ESG Reports Aren’t a Replacement for Real Sustainability

Dayana Jones

Corporate leaders face conflicting signals on the need for environmental, social, and governance reporting. A predictable backlash against ESG investing has arrived, with right wing politicians attacking ESG investors for promoting what they see as a “woke” agenda, and the SEC cracking down on “ESG-washing” by asset managers.

While more scrutiny of ESG claims is needed, corporate leaders and investors who focus solely on ESG disclosure are missing the point. ESG disclosure uses process-oriented output measures, such as whether a company has a policy on chemical management. These metrics, while necessarily broad, do not track performance. There’s a big difference between a company that has a chemicals management policy, and one that has a bio-based dye that reduces waste and water use (and cost) and creates new sales opportunities.

There is a growing consensus that ESG issues are material to corporate resiliency and competitiveness today. In fact, our research on the return on sustainability investment (ROSI), as reported in HBR, has demonstrated that embedding sustainability core to business strategy can create a competitive moat for business leaders by driving operational efficiency, innovation, employee engagement, supply-chain resilience, risk mitigation, improved sales, and other strategic business benefits.

However, just as with any business activity, competitive advantage through sustainability comes from good strategy, culture, KPIs, and execution. Reporting metrics are the last step, not the first. So how does a company avoid the ESG disclosure morass and develop a robust sustainability strategy that improves the bottom line?

Every company’s strategic planning and work plans are different, but there are some useful tools and approaches to embedding sustainability for competitive advantage.

Step 1: Identify material ESG issues and associated stakeholder perspectives.

Broadening the planning lens to include incorporation of material ESG issues for your industry is the first step. Looking at existing standards, such as those from the Sustainability Accounting Standards Board (SASB) or the Global Reporting Initiative (GRI), will provide initial insights. For example, SASB will tell you that if you run a consumer packaged goods (CPG) industry, climate, water, and labor practices are amongst 10 material topics that need to be managed. Critical stakeholders such as employees, investors, customers, regulators and civil society should also be consulted as their insights may help identify priorities that business leaders may otherwise ignore.

The business assessment and the stakeholder assessment can be combined into a materiality matrix, which helps prioritize topics that that are important to both stakeholders and the business and potentially lead to competitive advantage. For example, a materiality matrix in CPG may identify food safety as a material ESG issue, but one that is table stakes for all. It may also identify water stewardship as a material risk, where companies who reduce their water use will be less likely to experience water-related production disruptions or regulatory or consumer backlash.

Step 2:  Undertake Strategic Analyses Through an ESG Lens

With the materiality matrix in hand, a sustainability-oriented PESTLE (Political, Economic, Social, Technological, Legal, and Environmental) analysis and then a SWOT (Strengths, Weaknesses, Opportunities, Threats) analysis may be helpful next steps.

The PESTLE analysis helps with understanding ESG trends related to your material issues.  For example, how might the changing legal framework regarding greenhouse gas emissions affect your business? What type of blockchain technologies for managing sustainable supply chains might help improve supply-chain resiliency and performance? What type of political regimes in supplier regions might affect supply volatility, ethical challenges, corporate reputation? There are consultants and NGOs who actively monitor these trends and could provide essential insights.

The SWOT analysis will help you assess how well you are currently positioned to manage these material ESG issues and trends across your business units. As you assess your strengths and weaknesses, for example, you may find that you have already developed a sustainable supply-chain network, but your marketing team has failed to capitalize on it. As you look across the industry to identify opportunities and threats posed by material ESG issues, you may note that all your competitors have made commitments to phasing out plastic packaging and that you are a laggard, or that you are one of the few with a compelling carbon labelled offering, but it is still niche and others could rapidly overtake you.  This analysis should help you identify where you should focus your efforts.

Step 3:  Get granular with how to tackle business risks and opportunities in your business planning.

For example, if water use is a big challenge for your business, you’ll need to understand where those risks are in your supply chain and explore potential solutions.  You’ll need to define the future state you’d like to achieve and how to get there. If you use a lot of water in manufacturing facilities located in regions with water quantity and quality issues, extreme weather events related to climate change, as well as poorly managed water withdrawals that threaten local water supplies, then you will need to explore strategies such as watershed conservation and technologies and procedures that reduce your own water footprint.

Then, define goals and key performance indicators (KPIs):  How much water reduction is needed, how much is feasible, and what is your action plan? You’ll need to understand your current water-use performance, benchmark against competitors, explore technologies that can reduce water use, and reach out to key stakeholders, such as NGOs, community groups and regulators working on water in your operating regions.

