- In recent weeks, management teams have had to regroup to respond to the most severe public health and economic situation many of them have ever faced.
- Immediate consequences aside, this pandemic calls into question how companies prepare for black swan risks, which are harder to predict, measure, and prioritize.
- In addition to ensuring they can buoy themselves in the near term and upskill leadership teams on rapidly evolving epidemiological matters, senior management must weigh the needs of a variety of stakeholders in their response plans and effectively execute enterprise risk management amid the crisis.
- Furthermore, we'll monitor how the economic recovery takes shape in coming months, to understand how ESG and sustainability initiatives and attempts at fostering an effective, unified culture are influenced by the events stemming from this pandemic.
The strategic threat posed by the spread of infectious diseases is by no means a new risk, but the COVID-19 pandemic has made this risk a reality. It has already illustrated how one microscopic virus can rapidly spread around the world and bring the global economy to a grinding halt, leaving significant and lasting disruption in its wake. While the pandemic has displayed the immediate and striking social consequences to business and society alike, as described in the accompanying commentary, "The ESG Lens On COVID-19, Part 1," published April 20, 2020, this catastrophe also may give us some insight as to how the companies S&P Global evaluates prepare for disruption amid a rapidly evolving risk landscape. Indeed, disruption rarely occurs in isolation. Today, companies around the world are confronting this unprecedented health threat, while reeling from the dual shock posed by the breakdown in OPEC negotiations and accompanying collapse in global oil prices, along with the looming systemic threats posed by climate change. The growing complexity posed by these emerging and intersecting risks and megatrends are conspiring in ways that require deftness, adaptability, and resilience for entities to remain relevant, both now and for the long run.
Of course, there is no prescribed response to this pandemic, and appropriate steps for recovery will vary sharply by industry. But, for many sectors, this current economic shutdown, which some medical experts believe could persist until a vaccine is ready, is the gravest disruption in recent memory. Even for companies that survive the tempest, it's likely to irreversibly alter the way they conduct business and ultimately, their long-term strategy and sustainability.
Our ESG Evaluation considers near-term environmental, social, and governance risks. However, it also considers Preparedness--that is, the extent to which a company's readiness to contend with emerging and strategic risks and opportunities permits it to be sustainable over a longer period. When assessing an entity's preparedness under our ESG Evaluation Analytical Approach, we typically meet with members of the senior management team and the board. This meeting ideally gives us insight into a company's strategy and the way it seeks to position itself over the long term. However, it also informs our assessment of management's disruption readiness. Indeed, companies that fare best under our preparedness framework are typically distinguished by their ability to foresee, plan, and adapt to risks better than others. In this report, we frame our views on the current pandemic through the lens of our preparedness framework, and outline how we anticipate companies may respond and adapt to this once-in-a-generation phenomenon.
Awareness: Knowing The Unknowns
In our ESG Evaluation Analytical Approach, the first component of understanding preparedness is gauging the entity's ability to become aware of risks and opportunities. This is the most influential of the preparedness indicators in our scoring because, in our view, strong awareness--characterized by a deep fluency in the nature and dynamics of material risks and opportunities--is a fundamental prerequisite to agile and effective response plans. The novel coronavirus, specifically, has emerged only in the past few months. But the concept of a sweeping pandemic causing devastatingly large numbers of infections and upending global macroeconomic conditions isn't a new one. In fact, the World Economic Forum has listed pandemics as one of the top global risks since it first published the Global Risks Report in 2006. However, as recently as 2015, in part because of recent experiences with SARS and the H1N1 influenza, the forum elevated pandemics to the second most substantial societal threat. In truth, certain companies we've spoken with, specifically those in the leisure, retail, and airline industries, have identified and discussed major, global public health catastrophes as disruptive risks, in part because the impact is more direct and immediate for them. Going forward though, as the ripple effects and indirect financial consequences are felt throughout the economy, we expect more companies will become increasingly conversant on epidemiological matters and the systemic nature of public health issues, leveraging the expertise of scientists and the medical community to educate their boards and executives. However, awareness amid a emergencies like this can also be enhanced by engagement with employees on the ground and other relevant stakeholders. Those companies with stronger levels of preparedness are those that solicit unique perspectives from stakeholders to ascertain the business implications of this pandemic, along with other risks that are linked or may lie on the horizon.
Given the sharp erosion in shareholder value since the beginning of the pandemic, we expect it will prompt board intervention, and, under our analytical approach, the board's expertise and effectiveness is critical, especially in a situation in which short- and long-term goals may conflict. Given the acute focus these companies have also been showing on understanding climate change and its repercussions, the tie between this growing risk and attendant public health risks is also likely to be drawn out. There is some evidence that rising global temperatures will begin unlocking long dormant viruses as permafrost melts. In our view, companies with strong awareness recognize that the risk landscape is dynamic and evolving, with board members and executives alike beginning to demonstrate a deep understanding and fluency, not only in discussing the COVID-19 pandemic and the disruption it has wrought, but also the broader market context and the ways in which multiple risks are intertwined, yet are also distinct. For example, we would expect boards to explain how the dual shock of the COVID pandemic and the breakdown of OPEC negotiations and the accompanying oil price collapse is influencing their long-term strategy. Our assessment incorporates how boards and management teams monitor the signals indicating the direction of change and understand the implications of each risk and their influence on an entity's long-term strategy.
