ESG is fast becoming a hot topic in boardrooms across the UK. The potential in helping to solve global environmental and societal problems and creating more resilient companies means directors are looking closely at how to devise and operationalise ESG strategies to achieve sustainable value creation.
This introductory guide explores ESG:
- The definition of ESG
- What it means for different stakeholders, and the primary goals of ESG
- How ESG has evolved over the years and the latest ESG developments
- Why ESG is important for all of us
What Is ESG?
Environmental, Social and Governance — commonly abbreviated to ESG — are the three pillars of performance by which a business or country’s impact on society, and its effect on environmental sustainability, can be evaluated. By understanding a company’s strategy and performance in each area, stakeholders — from investors and employees to consumers and governments — can decide how they interact with that organisation.
Initially, ESG was used as a tool by investors to identify businesses with the potential to deliver better long-term returns. Now, ESG is becoming the defining challenge of the 21st century for sobering reasons.
The first decades of the 21st century have seen growing volatility, uncertainty, complexity and ambiguity. This has culminated in a devastating global health crisis set against the backdrop of the climate emergency, systemic social injustice, and persistent inequality.
Solving these problems is not a quick fix; indeed, merely preventing them from growing worse demands action on a scale and unity never before achieved.
There has been a growing urgency to develop a common approach to address these issues by agreeing on standard metrics in each area of ESG, on which organisations will be required to report to show their commitment to improvement. This allows for meaningful and consistent comparisons between businesses and indicates their resilience to external factors, such as economic shocks or crises like the pandemic.
The World Economic Forum recently published its draft ESG metrics, which incorporate elements of the earlier Task Force on Climate-Related Financial Disclosure. These WEF metrics align with the United Nations sustainable development goals (SDGs) and look set to become the global standard for ESG reporting.
Before such metrics can be understood, it is essential to define each factor.
What Are the ESG Factors?
The definition of “E” in ESG: The Environment component of ESG covers how the business interacts with the natural environment, the impacts of its operations, and the actions the company takes to mitigate negative effects.
When businesses evaluate their environmental footprint, they must account for the entire value chain. This includes direct impacts, such as greenhouse gas (GHG) emissions (scope 1), raw material use, land use, water consumption, pollution and waste creation. The assessment must also include indirect effects that occur upstream or downstream from the business, such as GHG emissions from product use (scope 3) and the company’s supply chain activities.
According to the WEF’s ESG metrics, corporate reporting on environmental performance should align with the following six UN SDGs:
- Clean water and sanitation
- Affordable and clean energy
- Responsible resource consumption and production
- Climate action
- Life on land
- Life below water
The definition of “S” in ESG: The Social component of ESG covers how an organisation’s activities affect people — from its own workforce to customers, local communities and those who work in its extended supply chain.
The social element covers a broad range of factors, including fair pay and safe working conditions; workforce health and wellbeing; diversity and inclusion; equality; guarding against modern slavery and child labour; and anti-corruption measures. It also recognises a business’s obligation to support society proactively through initiatives such as education programmes and upskilling employees.
The quality of a company’s relationships with its stakeholders can significantly impact the organisation’s performance and stability. For example, good employee relationships mean the workforce is more productive, while poor relationships may give rise to industrial action and pay disputes.
The S in ESG should align with the following five UN SDGs:
- No poverty
- Good health and wellbeing
- Quality education
- Gender equality
- Reduced inequalities
The definition of “G” in ESG: The Governance component of ESG relates to the policies, structures and procedures by which an organisation or country is run. It explores the decision-making process and the distribution of rights and responsibilities between elements of the organisation, including the board and senior executives or, in national terms, the government, parliament and senior ministers.
Elements that come under the governance umbrella include:
- Demonstrating clear organisational purpose and values embedded in the business.
- Monitoring board composition and skills.
- Executive compensation.
- Oversight and scrutiny.
- Reporting transparency and accountability.
Governance also incorporates the organisation’s compliance with regulations and how it manages risk. Risk management should cover risk arising from the environmental and social pillars of ESG, incorporating people, planet and prosperity into risk monitoring alongside more conventional scrutiny of economic and market trends.
When devising governance roadmaps, the WEF advises organisations to consider the following three UN SDGs:
- Responsible resource consumption and production
- Peace, justice and strong institutions
- Partnerships for the goals
These definitions of the ESG factors tell us what they are and their issues at a high level, but ESG is viewed through different lenses by different stakeholders. As Ezekiel Ward, Founder of North Star Compliance Ltd., puts it: “ESG means a lot of different things to a lot of different people. It’s really important to start answering this by addressing that there’s a bit of a disconnect […] between who you’re talking to about ESG and what it really means.”
It is, therefore, useful to explore what ESG means to investors, corporates, governments and society.
Understanding ESG Scores and Ratings
What Is ESG for Investors?
ESG for investors is the application of non-financial standards in the areas of environmental, social and governance performance to screen potential investments and identify those likely to outperform the market.
