ESG as a term remains politically fraught, but that doesn’t mean companies, especially those bound by reporting regulations, can take it off their agendas. And as widespread awareness of the corporate concept turns 20 years old this year, leaders should understand that they still may be falling short, writes business veteran Frank Orlowski.
Compliance has become a cornerstone of sustainable growth and long-term success in the ever-evolving business world. While traditional compliance frameworks, such as those established by Sarbanes-Oxley (SOX) and the Foreign Corrupt Practices Act (FCPA), have been instrumental in safeguarding financial integrity and ethical conduct, the modern compliance landscape demands a broader approach beyond just “dollars and cents.”
The climate change movement has increasingly taken center stage in recent years years (regardless of where one stands politically) with a growing focus on environment, social and governance (ESG) factors is driving a new era of compliance management, one that extends beyond financial and legal considerations to encompass a holistic view of corporate responsibility.
The term “ESG” was made popular in a 2004 report by the World Business Council for Sustainable Development (WBCSD) titled “Who Cares Wins.” The report found that companies that considered ESG factors outperformed their peers over the long term.
However, ESG investing has its roots in the 1960s with the rise of socially responsible investing in which some investors excluded from their portfolios companies that were involved in activities they considered harmful, including tobacco or apartheid.
In the 1980s, these investors began to focus more on positive screening, investing in companies that were actively promoting environmental and social responsibility. In the 1990s, the term ESG began to gain traction as investors realized the importance of considering these factors in their investment decisions.
But “Who Cares Wins” proved a watershed moment in ESG investing. The report, which the United Nations commissioned, found that ESG factors could significantly impact a company’s long-term financial performance. This led to a surge of interest in ESG investing, and a number of ESG-focused investment products proliferated.
Today, ESG investing is a mainstream practice. According to the 2023 Global Sustainable Investment Review, ESG assets under management reached $46.6 trillion in 2022, up 27% from 2021. ESG investing is now considered an essential part of many investment strategies. Clearly, with this movement and enormous economic impact, the term ESG is no longer a mere buzzword or peripheral consideration but has become an integral part of the evolution of a company’s overall performance on sustainability, requiring a need for a new form of compliance and controls.
The challenge, however, is that this new form of compliance and controls is in its infancy. One only needs to look at the early days of compliance for SOX and FCPA, where companies spent millions on consultants to help them ensure adherence and compliance despite the fact that the scorecard of what constitutes compliant vs noncompliant was not yet solidified.
The same holds for ESG. In practical terms, the rules of what constitutes an ESG gold star are not fully clear. For example, Whole Foods was ranked 26 out of 100 progressive grocers in ESG and is considered the first “fully organic” grocer. However, one needs only to purchase an instant soup at Whole Foods to see over seven individually nonrecycled plastic-wrapped ingredients inside the soup container and the external packaging to question the company’s commitment to sustainability. The point is not to condemn Whole Foods per se but to illustrate that adherence to ESG and what defines terms like organic is undefined and not standardized, regardless of what an organization publishes/advertises. Therefore, a robust ESG compliance and controls program is essential.
Hallmarks of effective ESG
ESG factors are no longer mere buzzwords or peripheral considerations to which companies can say they are adhering as they have become integral to evaluating a company’s overall performance and sustainability. Investors, regulators and consumers require a rigorously designed, implemented and supported compliance and controls program. A robust compliance and controls program must be implemented to scrutinize companies’ ESG practices, demanding transparency, accountability and a commitment to positive social and environmental impact.
As a start of any effective ESG program, a formalized approach is required, which can be outlined in five areas:
- Risk assessment: Identifying and evaluating ESG-related risks, such as climate change impacts, supply chain disruptions, and reputational damage.
- Policy development: Establishing clear policies and procedures that address ESG considerations, ensuring alignment with industry standards and best practices.
- Data management: Collecting, analyzing and reporting ESG data, providing stakeholders with insights into the company’s ESG performance.
- Training and awareness: Educating employees about ESG principles and their role in implementing ESG practices.
- Assessment and certification: The most critical element is an assessment or a certification to ensure an understanding of ESG-related matters by all stakeholders. This does not have to be a complicated test but can include case studies or scenarios where an understanding of ESG knowledge can be appropriately assessed. Once completed, a certification solidifies the full understanding.