Key things to know about building an ESG-conscious business
For decades after Milton Friedman’s seminal essay was published, people believed that profits were the only real goal of business. But today, it’s the purpose behind the profits that’s in focus.
“Society is demanding that companies, both public and private, serve a social purpose,” wrote BlackRock Founder, Chairman, CEO, Larry Fink, in his 2018 letter to CEOs. “To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society.”
That “contribution” is arguably best exemplified in a company’s environmental, social, and governance (ESG) practices. Ranging from carbon footprint reduction to pay parity, ESG practices enable sustainable and purpose-driven business growth.
The International Finance Corporation (IFC) found that out of 656 companies in its portfolio, those with good environmental and social practices outperformed clients with worse practices by 210 basis points on return on equity and by 110 basis points on return on assets.
Similarly, Morningstar found that sustainable funds attracted a record $51.1 billion in net new money from investors in 2020, more than double the previous record set in 2019.
In other words, ESG isn’t just the right thing to do. It also impacts business performance positively.
The E in ESG refers to a company’s environmental impact and practices, including energy consumption, waste management, carbon emissions, and use of natural resources.
The S refers to a business’s social impact on employees and other stakeholders, as well as its ripple effects on the larger community. It covers issues like labor practices, working conditions, diversity, inclusiveness, pay equity, employee engagement, and data protection and privacy.
The G stands for governance, or the internal controls and procedures that a company adopts to ensure integrity and transparency in business activities and decisions. It encompasses issues like boardroom diversity, executive compensation, anti-corruption, and whistleblowing.
Together, E, S, and G seek to encourage more socially responsible behavior in businesses, boardrooms, and investor communities.
GRC is no longer just about monitoring regulatory compliance or managing known risks. It’s about sustaining an organization’s license to operate—ensuring that business practices, operating procedures, and corporate behaviors are acceptable to employees, stakeholders, and the public at large. ESG is integral to that effort.
How a business manages its environmental footprint, gender diversity, or transparency in reporting impacts the company’s license to operate and therefore its GRC mission.
The link between ESG and GRC is even more evident when you look at the World Economic Forum’s (WEF’s) Global Risk Reports. Back in 2010, fiscal crises and underinvestment in infrastructure dominated the risk report. But in 2021, all the top 5 risks by likelihood and four of the top 5 risks by impact are related to ESG issues, including climate action failure, infectious diseases, and biodiversity loss.
GRC professionals have a significant role to play in mitigating these risks and building trust with stakeholders through robust ESG measures. In fact, at MetricStream, we believe that ESGRC will be the future of GRC.
The focus on ESG has intensified in recent years for several reasons:
The climate crisis demands urgent action: July 2021 was the world’s hottest month ever recorded (NOAA) – a sign that global warming is intensifying. In Australia, human-induced climate change increased the continent’s risk of devastating bushfires by at least 30% (World Weather Attribution). In the US, 36% of the costs of flooding over the past three decades were a result of intensifying precipitation, consistent with predictions of global warming (Stanford Research). If businesses don’t act now to help mitigate the impact of these risks, and to use natural resources more sustainability, we run the risk of total ecosystem collapse.
ESG risks aren’t just social or reputational risks – they’re also financial risks: ESG issues can significantly impact an organization’s financial health. For example, a failure to reduce one’s carbon footprint could lead to rating downgrades, share price losses, sanctions, litigation, and increased taxes. Similarly, a failure to improve employee wages could result in a loss of productivity and high worker turnover which, in turn, could damage long-term shareholder value. To minimize these risks, strong ESG measures are essential.
Customers and employees prefer ESG-conscious companies: Millennial and Gen Z consumers increasingly want to buy from or engage with brands that care about ESG issues. In fact, 35% of consumers are willing to pay 25% more for sustainable products, according to CGS. Employees too want to work for companies that are purpose-driven. Fast Company reported that most millennials would take a pay cut to work at an environmentally responsible company. That’s a huge impetus for businesses to get serious about their ESG agenda.
Investors are shifting their sights to ESG-focused investments: More than 8 in 10 US individual investors (85%) are now expressing interest in sustainable investing, according to Morgan Stanley. Among institutional asset owners, 95% are integrating or considering integrating sustainable investing in all or part of their portfolios. By all accounts, this decisive tilt towards ESG investing is here to stay.
Regulators are demanding ESG disclosures: In the EU, the new Sustainable Financial Disclosure Regulation (SFDR) and the proposed Corporate Sustainability Reporting Directive (CSRD) will make sustainability reporting mandatory. In the UK, large companies will be required to report on climate risks by 2025. Meanwhile, the US SEC recently announced the creation of a Climate and ESG Task Force to proactively identify ESG-related misconduct. The SEC has also approved a proposal by Nasdaq that will require companies listed on the exchange to demonstrate they have diverse boards. As these and other reporting requirements increase, companies that proactively get started with ESG compliance will be the ones to succeed.
It’s never too early to incorporate ESG propositions into your GRC and business strategies. By embracing ESG practices, you gain multiple benefits, including:
Stronger revenue growth: There is growing evidence that a higher ESG rating correlates with higher financial performance. Companies that prioritize ESG are perceived as credible and trustworthy. This helps them attract more customers, enter new markets with ease, and acquire permits and approvals faster.
A competitive edge: Sustainability and good governance matter to consumers. When you demonstrate a clear commitment to ESG and a purpose beyond profits, you’re more likely to win consumer favor and loyalty. In fact, 52% of consumers say that what attracts them to buy from certain brands over others is that those brands stand for something bigger than just the products and services they sell, which aligns with the consumer’s personal values (Accenture).