But it also gives rise to another question: How do we measure this risk?
Assessment: Exploring The Known Unknowns
Under our preparedness framework, we next consider assessment--that is, how companies explore, measure, and prioritize risk and opportunity. How does a company incorporate the risk of black swan events? How can a company adequately prioritize the response to events where the likelihoods and time horizons are seemingly remote, but the magnitudes are uncertain and difficult to measure, but are perhaps existential? When we consider more measurable disruptors like climate risk, or the risk of changing consumer preferences and technological advancement, management teams are generally able to articulate and justify the assumptions that inform their materiality, sensitivity, or scenario analyses. However with black swan events like this, there are fewer resources for these types of assessment exercises. Even now, publicly available estimates on metrics like infection rates, mortality rates, unemployment rates, and GDP contraction vary wildly and change regularly, in part due to the lack of a comparable historical precedent and the rapidly evolving situation. Indeed, disruptive risks like this pandemic carry with them considerable uncertainty as to how they'll ultimately unfold. In our view, entities that are able to assess risks in the face of uncertainty through more advanced, realistic and considered assessment exercises, like scenario analysis (see the "What is Scenario Analysis?" section below), enable more flexibility in their strategic thinking, which translates into more adaptive and resilient responses. This is because they're able to uncover and explore potential vulnerabilities under different scenarios and prepare adequately for surprises.
Unfortunately, some of the adverse consequences of this pandemic are likely inevitable at this point. But beyond measuring the financial risk stemming from the pandemic, this should also frame a discussion on how companies weigh a panoply of outlying, low-probability, high-impact risks against more conventional, better understood, more measurable risks. It's also essential that companies, and their boards in particular, keep themselves sufficiently informed and up-to-date about the risks they're facing to ensure they can deliver an informed and commensurate response to external stakeholders. Are these black swan, non-linear events not being prioritized because they are indeed lower risks, or because we just don't understand them as well, yet? Given the enormity of this disruption, we expect companies to begin prioritizing scenario planning for "unknown unknowns," though the form this takes is still very uncertain.
What is Scenario Analysis?
Scenario Analysis is a tool commonly used for strategic planning to enhance an entity's flexibility and resiliency for a range of future states. Scenario analysis involves constructing a set of equally plausible yet hypothetical possible future outcomes, describing the key factors that will drive the development pathway, and exploring how an entity's organizational capabilities may need to evolve under these circumstances. They aren't forecasts, predictions, or sensitivity analyses. Effectively, each scenario describes a potential future state and conveys a plausible narrative describing what could occur and how and why it could happen. Companies should use multiple scenarios to explore different risk outcomes and pathways. Scenario analysis helps entities explore uncertainty by identifying alternatives that could influence the business-as-usual assumptions and examining the resilience of their business models under these constructs.
Action Plans: Rapidly Responding
We also consider action planning; that is, how capable companies are in establishing and monitoring risk tolerance thresholds, developing responses, and executing contingencies when risks reach an intolerable level. When emerging risks like the coronavirus pandemic quickly translate into strategic threats, entities with strong preparedness respond confidently and with clarity and precision. In an early review of companies we evaluate, we've found that changing supply chain partners in response to uncertainty on recovery timing is a major decision point. However, even the responses are themselves subject to thresholds. Many companies throughout the world have implemented unprecedented work-from-home provisions to avoid the risk of community spread; but, as more data become available, we expect companies will weigh this risk against the costs associated with having employees working remotely (or in some cases, not working at all) for an indefinite period. In addition to this, we expect that companies, especially ones with a global presence, are going to have to consider how rapidly they should retool their supply chains.
The current medical situation in the U.S. also bear out this supply chain risk. Health care providers, despite the best intentions, are facing shortages of COVID-19 tests and personal protective equipment that render them less able to respond to the situation at hand. It may never be possible to be fully prepared for crises of such magnitude; however, effective governance and enterprise risk management dictates that well-defined processes are set up ahead of time for the board and management to use in crisis times, to allay concerns that short term-ism may predominate decision-making in such emergencies.
But we also consider accountability. It's important for us to understand whether there is clarity of ownership in the response to a major crisis, and that roles are well articulated throughout the organization. While there isn't yet any well-understood best practice, we note that some organizations we've engaged with have task forces and working groups consisting of senior management, security experts, and outside medical professionals that are responsible for making recommendations as to how to modify business practices. It's still too early to gauge the efficacy of this approach, but we'll continue to monitor who bears ultimate responsibility for the successful implementation of these strategies. That said, the fluidity and agility with which companies respond to this pandemic provides us with insight into their enterprise risk and crisis management systems, and, in turn, will influence our views on how effectively they'll be able to execute on strategic plans and pivot if and when conditions deem it necessary in the future.
