The Critical Importance of Sustainability Risk Management

Sustainability risk management deals with emerging environmental and social justice risks. Risk managers will need to anticipate these risks and develop appropriate risk mitigation and financing strategies for them, but since many sustainability risks are new and emerging, the best strategies for

Examples of emerging sustainability risks are useful in demonstrating their broad scope. The Exxon Valdez Alaskan oil spill in 1989 was catastrophic in terms of environmental damage and disruption of local businesses. The $5 billion punitive damage award, which has still not been settled, was one of the largest at the time. Asbestos resulted in the worst product liability toxic tort to date, and instead of abating as was expeered, claims have begun to increase again. Superfund liabilities have been incurred for over 20 years, and continue to disrupt organizations. New litigation involving silicosis, MTBE (a gasoline additive), perchlorate (a main ingredient in rocket fuel) and PFOA (a chemical used in the production of Teflon), have the potential to create additional liabilities.

Boycotts against a firm's products are similar to business interruption risks, except no insurance is available to compensate for loss of revenues. Boycotts are often triggered by sustainability risk events. Greenpeace's boycott of Shell oil for its plans to sink the Brent Spar, an offshore oil platform, caused retail sales in some European countries to fall by 30% in a week. Boise Cascade's operations were disrupted by the Rainforest Action Network's boycott because of the cutting of old growth forests. Boycotts by this same group resulted in three of the world's largest banks, Citigroup, Bank of America and J.P. Morgan Chase, agreeing to alter their lending practices by taking meaningful measures on forest protection, indigenous rights and climate change. Boycotts against Nike by United Students Against Sweatshops and other groups for their sweatshop practices resulted in its stock price and revenues dropping. These boycotts eventually resulted in all these firms making substantial improvements in their sustainability strategies.

Global warming/climate change may be the most significant sustainability risk. While Hurricanes Katrina, Rita and Wilma in 2005, the four Florida hurricanes in 2004, and flooding in Europe, Africa, Central America and China cannot yet be proven to have been caused by global warming, almost all climate change models predict increasing storm severity with greater precipitation levels and higher wind velocities. The property risk exposure of coastal buildings and businesses increases.

While this may seem obvious, a series of other risks exist, which are also associated with global warming and climate change. For instance, the island states of Tuvalu, Kiribati and the Maldives, the Inuits and various environmental groups are exploring litigation against the United States and fossil fuel companies to recoup financial damages caused by global warming. The failure of the United States to ratify the Kyoto Protocol, while most of the industrial world-European Union, Japan, Russia, Canada-have signed, presents dilemmas for U.S.-based multinational companies. The uncertainty of not knowing if and when the U.S. might ratify the Kyoto Protocol has prompted many firms to take preemptive action by voluntarily reducing their greenhouse gas emissions. DuPont, United Technologies and Cinergy even appeared before a House Science Committee in May 2005 to testify in favor of mandated reductions.

Recently adopted sustainability legislation in the European Union produces similar problems for U.S. firms operating in Europe. The Directive on Waste Electrical and Electronic Equipment (WEEE) mandates the taking back and recycling of most electrical products and equipment by manufacturers. The Directive on the Restriction on Hazardous Substances (RoHS) effectively bans the use of lead, cadmium, mercury and some flame retardants in electronic products sold in Europe. The Registration, Evaluation and Authorization of Chemicals (REACH) Directive requires the environmental safety and testing of thousands of chemicals. This testing will result in the ban or restricted use of the most hazardous chemicals. U.S.based companies with European operations must decide whether to make two sets of products or use two sets of chemicals, or whether to follow the higher standards set in the EU for all their products and operations.

Social justice risks arise out of the unfair and inequitable treatments of workers, communities or peoples in foreign lands. An example of such risks for global corporations involves litigation brought under the 1789 Alien Tort Claims Act (ATCA). Originally intended to allow foreigners to sue international pirates in U.S. courts, the Act is now being used to sue U.S. corporations for their actions in harming peoples in foreign countries. One of the more significant cases was brought against Unocal, which was constructing a natural gas pipeline in Myanmar (Burma). Unocal paid the military to provide security and was implicated in allegations that the military engaged in torture, genocide and abuses of local villagers. Unocal chose to settle for an undisclosed sum. ATCA litigation has been brought against other multinational corporations, including IBM, Citigroup, Coca-Cola, ExxonMobil and Chevron Texaco.

