By Samantha Mueller, Senior Manager of Sustainability Reporting and Assurance, AICPA
There’s a three-letter acronym used frequently in the financial services industry, in the halls of academia, and in public sector institutions: ESG.
ESG stands for environmental, social, and governance, and it represents a new framework for how businesses can contribute to solving global challenges related to climate change, human rights, and ethical business practices.
This area of interest represents a shift in focus from a shareholder perspective to a broader stakeholder perspective. In the past, sustainability, employee well-being, and ethical supplier relations were often sacrificed in order to maximize shareholder wealth. Businesses are now realizing the importance of considering the needs of each stakeholder: customers, employees, suppliers, creditors, governments, communities, and of course, shareholders.
There is a general misperception that ESG applies only to climate change, but environmental issues are only one component of the framework. To gain a clearer understanding, let’s first consider each pillar of ESG:
Environmental initiatives could involve reducing carbon emission or the environmental impacts of various company operations. This involves closely monitoring and reporting detailed data about carbon emissions, water and energy usage, and electronic waste.
Social initiatives include detailed reporting on human resources issues like worker health and safety, human rights, working conditions, gender pay equity, as well as diversity and inclusion.
Governance involves board diversity, executive compensation, enterprise risk management, and local community philanthropy.
To understand what ESG means to businesses today, we must consider its origins. The concept of corporate social responsibility (CSR) has been around since the 1960s, but it was further popularized by two major events: The 2008 financial crisis and a trio of accounting scandals (Enron, WorldCom, and Tyco).
These tragedies were the result of shady business practices (cooking the books, predatory lending, fraudulent financial statements) that ultimately destroyed millions of jobs, wiped out trillions of dollars of shareholder wealth, and destabilized economies across the globe. They brought to light not only the importance of ethical business practices, but also how ethical failures have societal consequences for all stakeholders: customers, employees, communities, shareholders, and even governments, who are often asked to bail out corporations deemed “too big to fail.”
In the wake of these scandals, many corporations began releasing annual CSR reports to update stakeholders on their progress related to employee well-being, climate change, and philanthropic efforts. CSR reporting was strictly voluntary and was viewed as a way for companies to boost employee morale, customer loyalty, and investor sentiment. For most of the businesses that participated, CSR reporting was not under the finance function, but rather was performed by public relations or marketing.
Considering ESG-related matters, on the other hand, is the notion that long-term business success is closely interlinked with corporate sustainability. It helps to strengthen individual business internally: reducing risks, enhancing regulatory compliance, driving cost savings, investing in innovation and helping companies engage with customers, staff and the wider community. (For more on this, see the CGMA paper, Creating a Sustainable Future: The role of the accountant in implementing Sustainable Development Goals.)
Finance is primarily about protecting assets and mitigating risks, and there are a variety of risks inherent in businesses who fail to develop and implement an ESG strategy. One of the greatest potential risks is a higher cost of capital.
Financial institutions, such as Blackrock, Vanguard, and State Street, are beginning to use ESG scores as an input in their analyses to help them determine the riskier investments in their portfolios. Banks are also beginning to offer more favorable financing terms to businesses with lower perceived risk. The lower a company’s ESG score, the more difficult and expensive it will be to secure debt or equity financing. This is a risk most companies simply cannot afford, especially with rising interest rates and falling stock valuations.
Another potential risk is talent acquisition and retention. In particular, Gen Z gravitates toward employers who not only care about ESG issues, but are actively involved in doing something about it. In fact, 69% of people say they would leave their current company for a brand that takes sustainability more seriously. Businesses that fail to recognize this trend risk alienating their workforces.
On the other hand, business leaders who step up and take these issues seriously have potentially great rewards in store: lower cost of capital, happy employees, loyal customers, and satisfied shareholders. There is no more middle ground.
Ultimately, ESG reporting is no different from what finance teams already do. If you follow your normal process for identifying risks, developing controls and processes around those risks, and establishing a single source of truth for collecting and reporting ESG data, you have all the tools necessary to develop a winning ESG strategy.