This may be stating the obvious, but running a business is more challenging than ever. Decades ago, CEOs worried about turning a profit; getting a good return on investment; and, if leading a public company, pleasing investors. But today’s corporate success demands that businesses reach environmental, social and governance (ESG) goals as well — and rightfully so. In many ways, ESG efforts are even more important than profits because they enable an organization to make a positive impact on the world.
ESG is a combination of three initiatives:
- E represents environmental issues. This includes how an organization uses resources and manages its waste, ultimately trickling down to its overall effects on the planet. Most recently, the major focus in this area has been carbon emissions and climate change.
- S stands for social responsibility awareness, addressing an organization’s relationship with, and reputation within, the communities in which it operates. Specific areas of focus include labor relations and diversity and inclusion.
- G is for corporate governance, meaning the internal system of practices, controls and procedures adopted in order to govern itself, make effective decisions, comply with the law and meet the needs of external stakeholders. This area includes topics such as transparency in corporate reporting, income tax practices, hiring practices and company culture.
ESG has been presented as a more tangible, more measurable version of corporate social responsibility. The addition of governance here is also noteworthy, particularly from a bottom-line perspective. One study found that a positive corporate culture improves company profits, but a poor culture can damage a company's reputation, results and recruitment.
Companies looking to improve their ESG performance have a variety of opportunities within each of these categories. Environmental concerns can be found in product and process design. For example, automobile manufacturers are shifting to more eco-friendly battery-operated electric vehicles. The electricity industry is working toward sourcing more energy from renewable resources instead of fossil fuels. Product packaging also is being designed to be more recyclable.
The social responsibility area is focused largely on employees, both within the company and along its supply chain. Suppliers are expected to not employ child labor or tolerate unsafe working conditions. Retail customers are expected to use responsible advertising and provide prompt and professional service to the ultimate customers.
As for governance, executives and boards of directors must ensure that organizations are run in an ethical manner, including diversity of the workforce, paying workers fairly, dealing with suppliers and customers in a transparent manner, accurately reporting financial results, and collaborating with government agencies in a professional manner.
How ESG opportunities can pay off
As with the triple-bottom line — which considers people, planet and profit — companies have to consider the costs of their ESG investments and determine if they make financial sense for the organization. Although the answer will vary based on the type and size of the organization as well as the type of initiative, overall, ESG efforts have been shown to improve an organization’s financial results.
A report from McKinsey & Co. determined that ESG links to cash flow in five important ways, namely:
1. Facilitating top-line growth by attracting more customers with more substantial products and achieving better access to resources through stronger community and governmental relations
2. Reducing costs by lowering energy consumption and water usage
3. Minimizing regulatory and legal interventions, which in turn helps companies achieve greater strategic freedom through deregulation and earn subsidies and government support
4. Increasing employee productivity because the positive company culture attracts a higher caliber of employees and keeps worker moral high
5. Optimizing investment and capital expenditures because capital is better allocated for the longer term and investments that might not pay off because of environmental issues are avoided.
Challenges of ESG initiatives
Despite these ties to financial benefits, balancing financial objectives and ESG objectives still is a top concern for many executives. There is growing evidence that investors, customers and employees tend to favor companies that invest time and resources in ESG programs. However, even in the face of this overwhelming support for organizations to expand their ESG initiatives, leaders must not lose sight of their responsibility to maintain their organizations’ financial well-being. Consumers are aware of this too, and some are even skeptical that companies’ ESG initiatives are motivated by ethics. Instead, they can see that some are caving to external pressures from consumers and increasing regulatory requirements. Therefore, it’s important to prioritize performance needs while finding a balance that works best for the company because consumers will see through any superficial attempts at ESG.
Measuring ESG is another challenge. First, there is the question of what to measure. Then, there’s the question of how to measure those factors. For environmental initiatives, carbon emissions tends to be one of the most popular measurements of sustainability efforts, and some companies have made real progress in identifying the level of carbon emissions within their own operations. However, gauging carbon emissions is complex too because there are three main sources of carbon emissions: those the company makes directly; those the company makes indirectly, such as those that are made by electrical or gas companies that provide energy to the primary company; and the total supply chain emissions, including those created by suppliers and even customers and consumers. This last part can make up as much as two-thirds of a company’s emissions, but it’s difficult to know for sure because there are so many emissions sources in this category.
The measurement problem deepens when considering social responsibility practices. Should a company report accident rates, percentage of suppliers who employ child labor, turnover rate of employees or violations of company policy? All of these are relevant, but it’s challenging to pinpoint their relative merits. One of the measures that has received some attention is the distribution of employees by gender or ethnic background. U.S. companies with more than 100 employees are required to report this information to the U.S. Equal Employment Opportunity Commission. Although this measure is relevant, it really only represents part of the social aspect of ESG.
Measuring corporate governance might be the toughest task of all. Some activities to be considered for measurement include tax strategy, cybersecurity, data privacy and protection, bribery and corruption, executive compensation, culture, and ethics. It likely will be years before meaningful and reliable measures will be developed for these corporate governance activities.
