Environmental, Social, and Governance (ESG)

Sustainability within Reach


Kolumne

Why is Environmental, Social and Governance more relevant today than it was before? What is it exactly and how can it be applied? What next thoughts and steps should be considered? The purpose of this article aims at providing the answer to these four main questions. Additionally, it is to be understood as a guide to identify, measure, and analyze risks associated with, for example, the lack of a sustainability initiative within companies. Lastly, throughout the article, new ideas are being deployed into the ESG discussion enabling untackled views on the sustainability topic.

The "WHY"

What is one of the most urgent issues related to the business world that the current pandemic revealed? Isn’t it, yet again, the necessity or rather lack of sustainability in our business world (Craig, 2020)? The term "build back better" is eminent throughout the media and echoes in the literature. A lot of more terms come up, when addressing Environmental, Social and Governance, like "Impact Investing", "Socially Responsible Investing" or "Green Economy". While the topic of ESG is not a new one at all (Hill, 2020), it required the global financial crisis of 2007/08 for the worldwide communities to recognize the crucial importance of integrated sustainability for our future (Clapp, et al., 2009).

Unlike the situation in 2007/08, today we stand at a turning point. In Figure 1 this statement is illustrated by displaying the currently most influential factors, pushing the topic ESG into awareness.

Figure 1: ESG and its currently most influential factors in the sustainability universe [Source: ifb]Figure 1: ESG and its currently most influential factors in the sustainability universe [Source: ifb]

The factors were separated into two categories and four subcategories, to provide an improved overview. The dark blue topics deal with technical-based aspects of the ESG ecosystem, while the light blue ones deal with content-based aspects. The upper left two represent more socially motivated content, whereas the bottom right deal more with knowledge-related arguments. The bottom left two cope more with data-driven aspects, while the upper right directly emphasize monetary arguments. Additional yellow circles are displayed for the reason of underlining further matters within the sustainability environment, i. e. that there are criteria other than ESG.

Hereinafter, each factor in Figure 1 is briefly explained:

  • Recognition: The discussion about sustainability, ever since being pointed out, is gradually gaining recognition in the developed world as well as in the developing world (Stevens, 2020). Take the ESG reporting for example, in the years from 1992 Rio Earth Summit up until now, the number of sustainable reporting requirements increased more than ten-fold (Ming, 2019). Furthermore, philanthropy, especially on the business dimension, is widely seen as a must-have for current but also future leaders, since it improves shareholders’ values and is strongly linked to ESG aspects, even more so from year to year (Matos, 2020). This enhanced movement towards sustainability recognition is also due to the newer generations of investors emphasizing and embracing topics like ESG more and more (Shapiro, 2019).
  • Social Equality: Yet another crucial reason, why we are standing at a turning point regarding the ESG discussions, is that the social aspect of ESG criteria moves increasingly to the fore, underlined by e. g. the current worldwide anti-discrimination protests (Lacalle, 2020). While the main attention regarding ESG remained heavily on the environmental part so far, the social factor is presently undergoing an increased consideration. Aspects like the degree of diversity at workplaces become essential for corporations. The growing importance of this aspect stems from the more so acknowledged view that diversity at the workplace results in a sophisticated workforce, which benefits the company in many ways (Tamunomiebi & John-Eke, 2020), resilience, change affinity, knowledge diversity, know-how and creativity, just to name a few.
  • Data Sustainability: Apart from the recognition and social equality, the accelerated digitalization of the world requires ever so sustainable data security strategies. The debates about implementations of digital security measures have become tense in the face of the increasing cybercrime threat that companies are being exposed to with the degree of their digitized structure (Matthews, 2019) (Data Security), but also due to the lack of ethically and morally correct usage of collecting and collected data in some organizations (Data Compliance) (United Nations, 2019). Apart from these two arguments, the question of appropriate data usage arises, meaning for example the creation of redundant or obsolete data (Data Trash) and thus, resulting in the consumption of more resources. Resource consumption leads to the next question: The one of energy usage, i. e. how the energy infrastructure within the data branch looks like (Energy Source). Figure 2 summarizes the topics to be considered within the Data Sustainability context.

