Making ESG real means integrating it into business strategy

18 August 2022

Investors should examine how directors relate ESG to company strategy

This week, global consulting giant McKinsey and Company published a report entitled “How to make ESG real”, in which it outlined how companies can take a more systematic and rewarding approach to ESG.

The underlying argument is that there needs to be a more robust approach to assessing ESG criteria, so that potential investors can determine which companies are paying lip-service to sustainability questions and which are “next level” in their approach to environmental, social and governance. This is clear to see, with recent examples such as Tesla’s exclusion from the S&P 500 ESG Index demonstrative of the need for better quality metrics to determine ESG performance.

The fundamental difference is that companies that see ESG as mere risk mitigation should be differentiated from the ones which fully integrate ESG into their strategy and operations.

It is important to make this distinction. Investors should be looking to back companies which actively consider the needs of a variety of stakeholders and continually adapt to meet them. True sustainability will come from companies considering their overall strategy and thinking continually about how to implement ESG criteria into it, rather than reacting to escape penalties and preserve their share prices.
As I have argued previously, a failure to consider and implement ESG into company operations represents a material financial risk which investors should take heed of. Any experienced investor will reasonably demand to meet a company’s management before deciding to invest so as to understand the organisation’s strategy and long-term approach meaning that a management team with a visible and constructive approach to ESG matters should be a clear indicator that the company represents a good investment.

The report argues that thoughtful analysis of ESG quantifies both downside exposure to risk and upside opportunities. The example is given of the incorporation of ESG directly into capital raising, by issuing green or sustainability linked bonds, with the case-study of global healthcare company Novartis pricing €1.85 billion of SLBs linked to specific ESG targets in 2020. This shows a proactive and forward-thinking approach to ESG where the company is actively taking the reins in dictating its strategy, rather than falling hostage to unreliable third-party analytics.

Integration of ESG into company strategy requires companies to think about which concerns matter the most to their respective business models. For example, polluting energy companies must rightly prioritise cutting carbon emissions over and above anything else given that this represents the highest category of material risk to sustained access to capital, reputation, and protection from litigious action. A well articulated plan on how a multinational energy company plans to curb its emissions over the next twenty years can give investors a greater indication of the company’s commitment to ESG than reliance on imperfect analytics from third-parties which look at the company as it stands today (often using data which is no longer up to date nor informative).

There will be trade-offs between prioritising ESG concerns. However, this can be integrated into strategic planning and articulated to investors ahead of time, emphasising the relative cost savings and reasons for pursuing trade-offs. This way, companies can demonstrate a thoughtful approach to choosing one set of priorities over another, rather than being called out for ignoring certain criteria.

A company that can explain why it is prioritising one ESG concern over another with reference to economic fundamentals gives potential investors a more holistic picture of its overall commitment to sustainability, insofar that these concerns have been properly thought through and are actively aligned with a business plan focused on improvement and long-term growth.

When investing in any company, an astute investor will take the time to think about what ESG concerns are relevant to the business in question, preparing and asking detailed questions in advance, rather than simply opting in on account of a green tick or inclusion in a sustainability index.

Just because a company is not rated highly on ESG today, does not mean that it will necessarily rank poorly on ESG in the future. With the right approach, and a sensible roadmap to integrate ESG factors into the long-term strategy of the business, there is every reason to believe that ESG can avoid being a passing fad and that it can be made real.

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