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

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

ESG stands for Environmental, Social, and Governance. The E in ESG refers to a company’s environmental impact and practices, including energy consumption, waste management, carbon emissions, and use of natural resources.

The S refers to a business’s social impact on employees and other stakeholders, as well as its ripple effects on the larger community. It covers issues like labor practices, working conditions, diversity, inclusiveness, pay equity, employee engagement, and data protection and privacy.

The G stands for governance, or the internal controls and procedures that a company adopts to ensure integrity and transparency in business activities and decisions. It encompasses issues like boardroom diversity, executive compensation, anti-corruption, and whistleblowing.

Together, E, S, and G seek to encourage more socially responsible behavior in businesses, boardrooms, and investor communities.

What Does ESG Have to Do with GRC?

GRC is no longer just about monitoring regulatory compliance or managing known risks. It’s about sustaining an organization’s license to operate—ensuring that business practices, operating procedures, and corporate behaviors are acceptable to employees, stakeholders, and the public at large. ESG is integral to that effort.

How a business manages its environmental footprint, gender diversity, or transparency in reporting impacts the company’s license to operate and therefore its GRC mission.

The link between ESG and GRC is even more evident when you look at the World Economic Forum’s (WEF’s) Global Risk Reports. Back in 20frea10, fiscal crises and underinvestment in infrastructure dominated the risk report. But in 2021, all the top 5 risks by likelihood and four of the top 5 risks by impact are related to ESG issues, including climate action failure, infectious diseases, and biodiversity loss.

GRC professionals have a significant role to play in mitigating these risks and building trust with stakeholders through robust ESG measures. In fact, at MetricStream, we believe that ESGRC will be the future of GRC.

Why is ESG So Important?

Worsening climate conditions, grievous social injustices, and corporate governance failures are catapulting ESG to the top of global agendas. Here’s why it matters:

If societies don’t pressurize businesses and governments to urgently mitigate the impact of these risks, and to use natural resources more sustainability, we run the risk of total ecosystem collapse.

To society 

Around the world, people are waking up to the consequences of inaction around climate change or social issues.July 2021 was the world’s hottest month ever recorded (NOAA) – a sign that global warming is intensifying. In Australia, human-induced climate change increased the continent’s risk of devastating bushfires by at least 30% (World Weather Attribution). In the US, 36% of the costs of flooding over the past three decades were a result of intensifying precipitation, consistent with predictions of global warming (Stanford Research).

If societies don’t pressurize businesses and governments to urgently mitigate the impact of these risks, and to use natural resources more sustainability, we run the risk of total ecosystem collapse.

To businesses 

ESG risks aren’t just social or reputational risks – they also impact an organization’s financial performance and growth. For example, a failure to reduce one’s carbon footprint could lead to a deterioration in credit ratings, share price losses, sanctions, litigation, and increased taxes. Similarly, a failure to improve employee wages could result in a loss of productivity and high worker turnover which, in turn, could damage long-term shareholder value. To minimize these risks, strong ESG measures are essential. If that wasn’t incentive enough, there’s also the fact that Millennials and Gen Z’ers are increasingly favoring ESG-conscious companies.

In fact, 35% of consumers are willing to pay 25% more for sustainable products, according to CGS. Employees also want to work for companies that are purpose-driven. Fast Company reported that most millennials would take a pay cut to work at an environmentally responsible company. That’s a huge impetus for businesses to get serious about their ESG agenda.

To investors 

More than 8 in 10 US individual investors (85%) are now expressing interest in sustainable investing, according to Morgan Stanley. Among institutional asset owners, 95% are integrating or considering integrating sustainable investing in all or part of their portfolios. By all accounts, this decisive tilt towards ESG investing is here to stay.

To regulators 

In the EU, the new Sustainable Financial Disclosure Regulation (SFDR) and the proposed Corporate Sustainability Reporting Directive (CSRD) will make sustainability reporting mandatory. In the UK, large companies will be required to report on climate risks by 2025. Meanwhile, the US SEC recently announced the creation of a Climate and ESG Task Force to proactively identify ESG-related misconduct. The SEC has also approved a proposal by Nasdaq that will require companies listed on the exchange to demonstrate they have diverse boards. As these and other reporting requirements increase, companies that proactively get started with ESG compliance will be the ones to succeed.

