Compare and Contrast Costing Systems

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Examining A New Paradigm of Enterprise

Sustainability Risk Management

Mustajab Ahmed Soomro*

Management and Humanities Department, Universiti Teknologi PETRONAS, Malaysia

Fong-Woon Lai

Management and Humanities Department, Universiti Teknologi PETRONAS, Malaysia

*Corresponding author

Abstract

Purpose – The purpose of this paper is to conceptualize a framework, created to embed

sustainability management and enterprise risk management (ERM). The framework will

highlight the relevant theoretical underpinning to postulate that Enterprise Sustainability Risk

Management (ESRM) will lead to Corporate Sustainability Performance (CSP).

Research Methodology – The conceptual framework espouses the notion to develop the

measurement scales of the constructs and to examine the causal relationship between ESRM

and CSP with reliability analysis, Exploratory Factor Analysis (EFA), Confirmatory Factor

Analysis (CFA) and Structural Equation Modeling (SEM).

Findings – This paper developed a new paradigm of Enterprise Sustainability Risk

Management which is underpinned by two pillars, namely Sustainability Management (SM)

and Enterprise Risk Management (ERM). ERM is supported by four dimensions, i.e. structure,

governance, and process. On the other hand SM is supported by four dimensions, i.e. employee

relations, customer relations, environmental relations, and community relations. It is

hypothesized that the developed ESRM framework will have a positive significant

correlationship with Corporate Sustainability Performance (CSP), which is measured by

financial and non-financial benefits.

Originality/Value – The notion of ESRM is still new especially in Malaysia. It proposes an

execution model by integrating SM and ERM. It provides a value maximization transmission

mechanism supported by a theoretical underpinning which gives a perspective on how an

integrated ESRM framework will lead to enhanced CSP.

Keywords: Corporate Sustainability; Corporate Sustainability Management; Enterprise Risk

Management; Corporate Sustainability Performance; Institutional theory; Agency theory;

Resource dependence theory; Stakeholder theory.

Paper Type: Conceptual Paper

Introduction

Risk is inherent in every business transactions. Historically, risk was managed by transferring

it to a third party by way of engaging in insurance contract. Over time, the concept of managing

risk has revolved around handling financial related risks such as liquidity risk, interest risk,

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foreign exchange fluctuations and credit risk. The risk management approach was then narrow

in nature. It used a silo approach. Nevertheless, corporate risk management had evolved with

more macro and holistic approach to address issues around all aspects in an organization’s

business activity (Lai, 2011).

This change in approach from silo to holistic had compelled corporation to start realizing the

changing sphere of risk game and its multidimensionality. Almost everything in a business

becomes a risk factor that will have a strong, direct, and distant impact on business, where

traditional risk management failed to oversee these new emerging risks. Thus, the demand for

incorporating a dynamic approach in corporate risk management had brought up a new concept

named Enterprise Risk Management (ERM) in 1990 to face the constant and fierce changes in

the business operating environment (Lai, 2011). The vision of ERM is to help the board of

directors and senior management to develop a holistic and top-down view of enterprise-wide

risks. These risks may otherwise hinder the organization to achieve its growth and objectives.

The Global Phenomena of change (rise or decline) in energy prices, diminishing natural

resources, uncontrolled change in climate, growing competition from emerging economics and

trade liberalization, as well as the increasing awareness of consumers and their concern about

the quality of life, health and safety, have a great impact on socio-economic development across

the world. This escalation of consciousness propels the relevant stakeholders i.e. government,

businesses, customers, local communities and alike, to convey the responsibility of promoting

sustainability (Lai et al., 2012).

Sustainability is an emerging discipline. It is grabbing the attention of corporations, research

communities, regulatory bodies and alike. Yet, it still means many things to many people.

However, in the business settings, sustainability means Corporate Sustainability (CS), which

tantamounts to corporate survival. For corporations focusing on sustainability is to ensure that

the enterprise is able to manage the business risk whilst meeting the stakeholder expectations.

The fine corporation citizens which seek to carry out their businesses in socially responsible

and holistic manner should endeavor to put in place a Corporate Sustainability Framework

within their management structure, with the vision that continuous growth and success is for

the benefit of both the current and future generations (Lai et al., 2012). Hence, sustainability

management (SM) focuses on embracing the opportunities and managing risks, while

considering the limited availability of resources.