Another social justice exposure is exemplified by 1.6 million women who are bringing the largest class action gender discrimination suit ever filed against Wal-Mart for alleged poor treatment, under-compensation and lack of promotion opportunities. This could result in a liability judgment or settlement in the billions of dollars and substantial damage to Wal-Mart's reputation and future revenues. Other companies paying sizeable recent settlements or judgments for gender discrimination include Morgan Stanley, Boeing, Merrill Lynch and UBS.

Oil shortages and the resulting increase in gas prices have attracted considerable recent attention. Indeed, many knowledgeable experts predict that world peak oil production will be reached in the not-too-distant future. Oil is an example of a natural capital asset, one that essentially has been provided "free." Other natural capital assets or ecosystems are coming under increasing pressure including groundwater, oceans, forests, and biodiversity of plant and animal species. This presents global societal risks, and also impacts industries dependent on ecosystems or firms that may be held accountable for damaging these systems.

Even the stock market is being confronted by the emergence of new sustainability exposures. Socially responsible investing (SRI) has a long history, but a recent growth spurt has resulted in over 10% of invested money under professional management being directed by SRI screens and evaluations. Traditionally, it was felt that SRI stocks would not perform as well as other stocks. Investments in environmental and social initiatives were looked at as costs that would reduce a company's profits and result in lower stock prices. But recent studies are providing empirical evidence that some SRI funds may actually have higher returns. For instance, as reported in a July 2005 RM article by Jared Wade entitled, "Easy Being Green," the Dow Jones Sustainability Index outperformed the Dow Jones Global Indexes, 15.8% to 12.5% over the period of August 1996 to August 2001. The Dow Jones Sustainability Index also publishes leaders across 60 industry groups. Being an industry leader greatly enhances a company's sustainability reputation, particularly when compared to competitors.

If directors and officers needed to be persuaded that sustainability risk management is important, they might heed the advice of Matthew Kiernan, CEO of Innovest Strategic Value Advisors, in a Financial Times article:

"The "prudent fiduciary" equation is being turned on its head. Since there is now evidence that superior environmental and social performance improves the risk profile, profitability and stock performance of publicly traded companies, fiduciaries can be seen to be derelict in their duties if they do not consider sustainability."

Another investor-related sustainability risk facing directors and officers are shareholder resolutions. Global warming resolutions, which ask companies to calculate and disclose their annual greenhouse gas emissions, and to draft a plan for reducing these emissions, put considerable pressure on directors and officers. The Coalition for Environmentally Responsible Economies (CERES) and the Interfaith Center on Corporate Responsibility (ICCR), which represents 275 faith-based institutional investors with combined holdings of around $90 billion, have coordinated the filing of shareholder resolutions over the last 10 years. They filed 31 global warming resolutions against 28 companies in 2003. Support levels for these resolutions at several companies ranged from 22% to 32%. The 2005 global warming resolution at ExxonMobil was watched closely, and resulted in a 28% approval rate.

Sustainability risk management is also related to the concepts of sustainable development and the triple bottom line. Sustainable development's clearest articulation was captured in the 1987 Brundtland Report entitled "Our Common Future," as "development that meets the needs of the present world without compromising the ability of the future generations to meet their own needs."

John Elkington, author of Cannibals with Forks and Chairman of Sustainability, the leading U.K. sustainability consulting firm, introduced the concept of the triple bottom line in 1997. The triple bottom line includes the financial performance of the company, its environmental record and its social efforts in treating workers, peoples and communities in a fair and equitable manner. Maximization requires attention to all three legs of the triple bottom line. If emphasis is only on the economic performance of the firm, then escalating risk costs in the environmental and social justice areas will ultimately cause the financial condition of the firm to deteriorate.

