What is ESG?
Why you’ve heard of it and where it’s heading
June/July 2021 Footnote
Editor's note: Updated May 27, 2021
One acronym has quickly risen to the top of many C-suite and board agendas in the past year: ESG, or environmental, social and governance.
The pandemic has provided a reason to spotlight the importance of a purpose-driven strategy to drive business and societal value and has highlighted the interrelationship between long-term corporate strategy, the environment and society. Many companies have reevaluated their corporate purpose and ability to drive the long-term sustainability of their enterprise by addressing ESG strategies and challenges.
At the same time, to better evaluate how companies are managing ESG, institutional investors, asset managers, lenders, credit raters and insurers are increasingly relying on companies’ ESG disclosures to make important decisions regarding allocation of capital. This has resulted in an overwhelming demand for enhancements in the quality and comparability of ESG disclosures.
According to the Center for Audit Quality: “ESG reporting encompasses both qualitative discussions of topics as well as quantitative metrics used to measure a company’s performance against ESG risks, opportunities and related strategies:
- The E, or environmental, component of ESG information encompasses how a company is exposed to and manages risks and opportunities related to climate, natural resource scarcity, pollution, waste and other environmental factors.
- The S, or social, component of ESG includes information about the company’s values and business relationships. For example, social topics include labor and supply-chain standards, employee health and safety, product quality and safety, privacy and data security, and diversity and inclusion policies and efforts.
- The G, or governance, component of ESG incorporates information about a company’s corporate governance. This could include information on the structure and diversity of the board of directors; executive compensation; critical event responsiveness; corporate resiliency; and policies on lobbying, political contributions, and bribery and corruption.”
Significant progress has been made in corporate reporting of ESG information, as evidenced by the rise in the number of companies that publish some form of disclosure — whether it is referred to as an ESG report, sustainability report or another variation that resonates with the company. In addition to building trust and credibility with a growing number of stakeholders seeking greater transparency, ESG disclosure also helps organizations set goals, measure performance and manage change around ESG impacts and how they drive value to the organization.
As the practice of ESG disclosure continues to mature and evolve, companies can gain a better appreciation of how ESG impacts drive their business. As the adage goes, “You can’t manage what you don’t measure.” From an operational perspective, businesses are increasingly applying an ESG lens as they consider the full costs and availability of required inputs, beyond direct material input costs, to the development and delivery of their products and services. Such factors include investment in labor and human rights practices, as well as environmental practices and impacts, across the supply chain — from sourcing of raw material to delivery to the end customer.
Common questions concerning the rapid acceleration of focus on ESG disclosure
Is ESG disclosure mandatory?
While ESG disclosure remains broadly voluntary in the U.S., there have been a number of recent developments signaling that change may be on the horizon. The first occurred through a 2020 amendment to Regulation S-K. This required registrants to disclose a description of company human capital resources, including any human capital measures or objectives on which management focuses, within “Description of Business” in the 10-K. There has also been a flurry of activity throughout 2021 by the SEC, including a series of public statements emphasizing the importance of climate related and other ESG disclosures to investors and the capital markets. The SEC established a website to highlight its actions and provide information about ESG investing.
What are the company’s relevant ESG topics or issues?
Engaging with stakeholders on ESG is a fundamental starting point for companies as they seek to identify, manage and integrate ESG into the business strategy. Performing a periodic ESG materiality assessment, and supplementing with ongoing stakeholder engagement activities, enables companies to have a multi-stakeholder view of priority ESG topics for the business.
Which ESG topics or issues have the greatest impact on enterprise value creation?
Degree of financial consequence for the business may vary by ESG topic or issue. Aligning and driving ESG integration into a company’s purpose, strategic planning, enterprise risk management activities and resource allocation requires prioritization of certain issues over others. It is important for businesses to work cross-functionally to fully understand the risks and opportunities associated with each ESG topic or issue.
How is ESG performance measured and is the information reliable?
There is a clear marketplace mandate for standardization of ESG performance measures. Companies that have identified priority topics may look to leading global standards and frameworks as a starting point for monitoring and reporting on performance, allowing for enhanced comparability across peers and marketplace leaders.
While 90% of the S&P 500 provide some form of sustainability or ESG disclosure, according to the Governance & Accountability Institute, Inc., investors and broader stakeholders are still asking for more high-quality, consistent and reliable ESG disclosures in accordance with recognized standards. Using recognized standards, such as the Sustainability Accounting Standards Board (SASB) and the Global Reporting Initiative (GRI), or other recognized sustainability frameworks, such as the Task Force on Climate-Related Financial Disclosures (TCFD), can help provide consistent and meaningful disclosure.
Further, obtaining assurance can be important in signaling confidence in the quality of ESG disclosure to the market and giving both external stakeholders and decision-makers more confidence in its integrity. Third-party assurance, on a limited or reasonable basis, can be provided by a company’s financial statement auditor, who can also bring insights on how companies can evolve their focus on ESG to meet the increasing demands of investors and other stakeholders.
ESG is more than just another item in the long list of concerns companies must manage. It’s an important business driver that has strong potential to power performance. ESG initiatives contribute to outcomes across the value creation continuum, from reducing costs to enabling differentiation in the marketplace. The significance of ESG opportunities and risks to businesses is growing in the face of heightened expectations among investors, regulators and other stakeholders.
It is clear companies will need to be thoughtful about their ESG strategy and how it is communicated. Incorporating ESG performance, measured through a thoughtful reporting process that leverages recognized standards and frameworks, is a signal of its importance to stakeholders.
Jenny Lynch is an audit & assurance senior manager at Deloitte & Touche LLP. She is a CPA licensed in Illinois with 15 years of client service experience and has been focusing on sustainability and ESG for more than eight years. You may reach Deloitte’s Sustainability and KPI Services Team at email@example.com.
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