Five trends driving ESG risks

Insureds must monitor global environmental, social and governance (ESG) matters to assess perils and how they can manifest into liabilities.

Environmental, social, and corporate governance (ESG) is an evaluation of a firm’s collective conscientiousness for social and environmental factors, according to Wikipedia. (Photo: Blue Planet Studio/Adobe Stock)

Environmental, social and governance (ESG) metrics can be hard to measure, but the risks surrounding them are increasing as governments and citizens exert pressure on businesses to change their ways for the greater good.

Despite the shock it inflicted across the globe, the COVID-19 crisis does not appear to have halted the march of ESG activists and agendas into the boardroom. If anything, it seems to have accelerated it, as a concern for the collective well-being has been thrown into sharper relief.

Social justice protests took place during the pandemic and environmental activists took to the streets, reflecting ongoing disquiet about ESG topics like climate change and diversity.

But it’s not just citizens who are putting the pressure on. Investor and shareholder action is increasingly focused on ESG. A raft of regulation and guidance in many territories is leading to tougher disclosure and reporting rules for companies and their directors and officers (D&Os). Growing concerns about social inequalities are also leading to new requirements for businesses around diversity, pay and supply chains.

Companies, their D&Os — and current and future D&O insurance underwriters — need to be aware of ongoing global ESG matters in order to adequately assess potential perils and how they can manifest in terms of potential liability. Here are five trending ESG risks on the radar of commercial insurers:

1. Climate change and pollution actions

The coronavirus pandemic may have pushed climate change down the list of board concerns in 2020, but a series of extreme weather events has seen it rise back to prominence this year. Unprecedented wildfires, a winter storm in Texas, the ‘heat dome’ over parts of North America, and floods in Europe and China have changed the perception of climate change from an abstract peril to an everyday risk. There is also rising activist and societal pressure on governments and businesses to address this.

The sense of urgency has been heightened by the recent landmark report from the UN-backed Intergovernmental Panel on Climate Change (IPCC), which issued a “code red for humanity” and warned the world is likely to reach the key 1.5°C warming threshold within 20 years unless fast and far-reaching action is taken to cut emissions. “It is unequivocal that human influence has warmed the atmosphere, ocean and land,” wrote the authors of the report. The report comes ahead of the COP26 UN Climate Change Conference in Glasgow in November 2021, when delegates will attempt to finalize the ‘Paris Rulebook’ — the rules required to implement the Paris Agreement.

As the world transits to a low-carbon future, we are seeing a surge in climate-related legislative activity and a change in the regulatory landscape. In the U.S., President Joe Biden has pledged to cut carbon emissions by 50% by 2030 (from 2005 levels) and set the country on a path to carbon neutrality by the middle of the century. The European Green Deal sets out similar carbon-reduction goals.

Climate change litigation is increasing, with ‘strategic’ cases — or those that aim to create a societal shift — dramatically on the rise. According to a report published by the London School of Economics, the cumulative number of climate change-related cases has more than doubled since 2015. Over 800 cases were filed between 1986 and 2014, while over 1,000 cases have been brought in the last six years. Much of the litigation has been around disclosure when companies and boards have failed to disclose the material risks of climate change adequately. For example, there have been lawsuits in the U.S. where it was alleged companies did not disclose changes in the environment that were leading to wildfires and how this could negatively impact the business.

Companies’ boards of directors have a vital duty to ensure solid corporate climate responsibility with appropriate reporting and due diligence. The prospect of climate change litigation risk increases the more there is a discrepancy between what a company does and says internally and what it does and says externally (even further to the extent to which any public statements or actions of a company might contravene a legally binding framework).

Pollution and environmental disasters are also an area of concern. Following incidents such as the explosion of hazardous cargo or the collapse of a dam affecting an ecologically sensitive area, the boards and directors of companies involved are being increasingly questioned about their risk-management strategies to prevent such events and the extent to which they were aware of potential risks.

