ESG investing has advanced to the point where it can considerably accelerate positive market transformation. As companies and investors gain more power and clout, their policies and decisions have a greater impact on the future.
While the effort of incorporating ESG in business strategies is commendable, we still have a long way to go. To make it easier to incorporate ESG factors into the investment process, various international institutions such as the Global Reporting Initiative (GRI), Sustainability Accounting Standards Board (SASB), the Task Force on Climate-related Financial Disclosures (TCFD) and International Integrated Reporting Framework (IRF) are constantly showing efforts to form standards and define materiality.
The Sustainable Development Goals by the United Nations are increasingly being seen as a way to bring in a new and refined era of affirmative action through responsible investing. United Nations Principles for Responsible Investment (UNPRI) also promotes incorporating ESG factors into investment decision-making. Other ESG regulators such as the United States Environmental Protection Agency have developed processes and guidelines for major companies to follow ESG regulations in the respective regions.
The aim of the article is to help you understand the importance of a well-developed ESG strategy that can give you a competitive edge while demonstrating climate-conscious behavior, stakeholder wellness and governance needs. The article is divided into the following sections:
- What is ESG?
- Understanding ESG factors, metrics, and reporting frameworks
- Importance of an ESG strategy due to investors and consumers’ demand
- Benefits of an ESG strategy for business
- ESG strategy framework for business operations
- ESG strategy and supply chain
- 5 Steps to develop an ESG strategy
- Implementing an ESG strategy by overcoming common challenges
- Measuring the ultimate success of an ESG strategy
- Reporting and communicating ESG performance
- Reviewing and improving the ESG strategy
- Final thoughts on ESG strategy
- Speak to the experts
What is ESG?
The term ESG is an acronym for Environment, Social, and Governance which are central factors used in measuring the sustainability, ethics, and social impact of a company or a business. ESG factors aren’t necessarily transactional, but they play a significant role in identifying & managing a company’s risk and their Return on Investment (ROI). With growing alertness and demand for climate action amongst consumers, adopting Environmental, Social and Governance (ESG) measures is now more important than ever for businesses of all sizes to thrive in the present and also future proof itself.
The Environmental, Social and Governance factors help to evaluate companies and countries on the way they can advance with respect to sustainability and climate issues. Once enough data on these three factors has been gathered, they can be integrated into an investor’s decision-making process when determining which stocks or bonds to buy.
Understanding ESG factors, metrics, and reporting frameworks
ESG factors span a wide range of concerns that aren’t often considered in financial analysis but may have financial implications. Reporting ESG metrics is not mandatory in a lot of companies. However, investors are increasingly shifting their focus to invest in companies which have an ESG disclosure.
There are no standardized methods for calculating ESG metrics. But to address the ESG factors, investors might use several analytical methodologies and data sources. These ESG factors include metrics seeking for ways corporates should be responding to:
- Climate change for reducing Greenhouse Gas emissions by adopting green practices like reducing, reusing and recycling; investing in renewable energy; and water management strategies.
- Health and safety policies and measures taken up by the companies for the protection of employees
- Supply chain management to ensure the sustainable performance of all the different stakeholders involved
- Corporate culture and trust fosters innovation of their employees
- Various diversity on board, business ethics and accounting transparency
Further, the metrics can be used for a range of ESG integration approaches such as climate-related risks, benchmarking, and scenario analysis. ESG factors are increasingly being factored into investment evaluations by the financial industry.
UNPRI has published a report providing a comprehensive description of the integration of ESG into investment strategies along with case studies[1]. The case studies demonstrate the way investors can use ESG factors in the same quantifiable way as financial factors. Further, the metrics can be used for a range of ESG integration approaches such as climate-related risks, benchmarking and scenario analysis. Businesses can develop an ESG Risk Dashboard that includes ESG data as well as portfolio risk metrics. Such tools can enable trustees to holistically assess its pooled fund portfolio exposure, map carbon indicators and its journey to net-zero targets, get updates on regulations and look into each manager and company to assess risk exposure.