The idea of using metrics beyond mere financial analysis to assess the long-term potential returns has been around for longer than you might think. In the 1960s, socially responsible investors began to exclude companies or industries from their portfolios if they were involved in ethically or socially undesirable activities or regimes, such as tobacco-growing or apartheid.
However, ESG investing has really gained traction since the turn of the century as investors have come to appreciate that a company’s ability to respond to supranational issues such as climate change and large-scale societal shifts is a good indicator of its potential to deliver good long-term returns.
This is particularly important in an increasingly volatile world, which makes predictions of future performance difficult.
Evidence suggests investors are right to take this approach. Organisations with stronger ESG have performed better during the pandemic. Larry Fink, CEO of the world’s largest institutional investor Black Rock, noted in his 2021 letter to CEOs: “During 2020, 81% of a globally representative selection of sustainable indexes outperformed their parent benchmarks.” Fink continues to emphasise ESG and has considerable leverage over the corporate world when he clarifies that Black Rock demands companies in its portfolio make improvements across the ESG landscape, from diversity and inclusion to GHG emissions reductions and much more.
What Are the Goals of ESG Investing?
The goals of ESG investing are:
- To gain long-term returns that outperform the market by identifying companies with strong ESG performance.
- To insulate investments against uncertainty by selecting companies that are well-equipped to survive and thrive during turbulence.
- To create a rising tide of responsible activity among businesses seeking investment and promote ethical investing.
ESG investing continues to grow, partly stimulated by a younger generation of more socially and environmentally aware investors who are reaching positions of influence in the investor community.
What Does ESG Mean for Corporates?
ESG is both a risk and an opportunity for corporates. Investor and consumer scrutiny, together with growing regulation, means that ESG failures are a significant risk to the future prosperity of the business. As such, they must be included in organisational risk management; compliance needs to be a priority.
There are also significant opportunities around ESG for businesses. Strong ESG performance increases trust in the organisation and can make it easier for the business to expand into new markets. As consulting group McKinsey put it: “When governing authorities trust corporate actors, they are more likely to award them the access, the approvals, and licenses that afford fresh opportunities for growth.” McKinsey’s report also highlights opportunities for cost reduction, support from regulatory authorities, and increased productivity through engaged and motivated employees.
What Are the Goals of ESG for Corporates?
Therefore, ESG has a dual aspect for corporates, prevention of risk and access to opportunities through achieving the following objectives:
- Creating sustainable value for stakeholders and attracting investment.
- Identifying and addressing risks related to ESG factors to build organisational resilience.
- Getting early warning of future issues through closer engagement with emerging ESG issues.
- Capitalising on consumer, investor and regulator trust to boost reputation, expand into new markets and grow revenue.
- Identifying cost and resource efficiencies.
- Mitigating regulatory and compliance risk.
Operationalising ESG to achieve these objectives requires the business to have a detailed picture of its performance on crucial ESG metrics. Progress against these metrics must be monitored and reported on to give stakeholders comparable data on which to assess the business.
This focus on data and measurability is what sets today’s ESG apart from previous corporate social responsibility initiatives; getting access to the correct data and ingesting it into systems for analysis and ESG reporting is one of the key operational challenges for corporates.
Modern Governance Meets The ESG Imperative
How Is ESG Defined for Governments?
Governments are arguably morally obliged to pursue an ESG agenda. Through policy-setting, regulation and public awareness programmes, responsible governments today are expected to protect the natural environment, improve citizen wellbeing and promote social cohesion. However, as Ward explains, these priorities are governed by electoral forces and “some hard realities on security and infrastructure”.
Governments must make difficult decisions when allocating limited public resources to tackling ESG issues, and these decisions are played out in public — highly politicised — arenas. Of course, not all governments prioritise ESG, and this is where we see severe consequences in the form of human rights abuses, destruction of natural habitats, the plundering of scarce resources, and corruption at the governmental level.
What Are the Goals of ESG for Governments?
Ultimately the ESG objectives for governments are to:
- Improve citizen wellbeing through a focus on health, education and environmental protection.
- Promote social cohesion, reduce inequality, and protect vulnerable communities and individuals.
- Protect the country, its citizens and economy from the impact of external factors such as climate change and global economic conditions.
What Does ESG Mean to Citizens, and How Is Society Driving ESG?
The majority of citizens wouldn’t use the term “ESG” to explain how they view organisations and countries. Instead, they might talk about a company’s reputation for sustainability or workers’ rights or a government’s record on human rights, but all this is part of ESG.
While they might not call it that, awareness of ESG factors among the general population is proliferating. The pandemic has shone a light on global inequality, while the successes and failures of each government’s response have been closely scrutinised. At the same time, climate events such as wildfires and floods have competed for headlines, while issues of racial injustice and gender inequality have also risen in profile. Increasingly, citizens want to know what corporations and institutions are doing in response. Many also want to understand more about what they can do to reduce their impact on the planet.
