(Not) Everybody Wants to Save the World

If you lined up one hundred business people in a room and asked them, “What is ESG?” I suspect you will get fifty blank stares and fifty different answers. Some might conflate ESG with Sustainable Finance, while others focus on carbon emissions. Some might make pleas about global inequities or get mired in ESG data and analysis tools. Others will say ‘sustainability’ and mean everything under the sun, while others are adamant it means environmental sustainability. In some cases, ESG might even carry a moral judgment!

After many conversations, I’ve come to realize that a person’s opinion on ESG and sustainability tends to be colored by that person’s or company’s priorities, as is true of many things. What I see most often is this:

• Sustainability = Environmental Sustainability
• Diversity, Equity, and Inclusion = a range of definitions here
• ESG = short-term financial risk

Besides the lack of focus or understanding around social justice issues, there is a real challenge here. Right now, much of ESG focuses on short-term risk mitigation while there are looming long-term disasters. If we motivate companies to change through capital allocation and investments, what good is it if they aren’t addressing the long-term risks?

A stark example of this was called out in PwC’s 2021 Corporate Director’s Survey . The survey found that only 54% of boards understand the financial impact of ESG (albeit up from 38% in 2020). This means about half of boards simply don’t get it.

Getting financial institutions, boards, and stakeholders together requires clearly communicated objectives, and all of us have a part to play. If ESG becomes embedded in what we do, we can address both short-term and long-term risks.

NOTE: I will be talking in generalizations here. People can be more than one thing as they are wonderfully complex creatures.?

Materiality and Risk

Supporting Financial Services, most of my conversations about materiality and risk. The definition of materiality can mean a financial risk. This is something that needs to be disclosed to investors.

Many people, especially accountants and lawyers, point to the Supreme Court’s definition from 1976: “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”

However, materiality can also mean the non-financial issues around immediate crisis or short-term and long-term risks.?

Similarly, sustainability means both building sustainable business operations and lowering risk. This is also referred to as ESG, but often ignores the long-term implications. In my observations, it stops at the walls of the company and its suppliers and rarely extends out to industry or global issues in reality. In practice, ESG should extend into the future.

One common framework to measure the materiality and risk of ESG issues is through a Materiality Map, which measures stakeholder impact (not necessarily shareholders) and the impact on the business. This type of assessment is relatively standard, but note that it can be easy to miss the impact on the earth, industry, or society due to a focused definition for ‘stakeholder’ (i.e., investor, customer, employee).

A materiality assessment can yield areas to focus on, like communities where the business operates, local water tables, or other immediate impacts. Again, there is value here. Still, companies may not use this exercise to meet broader goals that represent long-term risks.

This may be due to a lack of ESG professionals or simply embedding sustainability into business practices. Regardless, meaningful yet provincial, incremental, and short-term improvements only are achieved.

For example, a fashion company might examine human slavery in their supply chain and work to eliminate it because it represents a reputational risk and could expose the company to fines. Investors favor lower risk, so the company may experience a boost in its stock price. However, they won’t take up global advocacy unless they understand their overall systemic risk.

Materiality and risk can be uncovered by scanning CSR reports, news feeds, social media, public statements, and with industry experts. In addition, data aggregators and ESG rating agencies will pick this information up to help drive attention to how they believe the company is addressing these risks, using their research and analysis.

Understanding this analysis and capital allocation can drive specific relevant improvements for the company and make incremental global improvements. Still, these may not be addressing long-term risks without careful consideration. This certainly may not keep us on the track towards a 1.5°C future. Not addressing these aspirational issues means that ALL companies have long-term risks.

For many firms and investors familiar with quarterly reporting, this is too big of a problem to worry about. So with ESG, we’re left with something companies should already understand — embedded risks to their business and left wanting more — a sustainable planet.

Commonly leveraged standards: SASB, industry regulations

Aspirations, Sustainability, and Equity

I talk to a lot of environmentalists and social justice advocates. For this group, long-term, systemic change is needed across world leaders, countries, and companies, to individual choices we all need to make as consumers and participants in a sustainable society.

The terms that often get used here are (environmental) sustainability, and diversity, equity, and inclusion.