For reporting the ESG factors there are several frameworks available which consider various aspects of ESG. Some of the commonly used frameworks are as follows:
- The GRI provides the most extensively used ESG framework. More than 10,000 organizations in over 100 countries are using GRI to report on sustainability, and the standards are available in 12 languages[2]. Companies of all sizes, across all sectors and locations, can use the GRI standards.
- IRF’s goal is to provide complete sustainability information to investors and lenders. The IRF is seen as a landmark in market-led corporate reporting.
- SASB is a set of 77 industry standards that businesses can use to identify and report financially important sustainability data to their investors.
- TCFD aims to improve and provide recommendations for reporting on climate-related financial risks.
- Carbon Disclosure Project (CDP) is another regularly used framework for disclosing environmental information to their investors, employees and customers. The framework primarily focuses on climate change, forests, and water security.
One limitation that exists with these frameworks is the overlap of content and no standardized framework which causes confusion in many companies.
Thus, many investors and corporates have argued for a standardized ESG framework. With this challenge on the rise, 120 of the world’s greatest corporations backed efforts to create a basic set of non-financial measurements and disclosures for their investors and other stakeholders, known as the “Stakeholder Capitalism Metrics.”[3]
Importance of an ESG strategy due to investors and consumers’ demand
ESG strategy deals with the ways environmental, social and governance issues affect a business’s strategies and ESG objectives, ultimately leading to the company’s value. Implementing ESG strategies is not only an imperative way to care for people and the planet but is also an increasingly important factor in the way investors and consumers are making their decisions.
Institutional Investors, including asset managers, private equity firms, and asset owners seek to invest in companies, whether large enterprises or SMEs, with high ESG standards. They broadly consider seven strategies to integrate ESG factors in their investment decisions[4]:
- Best-in-class: The investors identify the best organizations through ESG research, and they are usually chosen by comparing ESG ratings from several rating agencies.
- Engagement and voting: This is a long-term strategy in which active ownership is achieved through stock voting and engagement with companies on ESG issues.
- Exclusions: Businesses whose activities seem to have a negative effect on society are excluded by investors. Activities or products such as “controversial weapons, pornography, tobacco and alcohol, fossil fuel extraction and nuclear energy”[5] companies fall in this category.
- ESG integration: It is the integration of financial factors along with ESG factors influenced by the impact of ESG factors on transactional performance.
- Impact investing: Impact investments are made with the goal of producing positive social and environmental outcomes as well as financial gains.
- Norms-based screening: This approach involves excluding the companies which do not abide by international norms and conventions set by international organizations.
- Sustainability-themed: Companies and firms are selected for their involvements in solving sustainable development challenges.
Benefits of an ESG strategy for business
A strong ESG strategy can aid in the development of a strong business brand, the ability to access large pools of capital, and the enhancement of long-term growth that benefits all stakeholders. The following section will explore the benefits that an ESG strategy provides to a business.
1. Top-line advancement:
By committing to sustainable practices in a business plan for a product or service range offered, a corporation draws a wider range of B2B or B2C consumers while being compliant with legal rules. According to one report, “88% of the studies show that solid ESG practices result in better operational performance; 90% of the cost of capital studies show that sound Environmental, Social and Governance (ESG) standards lower the cost of capital and 88% studies show that the stock price performance is influenced by good sustainability practices”[6].
2. Attract young investors:
The next generation of investors is thought to have been instilled with environmental and social consciousness because of growing up with the climate crisis being taught in schools and witnessing the rise in collective focus on mental wellbeing, social welfare, and the value of a rewarding working environment. According to a survey held in 2019 by Morgan Stanley Institute for Sustainable Investing, 95% of millennials were interested in sustainable investing[7].
3. Productivity Boost:
Having a strengthened internal structure which focuses on employee morale, along with well-being will motivate the employees further to work for the company. This will help in boosting the corporate governance factor of an ESG framework.
4. Long-term viability:
Businesses that incorporate ESG into their plans, communicate their strategy and data transparently, have showcased lower risks, higher investments, and better resilience during an external shock. Thus, the business which inculcates ESG in their business model’s DNA will have a competitive advantage.