Better talent acquisition and retention: Young and talented workforces are choosing employers whose values are aligned with theirs. So, when potential recruits see that your business genuinely cares about issues like employee development, diversity, ethics, and climate change, they’re more likely to want to work for you. Employees are also more motivated, engaged, and productive when they know that their work is purposeful and makes a difference.
Lower costs: Being more energy-efficient or using less packaging material will help you cut costs. McKinsey research finds that reducing resource costs can improve operating profits by up to 60%.
Fewer regulatory compliance risks: By demonstrating strong ESG measures, you minimize the risk of regulatory sanctions, penalties, fines, and other enforcement actions. ESG-focused investing also often comes with attractive tax incentives, as governments seek to reward responsible financial behavior.
ESG, while important, can often be a challenge to implement. For starters, it’s a very broad discipline that covers a range of issues – from carbon footprint and biodiversity loss, to labor practices and corruption. Many of these issues can be hard to quantify in terms of their magnitude as well as their impact on financial risks.
But perhaps the biggest obstacle is the lack of a universally accepted ESG framework to assess and report ESG progress. Without it, companies end up using multiple different standards and metrics, which leads to inconsistencies and confusion. Stakeholders often find it difficult to compare ESG data or determine how it links to financial performance.
However, steps are being taken to standardize ESG reporting. For instance, the WEF, in association with the Big 4 accounting firms and Bank of America, have released a set of universal ESG metrics and disclosures. These “stakeholder capitalism metrics” are organized around the principles of governance, planet, people and prosperity.
Further, the International Financial Reporting Standards (IFRS) Foundation is actively engaging with authorities like the International Organization of Securities Commissions (IOSCO) to develop a common set of global sustainability standards. These initiatives will help make ESG reporting more consistent, comparable, and reliable.
The Global Reporting Initiative’s (GRI’s) sustainability reporting standards are widely used by companies to understand and disclose their impact on the economy, environment, and people. The GRI Universal Standards apply to all organizations; the GRI Sector Standards cover sector-specific impacts; and the Topic Standards list disclosures relevant to a particular topic.
The Sustainability Accounting Standards Board (SASB) has created a set of 77 industry-specific sustainability metrics that help companies and investors analyze how ESG issues impact financial performance.
The International Integrated Reporting Council (IIRC) developed the International Framework to improve disclosures about value creation, preservation, and erosion. It encourages reporting around six broad capitals, including natural capital, human capital, and social and relationship capital.
The Climate Disclosure Standards Board (CDSB) offers companies a framework to report environmental information with the same rigor as financial information. This approach benefits a range of stakeholders, including investors, analysts, companies, regulators and stock exchanges.
CDP runs a global disclosure system that enables thousands of companies to measure and manage their risks and opportunities on climate change, water security, and deforestation.
The Task Force on Climate-related Financial Disclosures (TCFD) has developed a framework to help public companies and other organizations effectively disclose climate-related risks and opportunities. The TFCD recommendations are designed to solicit decision-useful, forward-looking information that can be included in mainstream financial filings.
The UN Sustainable Development Goals has set out 17 broad objectives for companies to achieve. They range from responsible consumption and production, to climate action and gender equality. These goals provide a foundation for companies to shape and prioritize their business strategy and reporting.
While there isn’t a one-size fits all approach to ESG, here are a few best practices that can help:
Define clear roles and responsibilities to oversee ESG risks and issues.
Ensure you have sufficient staff with the required skills, knowledge, and expertise to manage ESG effectively.
Remember, ESG encompasses a wide range of requirements that can’t always be managed by a single department or person. Consider creating a cross-functional ESG team, including stakeholders from compliance, risk management, HR, investor relations, legal, and senior management.
Conduct a materiality assessment to identify and prioritize the ESG issues that could most affect the business. Use it to inform company strategy, targets, and reporting.
Adopt a systematic approach to ESG risk management
Identify and document your ESG risks. Determine how they might impact the achievement of business objectives and strategy.
Embed ESG risks into your risk appetite statement and ERM frameworks. Define specific KRIs.
Assess ESG risks periodically to understand their impact and probability at various levels of the business. Incorporate scenario analysis tools to measure the financial implications of ESG risks like high carbon taxes.
Extend your ESG risk assessments to third parties, including vendors, suppliers, service providers, contractors, consultants, and partners. Understand what they’re doing to improve sustainability and ESG ratings.
Document and investigate ESG-related issues stemming from risk assessments.
Embed ESG into compliance programs
Capture ESG related regulations and disclosure requirements in a central database. Map them to controls, policies, and risks to identify compliance gaps.
Establish specific policies and procedures around ESG. Review and reassess these policies regularly.
Provide periodic training and communication on ESG goals and issues. Share ESG wins with the enterprise.
Establish hotlines and other reporting mechanisms for employees to report ESG violations, risks, and incidents. Provide incentives and rewards for risk-appropriate behaviors.
Measure and audit ESG performance
Establish quantitative and qualitative KPIs to track and evaluate ESG performance.
Engage independent auditors to provide assurance around the accuracy of ESG reports and data.
Communicate and report progress towards ESG goals
Keep the board and senior management updated on ESG performance. Demonstrate how ESG activities align with business strategy, financial performance, and value creation.
Create an effective communication strategy to disclose your ESG vision, mission, and performance to investors and other external stakeholders.
Ensure that your reporting is credible, consistent, and authentic. Be transparent about where you are in your ESG journey.
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