Author: Graham Meller, Founder – Buttonwood Marketing Ltd, a PR Agency specialising the environment and sustainability.
To really understand ESG, it helps to know its roots. In the 1990s, a similar, but less well defined, concept was known as ‘Business Ethics’ involving environmental initiatives, codes of conduct and management systems. For many, these issues were published in Corporate Responsibility Reports and mostly contained aims and aspirations with very little data, which meant that they were only of limited value to investors.
Of course, some people have always wanted, to a greater or lesser degree, to invest in ‘good’ businesses, but its only really in recent years that the processes for measuring ‘good’ have been formalised beyond just financial measures.
A brief history of ESG
The origins of the term ESG can be traced to Geneva, where the Principles for Responsible Investment were initially created by the UNEP Finance Initiative. This is a network of banks, insurers and investors seeking to catalyse the financial system to deliver more sustainable global economies.
In 2003, a group of free-thinking individuals at the UNEP FI sought to fix the disconnect between the aims and values of societies and the investment policies of long-term investors such as pension funds. In January 2004 their work prompted the UN Secretary General Kofi Annan to write to over 50 CEOs of major financial institutions, inviting them to participate in a joint initiative to find ways to integrate ESG into capital markets. A year later this initiative produced a report(1) entitled “Who Cares Wins” which provided guidelines and recommendations on how to better implement ESG.
One member of the UN team had a background in the British media so he understood the importance of a snappy title, like ‘Who Cares Wins’, as well as referencing ‘ESG’ rather than ‘environmental, social and corporate governance issues’. It’s called ‘The Rule of Three’ – like ‘Hands, Face, Space’, ‘Get Brexit Done’ or ‘Build Back Better’. As a result, ‘ESG’ as a term was born. At a time, don’t forget, when anthropogenic climate change was still the subject of debate, yet here we are, in a world where many critically important staff have the job title ‘ESG Analyst’.
In February 2022, Bloomberg Intelligence predicted ESG assets to balloon to $50 trillion by 2025 from about $35 trillion: “The growth has been spurred by record-breaking fund inflows amid concerns about climate change and other societal issues.”
It’s worth mentioning that Socially Responsible Investment (SRI) has been around for a long time and is based on ethical and moral criteria; using mostly negative screens, such as divesting in alcohol, tobacco or firearms. SRI is therefore values-based, whereas ESG metrics are evidence-based and have clear financial relevance.
What is ESG?
ESG allows investors to put their money where their values are, but more than that, ESG allows investors, and other stakeholders, to compare companies on key metrics, which in combination represent a risk score.
It is important to highlight however, that the ESG metrics which matter to one company, may not matter to another. For example, efficient water usage is vitally important for fruit growers, whereas airlines, vehicle manufacturers and waste incinerators will be more concerned with greenhouse gas emissions and air quality. Similarly, clothing retailers will place a higher emphasis on responsible sourcing.
In order to better understand how ESG reporting helps to manage risk, we need to drill down a little on the E, the S and the G.
Environmental issues can be managed across the entire value chain with metrics for natural resource protection, pollution (air, water & land), waste management, greenhouse gas emissions, energy efficiency, green technology etc. These issues impact businesses in a number of ways. For example, businesses that are perceived as environmentally friendly enhance their brand, and conversely, businesses that harm the environment can suffer serious brand damage. It is vital therefore, for businesses to assess their impacts on the environment, establish appropriate metrics, have them independently verified, and generate insights for continuous improvement.
Social factors include a company’s strengths and weaknesses in dealing with staff, including wages, working conditions, wellbeing, skills, training & development, equality, diversity and inclusion. Social factors also include suppliers and customers, and the communities in which the company operates, as well as society generally. In recent times, social issues have been the focus of greater attention as the pandemic forced working and living practices to change. Importantly, for every business decision, there can be unintended social consequences, so maintaining the balance between social responsibility and profit requires constant and vigilant examination.
Governance is a term describing the way in which companies define objectives and govern themselves. It defines how decisions are made and responsibilities assigned, including the composition and role of the board, the oversight of executives and their compensation, and the company’s relationship with shareholders. Governance is where the main decisions around company risk management are made, and this shapes policies with regard to environmental and social risk.