5. Supply chain resiliency:
Adoption of an ESG strategy will help you in making the supply chain more transparent and traceable for identifying risks and opportunities on time and managing it in an efficient manner. Minimizing risks, good governance through stronger connections with suppliers, and responsible stewardship of raw materials are critical for the profitability of a business. UNPRI has provided guidance and frameworks on the ways a company can manage its supply chain ESG risks, which can be used by both businesses and investors for their investee company[8].
ESG strategy framework for business operations
A successful ESG strategy is seen as an important benchmark for understanding how a company or an organization is operating by covering its three pillars of sustainability: Environment, Social and Governance.
While there is no single framework or standard for establishing the major principles of a business’s ESG strategy, there are some globally accepted frameworks on which it may be based:
- The Sustainable Development Goals (SDGs) are a set of 17 goals set by the United Nations to promote peace and prosperity for the world and its inhabitants.
- The SASB Standards, which highlight the ESG challenges that are more relevant to 77 distinct industries; and the SASB Materiality Map is a tool for determining the financial importance of ESG problems.
- The United Nations Guiding Principles on Business and Human Rights assist businesses in preventing and responding to human rights violations in their operations.
It is crucial to understand that an ESG strategy should deliver value and the priorities that are aligned with the business strategy and stakeholder preferences. While developing an ESG strategy, organizations need to consider their visions, missions, policies, different expectations of stakeholders and set priorities for integrating the ESG strategy into specific organizational functions[9].
ESG strategy and supply chain
In a hyper-globalized economy, integrating ESG strategy with the supply chain is critical to incorporate any company’s end-to-end operations throughout the chain.
Supply networks may expose businesses to disruptions that negatively impact ESG, such as natural resource exploitation, human rights violations, top-level corruption, and more. In fact, most multinational corporations’ greatest risk of non-compliance with ESG regulations is in their supply chain[10].
Investors can advise and push their companies to evaluate the impact of their products and services, in a pragmatic approach of research and resource management, which can result in a more developed ESG approach to tackling potential risks in the supply chain, with a larger reach than one might expect from a company of a small size. This process has prompted the two to incorporate ESG into the company’s overall strategy[11].
Academic studies have revealed the importance of establishing supply chain ESG measures and how the disconnection between supply chain and ESG strategy can cause business disruptions[12]. Therefore, effective supply chain management will help organizations calibrate their ESG strategies and contribute to their overall ESG performance.
5 steps to develop an ESG strategy
1. Commitment of leadership:
First and foremost there must be an alignment of the board with leaders and key stakeholders on the essential matters, in terms of risk, opportunity, efficiency, and financial performance, in business terms. Materiality and gap evaluations support this form of interaction by providing executives with insights into risks and opportunities through the eyes of many stakeholders, including workers, clients, regulators, and rivals[13]. Companies need to step away from a strategy that isolates sustainability within one team or leader to one that incorporates stakeholders across departments and includes the CFO.
2. Materiality and gap assessments:
The purpose of a materiality assessment is to understand the key ESG issues, risks and opportunities that are most likely to affect a company’s business performance and stakeholders. This step helps to move further up the ladder towards achieving your ESG goals by carrying out a gap analysis to identify the disconnection between a company’s current practices and its objectives to know where a company might lag. Management specifies the activities and adjustments to policies and processes that must be made to result in measurable change after prioritizing the essential gaps and risks.
3. Engaging an audit committee:
Members of the audit committee are in charge of ensuring that relevant information is reported to investors in a responsible manner. Members of the committee may not be in charge of ESG strategy, but they must be aware of the ESG priorities and indicators. Auditors are in a good position to help with ESG reporting. They check to see if metrics have been presented systematically and clearly, ensuring that data collection and processing follow defined standards and procedures and that the statistics match what a company claims to do.
4. Adopting technology:
Technology is constantly evolving and increasingly being used for ESG management, businesses should assess their current systems to see how they might be used to capture meaningful data for analysis. Similarly, if a company is experiencing a digital transformation, ESG should be discussed as part of the process to ensure that new and advanced technologies are prepared to incorporate ESG.
