Environmental, social and governance (ESG) concerns have risen over the past 18 months as the turbulence of COVID-19, extreme climate events and social injustice prompted stakeholders to hold companies to account for their response. As scrutiny of corporate ESG performance grows, the discussion around achieving companywide ESG integration has grown with it. So, what are the challenges to incorporating ESG into business-as-usual, and why should boards advance an agenda of ESG integration in the businesses they serve?
First, we should look at what is meant by ESG integration through different lenses:
1) What Is ESG Integration for Investors?
For investors, ESG integration is the practice of analysing data about the ESG performance of potential investment targets to identify the likelihood of delivering healthy returns and minimising risk over the medium to long term.
Evidence for the link between a company’s ESG performance and its potential to generate long term value in challenging conditions continues to accumulate. In 2020, ESG-screened funds rose faster than their conventional counterparts. A study by S&P Global Market Intelligence found that, of 26 ESG exchange-traded and mutual funds, 19 performed better than the S&P500, with those outperformers rising between 27.3% and 55% over that period. In comparison, the S&P 500 increased 27.1%.
Consequently, asset managers — particularly those operating funds with long horizons such as pensions — continue to refine the tools and data they use to assess corporate ESG performance for investment decisions.
2) What Is ESG Integration for Businesses?
For businesses, ESG integration is the proactive inclusion of environmental, social and governance factors into strategic planning, risk management, operational delivery and reporting. Effectively it is about viewing the business through an ESG lens so that the wide-ranging benefits of ESG — which together add up to sustainable value creation — can be achieved.
While many corporations are now paying more attention to ESG, few can claim to have fully integrated it. However, the need to do so is becoming increasingly crucial. Regulators, investors, employees, and consumers seek clear, objective evidence of an organisation’s impact on the global bottom line of “people, planet, and prosperity”.
Why Should UK Boards Care About ESG Integration?
Boards are the custodians of long-term value creation, and as the commentary above suggests — this now incorporates a broader range of metrics beyond financials taken in isolation. Boards must recognise and understand how the complex and interconnected web of climate-related risk and broader socio-political risk affects the business’s ability to function successfully and safely. Boards are also responsible for upholding the business’s values and purpose, which must go beyond the organisation’s ability to make sales in today’s environmentally and socially aware landscape.
In tandem with the ethical obligation on businesses to monitor ESG practices, the regulatory landscape is also evolving. Tighter controls and the specification of operational standards, from pollution and natural resource depletion to anti-slavery and cybersecurity, create a complex set of interlocking business pressures.
These are accompanied by an increasing focus on ESG reporting — both mandatory and voluntary. Section 172 of the Companies Act requires medium to large organisations to report performance on ESG issues, including environmental impact, employee social, community and human rights issues. Larger organisations must also report on greenhouse gas emissions and energy consumption. Organisations also frequently report on CSR activities undertaken by the business.
However, there is growing consensus on the importance of standardising non-financial performance reporting through a common framework. The Task Force on Climate-Related Disclosure (TCFD) set out its recommendations for reporting environmental performance in 2017. And then, in November 2020, the UK became the first country to commit to making TFCD-aligned disclosures mandatory across a range of sectors by 2025.
However, while this covers environmental factors, ESG is broader. The World Economic Forum’s International Business Committee has proposed a list of 21 core metrics and 34 expanded stakeholder capitalism metrics that align with the UN’s Sustainable Development Goals (SDGs) and aim to help companies measure and communicate sustainable value creation. There is considerable support for adopting these globally as a consistent framework for non-financial disclosures. They will require companies to have a comprehensive view across the ESG spectrum to report effectively against them.
Effectively, if investors, consumers, regulators and reporting authorities are focused on ESG performance, UK boards can’t afford to deprioritise it. Directors need to ensure ESG integration is a standing agenda item. Additionally, that the business works towards gaining a holistic picture of the impacts the business makes, the risks it is exposed to, and the contributions it makes to society. Only by establishing this critical oversight can directors gain visibility of potential risks and long-term threats to sustainable value creation.
Understanding ESG Scores and Ratings
ESG Integration as Part of Integrated GRC
This regulatory and reporting focus means integrating ESG across the business falls into the realm of the governance, risk and compliance (GRC) activities that underpin organisational resilience. Industry commentators such as North Star Compliance Ltd. Founder Ezekiel Ward have noted that incorporating ESG into integrated risk management is a trend that has been emerging for some time as businesses begin to “join up the dots between different functions like internal audit, compliance, health and safety […] you really start to see boards [are] being conscious of [this].”
What Are the Barriers to ESG Integration?
Integrating ESG is a significant undertaking due to the diversity of areas covered. Organisations typically have multiple departments reporting through different mechanisms with data held in disparate siloes and lacking a common approach and vocabulary. This makes it difficult to ‘join the dots’ to gain a realistic picture of strengths, weaknesses and benchmark positions against competitors. And without this picture, executive teams and boards can’t make strategic decisions that incorporate ESG.
The challenge of collecting, analysing and reporting data is not just a problem for internal ESG integration. According to BNP Paribas’ ESG Global Survey, 66% of investors rank data as the main barrier to integrating ESG into investment decision-making. As Charlotte Hormgard, Senior Manager at Swedish Pension Fund AP3, told the survey’ authors: “One barrier that we are all talking about is access to data. There is lots of data. The challenge is finding the right data in the right format and knowing what to do with it.”
Tools To Support ESG Integration
Large data challenges such as this require an intelligent approach to acquisition, monitoring and reporting. Governance professionals can support the integration of ESG in their business by deploying technology to facilitate, track and report on compliance with existing regulations and emerging frameworks such as the WEF’s stakeholder capitalism metrics.
By implementing a common solution that connects the entire organisation, from the board to day-to-day operations, siloes and poor cross-department communication are resolved. Governance teams and boards can gain a comprehensive, reliable picture of organisational performance, possible gaps and risks.
Data from within the business is just part of the challenge. Companies also need visibility over the changing external landscape and the ability to benchmark against competitors on critical governance factors such as board composition, effectiveness and compensation. This can be delivered through a combination of governance analytics and curated intelligence from news sources that deliver timely insight into rising trends, reputational issues and market movements.
Diligent’s ESG Solutions are designed to support boards and governance teams to achieve comprehensive oversight of ESG activities and provide the tools needed to monitor and report on progress and identify risks as part of integrated GRC.
As ESG performance becomes a core element of how key stakeholders evaluate organisations, ESG integration is the appropriate next step for businesses aiming to adapt to a corporate environment where sustainable value creation depends on it.
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