Consumers, investors and employees increasingly want companies to be more socially and environmentally responsible.
Why is this an issue for finance directors and CFOs?
Because ESG is undeniably a financial matter.
Done right, environmental, social and governance performance can reduce costs and create value.
Done wrong, it can cost sales, investments and soon even raise costs like insurance rates.
This means ESG should be at the forefront of every finance director's mind, which is precisely what we’re looking at in this article.
What is ESG and Why is it Important?
ESG stands for environmental, social and governance. This criteria is used by a range of external stakeholders to assess the good a company does, whether that be for its staff, the wider community or the planet. We'll look at each section a little more in depth.
Environmental criteria could include things like a company's energy use, water use, waste, pollution or even treatment of animals in some instances.
Social criteria looks at the company's business relationships. This could be to examine the suppliers it uses to ensure they meet the ethical standards they proclaim to value. It could also be whether the company donates to local community non-profits or allows employees volunteer days.
Social criteria also applies to how the business treats its employees, so this would include working conditions, diversity, equal pay and so forth.
Governance criteria looks at how ethically a company is run. This includes the relationships between a company's board, shareholders and stakeholders. For example, if a company had a conflict of interest apparent for a board member, this would be an ethical issue and poor governance. Broadly, governance refers to how a company decides to run things and how it may affect others.
Many companies, particularly larger companies, are doing their best to improve these criteria and their standards in order to attract more customers and more investors. The facts speak for themselves here:
- 92% of consumers are more likely to trust a company that supports social or environmental issues.
- 88% of consumers are more likely to be loyal to a company that supports social or environmental issues.
- 58% of employees consider a company's social and environmental commitments when deciding where to work.
- 68% of investors have integrated ESG into their decision making.
This shift in focus towards companies with strong ESG criteria is representative of a wider shift in the purpose of business. While the purpose of business was once thought of to be to make a profit for shareholders and stakeholders with little regard to anything else. Over more recent years, the purpose of a successful business is more than that. They cannot only serve the top dogs, but must also serve their employees, communities, suppliers and the planet.
We’ll examine this in more depth.
ESG is Important for External Stakeholders
Once upon a time, investors only cared about revenue, profits, costs and so forth. But it is no longer the case.
For some investors, it is simply a matter of ethics. But for many more, it is because companies with a robust ESG framework are a better investment than companies who fail to address pressing issues like diversity and emissions.
Insurance companies are facing an increase in climate-related claims. As such, rates and premiums are increasingly linked to environmental performance and carbon targets. In a similar vein, it’s also believed that soon financing rates may be directly linked to ESG performance as part of the appraisal process.
For example, Asian bank DBS, converted Swire Pacific’s existing five-year revolving credit facility into a sustainability linked loan. Swire Pacific can then reduce the interest rate payable by meeting ESG goals in areas like energy consumption and diversity.
As it is the responsibility of the CFO or FD to deal with these external stakeholders, this means ESG is no longer a concern for PR and marketing.
This is great news for businesses. Without the financial guidance of the FD, ESG implementations and frameworks may lack results. If they are thought of merely as a PR exercise to keep the general public at bay, chances are they will bring less value to the business.
Whereas if ESG frameworks are tracked and measured, with results quantified and analysed, they can not only please external stakeholders and consumers, but create value for businesses.
How Can ESG Create Value?
We’ve mentioned investors already, but this is just the beginning of how a strong ESG framework can create value.
ESG goes some way in driving consumer preference. Research shows one in three customers buy from brands they perceive to be doing good for the environment, with further research suggesting that many consumers would also be willing to pay more for environmentally friendly products.
A solid ESG proposition can also help companies expand into new markets. Governing authorities are more likely to approve and aid sustainable and socially responsible businesses, while businesses can use it as means to attract new consumers within the new market.
A great example of this comes in the form of Neste. Originally an oil company, the business has moved onto sustainable practices and generates two thirds of profits from renewable fuels.
As we mentioned above, when implemented with purpose and thought, ESG can also reduce costs by combating operating expenses. Research also shows a significant correlation between resource efficiency and financial performance, with companies who had taken their sustainability strategies the furthest performing the best in this study.
Increase Employee Engagement With ESG Goals
For employees, an ESG framework can attract great talent, as well as enhance employee engagement and business productivity through creating a larger sense of purpose.
A study of top employers, measured by employee satisfaction and attractiveness to talent, have significantly higher ESG scores than other employers. This pattern is evident across environmental performance and more specific social and governance issues.
As Millennials and Gen Z slowly become the majority of the global workforce, ESG will become a more pressing issue for employers. By 2029, these generations will make up 72% of the global workforce. Both these generations, particularly Gen Z, place a far greater importance on environmental and social concerns than predecessors do and will expect employers to act accordingly.