Figure 2: ESG in Data Sustainability [Source: ifb]Figure 2: ESG in Data Sustainability [Source: ifb]

  • Measurability: A variety of indicators and tools were introduced up until now, enabling to have an elaborated discussion, critical perspectives and measurable outcomes regarding the impact and performance of ESG factors (Ezeokoli, Layne, Statman, & Urdapilleta, 2017). This crucial point, ringing in the era of ESGcompliance, converged over time from first diverse approaches and differing KPIs to meanwhile more and more uniform indicators, enabling a controllable and tangible implementation of ESG criteria into one’s own corporation (Bouye & Menville, 2020). At the same time, various approaches and methodologies meet the heterogeneous and nuanced preferences of ESG-oriented investors and companies themselves (Logan, 2019).
  • Profits and Benefits: The view of ESG aspects being profit reducing is becoming obsolete. On the contrary, businesses striving for Environmental, Social and Governance goals have been proven to turn out beneficial in many ways, also directly as well as indirectly profit increasing on the long run (Inderst & Stewart, 2018). As a 2019 publication of the Bank of America indicates, the implementation of ESG can generate excess returns and simultaneously reduce risks to the extent, that in this specific study of the Bank of America companies with high (top quintile) ESG ranks have outperformed their counterparts with lower (bottom quintile) ESG ranks (Subramanian, et al., 2019).
  • Government Support: Governments around the globe provide financial but also structural (i. e. expertise, logistics etc.) support for projects focusing on sustainability, responding that way to the array of aspirations stemming from their populations, international co-operations as well as collaborations, realizing the urge to establish a coherent interplay between progress, security and nature. These support efforts are provided for private companies and government projects alike to push the topic of ESG forward and act as a global role model or rather pioneer (Bloomberg Briefs, 2018). Based on that realization as well as societal pressure, an increasing number of regulation approaches enacted, and more are being discussed.
  • Scientific Backup: Integrating ESG aspects, especially in businesses, is backed up by scientific research suggesting different approaches to sustainability, all resulting in diverse advantages for the businesses and other participants equally (DWS KGaA, 2019). Additionally, the increasing scientific debate of the topic of Environmental, Social, and Corporate Governance generates ever increasing attention. To underline the scientific backup of the topic, hereinafter is the result of an analysis, conducted by McKinsey, which screened studies dealing with the impact of ESG on equity returns for their conclusions (Henisz, Koller, & Nuttall, 2019):

Figure 3: Results of >2000 studies on the impact of ESG propositions on equity returns [Source: ibf]Figure 3: Results of >2000 studies on the impact of ESG propositions on equity returns [Source: ifb]

The root cause for many of the points above to be relevant today is the information omnipresence or proliferation due to the global digitalization. As it is for this reason, why the awareness and thus, the recognition among the societies for climate change, air pollution, unethical company behaviors, equality differences, etc. arose and was reinforced. And it is for this reason, why more data with correspondingly better insights on, for example, profits, measurements, etc. were provided. Lastly, as it is for this reason of digitalization that organizations were enabled collaborating with each other way easier and comprehensive at the same time by e. g. sharing information and results.

All in all, it is not exaggerated to assume that ESG criteria are moving from being optional to becoming mandatory as can be observed in the EU and EBA Action Plan on Sustainable Finance or the ECB endeavors regarding climate-related and environmental risks. This assumption is additionally based on and driven by the three key points increasing recognition of the values, advancing perception of necessity and improved measurability. To exemplary address the first key point, the link between tangible advantages for companies acting ESG criteria compliant, the following figure depicts five ways according to a McKinsey approach (Henisz, Koller, & Nuttall, 2019):

Figure 4: Link between value creation and ESG proposition in five ways [Source: ifb]Figure 4: Link between value creation and ESG proposition in five ways [Source: ifb]

As a recent example, different case studies regarding business performances during the COVID-19 pandemic underline the resilience of ESG-oriented corporations (Examples: medium.com/@sensefolio/case-study-top-esg-company-performance-during-a-pandemic-example-of-covid-19-e57d84e3b066, www.cnbc.com/2020/06/07/sustainable-investing-is-set-to-surge-in-the-wake-of-the-coronavirus-pandemic.html, www.funds-europe.com/news/esg-rating-linked-to-outperformance-amidst-coronavirus-pandemic). The focus on non-traditional, i. e. non-financial risks led to portfolios of companies that explain this toughness during the COVID-19 downturn. The values of a "designed for sustainability" strategy plan can therefore be broken down not just to intangible advantages, but also facts based on tangible evidence: The figure below indicates the results of a research on 2,000 largest companies (by market capitalization) of the regions USA, Europe and Asia conducted by Sense Folio. The general takeaway is that top ESG-score companies are generally outperforming bottom ESG-score companies and even more so, during a crisis like the COVID-19 pandemic (Sense Folio, 2020). The dark blue line represents Top Companies with an ESG Score > 60 and Top 2-Months∆ESG Score (Portfolio 100 Top). The light blue line represents Bottom Companies with an ESG Score < 40 and Bottom 2-Months∆ESG Score (Portfolio 100 Top).

