The Business Case for ESG Reporting
With social and regulatory momentum building behind environmental, social, and governance reporting, business leaders and their advisors should make meaningful ESG practices an immediate priority.
Environmental, social, and governance—more commonly known as ESG—reporting is having a moment. As investors, employees, supply chain partners, and stakeholders of all stripes turn to ESG reporting to inform key business decisions, business leaders and their advisors are struggling to establish and prioritize ESG efforts. The challenge is that while ESG reporting becomes increasingly popular and valuable, the lack of formal regulations and standards stymies leaders looking to make meaningful changes to how they do business.
Part of the problem is that ESG reporting examines a wide variety of factors, both tangible and intangible. Put simply, ESG reporting is an examination of an entity’s involvement in environmental, social, and governance issues. Environmental factors could include an organization’s impact on climate change, natural resource scarcity, pollution, and waste. Social factors commonly explore an organization’s values and practices around issues such as labor and supply chain standards; diversity, equity, and inclusion efforts; and customer privacy. Governance factors often delve into issues like oversight and management structures, diversity within the board of directors, executive compensation, and crisis response. While some issues like diversity within the board may be easier to quantify, other factors like sustainable supply chain measures or the effectiveness of oversight aren’t immediately apparent in financial statements—yet the appeal and influence of these standards are undeniable.
“Investors, executives, and consumers increasingly understand that a company’s value is largely intangible and consists of more than just assets and products,” explains Marcy Twete, CEO and founder of ESG consultancy firm Marcy Twete Consulting. “How a company interacts with its stakeholders, community, and the planet is a value driver that directly impacts its bottom line.”
The Bottom Line for ESG
The COVID-19 pandemic is an active example of how ESG factors impact the bottom line. Organizations with solid lines of support for employees, nimble business operations that were able to pivot to serve rapidly changing needs, and adaptable strategies for successfully navigating uncertain times were more likely to survive—or even thrive—during the pandemic.
Mary Adams, founder of Boston-based Smarter Companies, believes that the pandemic’s impact on ESG investment activities proves that ESG is more than just a passing fad. “If it was a fad, then everyone would drop it in a crisis,” Adams explains. “What happened during the pandemic is that companies that had the trust and confidence of their employees and customers performed better through the disruption. We know there’s a link between ESG and a company’s performance. It may not be easy to pin down, but there’s definitely a connection.”
Even if we can’t see the impact of ESG on the bottom line, we can definitely see it in the flow of investment dollars. According to Moody’s Investors Service, investments in ESG products increased 140 percent in 2020. Similarly, Morningstar reported that ESG-rated funds took in $51.1 billion in new investments in the same year.
Chirag Shah is chairman of Simfoni, a company focused on leveraging spend analytics to help companies achieve supply chain sustainability. In July 2021, he successfully raised $15 million in Series B funding. “ESG goals are a moral and ethical necessity. As responsible corporate citizens, it’s our duty to take care of the future of our society,” he emphasizes.
Shah believes that product and technology innovations have progressed to the point where companies are able to achieve both ESG goals and business benefits. He says that raising the bar on ESG efforts not only mitigates risks but improves corporate performance.
“Focusing on ESG can reduce unnecessary costs,” Shah says. “Additionally, with social media enabling customers to have more of a collective voice, it’s evident that making responsible choices can result in higher brand value. Corporations that make a positive impact can increase their appeal to existing and potential customers and attract new market opportunities.”
Corinne Dougherty, audit partner with IMPACT, KPMG’s sustainability program, and a member of the AICPA Sustainability Assurance and Advisory Task Force, agrees that there are measurable business benefits: “Implementing an ESG strategy and reporting on progress will help companies unlock new value, build resilience, and drive profitable and measurable growth today and in the future,” she says.
Dougherty adds that ESG reporting further benefits the bottom line by helping business leaders understand and address emerging risks that threaten profitability; attracting a new investor base while meeting the ever-changing and increasingly stringent requirements of institutional investors; gaining access to capital; competing for top talent; and building a loyal customer base.
The Momentum Behind ESG
The motivation to implement ESG practices is driven by both external and internal factors. Externally, investors, customers, and regulators are calling for increasingly rigorous and sophisticated ESG reporting to help inform investment decisions and to hedge systemic risks in their portfolios.
“There’s no way you can hedge against climate change, right? You have to start advocating for a systemic solution,” Adams explains. “Additionally, during a time of great disruption, we often see exciting and innovative solutions, so that could be driving external interest in ESG efforts as well.”
According to a November 2020 report issued by the Forum for Sustainable and Responsible Investment, 33 percent of total U.S. assets under professional management are using sustainable investment strategies. By their count, those assets grew from $12 trillion at the start of 2018 to $17.1 trillion at the start of 2020—an increase of 42 percent.
