Why ESG Scores for Companies Matter. A Lot.
The Lowdown on ESG Governance: Insights, Best Practices, and More
Governance success stories don't make many headlines. They just lack the combustible pizzazz that epic governance failures like Enron and so many others have permanently wedged into the zeitgeist. Still, we'd bet our bottom dollar corporate leaders are perfectly content staying out of that especially harsh spotlight.
However, whether you think ESG is fair and necessary or an egregious overreach, mandatory ESG reporting is not only inevitable, but just around the bend. Therefore, companies will soon have to air their ESG laundry out for the world to see, dirty socks and all. And that can be problematic if you're still kicking the can down the road or focusing your efforts exclusively on ESG’s environmental and social factors. So let's take a closer look at the G in ESG, what changes it might mean for your company, and discuss a few governance best practices while we're at it.
Corporate Governance in an ESG-Focused World
Corporate governance is expansive. Or at least it should be. It's both a shield and a sword, protecting a company from the countless sources of risk lurking in the shadows, while also actively rooting out and, most importantly, reducing the risk associated with harmful negative trends, dynamics, and shortcomings that can harm the organization.
Inequity in pay and hiring practices, ineffective management, myopic internal policies and procedures, regulatory and compliance issues – they're all symptoms of poor governance. And as we said up top, those are the types of things that put an unflattering focus on a company, firmly planting grimaces across the faces of stakeholders and investors alike.
The bottom line – you probably won't receive many accolades for glowing governance because people now expect it of you. In the age of ESG, social media, and 24-hour news cycles, forward-thinking and diverse, equitable governance practices don't garner much attention. But the slightest hiccup sure will, and given the public's insatiable appetite for miscues, fumbles, and flat-out catastrophes, ESG issues like poor governance are a sure-fire way to damage your brand and relationships with employees, partners, and other stakeholders. The stakes are indeed high.
The Benefits of Effective Governance in the Age of ESG
Before we get too dour, though, there's a ray of sunshine amongst all that potential damage and heartache. Because it's not like governance – both as a concept and set of practices – is new to you. In fact, you already understand the importance of good governance by way of ethical business practices, diversity, and management structure. This isn't your first governance rodeo.
Thus, little of what we say on a variety of topics – whether it’s the importance of top-down diversity and inclusion (D&I), establishing limits on executive compensation, integrating proper internal controls and policies, or simply providing sound oversight – should be entirely foreign to you. Further, given the excessive amounts of risk and uncertainty every organization has battled through in recent years, a risk mitigation initiative and strategy – or, even better, a comprehensive enterprise risk management (ERM) framework – is also familiar territory. Hopefully.
Ultimately, that's what ESG is all about from a company's perspective – mitigating risk. When people believe you have a sound strategy to address ESG risk, including governance issues, it can help you navigate the capital markets, attract top talent, expand your customer base, and develop key strategic and supply chain partnerships.
On the flip side, if your ESG strategy and related disclosures expose gaping holes in your governance that subject the entire organization to increased risk, all those benefits suddenly turn into corporate kryptonite.
ESG Investing Moves the Needle
Nowhere is the importance of ESG more evident than on the investing side of the equation. Long story short – ESG investing is already big business, and will continue to grow exponentially in the coming years. In fact, according to Bloomberg, ESG assets will exceed $50 trillion by 2025, accounting for well more than a third of total global AUM.
Therefore, with 85% of investors already integrating ESG factors into their investment decision-making – and ESG still being in its infancy stage – it's difficult to overstate the importance ESG will play in every company's future success or failure.
Zooming in even further, greenhouse gas emissions and corporate social responsibility factors obviously have a frontrow seat in the collective mindset of asset management firms and sustainable investing as a whole. But how can a company ensure its ESG metrics and performance meet such specific investor expectations? You guessed it – effective governance.
Although we'll get to ESG governance best practices in just a bit, keep in mind that investment strategies aren't just about financial performance anymore. Today, people want to know you take human rights seriously, have a board composition that appropriately reflects your people and customers, and actively vet partners in light of climate change risks and social issues. And none of that is possible without the proper governance structure supporting and propagating them.
Governance, ESG Scores, and You
But how, exactly, does your governance framework tie into socially responsible investing? Institutional investors will, of course, pore over your annual report and EDGAR filings to better understand your ESG strategy. However, an average investor, banker, potential strategic partner, or customer might not have the time or savvy for such in-depth research, but still consider ESG essential.
That's where ESG scores and ratings play such a critical role. As we've said before, scores are a convenient way for people to gauge the effectiveness of your ESG strategy against risk. But unlike media headlines and trending hashtags, governance factors don't play second – or third–fiddle to their environmental and social cousins.
Let's choose one of the more prominent third-party rating agencies as an example – MSCI. Although the exact ESG criteria they use is a secret blend of herbs and spices, their score methodology isn't. MSCI's rating framework begins with 1,000+ data points on a company's ESG policies, programs, and performance. From there, it whittles the information down into a set of specific metrics:
- 80+ business and geographic segment metrics
- 150 policy/program metrics
- 20 ESG performance metrics
- 100+ governance metrics
Does anything in that breakdown stick out to you? Perhaps the overwhelming importance governance plays on what ultimately becomes the final ESG rating? With 100 data points directly attributable to governance, and 150 more stemming from the policies and programs governance oversees, a certain theme sticks out like a sore thumb – governance is absolutely essential to the ESG scores that investors and other stakeholders depend on to judge your overall ESG strategy and performance.
