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 (E&S) practices outperformed clients with worse E&S 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.
Worsening climate conditions, grievous social injustices, and corporate governance failures are catapulting ESG to the top of global agendas. Here’s why it matters:
If societies don’t pressurize businesses and governments to urgently mitigate the impact of these risks, and to use natural resources more sustainability, we run the risk of total ecosystem collapse.
To society: Around the world, people are waking up to the consequences of inaction around climate change or social issues. 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 societies don’t pressurize businesses and governments to urgently mitigate the impact of these risks, and to use natural resources more sustainability, we run the risk of total ecosystem collapse.
To businesses:: ESG risks aren’t just social or reputational risks – they also impact an organization’s financial performance and growth. For example, a failure to reduce one’s carbon footprint could lead to a deterioration in credit ratings, 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. If that wasn’t incentive enough, there’s also the fact that Millennials and Gen Z’ers are increasingly favoring ESG-conscious companies.
In fact, 35% of consumers are willing to pay 25% more for sustainable products, according to CGS. Employees also 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.
To investors: 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.
To regulators: 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.
ESG investing is rapidly picking up momentum as both seasoned and new investors lean towards sustainable funds. Morningstar reports that a record $69.2 billion flowed into these funds in 2021, representing a 35% increase over the previous record set in 2020. It’s now rare to find a fund that doesn’t integrate climate risks and other ESG issues in some way or the other.
Here are a few key trends:
COVID-19 has intensified the focus on sustainable investing: The pandemic was, in many ways, a wake-up call for investors. It exposed the deep systemic shortcomings of our economies and social systems, and emphasized the need for investments that would help create a more inclusive and sustainable future for all.
About 71% of investors in a J.P. Morgan poll said that it was rather likely, likely, or very likely that that the occurrence of a low probability / high impact risk, such as COVID-19 would increase awareness and actions globally to tackle high impact / high probability risks such as those related to climate change and biodiversity losses. In fact, 55% of investors see the pandemic as a positive catalyst for ESG investment momentum in the next three years.
It helps that ESG funds proved remarkably resilient during the crisis with many of them outperforming the broader market. Jon Hale of Morningstar wrote, “In 2020, three out of four sustainable equity funds beat their Morningstar Category average, and 25 of 26 ESG equity index funds that I've been following this year beat index funds tracking the most common traditional benchmarks in their categories.”
Unsurprisingly, massive investments are being channelized into ESG funds, and will likely continue this way.
The S in ESG is gaining prominence: For a long time, ESG was almost entirely associated with the E – environmental factors. But now, with the pandemic exacerbating social risks such as workforce safety and community health, the S in ESG – social responsibility – has come to the forefront of investment discussions.
A BNP Paribas survey of investors in Europe found that the importance of social criteria rose 20 percentage points from before the crisis. Also, 79% of respondents expect social issues to have a positive long-term impact on both investment performance and risk management.
The message is clear. How companies manage employee wellness, remuneration, diversity, and inclusion, as well as their impact on local communities will affect their long-term success and investment potential. Corporate culture and policies will increasingly come under investors’ radars. So will attrition rates, gender equity, and labor issues.
Investors are demanding greater transparency in ESG disclosures: No more greenwashing or misleading investors with false sustainability claims. Companies will increasingly be held accountable for backing up their ESG assertions with data-driven results. Transparent and truthful ESG reporting will become the norm, especially as Millennial and Gen Z investors demand data they can trust. Companies whose ESG efforts are truly authentic and integrated into their corporate strategy, risk frameworks, and business models will likely gain more access to capital. Those that fail to share relevant or accurate data with investors will miss out.
ESG risks are business risks – which is why they can’t only be the responsibility of Chief Sustainability Officers or compliance and ethics committees. Ownership must begin with the board. Corporate directors have a duty of care to consider how ESG factors impact the corporate strategies, performance, and risk health of the companies they serve.
Here’s how boards can lead the way on ESG:
Provide effective oversight of ESG risks and opportunities: ESG risks are typically varied and dynamic with wide-spread impacts on corporate reputations, bottom-lines, compliance, litigation, and more. Therefore, they need to be examined not just in isolation, but in terms of their connection with other risks.
Boards must be clear about who owns ESG risks, how they impact strategy, and where the organization’s risk appetite ends.Boards must also determine whether existing enterprise risk management (ERM) processes are effective enough to keep ESG risks in check. Wherever there are gaps, directors must work closely with the executive team to identify steps for improvement.
