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ComplianceFinanceTax & AccountingSeptember 29, 2022

What internal audit should know about ESG risks: S is for Social

Having considered how internal audit can address environmental risks in the first article in this series, this article turns to the second element of ESG, social risk. This can be a sensitive area, and many risks are hard to quantify. But over the last decade, expectations of organizations have evolved significantly, and internal audit has a key role in providing assurance over the risks that this presents. 

Social risks

Social risk can be viewed from several perspectives. While we traditionally look at business activities, here it can also be helpful to look through the lens of different stakeholders to ensure all risks are captured and completely understood. For example, consider impacts on the organization itself, staff, customers, suppliers, investors, other third parties, and the wider communities in which you operate. Below are some of the key risks – not an exhaustive list — but those that outline the main risk areas you will want to capture:

  • Health and safety – consider both workplace and customer safety.
  • Labor standards – your own and those throughout your supply chain. This goes beyond compliance with legislation and international protocols to include issues such as well-being, benefits, and employee engagement.
  • Equality, diversity, and inclusion (EDI) – very important to staff, customers, and the community, this is a significant topic in and of itself
  • Sales practices – important to your customer base and the wider community, poor practices can quickly damage a reputation.
  • Data privacy – sometimes considered a social risk, given its impact on staff, customers, and other partners.
  • Community engagement – how effective is your organization in working with local (and broader) stakeholders to maximize the positive and minimize the negative impacts on the community. This started with CSR (Corporate Social Responsibility) but often goes much deeper.
  • Other broad, but important, issues such as human rights and the rights of indigenous peoples. 

Typical impacts for the organization will be the same as for many other ESG risks – reputational, legal and regulatory, financial, operational, and ultimately strategic. Other than potentially using different stakeholder perspectives when considering risks, this fits well into your risk assessment process.

Getting started – Determining the key risks

Your risk assessment should always be the starting point. In order to do this, you will first need to go through several steps to get sufficient background context:

  • Understand your organization’s approach to social risk. Given the variety of risks and the number of stakeholders, it is likely that it will sit across the organization with many different risk owners. For example, staff-related risks and issues will be owned by Human Resources, whereas supply chain risks will be owned by the relevant business unit or a procurement function. Are there anywhere these risks are also considered and assessed together or across the organization, such as part of a risk function?
  • Consider who the key stakeholders are. Some will be common to all organizations – staff and customers for instance. Others will be specific to your business – such as a community close to a quarry.
  • As always, consider key sector and industry risks, drawing on industry guidance, frameworks, and other resources, and on standards such as GRI (Global Reporting Initiative).
  • Pay attention to your supply chain, particularly if sourcing (directly or indirectly) from jurisdictions where labor or safety standards may not reflect those in your home country. 
  • Understand legal and regulatory requirements in all jurisdictions in which you operate.

With this background information, you can start to include social risks into your risk assessment, leveraging work done by the first and second lines, and begin to provide assurance over these key risks. 

How internal audit can make an impact

Clearly, we should be focusing on the biggest risks for the organization. However, we often need to consider the impact on stakeholder groups in aggregate, rather than just for each risk. Staff is a good example. We should certainly consider risks around compliance with labor laws but understanding the impacts on staff also requires the inclusion of wellbeing, health and safety, benefits, employee engagement, and EDI to assess the potential risk around staff as a group. Internal audit can add value by looking at risk in this way and provide more holistic assurance over risks relating to specific stakeholders. 

Internal audit can also take a broader look at the organization’s approach to social risk. As I suggested earlier, it is often a distributed responsibility, but the risks do not exist in isolation. Some questions you can ask:

  • What is the organization’s attitude towards social risks? Are social factors (collectively or specific issues) considered in strategic planning or discussed at the Board level?
  • Have key stakeholders been identified? Do these make sense given what you know?
  • Is social impact considered in decision-making, particularly investment decisions and project evaluation? For government and social-purpose organizations, this will often be a core part of the decision-making process. But even in commercial organizations, evaluation of social risks and impacts will often be built in. 
  • Are there targets and performance metrics in place? For key risks there often are metrics, but they may not be evaluated as a whole – which could be acceptable if they have sufficient prominence. As for other ESG risks, the availability and quality of the data may be a challenge as standards, systems, and processes are evolving. This provides an opportunity for internal audit to make an impact by evaluating systems and processes and by validating the data.

