The board’s guide to ESG integration

As environmental, social and governance (ESG) considerations move center-stage for investors and buy-side firms, ESG integration has become a crucial ingredient in a successful ESG strategy. Modern boards must realize that to fully leverage the potential benefits of improved ESG performance, they need a robust and company-wide strategy.

Ad-hoc ESG initiatives or programs that take a siloed approach to operationalizing ESG principles won’t deliver the confidence that investors seek. That makes complete ESG integration the order of the day, but what does this really mean? This article will help boards understand the role of ESG in investment decisions by explaining:

• What ESG integration in investing is, and why it’s important
• The impact of ESG integration and data on buy-side firms
• ESG integration examples
• Elements and challenges of an ESG integration strategy
• How boards can integrate ESG successfully

What is ESG integration?

ESG integration definition: ESG integration is a process that uses ESG data to inform investment decisions. It’s also the practice of embedding ESG into your corporate strategy.

If you want your ESG program to deliver value to investors (and what organization doesn’t?), it’s vital to ensure that you fully understand how investors integrate ESG, then take steps to adopt ESG company-wide. Investors that prioritize their ESG considerations will want to see corporate actions like:

• Identifying ESG risks throughout your supply chain
• Making purchasing decisions with an eye to suppliers’ ESG credentials
• Implementing policies to improve diversity and inclusion
• Embedding ESG into your corporate investing strategy
• Incorporating ESG goals into your approach to executive compensation
• Ensuring strategic objectives include ESG considerations
• Educating your workforce on the need to embed ESG across their operations

Moreover, your ESG strategy must also fit within your broader GRC (governance, risk and compliance) strategy. GRC is a way of structuring governance, risk management and regulatory compliance to create a more unified approach, often making use of proprietary software to order and manage compliance, risk and governance programs. Therefore, there’s plenty to consider when exploring the benefits and ramifications of implementing a more integrated approach to ESG.

Why is ESG integration important?

ESG integration is important because it’s become a critical factor for both investors and buy-side firms. As buy-side firms look to ESG to adjust the risk of their portfolios, boards must respond by presenting ESG strategies that are integrated effectively across the enterprise.

Integrating ESG is essential for many reasons, including:

1. Increased ESG investment: A 2019 report from McKinsey notes that “ESG-oriented investing has experienced a meteoric rise”; improved ESG, therefore, has the potential to translate into increased investment.
2. Better stock performance: Companies in the S&P 500 who ranked in the top quintile for ESG factors outperformed those in the bottom quintile by more than 25 percentage points between the start of 2014 and the end of June 2018. This is also great for investors — higher stock prices reward investors, while the lower stock prices associated with lackluster ESG performance can help weed some investments out.
3. Stronger reputation: Intangible assets — such as brand reputation — are growing in importance; KPMG reports that today, intangible assets account for more than 80% of a company’s S&P asset value. An integrated and effective ESG strategy tends to enhance your brand reputation. Conversely, so-called “high ESG controversy” events can cause a company’s stocks to underperform in the market for as long as two years.
4. Improved recruitment: When hiring or retaining staff, ESG can be a strong motivator; employees want to work for companies that demonstrate commitment to making the world a better place. As the post-COVID talent war gains pace, your ESG performance might tip the balance when a potential employee weighs up offers.
5. Reduced costs: Borrowing money can be cheaper if you perform strongly on ESG. Research from MSCI shows that on average, companies with high ESG scores experienced lower costs of capital compared to companies with poor ESG scores.
6. Proactive compliance: Increasingly, regulators and legislators worldwide are mandating ESG reporting — and while regulations can change dramatically with the arrival of each new administration, the general direction of travel is clearly towards more compulsory ESG reporting. Staying ahead of the game better positions your organization to meet its regulatory compliance obligations.

ESG is also important simply because it’s becoming more commonplace. The increased availability of this ESG data to investors via reporting like that required by the Task Force on Climate-Related Financial Disclosures (TCFD) makes it easier to separate the ESG winners and losers. As ESG gains momentum globally, the likelihood is that this type of reporting will become standard — a virtuous circle for investors wishing to include ESG factors in their decisions.

How ESG data and integration are changing buy-side firms

ESG data and integration have fundamentally changed the investment landscape. While returns are still paramount, buy-side firms have begun prioritizing sustainable investments that make investment decisions based on ESG-related risks and opportunities.

Firms like Blackrock use the term “ESG integration” to define this practice, and subsequently, boards have begun to examine what corporate ESG integration should be. As buy-side firms and investors balance investment risk with ESG risk, they’ll use sustainability data to evaluate issues like:

• Climate risk
• Resource scarcity
• Labor conflicts
• Cybersecurity
• Stakeholder sentiment
• Corporate governance
• Board diversity
• Board effectiveness

What is an example of ESG integration in investment decisions?

