An extra ‘G’ in ESG. The integration of geopolitics in sustainability indices
As time goes on, geopolitical risk oversight and its integration into ESG criteria appears to be becoming of greater necessity. We have seen how the war in Ukraine, China’s zero-covid policy, the net-zero policies around the world as well as many other instances have been widely impactful on businesses. Such geopolitical changes impact companies not only with regards to supply chains, but also cyber-attacks, consumer behaviour, tariffs and investment restriction. These factors create a more complex formula for ESG metrics, causing it to become challenging to evaluate, especially in terms of their impact on businesses. With this in mind, doubts begin to surface as to whether boards are able to identify and effectively take into account these risks. In saying this, do we need an extra ‘G’ in ESG?
An EY survey identified that executives are finding it more and more challenging to manage political risks, going from a confidence rate of 74 per cent pre pandemic to 55 per cent in 2021. The increasing geopolitical challenges that CEOs and board members are currently facing are not fading away anytime soon, but are more than likely to grow. The Russia-Ukraine war has deepened the supply chains disruptions that started with the global pandemic in 2020. While the war has led to a series of sanctions contributing to the energy and food supply chain disruption, the ongoing US-China tensions combined with (until recently) a strict zero-Covid policy in China, materials more difficult to source, semiconductors more problematic to produce and an ever-increasing number of firms quietly moving their production plant from China to elsewhere in Asia, such as Vietnam or even Europe and Latin America.
As a result of this new trend of deglobalisation of production and supply chains, CEOs and board members have been left with no choice but to place the geopolitical issues as a high priority on their agendas. About 80% of companies interviewed by EY for their 2021 Global Capital Confidence Barometer altered their strategic investments, especially to include sectors such as technology and digital capabilities. Other common choices are to re-think the corporates’ M&A plans, market entry and exit, digitalization of customer experience and business processes, as well as the international footprint decisions.
Geopolitics has a strong link with Environment, Social and Governance issues. On one side, the wide spectrum of topics linked to geopolitics cuts across the ESG issues. For example, human rights abuses are likely to trigger sanctions and supply chain shifts, while climate change can generate resources scarcity as water and food insecurity across national borders and exacerbate migration flows. On the other side, sustainability frameworks and ESG regulations play a role in driving geopolitics. The ‘Carbon Tax’ further increased the tensions between China, France, and Germany over the best approach to achieve the 1.5C goal, while the ‘Net Zero’ for oil-exporting states in the Middle East may be a driving contributor towards countries’ alignment shifts.
The importance of geopolitics for businesses is clear and its interconnection with ESG issues has been established. However, the question remains as to how this factor can be measured. Currently, only one major index captures geopolitical issues, the Geopolitical Risk Index (GPR), compiled by Fed economists, but not commonly used by CEOs. On the other hand, ESG factors are widely covered by rating agencies and used by investors, but they differ extensively in what they capture and how, of which has certainly helped in generating confusion in the decision-making process. The Risk Coalition, a UK network of not-for-profit professional bodies and membership organisations, drafted a ‘principles-based guidance for geopolitical risk oversight and its integration with ESG issues for boards, risk oversight committees and risk functions’. Despite the guidance serving as a useful navigation tool for companies, what is still missing is an integrated ESG-Geopolitical index highlighting the links between the two which is also up to date.
An ESG-Geopolitics ratings could be developed as an integration of the existing ESG indices by taking into consideration where companies’ activities are carried out or where the physical resources are gathered from. For example, a company sourcing key materials from a politically stable country would have a different risk rating compared to a country sanctioned or one involved in civil conflicts. In this way, any type of company issue can have a geopolitical risk score associated to its activities. In addition, this would enable metrics to continuously capture the risk change based on tangible parameters such as regulations, military operations, and much more.
Hence there is a clear need for an index focusing on geopolitics and even more for some sort of integration with the ESG issues. However, how this will be played out with the already existing issues in methodology differences for ESG indices is challenging to say the least, especially since adding another complex variable that is geopolitics might add further confusion rather than clarity in the measuring system. With this taken into account, what is most clear is the potential need to reform the existing system of ESG reporting.