Key things to know about building an ESG-conscious business

For decades after Milton Friedman’s seminal essay was published, people believed that profits were the only real goal of business. But today, it’s the purpose behind the profits that are in focus.

“Society is demanding that companies, both public and private, serve a social purpose,”   wrote BlackRock Founder, Chairman,CEO, Larry Fink, in his 2018 letter to CEOs. “To prosper over time, every company must not only deliver financial performance but also show how it makes a positive contribution to society.”

That “contribution” is arguably best exemplified in a company’s environmental, social, and governance (ESG) practices. Ranging from carbon footprint reduction to pay parity, ESG practices enable sustainable and purpose-driven business growth.

The International Finance Corporation (IFC) found that out of 656 companies in its portfolio, those with good environmental and social (E&S) practices outperformed clients with worse E&S practices by 210 basis points on return on equity and by 110 basis points on return on assets.

Similarly, Morningstar found that sustainable funds attracted a record $51.1 billion in net new money from investors in 2020, more than double the previous record set in 2019.

In other words, ESG isn’t just the right thing to do. It also impacts business performance positively.

What are the Current Trends in ESG Investing?

ESG investing is rapidly picking up momentum as both seasoned and new investors lean towards sustainable funds. Morningstar reports that a record $69.2 billion flowed into these funds in 2021, representing a 35% increase over the previous record set in 2020. It’s now rare to find a fund that doesn’t integrate climate risks and other ESG issues in some way or the other.

Here are a few key trends:

COVID-19 has intensified the focus on sustainable investing

The pandemic was, in many ways, a wake-up call for investors. It exposed the deep systemic shortcomings of our economies and social systems, and emphasized the need for investments that would help create a more inclusive and sustainable future for all.
About 71% of investors in a J.P. Morgan poll said that it was rather likely, likely, or very likely that the occurrence of a low probability / high-impact risk, such as COVID-19 would increase awareness and actions globally to tackle high-impact / high probability risks such as those related to climate change and biodiversity losses. In fact, 55% of investors see the pandemic as a positive catalyst for ESG investment momentum in the next three years.
It helps that ESG funds proved remarkably resilient during the crisis with many of them outperforming the broader market. Jon Hale of Morningstar wrote, “In 2020, three out of four sustainable equity funds beat their Morningstar Category average, and 25 of 26 ESG equity index funds that I've been following this year beat index funds tracking the most common traditional benchmarks in their categories.”
Unsurprisingly, massive investments are being channelized into ESG funds, and will likely continue this way.

The S in ESG is gaining prominence

For a long time, ESG was almost entirely associated with the E – environmental factors. But now, with the pandemic exacerbating social risks such as workforce safety and community health, the S in ESG – social responsibility – has come to the forefront of investment discussions.
A BNP Paribas survey of investors in Europe found that the importance of social criteria rose 20 percentage points from before the crisis. Also, 79% of respondents expect social issues to have a positive long-term impact on both investment performance and risk management.
The message is clear. How companies manage employee wellness, remuneration, diversity, and inclusion, as well as their impact on local communities will affect their long-term success and investment potential. Corporate culture and policies will increasingly come under investors’ radars. So will attrition rates, gender equity, and labor issues.

Investors are demanding greater transparency in ESG disclosures

No more greenwashing or misleading investors with false sustainability claims. Companies will increasingly be held accountable for backing up their ESG assertions with data-driven results. Transparent and truthful ESG reporting will become the norm, especially as Millennial and Gen Z investors demand data they can trust. Companies whose ESG efforts are truly authentic and integrated into their corporate strategy, risk frameworks, and business models will likely gain more access to capital. Those that fail to share relevant or accurate data with investors will miss out.

What is the Board’s Role in Shaping ESG Strategies?

ESG risks are business risks – which is why they can’t only be the responsibility of Chief Sustainability Officers or compliance and ethics committees. Ownership must begin with the board. Corporate directors have a duty of care to consider how ESG factors impact the corporate strategies, performance, and risk health of the companies they serve.