Governance issues also include company policies on issues such as business ethics, anti-competitive practices, tax transparency, corruption, cyber security, and occupational health & safety. Both public and product liability are both governance issues, with policies relating to the quality, safety and the reliability of the company’s products and services.
Why is ESG so important to today’s businesses?
Globally, society faces a number of major challenges, including the climate crisis, the energy crisis, environmental degradation and biodiversity loss, for example. These are issues which governments cannot solve by themselves, so a heavy responsibility also lies with the private sector.
Financial institutions and governments are developing rules and regulations, and financial institutions are actively avoiding investments in companies that use those funds for purposes that do not align with ESG objectives.
In the early days of Corporate Responsibility, companies sought to ‘do the right thing’ and to distinguish themselves in their market from a reputational perspective. Today, for many companies, ESG metrics represent a licence to operate; demonstrating to stakeholders that the business is being managed responsibly and fulfilling its obligations to society.
The KPMG 2022 CEO Outlook surveyed 1,300 CEOs at the world’s largest businesses about their strategies and outlook, including their approach to ESG. The survey found CEOs increasingly agreeing that ESG programs improve financial performance (45% compared with 37% a year ago). Importantly, 69% reported stakeholder demand for increased reporting and transparency on ESG issues (up from 58% last year), and 72% of CEOs believe stakeholder scrutiny on ESG will continue to accelerate (up from 62% last year).
Interestingly, 17% of CEOs said that stakeholder scepticism around greenwashing is increasing (up from 8% last year). However, I believe that one should always take surveys such as these with a pinch of salt, because I know that CEO’s themselves do not normally contribute personally to them.
The Benefits of ESG:
- Stakeholder engagement
- Investor support
- Brand enhancement
- Attracting talent
- Employee retention
- Waste avoidance
- Risk identification & mitigation
- Better visibility of business processes
- Better insights for improvement
- Cost savings/efficiency improvements
- Transparent supply chains
- Building resilience and avoiding disasters (e.g., VW emissions scandal, BP’s Deepwater Horizon oil spill, Equifax data privacy scandal)
- Avoiding regulatory penalties
- Providing access to new opportunities (e.g. government tenders)
What are the other Drivers for ESG?
Clearly, there are significant potential gains from implementing ESG; not just for organisations individually but also for society and the environment generally. Recognising this imperative, regulatory authorities around the world are creating new requirements to help achieve ESG goals. For example, new regulations and reporting requirements are being created to address greenhouse gas emissions and carbon footprint.
- It’s the right thing to do
According to the UN’s Sustainable Development Report 2022, for the second year in a row, the world is no longer making progress on the SDGs. The pandemic and war in Ukraine have meant that the world has taken its eye off the ball, which increases the urgency with which ESG should be implemented.
A wide variety of regulations and associated standards impact every single ESG metric. These include both voluntary and binding issues such as emissions monitoring and control (including GHGs), health & safety, carbon disclosure, environmental management, energy management, information security, business continuity, equality, diversity, anti-corruption etc. By monitoring and managing these issues, organisations are able to lower organisational risk and make progress of the UN SDGs.There are also new regulations covering ESG reporting itself. Building on the initial premise behind ESG, the EU has the Corporate Sustainability Reporting Directive (CSRD), amending the Non-Financial Reporting Directive (NFRD). The CSRD is part of the bigger Sustainable Finance package, which enables the Green Deal by helping to channel private investment behind the transition to a climate-neutral economy. The Sustainable Finance package includes the EU Taxonomy (with the Climate Delegated Act), which provides clarification around the economic activities that most contribute to meeting the EU’s environmental objectives. This includes a requirement for financial firms to include sustainability in their procedures and investment advice to clients.In the United States, in March 2022, the U.S. Securities and Exchange Commission proposed major rule amendments to the disclosure of climate-related risks and opportunities for public companies. Importantly the proposals included a requirement for greenhouse gas emissions reports to be independently verified by a specialist third-party.As part of its mission to shape policies that foster prosperity, equality, opportunity and well-being, the international Organisation for Economic Co-operation and Development (OECD) has published a number of documents providing guidance on ESG investing.The international Financial Stability Board created the Taskforce on Climate-related Financial Disclosures (TCFD) to develop recommendations on the types of information that companies should disclose to support investors, lenders, and insurance underwriters in appropriately assessing and pricing risks related to climate change. Governments, such as the UK, are making it mandatory for the largest businesses to disclose their climate-related risks and opportunities, in line with TCFD recommendations.