2. Board diversity

Diversity issues are growing in prominence and businesses are coming under increasing scrutiny. This was seen in the wake of the Black Lives Matter protests of 2020, which were followed by an uptick in diversity-related litigation, particularly in the U.S. Cases typically allege a failure in the fiduciary duties of directors given the inadequate level of diversity on the board or in management positions.

With changes in regulation and legislation on diversity increasingly likely, D&O litigation risk will increase further still as will the risk to a company’s reputation if it is deemed negligent in this area. For example, the U.S. Securities and Exchange Commission (SEC) recently approved a proposal from stock exchange operator Nasdaq that requires its listed companies to have diverse boards or explain why they do not. The U.K.’s Financial Conduct Authority is exploring diversity requirements as part of its listing rules.

A number of studies have shown diversity to bring better risk management and financial performance to a board. A study in 2019 by McKinsey & Co. showed companies in the top quartile for gender, ethnic and cultural diversity on their executive team were 25% more likely to have above-average profitability of outperformance on the earnings before interest and taxes (EBIT) margin than companies in the fourth quartile. Diversity also brings advantages to recruitment and can help address skills gaps and the shortage of talent.

In an increasingly interconnected world, diversity of race, age and gender should be a governance priority for all boards of directors. While it might be too early to talk about a D&O claim trend, the frequency of diversity lawsuits brought since the beginning of July 2020 should raise the concern that any company lacking racial, gender and age diversity in its board of directors might be impacted by similar lawsuits.

One other expected impact on the D&O insurance market is the type of information underwriters will be looking for and questions that can be expected at customer/carrier meetings. D&O underwriters will increasingly be interested in understanding how important diversity, equality, and inclusion are to the management team and how this is reflected in key related performance indicators.

3. Greenwashing

As the pressure on businesses to improve their carbon credentials mounts, concerns have been raised about ‘greenwashing’ — when businesses produce misleading information to exaggerate their ESG credentials and present a more responsible public image. With legal action by stakeholders and investors in this area on the rise, directors should be wary of setting unrealistic ESG targets they might fall short of, or they could become the subject of litigation. For example, pressure groups often use institutions’ own ESG reports when it comes to assessing progress on carbon-neutral targets.

4. CEO pay

Executive remuneration is another potential hot potato, particularly for investors. Norway’s $1 trillion sovereign fund — one of the largest in the world — is just one that has developed active stewardship of management compensation proposals in the companies it invests in, amid concerns about pay transparency. Several large global companies have announced they are linking executive pay to ESG and climate-related targets and outcomes, such as greenhouse gas reductions. Nearly half (45%) of FTSE 100 companies have linked executive pay to ESG targets, according to research published by PwC, with just over a third including an ESG measure in their bonus plans.

Although metrics such as health and safety, risk, and employee engagement have been a component of bonuses for some time, the newer ESG targets in executive pay reflect emerging stakeholder concerns around climate change, sustainability and diversity.

Investors are increasingly expecting boards to reflect a broader view of corporate responsibilities to their stakeholders but their targets need to be realistic and attainable, or they may not stand up to scrutiny.

5. Cybersecurity

Whether it’s the rise of home working, the acceleration of digitization or the far-reaching effects of the ransomware attack on the Colonial Pipeline in the U.S., the potential and actual vulnerabilities exposed by cybercrime and other cyber incidents have become shockingly apparent over the last year. The consequences of a data breach in terms of financial and reputational costs to a company can be grave — even if it is the result of an accident — and high-profile cases have raised ESG concerns, particularly surrounding the sustainability of businesses.

Investors are increasingly concerned about establishing the cyber resilience of companies. Potential cyber exposures are becoming an essential part of any M&A process, especially as an acquiring business can be liable for incidents predating a merger.

Shanil Williams is global head of financial lines at Allianz Global Corporate & Specialty. Based in Munich, Shanil leads a global team offering a suite of financial lines insurance solutions specifically designed to address the liabilities of companies, managers and professionals in today’s increasingly litigious and demanding business world.

This article is printed here with permission from AGCS. 

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