Here’s how boards can lead the way on ESG:

Provide effective oversight of ESG risks and opportunities

ESG risks are typically varied and dynamic with widespread impacts on corporate reputations, bottom lines, compliance, litigation, and more. Therefore, they need to be examined not just in isolation, but in terms of their connection with other risks.  
Boards must be clear about who owns ESG risks, how they impact strategy, and where the organization’s risk appetite ends. Boards must also determine whether existing enterprise risk management (ERM) processes are effective enough to keep ESG risks in check. Wherever there are gaps, directors must work closely with the executive team to identify steps for improvement.  
Another board responsibility is to drive the adoption of ESG frameworks – be it the Sustainability Accounting Standards Board's (SASB) sustainability metrics or the Global Reporting Initiative’s (GRI’s) reporting standards. Determining which framework to use depends on a number of factors such as whom the company will be reporting to, what that audience needs to know, and what kind of resources the company has to dedicate to disclosures.

Track ESG progress

By regularly monitoring ESG objectives and metrics, boards can keep companies on their toes. The key is to ask the leadership team specific questions: Are our ESG goals compelling enough? What are we doing to achieve them? Where do ESG responsibilities and accountabilities lie? Are our ESG efforts integrated with strategic decision-making? Are they aligned with relevant standards and reporting frameworks? Are investors and regulators satisfied with the quality of our reporting?

The more informed boards are about ESG performance, the more effectively they can guide and support their companies in delivering long-term value.

Ensure that disclosures are reliable and credible

Boards must ensure that robust control systems and processes are in place to regulate the ESG information that’s reported, including how, when, and where. Is the information accessible, credible, and backed by quality metrics? Is the messaging consistent across the corporate website, sustainability reports, and regulatory filings? Is it aligned with the company’s purpose? Has it been validated by a third party? Boards also need to probe deeper into the transparency and truthfulness of disclosures. Too often, companies cover up the shortcomings of their ESG programs, focusing only on their successes and achievements. This makes the content sound biased. Having the courage to talk about both the good and bad in an ESG journey goes a long way towards building trust and credibility. The board must help their organizations drive towards these objectives.

How is ESG Evolving?

The practice of socially responsible investing can be traced back hundreds of years ago to when religious groups such as the Jews, Muslims, Quakers, and Methodists established ethical guidelines to govern investing. Stocks that conflicted with their personal beliefs or values were typically avoided (e.g., slave trade, smuggling, alcohol, tobacco, or gambling).

In the 1960s-80s, socially responsible investing gathered steam, as activists and protestors raised their voices against the Vietnam War and apartheid in South Africa, as well as environmental incidents like the Chernobyl nuclear disaster and the Exxon Valdez oil spill.

In 1971, the first sustainable mutual fund was launched. By 1994, 26 sustainable funds were available to investors, with assets roughly around $1.9 billion.

From the year 2000 onwards, multiple ESG standards came into being – be it the Global Reporting Initiative (GRI), the UN’s Principles for Responsible Investment, or the Sustainability Accounting Standards Board (SASB).

Today, ESG is no longer just a passing trend – it’s a key competitive differentiator that may soon become a basic survival requirement for businesses. Investors value companies that care about their environmental and social impact, as well as the quality of their governance. In fact, directors now report that ESG is the topic investors most want to discuss during engagements with shareholders (PwC).

So, what’s next? How will ESG evolve in the next few years?

For starters, we’re likely to see new regulations, reporting requirements, and standards. The proposed European Green Bond Standard and the EU Due Diligence Regime will demand more focused and transparent ESG disclosures. Meanwhile, from April 2022, over 1,300 of the largest UK-registered companies and financial institutions will have to disclose climate-related financial information on a mandatory basis – in line with recommendations from the Task Force on Climate-Related Financial Disclosures (TCFD). This is only a sign of things to come.

We’re also likely to move towards a globally harmonized set of reporting standards that can provide more consistent and comparable information for investors.

At a corporate level, boards will likely come under greater pressure to improve their ESG skills and fluency. With investors scrutinizing ESG measures, boards will need to demonstrate effective understanding and oversight of ESG issues – be it carbon emissions, racial injustice, or economic inequality.