As mentioned earlier, most reporting and disclosure standards have process-based KPIs.  To improve competitive advantage, companies need to develop outcome and impact-based KPIs (which they can later map to the reporting metrics). For example, let’s say a company aims to improve diversity and inclusion. It may hire a chief diversity officer, which is an input; publish a diversity, equity and inclusion policy, which is an output; and train 50 people in diversity and inclusion, also an output. The outcomes are what results from these inputs — e.g. 20% managers of color or 100% pay equity. Assessing the impact of those outcomes will require the company to determine what state is necessary to achieve for it to be diverse and inclusive and drive better results for the company such as increased productivity and creativity. Organizational ESG KPIs should tie back to the business strategy and provide accountability for executive leadership as well as the rank and file.

Build these ESG goals and strategies into your core business strategy. Using water in your factories, as an example, you likely have overall goals related to the high-quality functioning of those factories, related to operational costs, quality of goods produced, capital investments planned, etc. Improving those factories’ performance on water becomes part of your overall goals associated with manufacturing. Investing in better water management can reduce costs (less water in, less waste out, less likely factory shutdowns due to lack of water) and improve performance (better community reputation and relationship with regulators, etc).

Step 4: Build a governance structure focused on ESG.

Change is hard. As with any transformational process — and sustainability is transformational — the culture, the governance, and incentives must be aligned to be successful. A first step is organization-wide ESG KPIs, signed off on by the board, supported by executive leadership, and included in staff work plans and compensation.

From a governance perspective, board leadership in the form of a sustainability committee, an executive-level cross-divisional sustainability committee, and management-level cross-divisional committees will be essential to delivering against the plans as most ESG issues are cross-divisional.

A chief sustainability officer, ideally reporting to the CEO, with authority as well as responsibility (usually they have a lot of the latter and none of the former) can help coordination across the company and support business unit efforts through functioning as a center of ESG excellence with access to the latest thinking, technologies, and tools. The CSO can work with HR and the executive leadership team to build a sustainability culture across the company, including training, sustainability committee, and ambassador roles as part of accelerated development. Conventional HR techniques can be used to embed sustainability into the purpose and culture of the company, which is likely to have the added benefit of improving employee recruitment, retention and productivity. The CSO will also work closely with finance, procurement, brand managers and the other key business units to support them in meeting the organizational ESG KPIs.

Step 5. Understand and track the return on sustainability investment (ROSI).

Businesses that don’t manage the bottom line well don’t stay in business.  Why, then, are most companies not tracking the return on their sustainability investments? In order to improve decision-making and build competitive advantage, corporate leaders must begin to track the financial returns, intangible (e.g. risk mitigation, employee engagement) as well as tangible (e.g. operational efficiency, sales) associated with their embedded sustainability strategy.  One major shortcoming, for example, is that the CFO’s office does not track avoided costs (e.g. savings from used automotive components in new cars or factories not being shut down due to lack of water). That means assessing the potential benefits using a model, such as NYU Stern’s open source ROSI, developing benchmarks, and tracking financial performance over time. This should improve the analysis of projected ROI related to ESG-related capital investments, and make it easier to meet internal hurdle rates. In working with apparel company Eileen Fisher and spice company McCormick, for example, we identified $1.8M and $6M respectively in terms of benefits related to circular practices and sustainable sourcing.

B2C brands with sustainable offerings will be rewarded by consumers, and B2B brands can help companies deliver sustainable goods and services. Working with IRI, a market research firm that collects all bar-code data for consumer packaged goods (CPG) sales in the U.S., we found that sustainability marketed products delivered 32% of the growth in CPG in 2021 while enjoying 30% premiums on average. We also discovered that half of all new CPG products in 2021 had some type of sustainability attribute (e.g. plant-based cleaners, sustainable soups). In response to these trends, most CPG companies, including Unilever, Nestle, General Mills, PepsiCo, and Coca-Cola are making significant investments in improving the sustainability and nutritional value of their products.

. . .

Sustainability is the new digitalization but with even more impact on competitiveness. Take climate change: Fees are being charged for carbon emissions, investors are asking for assessment of climate risks and penalizing companies with high carbon exposures, energy price volatility is increasing the cost of goods sold, and companies and consumers are looking to reward carbon positive companies and products. In 2021, for example, carbon-labeled consumer packaged goods represented $3.7B in sales, two years after introduction!

Companies who want to win in their markets will be more likely to realize that dream if they embed sustainability core to business strategy, manage implementation and ESG KPIs well, and track the returns on their sustainability investment.  Audited reporting to globally recognized disclosure standards will be the icing on the cake.

 

Editor’s Note: This piece was updated for clarity on 7/27/2022 with a small change to the “Step 1” subhead.

https://hbr.org/2022/07/esg-reports-arent-a-replacement-for-real-sustainability

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