What is Environmental, Social and Corporate Governance (ESG)?

Short for “environmental, social and governance,” ESG represents a more stakeholder-centric approach to doing business. As ESG increasingly becomes top of mind for directors, it’s essential to consider the global nuances that drive focus region by region.

 

Companies that adhere to ESG standards agree to conduct themselves ethically in those three areas, and can draw on a range of ESG strategies, tactics and ESG solutions to do so.

 

But with such a wide range of possible approaches and solutions, and a panoply of issues that fall under the ESG umbrella, where should organizations focus? How should they make a start?

 

A good first step is to identify the issues fit into the umbrella categories of environmental, social and governance. Those can include:

 

Environmental

Preservation of our natural world

• Climate change
• Carbon emission reduction
• Water pollution and water scarcity
• Air pollution
• Deforestation
• Greenhouse gas emissions

Social

Consideration of humans and our interdependencies

• Customer success
• Data hygiene and security
• Gender and diversity inclusion
• Community relations
• Mental health

Governance

Logistics and defined process for running a business or organization

• Board of directors and its makeup
• Executive compensation guidelines
• Political contributions and lobbying
• Venture partner compensation
• Hiring and onboarding best practices

 

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Operationalizing ESG: A Roadmap for Boards & Their Organizations

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This Short Video Breaks Down the Meaning of ESG Further

ESG can be defined in several different ways, depending on the audience. In this video clip from our recent GRC webinar, Ezekiel Ward, founder of North Star Compliance Ltd., shares the meaning of ESG for investors, corporates,  governments and society.

 

 

Let's explore further.

 

 

How Does the Meaning of ESG Vary for Corporates, Investors, Governments and Society?

 

For Corporates

 

New markets could include:

• Millennials, where  83% of consumers want brands to align with their values
• The LGBTQ+ community — and potentially their friends and families
• Environmentally-conscious consumers
• People from demographics or ethnic groups that have previously not engaged with your brand

Cost reductions could include:

• Reduced employee attrition and associated reduced recruitment and retention costs
• A lowered risk of financial penalties resulting from regulatory compliance breaches
• The cost benefits of more sustainable, less volatile supply chains

 

What is meant by integrated risk management and how is it a business opportunity?

Integrated risk management (IRM) is a set of practices and processes designed to improve corporate decision-making and performance. IRM is designed to provide an integrated view of an organization’s risk management approach, often assisted by supporting technologies, and is an accepted approach to managing corporate risk.

At Diligent’s Future of GRC webinar in April 2020, Ezekiel Ward, the founder of North Star Compliance Limited, noted the close connection between ESG and IRM, saying that “a trend like ESG is actually the same thing as integrated risk management,” enabling organizations’ leaders to gain a holistic view of risk across internal audit, compliance, health and safety, HR, and other functions.

"ESG, as I refer to integrated risk management in corporates, is one thing that I see carrying on in 2021."

— Ezekiel Ward, founder of North Star Compliance Ltd.

 

For Investors

For investors, environmental, social and governance considerations are a growing priority — and with good reason. ESG performance has been shown to correlate strongly with financial performance; companies in the S&P 500 that ranked in the top quintile for ESG factors outperformed those in the bottom quintile by more than 25 percentage points between the start of 2014 and the end of June 2018.

Stock prices of companies with high ESG rankings also tend to be less volatile, whereas “high ESG controversy” events can cause a company’s stocks to underperform the market for as long as two years.

With ESG scores and rankings increasingly being published in the public domain, the importance of investing in ESG-focused organizations is growing. And it’s not just published ESG metrics that are attracting investor attention; the reputational value of a proactive approach to environmental, social and governance issues is also being recognized. Today, intangible assets like reputation account for more than 80% of an organization’s S&P asset value. Not surprising, then, that ESG-oriented investing has experienced a meteoric rise in recent years.

 

For Governments

 

Increased focus on ESG across the business and political spectrum has made this a vital issue for governments worldwide. Although the coronavirus pandemic may have pushed ESG down the agenda in the short term, imperatives like the publication of the 2021 IPCC report on climate change are again making it a priority topic.

Although governments may have had to take their eyes off the ball momentarily, ESG issues like social injustice and climate change threaten to damage the fabric of society unless they are tackled.

 

For Society

 

Society faces challenges from the issues outlined above; the government’s strategies for tackling injustice and inequality and addressing environmental impacts will fundamentally impact societies’ ability to function.

As investors drive corporates towards greater ESG accountability, the broader society will be impacted, whether as employees, consumers, stakeholders or those living in the shadow of organizations operations.

 

Relationship Between ESG and the Board of Directors

The relationship between ESG and the board of directors is still being defined.

• Discussions around the “G” (i.e., governance) are often spearheaded by the nominating & governance committee with involvement from the full board — particularly when assessing how these risks integrate with the enterprise risk management (ERM) program or impact long-term strategy.

