Some design firms have probably heard of ESG risks, which refer to environmental, social, and governance risk factors that can impact a firm’s performance, long-term value, and reputation. There is a common misconception that ESG risk factors are non-financial risks, which is inaccurate. In fact, many ESG risks pose significant financial consequences to businesses and the overall economy, including design firms. ESG risk factors are simply an additional layer of financial risk analysis that goes beyond traditional financial risk assessment to include environmental, social, and governance risk considerations. This modern and more sustainable financial assessment of risk helps companies and their investors see the longer-term financial outlook of their investments, underwriting, and lending. See the Sustainable Financial Assessment model figure below.
Financial Risks of ESG to Businesses and the Overall Economy
Starting with some of the “E” risks, for example, it is obvious that severe climate-related weather events can result in property losses, injuries or fatalities, business interruptions, and supply chain disruptions. All of these losses are financial in nature. Specifically, just in the US alone last year, there were 18 separate severe weather events where the losses for each exceeded $1 billion. As climate change continues to worsen, the frequency and severity of such events are likely to increase.
In addition, there’s the problem of sea level rise, which will not only have financial impacts on US coastal communities, but military installations as well. According to an article in Defense News, Climate change is going to cost us: How the US military is preparing for harsher environments, the Department of Defense manages 1,700 global military installations on coastlines, many of which are vulnerable to more severe and frequent climate events, especially naval bases. Adapting and protecting these installations will cost money now, and more later if the underlying problem of global warming isn’t addressed today.
Biodiversity declines are also associated with serious financial consequences. According to the Sustainable Policy Institute, “pollination, nutrient-cycling, and carbon sequestration” supports global economic activities to the tune of $125 – $140 trillion annually.
Transition risks are another risk factor associated with climate change that carry financial implications. With legislative policy changes, market shifts, and technological advancements, businesses have to keep up with regulations, and if they don’t, there can be grave financial consequences. As more companies prioritize sustainability and carbon reduction, and investor and customer demand continues to grow, those that do not adapt to these changes may find themselves at a competitive disadvantage.
Social (“S”) risks with ESG frameworks can also be associated with severe financial consequences. It’s not hard to imagine the negative financial consequences of penalties, customer and client losses, brand and market reputational risks, or lawsuits associated when a company fails to account for certain social risks. Bad press or media coverage due to poor protocols and procedures in managing discrimination claims, harassment claims, the unlawful employment of migrant child workers, work-related injuries, or cybersecurity breaches, for example, are business risks to avoid at all costs.
Financial Risks of ESG to Design Firms
For design firms, ESG risk management is impactful to business for several reasons.
Improving Project Profiles
All projects require funding or financing, as well as insurance. As a project stakeholder, what a design firm does, or fails to do, and how they perform on ESG risk factors matters. The reality is that there will be more projects involving green bonds, social bonds, and sustainability bonds. All of these financial instruments will require more rigorous proof of positive environmental and social outcomes.
It is important to recognize that investors, underwriters, and lenders are sensitive now more than ever to prioritizing ESG-aligned project attributes. Project owners are under pressure from investor and customer demand due to the momentum behind net-zero commitments and increasing regulatory scrutiny.
With the recent passage of historic federal legislation—the Infrastructure Investment and Jobs Act (IIJA) and the Inflation Reduction Act (IRA, aka, the Climate bill)—it is important to remember that federal funding from these acts have “strings attached.” Through both acts, the Biden Administration prioritized climate change mitigation, adaptation, community resilience, social justice and equity, and safety. Projects that are ESG-aligned will be better positioned to receive federal funding support.
The big picture here is that projects with good ESG profiles (project goals, features, procedures for community engagement, and project stakeholder ESG performance) will attract more favorable financing terms. Likewise, public projects being funded by IIJA and IRA funds will seek-out ESG-aligned stakeholders and project ideas that are consistent with ESG best practices.
ESG management is growing and performance expectations are becoming standardized. There is momentum behind global standardization for reporting and disclosing ESG performance so acting now to anticipate this growing demand will place firms at a competitive advantage. It’s also important to consider that design firms may be asked about their ESG corporate performance during project procurement or the pre-interview process. Being prepared for those questions is best managed before they happen. Notably, ESG performance supplier standards will increasingly become a “thing to watch” in professional services agreements.
ESG, fundamentally, is about managing emerging and future risks in an era of heightened environmental and societal concerns. A firm that proactively manages these heightened risks with proper governance, protocols, and procedures will be better positioned to reduce claims exposures. By integrating ESG considerations into business strategies and decision-making processes, firms can identify and manage these emerging and future risks more effectively. This includes implementing protocols and procedures that prioritize environmental sustainability, workforce safety, cybersecurity protections, and ethical governance. By doing so, firms can not only reduce their claims exposures, but also build resilience and maintain long-term profitability in a changing landscape of evolving stakeholder expectations and regulatory requirements.
Design firms with a robust ESG record tend to have a stronger corporate brand value, which attracts talent. In today’s market, where talent scarcity is an enormous challenge, it is especially critical to hold onto existing talent and support them with ongoing training and upskilling for the future. Good talent helps design firms deliver top quality services, and delivering top quality services means profit, client retention, and a steady pipeline of business and growth.
Design professionals have a unique role in ESG. By virtue of the license to practice, design professionals have an obligation to protect the public’s health, safety, and welfare. While protecting the public’s health, safety, and welfare has always included some level of accounting for environmental and social risks, today’s world has changed. Since COVID-19, the world has been in constant transformation. Crisis after crisis related to climate change, technological advancements, geopolitical instability, growing social inequality, inflation, and paradigm-shifting demographic changes have heightened the urgency around managing environmental and societal risks. The more awareness a design firm has about ESG risks and opportunities, the better the public is served in all aspects of health, safety, and wellness.
In conclusion, while ESG risks may be categorized by some as non-financial risks, the reality is quite the opposite. ESG risks are squarely financial in nature, but simply don’t align with traditional financing considerations. Profit and loss statements, balance sheets, income statements, and cash flow statements will continue to be part of the world of financial risk assessment, as they should be, but ESG takes a broader and deeper look at financial risk. Design firms, along with all companies, can better position themselves for long-term success and sustainability by realizing the distinction.
To learn more about how to assess your firm against ESG risk factors and receive an ESG Rating/Score, be sure to watch Victor’s webinar, Unlock Your Firm’s ESG Potential with Victor’s ESG Risk Rating Tool. Current Victor design firm insureds are encouraged to use Victor’s new ESG Risk Rating tool by requesting access. Insureds will need a Victor website account before they can access the tool.
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