Since the past two decades, many business paradigms have evolved; but two paradigms – SM

and ERM – have helped organizations to oversee risks relating to their strategic focus. The

ultimate objective of both paradigms is to help increase an organization’s long-term viability

by identifying and managing key risks to the business. The SM and ERM implementations,

however, more often than not have been apparently disparate initiatives in many organizations

(Beasley and Showalter, 2015).

Literature shows that many organizations adopt either ERM or SM paradigm, but it has rarely

been observed that they have integrated their sustainability and ERM processes together. This

has created boundaries for organizations to realize their potential synergies. As such, a notion

that espouses an integration of SM and ERM processes will be strategic (Beasley and

Showalter, 2015; Yilmaz and Flouris, 2010).

Thus, this paper aims to discuss the theoretical argument towards integration SM and ERM.

Based on the discussion, this paper proposes an implementation framework for Enterprise

Sustainability Risk Management (ESRM) which integrates SM and ERM. ERM framework in

most organizations considers the shareholders’ interest as their core focus. The ESRM

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framework proposed by this paper however, whilst retaining the essence of the primary ERM

objectives, extends to embrace the rising concern of sustainability issues relating to the

environment and society with the goal to achieve a balance corporate performance in terms of

wealth creation for the shareholders as well as environmental protection and societal well being

for the ineterest of other stakeholders.

Sustainability Defined

Sustainability has been defined in a number of ways. The Brundtland Commission, formerly

known as World Commission on Environmental Development (WCED), in 1987, defined

sustainability as “the development that meets the needs of the present without compromising

the ability of future generations to meet their own needs” (Breitstone et al., 2007; Faris et al.,

2013; Saardchom, 2013). This definition has highlighted two major concepts relating to

sustainability. Firstly, the concept of “Need”, which refers to the need of organization (value

maximizing) and the need of stakeholders (present and future stakeholders). Secondly, the

concept of “Limitations”, which imposed by the state of technology and social organization on

the environments ability to meet the present and future needs.

Enterprise Risk Management Defined

A paradigm shift has changed the view organizations see their risk management approach.

Instead of using silo perspective of risk management, they start looking at the holistic approach

for risk management. This approach is known as Enterprise Risk Management (ERM) (Gordon

et al., 2009; Lai, 2011; Shad and Lai, 2015).

The term Enterprise Risk Management is used interchangeably with Enterprise–Wide Risk

Management (EWRM), Holistic Risk Management (HRM), Corporate Risk Management

(CRM), Business Risk Management (BRM), Integrated Risk Management (IRM), and

Strategic Risk Management (SRM) (Hoyt and Liebenberg, 2011; Kleffner et al., 2003;

Liebenberg, 2003; D’Arcy, 2001). Generally, the terms refer to the same generic concept and

essence of the holistic approach of risk management. Nevertheless, each term may be defined

differently based on its focus and primary concern to the organization (D’Arcy, 2001).

While the concept of ERM is widely cited and accepted today, it still lack of unified definition

and standardized operational framework (Kleffner et al., 2003; Liebenberg, 2003; D’Arcy,

2001). Casualty Actuarial Society (CAS) defines ERM as “The process by which organizations

in all industries assess, control, exploit, finance and monitor risks from all sources for the

purpose of increasing the organization's short and long term value to its stakeholders"

(D’Arcy, 2001). CAS categorizes the types of risk to the organization as hazards, operational,

strategic and financial risk. The Committee of Sponsoring Organizations of the Tradeway

Commission (COSO) in 2003 defined that “Enterprise Risk Management is a process, effected

by an entity’s board of directors, management and other personnel, applied in strategy setting

and across the enterprise, designed to identify potential events that may affect the entity, and

manage risk to be within its risk appetite, to reasonable assurance regarding the achievement

of entity objectives” (Faris et al., 2013). This definition is purposefully broad. It provides

fundamental concept on how companies and other organizations should manage risk and

provides a basis for application across organizations, industries, and sectors.