Culture: Disruption Endured
While a company's purpose, vision, mission, and values underpin its long-term strategy, its culture guides how it will embed, implement and reinforce them. Inevitably, an event as catastrophic and disruptive as this pandemic is going to upend society, and can irreversibly change a company's culture. For example, since the early days of the crisis, large companies have been attempting to halt the spread of the virus by encouraging or demanding employees work remotely. To be sure, this is a sensible adaptation to an unforeseen development. But the longer the pandemic persists, the more a change like this can become transformative as new behaviors between and among employees and stakeholders take root. In turn, it may be harder for management teams to fashion an effective, unified, and sustainable culture, and could be more challenging to align incentives with desired behaviors. Additionally, while the sharp economic downturn stemming from the pandemic has had immediate financial consequences, the nature of recovery will also influence the compact between employees and employers. A company that suffers significant revenue contraction in the first part of 2020 but which expects a pronounced recovery in the latter part of the year and into 2021, may find itself in the position of laying off or furloughing large numbers of employees, only to need to rehire them when normal business resumes. As we continue to assess corporate culture and how it links to an entity's strategic goals and enables longer-term sustainability, we'll determine whether this unprecedented and temporary uptick in unemployment could undermine these efforts. We'll also monitor how companies are examining and reflecting on changing employee dynamics under these unprecedented circumstances and re-emphasizing and potentially re-orienting the desired set of behaviors that characterize the entities culture amid changing circumstances.
Additionally, we'll closely monitor if companies realign their priorities in the wake of the pandemic and whether they change the messaging with internal and external stakeholders with respect to ESG initiatives. We think this is critical. As the business environment has shifted in the past decade to compel companies to appeal to a broader array of stakeholders, they have given their ESG-related goals and targets priority. We believe companies will now likely have to signal how they'll balance nearer-term concerns regarding economic viability with longer-term aspirations to be more sustainable.
Decision Making: Leadership During Disruption
And finally, we consider decision-making. While executive decision-making is always important in our assessment, it bears heightened relevance in periods of distress. This is especially true in a situation like this, which is without historical precedent, and is evolving very rapidly. The ability to demonstrate leadership under tremendous pressure and make decisions quickly, and then potentially pivot away from them as new information comes in, all within relatively short timeframes, counterintuitively may be critical to survival in the coming months. Our analysis importantly considers how effectively and efficiently leaders decide on a course of action and execute their plans as the situation evolves. We also consider whether the company's structure enables rapid decision-making: That is, is the senior management team empowered by the board to act decisively? How good are the communication channels between the board and management? As the crisis continues to unfold over the next weeks and months, it will also be imperative for us to understand how companies reallocate capital commitments to confront new challenges.
But in a unprecedented disruption like this, the selection of partnering organizations is also of critical importance. Dealing with a highly infectious global pandemic is new terrain for just about every management team and chances are that few have the in-house competency to fully understand the magnitude of the disruption and the potential implications for their business. Working with non-governmental organizations (NGOs) and government agencies may also be new, but these could become potentially worthwhile collaborations for companies that hadn't foreseen the risk of a pandemic. Nevertheless, we note that in times of uncertainty such as this, government policy can also create bottlenecks. Indeed, in the early days of this crisis and since then, through quick decisions, some utility companies have been able to burnish their reputations by extending more lenient payment terms to customers or industrial firms that are repurposing equipment to produce supplies necessary for defeating the virus. Other companies may take reputational hits for their inadvertent roles in spreading the virus.
Preparing For A Paradigm Shift
So, as we discuss this paradigm shift in response to COVID-19 with management teams and their respective boards, we'll seek to understand their next steps, and how they'll contend with a business environment and policy landscape that will be dramatically altered for the foreseeable future. We believe the manner in which companies interact with their stakeholders will be irreversibly transformed, in part, because the pandemic is exposing companies to stakeholders whose influence they may not have fully appreciated until now. But our preparedness assessment is inherently a long-term one, and we'll also seek to gain insight into the lessons learned during the ordeal and how they'll contribute to readiness for the next major disruption, as well as how the challenges faced today will support more sustainable business long in to the future.
- The ESG Lens On COVID-19, Part 1, April 20, 2020
- ESG Evaluations Remain Unchanged For Now In Light Of COVID-19, April 8, 2020
- Environmental, Social, And Governance Evaluation Analytical Approach, April 12, 2019
- How To Navigate The ESG Risk Atlas, April 11, 2019
- How We Apply Our ESG Evaluation Analytical Approach, April 10, 2019
- The ESG Advantage: Exploring Links To Corporate Financial Performance, April 8, 2019
This report does not constitute a rating action.
|Primary Credit Analysts:||Michael T Ferguson, CFA, CPA, New York (1) 212-438-7670;|
|Corinne B Bendersky, London + 44 20 7176 0216;|
|Caitlin Harris, San Francisco;|
|Secondary Contacts:||Bruno Bastit, New York;|
|Noemie De La Gorce, London + 44 20 7176 9836;|
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