What is ESG and why does it matter?

As the climate crisis becomes increasingly urgent and societal expectations require more attention to be paid to issues such as diversity and workers’ rights, companies are under pressure to prove that their operations are not having a negative impact on the world. And, if they do, that they’re taking action to turn things around.

 

This focus is commonly referred to as ESG. The ‘E’ stands for the environment, and takes into account aspects like climate change, biodiversity, nature and pollution. ‘S’ stands for social, and covers human rights, gender equality, health and education. ‘G’ relates to governance, and accounts for metrics such as board diversity, executive pay and the organisational frameworks in place that make a business run. A company’s overall ESG performance indicates what impacts it’s having in these areas.

 

The term ESG was first coined in 2005, but since 2019 it’s been something of a buzzword in the world of business – according to McKinsey, there’s been a fivefold growth in internet searches for ESG over the last four years.

 

While companies have traditionally been slow to adopt good ESG practice due to concerns about costs and effort, it’s now generally regarded as critical to business success. Consumers want the companies they engage with to show responsibility for the world and its inhabitants, and investors want to align with companies that will be able to weather future climate and social challenges. The next generation of workers, meanwhile, increasingly wants to work for companies that have a positive culture, fair work life balance and deliver a progressive and positive impact on the environment and society.

 

In short, ESG may be ‘the right’ thing to do, but it also helps keep businesses competitive – and it pays off. One study from Deloitte shows that solid ESG practices generally lead to better operational performance, better stock price performance and lower operational costs.

Is ESG the same as CSR? What about the term ‘sustainability’?

ESG, CSR and sustainability are often conflated. CSR, which stands for ‘corporate social responsibility’ was introduced as a form of self-regulatory governance that tried to incorporate social and ethical factors into business management, such as employee healthcare and well-being. It was the first attempt by businesses to take into account their impacts, but over time it became something of a communications and marketing tool – a ‘tick-box’ exercise that didn’t really prompt proactive improvements. ESG goes beyond CSR, taking a more holistic approach to a businesses’ operations, and acting as a catalyst for positive action.

 

ESG is also sometimes used interchangeably with ‘sustainability’, but this is a vague term that can be interpreted in numerous ways and is therefore more susceptible to greenwashing (read more about greenwashing here). ESG comes with a more rigorous and precise framework.  

How do companies measure and communicate ESG?

While ESG has far more substance to it than CSR, it too serves as an important marketing tool for companies that want to demonstrate their good credentials to consumers, customers, clients and investors. An ESG report is central to this.

 

ESG reporting is not compulsory but it’s increasingly becoming the norm. More than 90% of S&P 500 companies now publish ESG reports in some form, as do approximately 70% of Russell 1000 companies, according to McKinsey. Such reports are intended to clearly show what a company is doing in the ESG arena, how its activities are governed, and what its future plans are. But this is where things get slightly murky.

90% of S&P 500 companies and  70% of Russell 1000 companies publish ESG reports

ESG deals with non-financial factors, and there’s no universally-agreed or standardised scale for the measurement of these. Because it’s voluntary, ESG reporting therefore varies widely across businesses, sectors and countries. It can therefore be difficult to judge exactly how a company is performing and, of course, there’s always the potential for greenwashing.

What are ESG disclosures and ratings?

While ESG reporting in itself is voluntary, there is a growing body of legislation that requires companies to disclose information on various ESG factors. These don’t have to be published in a dedicated ESG report (although many companies choose to do so), but they have to be made available somewhere.

 

In 2021, for example, the Sustainable Finance Disclosure Regulation (SFDR) came into play, making it compulsory for financial market participants to disclose their ESG data. This EU regulation was introduced to improve transparency in the market for sustainable investment products, to prevent greenwashing and to increase transparency around sustainability claims made by financial institutions.

 

Next on the agenda for the EU is the Corporate Sustainability Reporting Directive (CSRD), which will be applied in phases from 2024. Here, affected companies will need to disclose the impacts of their activities and supply chains on the environment and on people each year, as well as ESG-related risks and opportunities. All disclosures must be externally audited, which will, in theory, reduce opportunities for greenwashing.

 

Meanwhile, the US Securities and Exchange Commission (SEC) is getting ready to enact similar disclosure requirements, although exactly what this legislation will look like isn’t clear yet.

 

In the case of the CSRD, reporting will be standardised so it will be easier to compare the performances of different companies. However, there are a number of frameworks – many of which existed long before the announcement of the CSRD – that have been designed to help companies make sense of their ESG data.

 

The Global Reporting Initiative (GRI) and Sustainability Accounting Standards Board (SASB), for example, both offer globally-recognised ways of presenting ESG information (companies that are already using a robust framework will undoubtedly find it easier to meet disclosure regulations as they arrive).

 

Then, to complicate matters, there are ESG ratings. These are voluntary to obtain and there’s no legislation on the horizon to suggest they will become compulsory any time soon. Unlike disclosures, which simply outline what a company is doing in a particular area, ratings attempt to quantify a businesses’ efforts so they can be compared against others’.

 

This works in theory, but again, there’s no standardised system. Some ratings companies, such as MSCI, use a seven-point scale from AAA to CCC to rate a company’s ESG efforts, while others such as ISS use a 12-point scale from A+ to D-. Others still publish scores on a percentile basis using a scale of one to 100. This variety makes drawing comparisons between companies extremely challenging.

How do companies manage their ESG data?

Many businesses these days have some kind of function to oversee ESG (from a dedicated ‘sustainability person’ to an entire department), or may enlist the help of an outside party, such as a consultancy. But since ESG encompasses such a wide variety of factors, companies can struggle to keep on top of all the data involved, especially when it’s not easily quantifiable. This will be a problem as disclosure and reporting legislation gets tighter.

 

For example, one study by Workiva found that two-thirds of UK-based professionals believe their organisation is not prepared to meet changing ESG reporting mandates, while three-quarters said they do not have confidence in the data currently available to them.

 

These numbers certainly don’t correlate with the wider business narrative, where ESG appears to be booming and companies are making bold claims about the good they’re doing. Another survey by Google, for example, found that 86% of global executives believe their ESG efforts are making a difference in the world, and yet just 36% of respondents said their organisations have measurement tools to quantify their sustainability efforts, and just 17% use these to optimise their efforts.  

Do consumers even care about ESG?

Yes and no. Consumers certainly care a great deal about the way businesses behave and the steps they take to minimise their impact on planet and people. Research by Glow, for example, shows that in the US, 50% of consumers have switched brands based on ESG-driven factors, while one in five says ESG is one of the top three drivers of deciding what brands to purchase. And it’s only becoming more important, with IBM finding that 51% of consumers say environmental sustainability is more important to them today than it was 12 months ago.

 

But do consumers care about ESG reporting? Not particularly. They care more about trust, with one report from PwC indicating that 50% of consumers say accountability to customers and employees builds trust in companies, while 48% say “clear communication” and 40% say “admits mistakes” as the most important drivers of trust. Meanwhile, only 19% of consumers cited ESG reporting as an important factor in building trust. According to Deloitte, nearly 50% of consumers either do not know what ESG commitments businesses have made that they can trust, or they simply do not trust businesses on climate change and sustainability issues.