ESG's complexities: How to navigate the complicated world of ESG

In response to our The Real Economy survey, only 56 percent of middle market businesses said they are familiar with Environmental, Social and Governance (ESG). This potentially leaves thousands of businesses unaware of both the concept of ESG and why it is so important. 

So, based on our survey we asked why awareness of ESG in the middle market is not higher and what the risks are of staying in the dark. 

It’s a branding issue

ESG is complicated. It is difficult to define, difficult to discuss and covers a huge number of issues. To complicate matters further, these issues can mean different things to different businesses. 

At its heart, ESG is about responsible business. Businesses may have different motivations for embracing it, such as managing reputational risk or seizing opportunities for growth, but considerations are becoming increasingly pervasive in business decision making – whether leaders fully recognise it as ESG related or not. 

Responsible business is not a new concept. Organisations have been engaging with the concept of responsible business for many years. Notable examples of ESG, sometimes referred to as Corporate Social Responsibility (CSR) reporting, include engaging and reporting on ‘issues’ such as: gender diversity in top management teams, declaring carbon dioxide emissions associated with operating activities, working with external charities and addressing the gender pay gap. In short, ESG requires firms to measure and declare their societal and environmental impact.  

In The Real Economy’s most recent survey, we asked what was motivating the middle market to engage with ESG. The responses were varied; however, some of the top ranked answers included:

• To reduce environmental impact, 46%
• To attract or retain customers, 45%
• It is the right thing to do, 43% 
• To communicate their values to the public, 41%
• ESG is consistent with their commitment to sustainability, 39%
• To enhance or maintain our working environment and culture, 39%

These levels of response illustrate why ESG can be difficult to get to grips with. There is no one, clear reason to engage with ESG. Different businesses interact with the concept in different ways, and this issue is exacerbated when observing the difference between markets and industry sectors. For instance, the issue of ‘environmental impact’ may vary between the ‘real estate’ and ‘fossil and gas’ sectors – as the latter is directly associated with extracting fossil fuels from the earth, identified by the media as key contributor to global greenhouse gas emissions. 

‘It’s become very complicated because of the number of voices trying to steer and guide the debate. We have the World Economic Forum, the IFRS Foundation and numerous other bodies that are trying to tackle ESG. That's where some of the complexity comes from. It's a global problem but lots of national and international bodies have realised they need to do something. It makes for a bewildering landscape because people are thinking, “well, where do I turn?”. And there is not a simple answer to that question,’ comments Taylor.

The plethora of standards

To start with, there are more than 20 ESG standards available and it is a matter of judgement as to which path – or paths – to take. Our survey respondents with external reporting capabilities use on average three standards for guidance, illustrating that there is not necessarily an obvious right answer for many businesses.

‘It’s all a bit Wild West at the moment as we wait for dominant standards to emerge. Currently, businesses can choose a standard that they like – and cherry pick their preferred bits of it – probably without facing too much challenge. If you want to compare organisations now, there is often little cross compatibility. This is a real challenge. Many organisations are doing this as a choice, not because it’s a legal requirement, but the lack of clarity limits how useful some of this reporting is to interested stakeholders’, said Taylor. 

Many are choosing to voluntarily report on their data, but are calling out for a more unified and accessible approach to the standards. Our survey respondents with external reporting capabilities use on average three standards for guidance.

Some businesses in the UK are already legally required to report on certain aspects of ESG. For example, businesses with 250 employees or more are already required to disclose the details of their employees’ gender pay gap differences, known as Gender Pay Gap (GPG) reporting. It is increasingly likely that this type of mandatory reporting will be expanded. Already, in anticipation of increased pay gap reporting, some businesses are choosing to voluntarily report on their GPG and include their ethnicity pay gap data.

As the regulatory landscape evolves, businesses will need to consider the skills and experience they need in order to effectively and accurately report data to important stakeholders, as required by external legislators. Already the demand for those skilled with producing such data has skyrocketed.

‘Access to these skills, knowledge and guidance is limited, but it’s a developing arena. It’s like the challenge around skills with cyber security. We have seen the education sector responding to the need for those skills and we're starting to see it responding in a ramped-up way with education around ESG. We are going to need to educate and train more people with these skills to be able to deal with these issues, particularly around sustainability,’ comments Taylor.

The threat around greenwashing

The rise of the ‘ethical consumer’ now means that prospective customers and clients actively seek out businesses marketing products or services as ‘ethical’ or ‘green’. However, businesses that make false or ‘greenwashed’ claims are contributing to the complexity with ESG. The term ‘greenwashed’ refers to a ‘smoke and mirrors’ approach used by some businesses to make their operations appear socially ethical and ecological, when in truth this is not the case.

Notable examples of ‘greenwashed’ corporate reporting can be seen in the annual reports of businesses in the ‘fossil & gas’ sector, which often depict pictures of open grassland and turquoise seas – stakeholders seldom see pictures of fossil and gas extraction. This issue is not limited to one single industry sector, any business may use false or ‘greenwashed’ reporting to make their operations seem environmentally and socially responsible.

As many businesses do not need to have the data they produce verified, the exception being large businesses listed on the FTSE 350 index, the customer has to take the information as it is presented to them. This leads to a considerable amount of mistrust when those claims are discovered as false or misleading. Until assurance frameworks become more developed the risk of greenwashing will remain an issue.

‘What's going on in different parts of the world and in different sectors is painting quite a complex picture. Having faith in the numbers that you're looking at and comparing and contrasting them in different businesses requires real work and experience. Assurance frameworks to make this task easier have yet to evolve. Some are calling out and saying, “well, actually, you're making these bold claims, but you seem to have cherry picked something that makes you look good - when actually you've got all these other issues over here”. It’s causing a real challenge around the trust people can place in these disclosures which undermines the entire exercise’, said Taylor. 

Industry in the UK are calling out for some regulation in this area that can help consolidate reporting standards and help businesses understand how and what they need to disclose. 

‘The UK government on climate report have pinned themselves to the Task Force for Climate Related Financial Disclosures (TCFD). That's coming over the next few years and will become increasingly mandatory for different parts of the UK economy. The likelihood is that the stakeholders may demand an improved level of assurance over what's being said when they make decisions before that. If a bank is going to offer preferential lending rates because of hitting certain targets, then they want to understand that the business has actually done what they have said. So, it needs to be verifiable and that could drive a push for third party assurance over what is reported,’ said Taylor.

The take home message

Although ESG may be unavoidably complex, it is now an important consideration for businesses, employees, shareholders, and other key stakeholders alike. Understanding the changing regulatory landscape, as well as matching or exceeding the standards set by competitors, promises to keep organisations on the right ESG path - a path that leads to future benefits for businesses.

‘Businesses are going to need to maintain a certain level of flexibility with this. The law will change, client expectations will change and it’s important to stay abreast of that and adapt. Making sure that you are talking to the right people so that you understand what obligations are coming so that you can make preparations will be really helpful,’ said Taylor. 

For further information on the research please click here.