Defining, understanding and measuring the ‘S’ in ‘ESG’

Defining, understanding and measuring the ‘S’ in ‘ESG’

Organizations today are familiar with Environment, Social and Governance (ESG) policies, but only recently have businesses started to realize how a focus on the ‘S’ can lead to very real material difference in understanding an organization’s culture, its value and its risk profile.

The concept of ESG was originally framed around an objective of ‘do no harm’. Today, we need to shift organizations away from such a potentially negative mindset towards a more positive approach that asks: ‘is this world a better place because my company is in it?’ What this means in practice, is that ESG is not an outlier; it must be core to the business of the organization it serves.??

And there is a real benefit in doing so. By clearly defining ‘S’, and extending its definition to mean stakeholder welfare, organizations can release capital flows and investment precisely because ‘S’ can affect the way in which an organization is performing - and will perform - in the future. It also affects how it is perceived in the market and by the investment community, at a time when ESG-invested Funds are increasing. Organizations that are seen to ‘protect’ their stakeholders are those organizations in which we are keen to invest, and it is no surprise that organizations with a strong and a shared culture have ‘S’ practices that are also strong and shared, because there is a common sense of purpose and reason as to why that organization exists. It speaks to how robust and sustainable a brand may be, and that in term determines the level to which an investor may be prepared to take a risk.?

Organizations need to be clear on how its ‘S’ is communicated to its wider public. There is always the danger of a gap between what it says and what it does, and certainly how it holds itself accountable on its journey to delivering meaningful change. It is this last point that has led to organizations being accused of greenwashing, a word that has fast become a ‘generic’ term for an action that gains a headline to satisfy a particular audience when there is no real substance or accountability for what lies behind the claim. In this context, ESG cannot be properly considered without reference to the wider sustainability agenda and role of public policy in driving a fundamental change to the relationship between economies, society and the environment. ESG is now clearly mainstream within a corporate strategy, and of the three ‘elements’, the need to define, understand and promote ‘S’ has become the most important of the triumvirate.?

Measuring the ‘S’ requires a standardized approach?

Which leads us to the most challenging part of the modern-day conversation, namely how the ‘S’ in ESG can be - and should be - measured. This is a particularly crucial question for those researching potential ESG investments. Social factors to consider in sustainable investing include a company’s strengths and weaknesses in its management of social trends, labor, and politics. Organizations that focus on these areas not only demonstrate their corporate responsibility (where the ‘S’ intersects with the ‘G’), but also directly impacts their profitability. But how are they measured??

The answer is not easy. The 2019 Global ESG Study from BNP Paribas found that 46% of investors from the 347 institutions surveyed said that the ‘S’ in ESG was the most difficult to analyze and embed in investment strategies. In the 2021 edition of the same study, that figure had increased to 51%. Historically, ratings agencies (and, in turn, investors) have looked only at policies and commitments, and whether they exist, rather than the impact they are having. This is beginning to change, but to accelerate the rise of ‘S’ in today’s world, we need to measure its ‘S’ in a standardized way so we can more accurately compare one organization’s progress in creating shared value against another. This is critical, because different rating agencies, capital markets, and indices, all rely on ‘S’ to know what success looks like.??

While capital and capital markets are important to raising standards, so too are governments and the creative use of legislation. They can, for example, use tax systems to encourage voluntary efforts. And they can require compulsory disclosures. KPMG terms this ‘progressive legislation’ – which encourages the adoption of voluntary standards and market-based mechanisms to shift market trends and expectations and improve social outcomes.?

Risks and backlashes?

Rigorous measurement, standardization and comparability not only bring credibility to an organization’s data, and makes it clearer to understand and interpret, but they also protect that organization from accusations of greenwashing, pinkwashing and other forms of misrepresentation that can damage its reputation.?

To continue an earlier theme, in addition to their own in-house ESG research, financial institutions often rely, to a large extent, on the information provided to them through external data and research providers, and the ESG ratings agencies and indexes. But where, in turn, do they source their information from??

Essentially this is either through their own review of company disclosures and publicly available information, or through dedicated ESG-related assessment questionnaires that companies within each defined universe are requested to complete. Both run the risk that unvalidated data (i.e data and information without meaningful expert third-party verification against an objective set of standards) is being used for mainstream ESG investment analysis.???

Some research and indices’ providers recognize this and are already, for example, looking to more reliable sources of information which independently verify an organization’s ‘social’ performance and impact. In the area of DE&I, S&P Global takes advantage of a methodology developed by the EDGE Certified Foundation and uses this methodology to influence the questions asked in the S&P Global Corporate Sustainability Assessment which is the basis for the Dow Jones Sustainability Indices. Similarly, EDGE Certification – which measures an organization’s commitment to DE&I – is used in the scoring criteria for both Bloomberg and Equileap in their Gender Equality-specific assessment frameworks, and as such the EDGE Certified Foundation is part of the journey in building credibility into ESG Funds (i.e in terms of providing a reliable source of data regarding the organizations in which the Fund is investing) and in delivering confidence to the consumer. EDGE Certified organizations, therefore, not only have a greater chance to score highly in ESG rankings and indices, but also of being included in ESG mutual funds.??

Financial performance will always be the key measure of an organization’s ‘value’, and ESG will never replace that. But the two are inextricably linked. Favorable ESG ratings help drive down the cost of capital for those organizations because investors know that lower risks equate to better management. And in turn, those organizations will be able to attract, retain, develop, and motivate the kind of talent that they need to succeed.??

Put in the words of Paul Polman’s Net Positive Manifesto: ‘The economy won’t thrive unless people and the planet are thriving.’?

Nadine Jürgensen

Co-Founder and COO ellexx, Columnist, Co-President WE/MEN, Lawyer

2 年

Thank you, great speech and very important topic Simona Scarpaleggia . I hope we soon have more companies following your advice and start being pioneers! ??

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