.” Now compound this issue with another as Netflix struggles to balance cost constraints against customer satisfaction and viewership.
The Cost-of-living crisis is a pretty straight line to governance because, while employees are crucial to understanding and interacting with stakeholders, leaders are more empowered to make the systemic changes to influence those stakeholder interactions if the signals are surfaced and then analyzed.
It’s not just customer stakeholders either, but employee stakeholders, too. Rana Foroohar points this out in this excellent Financial Times read:
This lesson around treating labour as an asset rather than just a cost on the balance sheet has particular resonance now, when jobs markets remain tighter than usual as we go into what could be a global recession.
This leads us to the next risk.
Economic Downturn
On its face, this is undoubtedly one for governance as it intersects with inflation, warns of recession, and can lead to corporate debt crises, as WEF points out. Companies respond with ‘pullbacks’ such as laying off employees (S) and shutting down projects in the short term (often E and S efforts). These activities are often heralded as historically proven ways to weather the economic storm.
Admittedly, having joined the workforce during the dot-com bubble, working at companies that have gone through M&A/bankrupcies, and living through the 2008 Financial Crisis, I am not a fan of layoffs and program cuts to cushion the economic blow and protect shareholders.
After all, the value of layoffs seems to be an illusion with tangible and intangible costs per “What companies still get wrong about layoffs”:
Higher valuations were given for layoffs perceived as helping firms in financial distress return to profitability as well as those that were strategic and forward-looking. Layoffs undertaken only for the purpose of reducing costs tended to lead to drops in share price.
WEF focuses less on layoffs and more on another issue: the availability of cheap debt and a pullback of development projects.
Growth agendas, including the critical pivot to greener economies, have been based on the availability of cheap debt. The extent to which countries continue to finance development will be dependent on domestic political and debt dynamics.
So here’s the question for company leaders: When a storm is on the horizon, does a ship throw its valuable cargo overboard or batten down the hatches?
Post-COVID, companies are operating in a new world where stakeholders rule, challenges are constant, and the traditions of pullbacks may no longer work. Moreover, the Economic downturn isn’t the only thing happening, as there is a confluence of traditional and interconnected risks impacting companies. In Section 3.1, WEF talks about how we haven’t seen this before:
…these present and future risks can also interact with each other to for a “polycrisis”—a cluster of related global risks with confounding effects, such that the overall impact exceeds the sum of each part.
So, if this is new, how would what worked before work now?
Key ESG point: What’s worked in the past may no longer work. You can’t ignore the interconnected nature of ESG risks.
The issue of an Economic downturn is one where companies can decide who they are. It might not feel like it is in the company’s control, but their response certainly is.
ESG considerations and the interconnected nature needs to play into how decisions are made and which path will be followed. Will risks be ignored as E, S, and G projects are tossed overboard? What will companies who espouse values (which are not the same as ESG) and cast them aside look like on the other side?
Geoeconomic warfare
While Interstate conflict ranks as an influential risk in the chart above, it manifests through government sanctions and Geoeconomic warfare. In perhaps the most recent and prominent example, we’ve seen this over the past year with companies pulling out (or being shamed and then pulling out) of Russia.
But WEF alludes to another type of Geoeconomic warfare that isn’t as obvious. The drive to localization, on-shoring, and even simply incentivizing lowering emissions could all result in unintended Geoeconomic warfare.
For example, trade partners could be punished as companies move supply chains locally to stem the Cost-of-living crisis and address the near-constant supply chain disruptions from the pandemic and extreme weather events. As WEF puts it:
Defensive measures to boost local production and minimize foreign interference in critical industries include subsidies, tighter investment screening, data localization policies, visa bans and exclusion of companies from key markets.
We’ve seen this already with favorable climate legislation. The US Inflation Reduction Act and the EU Carbon Border Adjustment Mechanism have received criticism because they balance national economic investments with little international considerations.
Key ESG point: Don’t solve an ESG issue in isolation. You might solve one issue but cause more significant problems in other areas.
For example, suppose you hire an environmental expert with little other experience to reduce your Scope 3 emissions. In that case, they may tell you to shut down factories in emerging markets where clean energy isn’t available. The result may be localized political instability, helping your company meet a disclosure at the expense of a vulnerable population. That is a kind of Geoeconomic warfare, too.
Climate action hiatus
I often talk about how busy I am meeting with companies as an indicator of their continuing commitment to addressing climate change. Still, this risk makes me wonder if I could be thinking about this wrong. Between the Economic downturn and Geoeconomic warfare, the pullback previously mentioned may also manifest here.
These challenges, against the backdrop of a deteriorating economic landscape and inflated input costs, may postpone investments in greener production methods – particularly in heavier, “dirtier” industries.
While I am still busy, I feel that companies might start pulling back holistic ESG or sustainability and DEI approaches that have developed since 2020 for slimmed-down projects or canceling projects and simply hiding amongst their peers. This would be a colossal mistake because risks will be overlooked.
Today, companies worldwide are focused on climate mitigation (i.e., carbon disclosures and activities to drive down carbon). This is the majority of projects I see. But, unfortunately, companies often have a huge blind spot - adaptation.
Although climate mitigation has been overwhelmingly favoured over adaptation in terms of financing to date, particularly in the private sector, EOS results indicate that climate adaptation may now be seen as a more immediate concern in the short term by business leaders.
I can usually get companies to see this risk if they are already focused on the environment in another area. Adaptation is climate risk; this critical point may be missed if other projects are scaled back. Merely thinking about something like operational reductions could lead to exposing the risk. In other words, a governance failure to recognize the environmental issue could impact the social (stakeholders) and financials.
Key ESG point: ESG is risk. You can deal with it on your terms or the risk’s.
Hopefully, most companies will carefully consider their material issues and proactively deal with risks. Still, we could see a reduction in philanthropy, sustainability, and DEI efforts, which could open up opportunities for competitors to emerge who understand the importance of this topic to stakeholders.
Societal polarization
There can be no doubt that the edges now define our societies, resulting in Societal polarization. Ultimately, this near-term risk, which even plays out sometimes within a news cycle, may result in paralysis against the systemic issues we need to address to solve our most pressing challenges.
The problem is this risk isn’t going away, and it compounds around itself.
The erosion of the social and political centre risks becoming self-perpetuating. Divisions incentivize the adoption of short-term, more extreme policy platforms to galvanize one side of the population and perpetuate populist beliefs.
In other words, this highly influential risk keeps us from civil discourse, let alone solving anything. Appropriately, misinformation and disinformation are mentioned here as significant contributors. These mechanisms have weaponized information into agendas society can’t see.
Companies must center around education, accurate disclosures, and clear and transparent communication. These are some of the only tools companies have to articulate their intentions internally and externally to secure support from stakeholders. Follow-through and execution are critical as well. If a company can do all this right, it can ride in the middle while working to solve its and the world’s biggest challenges.
In the chart above, you can see the view of Societal polarization across the interconnected issues, including many previously mentioned ones. This makes it perhaps the best one to close out the newsletter (and maybe why WEF left it last).
Key ESG point: You won’t get everything right for every stakeholder or risk consistently but listen carefully, communicate well, fund the efforts, and drive change.
People influence everything, and trust is a valuable commodity in a world where we are less sure about the truth. Trust can be a lever that drives impact across risk if we’re brave enough to wield it in pursuit of more responsible and sustainable growth.