5. Reporting ESG achievements:
While there are a number of standards and frameworks that can be used to report a company’s ESG strategy, the most important component is to communicate it effectively and coherently. An external party assurance can also be included to ensure credibility and authenticity in the reporting process. The reporting plan should be in line with the company’s overall ESG strategy and conform to changing regulatory and investor expectations. ESG data targeting this audience or stakeholders should be scrutinized with the same rigor as conventional financial reporting.
Implementing an ESG strategy by overcoming common challenges
While implementing an ESG strategy, there are certain challenges that need to be overcome. Which are they?
1. Availability and reporting of data:
While integrating real-time data is the key to an effective ESG strategy, sometimes companies with global supply chains find it hard to keep a track of data from their suppliers overseas. One suggested way to overcome this challenge is by collecting all the data on a company’s platform along with setting clear benchmarks for keeping consistency in reporting.
2. ESG regulations:
Different national and regional approaches to ESG regulations make it difficult for a company to operate its ESG strategy. Large companies with a global presence are sometimes unable to track the ESG performance of their suppliers due to impromptu regulatory changes by the government or financial conduct authority (FCA) – for such instances various AI and ML tools will instantly notify the company about any change and the ESG strategy can be modified accordingly.
3. ESG rating methodologies:
Another common challenge while implementing an ESG strategy is the ESG rating methodologies. With ESG being a new field, rating agencies are constantly making changes in the rating methodologies which makes the ESG indexes more dynamic than required. For such a challenge, a company could follow internationally recognized ratings such as CDP and Bloomberg which are followed heavily by market investors[14].
4. The real value behind ESG:
Due to a non-standardized procedure, several private equity firms find it hard to track the value that the implemented ESG strategy brings. Therefore, for such implementations, ESG consultants and specialists are required who would establish a reporting framework and align it with the portfolio of the firm.
Measuring the ultimate success of an ESG strategy
There are various steps that can be taken to measure ESG performance. First and foremost is to improve data collection and enhance the reporting of the same. The non-financial data reported will become an integral part of the financial reports.
Benchmarking across sectors compares companies in the same industry and shows the leaders in respective industries. Scoring methods is another initiative that is adopted by companies to measure their ESG performance. In this approach, the raw data is collected, ranked by performance, and gives an overall view of the way a company is performing. While the company has one overall ESG score it still has sector-specific scores shown.
It is crucial that third parties are educated on the core values of the ESG practices. The ESG due diligence should also incorporate the third-party supply chain with evidence of impact risk assessment for full transparency of any potential issues. An integrated approach combining ESG strategy, process, technology, and data should be considered across the supply chain to guarantee alignment across the firm. Supply chain resilience, compliance and sound relationships with suppliers are critical for a company’s successful ESG strategy.
Certain companies have taken initiatives towards integrating ESG and human rights as another step towards measuring the success of an ESG strategy. They may have a special guideline on Supplier’s Code of Conduct which details the requirements for its supplier and partners to incorporate. Some companies have also linked employee compensation with ESG goals especially for improving carbon neutrality, financial inclusion and gender pay parity throughout its global supply chain.
Reporting and communicating ESG performance
Communicating a company’s ESG performance is a great way to build a rapport with customers, partners, sustainability experts, regulators and journalists, and helps improve employee retention and a company’s reputation. ESG reporting should become a fundamental part of the company’s story, should be authentic and transparent to build trust among all stakeholders, and find a unique ESG value proposition. A company’s ESG needs to be interwoven with business values and objectives along with making it a part of employee policies. Along with this, a company could participate in various net zero initiatives that can help in building good collaborations with other ESG related stakeholders. Communicating your ESG performance and what you mean by long-term value shouldn’t be a once-a-year exercise, but rather a year-round effort.
To extensively integrate sustainability into financial markets, businesses need to incorporate the ESG information into all communications with investors. Companies can use a tool established by the United Nations Global Compact and the Principles for Responsible Investment (PRI) to better measure and communicate the financial effect of their sustainability strategy and also, help investors integrate sustainability data into their existing investment processes[15]. The value driver model helps in utilizing the business metrics of a company to illustrate the ways sustainable activities will contribute to overall performance.
