Unlocking the Power of ESG: How Systems Thinking Drives Smarter Sustainability Decisions

ESG as Risk Management

Viewing business decisions through an ESG lens is not about increasing costs. Fundamentally, incorporating ESG into business decision-making is a form of risk management. Without understanding how affected a company is by potential physical climate risks, a company cannot evaluate the financial impact of operational disruptions from such events like severe storms or droughts. Without understanding how affected a company is to climate transition risks, a company cannot evaluate the cost of upcoming taxes or regulations. It cannot evaluate the changing preferences of customers and their ability or willingness to pay for higher quality sustainable products. And it also cannot evaluate the opportunity cost of foregoing more advanced technologies that support a sustainable transition. Without an understanding of how reliant a company is on natural resources, a company cannot evaluate the cost of supply shortages or the cost of finding alternatives.

To elaborate further, a beverage company that relies heavily on clean water for production cannot accurately evaluate the risk or cost of supply shortages without understanding how water quality impacts its operations. Similarly, an agricultural business must consider soil health and climate conditions—without this, it can’t plan for the financial or operational consequences of declining yields or sourcing alternatives. In short, without insight into how dependent a company is on natural resources like water, soil, or raw materials, it’s impossible to fully assess the risks or costs associated with environmental changes or scarcity.

This non-exhaustive list demonstrates that related business costs, disruptions, and changing market dynamics stem from inherent ESG risks to which a company is already exposed. These costs did not arise because a company chose to be more sustainable. As a result, companies that don’t identify ESG risks may be flying blind and hoping to continue with business as usual despite a rapidly changing landscape.

In a recently published piece on creating value through strategic ESG integration, we’ve noted that incorporating ESG into a business’s strategy can drive innovation and differentiation, improve efficiency and reduce costs, expand market access and strengthen customer trust, among other value-creating opportunities. However, we’ve also noted that many companies hesitate to take action due to up-front costs and administrative burdens. Nevertheless, companies must consider the hidden costs of poor ESG management – such as high employee turnover, legal fines and reputational damage leading to decreased sales.

While sustainability regulation may be delayed or some requirements relaxed, delays in thoughtfully thinking about the impact of ESG factors on a company can be value destroying in the longer term.

In a recent study by the Institute for Energy Economics and Financial Analysis (IEEFA), a key finding highlighted that externalities (specifically from carbon emissions) of just five portfolio constituents contributed to an implied portfolio performance drag of around -0.36%. What this means is ESG risks, in this case carbon emissions, resulted in lower financial performance of individual companies than if the ESG risks were reduced or avoided. While the study focuses on portfolio performance of asset owners, it points to the aggregated negative impact on companies from not addressing ESG risks and their influence on the performance of other companies in a broader interconnected system.

The IEEFA proposes asset owners make portfolio investment decisions based on “systemically adjusted” investment models, which incorporates systems dynamics, i.e. the impacts of social and environmental damages on market performance. This implies the need for individual companies to incorporate this in their own ESG strategy and investment decisions to ensure ESG risks are managed in a way that actually creates value.

Business as a Complex System

So, how does a company go about analyzing whether certain sustainability investments incur costs or lead to opportunities? And how does a company try to understand if it is worth the resources to implement these sustainability decisions? One practical way of understanding the effects of integrating sustainability into business practices is through using one of the tools of systems thinking – causal loops.

Before getting into causal loops themselves, let’s take a step back and understand a systems thinking approach. In an earlier piece published on systems thinking, we highlighted that businesses are complex systems. They are nested in even more complex systems like the economy, society, and, even more broadly, the environment, as illustrated in the figure below. All these systems continuously influence one another.

By understanding the channels through which one system impacts another system, business leaders can begin to identify how their business is affected by one or several variables across these systems and whether they have any control in influencing those variables.

Where they can exercise control directly, e.g. by choosing which products to produce, business leaders can make decisions that increase the likelihood of continuity.
Where they can’t exercise control directly, e.g. weather patterns have changed, they can put in place contingency measures to mitigate the negative impact of such events occurring in order to build a more resilient business. From this systems thinking approach and a zoomed out view, companies can understand where they sit in a broader ecosystem and the factors influencing their operations.

