External risk evaluation needs better tools and transparency

external evaluation tools transparency
Image by Andrey Popov | Bigstockphoto

Companies need to evaluate and monitor many external factors all the time. They need this data to make decisions and evaluate possible changes in the current business and its environment. Some information is based on internal discussions or ad hoc consultant reports, and some information is from publicly available metrics, reports and indexes. But ad hoc reports are not enough for many purposes, and they also have transparency issues.

Credit ratings, stock market indexes, real estate bubble indexes, ESG (Environmental, Social, and Governance) reports, political freedom indexes, stock analyst reports, consultant reports to evaluate different markets and suppliers and many other reports basically serve the same purpose: how to better understand countries, businesses, and external factors to make better business decisions. However, there are huge differences in the degree of transparency among different reports and indexes, especially in terms of how systematically they are updated and how they track trends.

On the other hand, the fact that they are public metrics, indexes and intelligence also means that it’s more difficult for management to simply ignore or discount them in their decision-making processes. If metrics and intelligence are publicly available, the company can’t claim afterward they didn’t know something.

Credit ratings, ESG and geopolitical data are good examples of how different sources and models to get information can give very different outcomes.

External metrics produce different outcomes

Credit ratings are well respected and quite transparent tools to evaluate the risk of lending money to a country, business or individual. No professional lender can ignore them; no one can say they didn’t know a credit rating before making a lending decision. The ratings also help define each loan’s risk and interest rate. There are, of course, many things that could be improved, e.g. having more up-to-date data and how different loans can be bundled to manage risks. But credit ratings are commonly accepted ‘currency’ for the lending market.

ESG has become an important metric for many companies and investors, but ESG reports and metrics have many issues. Especially problematic is that ESG has many qualitative components that lead different ESG reports to produce very different results. This also creates opportunities for greenwashing; you just need to find or buy a report that supports your decisions.

Geopolitical data. Here, the situation is even worse than with ESG reports. In the last year following the Russian invasion of Ukraine and resulting sanctions, many companies realized they hadn’t evaluated geopolitical risks properly. There is a lot of data and evidence that companies had a lot of information on risks with Russian businesses, but it was often ignored.

This illustrates a fundamental difference from credit ratings: many companies and executives claimed they couldn’t have known it was a risk to buy oil and gas from Russia, or to set up operations in Russia. But many of these companies also likely did internal evaluations and bought expensive consulting reports about Russian risks – and as long as those reports remain confidential, it is impossible for us to know how well management was informed about the risks, and whether they just decided to ignore them.

Open decision making

There are many areas to evaluate in any business, and of course there are many more information sources, indexes and reports out there. But the examples above illustrate the point – some information sources and ratings are more transparent than others, and some give a much clearer basis for decision-making, while others can be misused or hidden. This is a very important aspect of risk management, corporate governance and accountability.

Obviously, no company wants to open all its decision-making processes to the public and reveal all the information they have. It is normal for any company to try to get more and better information than its competitors. Executives and management teams also have their own considerations, and some businesses want or need to take more risk than others.

But at the same time, it is of value to all parties to have enough respected and sovereign information sources. We can easily understand that the lending market would be very complicated and riskier if there were no credit ratings. This is especially true when we start talking about financial inclusion for emerging markets and unbanked people – you need a credit rating system of some kind before you can develop lending and finance services that will work for such markets.

Especially for listed companies, it is very important for the shareholders to have unchallenged information and data that has been used in the decision-making process. Or, if the management wants to challenge this type of information, they must clearly communicate why. Now, it is just too easy to select a consultant or ESG report that is suitable for them, or choose geopolitical facts that support their decisions.

ESG and geopolitics need better metrics and tools

It has been suggested in many places that ESG must be updated or even split into several metrics. At the same time geopolitical metrics such as political risks, dependencies on certain countries and governments, human rights and freedoms also need their own sovereign reports and indexes. That information is now too fragmented, with too many individual data points and dependences not being evaluated properly.

The current state of the world – the rising tension between China and the USA (with many countries caught in the middle), local wars and conflicts and disruptions in global supply chains – make it mandatory to understand these risks better.

There is a lot of data and information available in the world nowadays, and businesses must use it. But it requires proper tools and metrics to be able to systematically use data in decision-making. And it is not enough to take a snapshot – it is also fundamental to use data sources that give up-to-date information that can be tracked and followed systematically.

This will not only help companies to make better decisions but also give much more visibility of the decisions to all stakeholders, and hold the decision-makers accountable.

1 Comment

  1. By now, most multinational corporations and large financial services companies have not only appointed Chief Risk Officers (CROs) but have also made steps towards implementing an enterprise risk management capability. It’s not sufficient to rely on heads of functions to make risk assessments centred on their own stove pipes; take, for example, supply chains where ideally there needs to be a cross-functional perspective, incorporating at a minimum perspectives from Procurement, Strategy, Operations/Logistics and so on. Who is going to draw together a wide range of actual/potential issues if not the CRO, as well as to assisting/ensuring its progression through to suitable mitigation?

    But what of the large, predominantly national companies who face much the same needs: have they also committed to actioning a tangible risk management approach? In my experience, not to a sufficient extent. It can certainly be an uphill task to persuade a senior exec that there’s yet something else to be concerned about, let alone to ‘take on board’, even more so if the responsibility for the issue largely falls outside his stove-pipe.

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