 

• More boards are incorporating the “S” (social considerations or corporate impact) into the strategy development process. According to PwC’s Annual Corporate Directors Survey, issues like health care cost, resource scarcity, human rights, and income inequality have all surged in importance.

 

• When it comes to structuring oversight around the “E” (i.e., environmental issues), a recent global study by the Diligent Institute found that best practices are still largely undetermined. Half of the 447 survey respondents indicated some form of board-level oversight, either by the full board or a board committee, while 19% indicated that oversight lived within the organization. Another 35% percent indicated that environmental issues are “not overseen” by the company or that they “don’t know.”
  
  

ESG Oversight for Corporate Directors

We’re seeing a rise in ESG conversations, an increase of ESG issues on board agendas and even more sustainability disclosures. Within Diligent’s Inside America’s Boardrooms video below, Barbara Berlin discusses highlights from PwC’s recent guide while addressing the board’s ESG responsibilities and risk mitigation for ESG disclosures.

 

 

How Boards Can Measure ESG

Corporate issuers are finding that the types of ESG metrics that matter to one company may not matter to the next. Both boards and investors are increasingly turning to organizations like the Sustainability Accounting Standards Board (SASB), Sustainalytics or MSCI for ESG reporting frameworks that offer some level of consistency and financial materiality among companies within a given industry.

• Equipping boards with the right data: Effective oversight of ESG data will depend on whether today’s boards have the right information at their fingertips. In a research report by Forrester and Diligent, governance professionals indicated that “visibility into sustainability and ESG issues” was their greatest dissatisfier.
• Do you have the data your investors have? How does your board composition compare to your peers? What skill sets is the board lacking?
• What conflicts of interest might your investors have uncovered? Tools like Diligent Nominations provide quick access to information that helps board members identify governance red flags raised by shareholders and activists.

 

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ESG Reporting — Sustainability Reporting for Your Organization

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ESG Trends for Corporates

According to the recent OCEG ESG Research Survey, corporates are currently at the following stages of implementing, documenting and disclosing ESG risks:

Metrics:

• Over 50% currently publish no ESG metrics
• 20% consider ESG metrics when making all investments; 50% consider them for some investments
• 37% do not consider ESG metrics when evaluating vendors or suppliers
• 44% report that their investors do not consider ESG
• Only 20% report increasing alignment between ESG metrics and executive compensation
• And less than 10% say the same for compensation across the organization

Disclosures:

• 46% have a formal documented ESG program, with another 34% planning one
• 43% have ESG-focused KPIs with a further 30% planning to put them in place
• 30% have undertaken an ESG assessment in the last year
• Only 9% are highly confident that their organization has mature, well-documented ESG policies

Risks:

• Brand reputation is the highest ESG impact according to respondents

Technology:

• 61% are not yet using software, but 54% want to learn about ESG technology

Discover an in-depth analysis of ESG trends here.

 

How ESG Investing Is Growing and Changing

ESG investment began in the 1960s. While certain ethical concerns have changed, the principle of sustainable investing remains the same. More and more investors are adopting ESG criteria as a tool to evaluate potential investments alongside traditional financial analysis.

According to a report by PWC, the practice of ESG investing has grown over the last few years. The report states that the ESG asset pool will continue to grow rapidly and become essential in the investment process in the coming years.

The growth of ESG investing can be boiled down to three reasons, according to financial firm MSCI:

• The world as we know it is changing.
• The next generation of investors is changing the way investment works.
• Data and analytics have evolved to provide more information than ever.

 

The World

The face of our planet is literally shifting as a result of climate change. Droughts, food insecurity, and rising temperatures have a domino effect on the environment that impacts multiple sectors.

New risk factors are cropping up for investors, and new regulations are being enacted to mitigate the effects of environmental damage. Mass migrations and displacement from climate crises are changing the demographic makeup of certain areas — and preparing for those crises is changing the way we live our lives.

As technology advances and becomes more widely available, data privacy and security have also become something companies can’t ignore. In the wake of high-profile data breaches, companies are wisely tightening their security protocols. As these companies adapt, investors might change their strategies accordingly.

Investors

Today’s generation of investors is on the receiving end of a massive wealth transfer from the Boomer generation — as much as $68 trillion according to one report by CNBC. And the people inheriting that wealth may think differently about how it should be invested than the generation they’re inheriting it from.

According to a 2016 Bank of America report on ESG investing, $15-20 trillion of that money could go into ESG assets in the next couple of decades. If that happened, it could roughly double the size of the U.S. market.

Millennial-aged investors, and women, in particular, are holding the companies they invest in a higher standard.  believe that investments are a way for them to express “social, political, and environmental value,” as opposed to 36% of Boomers.

A few more statistics on the newest generation of investors as cited by MSCI:

• Millennials are more than twice as likely to be interested in investments that are dedicated to solving societal or economic problems.
• 90% of millennials wealthy enough to do so want to increase allocations to responsible investments over the next five years.
• 84% of millennials surveyed in a said they were interested in more sustainable investing.
• The Morgan Stanley report also claims 71% of individual investors are interested in sustainable investing.

