Environmental, Social and Governance (ESG) comprises the manner in which a company manages its impact on the environment, treats society/stakeholders, and conducts its business—in other words, how it governs itself. There are many ways companies can set ESG goals, establish processes and procedures to reach goals, and measure success for each element. To help companies set goals, there are some external sources of expert opinions, such as the Value Reporting Foundation or International Sustainability Standards Board. And there are city, state, and federal standards that regulate certain environmentally sensitive business outputs. Finally, specialized rating schemes from agencies evaluate a company’s ESG outcomes and assign it a specific rating, such as S&P’s Global ESG scores or Morningstar’s Sustainalytics, to name just two, to produce a company’s ESG score. The process of setting goals and evaluating entities’ progress in achieving them is illustrated in the Exhibit.
As if that were not enough, consortiums of companies or institutions put out challenges for businesses to try to reach that are more like contests than deliberately calibrated goals. One such challenge called for all companies in a certain sector to achieve a net zero carbon footprint by a date certain. As worthy a goal as this might seem to be, does it set unrealistic expectations, does it create negative unintended consequences, is it so extreme that it can cause the business to fail, or should it include carbon swaps instead?
Ultimately, the ability to successfully report on ESG will depend upon how well the company sets goals, establishes the processes and procedures to achieve these, and then measures the outcomes against the goals. Importantly, CFOs should be actively engaged in the ESG goal-setting process, as well as the ultimate reporting.
Some companies rushed to broadcast certain ESG goals, but did not do the fundamental work to achieve them. In the end, they could not quantify outcomes, and were accused of “greenwashing.” Another set of companies joined forces to take environmental protection action—notably, not investing in certain other companies, or withholding services from companies not considered ESG conformant—but then some were accused of anti-trust activity. Clearly, the stakes are high in this new arena. The impact to reputation, profitability, even viability can be significant.
To prepare for the most effective reporting of ESG metrics, the following is an illustrative list of questions CFOs should consider asking with respect to their company’s ESG data.
- Are the goals realistic? Are they clear and specific? Are they measureable?
- Which goals are governmentally mandated? How have the company’s results been verified, and by whom?
- Which goals have been set internally? Have there been any changes to the way results have been compiled? Is the trend line what was expected? How are results verified, and by whom?
- In order to achieve desired results, were there any negative developments, such as budget overruns, production issues, and sales or revenue issues?
- Which risks are being taken to deliver on the goals?
- Are any of the goals under consideration for changing?
- Which benchmarks are used to compare results with externally suggested goals, or to other companies in the same industry, or to companies in other industries?
- Are the goals realistic? Are they clear and specific?
- How will results be measured? Is there a risk that the goals or the efforts to achieve them will create unintended consequences? Are these risks being recognized and mitigated?
- Are the outcomes of ESG actions matching what was intended? What is the best way to report on this?
- How will the company explain not meeting any of the stated goals, should that happen?
- Which benchmarks are being used to compare a company’s goals and results?
- Are the goals considered in budgets and staffing levels? Are the goals supported by the necessary resources?
- Are the company’s financial statements in concert with external auditors’ opinions?
- Are the governance goals spelled out in specific, actionable terms of how to conduct business, and are they communicated transparently throughout the organization? No good can come of reporting what is not really happening in the day-to-day conduct of business.
- Has the finance function been exemplary in its own governance?
- How has internal audit shown itself to be objective?
- Does the composition of the board reflect the tenets of good governance, such as independence, relevant knowledge, objectivity, and diversity?
- What is the opinion of external auditors with respect to the company’s governance?
Linking Performance Evaluation and Compensation to ESG Metrics
When a company wants to promote a particular behavior or attain a particular result, the effective approach rewards good behavior or results and imposes consequences for poor ones. Any staff members, executive through entry level, who have an impact on how well ESG goals are met should include ESG among the various criteria in their performance evaluation. This approach sends a clear message about how important ESG is to the company and provides an incentive to do well. More boards of directors are demanding that these links be created; the authors expect that this trend will continue.
Keeping the Goal in Mind
With the mountain of content being written about ESG and the plethora of “experts” providing advice and measurement, the current state of affairs can be perplexing. Companies may want to consider setting up some internal goals without externally reporting them until they gain experience with them. This affords time to take remedial action if necessary. There are goals, however, that may need to be externally reported sooner rather than later for various reasons. In such cases, the same rigorous due dilligence given to financial reporting must also apply to how these ESG goals are measured and reported. Questions like the ones above may help to alleviate some of the potential issues in an organization’s effort to build a better world through ESG aspirations.