ESG (Environment, Social, and Governance) continues to be a hot acronym and trending topic for Boards and organisations. But there still is some confusion as to what it is and how Boards should respond.
In this article, we provide an overview of ESG and reasons why it should make its way into boardrooms everywhere.
WHAT IS ESG?
ESG criteria are a set of standards for a company’s operations that socially conscious investors use when deciding on potential investments. ESG hones in on – and measures – sustainability.
This CDC Group paper breaks down the definition of the acronym.
The ENVIRONMENT component monitors how a company performs as a steward of the natural environment. Examples of this would be:
- Using energy efficiently;
- Using renewable energies that contribute less to climate change;
- Managing waste responsibly;
- Having responsible practices across the value chain such as no deforestation policies or overseeing animal welfare;
- Disclosure of information
The SOCIAL criteria looks at how a company manages its relationships within the entirety of its ecosystem, e.g. employees, suppliers, customers, and the communities in which they operate. Examples of this would be:
- Diversity and inclusion policies to ensure no type of discrimination;
- Safe and healthy working conditions for employees;
- Labor standards across supply chains that guarantee fair wages and human rights protection;
- Good relations with local communities who give social license for companies to operate;
- Disclosure of information
GOVERNANCE tackles company’s internal processes and leadership. It looks into issues such as executive pay, audit and internal controls, and shareholder rights. Other examples include:
- Corporate risk management (e.g. security);
- Executive compensation;
- Board pay, diversity, skillsets;
- Donations and political lobbying;
- Corruption and bribery;
- Board structure and brand independence;
- Protecting shareholder interests;
- Disclosure of information
DIFFERENCE BETWEEN CSR AND ESG
Corporate Social Responsibility (CSR) and ESG are often used interchangeably, but they are two different concepts for two different target markets.
CSR is internally driven with a focus to give back to the local communities in which the company operates and/or serves. It’s about engaging stakeholders (i.e. consumers, employees, clients, communities).
Examples of CSR initiatives would be sponsorships of community initiatives, volunteer hours, etc.
Therefore the target market of CSR initiatives is the company’s stakeholders.
ESG has a broader purview. ESG, as best explained by this You Matter paper, is used by investors in capital markets to assess corporate behavior and to evaluate the future financial performance of corporations by measuring their sustainability. Investors look into how ESG can impact profitability and the company’s financial value in the short and long-term.
The target market of ESG initiatives are capital markets (e.g. shareholders, bondholders, financial regulators, rating agencies, etc.)
To put it succinctly, “CSR is focused on values, while ESG is focused on value.”
IMPACT OF ESG ON COMPANIES
ESG issues are no-longer optional concerns that Board and leaders can afford to neglect. Companies who “get ESG right” properly identify ESG-related risks and opportunities and integrate them into their narrative for long-term value creation.
a. Proactive Approach to ESG
It is important to note that the emergence of a more socially conscious society has bled into employee, consumer, and investor behaviours. Many seek out “purpose-driven” companies whose values align with their own. That doesn’t necessarily mean they overlook financial performance and long-term value.
Companies with solid ESG performance and strategies tend to mitigate future business risks. They keep watch over trends and changes, allowing them to respond and adapt more quickly to disruptions. These companies are also likely to have a more stable and loyal investor base. Studies have reflected gains in customer purchasing behaviour and employee engagement as well – critical components of competitive advantage and profitability.
Strong ESG performance can lead to the following opportunities:
- Enhanced brand reputation;
- Improved stakeholder relations;
- Attracting human talent on the merits of responsible practices;
- Increased access to markets and investors who demand robust environment and social management;
- Innovation to move into new markets and products;
- Increased operational efficiency (e.g. resource conservation, energy conservation, etc.);
- Avoidance of penalties for non-compliance;
- Reduced insurance premiums
An interesting example is presented by PwC . It describes what a proactive ESG frontrunner looks like:
“Take, for example, a logistics company. Shipping and delivering goods is carbon intensive, and labor intensive. By relying solely on traditional forms of energy, the company risks losing business due to inefficiencies, or facing rising costs when oil prices rise. The company could be targeted as a carbon polluter and face negative attention from consumers. These are ESG risks, but really, they are business risks.
So the company invests heavily in electric vehicles to reduce their carbon footprint – and as renewable energy sources continue to become more readily available and cost efficient, the company can capitalize on alternative sources of fuel, rather than being overly dependent on oil products.
