What investors want: an ESG field guide for businesses

Environmental, social, and governance (ESG) isn’t just transforming how businesses operate, but their relationships to capital markets as well.

We’re witnessing a seismic shift in impact investing: what, as recently as two or three years ago, many regarded as a niche group of socially and sustainably focused individuals is fast becoming an institutional norm. Revenue and profitability are no longer enough to attract equity partners. Investors want to know how organizations are committing to transparency, accountability, and sustainability — and where they are on the path to net-zero.

This shouldn’t come as a surprise. Capital has always flowed to sources that offer the greatest potential return. Given the risks and opportunities of our rapidly changing world, it’s clear the established ways of doing business aren’t going to cut it in the decade to come. ESG can be a powerful instrument to understand who’s willing to adapt, who’s ready to deliver, and who’s best positioned to thrive in a low-carbon, post-pandemic economy.

But what exactly do investors want to see from businesses, and how are their expectations evolving?

Last year I had the opportunity to moderate a panel at ACG Toronto’s 19^th Annual Capital Connection Conference that specifically looked at this topic of impact investing. And as I reflect on that event, several eye-opening insights remain top of mind today — including a strong desire to mature the ESG conversation, and for industry, equity, and regulators to align on shared objectives.

Following are four key themes that emerged repeatedly throughout the conversation, and which business leaders would be prudent to heed throughout 2022 and beyond.

Get clear on materiality

Investors want to see a more concerted effort from businesses to demonstrate not only how they’re improving on specific ESG measures, but also why.

Many organizations struggle to understand where they should invest limited time and resources: What’s important to consumers doesn’t always align with what’s important to employees, regulators, stakeholders, or the organization itself. Trying to appease everyone risks spreading resources too thin, while aimlessly following trends risks neglecting key issues, both of which result in failing to make a measurable impact.

A clear understanding of materiality helps to address this challenge by highlighting the specific ESG issues that:

1. directly impact the organization’s performance and bottom line, and
2. mitigate an organization’s impacts on society and the environment (i.e., externalities).

Focusing on material issues such as reducing greenhouse gas emissions across the supply chain or closing the gender pay gap helps organizations pinpoint and prioritize specific areas to improve upon. This, in turn, connects ESG to organizational strategy and provides structure and substance to ESG investments.

Rather than making ESG a bolt-on addition, materiality ensures it becomes an integral part of the business model that improves performance and creates sustainable long-term value. Materiality is key to understanding how organizations are deploying capital, how leaders are thinking about the ESG risks and opportunities ahead, and how the organization will fare in a changing world. All of these are key concerns for investors when calculating the likelihood of getting a return on their investment.

Common questions they’ll ask when evaluating a potential investment opportunity include:

• How do the organization’s ESG priorities align with other organizations of similar size and scope?
• Has leadership given serious thought to the long-term sustainability of their business model?
• Is there change to business as usual and evolution of business practices meant to capture opportunity and thereby build market share?
• How do the material issues outlined in the ESG strategy reflect in initiatives and reporting?
• Is the organization taking steps to regularly assess emerging material risks and opportunities — and is it adjusting ESG initiatives in kind?

Present information in actionable terms

While the focus on sustainability and accountability has been evolving for years, the relatively sudden emphasis on ESG has imposed a steep learning curve for investors and business leaders alike.

If we look just a short time ago, comparatively few decision makers on the industry or equity side solidly understood ESG or how it should look in practice heading into 2020. This led to an initial surge of (hopefully unintentional) greenwashing, fueled by capital flowing to attractive (but ultimately hollow) marketing ploys.

The business community has made significant strides since then — with both better efforts to develop meaningful and impactful ESG frameworks and more pointed questions to verify organizations’ sustainability and accountability claims. Moving forward, business leaders should be prepared to support any bold policy, practice, and reporting claims with transparent plans and independently verified disclosure documents. Having these ducks in a row is a significant advantage now, but it's quickly becoming table stakes as investors become more discerning and regulations continue to catch up.

With the 2021 UN Climate Change Conference (COP 26) fresh in memory and the conversation around net-zero continuing to gain momentum, investors are also looking a lot further into the future. Simply touting ESG isn’t enough to get them to the table anymore. They increasingly want to know:

1. what the business’s long-term prospects are in a low-carbon / net-zero economy — and, by virtue, whether they can expect a long-term return on their investment, and
2. how investing in a company will help or hinder their own institutional journey to net zero.

Some entities will thrive in a transparent, low-carbon landscape; their business model and ESG materiality issues will create opportunities to grow and thrive. Others will struggle to stay relevant. Even the most earnest and stringent commitment to ESG will not be enough to survive without significant changes to their value creation model. Investors are already looking beyond the short-term commitments and toward opportunities to future-proof their portfolio.