Customers, employees and investors are increasingly putting ESG issues front and centre when making decisions about the companies they engage with. Rising shareholder and consumer activism, as well as new forms of regulation, mean that it is no longer enough to simply state ambitions or good intentions. Additionally, many companies are now declaring Net Zero objectives, and progress towards these objectives needs to be measured reliably.The challenge is to prove to stakeholders that policies and initiatives are translating into meaningful action and impact throughout the company’s business plan and its supply chain. Brands that can achieve this have an opportunity to establish long-term loyalty, advocacy and competitive advantage.
Standardising ESG practices
Building trust in ESG practices is complicated by regional and corporate variations in reporting requirements. However, international initiatives are underway to standardise ESG reporting. For example, the International Sustainability Standards Board (ISSB) was launched at COP 26 as an independent, private-sector body to develop and approve IFRS Sustainability Disclosure Standards.
In Davos (2022), Sarita Nayyar from the World Economic Forum, explained that better transparency is crucial to improving trust in the ability of businesses to address ESG issues. She said: “People are looking to see that organisations are playing a bigger role than just delivering bottom line profits. This is where transparency around ESG performance is critical.”
As different countries and regions look to launch their own regulations on ESG reporting, Unilever CEO Alan Jope believes it is becoming more onerous for multinational companies to monitor their progress in these areas. Also speaking in Davos, he said: “We want to be at the leading edge of this, but we are at a point of great danger right now of letting perfect get in the way of good, of letting complex get in the way of simple and of letting local get in the way of global.” From Unilever’s experience, he said: “Consumers, particularly young people, are making brand choices based on their social and environmental impact. Our brands that outperform on environmental or social contribution are growing much faster than the rest of our portfolio,” he explained.
Sarita Nayyar hopes the World Economic Forum’s own sustainable capitalism metrics, covering the four pillars of people, planet, prosperity, and principles of governance, can help. The idea is to have a similar set of international standards for companies to measure their performance against others.
She said: “We have a substantial project in that arena to create a globally consistent, comparable and reliable reporting and disclosure system that can really demonstrate whether a corporation is moving in that direction, and being more sustainable.
“Creating ESG metrics so that organisations across various sectors and various geographies could have common standards, can really improve trust.”
Trust is arguably the most important asset of any business or brand, but to establish trust, third party corroboration is essential. Building credibility through independent assurance can help demonstrate an organisation’s commitment to openly tracking progress against its goals and values.
Standards set by bodies such as ISO have long been established as marks of trust and integrity. In the world of sustainability, verification and assurance standards such as WBCSD/WRI GHG Protocol, ISO 14064, SASB, SMETA and TCFD are widely recognised by investors and stakeholders and support the comparability and transparency of reported ESG data.
Don’t let perfect get in the way of good!
The ESG reporting landscape is rapidly evolving, which means that some businesses may be tempted to delay action until the world has agreed a standard set of ESG taxonomies founded on complementary principles. (Taxonomies being the systems that determine which economic activities should be considered sustainable, for example.) However, it is doubtful that ESG taxonomies will ever be cast in stone; they will always evolve. Let me give you an example. Some of the UK’s power stations have switched from coal to biomass in a move to increase renewable energy, but in 2022 the UK’s business and energy secretary said that burning wood (imported from the USA) in Drax power station “is not sustainable” and “doesn’t make any sense.”
Similarly, a certain electric car manufacturer was a little upset in 2022 when his company was excluded from the S&P 500 ESG Index, while the likes of Amazon and ExxonMobil remained in place. In response to his complaints S&P responded by pointing out that these ratings are based on more than one dimension of sustainability.
Future-proof your business!
If companies stand on the sidelines waiting for ‘perfect’, they are going to be there for a very long time; instead they should strive to be ‘better than the legislation’. If they remain reactive; they will be forced by regulators to move later, risking reputational damage and playing catch-up to remain competitive in an increasingly ESG-focused world. To gain first-mover advantage, businesses that want to achieve the greatest return on their ESG investments need to establish robust methods of measurement and assurance now.
