The COVID-19 global pandemic has exposed the fragility of our global systems. It has exacerbated economic and social inequalities and is unfolding at the same time as the climate crisis that is no longer merely a threat to humanity, but a reality we must live with. Leaders from every sector—government, business, civil society—find themselves at a crossroads. Seizing this historic opportunity to rebalance our world for the benefit of all will require strong mobilization of the private sector, which has a decisive role to play.
According to a recent publication by the WEF, to continue to thrive, companies must “build their resilience and enhance their licence to operate, through a greater commitment to long-term, sustainable value creation that embraces the wider demands of people and planet”. This means having a net positive impact, not only on shareholder financial capital, but also on human, social, and environmental capital.
“Our system is more than two centuries old. Our problems have changed, so our response must change too.”
One way for companies to demonstrate their contribution towards creating more prosperous societies within planetary boundaries is by reporting on Environmental, Social, and Governance criteria (ESG). These criteria constitute a set of standards for a company’s operations that socially conscious investors use to screen potential investments. ESG metrics provide an alternative method to assess a company — rather than looking at its balance sheet, ESG metrics examine how a company impacts broader society.
In terms of demand, consumer expectations have changed considerably. There’s increasing demand for ‘green’ products, and customers are willing to pay a premium for ‘socially responsible goods'. As for supply, investors increasingly expect businesses to embed environmental and social metrics into their value chains. BlackRock, the world’s largest asset manager, recently discussed the fundamental reshaping of finance in an open letter published by their CEO, Larry Fink. Fink warns the business community not to overlook purpose, long-term strategy, and climate change. With the expectations surrounding ESG, and the current global pandemic, it seems clear that companies are under growing pressure to implement transparent ESG dimensions within their business model.
Although investors are increasingly interested in ESG metrics, reports and rating methodology, scope and coverage vary significantly between providers, which has led to a lack of standardized metrics.
A decade ago, ESG information was of interest to only a small segment of the investment community. Yet today, most institutional investors use ESG research to some extent, primarily due to the increasing awareness that this data has real value and can generate better investment outcomes in enough cases to make a material difference to investors. According to the Global Sustainable Investment Alliance, over the past two years, the ESG market has grown from $22 trillion to $31 trillion, representing 15 percent of all investable assets in the world and equivalent to more than a third of professionally managed assets. Furthermore, ESG factors also affect a company’s reputation and business leaders as well as investors are recognising the potential costs of not managing firms’ ESG risks.
However, creating the ratings is challenging work. There are no uniform requirements for reporting ESG information, and frequently the environmental and social impact is tricky to quantify. Hence, the data input is fundamentally less structured, less complete, and of lower quality than the audited financial data companies must present in a standardized form. The lack of rules and robust metrics creates a challenging situation, but also represents an opportunity to generate insight that investors have previously neglected.
Nevertheless, many corporate leaders fail to truly grasp where they should focus their attention on ESG, and how they can communicate their efforts. Many executives incorrectly believe that simple actions will suffice, such as improving ESG disclosures or releasing a sustainability report. According to George Serafeim, corporates tend to fit into two main categories for ESG integration: “box-ticking corporates” and “action-driven corporates”. However, external pressures such as increased consumer expectations, social unrest and government intervention are likely to push more companies to become “action-driven corporates”. In a world that increasingly judges them on ESG performance, companies are increasingly aware of the risks (and costs) of inaction. There has also been widespread debate on whether these metrics should be industry-agnostic or industry-specific, given the differences between different sectors of the economy. The question is: would state intervention be appropriate in the global endeavor to standardize these metrics? Some argue that state intervention could accelerate this transition via new legislation, regulation, and other compliance mechanisms.
Getting ahead of the curve:
Why ESG Issues Matter
A crucial reason for businesses to integrate ESG criteria is that human beings, in or outside corporate settings, have a civic responsibility and moral obligation to behave in prosocial ways. Many have argued that companies have been focusing on short-term profit maximization for too long. This profit-driven approach has led to a dysfunctional and obsolete economic system. Companies must understand that their purpose is not merely to make money but, more importantly, to serve the community and satisfy societal needs sustainably. Doing this requires properly valuing the impact of economic activity on natural, social and human capital.
Apart from the moral argument, focusing on ESG issues provides very tangible benefits. And this extends far beyond benefits such as greater productivity due to higher employee involvement or sales increases due to more loyal and satisfied customers.
