Positive ESG impact, for value creation

This century we have witnessed the world changing at speed as a result of increasing risks from climate change, the backlash of inequalities and brand damage from poor decisions and judgement.?

When analysing growth potential, investors increasingly want to understand both the risks and opportunities that arise as a result of the environmental, social, and governance (‘ESG’) issues every business is intertwined with. In the future it is likely that ESG criteria will be integrated into all portfolio management. However, far from just mitigating the risks and increasing costs, research has shown that companies with a strong ESG strategy, see higher equity returns:

‘Firms with good ratings on material sustainability issues significantly outperform firms with poor ratings on these issues’.

It is perhaps unsurprising that today CEOs are increasingly being incentivised with bonuses aligned to ESG performance and we are even starting to see firm wide ESG bonus incentives. Understanding the drivers and levers of ESG for value creation is critical for the board and leadership. This guide is aimed at future-thinking corporate leaders of privately owned companies who see ESG as a proactive opportunity to rethink corporate and innovation strategies to create future enterprise value. It is a practical guide that recognises the importance and challenges of ESG disclosures and reporting requirements, but seeks to prioritise the use of ESG as a value creation lever to provide intent for sustainable innovation.

1. Five dimensions of ESG value creation?

There is a growing demand for clear and transparent disclosure on companies’ long-term ESG commitments as government regulation strengthens and expectations from investors, suppliers, customers and employees rise. Companies are now required to report on non-financial metrics alongside their financial statements to provide insight into the climate related and societal impact they are making. Accountability resides with the board and disclosures will be signed off by the CEO.?

However, a company improving its environmental and social impact can also create cash flow and enterprise value and safeguard a company’s long-term success. This is why investors and executives are committing to ESG rather than just for regulatory compliance or benevolent or philanthropic ends.?

Below are five recognised dimensions of value that can be created.

• Productivity uplift: Purpose driven organisations providing meaningful work, great employee communication and mentorship can attract and retain top talent and lead to a more motivated workforce.
• Revenue Growth: Selling sustainable products will attract new customers. Stronger community and government relations will also achieve better access to resources and markets. Building customer satisfaction, loyalty and lifetime value will lead to increased revenues at a lower cost of sale and advocacy will lead to new customer acquisition.
• Cost reductions: Continuously and automatically monitor your environment and analyse data to identify opportunities to optimise operations.
• Regulatory and legal interventions: Achieve greater strategic freedom through deregulation, reduce fines and penalties. Reduce restrictions on advertising.
• Investment and asset optimisation: Attract investors. Lower cost of capital. Enhance returns by better long term capital allocation. Reduce risk on longer term environmental issues.

2. Five steps to ESG value creation

In order to identify the opportunities for value creation, a company should consider the following five steps:

i. ESG responsibility

Responsibility for ESG strategy should be assigned to a cross functional team that has access to both the board and management team. The team should have experience in corporate strategy, corporate affairs, governance, risk management, compliance and reporting as well as sustainability, HR and cross business stakeholder management.

ii. ESG assessment?

During an assessment the following issues should be evaluated:

• Mandatory reporting based on regulatory requirements vs voluntary disclosures
• The vision and purpose of the organisation aligned with ESG?
• The materiality of ESG to identify and prioritise issues and value creation opportunities that are most likely to affect the company’s financial performance?
• Existing programmes, policies, metrics and engagements
• Company’s performance in key areas benchmarked against peers
• Methodologies to prioritise roadmap and action

The outcome of the assessment will provide a clear understanding of the current state of ESG and initial focus to establish objectives and a clear statement.

iii. ESG objectives & statement

Once the current state is understood, goals can be developed and agreed. Work with cross-functional stakeholders to define strategic objectives that map to either regulatory requirements or quantifiable value creation opportunities and risk mitigation.