In May 2022, the US Securities & Exchange Commission charged BNY Mellon with misstatements about its ESG ratings, resulting in a first-of-its kind 1.5-million-dollar settlement. This emphasises the importance of accuracy and transparency in ESG reporting.
- How do you start?
First, businesses have to decide:
1. which metrics matter most to their strategic aims
2. which metrics matter most to their stakeholders
3. whether processes and systems are in place to measure these key metrics effectively, reliably and transparently
4. how the metrics will be independently verified and disclosed
5. who needs access to the data
Let’s drill down into an example to see how this process lowers risk and brings business benefits. Imagine your business imports bananas. Agriculture uses 70% of the world’s freshwater and bananas have a relatively large water footprint. So, climate change is a major risk for your business, and water usage is going to be a key ESG metric for you. Similarly, businesses that use water generate effluent that can pollute water resources, so effluent water quality will be another valuable metric, helping to protect the environment and avoid regulatory penalties.
Conveniently, ISO14046:2014 is an environmental management standard detailing the principles, requirements and guidelines for the monitoring of water footprint. When you start monitoring water usage in processes like irrigation and cleaning, it sends a message to staff that this is an important issue, and frequently the numbers get better. However, once you have the data, you can find opportunities for improvement, such as:
• Irrigation should maintain the correct soil moisture – and no more
• Washing water could be collected and recycled
• Rainwater could be harvested
• Mulching could lower evapotranspiration
• If pumps are employed, are there opportunities to lower energy consumption?
By selecting the right metrics, businesses can open up a treasure trove of opportunities to lower the risks from climate change and regulations, whilst saving costs and improving the company’s ESG performance.
In order to leverage the value of data (ESG metrics) it is not just important to measure the right things; it is also necessary for the data (and insights!) to be made easily available for all stakeholders.
Without transparency it is difficult for an audit to report on risk exposure associated with wage underpayment, excessive working hours, child labour, unauthorised subcontractors, harassment etc. Supplier transparency is therefore vital for the effective mitigation of risk.
Some say “numbers don’t lie” but in reality, people use numbers to ‘prove’ all sorts of points, so the way for organisations to ensure that their numbers tell the absolute truth and nothing but the truth, is to make sure that they are disclosing the right numbers – relevant, key metrics, AND most importantly, if they want people to trust their numbers, they have to be checked and validated by an independent third party.
Supply chain due diligence
ESG can no longer be regarded as a feature of big business. Every year more SMEs are looking to do the right thing, and to be seen to do the right thing. Also, the need for supply chain vigilance means that smaller businesses now have ESG as a business imperative.
In the past, approaches to supply chain due diligence simply involved yearly checks – but as reputations are at stake for brands connected to unsustainable practices or human rights violations, the approach has shifted from a basic compliance check to a year-round risk-based monitoring and mitigation program.
The KPMG CEO survey showed that nearly half of CEOs (47%) plan to diversify their supply chains in the next 6 months in response to geopolitical challenges. The number one strategy CEOs are considering to mitigate supply chain issues is to monitor deeper into their supply chain (i.e., at the third and fourth levels) to better anticipate problems.
Businesses need to find ways to embed ESG into their extended supply chains; to promulgate a code of conduct with issues such as carbon reduction or ethical performance etc., and then to perform due diligence. They should try not to bring in bad actors, but work with the actors in their supply chain to make them better. Purchasing decisions and the procurement process can be used to reward suppliers that meet prescribed ESG objectives and penalise those that do not. Many progressive companies have been transparent about their suppliers; publicly sharing audit reports on their ESG performance.
Seventeen years ago, ESG was an adjective for ‘issues’ and ‘factors’ – today it has evolved into an adjective for ‘metrics’ and ‘performance’. The implementation of ESG is no longer a burden; expertise, tools and processes (such as the digital transformation of assurance) are available to ensure that ESG can be seamlessly integrated into businesses so that they can manage risks and exploit the many benefits listed above.
All stakeholders are investors in one way or another, and transparent, verified ESG metrics allow investors to spend their time, money or resources in those businesses that are able to demonstrate good risk management – a vital attribute in any geopolitical climate, but especially now.
Click here for more information on Green PR from Buttonwood Marketing