Environmental, Social and Governance Risk

Environmental factors include climate change, pollution and resource use. Social factors cover labour practices, safety, human rights, product safety and community relations. Governance factors cover board quality, ethics, pay, control systems and transparency. These factors can hurt a firm directly, for example through a fine or a strike, or indirectly, through clients and suppliers. ESG risk is not a separate risk class in most frameworks. It feeds into credit, market, operational, legal and reputation risk, which is how banks and insurers usually manage it. Rating agencies give scores for it, though they differ in method and often disagree. The risk can also run the other way: a firm's activities can harm the environment and society, which the idea of double materiality captures. These factors increasingly drive a firm's costs, access to funding and valuation.

A fund manager reviews a garment exporter with a large order book. The credit file shows repeated factory safety violations, high staff turnover and pending litigation by workers. Reading these alongside the financial statements, the manager lowers the internal rating and halves the planned position.