ESG: Importance, Issues, and Business Model Integration

Today, most companies have committed to improving their environmental, social, and governance (ESG) performance to meet growing demands from investors, regulators, and customers. In an era of climate change, global conflict, and social inequality, ESG has become one of the most important trends in capital allocation, risk assessment, and corporate value creation.

What is ESG?

ESG stands for environment, social, and governance, a set of criteria used by investors, boards, managers, and other stakeholders to evaluate the sustainability, responsibility, and risk profile of a business.

While ESG focuses on "non-financial" performance indicators compared to classic investor metrics like profit and earnings-per-share, ESG issues increasingly have material, financial impact on a company's access to capital, operating costs, and long-term competitive standing. ESG criteria give decision-makers a holistic lens to evaluate a business' strategy, operations, opportunities, and risks, by accounting for all its stakeholders, including investors, employees, the environment, and society.

ESG: What it is and Why It's Important

While ESG scores and ratings are often grouped together by investment analysts, each of the three sections have their own distinct considerations:

Environmental

Environmental ESG activities, attributes, issues, and disclosure areas include:

This ESG category essentially encompasses our basic definition of corporate sustainability — balancing the environment, equity, and economy across products, packaging, facilities, energy usage, people, and waste in a way that doesn’t contribute to global warming, climate change, and biodiversity loss — through an investment and corporate decision-making lens.

Social

Social ESG activities, attributes, issues, and disclosure areas include:

  • Human rights
  • Labor standards and fair pay
  • Workplace health, wellness, and safety
  • Employee diversity, equity, and inclusion
  • Social and community impacts

Internally, this ESG category is closely connected to a company's HR (human resources) and CSR (corporate social responsibility) policies, programs, and practices.

Governance

Governance ESG activities, attributes, issues, and disclosure areas include:

  • Corporate ownership structure
  • Leadership and board diversity
  • Ethical decision-making
  • Risk management
  • Corporate policies and controls
  • Data privacy and cybersecurity

As well as other aspects that balance the rights, responsibilities, and identity of various shareholders and stakeholders in the company.

A helpful way to view corporate ESG is the social externality side of financial accounting. In modern history, public companies operate, account for their financial performance, and then issue shareholder reports like a 10-K which investors can use to decide if they want to invest in the company or not. The problem with this narrow approach however — as we've recently seen with companies like Exxon Mobil, JPMorgan Chase, Wells Fargo, and Tesla — is that financial accounting alone doesn’t fully account for the consequences and risks of operating a company, particularly long-term:

  • What if your business model fundamentally denies or contributes to climate change?
  • What's your business and value chain exposure to Russia as it invades and terrorizes Ukraine?
  • What does it mean for your company's long-term performance and competitiveness if you cultivate a toxic workplace culture that creates publicity issues, promotes racism or discrimination, and compels employees to leave?

These are the types of questions ESG attempts to interpret and answer.

The Growing Importance of ESG and Why it Matters for Every Company

Due to a variety of economic, social, scientific, and political factors, support for responsible, stakeholder capitalism and assessing the long-term role of companies in society has grown considerably over the past decade. The impact of the COVID-19 pandemic, climate change, Black Lives Matter, wealth inequality, government gridlock, and regulatory uncertainty have increased the need for companies to proactively integrate ESG issues and risk management into their strategy, policies, business model, company culture, and value chain.

Compared to quarterly earnings cycles and short-term decision-making, ESG is a longer-term lens on risks, opportunities, and value creation. But ESG also carries near-term, immediate consequences, particularly for companies who fail to consider and address material ESG considerations.

In particular, effective ESG integration (or lack thereof) informs important strategic considerations like:

  • Access to capital - From institutional ESG investors like BlackRock and State Street to private equity and banking lenders, more capital providers are using ESG indices, scores, and ratings signals to assess the risk-return profile of their allocation decisions. Emerging evidence suggests better ESG performance translates to a lower cost of capital for companies, plus broader liquidity access
  • Share price risk - Research from MSCI and Morgan Stanley indicate strong ESG performers have lower earnings volatility and lower market risk compared to lower-ranking companies
  • Board risk - From Engine No. 1's Exxon Mobil board activism campaign to State Street voting against the re-election of directors at 400 companies who failed to improve gender diversity on their all-male boards, directors who fail to act on material ESG risks and opportunities are increasingly seen as poor fiduciaries
  • Climate risk - As climate change and biodiversity loss fuel trillions of dollars in economic loss and risk, organizations need to identify, manage, and adapt to climate impacts across their business model, products, and value chain. Fortune 500 companies alone carry an estimated $2 trillion+ in financial risk from climate impacts
  • Regulatory risk - On the legal side, regulators in the European Union (EU), United Kingdom (UK), United States, Canada, Singapore, and other regions are pushing for more robust ESG implementation across financial reporting, non-financial reporting, and regular operational practices. The Corporate Sustainability Reporting Directive (CSRD) and European Sustainability Reporting System (ESRS) require thousands of companies doing business in the EU to improve their sustainability performance and ESG disclosures
  • Brand and customer risk - The majority of consumers (and a growing number of businesses) want to buy from sustainable brands, making ESG investment, integration, and innovation important ways to de-risk current and future revenue streams while strengthening public reputation
  • Financial ROI - There are many, proven ways sustainability and ESG integration can drive operational cost savings and tangible ROI for category leaders

In many ways, ESG performance has become a proxy for responsible management quality, brand reputation, and macroeconomic risk management. A well-run company that cares about its people, customers, and the environment will logically be more resilient over time and outperform its peers who don't.