Summing up, companies can differentiate themselves through communicating their ESG performance, demonstrating their value to society in the long run, and building confidence from stakeholders. At this stage there is no one-size-fits all formula for moving towards this positive change, however, a timely, accurate, and transparent presentation of material environmental, social, and governance issues is the most efficient way to start.
Reviewing and improving the ESG strategy
A company’s ESG strategy is not a one-time practice but rather companies need to review and improve their ESG performance in a timely manner for sustainable growth. ESG compliance checklist serves as an important document to evaluate whether the obligations have been completed by a company.
ESG review is essential in any company since it provides various insights into the ways ESG strategy has developed in the company’s structure and the products or services it provides. Adopting newer technologies such as data analysis and AI can process large sets of data from different sources across supply chains and further communicate the improvements that are needed in a company’s ESG strategy.
There are various frameworks and reports available on ESG monitoring and improving the strategy for a better impact. For example, the guidance issued by the UNPRI on ESG monitoring, reporting, and dialogue in private equity supports an exchange of information, based on dialogues, that keeps Limited Partners (LPs) informed about the ESG aspects of their private equity investments and their General Partners’ responsible investment practices[16].
Final thoughts on ESG Strategy
Today, businesses are at a crossroads. In addition to focusing attention on unanticipated pandemic consequences on workforce stability and supply chains; ESG demands board attention. To mitigate this risk, boards must collaborate with executive teams to develop a well-thought-out ESG strategy, with ongoing monitoring of execution and structural changes.
Having taken the above-mentioned strategies into consideration when establishing the core principles of your business’s ESG strategy, remember to report against at least one internationally recognized framework if not a combination of multiple frameworks.
Along with this, syncing the ESG report with the company’s financial reporting calendar will do justice to your ESG strategy as investors focus on both.
Finally, an ESG strategy must address the needs of all the stakeholders while also contributing to the company’s vision, mission and performance. Recognizing this is crucial to the design of a successful ESG strategy as ESG has already made it big, and it is only going to grow!
Speak to the experts
A company may be required to comply with regional or country-specific benchmarking regulations based on the location and size of your asset. The immediate change in any regulations or the establishment of new ones can lead to ESG risks. As a result, developing an ESG strategy to respond to and manage such risks is critical for businesses, and External consulting or platform tracking tools such as RegASK Horizontal Scanning Tool can be beneficial and provide the company with the right expertise.
Our ESG Horizon Scanning Compliance Platform is an advanced version of machine learning technology used for driving real-time ESG Data. The platform detects trends and signals in the ESG subjects that have been identified in the scope and will immediately notify you about such regulatory changes by scanning an array of sources such as latest news and insights, industry-specific websites, academic papers, and government and international websites.
RegASK also uses local regulatory affairs teams and a network of specialists as part of its advanced capabilities to deliver in-depth ESG intelligence as needed. To know more about the platform, contact us for a demo to ensure you choose the right path for developing an ESG strategy.
References:
[1] A practical guide to ESG integration for equity investing
[2] The GRI perspective: A business case for environment & society
[3] Measuring Stakeholder Capitalism: Towards Common Metrics and Consistent Reporting of Sustainable Value Creation
[4] Responsible Investment Strategies – EUROSIF
[5] Responsible Investment Strategies – EUROSIF
[6] From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance
[7] Sustainable Signals: Individual Investor Interest Driven by Impact, Conviction and Choice
[8] Managing ESG risk in the supply chains of private companies and assets
[9] Roadmap for Integrated Sustainability | UN Global Compact
[10] Managing ESG risk in the supply chains of private companies and assets
[11] Managing ESG risk in the supply chains of private companies and assets
[12] Frontiers in Service Science: Integrating ESG Measures and Supply Chain Management: Research Opportunities in the Postpandemic Era
[13] The ESG Reporting Journey: Take the first steps before it’s too late
[14] ESG Investing: Practices, Progress and Challenges
[15] The Value Driver Model: A tool for communicating the business value of sustainability
[16] ESG monitoring, reporting and dialogue in private equity: At a glance