Finally, a strong external-value proposition can ease regulatory pressure, reducing the risk of adverse government action and actually gaining government support. Many businesses are trying to keep up with new governmental policies, while businesses that stay ahead of this curve actively reduce risk.
Overall, ESG can pay off in a huge number of ways. But it must be tracked, measured and analysed, which is where the strategic skills of the finance director or CFO come in.
ESG Metrics and Reporting for FDs
ESG metrics are not mandatory in financial reporting across industries yet, but with another climate summit on the agenda and a goal of net zero carbon emissions by 2050, it is only a matter of time. Many forward-thinking companies are increasingly including ESG reporting within their annual report or in the form of a separate sustainability report.
As it isn’t mandatory, one of the main struggles for finance leaders currently is to define a reporting process standard. What this translates to is that a third of finance directors aren’t yet aware of their ESG reporting obligations.
But the CFO or FD has the unique skills necessary to successfully strategise to drive business performance and report on ESG targets.
When it comes to best practices, Michael Stanton, CFO of Diligent states:
“There’s a huge opportunity for CFOs to be ESG leaders… it's all about ensuring the company has the requisite infrastructure in place, the proper framework, top-to-bottom understanding, and the necessary systematic reporting and accountability so they can objectively measure, longitudinally, where it's starting, where it's heading, and what its gaps are.”
Investing in the correct technologies to give the most accurate data for the strategic planning of KPIs is a huge part of this. Companies need robust financial systems to gather ESG data, just as they have for collecting operational and financial data.
The NYU Stern Center for Sustainable Business has developed a Return on Sustainability Investment (ROSI) in an attempt to aid companies through this process. This five step process looks at:
- Identifying the current sustainability strategies
- Identifying related changes in operational or management practices
- Determining the resulting benefits
- Quantifying said benefits
- Calculating the financial value
Solutions like this and others are likely to become more commonplace as ESG frameworks increase in use.
The UK in particular is seeking to set itself apart from the rest of Europe as a sustainable investment reporting leader.
UK ministers made a stand back in November by refusing to align with the EU's Sustainable Finance Disclosure Regulation (SFDR). This is because the SFDR, while a step in the right direction, does not force disclosure of sustainability reports from companies. Businesses can choose not to comply without direct penalties.
Instead, the UK announced it would become the first country in the world to fully mandate climate disclosures for both businesses and financial institutions.
Experts believe this strict approach will spark a race to the top on ESG reporting regulations.
The good news from this is that sustainable reporting is likely to become far more standardised across the board. Investors have long complained that reports have been "greenwashed" to paint an unrealistically positive image. But as ESG reporting becomes increasingly mainstream, investors, financial institutions and the public are likely to demand more accurate and transparent information.
There are voluntary reporting frameworks currently in place. For example, the G20's Task Force on Climate-Related Financial Disclosures.
James Alexander, chief executive of the UK Sustainable Investment and Finance Association (UKSIF) said:
"We want the UK government to enhance sustainability disclosures, with strong taxonomies that drive us in the direction of net zero and that ensure leaders in ESG reporting can differentiate easily from those who are doing less. That will make us the world leader."
Of course, another issue rears its head for businesses that function in various international markets. To save lost time and resources, these businesses need a global standard of ESG reporting to avoid confusion.
The 'Big Four' accounting firms (Deloitte, PwC, Ernst and Young and KPMG) have launched their own international ESG metrics to attempt to align existing reporting standards. This was launched in partnership with the World Economic Forum (WEF).
Since the launch of these metrics last year, more than 60 of the world's largest corporations have committed to using them, including Dell and Mastercard. They're based on four pillars of governance, planet, people and prosperity.
What Can Finance Directors Do Now?
As you can see from the above, the lack of standardisation makes ESG planning and reporting a tricky thing to say the least.
This said, it is always worth making ESG a priority and using a process of continuous improvement to improve your reporting standards.
Finance directors can use one of the many global metrics mentioned above to begin tracking and measuring their ESG criteria.
For those with the time or resources, it may even be worth reporting against multiple ESG frameworks if ESG is of a high importance to your investors. Research what metrics your competition is using to benchmark where your reporting standard needs to be as a minimum.
A balanced ESG criteria sets both short-term and long-term goals, so both of these are worth considering in your strategy. Short-term goals can show the company is committed to making the changes necessary, while long-term goals show the forward-thinking necessary to realistically hit net zero by 2050.
Your ESG targets should be embedded into your company story. They're something to be proud of after all, something that sets the company apart as a thought leader. It represents a commitment to create value through more sustainable and ethical practices, as well as do better for the environment and society in the process.
The Future of ESG for Finance Directors
It’s clear the financial directors role has developed beyond finance function alone. A robust ESG framework is yet another way FDs can innovate and create value for businesses. Here they can be a key player in transforming businesses into profitable places that do better for people and the planet.