In addition, more attention will be placed on the supply chain ESG. Already, Germany has published the Supply Chain Due Diligence Act which obligates companies to safeguard human rights and the environment within their supply chains through appropriate due diligence measures. This law will come into force in 2023.

All these trends will require companies to up their ESG game. That, while challenging, will go a long way towards creating and enhancing business value.

5 Benefits of Building a Strong ESG Profile

It’s never too early to incorporate ESG propositions into your GRC and business strategies. By embracing ESG practices, you gain multiple benefits, including:

Stronger revenue growth

There is growing evidence that a higher ESG rating correlates with higher financial performance. Companies that prioritize ESG are perceived as credible and trustworthy. This helps them attract more customers, enter new markets with ease, and acquire permits and approvals faster.

A competitive edge

Sustainability and good governance matter to consumers. When you demonstrate a clear commitment to ESG and a purpose beyond profits, you’re more likely to win consumer favor and loyalty. In fact, 52% of consumers say that what attracts them to buy from certain brands over others is that those brands stand for something bigger than just the products and services they sell, which aligns with the consumer’s personal values (Accenture).

Better talent acquisition and retention

Young and talented workforces are choosing employers whose values are aligned with theirs. So, when potential recruits see that your business genuinely cares about issues like employee development, diversity, ethics, and climate change, they’re more likely to want to work for you. Employees are also more motivated, engaged, and productive when they know that their work is purposeful and makes a difference.

Lower costs

Being more energy-efficient or using less packaging material will help you cut costs. McKinsey research finds that reducing resource costs can improve operating profits by up to 60%.

Fewer regulatory compliance risks

By demonstrating strong ESG measures, you minimize the risk of regulatory sanctions, penalties, fines, and other enforcement actions. ESG-focused investing also often comes with attractive tax incentives, as governments seek to reward responsible financial behavior.

What are the Challenges of ESG Compliance?

ESG, while important, can often be a challenge to implement. For starters, it’s a very broad discipline that covers a range of issues – from carbon footprint and biodiversity loss, to labor practices and corruption. Many of these issues can be hard to quantify in terms of their magnitude as well as their impact on financial risks.

But perhaps the biggest obstacle is the lack of a universally accepted ESG framework to assess and report ESG progress. Without it, companies end up using multiple different standards and metrics, which leads to inconsistencies and confusion. Stakeholders often find it difficult to compare ESG data or determine how it links to financial performance.

However, steps are being taken to standardize ESG reporting. For instance, the WEF, in association with the Big 4 accounting firms and Bank of America, has released a set of universal ESG metrics and disclosures. These “stakeholder capitalism metrics” are organized around the principles of governance, planet, people and prosperity

Further, the International Financial Reporting Standards (IFRS) Foundation is actively engaging with authorities like the International Organization of Securities Commissions (IOSCO) to develop a common set of global sustainability standards. These initiatives will help make ESG reporting more consistent, comparable, and reliable.

7 Common ESG Frameworks and Standards

• The Global Reporting Initiative’s (GRI’s) sustainability reporting standards are widely used by companies to understand and disclose their impact on the economy, environment, and people. The GRI Universal Standards apply to all organizations; the GRI Sector Standards cover sector-specific impacts; and the Topic Standards list disclosures relevant to a particular topic.
• The Sustainability Accounting Standards Board (SASB) has created a set of 77 industry-specific sustainability metrics that help companies and investors analyze how ESG issues impact financial performance.
• The International Integrated Reporting Council (IIRC) developed the International Framework to improve disclosures about value creation, preservation, and erosion. It encourages reporting around six broad capitals, including natural capital, human capital, and social and relationship capital.
• The Climate Disclosure Standards Board (CDSB) offers companies a framework to report environmental information with the same rigor as financial information. This approach benefits a range of stakeholders, including investors, analysts, companies, regulators and stock exchanges.
• CDP runs a global disclosure system that enables thousands of companies to measure and manage their risks and opportunities on climate change, water security, and deforestation.
• The Task Force on Climate-related Financial Disclosures (TCFD) has developed a framework to help public companies and other organizations effectively disclose climate-related risks and opportunities. The TFCD recommendations are designed to solicit decision-useful, forward-looking information that can be included in mainstream financial filings.
• The UN Sustainable Development Goals has set out 17 broad objectives for companies to achieve. They range from responsible consumption and production, to climate action and gender equality. These goals provide a foundation for companies to shape and prioritize their business strategy and reporting.