To many investors and buy-side firms, ESG risk is investment risk. In that light, a common ESG integration example is firms that assess how climate change may threaten a company’s returns in the near and short term.

Let’s say, for example, that a buy-side firm is deciding whether to purchase shares in a consumer-packaged goods company that sells non-dairy products. Its products require a lot of water to produce and rely on crops traditionally grown in areas already experiencing the impacts of climate change. Before investing, the buy-side firm might seek ESG data to evaluate:

• How the company is working to reduce water usage
• How the company is reducing its carbon footprint
• What strategy the company has to shift the crops it uses
• How the company will diversify its product line if climate becomes an issue
• How the company supports the community where its crops come from

Elements of an ESG integration strategy

Boards need to consider many different elements to build an ESG integration strategy that will win the confidence of investors and buy-side firms. Doing so isn’t an overnight transformation but rather a long-term, consistent approach that integrates the many facets of effective ESG.

To create an effective strategy, boards should consider:

• Goals: Boards should get clear on what the strategy will achieve. Companies can’t tackle every last ESG issue, but they can make meaningful progress in the areas that both resonate with investors and tie back to their key goals.
• Financial materiality: Investors want to see that your ESG goals will bolster your bottom line, not just your image. Establish goals that increase the likelihood they’ll see a return on their investment.
• Data: Any goal you set should be based on data, as should the performance you measure. Build systems so that real-time ESG data is both available and actionable.
• Maturity: All boards have to start somewhere, but you mustn’t bite off more than you can chew. This ensures you don’t overpromise and underdeliver on ESG but successfully tackle the issues you can based on skill, capacity, resources, and more.
• Policies: Based on your maturity, develop policies that put your ESG priorities into practice. This demonstrates to investors that ESG integration isn’t just boardroom talk but an enterprise-wide practice.
• Reporting: Clear reporting structures are essential to offering investors the transparency they seek. Incorporate continuous monitoring, reporting and improvement into your strategy to keep up with the rapidly evolving ESG landscape.

Challenges of ESG integration

Integration can be a daunting proposition, whether it’s embedding ESG or even incorporating a new technology. ESG being an investment priority doesn’t make it any easier.

In fact, the heightened focus on ESG integration can only add to the challenge; boards are under pressure to meet investor expectations yet need time to craft strategies that can reach employees at all levels and in all departments.

This introduces numerous integration challenges, including:

• Data availability: There is no ESG without data — at least not ESG you can defend to investors. You need data to establish and measure goals to forecast your strategy’s effectiveness and offer performance insights to investors and regulators. Many organizations don’t have this data readily available, making it difficult to act on ESG in the boardroom, let alone across the entire business.
• Governance: For organizations that do have ESG data, it’s often unstructured. Lack of data governance leads to stockpiles of data that, while likely valuable, are unusable. A comprehensive data governance framework is a non-negotiable part of ESG integration.
• Time and cost: Creating, executing and reporting on an ESG strategy is incredibly time-consuming. It can also be costly, whether you hire new team members to help with the initiative or implement new processes that need their own budget.
• Complexity: The reality is that ESG integration is incredibly nuanced. It requires creating a clear strategy in the boardroom that employees all over the world can put into practice. The sheer complexity of ESG prevents some boards from fully committing to integration.

How to integrate ESG into business

Boards that want to respond to the integration of ESG into investment decisions need to similarly integrate ESG across the business. Here’s how.

1) Identify your company’s ESG-related strengths and weaknesses

Taking stock of current performance is always a good opening move. Conduct a gap analysis to understand the ESG risks you are currently facing. Where are you outperforming on ESG metrics, and where could you be stronger? First things first: Do you have a clear organizational definition of ESG; what it means to your company, stakeholders and employees? You cannot identify your strengths and weaknesses if you don’t know what you measure against. Consistency is key. Also, consider factors like leadership (whether you have robust senior leaders “walking the talk” on ESG action), employee understanding and buy-in, external rankings or ESG performance measures, and stakeholder sentiment. An insight into all of these will help you measure the health of your environmental, social and governance approach and identify any red flags.

2) Analyze the current state of all ESG factors in your organization

Due diligence around your current ESG approach means taking a granular look at all the ESG risks you face and your existing strategies to tackle them. Be candid about your achievements and any gaps in your approach. Many organizations face a fundamental challenge here because they do not have a complete and clear picture of their ESG strategies and performance. Explore the various solutions that can help you comprehensively understand your current ESG approach, warts and all.