A brief look at sustainability risk management techniques demonstrates how risk costs can be reduced. Waste reduction shrinks both operating costs and potential Superfund and premise liabilities. Several prominent corporations have made major reductions in waste and pollution. DuPont reduced toxic releases 74% from 1987 to 1993, halved its landfill waste, and cut its $1 billion per year waste treatment bill by $200 million. DuPont has also cut its emissions of cancer-causing chemicals by almost 70% since 1987. 3M's Pollution Prevention Pays program eliminated more than 1.5 billion pounds of air, land and water pollution for a total cost savings of $790 million. In the first 20 years, Intel halved its hazardous waste over a 10-year period during which Intel was increasing its revenues by ninefold.

William McDonough and Michael Braungart, authors of Cradle to Cradle, describe an amazing example. Their client, the Rohner textile mill in Switzerland, was experiencing substantial hazardous waste costs in disposing of upholstery fabric trimmings. McDonough and Braungart set out to create a fabric that could be safely disposed of as a biological nutrient when it was worn out. They eliminated thousands of potential chemicals, and ended up using 38 ingredients that had no mutagens, carcinogens, endocrine disrupters or persistent toxins. This mix was actually cheaper than the one the mill had previous used. When regulators later came to the mill to test the water effluent, they were shocked to find that their instruments could not detect evidence of any pollutants. In essence, the water coming out of the factory was as clean as the water going into the factory.

More efficient energy systems not only save operating costs, but also reduce risks associated with greenhouse gas emissions. Incorporating hybrid vehicles into transportation systems results in fuel savings and again reduces greenhouse gas emissions. In 2000, Environmental Defense approached FedEx with the idea of producing a hybrid truck to replace FedEx's old diesel trucks. After careful thought, FedEx made a commitment to replace its entire 30,000 express van fleet with hybrid gas-electric models in 10 years. Besides fuel savings, FedEx has reduced pollutants and greenhouse gas emissions from burning diesel that could present regulatory, liability, boycott and reputation risks. On a related note, Toyota, the leading producer of hybrid vehicles, is producing record profits and recently announced that its entire auto production will go hybrid in the future. For its efforts, Toyota was ranked number one in the Corporate Knight's list of the world's 100 most sustainable corporations at the World Economic Forum in January 2005.

Green building presents tremendous opportunities for innovation and developing new methods of design and construction. A critical juncture came in 2000 with the development of LEED (Leadership in Energy and Environment Design) certification by the U.S. Green Building Council. LEED certification involves minimization of energy and water consumption, use of sustainably produced, nontoxic and recycled materials, emphasis on access to public transportation or carpools, green roofs and maximization of the advantages of nature like fresh air, natural sunlight, views and outdoor access. Initial green investments pay for themselves over time with energy savings, less water use, less extensive mechanical systems, lower workers compensation costs, more pleasant working environments, more productive employees, and less turnover and absenteeism. A State of California commissioned study of its 33 LEED certified buildings found that they cost an average of $4 more per square foot, but over a 20 year period, they generate savings of $48.87 to $67.31 per square foot.

An effective sustainability risk assessment strategy is to prepare a corporate sustainability report. Preparing a report helps to assemble, organize and benchmark sustainability data and efforts of the firm. Excellent sources that can be utilized include the KPMG International Survey of Corporate Sustainability Reporting and the Corporate Register.

Life Cycle Assessment (LCA) and Design for Environment (DfE) assess the environmental and social costs during the whole life cycle of the product or service. A products liability control programs could be coordinated with LCA and DfE programs to produce products that minimize both products liability claims and environmental and social justice risks.

Certification programs, like ISO 14001, contribute to developing a sound sustainability risk management system. Requiring suppliers to be ISO 14001 certificated, as do such corporations as Ford, GM, IBM, Xerox and Bristol-Myers Squibb, can reduce sustainability risks from supply chains. Other useful sustainability certification programs include the Global Reporting Initiative, Social Accountability 8000 and AccountAbility 1000.