Third-party agencies have been established to offer an unbiased evaluation of ESG activities, but their ratings often are inconsistent and incomplete. An analysis of ESG grades issued for nearly 1,500 companies by three different rating firms found that nearly two-thirds of companies received different grades from different raters. Some were even labeled as a leader by one agency and a laggard by another.
Sharing more information is not necessarily the answer either. A recent study shows that the more information an organization discloses about its ESG practices, the more rating agencies disagree about how well that company is performing along the three dimensions.
To date, a few regulations are available to help organizations along their ESG journeys.
Sustainability regulations are the most visible. The Paris Agreement, a legally binding international treaty about climate change, was adapted by 196 countries in December 2015 and took effect the following November. Its goal is to limit global warming to well below 2 degrees Celsius — but preferably to 1.5 degrees Celsius — above pre-industrial levels. To achieve this long-term temperature goal, countries aim to reach global peaking of greenhouse gas emissions by the middle of the century. The Paris Agreement is considered a landmark in the multilateral climate change process because, for the first time, this agreement brings all participating nations into a common cause to undertake ambitious efforts to combat climate change and adapt to its effects.
For corporate governance. the European Commission has issued an array of regulations covering every type of asset manager and investment fund as well as a variety of financial services firms. However, given that asset managers are both issuers and users of financial and nonfinancial ESG information, these regulations bring both complexity and clarity to firms that are involved in furthering their ESG compliance.
To date, the reporting of full ESG information in the United States still is largely dependent on individual companies. However, it is becoming likely that the U. S. Securities and Exchange Commission will become a more active participant in developing reporting regulations. In March 2021, the commission announced the creation of a Climate and ESG Task Force in the Division of Enforcement to proactively identify ESG-related misconduct.
ESG initiatives still carry a stigma
Without concrete methods of measurement to show the success of ESG programs, organizations attempting to improve their sustainability, social and corporate governance practices are facing opposition.
For example, oil and gas industry giant BP LLC has announced a program that calls for a 40% reduction in oil and gas production throughout the coming decade, greater investment in low-carbon energy, and a ramp-up in wind and solar power production. No other major oil company has targeted such a steep decline in their main source of profit. As a result, investors are concerned about the company’s ability to execute these plans without hurting profit.
Solar energy projects are generally thought of as being a future major source of renewable energy. However, some states already have imposed temporary restrictions on large solar projects in farming areas, citing concerns about loss of farmland and the impact on rural character.
Efforts to curb plastic bag waste in retail by swapping out plastic bags with paper bags are being met with questions as well. Although environmentalists point out how plastic bags are polluting marine environments, the American Progressive Bag Alliance, a trade body for plastic bag manufacturers, is touting a U.K. government analysis that found that paper bags must be used three times for their carbon footprint to drop below that of single-use plastic bags made from high-density polyethylene.
A three-part approach to ESG
On the other side of this, consumers are pushing organizations to enhance their ESG initiatives. Some consumers say they are willing to pay more for products in order to help companies address ESG issues. This pressure is translating to job security for company leaders. In a recent KPMG survey, 65% of top leaders said that managing climate change-related risks will play an important role in determining whether they keep their jobs. So, how can a leader find ESG balance?
Some thought leaders are proposing a three-part solution to this three-part initiative:
- Reimagined reporting: The top priority seems to be reporting so that stakeholders can review data to see the effectiveness of initiatives and ensure organizations are managing the financial risks of ESG initiatives. However, financial measures do not tell the whole story. Companies need to reimagine their reporting strategy to include nonfinancial measures.
- Strategic reinvention: In some cases, reimagined reporting will inspire corporations to alter basic strategic questions about where and how to compete. In other cases, companies will move aggressively to redefine their ESG strategies before worrying about reporting challenges. Management teams are taking a fresh look at difficult strategic tradeoffs in response to both new opportunities and external pressures, such as those related to environmental and social issues. If an organization’s current strategic priorities are resulting in outcomes that are unsustainable, a business needs to reinvent its strategy to address concerns, take advantage of different opportunities and ultimately redefine what the business does and how it does it.
- Business transformation: A business that begins to report against broader nonfinancial metrics will quickly find that it needs to define objectives in order to manage these metrics and to drive transformation to achieve these objectives. Similarly, a business that has had to redefine its strategic priorities to ensure its sustainability and relevance will urgently need to transform if it is to deliver on the new strategic objectives. Either way, businesses will have to actively manage outcomes by internalizing ESG into strategy, by transforming to implement the related change, and by reporting on both progress and outcomes. Senior leaders have a critical role to play in driving this agenda for transformation — which is not separate from ongoing digital transformations but instead will inform and build on them, redefining their context and purpose.
ESG reporting is an imperative as the world moves toward greater supply chain transparency. Efforts in this area will not only reduce supply chain risk, but also create more honest, ethical and eco-friendly operations. Building organizations that support the greater good is arguable the most noble of corporate efforts. Achieving this will require organization restructuring as well as operational changes. However, these efforts are critical for building a better tomorrow.
Learn more about the ASCM Enterprise Certification for Sustainability, the industry’s first and only corporate supply chain designation that demonstrates social responsibility, economic sustainability and ecological stewardship.