Consider specific activities to maintain, improve or optimise activities and set measurable targets to allow the assessment of progress, support communication strategy and integrate practices into the business. Broad objectives should be supported by sub-goals. Draft objectives should be presented to the leadership team, Board of Directors and any relevant councils to build consensus and support.

Analyse gaps in resources or innovation and potential blockers that will be required to address to achieve objectives. Estimate order of magnitude investment and forecast returns to assess viability and innovation feasibility at an early stage.

An ESG statement should be prepared which has both headline medium term aspirational (but achievable) goals as well as short term sub-goals. This important statement will support strategy development and corporate disclosures as well as provide intent for innovation and guidance for communication strategy.

iv. ESG strategy & roadmap

The scope of ESG will differ across industries and even within industries it will be interpreted and acted on in different ways to create competitive advantages. Leadership must consider and define what ESG means to their organisation, the impact on their corporate strategy and the opportunity to create new value.

Whilst all ESG topics are important, they can’t all have the same priority. The materiality of each issue needs to be considered in line with business impact, financial materiality issues (impacts inwards) as well as environmental and social materiality (impacts outwards).?

An ESG strategy must align with the organisation’s vision and purpose and meet the objectives set. A roadmap of activities should be established with a phased approach showing accountability for action. ESG objectives should be used to inform the intent of innovation and drive the development of new products and services and the underlying value chains that support them.

A data strategy should be established to underpin objectives and provide critical intelligence to create value and support ongoing monitoring of ESG and value creation against KPIs (see section C).

v. ESG disclosures and reporting?

ESG disclosures provide the best way for stakeholders to understand the climate related and societal impact that companies are making and to make decisions that matter to them, as well as to influence board decisions.

The range of ESG targets and frameworks used to report against is both vast and varied by sector, size and complexity of business (several frameworks in development are documented in the following section). ESG metrics and targets are as yet not standardised and standards take years to develop and converge around leaving a gap today between the macro targets and micro measures. To fill this gap, pension funds, banks and PE houses are developing and testing their own metrics to create a forward looking picture of the impact of their portfolios which can highlight progress. These metrics will continue to evolve as standards converge over the coming years.

Alongside mandatory, quantifiable reporting, consistent, strategic messaging of progress and impact should be communicated.?

As ESG targets are achieved, authentic messaging can create value by building loyalty from customers and employees as well as build investor commitment. Critically, to create genuine value, stakeholder communication must not be ‘woke-washing’, that is signalling support for progressive causes as a substitute for genuine action. Stakeholders will filter this out and no sustainable value will be created.

Managing the data required to provide credible, verifiable and comparable data will require careful consideration of both data and data systems. If this is not considered with due care there is a danger that ESG targets may be hit but the opportunity ESG presents may be missed in the process.

3. Scope & frameworks

The impact of ESG is an inextricable part of how a company does business. The scope of issues considered by a company will be a combination of mandatory and voluntary. It will be driven by many factors including regulation and investor diligence. And whilst these are important drivers, to create value, leadership must define scope and develop strategy based on the materiality of issues relevant to their business, industry, geographical location and size.?

Leadership will need to consider a number of different frameworks and standards to inform their strategy.

Task Force on Climate-Related Financial Disclosures (TCFD)?

The Financial Stability Board (FSB) created the TCFD to develop consistent climate-related financial risk disclosures on the types of information that companies should disclose to support investors, lenders, and insurance underwriters in appropriately assessing and pricing a specific set of risks—risks related to climate change. In the UK TCFD became mandatory on 6th April 2022 for 1,300 of the UK’s largest listed companies.

Increasing the amount of reliable information on financial institutions’ exposure to climate-related risks and opportunities will strengthen the stability of the financial system, contribute to greater understanding of climate risks and facilitate financing the transition to a more stable and sustainable economy.

EU Taxonomy Regulation

The EU Taxonomy Regulation establishes the basis for the EU taxonomy by setting out 4 overarching conditions that an economic activity has to meet in order to qualify as environmentally sustainable. It entered into force on 12 July 2020.