Embrace standardization

One area that continues to lag in ESG is a universal standard to guide organizations on consistent, comparable, and transparent disclosures of their progress in adopting and pursuing ESG priorities.

We only need to look at accounting standards and laws for financial record keeping such as Generally Accepted Accounting Principles (GAAP), International Financial Reporting Standards (IFRS), National Instrument 52-109 (NI 52-109), and Sarbanes Oxley (SOX). These have been transformative in creating trust, consistency, and a level playing field to compare the financial performance of organizations of all sizes and industries. Consistency and certainty on the effectiveness of underlying controls are hallmarks of these standards — not to mention built-in accountability for reporting entities. Absent similar stringency in ESG, it’s difficult to draw reasonable conclusions on how sustainability initiatives translate to strategic and material outcomes.

Several independent verification and certification bodies have emerged in recent years promising to fill the regulatory void. However, one could argue these agencies have created more questions than they’ve answered. Reviews for the same business in the same year often swing wildly from glowing to critical depending on the reporting body and its assessment criteria. This serves neither the business nor the investors seeking to make better informed capital allocation decisions. Part of the problem is the lack of a clear and consistent methodology — different rating agencies rely on different assessment techniques — but the qualitative nature of ESG and varying materiality issues plays a role as well.

Securities regulators continue to place a higher priority on ESG and ESG disclosure requirements. Driving this trend are both increasing investor demands and growing public pressure for transparent ESG policy and practice disclosures — including organizations’ ESG-specific strategies.

IFRS created an International Sustainability Standards Board (ISSB) in 2021, which The ISSB is also coordinating efforts with the International Accounting Standards Board (IASB) to develop complimentary accounting and sustainability disclosure standards to meet users’ evolving needs with general purpose financial reports.

In addition, the Canadian Securities Administrators (CSA) published for comment the Proposed National Instrument 51-107 Disclosure of Climate-related Matters (NI 51-107) in 2021. This was largely in response to growing pressure on regulatory authorities to mandate an organization’s disclosure of exposures such as climate risk. If adopted, the CSA would mandate reporting issuers to disclose climate-related information in alignment with the four core disclosure elements of the Task Force on Climate-related Financial Disclosures (TCFD).

Consistency is essential to curbing the subjectivity of current narrative-driven approaches to ESG disclosures. Reporting standards may even prove liberating for businesses that will no longer need to grapple with the overwhelming question of how best to tell their sustainability story. These will also reduce the risk of companies cherry-picking those topics that they want to address at the risk of avoiding those that need to be addressed.

Businesses seeking to attract investment by highlighting the success of ESG initiatives might consider becoming early adopters of these approaches to standardization. While they will inevitably become mandatory, for the time being, it seems a clear opportunity to stand out from competitors who continue to embrace a narrative and marketing driven approach.

Link ESG and corporate strategy

At some point, every organization is going to need to grapple with the transition to a more open, more accountable, low carbon economy. How that looks will differ from industry to industry and business to business, but there’s no denying the landscape will look very different in the next five, 10, or 15 years. The sooner businesses can clarify ESG risks and opportunities across their operational, vendor, and supply chains, the better positioned they will be to compete for consumer trust and investment capital — especially in the wake of COVID-19 and COP26.

Part of this transition will require a significant change in mindset: The overwhelming focus of ESG continues to centre around ticking boxes and meeting expectations. Leaders and decision makers need to start looking inward and critically assessing how their initiatives relate to their risks, opportunities, and performance. They also need to look further outward and become more deliberate about working with organizations that are similarly committed to ESG — because investors will be, even if businesses are not.

The investment community already recognizes ESG has the potential to be either a major lever or a massive liability depending on whose hands it’s in. Businesses that are currently taking steps to assess materiality and integrate ESG with strategic objectives will enjoy a significant return on their prudence, with fewer near- and long-term risks and better operational performance. This, in turn, will reward them with cheaper access to capital and better share price performance. Those that choose to delay or cast a prohibitively wide net will struggle to keep up as change continues to accelerate and the risks of a very different future come into view.

Make haste

Now is the time to create an ESG strategy — beginning with the current global priority of identifying, understanding, and quantifying climate-related risks and opportunities. Within this strategy should be:

• building capabilities for a formalized approach to governance, oversight, and activities,
• embedding ESG into corporate strategy,
• integrating ESG-related risks and opportunities within the enterprise risk management program,
• identifying both metrics and targets for measuring ESG performance for communication with stakeholders.

This will take time and effort, but dedication now will pay dividends later.