The ESG Stress Test

Joanna Turner - Partner, Clara Bonnor - Consultant

The Development Finance Institution (DFI) community has a critical role in supporting the rehabilitation of the private sector in Africa in the wake of the COVID-19 pandemic, and promoting positive environmental, social and governance (ESG) practices that will result in more resilient and sustainable businesses.

Control Risks has been working with DFIs for decades, providing intelligence, risk-planning and incident response services to our clients globally, including in some of the world’s most fragile and complex markets.

In this article, we look at how ESG issues have become more pressing in Africa as a result of COVID-19, and the role that DFIs play in supporting companies to prioritise these challenges. We then provide recommendations on effective ways for DFIs to support their investees through this challenge to ensure a lasting impact.

Commitment to ESG will be even more important post-COVID-19

The COVID-19 pandemic has driven major disruption to the global economy, business operations, supply chains and workforces. Vulnerabilities in company operations have been exposed, particularly around the resilience of ESG mandates and working conditions. Nowhere are these vulnerabilities more prominent than in Africa, where historically ESG considerations have taken a back seat to more pressing concerns, such as the swift deployment of capital. Even aggressive private investors have termed the pandemic a long-awaited ESG “stress test”.

The ways that companies have responded to the range of challenges presented by COVID-19 will have lasting repercussions for both their short-term balance sheets and long-term recoveries. Companies that take proactive steps to address the risks related to the COVID-19 crisis in a way that mitigates adverse impacts on workers, human rights, supply chains and ESG management are likely to build more long-term value and resilience, while improving their viability in the short term. This will make them a much more attractive option for future private investment, in particular for DFIs looking for both growth and a broader development impact.

<>Maintaining and prioritising high ESG standards and commitments to the UN Sustainable Development Goals have always formed a key part of the investment strategy of DFIs, especially in African emerging markets. This commitment will be more important than ever in a post-COVID-19 world, where considerations of labour welfare, social impact and preparedness will need to be built into African businesses. 

The ESG impacts of COVID-19 

Pressures on vulnerable labour forces
The impact of COVID-19 on the global workforce has been significant. Incomes and livelihoods have been directly affected, with the International Labour Organization (ILO) estimating that global unemployment could rise by between 5.3m in its best-case scenario and 24.7m in its worst case-scenario. For companies that have continued to operate, ensuring the health and safety of their workers has been a key concern as protection of the “S” rights integral to ESG has moved to the fore. 

More than ever before, industry experts have cited labour welfare as a key consideration for long-term recovery during this crisis. In the Western world, concerns over labour welfare have included acknowledgement of the mental health challenges faced by workers, the need for increased flexibility in working conditions, and improved access to healthcare. In Africa, labour welfare concerns also include fears that employers might take advantage of distracted governments and regulators to take health and safety shortcuts. 

Hidden human rights issues
Businesses have also faced significant disruption to their supply chains. Many suppliers are no longer able to honour their contracts. In the garment and minerals sector, this has a direct, adverse impact on labour and human rights issues. For example, in Congo (DRC) metals supply chains are facing both demand and supply shocks linked to COVID-19. This has had a direct impact on both the formal and informal mining activities on which many local communities depend. Although due diligence programmes have helped to expose and reduce some of the links between conflict and mining, the pandemic has disrupted funding and resulted in a decreased ability to track these issues on the ground, meaning mining communities may be exposed to even greater adverse impacts. The need to rapidly restructure supply chains within short timeframes has sometimes led to rushed and often remotely conducted ESG due diligence, increasing the risk that suppliers do not meet or observe ESG requirements.  

New incidents of fraud and misconduct
Beyond “social” impacts on the workforce, COVID-19 is also presenting a range of new ESG concerns. Risks related to fraud and financial misconduct have become more acute. These have manifested in several ways, including a rise in counterfeiting, procurement fraud and anti-competitive practices. The European Anti-Fraud Office has launched investigations into imports of fake health and hygiene products, such as masks, testing kits and disinfectant. In April, Cameroonian authorities seized a large shipment of fake coronavirus medication from would-be scammers. 

The crisis has also significantly affected levels of disclosure. Travel restrictions and a focus on crisis management can delay or reduce the quality of available data. Meanwhile, although collaboration between competing companies has been cited as a way to respond to the urgent needs of this crisis, there have also – conversely – been reports of anti-competitive practices, including agreements between firms to inflate prices of essential goods such as protective products, or to lower wages in certain sectors.

How critical are DFIs to the ESG agenda?

The DFI community has long been an advocate and implementer of strong ESG standards. With patient capital and development impact mandates, DFIs ensure strict adherence to international standards such as the IFC Performance Standards, the Equator Principles and the OECD Guidelines for Multinational Enterprises. DFIs also aim to fulfil targets set out in the UN’s Sustainable Development Goals and the UN Global Compact. 

With this experience, DFIs have a significant role to play not only in helping their portfolio companies to address the ESG issues posed by the crisis, but also in ensuring that their responses do not create further risks to people or the environment. Although other private sector investors may deprioritise these commitments as they streamline “core” business workstreams, it is imperative that DFIs continue to ensure these activities remain a priority. By supporting the private sector to respond to COVID-19 in a way that mitigates adverse effects on workers and supply chains, DFIs are helping to build more resilient businesses with longer-term value.  

How are DFIs adapting?

Since the onset of the COVID-19 crisis, Control Risks has been supporting and standing alongside our DFI clients to better understand how they are addressing ESG challenges. 

It has become clear that approaches to the management of ESG issues need to be reshaped. In recent years, the priority given to environmental concerns has sometimes allowed the social and governance issues present in African markets – such as labour welfare and endemic corruption – to take a back seat. DFIs recognise that a shift in approach and skill set is required when doing ESG due diligence, to give equal weight not just to issues of pollution and deforestation, but to crisis management and labour welfare. 

We recommend the following approaches to manage these issues:

• Design and implement risk diagnostic tools: DFIs are showing broad support for the design and implementation of risk diagnostic tools that allow their portfolio companies to identify the risks COVID-19 presents and assign appropriate mitigation measures. Such tools highlight ESG risks such as supply chain disruption and labour welfare that more traditional ESG assessments may not include. Control Risks has worked with a number of clients to help them to develop risk screening tools that allow them to identify potential risks that may affect their operations or supply chains. Many of these have been modified or applied directly to the new COVID-19 environment.
• Rebalance stakeholder engagement to emphasise workforce: The principles of ESG centre on engaging all stakeholders, rather than only shareholders. Although DFIs normally take a robust approach to stakeholder engagement, they have shifted their approach to focus specifically on identifying workable short- and long-term solutions that prioritise worker welfare and minimise social impacts. Supporting labour welfare and building robust on-the-ground industrial relations teams can allow DFIs to manage their workforces and strengthen their capabilities to manage ESG risks on the ground remotely, ensuring portfolio companies can remain operative and risk-resilient. 
• Offer surge technical support: DFIs usually offer value-add support for their portfolio companies through advisory services or direct technical support. Certain areas can be more niche and require specific technical support. These include crisis management planning, review and walk throughs, human rights assessments that focus on changing dynamics in the post-COVID-19 supply chain, and labour assessments and compliance. We have seen a significant uptick in demand for support in these three areas and have been deploying our expertise to advise clients at both a regional and global level.
• Adjust supply chain due diligence: Now more than ever, transparency is needed around supply chain inputs to identify any weak ESG practices that may affect the performance of the portfolio company overall. Questions should be focused on labour welfare, labour practices and labour management systems, with a particular focus on any child labour or human rights issues that may arise.
• Test business continuity and crisis management plans: Crisis management planning can be a neglected part of ESG reviews. These plans have now been put to the test, and gaps and weaknesses can be much more easily identified post COVID-19. Walk throughs or live exercises, all of which can be conducted remotely, are the best way to stress test such plans. Given the potential for a “second wave” of COVID-19 in some countries it will be important to feed the lessons learnt from this response into ongoing action plans.

Future-proofing risk planning promotes long-term sustainable growth

Despite the widely accepted principle that sustainable companies perform better and generate more resilient long-term returns, ESG prioritisation in emerging markets is likely to be overshadowed by other pressing challenges – such as an anticipated liquidity crisis in Africa – out of fear that engaging with these issues will hold up urgently needed financial relief. In addition, there is the risk that the pandemic might be cyclical, with peaks returning as just as restrictions are eased. 

DFIs therefore need to “future proof” their approach to ESG management. This can be done in three ways: 1) monitoring and tracking trends and assessing levels of preparedness; 2) revisiting investees’ ESG practices and approaches, focusing specifically on labour relations and crisis preparedness; 3) deep stakeholder engagement, particularly around worker/management relationships.

The COVID-19 pandemic has served as a wake-up call for companies that have not been prioritising ESG principles and as encouragement for those that have. In vulnerable markets such as those in Africa, the protection of workers cannot be neglected for the sake of ensuring a fragile recovery. DFIs know that to best fulfil their mandates and take huge steps towards achieving the SDGs and Global Compact, all ESG principles need to be prioritised equally, even when faced with such a crisis.