 

Data and Analytics

Better data-gathering technology allows investors to examine companies in a much more granular way than they could in the past. Massive amounts of information can be harvested and used to drive objective, quantitative decisions.

Companies can be gathered and ranked according to how well they adhere to ESG principles and aggregate into ESG reporting standards. Investors can even see which principles they adhere to most closely and change the criteria to have different weights depending on the industry. Having that kind of data publicly available also puts pressure on companies that aren’t adopting ESG principles to do so or risk losing out on capital.

Companies themselves can better track ESG data using big data.

Today’s data tools allow companies to set benchmarks and measure how well they’re adhering to ESG standards like internal ethical governance. Diligent has several tools to help businesses in this area:

• Cyber Risk and IT Risk & Compliance: Diligent’s solutions enable you to protect your critical information by taking a proactive approach to cyber risk and IT risk. A centralized system ensures you can identify, assess and mitigate the threats you face.
• Compensation & Governance Intel: Use market and organizational data to design better executive compensation plans and benchmark against peers.
• Diligent ESG: Accelerate and improve the collection, monitoring and reporting of ESG metrics and sustainability data.

Third-party entities can use data to rank companies independently, comparing facts from multiple sources to come up with a more holistic picture than they’d have with the information given to them by the company itself.

 

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Rethinking the ESG Data Challenge

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Does ESG Investing Hurt Your Portfolio?

The short answer? No.

People used to believe that ESG investments were a sacrifice — an investment more morally than economically motivated. Today that isn’t necessarily true.

In fact, according to a report by the US SIF Foundation, ESG investing grew at a rate of more than 38% between 2016 and 2018. Assets grew from a total value of $8.7 trillion to $12 trillion.

 

Some studies have even suggested that companies with good ESG practices had lower cost of capital and lower volatility. They also displayed lower instances of bribery, fraud, and corruption over time. These results suggest that, in the long run, ESG investments are more stable and can even outperform other companies.

In a recent study, MSCI investigated the ties between ESG investments and the stock market, to see if there were any financially significant effects. The study used a three-channel model to look at how ESG data embedded in stocks gets transferred to the equity market.

The study found that, after examining idiosyncratic and systematic risk profiles for the companies involved in the study, ESG had an effect on many of those companies’ valuations and performance. Companies with higher ESG ratings showed:

• Higher profitability: ESG companies with high ratings showed abnormal returns and were more competitive. This often led to higher profitability and dividend payments — especially when contrasted against low ESG companies.
• Lower tail risk: High ESG rated companies experienced fewer idiosyncratic risk events like major drawdowns. Companies with low ESG ratings were more likely to experience these incidents.
• Lower systematic risk: High ESG companies had less volatile earnings and less systematic volatility. They also had lower betas and lower costs of capital than low ESG rated companies.

ESG investing can also cut risk in emerging markets. There is research to suggest that companies adhering to ESG principles have a lower chance of tail risk — the risk of unlikely events that lead to catastrophic damage.

 

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ESG Risks: What Today’s Boards Need to Know

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ESG Sets a New Standard in Finance and Operations Principles

What once was seen as a less profitable, niche area of investing is moving to the forefront. The rise of green energy, the need to combat climate change, and growing public knowledge of the supply chain are all driving consumers to brands that adopt ESG finance and operations principles. And investors are following suit.

Because of that, companies like J.P. Morgan and Goldman Sachs are tracking ESG investments closely, taking them more seriously than ever before. Organizations are responding by implementing actions to ensure their approach delivers on the ESG performance investors and their advisers are seeking. Diligent’s ESG Solutions can help by providing organizations with the structure, rigor and metrics they need to report comprehensively on ESG performance, track improvements and evidence successes.

The Role of ESG Software in Supporting Successful ESG Programs

ESG software is playing an increasingly central role in many organizations’ ESG programs. The data challenges posed by a need for robust ESG reporting may seem daunting, but there is a range of solutions available to make sense of your various ESG initiatives.

An ESG data management solution can help coordinate the moving parts, report on progress and stay ahead of activists, investors and competitors. Choosing the right solution is vital, and organizations should prioritize five key criteria and areas of functionality when shortlisting options:

• Flexibility
• Data collection
• Monitoring and reporting
• Specialized functionality in climate/sustainability and executive compensation
• Service and support

 

With ESG only anticipated to grow in importance among consumers, legislators, regulatory bodies and investors, you need to get ahead of the game when it comes to ESG data collection, benchmarking and reporting.

You need to be audit-ready, with documentation and reports that stand up to scrutiny as ESG reporting becomes the norm. And the solution you choose needs to be flexible and scalable, so it evolves with changing ESG priorities and external drivers.

All ESG solutions are not created equal, and so it pays off to be discerning in your choice. Find out more about the criteria you need to consider, the questions you should ask, and the benefits that different solutions can deliver in Diligent’s ESG Buyers Guide.

 

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ESG Buyers Guide

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