How to Integrate ESG into Your Business

While there isn’t a one-size fits all approach to ESG, here are a few best practices that can help:

Establish a strong foundation

• Define clear roles and responsibilities to oversee ESG risks and issues.
• Ensure you have sufficient staff with the required skills, knowledge, and expertise to manage ESG effectively.
• Remember, ESG encompasses a wide range of requirements that can’t always be managed by a single department or person. Consider creating a cross-functional ESG team, including stakeholders from compliance, risk management, HR, investor relations, legal, and senior management.
• Conduct a materiality assessment to identify and prioritize the ESG issues that could most affect the business. Use it to inform company strategy, targets, and reporting.

Adopt a systematic approach to ESG risk management

• Identify and document your ESG risks. Determine how they might impact the achievement of business objectives and strategy.
• Embed ESG risks into your risk appetite statement and ERM frameworks. Define specific KRIs.
• Assess ESG risks periodically to understand their impact and probability at various levels of the business. Incorporate scenario analysis tools to measure the financial implications of ESG risks like high carbon taxes.
• Extend your ESG risk assessments to third parties, including vendors, suppliers, service providers, contractors, consultants, and partners. Understand what they’re doing to improve sustainability and ESG ratings.
• Document and investigate ESG-related issues stemming from risk assessments.

Measure and audit ESG performance

• Establish quantitative and qualitative KPIs to track and evaluate ESG performance.
• Engage independent auditors to provide assurance around the accuracy of ESG reports and data.  

Communicate and report progress towards ESG goals

• Keep the board and senior management updated on ESG performance. Demonstrate how ESG activities align with business strategy, financial performance, and value creation.  
• Create an effective communication strategy to disclose your ESG vision, mission, and performance to investors and other external stakeholders.  
• Ensure that your reporting is credible, consistent, and authentic. Be transparent about where you are in your ESG journey.  
• Find an ESG technology solution that can help you streamline and automate ESG measurement, monitoring, and reporting

Why is Cross-functional Collaboration so Important in an ESG Program?

ESG commitments impact organizations at multiple levels. For example, waste reduction requires the participation of just about every business department, from Product Engineering to Administration and Finance. Therefore, the responsibility for meeting ESG targets can’t just be thrust on the sustainability function. It has to be a collective effort.

However, with distributed responsibilities, it can become difficult to coordinate and track the different ESG activities in different parts of the organization. Silos may crop up, resulting in ESG practices that overlap, or are inconsistent with overall ESG objectives. That’s why it helps to have a cross-functional group of stakeholders who can coordinate and align ESG efforts.

Some companies establish sustainability representatives from each business function to ensure that their departments are meeting ESG targets. Others establish forums or platforms where cross-functional stakeholders can meet regularly to exchange updates on ESG progress.

Each stakeholder brings value to the table. For instance, risk representatives provide a holistic perspective on ESG risks, while finance professionals bring a clear understanding of how ESG performance can impact the organization’s access to investments.

It’s important that all these participants have a 360-degree, shared view of ESG metrics, standards, reports, and other data. Only with this kind of transparency can they work together to meet ESG targets faster, more efficiently, and cost-effectively.

How Can You Leverage Compliance Best Practices to Strengthen ESG?

There has been considerable debate about whether or not the compliance function should own responsibility for ESG. Some see it as a natural fit, thanks to the compliance function’s expertise in handling governance matters, engaging with cross-functional stakeholders, and reporting to the board. But there are others who point out that ESG responsibilities will only strain an already overworked compliance function.

