By Moira Conlon and Leigh Ann Johnston for CFO Magazine
We often say today’s best practices are tomorrow’s requirements. Environmental, social, and governance (ESG) initiatives are no exception. Today, most large-cap leaders have well-established ESG programs and are evolving their approach and finding new ways to attract sustainability-focused investors. At the same time, many mid- and small-cap companies struggle with how to even begin to organize their ESG journey.
ESG is a complex and far-reaching topic. And often, when you peel back the onion, you end up with more questions than answers. For newcomers to the ESG game, we find it’s often most helpful to start with what ESG isn’t. ESG is not philanthropy, a sales pitch, a program of the month, a one-and-done, or your paper cup recycling program at work. It’s also not something that applies only to companies that are doing something good for the planet or household names that are highly visible to consumers. Perhaps most importantly, it’s not something that is only relevant to companies of a certain size or in a certain industry.
Put simply, ESG is a set of factors that position a company to create long-term, sustainable value for all stakeholders, and can be used by institutional investors in making investment and voting decisions.
ESG has been around for a long time. What is new, however, is the recently accelerated adoption of widespread reporting on ESG principles and practices. This is due to the confluence of many factors, including the shift to passive investing, COVID, social injustice issues, the Great Resignation and talent shortage, and the transition of power, money, and jobs from the baby boomers to millennials and Gen Z.
The Shift to Passive Investing
For many years, large, passive institutional investors have been among the most vocal stakeholders in the ESG conversation. Why? By definition, they are long-term holders of your stock for as long as it is in an index.
Over the past decade, we have seen a massive shift to passive investing, with passive investors now owning anywhere from 20 to 50% of the average public company. Today, passive investors include some of the world’s largest investment firms, such as BlackRock, State Street, and Vanguard. These firms are in the top 10 list of institutional holders for most public companies today. And while they can’t sell your stock, they can demand reporting on ESG, vote against you, and partner with activists to drive change. As it turns out, they may be passive investors, but they are not necessarily passive owners.
Leigh Ann Johnson
Long-term, actively managed institutional investors are also demonstrating a growing interest in ESG. Many of these active institutional managers have launched ESG and sustainability funds to follow the money in the greatest wealth transfer unfolding right now. The pressure is on because younger generations care a lot about ESG issues. They want to buy products, work for, and invest in companies that share their values.
The pandemic was a turning point. For many companies, a new set of priorities emerged beyond creating shareholder value. They had to pay closer attention to their employees, customers, and communities to weather the storm. Social issues and diversity, equity, and inclusion were into the forefront, and the Great Resignation and talent shortage followed this period of social upheaval.
Against this backdrop, ESG has gone mainstream, and it is here to stay. There is growing recognition that ESG and an all-stakeholder approach to managing a business is a competitive advantage in attracting capital, talent, customers, acquisition partners, and other stakeholders. Board oversight of ESG is also front and center with executive compensation increasingly being tied to execution against ESG goals and metrics.
Reporting Standards Are On the Way
One of the biggest challenges around ESG — and a reason that many mid- and small-cap companies have delayed their ESG journey — is the lack of a reporting standard. There are currently no requirements for companies to report on ESG, and companies use a variety of frameworks ranging from the Sustainable Accounting Standards Board (SASB) to the Task Force on Climate-Related Disclosures (TCFD) to report on their progress. Companies in different industries rely on different frameworks to report on ESG factors that are material and relevant to them. This makes it challenging, if not impossible, for institutional investors to compare a company’s ESG risks and opportunities on an apples-to-apples basis.
That is about to change. Last May, the IFRS Foundation’s International Sustainability Standards Board (ISSB) announced plans to establish a global baseline for ESG disclosure by the end of 2022. Additionally, last March, the SEC announced proposed climate disclosure rules that would require public companies to disclose climate-related risks, performance targets and goals, greenhouse gas (GHG) emissions, and how the board and management oversee climate-related risks.
Yes, ESG Expectations Apply Even to You
Gone are the days when companies could easily opt out of ESG, assuring themselves the new world order of sustainability practices wasn’t relevant to them. The message is becoming clear that having some sort of an ESG program is now table stakes.
Is your company still sitting on the ESG sidelines?
- Doing nothing is no longer an option. Remember that every company, regardless of size or industry, has an ESG story.
- Think of ESG as a journey, not a sprint. Start smart, beginning with the obvious steps and what is realistic and appropriate. Consider the initiatives you already have in place that qualify.
- Don’t rush into providing ESG metrics right out of the gate. Credibility matters and promises about carbon reduction in 2040 could easily backfire.
- Remember there are two parts — developing your ESG narrative and then effectively communicating it.
- Get the right cross-functional team and resources in place to tackle the project and assign a point person.
Getting started is the hardest part. But once you get in the game, you’ll discover many opportunities to refine an approach that reaps considerable benefits for your company and all of your stakeholders.