3) Set priorities based on your analysis and plan ahead

Too often, the steps needed to operationalize your ESG goals can be abstract and unclear rather than concrete and actionable. Having a comprehensive understanding of your performance, goals, and gaps in between will enable you to set defined priorities that work toward your objectives. External factors also influence these priorities — the ESG Global Standards published last year by the World Economic Forum’s International Business Council, for instance, or the need to comply with reporting requirements such as those defined by the Task Force on Climate-Related Financial Disclosures (TCFD). Recognizing best practices and working towards them is another crucial stage in prioritizing and planning your next steps. Identifying what ESG best practice looks like is one of the five critical steps in setting an ESG strategy. Once you’ve identified your priorities, devise a plan that will close the gap between the current and desired state.

4) Implement controls to achieve your targets

One area that many businesses struggle with is the issue of controls when it comes to ESG integration. The areas you need to monitor for ESG compliance will vary depending on the industry — but across all industries, there are some common issues:

• Organizations often struggle to know where they need to implement ESG controls
• They may already have controls in place but do not recognize them as such
• They may not know how to implement controls for some of their priority areas or have the resources to start building these controls from scratch

Think about the controls you need in the context of your industry and your goals. For example, if your organization has significant environmental risk exposures, you may want to focus on controls that evaluate your buildings for greenhouse gas emissions. On the other hand, a professional services firm may prioritize controls on business travel; for instance, employees must take the shortest route or build a business case that the travel meets a specific business value and/or cannot be achieved remotely.

Good governance is the essential foundation of ESG; if you do not have measurements and controls in place, an effective ESG program becomes impossible to achieve.

5) Define clear metrics and report on your ESG progress

For this reason, implementing appropriate metrics and reporting needs to be the next step in your ESG integration journey.

Capturing and analyzing ESG data has historically been another stumbling block for many businesses wanting to improve their ESG performance. While ESG as a concept has gained momentum, the ability to develop concrete metrics has failed to keep pace, making real-time analysis of ESG compliance challenging to achieve.

Putting the controls outlined above in place will help you identify the non-negotiables in your ESG strategy. It is essential to set objectives — for instance, a defined reduction in your carbon footprint or a measurable goal for increased diversity among your senior leadership.

Then, ensure you report against progress to keep yourselves accountable. In some cases, this reporting may be mandated; in others, it will be purely optional. Commit to publishing your goals and your progress toward them. It may open you to scrutiny, but it is vital for transparency and to improve your ESG integration strategy.

The 3 components for successful ESG integration

The above steps are critical to ESG integration across the business. Yet, to accomplish them, boards need three components: people, tools, and processes.

1. People: When it comes to the people needed to integrate ESG successfully, there are several considerations. First is the issue of leadership, as we touched on above. You need the right people heading up your ESG integration program.

Your board and senior leaders are central to many elements of your ESG strategy and will set the tone for your entire organization when it comes to compliance. Creating organizational purpose and value, setting your ESG strategy, making decisions around priorities and actions, putting in place remuneration, recruitment, and engagement programs that drive D&I — all these fall to your senior leadership team.

Then you need the right people “on the ground” — ESG is a team effort; to succeed in ESG integration, you need to ensure that everyone involved understands your direction of travel and is on board with advancing your progress

2. Tools: Another imperative is having the best tools in place to deliver ESG integration. Trying to keep track of ESG measures and performance manually is a recipe for failure.

Fortunately, there are solutions available that can provide a framework for your ESG strategy:

• Tracking your risks, controls and compliance.
• Customizing metrics to your organization's needs: This might cover factors as varied as board composition and executive compensation, environmental risks, shareholder sentiment on your organization’s ESG performance, market trends, and upcoming ESG issues that you need to know.

3. Processes: These tools can also underpin your processes — giving you a defined structure within which to manage your ESG activities. Your processes need to align with external requirements, like the World Economic Forum’s ESG Global Standards we mentioned earlier.

A joined-up strategy here is crucial. In the same way that integrated risk management is now an accepted approach to managing corporate risk, we move towards a landscape where joining the dots on all things ESG is becoming recognized as the best strategy.

Protect your edge with ESG integration

As ESG continues to gain momentum, it’s no longer a nice-to-have. Rather, ESG is becoming an indispensable element of today’s organizational operations, largely because many investors won’t buy shares without demonstrable ESG commitments. Moreover, external reporting, ratings and scores increasingly play a role in corporate reputation as an employee engagement and attraction tool.

Success here is predicated on integration that builds ESG considerations into your corporate DNA. While you can make manual ESG advancements, it’s technology that turns ESG from a promise into progress.