ESG a critical compliance issue

ESG a critical compliance issue

Environment, Society & Governance has become a boardroom issue driving strategy, and there is a clear business reason

CEOs could once focus almost single-mindedly on their businesses and value chains. Now, along with driving a strategy that generates competitive advantage and enhanced value, they face another core task: satisfying a broad base of stakeholders with diverse interests who all demand sustainability policies and practices in different variations. Environment, Society & Governance (ESG) has become a boardroom issue driving strategy, and there is a clear business reason behind this.

Governments are coming out with regulatory measures that demand ESG compliance from organizations. The U.S. Securities and Exchange Commission (SEC) has recently released a proposal for public companies in the U.S. to report on material climate-related risks. The new German Supply Chain Act (Lieferkettensorgfaltspflichtengesetz) coming into effect in 2023 will require large companies to identify, assess, prevent, and remedy human rights and environmental risks and impacts both in their organizations and across their extended supply chains. Similar legislation and directives are expected in the EU (Supply Chain Due Diligence), the UK, and other major countries worldwide. Investors will only support a firm’s long-term strategic initiatives if they yield an above-market return and address the future needs of investors themselves, customers, regulators, and employees.

Consumers, employees demand ESG

A 2021 ESG consumer survey shows that overwhelming majorities of both consumers (83%) and employees (86%) said they are more likely to buy from or work for companies that share their values across the various elements of ESG. Seventy-six percent (76%) of consumers stated they will discontinue relations with companies that treat employees, communities, and the environment poorly. The survey noted “there is, however, a glaring disconnect between consumer and management perception. Many more executives than consumers believe that companies are increasing investments across ESG issues. Consumers make it clear that corporate actions matter more to them than words.”

Sustainability a strategic concern

Like digital before it, sustainability has become an overarching strategic concern today. Judgments about a company’s sustainability performance affect talent acquisition and retention, access to capital, and consumer choices. And new regulations, such as the U.S. Inflation Reduction Act, are translating sustainability imperatives into economic shocks, notably in the energy sector. CEOs also see competitors growing and increasing customer loyalty through sustainability-linked products and services.

As a result, CEOs have largely accepted the need to embed sustainability in their strategies to create competitive advantage. But while existing frameworks describe the elements of a sustainable business, they rarely show how to get there.

At the intersection of sustainability and strategy, many companies adopt ESG strategy. In doing so, they can be strongly influenced by the external focus on third-party ESG metrics, which are framed as a way of measuring a company’s performance in ESG.ESG strategies, which often aim to improve key metrics in a way that a firm finds acceptable or manageable, have given many businesses a pragmatic start toward becoming more sustainable. However, as a path to a better strategy, they have drawbacks.

Investors look for real sustainability gains

Managing to metrics isn’t the best way to deploy sustainability as a driver of competitive advantage and value, or to hasten meaningful improvements in environmental and social outcomes. Being still immature, metrics are far from comparable, rigorous, or transparent. And the evidence for a link between economic value and ESG ratings is modest. Investors support genuine gains in sustainability, but they won’t tolerate strategies that don’t deliver economic value. While stakeholders closely observe ESG metrics, financial performance remains much more important in corporate valuations.

Rather than focusing on ESG metrics, a more effective path to improving both financial value and sustainability performance is to integrate sustainability into the development and implementation of corporate strategy. In doing so, CEOs can ensure their strategy makes the most of the market, technology, customer, and regulatory trends created by sustainability imperatives.

According to ReutersCEOs can unite strategy with sustainability in three ways:

  1. Adapt classic, CEO-level strategy questions by viewing them through a sustainability lens. “Is my purpose the best possible fit with competing stakeholder demands?” “As sustainability plays out in my industry, how should I position my strategy and portfolio for maximum advantage?” The collated responses should be tailored for individual business units or portfolio sectors.
  2. Ensure strategic choices include sustainability imperatives by applying top-down and bottom-up analysis.From the top down, ask, “How will increased sustainability modify or create new strategic drivers?” To test existing strategic themes, use such means as moving from climate scenarios that capture climate risk to embedding climate elements in strategy scenarios and tailoring customer research to test hypotheses about critical sustainability issues. Insights gained can indicate how industry ecosystems will evolve as sustainability grows in influence.

From the bottom up, ask, “Which specific sustainability concerns will our strategy need to accommodate?” To identify such concerns, CEOs could consider which issues are most significant for stakeholders—and so, how likely they are to create competitive advantage. Three interrelated qualifiers can help identify these: the future prominence for stakeholders; uniqueness of contribution; and size of business value, net investment. Careful analysis helps rank these issues.

  • Use common methods to assess investments in sustainability and commercial initiatives. Investments with negative value miss the opportunity to increase meaningful impact. While some investments with unclear links to value may be pragmatic to avoid reputational risk, they should phase out over time. Most organizations can do more to use data such as that on stakeholder attitudes and future economic impacts, and connections to estimate the business consequences of investment.

Organizations need to execute sustainability initiatives with the same rigor as traditional strategic activity. They need to anchor these initiatives in the ambition, resourcing plans, and incentives of all key decision makers—not isolate them within a sustainability team. CEOs will need to identify early the new internal business and impact data they need to measure the progress of key sustainability initiatives, as legacy systems may not capture such data.

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