Joining voluntary business associations like CERES can bolster a firm's sustainability risk management efforts. Along with networking, these associations typically require adherence to a set of principles, some of which have direct risk management applications. For instance, among the 10 CERES principles are, risk reduction, safe products and services, reduction and disposal of wastes, environmental restoration, protection of the biosphere and sustainable use of natural resources.

Partnerships between corporations and various stakeholders can be an effective sustainability risk control strategy. Environmental Defense has partnered with such corporations as FedEx (see above), McDonald's, General Motors and S.C. Johnson; the Rainforest Alliance has joined with Kraft Foods; and Staples has partnered with the Natural Resources Defense Council. The Rainforest Action Network's alliance with Citigroup, Bank of America and J.P. Morgan Chase was previously mentioned. The World Resources Institute partners with 400 corporations, governments and NGOs in 50 countries around the world. All these partnerships work on a cooperative, rather than confrontational basis, while emphasizing the sustainability performance of the involved corporations. These partnerships reduce the probability of liability suits, help to insulate participating companies from boycotts and shareholder actions, and improve corporate reputation.

Environmental insurance markets have been actively developing since the late 1980s, after pollution was excluded from standard liability forms. Currently, the market generates approximately $2 billion in annual premiums. As liabilities expand, risk managers, their brokers and their boards of directors may find they are not covered for environmental risks. David Dybdahl, an environmental consultant, estimates that only around 1% of businesses carry some form of environmental insurance. The lack of insurance may be particularly troublesome for directors and officers. Most D&O insurers exclude claims arising out of pollution events. Claims may also be brought against directors and officers for failing to disclose environmental liabilities. In all likelihood, these claims are also excluded. Such claims are exasperated by the disclosure and signing off (by CEOs and CFOs) requirements under Sarbanes-Oxley. The purchase of environmental insurance is the most effective risk financing tool to protect against these claims, but it appears few risk managers have made this decision.

In the 1990s, risk management strategy has been expanded by the development of enterprise or holistic risk management and the rise of the chief risk officer. Legal and operational/event risks, traditionally handled by risk managers, are being combined with financial, business and political risks to construct an overall risk profile of the firm. Sustainability risks to date have only been marginally dealt with in these risk profiles. One elaborate risk consultant's chart, entitled "Enterprise Risk Management," listed 88 different risk areas, but none were titled environmental, social or sustainability risks.

In a May 2005 speech at the George Washington University Business School, General Electric CEO Jeff Immelt stated that "He would double G.E.'s investments in energy and environmental technologies to prepare it for what he sees as a huge global market for products that help other companies-and countries like China and India-reduce emissions of greenhouse gases."

In launching this new initiative, called "ecomagination," Immelt stated that both GE's research and development in new technologies and the marketing of more environmentally friendly products would double by 2010. New technologies include wind power generation, solar panels, coal gasification power plants, and advanced water treatment and conservation systems. Immelt expects that more then half of GE's product revenues will come from environmentally approved products by 2015. Immelt pledged that by 2012, GE's energy efficiency would improve by 30% and its worldwide greenhouse gas emissions would decrease by 1%, as opposed to a 40% increase if no action was taken. GE will release its first ever "Citizenship Report," which will lay out plans on this new initiative and other related issues.

GE's "ecomagination" campaign is a terrific example of how innovation, business opportunities and sustainability risk management all come together to make a cohesive whole. GE's strategic initiative will reduce the negative impacts of its operations on the environment and workers. The probability of future liability and boycott risks are also reduced, and the company's reputation is improved. GE expects its more environmentally oriented business strategy will result in increased revenues, profits and competitive advantage. Immelt may have summed it up best: "We're at a tipping point where energy efficiency and emissions reduction also equal profitability."

While some companies develop sustainability strategies based on ethical motives, most firms do so for business reasons. Sustainability strategies can decrease sustainability risk costs, augment competitive positions, protect reputations and improve bottom lines. Risk managers have a tremendous opportunity to contribute to their firms' overall management strategy by implementing sound sustainability risk management practices.