To be writing a blog positing the fundamental challenges with the acceptance and incorporation of ESG/Sustainability risks (or those risks affiliated with the UN Sustainable Development Goals – SDGs) within investment decisions and business strategy, seems to be writing about an antiquated subject; complaining about the milk that has already spilled. Yes, it is universally acknowledged that ESG/Sustainability is reported and addressed to an outward audience as an ‘add on’ to financial reports. Up until 3 months ago, ‘universal’ was the key phrase… everyone knew that the reported ESG/SDG issues were, in the majority of companies, not central to the business proposition. Then Covid-19 hit along with the voices of activists in the street focusing on racism and climate change. These catalysts or thundering topics have switched the reporting bar from, “watch what I say,” to, “watch what I do.”
How can the understanding and measurement of ESG/SDG risks be accepted as core to informing business strategy and investment decisions? Especially given the very real issue that such information is not valued outside of a purely marketing or communications aspect. It can only come with experience and understanding of material ESG/SDG issues and at the very highest level.
To be clear, understanding risk (all risk) is the bailiwick of the board or the investment committee, if they do not see ESG/SDG risks as central to their work, no one else will. In an article recently penned by Michael Holder as part of a piece at Business Green, “Study: Sustainability experience required in tiny fraction of top executive hires,” based on the report from the UN Global Compact (UNGC), “Leadership in the Decade of Action.”[1] Supports the premise that understanding ESG/SDG issues is not a key requirement for senior management. One key note from the study, illustrates the starkness of the situation, “There remains a glaring shortage of "transformational" business leaders who look beyond short term profits to instead prioritise long-term corporate resilience, according to new research, which indicates sustainability experience is a requirement in just four per cent of high level management hires today.”[2] Thus, how can ESG/SDG information be used in the Board room, if there is no one at that level who understands or values such corporate insight?
The UNGC study reported on 55 interviews with leading sustainability voices. The message is clear, there is a need for a “new model for leadership.” This new model should be based on four key attributes that every leader should strive to have; disruptive innovation, multi-level systems thinking, long-term activation and inclusion of stakeholder’s views. I would add a clear understanding of the materiality of risks based on ESG/SDGs issues.
Materiality as defined from the EU Non-financial reporting directive (NFRD), as “ […] in Article 2(16) of the Accounting Directive as “the status of information where its omission or misstatement could reasonably be expected to influence decisions that users make on the basis of the financial statements of the undertaking. The materiality of individual items shall be assessed in the context of other similar items.” ESG/SDG risks are, of course material. This definition is geared towards financial reporting, which is principally intended to serve the needs of investors and other creditors. By contrast, non-financial information serves the needs of a broader set of stakeholders, as it relates not only to the increasing impact of non-financial matters on the financial performance of the company, but also to its impacts on society and the environment. This may imply the need to provide an alternative definition of materiality for application in the context of nonfinancial reporting, or at least additional guidance on this issue. “[3] Given that ESG/SDG risks are material to the financial well-being of the company and should be used to inform business strategy and investment decisions, and therefore should be vital Board knowledge. I posit that there should be "holistic" risk assessments, where this distinction of what is financial and non-financial reporting is irrelevant. All risks, financial or not need to be taken into consideration as a whole and as equal parts.
Since working with the University of Birmingham on Materiality and the SDGs, a glaring pattern has emerged. There is a massive disconnect between the identification of serious corporate risks and the ESG/SDG risks highlighted by corporate reporting. It seems that the majority of companies see ESG/Sustainability at through the lens of CSR rather than a focal point to future proof their business and relevance, and at worst as marketing, not as a key process in identifying fundamental risks to the company, which can lead to better and more nimble business strategies. To put it plainly, there is a huge gap between ESG/SDG reporting and the risk register of the company. Yes, there are few (very few) exceptions, so one can only assume that the majority of companies do not see ESG/SDG risks as a danger to the financial well-being of a company.
There is one conspicuous faction that underpins this disconnect, that at most companies, there is no Board member who is responsible for ESG/Sustainability. In these companies, it is mostly all talk and no action, arguably due to the lack of integrated thinking; or connectivity to the risks that arise from ESG/SDG issues and their affiliated impact on the business. The higher the level of connectivity the better the reporting and strategy, and thus closer to and more aligned the actions of the company. In a word, ‘connective management’ of material risks (irrespective of where or how the risks arise).
The current slate of work we’ve done, has taken the identification of this UNGC observation and asked the question; how does this lack of experience at the board level, leave companies open to failings and restrict value creation? If, leaders need to look beyond profit generation and require transformational change, both from within and without the parameters of the companies.
In the context of a current example, the three most high-profile international issues which companies are currently facing; Covid-19, Climate Change and Racism are issues that would have been neatly tucked into ESG/SDG reports, tagged under social, environmental and diversity, respectively. But the management of the material risks pose a clear and present danger to the resiliency and responsibility of a company. It would seem that company value is now incumbent on how well companies respond to these (previously noted ESG/SDG) risks. Investors have taken note.
There is a disconnect between what companies say are their risks on a financial report, and the material risks highlighted on ESG/SDG reports. Thus, it is clear, given the public material risk registers of companies and the material ESG/Sustainability risks, leadership from the top on these issues, is sorely lacking. And according to the report from UNGC, this trend of little to no experience at the board level is set to continue.