The business is also labor intensive. The company is exposed to risks of labor shortages or disruptions, and its employees face additional risks, like injuries from driver collisions. So the company is investing in the development of driverless technology, in new technology available in delivery drones, and in collision mitigation systems in vehicles. These investments then pay off as deliveries become faster and more efficient."
b. Complacent approach to ESG
Skeptics of ESG believe it to merely be a soft/branding initiative that is disconnected from core business processes. But nonetheless, a complacent approach to ESG presents significant risks.
ESG related failures may result in events such as consumer boycotts, employee walkouts, or adverse proxy votes by institutional investors. Lawsuits can arise from inaction on issues such as unfair employment practises or cyber-attacks and security breaches.
Other risks include:
- Reputational damage to the company and individual directors;
- Reduced access to markets, clients, and investors;
- Increased cost of doing business;
- Reduced production efficiency and product quality;
- Negative financial consequences (e.g. penalties, fines, loss of revenue);
- Higher staff turnover;
- Negative operational impacts (e.g. employee strikes);
- Community unrest (e.g. protests, sabotage);
- Environmental liabilities for the company;
- Individual director liabilities;
Examples of ESG factors that resulted in significant financial implications for firms are cited in this ESG paper by ESG Global Advisors:
"Wynn Resorts – In January 2018, allegations of sexual misconduct by the CEO, Steve Wynn, were followed by a 10% stock price decline and his eventual resignation in February 2018. While the company had policies in place on sexual harassment, an alleged lack of board oversight and enforcement of these policies allowed it to become a material ESG factor.
Energy Transfer Partners – From 2014 to 2017, opposition from the Standing Rock Sioux Tribe to the proposed Dakota Access Pipeline resulted in global media attention, protests related to environmental and social concerns, and significant delays. While the company adhered to laws and regulations, the total cost of the project ballooned to an estimated $7.5 billion, with the company’s stock price declining by 20% over the period of the protests.
Facebook – In 2019, the Federal Trade Commission imposed an unprecedented $5 billion penalty, as well as operational and governance restrictions on the company, to settle its investigation of data privacy breaches. While the company had policies in place to protect user data, a lack of compliance led to a digital privacy breach affecting 87 million users.”
ESG AND THE BOARD
It becomes evident that poorly managed ESG activities can lead to crisis situations. To prevent these from happening, the Board needs to take an engaged, proactive, future-thinking approach in the development of ESG strategies. The following are suggestions to help Boards stay on top of ESG issues.
a. Insist that ESG be addressed at the Board level
- Ensure that ESG concerns have a place in the Board’s agenda.
b. Integrate ESG issues into every Board-level decision
- Not only does this mitigate significant business risk, but this also signals to the organisation (especially management) that sound ESG strategies are to be made a priority – and to be weaved into – company culture.
- The Board should approve ESG company policies. Policies are important to compliance assessment, especially when a company has contractual, legal, or regulatory obligations towards ESG standards.
c. Track, communicate, flag ESG risks and/or initiatives
- As per the CDC Group, it is best practice to have a quarterly report on key ESG issues and metrics from the internal audit, compliance, and risk function to report to the relevant Board committee(s). The full Board can then be informed and act on items that need approval or follow-up.
- Companies also should have a process for flagging key issues and escalating them to the committee chair(s) -- especially if they can potentially impact short-and-long-term performance, reputation, and value. In any of these cases, the Board is updated and can act swiftly and accordingly.
d. The Board may want to link remuneration to ESG performance via “SMART”(i.e.specific, measurable, attainable, relevant, and time-bound) key indicators
- This creates a culture of accountability for ESG issues for the Board and management.
ESG can no longer be merely on the periphery of issues for Boards. There is much at stake. Sustainability issues are becoming core concerns not solely for ethical reasons, but because they affect the company’s competitive positioning and value. ESG should, therefore, be part of the overall company strategy and integrated into the organisation with board oversight – just like any other strategic initiative that addresses long-term value creation.
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Carissa DuenasCarissa Duenas is a marketing consultant and content contributor for Praxonomy. She began her management consulting career at Accenture and has since worked in a consultant capacity for leading organisations in the technology sector and communications space. She is a contributor to The Globe and Mail, Canada’s leading national daily.