ESG Modelling Through Causal Loops

To gain another perspective by zooming in to the systems happening within a company, causal loop diagrams can help business leaders understand the cause–and–effect relationship to other parts of the business. This is helpful, for instance, when evaluating  the impact of implementing an emissions reduction initiative or the decision to use recycled materials. Causal loops are one of the tools used to illustrate interconnected elements within a system and determine whether those elements are reinforcing the system or offsetting, or balancing, the system. As an informal way of modeling outcomes from business strategy decisions, causal loops are helpful for business leaders when trying to understand the possible effects on financial statement line items from pursuing sustainability investments.

In the simplified casual loop diagram above, we can see the cause-and-effect relationship of a company choosing to invest in more wind energy production and the impact on sales, unit price, operating costs, and economic value from the purely financial perspective. We also see the effect of wind energy production on carbon emissions from a sustainability strategy perspective.

This diagram allows decision makers to understand:

• The variables that are impacted by making an investment decision

• How the different variables are connected to each other

• The direction of the impact, reinforcing (+) or balancing (-)

In a reinforcing loop, change in one direction results in more change in the same direction. In a balancing loop, change in one direction is met with change in the opposite direction. In the above example for instance, increased wind energy production results in reduced unit price which results in more sales. This is a reinforcing loop since all the changes influence more change in the same direction, perpetuating the change. In the other loop in the diagram, operating costs reduce the positive result of sales, but increased sales (from the previous loop) result in higher economic value of the investment, therefore reducing operating costs. The “pluses” and “minuses” do not denote “good” or “bad” impacts, rather it denotes whether the change has a reinforcing (+) influence or a balancing (-) influence.

What this diagram shows is that an initial investment is a cost, however, that investment can affect the pricing mechanisms of a product or service, which can influence sales numbers, which can impact operating costs, which can influence the economic value of the initial investment. To stop at the cost variable of an investment and evaluate it solely as a cost disregards the potential impact on other business factors that might increase the economic value of the investment or the company’s prospects as a whole.

To carry this analysis further, once the variables are identified in the causal loop diagram, business leaders can collect the data needed to quantify the impact of the those variables on the business as a whole. If generating more wind energy generates more sales opportunities and leads to a reduction in the unit price, which encourages more sales, it is the compound effect of these changing variables that indicate whether the investment is a worthwhile use of resources.

Traditional Analytical Tools Don’t Give the Full Picture

Using return on investment (ROI) is a common metric to try to quantify the performance of an investment. However, ROI uses static figures, i.e. the status quo business environment, in the calculation and may be missing some components that signal whether an investment is value-creating over the longer term. The difference with using causal loops is that this tool inherently incorporates the understanding that both the business and the external business environment are complex systems that can be influenced by changes in any part of those systems. Because the market parameters do not necessarily stay constant with the introduction of the sustainability investment, the change in these parameters should also be considered in the equation. Causal loops help to identify these interdependencies and in what way variables in the system are affected, creating a richer picture of the impact of investment decisions.

Evaluating ESG Investments

Through ESG modeling, first through a soft approach by identifying causal loops, and then by quantifying the impact of the variables identified, businesses can better assess whether the sustainability actions they are taking now can result in 1) better revenue-generating opportunities, 2) reduced volatility in operations due to better ESG-preparedness, 3) a more resilient business in the long term.

While overhauling an entire business model to be aligned with an orderly transition may be too big of an undertaking at one point in time, taking incremental steps to get there may be the better course of action. By combining a comprehensive ESG strategy with clear objectives and targets, prioritizing the most material ESG topics first, and then creating qualitative ESG models through causal loops and quantitative analysis, a company can make more informed decisions around the viability and value generation from their sustainable investment decisions. RiskSphere’s expertise can guide business leaders in identifying these causal loops and help them determine the ESG strategy and investments that make the most sense for their business model.