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Sustainability Risk and Opportunity

Sustainability should be considered as the firm’s strategic management agenda instead of as an

emerging area of risk. Many companies adopt and report sustainability due to the imposition

of legislative requirements. Their main focus of sustainability lies on the economic factor,

which is only one part of the wider philosophy of sustainability. According to Saardchom

(2013), ERM framework fails to consider the social and environmental issues. Consequently,

only sustainability risks that affect the financial liability or reputation to the company are

addressed under the compliance risk management framework. Nevertheless, the impact of

environmental and societal factors can radiate far beyond legal and compliance requirements.

As such, full legal compliance does not necessarily guarantee corporate sustainability.

Many businesses view sustainability as a constraint for business. Nonetheless, if treated

proactively, it can create opportunities for the businesses. Companies that believe sustainability

risks possess in-built opportunities and leverage the talent to capitalize those opportunities

through process improvement and new product development, ultimately, will increase the

stakeholders’ value. Hence, sustainability risk can be turned into a source of competitive

advantage if managed strategically (Saardchom, 2013).

The increasing awareness among the shareholders with regard to the company exposure, scarce

resources, greenhouse gasses, consumption of energy as well as the effects of sustainability

issues on reputation and quality of life, has imposed a huge pressure on senior executives and

the board of directors to consider and invest in sustainability strategy. For example, General

Electric (GE) is committed to energy and environmental friendly technologies. It has decided

to put more focus on and create a new market globally for the products that are environment

friendly. These products will help companies and emerging nations to meet the need for clean

energy. GE has planned to reduce its energy consumption by up to 30% and reduce greenhouse

gas emission by 1%. Another example is PepsiCo where it has committed to achieve its

competitiveness and maintain its production by reducing the use of water by up to 20% across

all manufacturing operations (Saardchom, 2013).

Sustainability Strategy and Enterprise Risk Management

According to Pollard and Stephen (2008), environmental sustainability is inseparable from

business sustainability and risk. Respect for ecosystems (Environment) and people (Social) is

basically the fundamental unchallengeable value set of sustainability. The well-being of both

human and eco-system is treated as the success of sustainability. Hence, an organization should

recognize and respond to environmental, social and economic risks.

The traditional model of ERM tends to focus on internal and controllable risks for compliance

and governance purposes but fails to assess business impact on society (Razali and Tahir,

2011).

Corporate ignorance on sustainability can be very damaging for business which may result in

unexpected financial losses. A case in point of sustainability ignorance can be refered to the

regulatory and public image reaction in the wake of financial crisis in the US in 2008. Several

established reputable financial institutions which had assumed large risk for potential huge

profit had succumbed to the full blown of the crisis which had resulted in the loss of trust from

their customers. The reputation of the entire banking industry, to a large extent, had also been

tarnished (Lam and Quinn, 2014).

Another example is related to Hindustan Coca-Cola Beverages (HCCB), a subsidiary of Coca-

Cola Company. After using more water in its production plants, it has come to realize the

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importance of managing sustainability in its strategy. Similarly, when PepsiCo was trapped

under the excessive use of water in 2004, it started to implement water balance program. The

objective was to reduce wastage of water usage. PepsiCo’s sustainability policy was achieved

through initiatives in agriculture (i.e. partnership with farmers named as “Farmers’ Friend”),

recycling, and recovery (Lam and Quinn, 2014).

The concept of sustainability was highly emphasized in the early 1990 by the United Nations

Conference on Environment and Development (UNCED). Although the early policy statements

for sustainability have addressed environmental stewardship very clearly, they failed to create

targets in terms of numbers and success metrics. Nonethless, they have since been improved

with the focus on quantifiable objectives and target dates for achieveing sustainability by the

nations in the area of health and safety, environment, corporate governance, shareholders

relations, customer satisfaction and community out reach (Lam and Quinn, 2014).

According to Saardchom (2013), the integration of sustainability strategy and ERM improves

the environmental and social performance of the firm by keeping the cost of risk below or equal

to the minimal level.

