A twin journey: ESG and Digital Transformation (Part I)
An ethical investment portfolio must take a joint perspective on ESG and Digital Transformation integration for business decisions. Successful companies greatly benefit from carrying out ESG and DT change processes together. Those who carefully choose the right path and the best suited IT partner, stay ahead and win.
This is part I from the blog series on the topic of ESG, created in Future Processing and AKFI collaboration. Jump to the second part and the third part below:
Many business decision-makers ask themselves questions like: How is it possible that this particular investment paid off so well or didn’t pay at all? Why does this particular business stay ahead of the competition? What makes an investment worth the risk in these uncertain times?
Let’s explore the topic of ESG – a framework for reporting, a point of reference for investors, regulators or employees, and a set of crucial ratings to take into account when making big business decisions for now and for the future.
What is ESG?
ESG ratings are an increasingly popular way for investors to evaluate companies in which they might want to invest. Let’s see the in-depth ESG definitions from two different perspectives:
According to Investopedia: ESG criteria are a set of guidelines for a company’s activities that socially conscious investors use to screen potential investments.
- Environmental (E) criteria concern how well a corporation manages the environment.
- Social (S) criteria focus on how it interacts with employees, suppliers, customers, and the communities in which a business operates.
- Governance (G) includes topics connected with the leadership of a corporation, executive compensation, audits, internal controls, and shareholder rights.
Internal business operations’ perspective
ESG is used as an operational framework as part of both the enterprise risk management systems and value creation. When properly used, ESG provides three separate lenses for senior management and the Board of Directors to develop plans and performance measurements (KPIs) for non-financial impact. Further, ESG provides metrics for optimising business operations resulting in increased sustainability, resilience and longevity.
The popularity of ESG continues to increase over time as a way of business evaluation in the area of promising investment directions. On the other hand, it can be extremely helpful in avoiding investing (or investments in) companies that create financial risk connected to their environmental practises. That leads to a wide variety of products and services on the global IT market that helps strategically employ ESG ratings and rankings.
Reasons to make crucial changes to companies’ purpose
As there is a heated worldwide discussion on reasons and challenges connected with ESG, it is crucial to emphasise that the ESG changes are derived from 3 major trends:
Increased scrutiny from investors acting on the finance industry to direct funds according to ethical and environmental metrics. For example, issues concerning child labour and carbon and methane emissions in the entire supply chain.
Customers and stakeholders vote with their wallets according to the business impact on the environment, society and employees, and adopting forward-looking management practises such as diversity in the executive management ranks.
Reaction to regulatory pressure on disclosures and streamlined reporting to parallel current financial reporting considered by IOSCO and national regulators.
Areas of ESG business actions
ESG ratings and rankings help companies measure how their investments perform in certain categories. Environmental factors refer to the conservation of the natural world, social factors include how people are treated inside and outside the company, and governance factors refer to the ways business is run.
Here are some examples of areas to look at in each category:
Why is ESG crucial for the future of business?
While the focus on ESG is relatively new, the role of stakeholders in enterprise management is attributed to Edward Freeman, who highlighted the role of the broader community impacted both positively and negatively by a business. Stakeholders can be active participants in the business e.g., employees and customers, or passive participants, e.g., local communities.
The moral, ethical and social roles of companies can be traced back to the Age of Enlightenment.J.J. Rousseau
Licence to operate
As shown by Statista, for ESG investors controlling large pools of assets under management (AUM), the environmental and transformative governance risks are top-of-the-mind in directing investments based on ESG ratings and rankings.
As of 2021, climate risk was the most relevant environmental, social, and governance (ESG) factor for the decision-making of institutional investors worldwide. 79 percent of the respondents stated that this factor is a top risk or opportunity factor. Governance followed, with 55 percent of the investors surveyed.STATISTASource: https://www.statista.com/statistics/1204036/top-esg-risks-and-opportunities-for-investors-worldwide/
It seems way easier for companies to enter new markets and expand their operations in the existing markets if they have a strong ESG approach. Countries with well-developed economies and eco-friendly business regulations will perceive ESG-compliant companies as better investors.
Effectiveness and cost reduction
Companies that switch to more sustainable methods of production tend to be more efficient and reduce their costs. For example, Nestlé will invest up to USD 2.1 billion by 2025 to fully replace plastic packaging with sustainable solutions. It will cut carbon footprint and also avoid non-compliance costs in countries with strict policies regarding plastic packaging.
There is no wonder that modern companies with good ESG scores attract great talent and specialists who highly value sustainable business actions and investments. The younger generation of employees seeks meaningful goals in companies that are aware of their impact on the future. The trend is even stronger when companies provide a clear digital transformation strategy to current and future employees. A strong ESG business approach can also prolong retention as a clear sustainability agenda helps maintain an internal sense of pride and belonging.
Is ESG delivering stakeholder value?
The financial industry consensus is that companies leading in ESG ratings and rankings provide better and more secure returns when measured in financial terms. To answer the question in more detail, study after study has shown that two important factors play a role in how ESG is reflected in a company’s stock:
- When ESG-related news is material for the company performance. In other words, if it affects financial metrics such as productivity increase, reduction in work accidents, as well as cost avoidance and cost savings. For example, a company replacing cheaper and environmentally friendly packaging will have a financial material impact reflected on the balance sheet of the company. In another case, a company removing the use of plastics in the cafeteria will not likely see a change in its stock price.
- Bad ESG practises are penalised. While stories of the Good Samaritan cross cultures, the reality is that companies are penalised for bad environmental or social behaviour, while good companies do not always get the benefits. In everyday business news, we hear about companies that saw large drops in valuation due to environmental damages or employees being subjected to sexual harassment, discrimination, or abusive management practices. More recently companies which fail on protecting their data assets during digital transformation, and suffer cyberattacks such as ransomware receive lower ESG ratings.
(Un)measured impact pays off
As mentioned, good ESG practises are not directly and immediately rewarded, hence economists, stockholders, and media are less able to measure the impact on stock performance. We can assess the indirect influence on other business-related KPIs, like employee satisfaction and productivity, employer hiring, and retention. This reflects how strong ESG policies are associated with excellent management practises. Positive media coverage of environmental awards, stockholder devotion to green brands and activist investors are among the other indicators.
But most importantly, phenomena such as the outbreak of the COVID-19 pandemic or climate changes make us all realise that we are not the earth’s owners and rulers. That is why ESG is gaining even greater significance, as companies have the responsibility and resources to take positive actions that can pay off on many different levels.
Furthermore, when good ESG practices are also aligned with successful digital transformation, companies benefit from new business models, new markets and the latest digital technologies.
Manuel Vexler is the Executive Director of AKFI, the Actionable Knowledge Foundational Institute, a non-profit global industry consortium. It serves as a platform for forward-thinking companies embarking on Digital Transformation and ESG initiatives. Members’ working groups integrate Digital Transformation and ESG expertise and together develop actionable plans. When implemented, the strategies safeguard stakeholders against catastrophic risks, resulting in substantial economic benefits for stakeholders.
For further information, go to www.akfi.org.