Sustainability expert Wouter Botzen on managing ESG-related supply chain risks
September 18, 2023
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In my field, three major trends influence the risk management of businesses that I would like to share with you: namely, the rapid depletion of natural resources, declining biodiversity, and lastly, I will discuss climate change in more detail.
First, increasing global consumption is accompanied by the accelerated depletion of natural resources. This includes the overfishing of oceans, deforestation on a large scale as is happening in the rainforests, and the scarcity of rare metals. A popular indicator to measure this is the Earth Overshoot Day - the point in a year when humanity's ecological footprint equals the natural resources the Earth can regenerate. In the early '70s, this date was in December, meaning humanity's consumption almost matched what Earth could produce. However, this date has been steadily advancing and was already on August 2nd this year.
Secondly, a related trend is the loss of biodiversity and the increasing number of endangered species. This is related to deforestation, among other causes. Changes in land use and direct human exploitation of nature are the primary reasons behind this. According to research published in the Living Planet report, populations of fish, birds, reptiles, mammals, amphibians, and reptiles have decreased on average by almost 70% since the '70s.
These two trends affect businesses. How much do you contribute to these trends through your supply chain and especially foreign suppliers? Or, on the contrary, to the solution through sustainable resource extraction and sustainable exploitation of nature? Additionally, more regulations are approaching, such as initiatives around the circular economy that promote local extraction, efficient use, and reuse of resources.
Thirdly, climate change is already leading to more extreme weather worldwide, and this trend will accelerate in the future. Take, for instance, the extreme drought in East Africa that has persisted for several years - the longest and most severe drought in over 40 years. Closer to home, in Southern Europe, extreme heat and wildfires had significant consequences this summer. Furthermore, more severe floods, such as those experienced in Limburg in 2021, are becoming common, as are hurricanes in the Caribbean, the US, and parts of Asia. Extreme weather has always occurred, but there's solid evidence suggesting that the observed increase in frequency and intensity is due to climate change.
Evidence for this trend leading to more economic damages is shown by data on total economic and insured damages caused by natural disasters. These figures, collected globally over a long period by major reinsurers like Munich Re and Swiss Re and adjusted for inflation, indicate that insured damages in the '70s were a few billion to a maximum of 10 billion per year. In the past decade, a damage of 40 billion would be considered a calm year regarding natural events, and damages around 100 billion or more are not uncommon. The total economic damages are even higher than these insured amounts because a significant portion isn't covered by insurance. This trend is partly caused by the growth of population and capital in areas vulnerable to natural disasters, but climate change is playing an increasingly significant role.
The consequences for businesses are primarily direct damages to company buildings and inventory hit by extreme weather, like a flood. Part of this depends on insurance coverage, which is often not comprehensive. For instance, a survey from the VU among companies in Limburg affected by the 2021 floods showed that 40% of their damage is not compensated by insurance or the government. Subsequently, a significant portion of the damage comes from lost revenue because the company isn't operational, or customers can't reach it. Companies in Limburg that were adequately insured and took other risk-reducing measures experienced less revenue loss, as they recovered faster from the disaster.
Moreover, through the supply chain, there are broader indirect financial consequences for companies not directly affected by the natural disaster. For instance, if a company purchases inputs for production, or services and products from other companies whose production stagnates after a disaster. This continuity risk can have significant effects. Companies sometimes need months or even longer to recover after severe storms or floods. Additionally, after major disasters, price effects can occur, like higher food prices following intense drought, which increases purchasing costs.
Businesses can address climate risks in their risk management. Firstly, it's essential to identify those risks for the business locations. Are they in flood-prone areas? Are insurance coverages in place? Or are other protective measures needed at the location? Secondly, analyze the climate risks of the suppliers you heavily rely on and consider alternatives if those suppliers fail. Thirdly, which goods you purchase are highly susceptible to price fluctuations due to climate change, and how can you absorb such cost increases?
From a consumer perspective, there's an expectation that companies contribute to reducing greenhouse gas emissions. Many businesses address this well. However, a risk here is that well-intentioned initiatives can be criticized as greenwashing. For instance, a recent publication in Science led by my institute shows that voluntary carbon offset credits, which can be purchased to offset CO2 by planting new forests, are often without substantial impact. In other words, no additional CO2 reduction occurs. If a company wants to go green for consumers, it should be done credibly to receive the right appreciation from the market.
In conclusion, the ESG risks I discuss here are complex. Additionally, businesses face intricate regulations on these risks from the EU and other institutions. The scientific community is rapidly advancing in knowledge, with more global datasets becoming available to assess these risks. Consultants like 3rdRisk can make this data accessible through automation. Ultimately, a collective approach, also with suppliers, is key to successfully mapping and managing these risks.
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