Thought Leadership  •  November 10, 2021

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What Is ESG?

What is ESG? ESG stands for environment, social and governance. Today, governments, regulators, lenders, investors, asset owners, employees, customers, ALL stakeholders, want to know more about companies than just their financial performance. They are interested in ESG factors, such as carbon emissions, waste management, water consumption, employee health and safety, gender representation, diversity, wage equality, child labor, culture and ethics, and cybersecurity, to name but a few. They want to know about these non-financial factors because they understand the effects they may ultimately have on companies’ financial performance, risk profile, and long-term value creation. Currently, the SEC — as well as many international entities — require companies to disclose only certain ESG aspects of their businesses, leaving many corporations to “voluntary” disclose information.

Many see ESG disclosure as an intelligent business move that appeals to investors and stakeholders alike. As such, public and private corporations are beginning to understand how to measure ESG performance, report on ESG and factor it into a company valuation.

Before diving into the importance of ESG reporting, discover what the acronym means — thus, what it measures. There is no question ESG is now a mainstream issue and institutional investors are requesting and expecting increased information. It is recommended that companies increase disclosure of ESG topics in a way that reflects their business. DFIN’s approach to ESG disclosures examines a corporation’s material ESG indicators, defining 5-7 relevant topics, aligned with corporate long-term risk and value creation.

ESG includes factors such as:

  • Environmental: How will climate change and other environmental factors introduce risk into a company’s operations? Identifying potential supply chain disruptions, the impact of rising sea levels on property, continuing impacts of COVID-19 and other related concerns can help guide investment decisions.
  • Social: What are the company's relationships with stakeholders — which include its customers, employees, suppliers and residents of communities where it operates? Factors considered regarding social impact include diversity, equity and inclusion; community relations; labor stands; and customer satisfaction.
  • Governance: What is the company's track record regarding executive pay, shareholder rates, internal controls and audits? Governance considerations include internal policies and controls, political contributions and lobbying, leadership and company board makeup, and shareholder rights.

Why ESG Matters

Some companies believe these factors matter on principle. Consider a B corp that has gone through high-level standards regarding social and environmental impact to obtain certification and is legally obligated to be socially responsible.

Other companies have historically been profit-driven, but want to move toward higher levels of ESG accountability. In some cases, this is driven by the market. Investors are willing to pay a premium for products and services that align with their principles, so adopting ESG criteria is good for business. Companies may also feel like they don't need to choose between making money and treating others well.

What Is ESG Reporting?

Companies generally fall into one of three stages of maturity based on how well they tell their ESG story through disclosures.

  1. Laggards

Companies that don’t have anything documented on corporate social responsibility, either in a report, on the website, or anywhere else. They haven’t identified material ESG topics. In addition, they have not taken into consideration insights from investors or other stakeholders and their views on ESG topics. Essentially, ESG efforts of companies in this stage of maturity may still be anchored in philanthropy efforts rather than incorporating a strategic business focus.

  1. Middle of the pack

Companies that may be publishing a sustainability or corporate responsibility report or disclosing information on a webpage, but do not have a cohesive ESG strategy that is linked to their business purpose and embedded in their core operations. They likely do not have standardized metrics to measure progress or the data gathering processes and controls required to do ESG reporting consistently and on a timely basis. Board oversight is scant at best.

  1. Front runners

ESG strategy is regularly reviewed by board/committees and embedded in core operations. The company has adopted commonly accepted ESG/sustainability standards and reporting frameworks to guide their ESG disclosures. Robust processes, controls, and governance are in place to ensure disclosures are “investor grade.”

How to Report on ESG Information

In the absence of clear guidance from a standard, what is a company to do when it comes to an ESG report or ESG disclosure? This five-step approach can help companies understand how to report on ESG elements:

  1. Find a focus: Given the many details that ESG covers, it isn't practical to report on all of them. To start, come up with five to seven areas on which to report — such as sustainability, social impact, labor practices, energy efficiency and climate change.
  1. Identify a partner: Partners familiar with ESG standards and ESG disclosure can help companies identify the most impactful benchmarks to measure and how to measure them.
  1. Define what makes the difference: With any ESG element, there are many ways to move the needle. Using peer groups, drill down on what the company can do to make a difference and how that difference can be expressed in data.
  1. Pick talking points: With ESG initiatives, select three to five key themes that show what the business is committed to and why. This might be reducing a carbon footprint or committing to a livable minimum wage.
  1. Create content: Once you know what is important, how to measure it and how to communicate it, work with the chosen partner to create data and a narrative text for ESG reporting.

How to Measure ESG Performance

While the process of reporting on ESG in finance seems straightforward, a stumbling block can be the measurements themselves. How is ESG tracked and measured when it can refer to a broad arrange of initiatives?

This is a tricky question. To date, there is no single standard or methodology companies can use to measure ESG. Given the range of initiatives that fall under one of the three arms of ESG, a checklist approach would be so long as to be meaningless. Different stakeholders have different priorities when it comes to ESG, which again complicates the measurement process.

This is where a partner can add value. The right partner will understand ESG reporting trends. It can work with the company to outline clear and measurable criteria that demonstrate ESG activities.

Even the most precise measurement, such as the diversity of new hires, doesn't communicate what the effect of this practice is. There is an assumption that diversifying hires benefits the business, and there is data that suggests businesses benefit from a diverse pool of employees. Simply tracking the number of new hires by race or gender doesn't display impact.

It’s suggested that companies zoom in or zoom out to alter their analysis. Zooming in to look at insights might go beyond the hiring practice to see how diverse hires are treated on the job. Are they compensated fairly? Mentored? Are they contributing in meetings or being shut down when participating? These details give more context than raw numbers, painting a bigger picture.

Zooming out also enhances the picture, in this case by showing how the ESG measure connects to systemic issues and contextualizing the measure in time. With something such as climate change, zooming out places a company's practices in context of how it can change the planet in decades — thus, what needs to shift now to reduce environmental impact.

ESG Impact on Valuation

ESG has a demonstrable impact on business valuation and perception of worth. Data shows that companies that honor ESG commitments are proven to offer lower risk and greater resiliency during times of crisis. They also offer shareholders a higher return on investment.

ESG reporting requirements are always subject to change, but one thing is certain: Consumers will continue to prioritize companies that are transparent and committed to ESG. Reporting on ESG is about identifying your risks and opportunities creating a governance and oversight structure, providing decision useful data, aligned with long-term value creation. Over time this ESG governance and data may provide a lens into the company’s commitment to ESG, the quality of management and alignment with corporate strategy and executive compensation plans.    

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joseph

Joseph Seitz

Marketing Analyst, DFIN