Proposed Enterprise Sustainability Risk Management Framework

This paper proposes an ESRM execution framework which is made up of 7 dimensions, namely

structure, governance, process, employee relations, customer relations, environmental relation,

and community relations. These seven dimensions take into account the internal and external

factors of active sources for risk, which can create hindrance to achieving organizational goals

towards corporate sustainability. For instance, the structure dimension is developed to cover

two factors, i.e. SM and ERM definition and performance measurement (shown as E1 and E2

in Figure 1 and Table 1). The governance dimension, on the other hand, is to cover two areas,

i.e. information and roles, and compliance. The process dimension is to include three areas, i.e.

integration of business strategy and objectives, risk identification, and risk quantification. The

employee relation dimension is to cover two areas, i.e. responsible human resource

management, employee motivation. The customer relation dimension is to stress on three areas,

i.e. multidimensionality of consumer, quality product and service offering, and information

disclosure. The environmental relation dimension is to highlight three areas, i.e. product

technologies, process technologies, and end-of-pipe control and management system. The

community relation dimension of ESRM framework is to emphasize on three areas, i.e.

education, health, and housing and society.

Based on the argument of the relevant theories (i.e. institutional, agency, resource dependence,

and stakeholder theory), we posit that the firm can create value for stakeholders and increase

the corporate sustainability performance by executing the proposed ESRM program. Our

conceptual framework espouses the positive causal relationship between ESRM and corporate

sustainability performance. ESRM execution will lead to some financial or non-financial

(social) benefits to the firm and stakeholders. The benefits include output such as the reduction

in earnings volatility (Lai et al., 2010), strengthening the confidence of management in business

operations and risk monitoring, creating smooth governance procedures, stirring corporate

reputation, improving clarity of organization-wide decision making and chain of command,

encouraging corporate entrepreneurship, boosting profitability, increasing positive relationship

with communities, new product development, increasing ability to identify and seize new

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opportunities, motivating employees, and increasing customer base (Lai et al., 2010). Benefits

derived from the execution of ESRM framework may contribute to the distinctive

competitiveness of an organization. The espoused causal relationship is depicted by the arrow

A in Figure 1.

Financial Benefits: ROA: Return on Assets ROE: Return of Equity

Non-Financial Benefits: IBP: Internal Business Process CS: Customer Satisfaction IR: Investor Relations EC: Environmental Concern

Figure 1: Conceptual Framework Diagram

This study adopts financial and non-financial performances as the measurements for corporate

sustainability performance which serves as the dependent variables in the conceptual

framework. Derivation of tangible and intangible benefits from the execution of ESRM

framework will lead to increased Return on Assets (ROA), Return on Equity (ROE) (financial

performance), improved Internal Business Process (IBP), increased Customer Satisfaction

(CS), stronger Investor Relations (IR), and increased competitive advantage through

Environmental Concern (EC) (non-financial performance). Accumulatively, financial

performance in terms of ROA and ROE indicates a solid financial and operational performance

to the stakeholders. Non-Financial performances include competitive advantage, tactical

knowledge of employees, organizational culture and structure, processes, practices as well as

technology.

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Table 01: Elements of ESRM Framework

Code of

Elements Description of Elements

E1 SM and ERM Definition

E2 Performance Measurement

E3 Information and Roles

E4 Compliance

E5 Integration of business Strategy and Objectives

E6 Risk Identification and Response

E7 Risk Quantification

E8 Responsible Human Resource (Management)

E9 Employee Motivation

E10 Multidimensionality for Consumers

E11 Quality Product and Servicing Offering

E12 Information Disclosure

E13 Product Technologies

E14 Process Technologies

E15 End-of-Pipe Controls and Management Systems

E16 Education

E17 Health

E18 Housing and Security

The Theoretical Underpinning

The literature of sustainability management (SM) and enterprise risk management (ERM)

presents various theories and approaches to espouse ideas for the subjects matter. The studies

by Clarke (1998) and Lantos (2001) presented two approaches, namely the classical and

stakeholder approaches, with regard to the role of the firms in the society. According to

Brummer (1991), as per the classical approach, companies should operate in the society as

economically responsible rather than socially or environmentally responsible. Freeman (1984)

on the other hand, arguing from the stakeholder approach, postulated that firms are responsible

to satisfy their various stakeholders rather than just their shareholders alone. This argument is

supported by Branco and Rodrigues (2006). Most ERM literature hold the classical view in

which the ultimate objective of ERM implementation should maximize companies’ profits as

well as enhancing the shareholders’ value (Lai et al., 2010; Lai, 2011; Shad and Lai, 2015).