Cap-Weighted Strategy — USA | Equal-Weighted Strategy — USA
Figure 6: Top-ESG company performance during COVID-19 pandemic, period: 2019/12–2020/05 [Source: ifb] 
Cap-Weighted Strategy — Europe | Equal-Weighted Strategy — Europe
Figure 6: Top-ESG company performance during COVID-19 pandemic, period: 2019/12–2020/05 [Source: ifb] 
Cap-Weighted Strategy — Asia | Equal-Weighted Strategy — Asia
Figure 6: Top-ESG company performance during COVID-19 pandemic, period: 2019/12–2020/05 [Source: ifb]Figure 5: Top-ESG company performance during COVID-19 pandemic, period: 2019/12–2020/05 [Source]

Since the reasons why ESG criteria matter now more than ever was tackled, in the following subchapter the localization of the term will be addressed and provided.

The "WHAT"

So, what are the ESG criteria and where do the data sources come from: They can be jot down as collections of guiding norms or standards applied by investors and companies alike on a company’s activities and strategies per se. While environmental criteria evaluate how businesses deal with pollution, energy use, security and so forth, social criteria disclose dealing with e. g. employment, customers, suppliers and communities. Environmental therefore indicates that every company exerts influence on the environment et vice versa and Social explains that every company operates within a broader, heterogeneous society. Governance, however, examines further internal structures like human rights, executive pay, audits and innovation (Corporate Finance Institute, 2020), pointing out that every company requires governance. To sum it up, ESG is a way more comprehensive screening of companies and therefore, a mean to achieve goals and not an end in itself.

Sovereign data on ESG stem to a major part from the World Bank. Despite the fact, that a variety of sources exist, substantial sovereign ESG research products obtain between 30% and 85% of their data from the World Bank’s open data catalogue (Herzog, 2019). Nevertheless, a trend towards more diversification of data sources can be observed, as more and more companies focusing on ESG, institutional investors, financial institutions and others engage into independent research efforts (Herzog, 2019). Even so, the data sources steer for diversification. Simultaneously, efforts towards converging measurements can be observed throughout the literature (Bouye & Menville, 2020) as the necessity of standardized evaluation methods and ratings prevailed within the businesses.

When approaching investments within the sustainability canvas, several ESG factors as mentioned in the previous paragraph, evaluation methods and data sources can be considered. The applied ESG criteria by the investors are usually related to industry-specific challenges: A petroleum corporation, for example, will most-likely face different ESG issues and risks than an E-Commerce company (MSCI, 2020). Against this background of sophisticated investing and evaluation strategies, there are extensive control and scoring opportunities for affected companies and investors. The solution here to minimize the risks for both parties lies in the tapping of the right sources and seeking the right consulting of businesses with appropriate expertise in these areas. Hence, the huge potential and the past as well as current growth in the ESG branch seems apparent and tangible.

Figure 6: Selection of further buzzwords within the sustainability universe [Source: ifb]Figure 6: Selection of further buzzwords within the sustainability universe [Source: ifb]

Furthermore, in the scope of addressing ESG, it is also required to list some of the buzzwords related to sustainability, which are mentioned broadly throughout the internet as well as literature itself. Consequently, the table above is listing the differences of these terms to the topic of ESG followed in connection. Here, the importance of keeping in mind that the table is far from complete and numerous more buzzwords will appear as time progresses and more data (like scientific researches), insights (like best-practices) as well as acceptance are found, is essential. Therefore, openness or rather adaptability to changing priorities and terms related to the sustainability discussions is recommended.

The "HOW"

The question remains of how to apply the ESG criteria. Initially, the following indicators can be used:

  • Based on the past and current behavior as well as currently and in the future publicly communicated plans of a company, insights on the sustainability-related performance can be deduced. >> Energy uses plans, waste and recycling plans, business relationships with ethically coherent suppliers, donations, transparent and accurate accounting, ethical influence etc.
  • Additionally, considering the opposed, opposing, and upcoming external (e. g. environmental) risks of a business, it provides more insights on its sustainability performance. >> Frequent natural disaster region, politically instable region, facing extractive structures (e. g. bribery) etc.
  • Building on the previous point, an organization’s management of those risks can also be evaluated according to ESG criteria (Zhou, 2019). >> Establishing resilient infrastructure, act as role models against corruption, compliance with international regulations etc.

