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, the owners, 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.
What are ESG principles?
You may think ESG (Environmental, Social and Governance) principles are only for investors and big business, but they’re not. Small companies have investors even if it’s just the owner and staff that need to feel they have a sense of purpose too.
The world has witnessed three previous major industrial revolutions which have harnessed emerging technology to change the way we live and work. The First Industrial Revolution used steam and water to mechanise industry. The second witnessed the invention of electricity and mass production. And, the third was the age of computers and information.
And that includes business. Business is often seen as corrupt or evil, its only interest being itself, its profits, its shareholders, not so much its customers and employees. But that is changing fast too. We’re all too connected now for anything to exist for itself.
Looking after the planet upon which your business operates. For most of us, no all of us, that is still earth. The days of our world being seen as an unlimited resource for us to plunder are over. Where does your energy come from, or the resources you use to serve your customers? Is the planet being sdepleted every day you are in business?
Economy-Wide Material Flow Accounting and Analysis (EW-MFA).
Increasing Global GDP (Gross Domestic Product) increases global material use, production, transportation and disposal that becomes unsustainable without impacting on the natural world, climate systems and biodiversity. So it’s necessary to harmonise national economic and environmental goals.
The measurement and analysis of raw material use on the national level is called Economy-Wide Material Flow Accounting and Analysis (EW-MFA).
Whilst reducing or replacing the energy we use to limit global warming is important, this is only an indirect contributor to global warming. If we use and make less and reuse more of what we have, less energy is needed and fewer resources are extracted from the ground in the first place. This would include fossil fuels but also the resources to make the products or deliver the services. A circular economy where products are made to be recycled can help to reduce resource consumption.
What is the Circular Economy (CE)?
In the circular economy products are designed to use the minimum amount of toxic and natural resources during production, transportation, usage and disposal. In doing so maximum utility is given to re-use, recycling, repair and refurbishment so that the most efficient use of the original material is achieved and minimal environmental damage is created. Ideally the original material would be used an infinite number of times, but the energy required and the associated environmental impact needs to be considered. With a clean energy source this becomes more practical. This replaces the linear economy using the Take-Make-Dispose approach, as opposed to the Make-Use-Return of the circular economy. Phillips, as an example, creates "productive loops" to maintain the value of their products, parts and materials while minimising waste and the extraction of natural resources.
New circular business models would include products being used as a service, not owned, then returned to the manufacture for re-use, recycling or refurbishment, or appropriate disposal, the costs of this being part of original purchase price.
The social principles are all to do with you how you treat your staff, your customers, partners and suppliers, anybody who comes into contact with your business. Think of all the things you think you should be doing or would like to do, and you’ve about got it – paying people on time, recognition, training, coaching, personal development, equal opportunities, being fair and equitable with everyone, this can all help with employee engagement.
The governance principles are all about the management structure, in the main those of the directors, owners and shareholders. It is also about the business’ transparency and ethics. It points towards creating a positive culture with the correct values and fair compensation.
So all this makes perfect sense, there’s not much you can disagree with there. These things aren’t generally considered as they don’t help to improve the bottom line when a business is run like a machine when it is very transactional. These things will start impacting your bottom line when they become essential to your customers, employees and suppliers.
How do companies benefit from ESG principles?
When Marks and Spencer implemented “Plan A” for their customers to have a positive impact on wellbeing, communities and the planet they saved $200M annually. Coca-Cola created a competitive advantage when it reduced the amount of water used with its sustainability approach.
All companies of any size can benefit from thinking about how they can operate more efficiently. Working more efficiently increases productivity and profitability, which becomes a competitive advantage.
Your company’s purpose, values and beliefs should be reflected in all that you do. Just considering ESG principles in your decision making is enough to get started. If your staff follow suit, then you’re on your way, nothing will develop a positive working culture better than a shared sense of purpose.
How investors are integrating ESG principles
Investors will consider these aspects of your business too. They’ll want to see you can make a profit while addressing these ideas, especially when your investors are thinking long term. There is not a single way of integrating ESG into your business. Zurich looks at ESG Integration with training, providing information, reviewing processes and the active involvement of the owners.
Is Corporate Social Responsibility (CSR) the same as Environmental, Social and Governance (ESG)?
People are sometimes confused as to the difference between CSR and ESG as the two encompass the same topics. But the fundamental difference between CSR and ESG is the perspective from which it was taken. CSR is more about the activities that businesses must do to build relations with stakeholders, while ESG is taken from an investor’s point of view by taking into consideration non-financial factors as well as financial factors in investment decisions.
Source: SK hynix Newsroom
Sometimes, though, in some businesses’ implementation of CSR, the term greenwashing has come into existence. Greenwashing means that companies mislead people into thinking that they are environmentally conscious but in reality they are not making any efforts to be sustainable.
The triple bottom line
Today companies should aim to adopt triple bottom line business growth, so not just growth in profitability but also in the value created for people, society and the planet.
Both people and the planet are essential inputs for business success, so long term business growth requires that these valuable business resources be both cared for and developed to create stronger long term, sustainable business growth. So the triple bottom line measures business profitability, people performance and the sustainability of the planet.
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.
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