Some literature argues that the concept and framework of ERM lacks consideration to the

external risk such as the environmental and societal risks (Saardchom, 2013; Pollard and

Stephen, 2008; Faris et al., 2013; Beasley and Showalter, 2015). It is therefore, imperative to

integrate Sustainability Management (SM), which shall be sensitive and response to the

environment and social issues in the firm’s external operating eco-system, to the strategic focus

of the firm in its preoccupation to generate profit and to maximize shareholders’ wealth. This

integration of SM to the firm’s ERM processes shall bode well to close the existing gap of

external risk oversight that may exist which is aimed at safeguarding external stakeholders’

interest. With this respect, this study proposes the Enterprise Sustainability Risk Management

(ESRM) execution framework which integrates sustainability management and enterprise risk

management. We postulate this ESRM framework by referring to the theories of organizational

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behavior (i.e. institutional theory), governance (i.e. agency theory, resource dependence

theory), and strategic management (i.e. stakeholder theory) as the framework’s theoretical

underpinning. For instance, the institutional theory supports the notion of meeting the emerging

stakeholder expectations, government regulations, and to ensure the organizational legitimacy

by conforming to the rules and norms of the institutional environment. Agency theory on the

other hand, hypothesizes that the governance mechanism will reduce the scope of information

asymmetries and opportunistic behavior by aligning the principal and agent interests. Resource

dependence theory suggests for environmental relations by reducing the environmental

interdependencies and related uncertainties. Stakeholder theory meanwhile, emphasizes on

considering stakeholders in strategic decisions of organization instead of just focusing on

stockholders only.

Hypotheses Development

The conceptual framework of ESRM espouses its execution towards corporate sustainability

performance (CSP). By implementing the proposed ESRM framework, it will result in some

tangible and intangible benefits (in the form of financial and non-financial measures) to the

organization and will increase the value of the firm. Based on the theoretical argument

presented, we can develop the below hypotheses to validate the theorized causal relationship

between ESRM implementation (measured through its elements execution intensity) and

corporate sustainability performance (whose measures as shown in Figure 1);

H1: ESRM implementation will lead to corporate sustainability performance.

H2: There is a significant (positive) relationship between ESRM structure and financial

benefits.

H3: There is a significant relationship between ESRM structure and non-financial benefits.

H4: There is a significant relationship between ESRM governance and financial benefits.

H5: There is a significant relationship between ESRM governance and non-financial benefits.

H6: There is a significant relationship between ESRM process and financial benefits.

H7: There is a significant relationship between ESRM process and non-financial benefits.

H8: There is a significant relationship between ESRM employee relations and financial

benefits.

H9: There is a significant relationship between ESRM employee relations and non-financial

benefits.

H11: There is a significant relationship between ESRM community relations and financial

benefits.

H11: There is a significant relationship between ESRM community relations and non-financial

benefits.

H12: There is a significant relationship between ESRM environmental relations and financial

benefits.

H13: There is a significant relationship between ESRM environmental relations and non-

financial benefits.

H14: There is a significant relationship between ESRM customer relations and financial

benefits.

H15: There is a significant relationship between ESRM customer relations and non-financial

benefits.

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Proposed Analytical Model

In this study, it is hypothesized that the ESRM and its dimensions (i.e. structure, governance,

process, employee relations, customer relations, community relations, and environmental

relations) will have a positive causal relationship with corporate sustainability performance

(CSP). To examine the causal relationship and to test the hypothesis relating to the ESRM

execution and CSP, we propose to employ statistical procedures Exploratory Factor Analysis

(EFA), Confirmatory Factor Analysis (CFA) and Structural Equation Modeling (SEM).

Conclusion

This paper highlights the importance of Sustainability Management (SM) and Enterprise Risk

Management (ERM) on Corporate Sustainability Performance (CSP). This paper proposes the

integrated Enterprise Sustainability Risk Management (ESRM) framework to guide companies

to execute the necessary elements to manage the sustainability (environment and societal

issues) and enterprise risks facing the organizations while pursuing its economic goals. This

paper also theorizes the integration of SM and ERM into the proposed ESRM framework for

value creation. The ESRM framework aspires to achieve corporate sustainability performance

by factoring in environmental and stakeholder concerns, apart from the financial measures.

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