In this article, an extensive list of risk factors has been omitted. Such lists already exist in countless literatures. However, one point that receives insufficient attention in the literature is that of the potential risks associated with implementing an ESG strategy, whether into an investment plan or for the companies striving for sustainability themselves. So, before diving into the corresponding steering mechanisms for facing these risks via measurability and controllability, the following figure will display some of the relevant hazards to constantly look out for and consider in the sustainability strategy plan:

Figure 7: Potential risks accompanying ESG criteria implementation strategies [Source: ifb]Figure 7: Potential risks accompanying ESG criteria implementation strategies [Source: ifb]

One way of a steering mechanism provides the collaboration network approach within the Knowledge Management discipline. The ever-increasing volume of the current Big Data, and Big Information era in general, requires the Knowledge Management discipline to scale up as well via companies and corporations alike collaborating. That way not only the risk responsibility is shared, but also the unpredictability of outcomes minimized, the "Update Compulsion" mitigated through knowledge sharing, potential "Reverse Impacts" almost non-existent by integrating different views of the collaboration network and the "Results Pressure" mitigated through common strategy plans.

It should be apparent, that it is almost an impossibility to meet every aspect of the ESG criteria. All the clearer appears the necessity of prioritizing (Zhou, 2019). For this purpose, a plan containing the most important sustainability goals of the business in a descendant order and how to acquire these can be the key to success. Whether establishing a department devoted to ESG criteria, collaborate and cooperate within a network of organizations with the same goals or seek advice from an external company with expertise within these areas, there’s no long-term circumvention of sustainability inclusion into an organization’s strategy plan. A combination of Knowledge Management and field expertise are essential for the well-conducted implementation and continuous improvement of ESG criteria. This combination and prioritizing are coherent with, for example, the suggestion of a collaboration and cooperation network, as tackling measurements or topics separately means focusing resources and this in turn, in most cases results in efficient problem solving. At the same time, that kind of approach means sharing information, making arrangements (who is tackling which topic) and thus, splitting the work packages into multiple smaller ones, which can be brought together upon completion like consistent puzzle pieces. Constant reciprocal updates could lead to fast establishment of Good-Practices with possible application to each network partner’s work package. Agreeing on binding partnership values with penalty options can build the foundation for such ESG collaboration networks. After all, it is true that we do not always know all of what we do not know and that this is mitigated by involving more and especially more diverse individuals or groups in the problem-solving process, which bring in their experiences, their background and thus, their views as well as tools.

The "NEXT"

Implementation of ESG criteria into business activities can be divided into three areas of activity. First, exposure to sustainability risks must be assessed and risk management frameworks have to be aligned comprehensively to this additional risk category. Given the increasing political awareness and advancing perception of necessity with regard to supervisory authorities, companies should furthermore assess their (negative and/or positive) sustainability performance in order to reach alignment with (inter)national sustainability goals and external expectations of stakeholder groups. As it is almost impossible to meet every aspect of the ESG criteria, it is advisable to carry out a materiality assessment to find out, where in the organizational structure there are business needs or regulatory and legal requirements (e.g. CSR-RUG) to implement ESG criteria. The third area is the consideration of new earning possibilities in the field of sustainability. Once an ESG strategy is implemented and aligned to the overall business strategy, companies can engage in new markets and costumer groups. Sustainability strategies should be in accordance with the positioning the company is interested in and the availability of human and capital resources. Potential risks associated with implementing an ESG strategy can be minimized by engaging an external consultancy.

There are various institutions and NGOs developing frameworks, assessment tools and guidance in the range of accounting principles, reporting standards and quantification methodologies. Lack of standardization as well as heterogeneous exposure to sustainability risks and the wide variation of individual strategic positioning with respect to sustainability necessitate the evaluation of an individual approach to integrate ESG criteria into business activities [based on own market research]. Following the pathway of the below shown ESG-cycle, companies are able to comprehensively integrate ESG criteria in accordance with regulatory requirements against the background of business efficiency. The procedure outlined should be understood as a possible and not sole way to integrate ESG criteria.

Figure 8: ESG implementation cycle [Source: ifb]Figure 8: ESG implementation cycle [Source: ifb]

As a first step, the management should give its commitment to the topic of implementing ESG criteria. Responsibility should be set at this level to ensure, that added value can be created. That’s also what supervisory authorities as e. g. the BaFin in Germany recommends. In the strategic analysis, sustainability and its opportunities and risks should be treated as non-financial aspects and therefore, it must be included in the non-financial risk management system of a company.

