The Importance of ESG Risk Management During Periods of Market Volatility

With inflation at a 40-year high in the United States, interest rates on the rise, global financial markets edging closer to recession, the war in Ukraine – with its disruption to global energy and food supplies - showing no signs of ending, and the lingering impact of the COVID-19 pandemic, there is no denying that we have entered a period of global market volatility. While this volatility will have implications for companies in many industries and geographies, for firms that have placed big bets on environmental, social, and governance (ESG) investments and strategies, this period of global market volatility may feel especially jarring.

For firms heavily invested in ESG, the past few years have been a period of rapid growth and increased attention from investors, boards, and customers. At the same time, there has been significant growth in the regulatory expectations around ESG-related matters, with new regulations being proposed in the U.S. (e.g., the Security and Exchange Commission’s climate disclosure proposal) and with new, stricter phases of existing regulations coming into force in other jurisdictions (e.g., Phase 2 of the Sustainable Finance Disclosure Regulation coming into force January 2023). This intersection of intense market volatility and increased regulatory expectations following a period of intense growth will result in some companies reevaluating their ESG strategies, but companies should not take their focus away from ESG risk management at this time, as those who have invested heavily in ESG risk management are likely better prepared to weather this market volatility.

The impacts of market volatility on ESG programs and strategies

While it is still far too early to know the full impact that our current period of market volatility will have on companies, based on current trends and past examples, we can reasonably expect investors to experience the following impacts, particularly for firms that have made significant investments in ESG programs and strategies.

Public Attention on ESG May Shift, but Risks Aren’t Going Away – Over the past few years, companies have rushed to demonstrate how they are considering ESG-related factors and risks in their growth strategies. There has been tremendous growth in terms of the number of ESG-related investments and funds offered by firms during the past few years, and more and more publicly traded companies are releasing sustainability reports to satisfy investor interest.   

While market volatility will likely mean that ESG risk may receive less investor and C-Suite attention, ESG risks are not going to become any less important for firms to manage. In fact, with increases in regulatory pressure around carbon disclosures and the continued threat of climate change-related disruptions means that the need to manage ESG risks effectively will only continue to increase and investor, board, and C-Suite attention on these risks will likely continue.  

An Increase in Regulatory Scrutiny and Enforcement Actions – The past few years have seen an increase in regulatory interest and scrutiny around ESG topics. Driven by investor demand, and countries and jurisdictions working to take active steps towards reducing greenhouse gas emissions, companies are under increasing regulatory pressure to validate their ESG-related claims. And, if past moments of market instability can help us understand what is coming for firms, we are likely entering a period of increased compliance challenges – as pressure mounts on employees to meet performance goals and increases in the volume of work required of employees raises the likelihood of intentional and unintentional misconduct.

This combination of factors – an increase in regulatory requirements and an increase in compliance risk – may precipitate a more aggressive enforcement posture from regulators around ESG issues. In fact, recent enforcement actions  and investigations around ESG conduct and disclosures help demonstrate that a more intense enforcement posture is indeed on its way. As regulators work to ensure investors are protected during periods of rapid market changes, it is likely they will increasingly focus on issues like “greenwashing” and other ESG matters that have seen rapid growth and investor interest, with relatively limited compliance controls from companies.

Having to Do More with Less – While it is still too soon to know if the potential downturn will produce widespread layoffs, cost cutting measures and hiring freezes can certainly be expected as companies work to remain profitable. It is likely these austerity measures will impact many parts of the business, with corporate functions that manage ESG risk being no exception.

ESG leaders and risk owners should begin planning for flat or reduced budgets and staffing levels for the near term. Given the increased regulatory expectations for many companies, this will mean extra strain on ESG managers increasing the likelihood that something slips through the cracks.

The need to remain focused on ESG risk

In moments of market volatility, there may be a knee-jerk reaction from companies to shift focus away from ESG risks and activities. However, even if the public attention on ESG matters wanes, ESG risks – be they regulatory, related to climate change, diversity and inclusion, etc. – are not going anywhere.

Instead of deprioritizing these risks, companies that remain focused on them will likely be better situated to survive an economic downturn and broader shifts in the market as it will help the company remain focused on aspects of volatility that are within its control. For example, companies that have been focused on their climate impact, and scenario planning for the physical and transition risks associated with climate change, are likely in a much better position to respond to the increased energy costs that have impacted businesses across 2022 than companies that have looked at environmental risk as unimportant.

The disciplined corporate governance that comes with a focus on ESG can serve as a hedge against many of the compliance violations that are more common during periods of market volatility. Whether it is the overstating of a firm’s environmental impact, poor hygiene around ESG data collection, or more serious issues of fraud or insider trading, ensuring that a company has robust governance structures in place can help identify these issues early and minimize the pressure that can allow them to happen in the first place.

How we help

ACA’s ESG Advisory Practice can help your firm weather this volatility by assisting with ESG program creation and assessment.

To discuss any aspects of this article, or how we can help build and improve your company’s corporate governance, or other aspects of your ESG program, please contact our ESG Advisory Practice.   

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