Another board responsibility is to drive the adoption of ESG frameworks – be it the Sustainability Accounting Standards Board (SASB) sustainability metrics or the Global Reporting Initiative’s (GRI’s) reporting standards. Determining which framework to use depends on a number of factors such as whom the company will be reporting to, what that audience needs to know, and what kind of resources the company has to dedicate to disclosures.
Track ESG progress: By regularly monitoring ESG objectives and metrics, boards can keep companies on their toes. The key is to ask the leadership team specific questions: Are our ESG goals compelling enough? What are we doing to achieve them? Where do ESG responsibilities and accountabilities lie? Are our ESG efforts integrated with strategic decision-making? Are they aligned with relevant standards and reporting frameworks? Are investors and regulators satisfied with the quality of our reporting?
The more informed boards are about ESG performance, the more effectively they can guide and support their companies in delivering long-term value.
Ensure that disclosures are reliable and credible: Boards must ensure that robust control systems and processes are in place to regulate the ESG information that’s reported, including how, when, and where. Is the information accessible, credible, and backed by quality metrics? Is the messaging consistent across the corporate website, sustainability reports, and regulatory filings? Is it aligned with the company’s purpose? Has it been validated by a third party? Boards also need to probe deeper on the transparency and truthfulness of disclosures. Too often, companies cover up the shortcomings of their ESG programs, focusing only on its successes and achievements. This makes the content sound biased. Having the courage to talk about both the good and bad in an ESG journey goes a long way towards building trust and credibility. The board must help their organizations drive towards these objectives.
The practice of socially responsible investing can be tracked back hundreds of years ago to when religious groups such as the Jews, Muslims, Quakers, and Methodists established ethical guidelines to govern investing. Stocks that conflicted with their personal beliefs or values were typically avoided (e.g., slave trade, smuggling, alcohol, tobacco, or gambling).
In the 1960s-80s, socially responsible investing gathered steam, as activists and protestors raised their voices against the Vietnam War and apartheid in South Africa, as well as environmental incidents like the Chernobyl nuclear disaster and the Exxon Valdez oil spill.
In 1971, the first sustainable mutual fund was launched. By 1994, 26 sustainable funds were available to investors, with assets roughly around $1.9 billion.
From the year 2000 onwards, multiple ESG standards came into being – be it the Global Reporting Initiative (GRI), the UN’s Principles for Responsible Investment, or the Sustainability Accounting Standards Board (SASB).
Today, ESG is no longer just a passing trend – it’s a key competitive differentiator that may soon become a basic survival requirement for businesses. Investors value companies that care about their environmental and social impact, as well as the quality of their governance. In fact, directors now report that ESG is the topic investors most want to discuss during engagements with shareholders (PwC).
So, what’s next? How will ESG evolve in the next few years?
For starters, we’re likely to see new regulations, reporting requirements, and standards. The proposed European Green Bond Standard and the EU Due Diligence Regime will demand more focused and transparent ESG disclosures. Meanwhile, from April 2022, over 1,300 of the largest UK-registered companies and financial institutions will have to disclose climate-related financial information on a mandatory basis – in line with recommendations from the Task Force on Climate-Related Financial Disclosures (TCFD). This is only a sign of things to come.
We’re also likely to move towards a globally harmonized set of reporting standards that can provide more consistent and comparable information for investors.
At a corporate level, boards will likely come under greater pressure to improve their ESG skills and fluency. With investors scrutinizing ESG measures, boards will need to demonstrate effective understanding and oversight of ESG issues – be it carbon emissions, racial injustice, or economic inequality.
In addition, more attention will be placed on supply chain ESG. Already, Germany has published the Supply Chain Due Diligence Act which obligates companies to safeguard human rights and the environment within their supply chains through appropriate due diligence measures. This law will come into force in 2023.
All these trends will require companies to up their ESG game. That, while challenging, will go a long way towards creating and enhancing business value.
It’s never too early to incorporate ESG propositions into your GRC and business strategies. By embracing ESG practices, you gain multiple benefits, including:
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.