The Taxonomy Regulation establishes six environmental objectives

• Climate change mitigation
• Climate change adaptation
• The sustainable use and protection of water and marine resources
• The transition to a circular economy
• Pollution prevention and control
• The protection and restoration of biodiversity and ecosystems

Different means can be required for an activity to make a substantial contribution to each objective.

BSI ISO14001

ISO 14001 specified an environmental management system that puts environmental management, including policies and objectives, at the heart of an organisation’s operations. It can help an organisation meet environmental regulations, improve efficiency and environmental performance and create enterprise value.

SASB?

SASB has developed a complete set of 77 Industry Standards (published in November 2018), providing a complete set of globally applicable industry-specific Standards which identify the minimal set of financially material sustainability topics and their associated metrics for the typical company in an industry. SASB provides an Engagement Guide for investors to consider questions to discuss with companies regarding financially material issues as well as an Implementation Guide for companies which explains issues and approaches to consider when implementing SASB Standards.

GRI

GRI provides global best practice for reporting publicly on a range of economic, environmental and social impacts. Sustainability reporting based on the GRI Standards provides information about an organisation’s positive or negative contributions to sustainable development. The GRI Standards is a modular system of interconnected standards. Three series of Standards support the reporting process: the GRI Universal Standards, which apply to all organisations; the GRI Sector Standards, applicable to specific sectors; and the GRI Topic Standards, each listing disclosures relevant to a particular topic. Using these Standards to determine what topics are material (relevant) helps organisations to achieve sustainable development.

MiFID II

The EU has proposed changes to the MiFID II suitability rules to ensure that investors’ environmental, social and governance (ESG) preferences are taken into consideration during the investment advice and portfolio management processes.

UN’s Sustainable Development Goals

One framework used by over 70% of the G250 group of companies are the UN’s Sustainable Development Goals (SDGs). They offer an effective way to look at ESG opportunities and risks, to translate the impact of investment activities into real economy outcomes and they provide a useful means of engaging with stakeholders and deepening their purpose. They are a plan of action for addressing the world’s most pressing challenges. The SDGs set forth 17 critical areas to solve economic, social, and environmental challenges by 2030. With 169 specific targets, the SDGs present a wide range of opportunities for businesses to make a difference.?

Even if not broadly adopted, SDGs can inform an ESG strategy and programmes for medium sized organisations and can align an organisation’s purpose with the world’s pressing challenges, with broad benefits for stakeholders. The following chart maps ESG type to SDG by goal:

Example ESG scope & criteria

The scope and criteria of ESG reported by a company will vary by company but may include targets on the following criteria and topics:

ENVIRONMENTAL

How a business performs as a steward of our natural world:

• Disclosing GHG emission (scope 1, 2 & 3 in tonnes of CO2e) and climate risk exposure
• Establishing sustainable procurement policies and supplier codes of conduct
• Promoting responsible consumption through marketing and PR events
• Supporting new business models that can deliver clean/renewable energy
• Assessing and correcting gaps in resource use and waste procedures
• Understanding the impact of business activities on natural resources, water and energy use
• Improving processes to reduce waste, including packaging and distribution

SOCIAL

How a business makes a positive social impact:

• Treats consumers as stakeholders, working to address the issues that concern them most with transparency and consistency that builds trust
• Contributions to equality, trust and welfare in society
• Providing employees with meaningful work?
• Product safety, respect for privacy and data security
• Including marginalised and underrepresented persons in the value chain
• Investing in local communities and building positive reputation
• Ensuring absence of slavery in the supply chain
• Labour relations, diversity and inclusion
• Paying fair prices to suppliers
• Improving methods of production
• Building domestic and global partnerships in healthcare & education programs
• Practising inclusion through corporate policies
• Revising internal policies to eliminate unintended bias and discrimination

GOVERNANCE

How a business makes decisions and behaves:

• Practices, controls, and procedures by which decisions are made
• Quality and scoping of reporting
• Accountability levels, audit findings & independent oversight
• Ethical behaviours on ESG and non-ESG
• Board structure, director and audit independence, executive compensation
• Educating and encouraging suppliers to adhere to strict standards
• Paying fair share of taxes in countries of operation and avoid tax evasion

4. Data & data systems

Boards and the C-suite must be comfortable with the accuracy and completeness of the underlying data sources used for ESG metrics and disclosures. This is what the market demands and expects.?

