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By the numbers

US$12.2 billion invested in ESG funds in the first four months of 2020.

Source: Morningstar Direct

Analysis of 3000 organisations’ data showed those perceived as behaving more responsibly had less negative stock returns.

Source: Harvard Business School

A 19% rise in participant numbers (238 newcomers) in 2020 showed increased corporate willingness to be scrutinised and report.

Source: S&P Dow Jones Indices

Something positive had to emerge from a global pandemic, and the seismic mind shift on environmental, social and governance (ESG) issues now being exhibited worldwide is the standout. The COVID-19 crisis amplified the importance of ESG — a shift welcomed by big thinkers, corporate titans and stakeholders alike, with huge opportunities for big-picture change being touted for the global economy through to individual companies.

The year 2020 offered a reminder of what we value — “sustainability, solidarity, fairness and resilience” — which makes it easier to pursue ambitious goals for people and our planet, said former Bank of England governor Mark Carney, who now serves as the UN Special Envoy on Climate Action and Finance, as well as the UK prime minister’s finance adviser for the COP26 UN climate change conference.

There’s proof positive in the numbers. In the first four months of 2020, investors countered the economic meltdown by doubling their investments for the same period in 2019. A Harvard Business School analysis showed that organisations perceived as behaving more responsibly had less negative stock returns than competitors. And the results of the Dow Jones Sustainability Indices Review revealed a 19 per cent increase in the measure of engagement at company level on 2019.

“No magic metric is going to give you the right answer about risk culture. There will always be a need to triangulate qualitative and quantitative data.” Alison Ewings, head of engagement Regnan

The new ESG mindset is putting paid to superficial notions of addressing issues such as reputation management and compliance and, in the process, eliminating greenwashing and box-ticking in favour of real action. ESG strategies increasingly aim to both “do well and do good”, according to Carney, by looking for factors that support risk management and value creation. This shift presents a massive task for boards and executives facing the challenge of integrating it into every aspect of corporate strategy and embedding it into operations.

In 2021, stress-testing ESG strategies is high on the agenda as a precursor to ensuring organisations stay competitive and resilient in the long term.

Changing views on ESG

First up, ESG needs reframing. When invited to discuss ESG stress-testing for 2021, Cory Davie, managing partner at Control Risks — a global consultancy that works with multinational corporations, governments and NGOs — captured the potential misunderstanding for directors with a question: “Which kind of ESG are we talking about?”

Sharper focus from investors and capital markets in recent years has driven differing approaches. Susheela Peres da Costa, head of advisory at Regnan and chair of the Responsible Investment Association Australasia, also clearly identifies a split between a “value approach” and a “values approach” to ESG.

“There are two kinds of questions investors, or the messengers of investors, ask about ESG issues,” she says. One set is based on value and how ESG issues may affect a company. The other is around the externalities a company creates. Is it having a negative effect on the environment or any of the myriad other issues that are wrapped into ESG?

Put simply: what are the risks to the company? And: what risks is the company creating for others? Or, more glibly: are you taking an inside-out or outside-in approach? “Investors themselves are often confused about this,” notes Perez da Costa, who reports an upsurge in investor interest in the values side of the equation. “Directors need to understand that investors may be talking about either of those two approaches, or both, and it needs to come through in corporate reporting.”

Bringing on integrated thinking

The environment and climate change have dominated corporate ESG focus. The 101 starting point is usually the emissions profile. Commonly overlooked are emissions in supply chains or arising from products once they are in the hands of consumers. Many companies are also short on understanding what changes in the climate might mean for demand for those products, says Perez da Costa.

She is a proponent of integrated reporting for the value approach. Integrated reporting requires the evaluation of six capitals in a business: financial, manufactured, intellectual, human, social and relationship, and natural. And it provides a way into developing the all-important “integrated thinking” on the interconnectedness of ESG issues for directors as they keep a weather eye out for what may disrupt a business. “If you are a big supermarket and your profits are coming from squeezing suppliers, that’s not helpful if you also happen to own the suppliers,” points out Perez da Costa.

Perhaps the most confronting aspect of stress-testing ESG strategy is its all-pervasive and almost infinite interrelated scope. “It is a really wide window and there’s a risk in taking a view that’s too narrow, says Davie. “If you are only looking at one kind of risk, you won’t be considering the impact on others. For example, a decision to eliminate governance risks in a supply chain that makes the conditions so stringent that no local supplier could meet them is causing a social harm.”

