Weathering the Impact of ESG Headwinds

Environmental, Social, and Governance (ESG) factors are increasingly recognized as key drivers of long-term business sustainability and success. Companies that prioritize ESG practices are better positioned to address risks, capitalize on opportunities, and create value for all stakeholders. Between shifting governance and regulation, ongoing health crises and political conflict, ESG challenges are sure to take centerstage in the near term. Companies must fundamentally rethink how they capture data, report their carbon emissions to meet regulatory standards, and act to reduce emissions by reshaping strategies, tactics, and operations. Sandeep Chatterjee, Supply Chain and Sustainability Leader, IBM Consulting, presents his take on the matter… 

Norwegian Politician Gro Harlem Brundtland was once quoted as saying, “Sustainable development is the development that meets the needs of the present without compromising the ability of future generations to meet their own needs.” Sustainability and ESG initiatives face heavy headwinds—namely from inflation, geopolitical upheaval, profitability, lack of uniform standards. Will good intentions wither in the face of a looming global recession? And to add to the misery is the constant reports on greenwashing. According to a survey done by IBM Institute of Business Value (IBV), consumer trust in corporate sustainability statements has nosedived.

Like any other wave, there is initially a mistrust followed by slow acceptance. According to the ‘ESG Conundrum’ report authored by IBM Institute of Business Value (IBV), roughly three in four (76%) out of the CEOs now view ESG as central to their business strategy and more than 7 in 10 (72%) approach it as a revenue enabler rather than cost centre. And while most ESG efforts focus on compliance and risk management, many now expect to see improved profitability (45%) and improved innovation (35%).

Though there is a lack of consumer trust, the same report iterates that roughly two-thirds of consumers say environmental sustainability (68%) and social responsibility (65%) are very or extremely important to them. And more than 7 in 10 agree that they would be more willing to apply for a job with a company they consider environmentally sustainable or socially responsible. More than 40% even say they would be willing to accept a lower salary to work for an employer that is environmentally sustainable or socially responsible—and nearly one in four of those who changed jobs in the last 12 months say they did just that. Overall, the salary cut people say they would be willing to accept is close to 20%.

According to an IBM study, across all organizations, the integration of ESG metrics into core functions is limited, mostly focused on risk management (44%), brand strategy (40%), and customer service/engagement (39%). Only 20% are integrating ESG metrics into supply chain operations; 26% into procurement and sourcing; and just 11% into real estate and facilities management.

THE ‘SCOPES’

GHG emissions are categorized into three groups or 'Scopes' by the Greenhouse Gas Protocol (GHGP) —the most widely-used carbon accounting tool. Scopes 1, 2 and 3 are a way of categorizing the different kinds of carbon emissions a company creates in its operations, and its wider value chain. These scopes cover the six greenhouse gases as covered by the Kyoto Protocol namely Carbon dioxide (CO?), Methane (CH?), Nitrous oxide (N?O), Hydrofluorocarbons (HFCs), Perfluorocarbons (PFCs), Sulphur Hexafluoride (SF?).

To reiterate, Scope 1 includes all direct emissions from an organization, such as company vehicles, emissions from manufacturing processes, and fuel combustion on site, such as burning gas to produce heat. Scope 2 encompasses indirect emissions from the consumption of purchased electricity, heat, or steam. Scope 3 includes all other indirect emissions that occur in a company’s value chain and include instances of carbon emissions outside of their direct physical footprint. Scope 3 emissions for one organization are often the supply chain processes and 2 emissions of other companies in its value chain.

While companies are comfortable with Scope 1 and 2 emissions, it is the Scope 3 emissions which is itchy. Scope 3 emissions are comparatively more difficult to measure and control because they are generated by third parties (e.g., a supply chain partner or investment holding) for which the reporting company has limited visibility or control.

When it comes to supply chains, they have the greatest room for improvement to meet sustainability goals. According to McKinsey, the typical consumer company’s supply chain creates much greater social and environmental costs than its own operations. Supply chain impacts account for more than 80% of greenhouse gas emissions and more than 90% of the impact on air, land, water, biodiversity, and geological resources. Embracing logistics and supply chain management practices focused on sustainability can drive positive change and reduce these impacts.

While all this looks positive, there is a mismatch between what consumers want to see vis-à-vis what corporates are actually doing. With stricter regulations coming in and a renewed focus on sustainability, lot of companies are serious about sustainability, but it seems to be channelised in a different direction though.

THE MISMATCH

With plethora of consulting firms jumping into the bandwagon, there are structural challenges in the ESG Journey. Some corporates assume it to be a reporting need while some view it as an overnight fix. The important point here is that it is a long-term journey and needs fundamental corrections in the structure and mindset.

First and foremost is Data. What cannot be quantified cannot be improved upon. In fact, Data is the lifeblood of ESG. It provides visibility into an organization’s operations, letting leaders see where the business is reaching the bar—and where performance has fallen behind. ESG goals for the future lose their significance if they are not tied to current performance data. And without the right information, it is impossible for executives to assess the company’s impact, identify improvement opportunities, or showcase successes. And equally important is automated data collection and reliability of data.

And to add to the confusion is the plethora of frameworks, standards, consulting firms, ESG Assurance services and so on. From the International Sustainability Standards Board (ISSB) and the Global Reporting Initiative (GRI) to the Task Force on Climate- Related Financial Disclosures (TFCD) and the EU’s Corporate Sustainability Reporting Directive (CSRD), companies find it difficult to keep up with the ever-expanding list of ESG disclosure standards, frameworks, and requirements. In fact, there are more than 600 reporting provisions globally, each offering its own interpretation of sustainability and social responsibility— and how companies can prove they are meeting the bar.

While all this looks a little gloomy, we do not have a choice but to march forward. If done with a long term strategic view, this can yield huge dividends for a company. In fact, a report published by global accounting firm Moore Global argues that companies seeking to embrace ESG principles in recent years enjoyed higher revenues, stronger growth of profits and greater access to finance. Businesses publicly placing greater importance on ESG saw an average increase in profits of 9.1%. But this jumped to 11% in the US versus 8.1% in Europe and 7.4% in Australia.

TRAVERSING THE ESG JOURNEY

While all this looks fine, it is time to get into an actional set of measures rather than discuss things theoretically. While there is no secret sauce, these are some of the potential ways in which an organization can traverse the ESG journey.

1. Do Not Wait for the Right Time: It is important to align the Business Strategy with ESG strategy and not wait for the right opportunity. It is important to look at profitability alignment as at the end of the day the goal of any organization is to make profits. We do not want companies burn cash just to be sustainable.
2. Be Authentic: If there is one element which is critical to this journey is trust. Transparency becomes the key for long term benefits.
3. Identify Needs: It is important to decide on the frameworks and the kind of data which needs to be collected. It is always advisable to break it into smaller projects rather than a big-bang approach. This gives an opportunity to relook at a totally new business process.
4. Rationalize Technology: The panacea is not automation or sensors or a piece of software. While these definitely aid, it is important to relook at business processes first to explore avenues for improvement in technology in supply chain management.
5. Executive Compensation: Human beings thrive on incentives and a useful way is to link executive compensation to ESG goals. While this is imperative, it should not be an obsession to meet short-term quarter on quarter financial targets.

Times are difficult, ambiguous but these are interesting times. To quote Peter Drucker, “The best way to predict the future is to create it.”