Risk vs. Riks: The Distinction Between Business-as-Usual Risk and ESG Risk

Risk is a term that often grabs our attention. In fact, it's now part of the everyday Hindi language, spoken as 'Riks' in rural areas. At its core, risk is viewed as something negative. Simply put, it's about the chances (statistical probability) of something unwanted happening – like slipping on a wet floor.

Imagine walking on a wet floor, a risk we face daily. Let's picture a household where this risk unfolds regularly, and elicits different reactions from family members. The husband, usually carefree, sees it as a routine – a medium-risk activity. On the flip side, the wife, more cautious, categorizes it as high-risk. Here, risk appetite – how much risk one is willing to take – determines how we perceive and deal with risk.

Now, let's dive into how we usually handle this kind of risk. Someone carefree might opt for health insurance, considering they visit an orthopaedic only once a year due to a slip. This is known as transferring the risk. On the other hand, someone cautious might avoid walking on a wet floor altogether, a mitigation strategy.

If the chances of slipping increase, say you start fracturing bones once every month due to slipping, you would treat the risk differently. Instead of transferring the risk, you'd opt to mitigate it. This might involve not walking on wet floors or finding a way to dry them quickly.

In the business world, risk is often seen negatively. CEOs, armed with a wealth of risk details like the probability and severity of falling, can swiftly decide whether to tread the wet floor or take an alternative route. This decision depends on the situation. For instance, if you're in a rush to reach the other end of your factory shop floor for an investor meeting, you might choose to take the risk due to time constraints and your knowledge of the risk details. In Hindi, this behavior is encapsulated in the phrase 'high-risk high-gain or no gain without pain.

However, for the CEOs of a business, a risk is that - a risk. They must understand the likelihood, severity, and impact to treat it through mitigation or transfer. Sometimes, you neither mitigate nor transfer it; instead, you decide to accept it. For occasional investor meetings, you might choose to walk the wet floor, understanding the risk details.

The key is understanding the specifics of a risk, which is fundamental to making a suitable decision. A CEO's priority is to understand risks that necessitate a decision and appropriate actions for treatment.

Some CEOs categorize 'business risk' separately from 'ESG risk'. These CEOs prioritize financial considerations when evaluating all risks. For instance, when deciding whether to walk on the wet shop floor in the factory, a CEO considers the probability of slipping and the consequences of a bone fracture once a year. Based on this, they rate the risk from high to low, factoring in the impact – the loss or gain resulting from it.

If hospital expenses pose a significant financial burden to the company every its CEO get hospitalized due to a bone fracture, it's a financial risk. In other scenarios, it's viewed as business as usual risk or business risk. On the other hand, if the orthopaedic doctor is a friend of the CEO and charges nothing, then it may be only an ESG category or some other category risk for the CEO.

However, some CEOs recognize that it's not just the direct loss, such as the fee paid to the orthopaedic, but also the indirect losses resulting from falling onto a hospital bed for a few days. This includes demotivation of staff members and ineffective daily reviews and feedback in the company, leading to low productivity.

To me, this is where the difference lies between ESG risk and business risk. ESG risk becomes a business risk based on how you understand and perceive it. ESG risks are usually indirect and have a long-term impact. They often lack a direct cause-and-effect relationship. The ESG risk may not come in the general scanner and the methodology that is used by businesses for as-usual risk (or regular risk or classic risk as different people call business risk by different names).

A CEO can pass off responsibility for ESG risk, especially if there's no direct relationship with the business. For example, while setting up a greenfield transport and logistics business, they might not consider the risk to the culture and traditions of a nearby village community. They can evade responsibility by stating that the business will have no direct give-and-take relations with these villagers and hence no impact on them, hence no responsibility.

However, over time, this may escalate into a social risk. With many trucks working for the business, they may park or start overnight hauls near the village due to the emergence of private food outlets. While this brings economic activity to the villagers, it also introduces truck drivers from different backgrounds, cultures, and habits for overnight stays in or near the village. This can increase the likelihood of the area turning into a red-light zone in the long term, constituting an ESG risk or a social risk for the business.

Thus, CEOs who are genuinely committed to understanding ESG risks fall into two subcategories - X and Y.

Category-X CEOs want to know and address ESG risk if they see its impact on the business (financials). Category-Y CEOs are willing to address ESG risk even if they don't see its direct impact on the business (financials).

Similarly, there are two types of ESG standards: one that requires you to identify and report ESG risk and impact only when it affects your financial prospects, and the other that mandates reporting on ESG risk and impacts regardless of their relations with your business financials. Examples of standards in these two categories are ISSB and GRI, respectively.

The story of different types of risk and their classifications starts from here. This can be a separate subject to delve into in the future. Stay tuned!