Reete Rool
Sustainability Analyst
The rising popularity of ESG investment creates a clear business case for sustainability.
The Potential of the ESG industry
Despite its current shortcomings, ESG could in fact be an effective tool for advancing towards a more sustainable world. Though the ESG industry grew out of the need to provide investors with a more accurate measure to assess a company’s performance, shareholders are not the only party to be interested in evaluating corporate sustainability. Mandatory and standardised ESG reporting could decrease the information imbalance between companies and their stakeholders as well as introduce balanced disclosure of both positive and negative impacts – an issue which the current voluntary reporting frameworks have been unable to successfully address.
Most importantly however, the rising popularity of ESG investment creates a clear business case for sustainability. Despite the talk about switching to “stakeholder capitalism”, a cost-benefit analysis is inevitably still part of any company’s decision to address sustainability issues. While carbon emissions reductions can be tied to cost reductions then social sustainability actions, such as increasing board diversity, are much harder to quantify to financial benefits. Therefore, the pressure on ESG risk management can push companies to address sustainability in a more holistic manner and increase focus on social sustainability, which has so far been playing second fiddle to environmental issues.
Aside from the wider societal benefits, integration of ESG considerations into the company’s strategy is advantageous for a variety of reasons:
- Competitive advantage – whether or not effective ESG risk management brings about higher financial returns is still a matter of debate (though there are indications that it might be the case), but regardless, given the high interest of investors and regulators in ESG, good ESG performance can be a source of competitive advantage. Consideration of ESG risks and opportunities in the company’s strategy can help stay ahead of regulations and make the company more attractive to investors as well as clients, since there is increased focus on ethical spending.
- Improved risk management – while ESG assessments should not be central to the company’s sustainability strategy, they do offer opportunities to learn about the potential risks the company is facing due to the changing climate. Carrying out TCFD and CDP assessments, for example, can help a company to map out its most imminent risks and define prevention and mitigation measures. Taking a proactive approach to ESG issues enables to increase operational resiliency.
- Increased stakeholder engagement – ESG assessments can be effective tools for communicating the company’s sustainability efforts to the wider group of stakeholders. Their value lies in compressing the complex concept of sustainability into a numerical value or a grade that is easily communicable and thereby enables to engage employees and customers who are not perhaps used to discussing the intricacies of the company’s sustainability performance on a daily basis. They also provide a snapshot view of the company’s progress and give an indication of the end goal that the company needs to work towards.
- Higher quality sustainability and ESG reports - as sustainability has become a buzzword and companies are attracting accusations of greenwashing, ESG standards and frameworks can guide companies on how to substantiate their sustainability claims with high-quality sustainability data and provide balanced reporting on both positive and negative impacts of their operations. ESG performance is now considered to be a factor affecting the company’s ability to attract and retain talent, so effective communication on ESG issues is a must.
- Measure of progress – we currently lack effective tools for benchmarking companies’ sustainability performance, ESG ratings and standards can give an indication to stakeholders on how the company is performing on certain sustainability issues. However, while the ESG standards can be used as yardsticks to evaluate whether the company is on the right track, they are yet to be as matured to accurately take into account all aspects of a company’s sustainability performance, and therefore they should not be treated as the be-all and end-all of sustainability performance and strategy.
Moving towards standardisation
The ESG ratings, standards and frameworks industry is not yet mature, rendering ESG reporting rather challenging, however steps are being taken to increase standardisation and transparency. The EU is in the process of developing the Corporate Sustainability Reporting Directive (CSRD) in the aim of creating higher standards to ESG and sustainability reporting, the International Sustainability Standards Board (ISSB) was created last year in the hope of establishing a global baseline for sustainability reporting. The US Securities and Exchange Commission (SEC) has also recently unveiled their proposal for climate disclosures, with disclosures on corporate board diversity, human capital management and cybersecurity risk governance still in the works.
The field of ESG reporting is developing rapidly and the discussion on the advantages and disadvantages of upcoming developments will need to be left into another blog post. What is clear, however, is that setting higher standards for ESG reporting is of crucial importance as ESG investment continues to reach new heights with Bloomberg estimating ESG assets to exceed $50trn by 2025[i]. If the underlying assumptions of these 600+ ESG ratings, standards and frameworks are erroneous, then we are misallocating enormous amounts of resources and considering that the 2050 deadline for achieving net-zero is approaching with neck-breaking speed, we have little margin for error.
[i] https://www.bloomberg.com/company/press/esg-assets-rising-to-50-trillion-will-reshape-140-5-trillion-of-global-aum-by-2025-finds-bloomberg-intelligence/
Further reading:
Chatterji, A. K. et al. (2016) ‘Do ratings of firms converge? Implications for managers, investors and strategy researchers’, Strategic management journal, (8), pp. 1597–1614.
Eccles, R. G., Lee, L. E. and Stroehle, J. C. (2020) ‘The Social Origins of ESG: An Analysis of Innovest and KLD’, Organization and Environment, 33(4), pp. 575–596
Kölbel, J. F. et al. (2020) ‘Can Sustainable Investing Save the World? Reviewing the Mechanisms of Investor Impact’, Organization and Environment, 33(4), pp. 554–574
Ştefănescu, C. A., Tiron-Tudor, A. and Moise, E. M. (2021) ‘Eu non-financial reporting research – insights, gaps, patterns and future agenda’, Journal of Business Economics and Management, 22(1), pp. 257–276.
Veenstra, E. M. and Ellemers, N. (2020) ‘Esg indicators as organizational performance goals: Do rating agencies encourage a holistic approach?’, Sustainability (Switzerland), 12(24), pp. 1–15.
