This article is sponsored by VelocityEHS.
As regulators, shareholders, boards of directors and consumers demand better ESG performance and transparency, the pressure is on for businesses to adapt. But many businesses struggle to develop mature ESG programs because they lack an effective way to engage stakeholders in identifying and controlling their most material ESG risks and opportunities. A risk bowtie, widely used in managing operational risk, could be especially useful for businesses as they widen their scopes to include ESG risks and opportunities.
Risk bowties are diagrams that help businesses to visualize a potential risk event, its root causes, consequences and the controls that could prevent the event or mitigate its impact. They’re particularly useful for helping businesses conduct scenario analyses, following guidance from the Taskforce on Climate-related Disclosures (TCFD). But before discussing more about risk bowties, let’s cover some background on ESG risks and opportunities, especially regarding climate.
Understanding ESG risks and opportunities
ESG has gained prominence in the business world over the past several years because a huge body of evidence links better ESG performance with higher profitability. Better ESG performance also helps businesses avoid major unplanned events that could significantly hurt business continuity and share price. In other words, there are risks to not taking ESG seriously or to putting plans in place to achieve and sustain a mature ESG program.
But as the late radio personality Earl Nightingale once put it, "You can measure opportunity with the same yardstick that measures the risk involved. They go together." For example, an automobile manufacturer who ignores growing customer demand for more energy-efficient vehicles risks losing market share to automobile manufacturers who are taking that demand seriously. But another, more positive way to look at it is that the automobile maker who shifts some of its manufacturing output to high efficiency/alternative fuel vehicles, before its competitors do, has an opportunity to gain by locking in market share.
Introducing the ESG bowtie
Preventive: These controls are on the left side of the bowtie diagram and, as the name implies, are in place to reduce the likelihood of the undesired event happening in the first place.
Mitigative: These controls are on the right side of the bowtie and include methods to reduce the severity of the unplanned event’s impacts, should the event still happen.
Detective: The purpose of these controls is to let you know when the event you were trying to prevent has happened, so that you can respond as quickly as possible.
Businesses can designate a subset of controls as critical controls if they play more significant roles in controlling risk. For any given control, escalation factors, which reduce or enhance the effectiveness of a specific control, can also be included and described.
Assessing market risks with the ESG bowtie
Now let’s use a risk bowtie to assess ESG risks, focusing on market risks, or risks that affect the overall performance of financial markets, such as climate change, as an example. The diagram below shows one possible mapping of a hypothetical company’s ESG risks in this category using a bowtie.
That’s a lot to take in, so here’s an expanded view of the left side showing the causes leading to market risks, and their associated preventive controls.
The blue boxes along the left-most side of the diagram show distinct identified causes of market risks, and the green boxes to their right show preventive controls an organization can put in place to reduce the likelihood of exposure to market risks. For example, changing customer behavior, such as preference for more sustainable products, can lead to market risks. Marketing efforts are one possible preventive control to avoid being blindsided by these trends. These might include, for example, market research on customer preferences as well as on actual customer behavior. Note also that there can be more than one control in place for a cause, and that two controls ("marketing" and "competitor intelligence") are designated as critical for this hypothetical company.
Here’s an expanded view of part of the right side of the bowtie showing impacts of market risks and associated mitigative controls.
This example shows escalation factors associated with two controls. "Emergence of disruptive technologies" is an escalation factor for "capturing emerging market share for energy efficient products" because the effectiveness of your company’s efforts to capture market share will depend on market conditions when the disruptive technology appears and how much market share it’s already captured.
The risk bowtie can help companies with TCFD scenario analysis
The Financial Stability Board (FSB) created the TCFD to encourage and improve disclosure of climate-related financial information. The TCFD develops guidelines to help organizations conduct scenario analysis to better understand how they might perform under different future states, or "scenarios," that may arise directly because of climate change or indirectly because of impacts on business dynamics and market preferences.
The TCFD lays out categories of climate-related risks and opportunities that companies should address in their scenario analyses in its 2017 Technical Supplement "The Use of Scenario Analysis in Disclosure of Climate-Related Risks and Opportunities."
While scenario analysis modeled on TCFD guidance has gained industry acceptance, the process is time-intensive and inefficient without the right tools, so many organizations have still not developed a good system for analyzing their own risks and opportunities. This is where the ESG bowtie can help.
As successful operational risk managers know, bowties are one of the best methods for sharing a common understanding of risk, because they convey a great deal of nuance within a single visual. And because so much of ESG boils down to stakeholder relationships, ESG bowties help to engage stakeholders by involving them in scenario analysis and sharing results to make sure everyone understands the biggest ESG risks and opportunities facing a company.
Of course, every company is unique in its specific operations, market position, financial profile and value chain relationships, and will have a different ESG bowtie for each TCFD risk category. And risk pathways may change over time as the organization or its divisions pivot their o
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