Whatever organizations decide, there’s no doubt that ESG could benefit greatly from the best practices that compliance functions have honed over the years. These include:

Building a structured compliance framework

Creating an integrated compliance framework helps organizations bring order and discipline to the chaos of ESG standards and reporting requirements out there. The first step is to identify all ESG requirements that are relevant to your business. Maintain these standards, frameworks, disclosure templates, and schedules in a central database where they can be easily accessed. Link them to business processes, risks, business units, and controls to better understand their impact. Conduct a gap analysis to determine where your organization’s ESG measures are lacking. And then, develop systems and controls to fill those gaps.

Integrating compliance into corporate culture

Building a truly effective ESG compliance program requires enterprise-wide commitment. Start with the board and leadership – they need to demonstrate through their words and deeds that ESG will be treated as part of day-to-day operations. Then, create and maintain robust policies and procedures that employees can follow. Weave ESG themes into internal training and communication, so that they’re top-of-mind for employees. Set up whistle-blower hotlines and other channels for people to report ESG violations such as bribery and corruption. Finally, ensure timely, effective investigations around these incidents.

Enabling cross-functional collaboration

ESG requires involvement from multiple stakeholders, including the board, HR, Compliance, Risk, Legal, Administration, and Finance teams. Seamless collaboration across these participants is essential, not only to avoid duplication of effort, but to also identify and respond to ESG risks faster. The key is to unify these stakeholders on a common platform where they can easily view all ESG metrics, exchange data, and ideas, define shared goals, and collectively work towards enhancing ESG compliance.

Proactively monitoring compliance

The accuracy of an organization’s ESG disclosures depends on how effectively the business is monitoring and measuring its ESG maturity. It could take the form of standardized self-assessments and surveys which help the organization understand their ESG performance, including progress towards established targets. Teams must analyze factors such as how well ESG has been integrated into the business, what controls are needed for ESG oversight, how effectively ESG risks are being managed, and where the gaps lie.

Ensuring third-party due diligence

Third-party compliance with ESG policies and standards is integral to the success of any ESG program. Organizations must know how their suppliers are managing waste and emissions, or preventing human rights issues like child labor. This requires that third parties sign specific codes of conduct, attest to sustainability and social responsibility practices, fill out due diligence surveys, and report on their ESG activities. Companies must also enable continuous third-party assessments, audits, and inspections to validate supplier claims.

What Role Does ESG Software Play in ESG Compliance?

ESG management isn’t a simple, linear process. There are so many frameworks, metrics, data sources, cross-functional stakeholders, and risks involved. How do you manage all of them in an efficient and intelligent manner?

ESG software can help by streamlining and automating processes like ESG data collection. It can also unify all ESG reporting requirements, metrics, and other information in a single source of truth. So, companies have all the insights they need at their fingertips to report accurately on their ESG posture, and make better-informed decisions.

Here’s a deeper look at what an ESG solution can help companies do:

• Simplify ESG compliance    
  Integrate ESG frameworks, standards, and disclosure requirements in a central repository for optimal visibility. Map them to business units and operational locations to strengthen accountability.
• Gain powerful ESG insights     
  Automatically capture ESG metrics from multiple sources onto a single platform. Enhance data analysis through graphical reports and dashboards. 
• Understand the organization’s ESG posture     
  Enable a systematic, automated approach to ESG self-assessments and surveys. Aggregate findings from across the enterprise into a central database where they can be easily sorted, analyzed, and compared.
• Monitor ESG performance in the supply chain    
  Set up a supplier portal to manage and evaluate suppliers based on their ESG posture. Empower suppliers to keep track of their own ESG performance through intuitive reports and dashboards.
• Stay ahead of ESG risks    
  Build a centralized risk library to document ESG risks, including risk description, category, hierarchy, and ownership. Simplify risk assessments and scenario analyses through streamlined processes. Stay updated on risks through real-time heat maps.
• Minimize ESG issues    
  Track and resolve ESG issues in a systematic and automated manner. Use AI-powered engines to classify issues, uncover similarities, and recommend remedial actions.          
• Integrate with third-party sources    
  Connect seamlessly with reliable third-party sources to capture ESG metrics, updates, and other information.
• Strengthen reporting   
  Gain real-time, granular visibility into the organization’s ESG performance through advanced dashboards and visualizations.