First, research suggests that an ESG focus can help management reduce capital costs and thus improve the firm’s valuation. As more and more investors look to invest in companies with more robust ESG performance, larger amounts of capital will become available. Second, positive action and transparency on ESG matters can help companies protect their valuations during the shift where more global regulators and governments mandate ESG disclosures.
Indeed, there are strong reasons to believe that, sooner or later, governments will make ESG disclosures mandatory for companies that operate within their territories. The Principles for Responsible Investment (PRI), a United-Nations-supported international network of investors, is an excellent example of this trend. The PRI initiative aims to help understand the implications of sustainability for investors by offering a vast array of possible actions for incorporating environmental, social, and corporate governance issues into investment practices across asset classes.
One of the PRI initiatives – “The Inevitable Policy Response”, argues that as the realities of climate change become increasingly visible, governments will be forced to act more decisively than they have done so far. According to the PRI, “the question for investors now is not if governments will act, but when they will do so, what policies they will use and where the impact will be felt”. This echoes what Larry Fink, BlackRock CEO, mentioned in his annual letter in 2020: “I believe we are on the edge of a fundamental reshaping of finance”. If businesses want to be ahead of the curve and remain competitive, anticipating upcoming regulation to avoid financial losses and mitigate risk, may mean they are better off in the long-term.
Standard setters & Ground-Breaking Initiatives:
“In business, what you can’t measure, you can’t change”. The systemic change required will not happen overnight. This process takes time, but the sustainability issues facing people and the planet are urgent. In light of this reality, several ground-breaking initiatives have been launched over the past few years. On September 20, 2020, the World Economic Forum (WEF) published a report of the CEOs of 120 companies in its International Business Council (IBC) entitled “Measuring Stakeholder Capitalism: Towards Common Metrics and Consistent Reporting of Sustainable Value Creation.” The report suggests 21 ‘core’ metrics in the categories of People, Planet, Prosperity, and Principles of Governance, with an additional set of 34 ‘expanded’ metrics in the same categories.
The purpose of this report was to develop a roadmap on how companies could demonstrate how they are serving the interests of a broad group of stakeholders beyond investors. During the same month, five global organizations – CDP, Climate Disclosure Standards Board (CDSB), the Global Reporting Initiative (GRI), the International Integrated Reporting Council (IIRC), and the Sustainability Accounting Standards Board (SASB) co-published a shared vision of the necessary characteristics for more comprehensive reporting and a statement of intent towards this goal. The fact that this came out at the same time as the WEF report indicates a serious commitment from all organizations involved to contribute towards convergence.
Another ground-breaking initiative, the Impact-Weighted Accounts Initiative (IWAI), incubated at Harvard Business School, was launched in 2019. It has been described by Sir Ronald Cohen, chair of the IWAI, as a system capable of measuring a firm’s environmental and social impacts (both positive and negative), converting them to monetary terms, and then reflecting them in financial statements. Though the science to do this has yet to be perfected, such a system holds great promise for three reasons: it would translate impacts into units of measurement that business managers and investors understand, it would allow for the use of financial and business analysis tools to consider those impacts, and it would enable an aggregation and comparison of analyses across types of impact that would not be possible without standardized units of measurement.
The Impact-Weighted Accounts Initiative is collaborating with the Global Steering Group for Impact Investing and the Impact Management Project on a simple approach: adjusting traditional accounting measures to consider the various types of impact that ESG actions might have. These include product impact, which affects revenue numbers; employment impact, which affects employee expenditures on the income statement; and environmental impact, which affects the cost of goods sold. For example, positive product impact could mean more revenue for a company and potentially higher growth. Positive employment impact (measured by, for example, resources spent on employee training) would send investors a strong signal that management views employee expenditure as investments that lead to future profitability and not merely as another expense. Negative environmental impact might raise the cost of goods sold, by triggering new and restrictive regulations. Valuing a company’s effects on people and the planet—and integrating that into traditional financial analysis—will offer a more comprehensive picture of actual corporate performance.
It is a basic management principle that you can’t manage what you can’t measure. Both reliable and accurate data are essential to achieving real change; not only do they create transparency and trust, but they also shed light on future opportunities. This is why standardized impact measurement is so important and will play a huge role in promoting systemic change.