While there isn’t a one-size fits all approach to ESG, here are a few best practices that can help:
Establish a strong foundation
Adopt a systematic approach to ESG risk management
Measure and audit ESG performance
Communicate and report progress towards ESG goals
ESG commitments impact organizations at multiple levels. For example, waste reduction requires the participation of just about every business department, from Product Engineering to Administration and Finance. Therefore, the responsibility for meeting ESG targets can’t just be thrust on the sustainability function. It has to be a collective effort.
However, with distributed responsibilities, it can become difficult to coordinate and track the different ESG activities in different parts of the organization. Silos may crop up, resulting in ESG practices that that overlap, or are inconsistent with overall ESG objectives. That’s why it helps to have a cross-functional group of stakeholders who can coordinate and align ESG efforts.
Some companies establish sustainability representatives from each business function to ensure that their departments are meeting ESG targets. Others establish forums or platforms where cross-functional stakeholders can meet regularly to exchange updates on ESG progress.
Each stakeholder brings value to the table. For instance, risk representatives provide a holistic perspective on ESG risks, while finance professionals bring a clear understanding of how ESG performance can impact the organization’s access to investments.
It’s important that all these participants have a 360-degree, shared view of ESG metrics, standards, reports, and other data. Only with this kind of transparency can they work together to meet ESG targets faster, more efficiently, and cost-effectively.
There has been considerable debate about whether or not the compliance function should own responsibility for ESG. Some see it as a natural fit, thanks to the compliance function’s expertise in handling governance matters, engaging with cross-functional stakeholders, and reporting to the board. But there are others who point out that ESG responsibilities will only strain an already over-worked compliance function.
Whatever organizations decide, there’s no doubt that ESG could benefit greatly from the best practices that compliance functions have honed over the years. These include:
Building a structured compliance framework: Creating an integrated compliance framework helps organizations bring order and discipline to the chaos of ESG standards and reporting requirements out there. The first step is to identify all ESG requirements that are relevant to your business. Maintain these standards, frameworks, disclosure templates, and schedules in a central database where they can be easily accessed. Link them to business processes, risks, business units, and controls to better understand their impact. Conduct a gap analysis to determine where your organization’s ESG measures are lacking. And then, develop systems and controls to fill those gaps.
Integrating compliance into corporate culture: Building a truly effective ESG compliance program requires enterprise-wide commitment. Start with the board and leadership – they need to demonstrate through their words and deeds that ESG will be treated as part of day-to-day operations. Then, create and maintain robust policies and procedures that employees can follow. Weave ESG themes into internal training and communication, so that they’re top-of-mind for employees. Set up whistle-blower hotlines and other channels for people to report ESG violations such as bribery and corruption. Finally, ensure timely, effective investigations around these incidents.
Enabling cross-functional collaboration: ESG requires involvement from multiple stakeholders, including the board, HR, Compliance, Risk, Legal, Administration, and Finance teams. Seamless collaboration across these participants is essential, not only to avoid duplication of effort, but to also identify and respond to ESG risks faster. The key is to unify these stakeholders on a common platform where they can easily view all ESG metrics, exchange data and ideas, define shared goals, and collectively work towards enhancing ESG compliance.
Proactively monitoring compliance: The accuracy of an organization’s ESG disclosures depends on how effectively the business is monitoring and measuring their ESG maturity. It could take the form of standardized self-assessments and surveys which help the organization understand their ESG performance, including progress towards established targets. Teams must analyze factors such as how well ESG has been integrated into the business, what controls are needed for ESG oversight, how effectively ESG risks are being managed, and where the gaps lie.
Ensuring third-party due diligence: Third-party compliance with ESG policies and standards is integral to the success of any ESG program. Organizations must know how their suppliers are managing waste and emissions, or preventing human rights issues like child labor. This requires that third parties sign specific codes of conduct, attest to sustainability and social responsibility practices, fill out due diligence surveys, and report on their ESG activities. Companies must also enable continuous third-party assessments, audits, and inspections to validate supplier claims.
ESG management isn’t a simple, linear process. There are so many frameworks, metrics, data sources, cross-functional stakeholders, and risks involved. How do you manage all of them in an efficient and intelligent manner?
ESG software can help by streamlining and automating processes like ESG data collection. It can also unify all ESG reporting requirements, metrics, and other information in a single source of truth. So, companies have all the insights they need at their fingertips to report accurately on their ESG posture, and make better-informed decisions.
Here’s a deeper look at what an ESG solution can help companies do: