To motivate the intuition on ESG risk management, I'm going to begin with the work of recently deceased Harvard professor John Ruggie, who worked for United Nations Secretary-General Ban Ki-moon as a Special Representative for Business and Human Rights. Ruggie worked to establish a precedent in International Law and United Nations policy to guide businesses and the management of their human rights challenges that ultimately became known as the UN Guiding Principles on Business and Human Rights. Early in this journey, he faced pushback from business leaders who felt adopting a standard to govern business relations with external stakeholders that would protect human rights would be costly, particularly for firms competing with firms from countries that might not enforce compliance with the UN principles. John challenged a group of companies responsible for 25 allegations of human rights violations to let him and his research team explore the actual financial implications of a human rights violation for their bottom line. After some back and forth the executives agreed and a team of researchers explored the profits and loss statements, the business forecasts, the financial information from these companies both before and after the allegation of corporate wrongdoing or negligence. They identified dozens of instances of cost variances across a wide range of revenue, cost, and productivity items. The 25 projects exceeded their expected costs on security guards, on the time and costs of redesign, on legal and insurance services, on the replacement of damaged parts and machinery, on media buys to address accusations and repair their reputation, on managing regulatory inquiries, lawyers managing lawsuits, paying damages, and more. The most frequently incurred cost was the delay or suspension of operation. The most surprising or unexpected to the executives was the amount of additional payroll spent on or dedicated to crisis management, including in many cases weeks of the CEOs time and his or her support staff. The most costly but often hardest to estimate impact was on precluded growth, permits were denied, plans were abandoned, and projects cut short of long-term plans. Every company possesses this data. Where have ESG issues and stakeholder reactions impacted your projects, your product launches, your sales, your costs? Do the analysis just as John Ruggie's team did and connect the dots. The data is already available in your organization, particularly where you can trace the projects from inception and business development through the various decision gates to implementation and operations. One example comes from a Goldman Sachs study, which looks at the largest oil and gas projects in the world. Cost escalation due to above-ground risk was estimated at 40-60 percent of the total cost of these projects. Examining a broader set of industries, the Washington DC based consultancy, the Independent Project Association ranks projects in this figure on what they call front end loading. Front end loading means looking ahead to the stakeholder conflicts that can be forecast over the life of a project and addressing them now at the front end rather than kicking the can down the road. The difference between a project with good front end loading and one that delays the reckoning is a 50 percent delay and a 50 percent cost overrun. Your project is 50 percent over budget and your revenue comes in 50 percent later than you forecast, here about two years. That means every dollar of revenue is discounted by that additional delay. In my own research on gold mining companies, we arrived at a similar estimate. We examined how the stock market valued gold mines were owned and developed or operated by single-purpose entities traded on the Toronto Stock Exchange. By studying these firms, we can really isolate the benefits of stakeholder engagement because after some accounting scandals relating to misstating gold-mining reserves, the Toronto Stock Exchange improved really strong disclosure standards for listing. Companies in the gold mining sector who want to list on the TSX have to reveal their expected costs, both fixed and marginal for the mine over its life as well as projections of its revenue. We can thus back out from the publicly audited financials, the expected value of the mine. According to financial theory, that should equal the market capitalization of the mine. However, we found that many of these stocks traded at massive discounts to that audited and appropriately discounted resource value. Essentially, the company was going to the market with publicly audited financials saying we're worth a billion dollars and the market would value them at a 100 million. What was going on? We surmise that the difference between these figures was related to whether investors, analysts, and others actually expected the gold to ever reach the market, which in turn was a function not of the engineering, not the financial plan, but the political, and social relationships with stakeholders that were in the financial statements. We hired dozens of research assistants to read and code 50,000 new stories covering the life of these mines. We recorded every instance in which the media reported that a stakeholder spoke about or acted on a mine in a way that connoted conflict or cooperation. We then scored the company's relational capital with its stakeholders. What we find and what you see here was striking. You could explain the variation between market capitalization and resource value by looking at this measure of relational capital. Where relational capital was high or where stakeholders were cooperative with the mine, the discount between resource value and market valuation was near-zero. As stakeholders conflict with the mine increased so did the discount. In some cases until it approached 100 percent. What was the relative importance of stakeholder relational capital to the reserve value of the gold at the cost structure to extractor? We could explain only 22 percent of the variation of the market capitalization these firms with reference to the information in their publicly audited financials. By contrast, we could explain 40-60 percent using our measure of stakeholder relational capital. Stakeholder relational capital was 2-3 times as important as gold. If you were buying the stock of these mining companies, you weren't really buying a mining company at all, rather you were buying a company whose value hinged on whether it's stakeholder relations were strong enough to ever allow it to mine.