For citizens, viewing ESG-conscious corporations and governmental institutions helps the citizens to align their actions with their values and make decisions across a broad spectrum of issues, including but not limited to: what companies to buy from, choosing an employment offer to accept, and voting for a political party.
What Are the Goals of ESG for Citizens?
As such, the goals of ESG for citizens include:
- Aligning their actions with their values and signalling those values to wider corporate and government audiences.
- Making conscientious purchasing decisions.
- Reducing personal impact on the environment.
- Reducing inequality and combating injustice.
- Contributing to a fairer society and building a better future.
- Society is driving ESG through “people power”. Significant shifts in public opinion can exert enough pressure to effect lasting change.
In a direct sense, that might be through forcing a political party to change its policy through voter dissent or political activism; or causing a company to change the way it operates by boycotting its products. But perhaps more effective over the long term are the changes in public habits that encourage businesses to adapt products and services to meet new demands. One example is the rise of vegan diets, which is encouraging companies to develop plant-based alternatives with lower environmental impact.
As people’s expectations change, businesses and governments evolve in response. This makes society a powerful driving force for ESG.
How Is Environmental Social Governance Evolving?
ESG has come a long way in the past 60 years. The frameworks and reporting initiatives that have emerged along with the way mirror emerging areas of concern:
- 1960s: Investors begin to exclude certain companies and industries from investment portfolios on ethical grounds.
- 1980s: The apartheid regime in South Africa prompts a focus on the ethics of investing. In 1983 EIRIS is established as the first ethical investment research service in the UK.
- 1992: UN conference on Environment and Development – known as the “Earth Summit” is held in Rio de Janeiro, resulting in Agenda 21, a programme calling for new strategies to invest in the future to achieve sustainable development.
- 1997: The Global Reporting Initiative is established to enable companies to prove their responsible environmental business credentials.
- 2000: Launch of the Carbon Disclosure Project.
- 2006: The UN’s ‘Principles for Responsible Investment’ report requires ESG criteria to be incorporated in company financial evaluations.
- 2011: The Sustainability Accounting Standards Board (SASB) is founded, an “independent non-profit organisation that sets standards to guide the disclosure of financially material sustainability information by companies to their investors”.
- 2012: Black Rock CEO Larry Fink publishes his first “letter to CEOs”, asking companies to reject short-termism and focus on longer-term outcomes.
- 2015: The Task Force on Climate-related Financial Disclosures (TCFD) formalised the link between environmental risk and financial risk with a way for companies to report their physical, liability and transition risks to stakeholders.
- 2018: Fink’s CEO letter shifts emphasis and calls on company’s to pursue ‘profit with purpose’.
- 2020: COVID-19 pandemic begins to sweep the globe.
- February 2020: The FRC announces that it is undertaking a significant review of how and the extent to which UK companies and auditors are responding to the impact of climate change on their business to ensure reporting requirements are being met.
- 2020: The World Economic Forum’s International Business Committee publishes 22 ESG metrics with a vision to standardise corporate reporting under a ‘stakeholder capitalism’ approach.
- January 2021: Larry Fink’s letter to CEOs underlines the importance of corporate reporting on ESG metrics and the use of consistent data to inform investment decision-making.
Why Is ESG Important?
ESG is crucial because it offers a focused framework through which governments, businesses and citizens can work consistently toward solving serious global challenges. It is grounded in the shared moral obligation to do the right thing by people and the planet but aims to make progress measurable in a way not previously possible.
ESG performance is an indicator of an organisation’s resilience and, by implementing an ESG strategy, organisations are better placed to respond as new challenges emerge. They can adapt to disruption and sustain value creation over the long term. This is attractive to investors aiming to maximise returns. The link between financial and ESG performance is becoming more robust than ever. The benefits of the shift from financial to stakeholder capitalism will accrue to the whole of society, not just those aiming for commercial benefit.
Technology for an ESG-Driven Future
ESG’s problem-solving potential lies in its emphasis on measuring, monitoring and reporting performance across the three pillars. When something is measured, progress can be tracked, reported, and a straighter course steered towards success. This means data is fundamental to ESG effectiveness.
This data is now easier to collect, analyse and report on than ever before, but its sheer volume and the diversity of sources present business problems. Establishing what is required, relevant and valid is a huge undertaking that requires technical tools and resources.
Diligent’s ESG Solutions help organisations get to grips with ESG obligations, regulations, metrics and industry trends, enabling the dynamic progress tracking against ESG goals and objectives. They facilitate the operationalising of ESG from the boardroom and throughout the business.
The shift to stakeholder capitalism, underpinned by the adoption of standardised ESG metrics, represents an important step towards harnessing the resources and reach of businesses worldwide to address the defining challenges of our time. By focusing on environmental, social and governance issues, we can ensure that the returns extend far beyond the financial, to build a better, fairer and more sustainable future for everyone.
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