It doesn’t necessarily make sense to talk about materiality or risk as inaction or focus on business relevance alone still results in broader systemic risks. Addressing one particular ESG risk at one company will not stop the planet from burning or erase centuries of systemic racism. For this group, saving the earth and building an equitable society are THE goals because otherwise, no other efforts will matter.

While this group has a valid perspective, this is a challenging proposition for those who need to change. For example, there is an argument to electrify everything and rely on energy companies to transition to green energy. However, this has been slow going. The urgent separation from coal ended up softened in the final commitments coming out of COP26 (from phase-out to phase-down ).

Further complicating the electrification argument is our dependence on coal. The International Energy Association has sounded the alarm, citing coal’s usage as “the single largest source of global carbon emissions.”

Graphic from IEA 2021 coal report — 2021 demand hits all time high, 2022 growth | Seeking Alpha

There’s no mistaking it — we must change these fundamental behaviors or face long-term risks. Universal standards are becoming a benchmark t measure these broad issues at the company level. However, this doesn’t necessarily show a 1:1 relationship as more prominent companies may emit more carbon through heavier energy use or have more diverse hires due to their size. In addition, private companies that aren’t looking for investors may skip reporting on these standards altogether if they don’t need to be benchmarked.

Commonly leveraged standards: Significant environmental and diversity standards are found across TCFD, TNFD, GRI, WEF ICB, and EEO-1.

Stewardship and Engagement

Still, there is hope to bring together short-term mitigation with long-term correction.

Even with long-term models, relevant industry and company ESG data only go so far. To harness the power of this data takes someone who understands the complexities and can tell a good story. When combined with a passionate human, ESG data can be a powerful force for risk management and aspirational global change.

Advocates can drive these difficult conversations by starting at a pertinent ESG risk (where most companies might be) and backing into the broader issues. In other words, short-term ESG risks can be a Trojan horse that leads to a more comprehensive sustainability perspective. Stakeholders like customers and employees play an important role in bridging the gap.

For example, the fashion company mentioned earlier may find their employees like the idea of advocating for human slavery reductions across the industry, which may open them up to lead an effort towards impactful change.

If sustainable values become embedded in a company, customers and employees can foster an organic feedback loop on managing ESG risk. Boards can effectively source risk visibility and aspirations from their stakeholders directly.

Still, Financial Services have an interesting engagement model. Investment stakeholders, like some banks and private equity firms, have robust ESG stewardship teams that leverage centralized, specialized knowledge to advise boards and leaders on material ESG issues. In addition, these teams provide playbooks and advice on what boards could be doing.

Just like any stakeholder, an ESG stewardship team’s motivations might be mixed across short-term and long-term goals. It could be that they want to meet a portfolio objective or lower risk, which leads to higher returns. It could be the aspirational work around socially responsible investing and addressing the aspirational challenges that drive them.?

Most often, I see these teams are passionate about long-term goals.

Bridge the Gap

There could be a chasm between material ESG risks and aspirational sustainability goals, depending on the company. However, if we’re going to maintain sustainable companies and a sustainable planet to host them, both perspectives need to be considered.

Stewardship and engagement can bring together the best of both works — aspirational goals and mitigating risk. Still, it is a lot of work, requiring industry experts and stakeholders to engage alongside a willing and open board.

Unfortunately, there are not enough sustainability or ESG experts to go around at the moment, which could be where consortia or public efforts come into play. For example, I’ve seen the non-disclosure list that CDP publishes completely transform a company, not only around reporting and managing their carbon metrics to include DEI and even material technology risks.

Revisiting our fashion company for the last time, what if a fabric supplier suddenly lost its water supply due to extreme weather conditions? The supplier may not be able to dye any of the fabric. It sounds so simple, but this is a real, localized risk caused by a global issue that could be overlooked for the short-term issues.?

Any country, company, or community could have a long-term risk like this.

Certainly, identifying and mitigating short-term risks is important. If we’re ever going to stick to a 1.5℃ (or less) future and mitigate our looming long-term risks, we must meet people where they are, push them to where we can, and always keep moving forward. Focusing on just a small, immediate part of ESG isn’t going to change the world.?

We must all be stewards who leverage our talent where we can and be active stakeholders in our world. The stakes are just too high for anything less.