Environmental, Social, and Governance (ESG): Combining Profits and Sustainability in Businesses

Some people might still wonder if business profitability and sustainability can coexist. Traditionally, businesses have prioritized profits for their shareholders. However, there is now an expectation for businesses to pursue larger goals, finding a way to balance both profitability and sustainability.

One of the pivotal debates in the history of management was between Friedman and Freeman, regarding shareholder and stakeholder capitalism. In 1970, Friedman argued that a company’s sole responsibility was to maximize shareholder profits. However, Freeman introduced a different perspective in 1984, suggesting that optimal outcomes could be achieved by ensuring all stakeholders, including workers, customers, and the environment also benefited from the business’ operations.

The paradigm shift, pushed by the global environmental issues as well, has prompted companies to include externalities when making business decisions. The Environmental, Social, and Governance (ESG) pillars have now become extensively integrated into business operations.

Why should companies care?

ESG brings numerous benefits to the companies incorporating it.

1. A growing trend among investors

   Investors are increasingly using ESG as a criteria to choose potential investments. Investors believe that companies with ESG as their business foundation are less risky as they are more prepared for uncertainty. A survey by EY in 2020 showed that 72% of investors carry out a structured review of ESG performance.

2. A boost for brand recognition

   Implementing ESG boosts companies’ brand recognition from the perspective of consumers since they have higher awareness about environment and social issues. They demand companies to care about the environment, treat their employees well, be transparent about their data, as well as adhering to the other criteria in ESG. Consumers don’t mind paying a bit higher for products from more responsible companies. Thus, incorporating ESG will help companies to have both their current loyal customers and new customers.

3. A drive towards innovation

   ESG initiatives drive companies to exceed their boundaries. For instance, they aim to minimize electricity and water consumption, decrease waste generation through recycling efforts, adopt renewable energy sources, among other actions. According to a 2020 podcast by McKinsey, companies with strong ESG strategies experience a 10 percent decrease in capital costs, attributed to mitigated risks resulting from their proactive measures.

A Deeper Look on ESG

ESG stands for three pillars that are equally important. We will dive deeper into each pillar in this section.

1. Environmental

   Environmental criteria examine how a company becomes a steward of the environment. These criteria are employed to assess both the environmental risks confronting a company and its management strategies to address them. Factors considered under environmental criteria may encompass a company’s energy consumption, waste management practices, pollution control measures, and efforts towards environmental conservation.

2. Social

   Social criteria evaluate how a company handles its interactions with diverse stakeholders, such as employees, suppliers, customers, and the community. These criteria measure the company’s commitment to employee health and safety, its contributions to the community through profit allocation, its inclusivity of stakeholders in decision-making processes, and others.

3. Governance

   Governance criteria rate how a company establishes regulations governing its operations. These criteria assess various aspects such as shareholder rights, transparency both internally and externally, board diversity, and other relevant factors determining the company’s governance structure.

Types of ESG Reporting

ESG report is published by a company to share its efforts and impacts in the ESG pillars. An ESG report is perceived as a way to show the transparency of companies about its risks and opportunities. Moreover, it helps to strengthen the relationship between the company and other stakeholders.

There are several types of ESG reporting framework that a company can use as its guideline. Companies can choose more than one framework for its ESG reporting depending on the purpose of the company. Below are some of the frameworks used for it.

1. Global Reporting Initiative (GRI) Standards

   The GRI standards are designed for organizations of any size, whether private or public, to comprehensively understand and communicate their impacts on ESG issues. GRI stands out as the most widely utilized reporting framework, with 82% of the world’s largest 250 corporations employing it for their reporting needs. This framework comprises two categories, universal and topic-specific standards. Companies are required to identify topics deemed significant to their operations. While GRI allows flexibility for companies to craft custom reports, they must include an “in accordance” designation indicating adherence to the GRI standards.

2. Task Force on Climate-related Financial Disclosures (TCFD)

   The TCFD was established to provide companies with guidance on financial risks associated with climate change, emphasizing four primary components: governance, strategy, risk management, and climate-related metrics. As of 2023, the TCFD was disbanded but companies can continue to use the TCFD recommendations. Using these recommendations is seen as advantageous for companies as they transition toward utilizing the Standards of the International Sustainability Standards Board (ISSB).

3. Sustainable Accounting Standards Board (SASB)

   The SASB Standards consist of sustainability-related risks and opportunities across 77 industries spanning 11 sectors, facilitating the comparison of SASB metrics among companies within the same group. SASB incorporates six disclosure topics and 13 accounting metrics across five crucial dimensions of sustainability: environment, social capital, human capital, business model and innovation, and leadership and governance. As of 2022, SASB played a role in shaping the ISSB alongside TCFD, but it remains available for use until replaced by the ISSB.

4. United Nations Global Compact (UNGC)

   The UNGC was established in 2000 to harmonize business strategies and operations based on ten principles covering human rights, labor practices, environmental conservation, and anti-corruption measures. Participating companies must annually submit a Communication on Progress (CoP) detailing their commitment to these principles. Moreover, businesses have the option to report their contributions to the Sustainable Development Goals (SDGs) via a different platform.

Deciding on ESG Reporting Type

It can be challenging for companies to choose which type of ESG reporting to use. Here are some factors to consider when determining which type of ESG reporting best suits your needs:

1. Regulations

   Ensure compliance with relevant regulations to guide your selection of the most suitable reporting framework.

2. Industry type

   Choose ESG reporting commonly used within your industry. In addition, identifying the ESG reporting used by your competitors will also help you decide.

3. Audience

   Tailor your choice of reporting to the specific audience you are addressing, as each reporting framework has its distinct characteristics.

Crucially, the paradigm shift has driven more companies to prioritize each stakeholder across the value chain. This approach enables the mitigation of negative impacts while also broadening opportunities. As more companies embrace this stakeholder-focused model, we can anticipate a future where business practices benefit everyone involved in the value chain.

References

1. https://www2.deloitte.com/ce/en/pages/global-business-services/articles/esg-explained-1-what-is-esg.html

2. https://www.thecorporategovernanceinstitute.com/insights/news-analysis/what-is-esg-and-why-is-it-important/#:~:text=Environmental%2C%20social%20and%20governance%20(ESG)%20is%20a%20set%20of,criteria%20to%20screen%20potential%20investments.

3. https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/our-insights/why-esg-is-here-to-stay

4. https://www.ey.com/en_gl/assurance/why-esg-performance-is-growing-in-importance-for-investors

5. https://www2.deloitte.com/hu/en/pages/energy-and-resources/articles/esg-explained-1-what-is-esg.html

6. https://www.pwc.com/sk/en/environmental-social-and-corporate-governance-esg/esg-reporting.html

7. https://www.ey.com/en_us/esg-reporting

8. https://www.techtarget.com/sustainability/feature/Top-ESG-reporting-frameworks-explained-and-compared

9. https://pro.bloomberglaw.com/insights/esg/comparison-of-esg-reporting-frameworks/#leading

10. https://assets.bbhub.io/company/sites/60/2021/10/FINAL-2017-TCFD-Report.pdf

11. https://www.ifrs.org/sustainability/tcfd/

12. https://sasb.org/standards/

13. https://www.ibm.com/topics/sasb

14. https://www.weforum.org/agenda/2020/01/sustainability-profitability-co-exist/