Social issues on the rise

The “S” in ESG was thrown into high relief in 2020. Only recently has it become a legitimate area of focus for profit-making companies as thinking has moved more to values, says Perez da Costa. “Typically, ‘S’ has been restricted to health and safety, internal human capital management and remuneration.” More broadly, it was the preserve of NFPs, charities and the philanthropic sector. Not anymore.

From the ubiquitous global impact of the pandemic itself to issues arising at Crown Resorts, icare, Rio Tinto, AMP and, more immediately, in federal parliament, the past year has laid bare a range of eye-opening social issues.

For directors, wrapping their heads around constantly evolving ESG issues is an increasingly massive undertaking. What’s striking is the dynamism of the issues — powered by accelerating climate change, shifting social attitudes and regulatory changes — that they need to understand.

Expectations now extend far beyond fiduciary duty to shareholders, says Jacki Johnson FAICD, who co-chairs the Australian Sustainable Finance Initiative (ASFI) and the UN Environment Programme Finance Initiative and also holds an advisory role on climate and sustainability with insurer IAG. Companies need to be looking beyond their own risks to those of all their stakeholders, insists Johnson, because in future “that’s how their shareholders are going to get their return”.

She says the new world order was glaringly apparent in how the Rio Tinto board sought to manage a trifecta of environmental, social and governance failures following the destruction of

Indigenous heritage sites in Western Australia’s Juukan Gorge last year. “The board called for a report. The directors thought they had put consequence management in place. And global investors said, ‘No!’ That’s a very different environment for directors,” she says. “When you hit a crisis like that, you have to make real-time decisions. And if you haven’t kept up with the context, in terms of changing attitudes and expectations, you can’t make the right decision.”

Directors have to be on top of environmental and social issues to successfully govern an organisation. “What the last year has taught us is that we need to be adaptable in our roles as directors and that means keeping abreast of everything that’s happening — and that’s hard,” admits Johnson, who is also a non-executive director on the Community First Credit Union board, which began meeting fortnightly in mid-2020 to stay across perpetual change. “In these times, you need to be able to guide and support the CEO and their team. You need to be looking at the crisis right now and looking at what you are building towards.”

Importantly, she argues, directors should haul up the anchor of their past experience and embrace future-gazing via scenario testing for the burgeoning range of issues they need to consider. “Without scenario testing, you’re not looking at what’s possible. Where’s your risk? And where’s your opportunity? It’s thought-provoking. You need time to go away and read up on the issues that the scenarios present.”

According to Regnan head of engagement Alison Ewings, “companies are getting better at understanding that [ESG issues] are not static. A board may spend its time identifying what is important this year, but that’s at a given point in time. The quality of scanning needs to take in not only understanding how risks might change, but also their relative importance to key audiences.”

Strategy-setting

Johnson calls out directors’ dilemma in identifying corporate purpose and integrating ESG into the strategy-setting process — a key tenet of the ASFI’s Australian Sustainable Finance Roadmap released late last year. “It’s a big, confusing area and everyone wants to make it simple,” she says.

In the roadmap, the ASFI recommends the UN’s Sustainable Development Goals (SDGs) as a sound framework. If boards become more familiar with these goals — beyond the colourful infographic — they will find them rich with indicators, says Johnson. Aligning a business with relevant SDGs not only makes a social contribution, it also delivers credibility and provides the ability to identify opportunities for the business, as well as direction for long-term investment.

“It’s not about picking one or two goals or relying on someone’s belief on the day. [It’s about] defining your purpose and then setting your strategy. You need to take a risk lens from a governance point of view, but you also need to consider how you will compete, because organisations that are addressing these issues attract capital and talent,” she says.

As an example, Johnson highlights insurer IAG’s purpose: “making your world a safer place”. The IAG board and executive prioritise four SDGs, including the broader Goal 8 — on the theme of decent work and economic growth — and Goal 9 around resilient infrastructure, innovation and technology progress. Goal 11 zooms in on sustainable communities and cities, while Goal 13 focuses on climate action.

“For an insurer, they go to the heart of thinking about how you make communities, customers and employers safe,” says Johnson. The ESG journey for IAG started with making long-term strategic decisions back when the newly formed NRMA Insurance Group was listed in 2000.

She believes clear directions are also being taken by other organisations, such as NAB, which has prioritised six SDGs — including goals 7 (affordable and clean energy) and 11 (sustainable communities and cities).

Mirvac, which has seven goals in its sights, is particularly outstanding for its clarity around measures. “They have not just been saying what they are doing, but actually holding themselves to account,” says Johnson. The property group is well on the way to being net positive on carbon by 2030, and its aim is that all new and existing buildings generate more water and energy than they consume and send zero waste to landfill.