Some examples

Labor standards

The subject of labor standards is broad, but if we consider it in two parts, it may help. First there are fundamental rights at a global level which most countries are adhering to as members of the International Labour Organization. These cover issues such as forced labor, child labor, maternity, working hours, discrimination, health and safety, and unionization rights. Second, there are expectations beyond this, which often vary by country and include benefits, well-being, and employee engagement. There are many ways for internal audit to make an impact here. I will address two very different audit examples:

  • An organization’s own employment activities have always been part of an audit universe. There is an opportunity to take this further, providing insight and assurance into, for example, employee wellbeing and engagement. Most large organizations conduct surveys covering one or both, but how effectively do they select, track, and use metrics? Also, how effective are follow-up plans? These are sensitive areas, but this is largely about how data is collected and used, and how effectively plans are defined and implemented. All are very well aligned to core internal audit skill sets.
  • The broader issue of labor standards risk incorporates many parts of a business. As well as an organization’s own employees, we need to consider those in the supply chain, service companies, and any other partners. The focus of an audit is likely to be on procurement and contract management processes. Do contracts stipulate appropriate measures (which vary on the size and nature of the organization)? What independent verification is available that standards are complied with? What monitoring is in place within the organization to highlight emerging issues? All questions internal audit is well-positioned to consider and provide assurance over.

Sales practices

Sales practices have been under the microscope at various points over the last century. Often it relates to providing dishonest or misleading information, or selling products or services are known not to be in the best interest of the buyer. The banking crisis of 2008 highlighted unethical practices which led to a significant shift to providing services based on the customer. Earlier examples are tobacco and baby formula, the health impacts of which were not accurately portrayed. In both cases, poor practices continued in parts of the developing world long after they were prohibited in the West. 

Risks are primarily reputational, but often there are legal and regulatory considerations that can be substantial. Let’s look at two ways in which internal audit can make an impact in this area:

  • The first is not about the sales process itself, but about whether organizations are considering the customer in the products and services they sell. All jurisdictions have regulations about product quality or the types of services that can be sold to different groups of consumers. Examples range from food standards to complex financial products. In addition, there are overarching responsibilities to ensure customer health and safety (whether on-site or through the products or services they are using) that should be considered. This could be as obvious as ensuring products don’t cause a choking hazard or more complex such as the danger posed when providing social media platforms to young people. Internal auditors should understand the relevant regulations, and any voluntary codes, to provide assurance that there are appropriate controls over these risks, often as part of an existing audit. But you can also go further by considering the more complex aspects of risk and raising concerns if these have not been appropriately considered as customer needs and welfare are an integral part of product/service design and production.
  • Internal audit can provide assurance over the sales process itself. In any setting and for any customer group, there should be defined processes for marketing, customer communications, and best practices and guidelines a salesperson should consider when making the sale. For complex products such as insurance, this may be very structured, whereas a very light touch would be expected for simple products. Controls may include guidelines, review, and approval for marketing materials, standard templates for communications, and certifications and training for sales. When auditing, we need to be mindful of having realistic expectations for the type of products and services being sold but also be prepared to challenge when processes are insufficient or not well-evidenced. Additional considerations include data privacy, avoidance of discrimination, and the need to look at practices in all relevant jurisdictions. 

To summarize, we have shown the variety of social risks within ESG and how internal audit can use their skill set to make an impact by providing assurance over some of these key risks. There are good sources of information freely available to understand different issues in more detail to help assess how social risks may impact your organization and your audit response.

The third and final article in this series will focus on the “G” (Governance) in ESG which covers a broad range of corporate activities. It is important to understand these risks as they provide the foundation for effective ESG program management.

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Kevin Gould
Audit Committee Chair | Internal Audit Consultant
Kevin is a Chartered Accountant with a strong background in Internal Audit and a recent focus on ESG. He has 25 years of experience as a consultant, adviser and auditor.
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