Is ESG the same as Sustainability?

ESG and sustainability are often used interchangeably within companies to mean similar things. However, there are important differences between ESG and sustainability. We think the best way to understand the difference is to consider an external vs. internal perspective.

In other words:

ESG looks at how the world impacts a company as an investment, whereas sustainability focuses on how a company (or investment) impacts the world

Strong, thoughtful corporate sustainability should correlate with strong ESG performance, but not always. A sustainable products company could still discriminate against certain workers. Or a firm with strong ESG governance and transparent reporting can still cause immense environmental harm in its day-to-day business.

Is ESG the same as Corporate Social Responsibility (CSR)?

Like sustainability, ESG and CSR are closely related, but fundamentally different. If we refer to our previous definition about the difference between ESG and sustainability, CSR and ESG have a similar relationship.

Inside companies, CSR departments run programs and initiatives centered around non-profit partnerships, philanthropic giving, employee engagement, and community relations designed to create positive social benefit. The same way corporate sustainability targets environmental impact, CSR proactively works to improve a company's social impact.

To summarize:

ESG looks at how society impacts a company as an investment, whereas CSR focuses on how a company (or investment) positively impacts society

Often, within a larger company, the sustainability department will lead the organization's environmental intitiatives, a CSR department will lead external social invitiatives, and HR will manage the company's internal social initiatives like diversity, equity, inclusion, and belonging. All three of these teams will share data with their ESG reporting colleauges, who turn that information into ESG reporting and investor communications.

Top ESG Issues and Trends in 2022

2022 continues to be an eventful and turbulent year. Much like the news cycle itself, ESG issues also trend in terms of global and stakeholder attention and prioritization. While every company's ESG materiality is unique, here are some of the most important ESG issues leaders, boards, and investors need to keep in mind in 2022:

  • Conflict in Ukraine - In addition to rampant human rights violations and war crimes, Russia's unprovoked and illegal invasion of Ukraine has led to supply chain shocks and driven up commodity prices for important resources like oil, wheat, and corn
  • Climate crisis - Record heatwaves across Europe, India, and other parts of the world continue to highlight the need for urgent climate action to prevent catastrophic humanitarian and biodiversity loss
  • Inflation - Commodity price inflation from war in Ukraine, pandemic supply chain frictions, and massive central bank liquidity during a recent low interest rate era have put strain on consumer prices, harming low-income earners, households, and vulnerable communities
  • Uyghur human rights in Xinjiang - China has been accused of human rights violations, forced labor, and possibly genocide against the Uyghur population and other ethnic groups in the north-western region of Xinjiang. Human rights groups believe China's detained over one million Uyghurs in "re-education camps," sentenced hundreds of thousands to prison terms, and required Uyghur's to produce cotton and other materials that are sold at home and abroad. In December 2021, U.S. Congress and President Joe Biden signed the Uyghur Forced Labor Prevention Act (H.R. 6256) which places import limits on goods produced using forced labor in China
  • COVID-19 and reproductive health - Three years into the global pandemic, the COVID-19 virus continues to evolve and mutate, requiring renewed public and private health responses, while putting further pressures on global supply chains. Meanwhile the U.S. Supreme Court overturning Roe v. Wade is forcing organizations to take a stand on abortion rights, and designate abortion access an employee health benefit
  • Board and leadership diversity - While many companies have made some progress on diversity, equity, and inclusion since the 2020 George Floyd protests, corporate diversity continues to lag, particularly at the management, leadership, and board level
  • Internal ESG alignment, integration, and resourcing - As ESG transitions from an investor framework to an operating discipline, firms are exploring how to better organize internally for ESG success to break down silos and improve data and program visibility, decision-making, and cross-team collaboration

Within ESG, it's critical for leaders to keep up with - if not anticipate - these trends, while also creating flexible structures, technology, and operating principles to adapt to new and emerging ESG issues.

The Importance of ESG in Perspective + Next Steps

While ESG may feel like a reporting obligation, dozens case studies demonstrate that strong, thoughtful, and strategic ESG performance is a competitive business advantage that delivers positive ROI. Many companies start ESG work due to compliance and investor reporting pressures, only to find that as their ESG investments, maturity, and capabilities evolve, their company realizes significant cross-company benefits and efficiencies.

ESG's Importance to Long-Term Business Value

Every company's ESG roadmap is different - and ESG truly is a long-term, strategic journey for boards and management teams. Nonetheless, the benefits of strong ESG performance on brand reputation, employee talent attraction and retention, culture, operational efficiency, risk management, and access to capital are not only numerous - many are quantifiable. And, as always, if we can help your organization improve your ESG data management or unlock more ESG ROI, please be in touch.