But there are also internal pressures driving companies to implement ESG best practices. “In both public and private companies, employees are demanding better supply chains, carbon footprints, and labor practices, leading companies to prioritize their ESG efforts,” Adams explains.
Bryan English is the CFO of Elkay, a global manufacturer headquartered in Downers Grove, Ill. He says the momentum toward ESG practices goes further than the financial or branding concerns, with much of it driven by societal expectations and the innate need to “do the right thing.”
“Today’s consumers and workforce, who are really one and the same, expect companies to do right by their employees and their customers, to do good within their communities, to be good stewards of the planet, to be good corporate citizens, and to be a company with a purpose,” English says. “Because these expectations drive buying behaviors and affect whether you’re an employer who can attract top talent, they’re at the heart of why ESG is becoming such a critical focus area for companies today.”
The Regulatory Vacuum
Currently, ESG disclosure is a voluntary best practice, though the U.S. Securities and Exchange Commission (SEC) is signaling that more formal guidance may be coming soon. In March 2021, the SEC announced the creation of a climate and ESG task force in the Division of Enforcement that will develop initiatives to proactively identify ESG-related misconduct. Their initial focus will be identifying any material gaps or misstatements in climate risk disclosures. And in April 2021, the SEC’s Division of Examinations issued a risk alert, noting deficiencies and internal control weaknesses within investment funds that purported to be engaged in ESG investing. The seven-page alert included examples such as portfolio management practices that were “inconsistent with disclosures about ESG approaches,” controls that were “inadequate to maintain, monitor, and update clients’ ESG-related investing guidelines, mandates, and restrictions,” and proxy voting that “may have been inconsistent with advisors’ stated approaches.”
“Regulators have certainly increased their ESG scrutiny,” acknowledges Kristie Paskvan, CPA, MBA, board director of Smith Bucklin, NCCI, First Women’s Bank, and the United Way Metropolitan Chicago and an Illinois CPA Society member and Insight columnist. “In the United States, we expect rules will be implemented that require banks to account for the sustainability impact of their lending and investment policies. Therefore, all banks have this on their radar and are moving at various speeds to implement policies and procedures.”
Twete says there’s a natural tension between wanting to emphasize materiality and wanting to achieve standardization. “As readers of sustainability reports or ratings, we want to be able to easily compare Apple to Exxon, Macy’s to McDonalds, even though their business models and material issues are different,” she explains. “That kind of standardization is not only difficult, but it can also be a slippery slope. But while no system will be perfectly ‘one-size-fits-all,’ there’s hope for a more streamlined measurement framework for companies.”
English believes that we’re starting to see some standardization among ESG models that work best for businesses, though he’s still hesitant about the possibility of the level of standardization associated with traditional financial reports. “There are too many variances between businesses and their impact on consumers, society at large, the planet, their own people, and the communities where they do business. When you standardize a reporting model, you leave out room for all the nuance—the good, the bad, and the ugly—that’s at the heart of why consumers care about ESG reporting in the first place,” English says.
Starting Your ESG Journey
Even without across-the-board standardization, English believes ESG reporting should be undertaken because it’s a powerful way to express corporate social responsibility. “ESG reporting backs up storytelling with data and facts, which adds credibility and helps distinguish those who are doing the work and making a real difference,” he says.
While each company’s ESG journey is unique, the process of implementation is similar across all industries. Here are Dougherty’s four steps to start your own journey:
1. Develop an ESG strategy. Understand and anticipate stakeholder expectations by identifying issues and assessing gaps, risks, and opportunities to integrate ESG into your business strategy.
2. Operationalize the strategy. Embed strategy into operations by understanding the implications for the workforce, supply chain, operations, controls, technology, infrastructure, and governance and managing the controls around collecting and processing data to track progress.
3. Measure, report, and assure. Understand the different standards, frameworks, and metrics for reporting ESG data, develop capabilities to measure the ROI of ESG initiatives, and provide accurate and fit-for-purpose disclosures and reporting.
4. Transform with ESG. Growing with ESG in mind requires a new approach to transactions, strategies, and partnerships. All these events create risks and opportunities for ESG strategy. Understanding those implications and developing processes to evaluate them during the transaction life cycle can future-proof your ESG approach.
Twete suggests that an initial step toward ESG reporting might be to conduct a materiality study to understand the risks and impact of ESG issues within your own company. “Consider which issues have the potential to negatively or positively impact your business. What do your stakeholders expect of you? From there, you can assess these key material ESG issues with your existing risk management process,” she says.
She emphasizes that companies need to address ESG issues with the same rigor they apply to operational or financial risk—and remember that ESG cannot succeed in a silo. These efforts will reach across and transform every aspect of an organization.
With increased regulatory and social attention on ESG issues, now is the time to identify, prioritize, and act on ESG measures that can improve your organization’s reputation and resilience—while also making the world a noticeably better place.
Carolyn Tang Kmet, MBA is a senior lecturer at the Quinlan School of Business at Loyola University Chicago.