The coalescence of strategy-setting and ESG is also observed by Liza Maimone, chief operating officer of PwC Australia. A lens for what’s on the horizon with climate change, human rights and regulatory issues is now being applied by many companies. “In strategy sessions, this means having people in the room with the right depth of capability to foresee the financial, operational and strategic impacts,” says Maimone. “Typically, this role has sat in the realm of the sustainability team, but now it should belong to the head of strategy or risk.”

At board level, sustainability, like finance, needs all-round expertise, argues Johnson.

The metrics shakedown

In operationalising ESG-infused strategies, the critical challenge continues to be the lack of consistent measures and frameworks to follow. However, hope is in sight. In 2020, the five leading voluntary framework- and standard-setters — the Climate Disclosure Standards Board, Global Reporting Initiative, International Integrated Reporting Council and Sustainability Accounting Standards Board — committed for the first time to working towards a joint vision.

The push for globally consistent reporting standards took another step forward last September with the release of a World Economic Forum report that identified a set of common Stakeholder Capitalism Metrics — the result of a collaboration with the International Business Council, which is made up of 120 of the world’s biggest companies.

It’s much needed and a good place to start, says John Tomac, a PwC Australia partner whose focus is trust, risk and ESG.

When PwC analysed ESG reporting on the ASX last year, it determined that 42 per cent of companies had not provided meaningful information and 62 per cent had no goals or targets. And little more than half of the 60 per cent of the more credible reporters had disclosed how they verify the accuracy of their reports — a pressing point in the ASX’s latest Corporate Governance Principles and Recommendations.

Regardless of what’s happening on home turf, boards must be asking if all the regulatory requirements and global reporting standards have been considered, because Australian companies can expect a flow-on effect from recent developments in Europe, cautions Tomac.

The European Union’s approach to boosting transparency and comparability is regulatory-driven. Its taxonomy providing definition for climate disclosures came into force in July 2020. Revisions to the EU’s Non-financial Reporting Directive demand companies disclose the amount of revenue derived from “green” activities as well as their operational and capital expenditures around these. Australian companies looking to raise capital in Europe should expect to be asked for information related to the EU taxonomy, says Tomac.

The ASFI is eager for Australia to follow the examples of New Zealand, the UK and Switzerland, which have all announced mandatory climate risk reporting for listed entities in line with the recommendations of the Task Force on Climate-related Financial Risk (TCFD). Some 1200 of the world’s largest companies currently report against TCFD metrics across G20 countries.

Metrics and reporting are a long journey for many organisations, says PwC’s Maimone. “Just getting data for a metric can be challenging.” Greenhouse gas (GHG) data is the most mature. But the emerging hot-button area is Scope 3 emissions, not least because they can represent the majority of organisations’ GHG emissions. These are defined as upstream — the emissions intensity of products consumed — and downstream in terms of the products sold and how they are used.

At the opposite end of the maturity scale is data for social metrics. Diversity and inclusion are often captured, but measuring and monitoring culture is particularly nebulous, says Ewings. “No magic metric is going to give you the right answer about risk culture. There will always be a need to triangulate qualitative and quantitative data.” For instance, directors might look for the verbatims of exit interviews for unfiltered information to illuminate dashboard metrics for employee engagement surveys.

It may involve asking different questions of existing data, says Ewings. “For example, when looking at sales data, you might think a particular site has gone off the charts — and that’s fantastic — but through a culture lens, a director might ask how that’s being achieved.”

What matters to stakeholders?

Central to the mind shift on ESG is understanding what’s material to stakeholders, whether they are shareholders, employees, customers, suppliers, communities or regulators. Just as the ESG profile of every company differs, so, too, will its approach to engaging with stakeholders. “What a small family company does, for example, is vastly different to a business at the top end of town,” says Tomac.

The GRI’s Global Standards for Sustainability Reporting require organisations to identify and prioritise stakeholders and explain how they have responded to their reasonable expectations and interests. They provide a process for stakeholder engagement, requiring benchmarking and gap analysis against peers and best practice, along with a stakeholder engagement plan.

Resources and financial institutions have been leading the way with stakeholder advisory forums to gather insights into priorities and invite challenge, supplemented by workshops on specific questions. “Companies should leverage what they already do before creating new touchpoints,” advises Liza Maimone. Ready cues are in customer complaint data or employee engagement surveys.

Most critical in 2021 is having a thorough communication plan for each stakeholder group. In the escalating and rapidly changing field of ESG, not everyone wants to read or wait for your annual or sustainability reports and there’s high risk in leaving them in the dark.

For the AICD’s guide on how to identify and elevate key stakeholder voices to the board, click here.