The new transformation

ESG: Environmental, social and governance

ESG is a way of measuring a business’ operations around three distinct sustainability categories: Environmental, social and governance.

Environmental disclosures include CO2 emissions, waste management, air and water pollution and more.

Social disclosures include diversity, employee health and safety, training and development and more.

Governance disclosures include executive pay, shareholder rights, board diversity, ethics, audits and internal control and more.

These disclosures form the basis on which companies’ ESG performance is rated by external ESG rating agencies.

Why put effort into ESG and the choice of reporting?

It may be tempting to see ESG reporting as a technicality. Something to be handled on top of financial reporting, diligently but reactively compiled by people with the right technical insights in your organisation.

If done right, however, your sustainability reporting can be much more than a trivial and potentially costly reporting exercise. Your reporting should be a lever for change and increased financial attractiveness, helping your organisation and suppliers to act according to your strategic targets and making your progress credible to your investors, creditors and customers.

Drivers for ESG reporting

Compliance may be the first and most obvious reason to report on sustainability. But if your reporting is shaped by compliance, you could be off on the wrong foot. Four strong drivers – each with its own dynamics – form the reporting requirements in a sustainable future.

Finance

Sustainability reporting for your investors and bank is a moving target as the financial sector is working hard to define requirements and processes for how to set a risk premium for financing “less than sustainable” assets. Nonetheless, examples of companies receiving cheaper or just as cheap financing through green bonds compared to traditional corporate loans are already present.

Other examples are sustainability-linked loans with CO2 performance target or loan portfolios where companies are assessed on CO2 emissions are potentially penalised through a downgrade at EBITDA level through a CO2 shadow price. The transition to a sustainable low-carbon economy will cause stranded assets, and investors may well ask you to demonstrate that those assets are not in your portfolio.

In connection, studies on credit rating agencies and ESG have shown that companies with high ESG scores, on average, experienced lower costs of capital compared to companies with poor ESG scores with cost of equity and debt following the same relationship.

With low interest rates on the one hand and political ambitions to reduce CO2 emissions on the other hand, plenty of capital is waiting to be activated. The EU estimates an annual funding gap of EUR 270 billion until 2030 to reach the Paris Agreement. The Danish pension sector has pledged to invest EUR 47 billion in responsible investment. The Danish business association for banks, mortgage institutions, asset management, securities trading and investment funds estimates a need for DKK 300 billion of finance in order to meet the greet transition.

Risk management

Identifying and being conscious about ESG metrics can enable risk mitigation. This can for example be when considering your corporation’s competitive business, financial risk through cash and financial forecast or management and governance. Common to these areas is that they include sharp attention to environmental and social parameters, in which your sustainability reporting can be used as an enabler. In 2019, The World Economic Forum published their Global Risk Report in which nearly 1,000 decision-makers from the public sector, private sector, academia and civil society assess the risks facing the world. Over a ten-year horizon, extreme weather and climate change policy failures are seen as the gravest threats. Conducting a risk assessment can serve as the basis for assessing ESG material activities specifically for your business.

Customers and supply chain

If you serve B2C customers, the demand for transparent sustainability reporting is evident in some segments but hard to predict. The price for being caught greenwashing can be harsh, so at least make sure that your reporting supports your brand message and puts you in sufficient control of your value chain and possible offsetting mechanisms. In B2B sales, the trend is much clearer. As your customers strive to get in control of their supply chain, they will demand that their suppliers can demonstrate the sustainability of their activities. A solid ESG score can be essential where manufacturers or procurement impose sustainable practices on their suppliers, for example through labour standards or tax requirements. In a recent survey, two thirds of CPOs reported sustainability as a top criterion when selecting suppliers.

Strategy

Where will you position your company vis-à-vis the sustainability agenda? Are you a front-runner, breaking new ground and creating new profitable niches through product and process innovation? Or are you an intelligent adapter, forecasting changes in demand? Given your risk assessment of ESG materiality, several companies have acknowledged that it may be more risky to ignore ESG conditions than to proactively respond to them in strategy and operations. Whatever your ambition, make sure that your reporting informs your baseline and progress – that it enables you to see what you are doing in the fields where you have decided to play.

Along those lines, many companies also view their ESG rating as a valuable benchmarking tool both from an internal perspective as well as compared to peers and competitors. Despite ongoing debate about external rating agencies’ methodology and ratings, these assessments can service as powerful incentives for action and decision-making.

Allow for experimentation when designing your ESG journey

ESG reporting and disclosure is still subject to several different methodologies and taxonomies, whilst regulators are also looking into defining criteria for how to classify sustainable activities.

In our experience, few organisations are able to choose the right reporting need based on their strategy, reporting history and external requirements. Unless your sustainability strategy is very clear and is specifically embedded in your corporate strategy, we suggest that you allow for some experimentation.

A typical iterative process for designing sustainability reporting includes these steps:

1. Make high-level assumptions on where you will want to report. Consider where you can create the largest impact in your industry or for your customers, where you have the largest footprint today – and make an educated guess about which of your assets may be at risk from strengthened regulation or customer preferences. Check the expectations from investors and customers, if possible.
   
   
2. Establish a baseline. What would your reporting look like if you were to produce it today?
   
   
3. Assess. Does the baseline provide new insights about your sustainability, which may lead you to adjust your focus? Is it granular enough for tracking your progress? Is data collection cumbersome, and if so are there options for automating it?
   
   
4. Define your reporting – and be sure to review it in a similar process to keep it relevant.
   
   
5. Look to consistently disclose it in your annual report over time – regulators will expect so.

The options for reporting on your sustainability is a sprawled and prodigious family. Taking a systematic approach to reporting will let you create much more impact with your investment – and should keep you from getting lost in a jungle of (reporting) opportunities.