The second step "assessment" means on the one hand the measurement of sustainability risks a company is exposed to and on the other the assessment of the individual sustainability performance and impact, since a good sustainability performance often results in a better financial performance. Establishing an own sustainability risk taxonomy is crucial to align them with the settled risk categories in order to enable quantification of exposure. That can be done by using adjusted measurement methods that are used by companies. Considering the performance assessment, it is advisable taking into account international sustainability goals like the UN Sustainability Goals, or more specifically in the area of environmental sustainability the Paris Agreement. Both sustainability objectives are widely recognized and scientifically substantiated.

Defining strategic objectives with respect to sustainability can be seen as starting point for developing an overall business strategy that contains every business function to enhance sustainability performance. Within this step, processual transformation should be set in place and metrics should be established to support the sustainability strategy to meet the strategic objectives. Due to the fact that metrics that fit into the areas of Environmental, Social and Governance are very different and furthermore cannot be used intersectoral, companies should contemplate implementing scientifically proved metrics that help assessing the performance and derive value to successfully meet sustainability goals (e. g. science-based targets, established by the Science Based Target Initiative). By doing so, companies should also establish or widen their scenario analysis and stress tests and integrate sustainability aspects that are material for their business model. Existing guidance can be found in the Paris Agreement Capital Transition Assessment (PACTA) ((2degrees investing initiative, 2018) or the methodology of the industry-led partnership called Partnership for Carbon Accounting Financials, to name just two of a variety regarding data and methodology providers in concerns of environmental sustainability (Partnership for Carbon Accounting Financials, 2020). Although existing tools and frameworks exist, companies should individualize them to be capable of efficiently managing ESG criteria.

Implementing in the context of ESG means to comprehensively align internal processes with the adjusted strategies as well as sustainability objectives and the introduction of the new guidelines, at best over the whole company. Furthermore, the above-mentioned tools and measurement methods should be set in place.

In the next step, companies have to measure their sustainability impact and exposure in using their aligned tools and instruments with the selected and individualized metrics. It is important that a continuous comparison of measurement and the strategic objectives is guaranteed. A number of companies have developed sophisticated methodologies for creating ESG ratings of one’s company and their working model. In their working paper "Aggregate Confusion: The Divergence of ESG Ratings" (Berg, Kölbel, & Rigobon, 2020), the authors show that defining the scope of different categories and measuring the categories account for divergences between different rating models. Therefore, those rating methodologies can provide a good point of reference, but it is recommended to develop one’s own methodology that is best suited to the specific purpose.

The last, but one of the most important activities, when integrating ESG criteria, is to communicate internally and report externally what a company does considering sustainability aspects, what is material to them and how they want to improve. Guidance in this area can be found in several reporting standard setters like the TCFD (Task Force on Climate-related Disclosure), the Global Reporting Initiative (GRI) or the International Integrated Reporting Council (IIRC). It seems advisable to choose a reporting framework in accordance with the individual materiality of sustainability, the IT infrastructure that is used and the strategic objectives. A frequently discussed challenge is data availability and quality. Both are improving and still will do so in the future. Nevertheless, there is still a long way to go to improve the data quality and thus, enhancing reporting. External data providers can help to deliver necessary information that can be included in the reporting framework.

Another important aspect that companies should keep in mind is future "soft regulation". It can get obligatory to be compliant with, when stakeholder expectations shall be met. Good guidance can be obtained (e.g. ECB Guide on climate-related and environmental risks).

To sum up, the business principle of "Doing nothing" and the corresponding business as usual should not be the purpose of business strategies anymore. Companies need to make the first step in reckoning with ESG criteria and the inherent implications for their specific business models. Hence, sustainability is a mainstream economical issue with growing importance for each financial and non-financial companies. Existing frameworks and sometimes an external view by a consultant can help to implement and individualize ESG strategies, quantification tools and reporting standards to successfully meet stakeholder expectations and lastly, also take advantage of new and sustainable earning possibilities.

 

Authors

Eljar Akhgarnusch is a consultant at ifb SE for more than 2,5 years now. Having attained his M. Sc. in International Economics and Policy Consulting he provides a broad variety of experience in topics like Data Management, Economic Development and Agile Project Management. With his insatiable thirst for knowledge he keeps an eye on a sustainable future and thrives in intercultural environments.

Hannes Vohrer is a consultant at ifb SE for two years now. He focused on sustainable financial management in his master’s degree study and has already published an article regarding sustainable risk management tools and their application.

 

Bibliography

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