Society has increasingly come to demand businesses deliver goods and services in a responsible manner that benefits both society and the planet, alongside financial returns for investors.
Post-COP26, and in the shadow of Covid-19, companies must rebuild, reinvigorate and abide by a form of capitalism that is acceptable to the majority, meaning the growing investor community interest in ESG (environmental, social and governance) funds and statistical measures will only rise in prominence during 2022.
Throughout the pandemic, the growth in ESG investment and pressure on asset managers to integrate ESG risk-factors into their portfolio has triggered a demand for comparable data, ratings and rankings through consistently applied and understandable metrics.
All of this has resulted in the championing of a brand-new industry, largely led by agile agencies specialising in a variety of ESG data and ratings intended to benefit investor decision-making. Further to this, the addition of numerous standards and guidelines for corporations have sprung up, which some observers refer to as a near impenetrable alphabet soup of questionable regulation.
These agencies are now calling for consistent and comparable ESG disclosure from companies, leading to a flurry of activity aimed at streamlining the proliferation of frameworks, standards and regulations. However, by prioritising a rules, rather than principles-based approach, to metrics, the majority of companies are obfuscating some of their most sensitive information.
This has strong echoes of past practice with ESG’s predecessor, corporate social responsibility (CSR), which similarly displayed potential at its outset. When effectively utilised, ESG can inspire significant change that remoulds business activity and societal expectations for the better.
Unfortunately, the current metrics mania actually detracts from pertinent disclosures regarding management capability and intentions that would provide invaluable information for investors.
These measurement failures are centred on a lack of reliable and appropriate corporate data detailing company ESG adoption. Insufficient transparency and a failure to fully disclose firms’ ESG activities present ongoing challenges for asset managers who are seeking conscientious investments, as does the difficulty in assessing links between long-term value creation and non-financial performance.
ESG activities
Despite these hurdles, companies continue to bolster their ESG credentials, often by publishing glossy sustainability reports which showcase supposed contributions to the United Nations Sustainable Development Goals (SDGs). This is largely a repetition of the days of CSR reporting.
In effect, the pooling of responsibility for CSR, the homogenising of its definitions, and the casual and ambiguous glossing over of objectives and the ultimate beneficiaries of CSR, provided a distorted view, which made it difficult to evaluate whether any corporation was in truth upholding its stated responsibilities. In fact it can be argued that a majority of enterprises successfully used CSR to gain credibility without achieving any material results.
Little has changed today in the way ESG is practised and interpreted. Most organisations continue to struggle with their delivery of any significant social impact for stakeholders, and mostly perform activities that create little more than an impression of environmental and sustainable benefit.
The three letters, ESG, are increasingly presenting challenges to boards tasked with overseeing their corporation’s efforts to navigate these governance issues. Most take the easy path of focusing on meeting standard sustainability reporting and narrowing the debate concerning enterprise value.
A cursory glance of available data suggests the connection between self-proclaimed ESG companies and ESG-orientated funds is underwhelming. ESG funds largely fail to pick stock with better “E” and “S”, relative to non-ESG funds. If anything, ESG funds tend to pick firms with inadequate employee treatment and “just tolerable” environmental practice when compared with non-ESG funds.
The inevitable questions arise:
- Is the declaration of a high-minded firm’s ideals little more than talk?
- Do the current ESG ratings truly capture an enterprise’s ESG orientation?
ESG and company strategy
Long-term investors are aware that sustainable value creation relies on the effective management of financial, physical and human capital.
Many ESG issues are common to all companies, regardless of sector. These include climate change and inequality, changing the social expectations of customers and employees, minimum wage rates and laws and regulations on carbon taxes.
Whether the issue is societal or industry specific, the way forward is to make ESG and its derivatives an integral part of company strategy. Like any other investment, incorporating ESG into a firm’s strategy can be costly. It would be unusual, if not unique, for a chair to be brave enough to report a lower return to shareholders as a result of ESG investment.
Neither the International Financial Reporting Standards (IFRS), nor the Generally Accepted Accounting Principles (GAAP) have developed necessary methodologies to assist enterprises to account for ESG initiatives financially. IFRS and GAAP were equally unhelpful in providing vigour to CSR reporting.
To make ESG real, and not simply a shallow replicate of CSR, yearly accounts must reflect the company’s social and environmental impact, and associated costs.
IFRS and GAAP reporting should include disclosures on the integration of sustainable development considerations in strategy, management activity and governance oversight. Reporting should also disclose the performance of metrics, results and associated costs.
To have real ESG effectiveness, IFRS and GAAP have to feature a level of information quality that is both relevant and significant to long-term organisational and societal value creation. This means advantages in terms of enterprise impact and sustainable development. This puts the spotlight on ESG issues at the AGM and throughout the year in terms of risks faced in the supply chain.
Possessing the capability to execute strategy and assess risk are the two key business levers that make a difference to ESG adoption. Neither are captured through IFRS or GAAP.
Consistent reporting
Not all is lost. Certain companies are broadening their thinking to encompass “value-beyond-profit” motives.
Similar to pursuing any strategic alternative, ESG requires investment which incurs costs and poses risks. Until these challenges are actively and consistently reported, sustainability and other environmental concerns will be little more than a patchwork of random vagaries, of particular interest to groups focused on promoting their own agenda.
The danger of this is leaving corporations vulnerable to critique from the media, NGOs and other important observers and stakeholders. The solution is to deliver a money-based number for ESG that makes sense to all involved parties.
Nada Kakabadse is professor of policy, governance and ethics, and Andrew Kakabadse is professor of governance and leadership, at Henley Business School.