However, this creates its own challenges for the underlying data systems and the data that supports reporting. The Financial Reporting Council (FRC) is responsible for regulating auditors and accountants and setting the UK’s Corporate Governance and Stewardship Codes. In their ‘Statement of Intent on ESG challenges’ based on their research and outreach, they documented the current issues they identified that need to be addressed to drive maturity of reporting and they grouped these data challenges into six stages:

1. Production – better internal information leads to better decisions and better insight for stakeholders
2. Audit and assurance – reported information is robust and reliable
3. Distribution – information is made accessible to interested parties
4. Consumption – this information leads to better decision making by stakeholders
5. Supervision – information and activity is appropriately monitored and requirements are enforced
6. Regulation – coordinated and coherent regulation leads to efficiency?

The FRC proposes detailed action against each of these areas in addressing them in their work with standard setters, regulators, market participants and other stakeholders.?

In time, this approach will help ensure that an effective framework fit for the future will be developed to support the growth of sustainable businesses.?

In the meantime, investors and companies will need to both find ways to tackle the day-to-day challenges and keep sight of the big-picture. They will need to develop ESG programs that will withstand the test of time, investor demands, and cultural shifts This will require centralisation of process, data integrity & system flexibility:?

1. There will need to be a centralisation of operational processes to support required ESG disclosures and create actionable ESG intelligence.?
2. There may be multiple sources of the same information however systems of record (SOR), providing the authoritative source for each data element, will need to be identified to ensure data integrity and transparency into underlying data sources.
3. Information systems will need to be designed that can be easily reconfigured as data requests change and different stakeholders require different sets of data.?

In addition, to create value, systems should support enterprise-wide data science practices and be able to:

• Directly address the challenges that the FRC have identified.?
• Contextualise data by comparing it with benchmark data, by sector, to make it meaningful and assess it against targets.
• Aggregate information from different information systems (and SORs) owned by different parts of the business.?
• Merge and transform this data as required.
• Model, analyse and visualise both quantitative and qualitative data and make sense of it.
• Deliver reports and data sets, in different formats, to be consumed by different stakeholders to allow insights gained to be leveraged.

Being proactive in ESG allows time to build more programmatic strategies versus one-off reactions to current events and demands and therefore a greater opportunity to not only respond effectively to external requests for information and regulatory disclosures, but to ensure value is created through the process. Companies that react to ESG as a reporting requirement, regulatory oversight or compliance process will miss the opportunity to use this lever to create value.?

About Anderson Strategy

Anderson Strategy provides ESG advisory services, backed by data science.?

• We help our clients assess the opportunities that ESG presents and develop an ESG strategy & roadmap to create enterprise value.
• We analyse quantitative and qualitative data to help our clients identify risks and opportunities in order to drive innovation intent and improve ESG ratings.?
• We help communicate these propositions and progress to stakeholders.

Our Managing Partner Justin Anderson previously founded and led a technology company that delivered GRC (governance, risk & compliance) systems to FTSE100 companies. KPMG invested in the firm and after a brief spell employed at KPMG Justin founded Anderson Strategy.

KPMG again became a client and Justin held leadership positions inside the firm for four years including Global Head of Technology CoE and Head of Digital, KPMG UK Private Equity Strategy team.

Justin sits on the BSI council for innovation with responsibility for integrating ESG into international innovation standards.