And that's just MSCI. We won't bore you by delving into the other ratings frameworks but, suffice it to say, governance is vital to them as well. But just in case we haven't driven our point home quite yet, we have a few more statistics for you – 91% of banks, 71% of fixed income investors, and 90% of insurers actively monitor ESG performance. And wouldn’t you know, ratings like MSCI are the fastest and easiest way for them to do it.
In the end, a robust ESG strategy propelled by effective governance is value creation and a massive competitive advantage waiting to happen. Or, conversely, an albatross wrapped around your organizational neck. The choice is up to you.
ESG Governance Best Practices
We admit that every organization is different. Maybe you're a noob on the ESG front, or maybe you're well-versed and already have a robust ESG strategy in place. Either way, it never hurts to cover your bases and deliberately set a course for the future.
On that note, we've assembled a series of best practices to get your governance in good working order, at least relative to ESG expectations. As you'll see, the following insights have a distinct lean toward ESG reporting. However, given the recently proposed climate risk disclosures from the SEC, the governance around climate-related risk and environmental issues is definitely top-of-mind these days.
Granted, an effective ESG strategy isn't just about reporting. It's an enterprise-wide initiative that encompasses everyone and everything from HR and marketing to logistics and IT. So while the following best practices favor CFOs and their teams, they're in no way comprehensive from an organizational perspective. Simply put, these tips are a great place to start or, for the more experienced companies, a valuable tool in gauging your progress.
Take Baby Steps
Newsflash – Rome wasn't built in a day, and neither will your ESG strategy. So while you're certainly not new to governance, ESG places different, more extensive demands on it. And many of those demands will require you to view governance through a new, more specific and transparent lens.
Therefore, if you’re just starting your ESG journey, don't think it will fall into place overnight. From internal controls to board diversity, hiring practices to your data environment, your governance is responsible for overseeing and guiding an awful lot within your organization. Consequently, it's going to take a fair amount of time to comprehensively evaluate everything and establish a game plan.
Determine What's Most Important (Material)
To build on the previous best practice, given the sheer volume of areas to examine, you'll need a sense of direction before assembling your ESG strategy. Thus, our advice is to begin with a fact-finding mission, a process that will help you determine the most significant sources of ESG risk and plan appropriately.
This process also includes a materiality assessment, where you identify which ESG factors matter most to your company, customers, investors, and other stakeholders. Naturally, this speaks to the very essence of effective governance, the principal, irreplaceable driver to any critical assessment or evaluation process. And as a result of your governance-propelled risk and materiality assessments, you'll be able to develop a course of action that helps you optimize the limited time and resources you have to devote to ESG.
Thankfully, the many existing ESG frameworks can help you gauge what to focus on, at least as you’re just starting. As we've said in previous insights, between GRI, TCFD, SASB, CDSB, ISSB, and GHG Protocol, choose one that will help you tell your ESG story and, more importantly, meet the expectations of your stakeholders, investors, and customers.
Equip and Support Your Board with Experience and Perspective
Like any major initiative within your company, your board members are the people with their hands on the steering wheel. However, a board without some semblance of ESG experience and expertise will be ill-equipped to help your organization navigate these particularly complex waters.
That makes it essential to have the right combination of experience and perspective on your board, people that ensure proper oversight of your ESG strategy, including internal policies, reporting, and performance. From there, you might even need project and change management teams to help your people get more comfortable with the process. This should also include clear and consistent communication from leadership, explaining what you're doing, why you're doing it, and how it benefits the entire organization.
Evaluate/Re-Evaluate your ERM Strategy and Program
To revisit a theme we've used throughout these insights, a huge part of ESG is ultimately about risk management for your company. And just like any source of risk, your governance must utilize a comprehensive, forward-looking approach to mitigate potential ESG risks that put your business and people in an uncomfortable set of crosshairs.
Of course, ERM is a massive and complex topic on its own, so our advice is to review our prior thoughts on ERM and start looking at ESG as a source of risk that's potentially just as potent as a pandemic, natural disaster, or crippling ransomware attack. Once again, ESG can either be a decisive competitive advantage or an anchor that drags you to the bottom of the marketplace.
Look at Your Data Environment and Systems
According to the World Economic Forum, data – or lack thereof – is the biggest challenge organizations face in their ESG journeys. Globally, a mere 9% of companies use software to drive their ESG efforts. And that’s just not going to cut the mustard.
Thus, if your data environment is in tatters and systems behave like a herd bratty toddlers that need a nap, the chances of you collecting, analyzing, and reporting critical ESG information are slim. And by slim, we basically mean nonexistent.
Think of it like this – clear, concise, and compliant financial reporting hinges on your governance establishing proper guide rails through effective internal controls, data, and systems. ESG is no different in this regard, dependent on your organization's ability to generate accurate, timely, and relevant ESG insights.
To that end, as you start refining governance to effectively lead your ESG strategy, make sure a thorough examination of your data repositories and systems is toward the top of your to-do list. If you don't, it won't matter how committed you are to all things ESG because your metrics and reporting won't correctly reflect any progress. And if the results don't show up in your reporting, all your efforts are for not. People need receipts.
Of course, if any of this is too confusing, convoluted, or chaotic, take comfort in knowing you're not alone. In fact, that's why our ESG and Sustainability practice exists – to ensure ESG is nothing but a strength and differentiator for your business. It's what we do best.