Welcome to a 3 part series on how to motivate portfolio companies to prioritize ESG.
Part 1: Understanding the Obstacles for Portfolio Companies
In a recent PricewaterhouseCoopers survey, 49 percent of investors responded that they would be willing to divest from companies that are not taking sufficient action on ESG issues.
Investors are under increased pressure to disclose their environmental, social, and governance (ESG) performance to general partners (GPs), limited partners (LPs), and other stakeholders. At the same time, many private companies do not report on their ESG performance. Among companies that do report, investors often find that data is incomplete, inconsistent, and not focused on actionable insights.
When asking their portfolio companies to disclose their ESG performance, investors must walk a careful line: understanding the impact and risk profile of their investments, without overburdening portfolio companies who are strapped for time and resources.
This article – the first in a three-part series – will provide investors with actionable steps to support their portfolio companies on their ESG measurement, management, and reporting journey, while also taking into account the resource limitations that companies face.
First, let’s define digital ESG…
ESG – primarily a tool for risk assessment and mitigation – provides a framework for evaluating an investment’s environmental, social, and governance performance alongside traditional financial performance indicators. ESG is comprised of three interconnected dimensions:
• Environmental (E) criteria comprise the company’s resource consumption (e.g. Water Usage), operational outputs (e.g. Greenhouse Gas Emissions, Waste Management), and risk resulting from its environmental context (e.g. Climate Risk).
• Social (S) criteria refer to the company’s human resource management (e.g. Employee Health & Safety, Employee Diversity, Equity & Inclusion) and broader societal contributions (e.g. Access & Affordability, Product Quality & Safety).
• Governance (G) refers to the policies, procedures, and governing bodies in place to manage risk, comply with legal regulations, and promote ethical behavior (e.g. Board Diversity, Business Ethics).
A company should report on a subset of ESG criteria and corresponding performance metrics based on its industry and sector. The Sustainability Account Standards Board’s (SASB) Materiality Map is a useful starting point to determine which issues and metrics are most material to the company’s ability to generate economic, environmental, or social value.
Investors seek to measure their portfolio companies’ ESG performance to:
1. Prove: Compare company performance data to expectations for a transaction, portfolio, or investment thesis.
2. Improve: Enhance company decision-making through data and set targets for improvement in prioritized categories.
3. Learn: Foster collaboration among portfolio companies and build an evidence base for future investment decisions.
It is critical that companies not only measure their performance but also manage it. Digital ESG leverages digital technology to streamline reporting and reduce manual burden on portfolio companies, so that companies can spend their valuable time acting on insights from reported data. Investors and their portfolio companies must be committed to learning from the data that they report, in order to make better decisions that mitigate negative contribution and maximize positive impact.
“ESG issues have become much more important for us as long-term investors. We seek to analyze material issues such as climate risk, board quality, or cybersecurity in terms of how they impact financial value in a positive or a negative way. That’s the integrative approach we are increasingly taking for all of our investments.” – Cyrus Taraporevala, President and CEO, State Street Global Advisors
Why should portfolio companies dedicate resources to measuring and managing their impact?
It used to be the case that companies could add a mission statement to their website or submit an annual corporate social responsibility (CSR) report and “check the box” on fulfilling their sustainability commitment for the year. Demand for transparent ESG reporting is higher than ever before due to three key factors:
• Stakeholder Pressure: Investors, employees, and consumers are increasingly demanding impact and ESG reporting, and they are acting with their pocketbooks. An estimated $40 trillion of wealth is transferring to a new generation that prioritizes both “doing good and doing well,” resulting in a foundational shift in the way that capital is allocated through investment and purchase decisions.
• Regulatory Compliance: From the EU Taxonomy to U.S. SEC statements on ESG disclosures, governing bodies around the world are tightening regulations to require and standardize ESG reporting. Although regulatory requirements vary by jurisdiction, each ESG reporting mandate contributes to a climate of holding businesses accountable for their actions that impact society and the environment.
• Market Growth: A staggering 72 percent of public companies mention the Sustainable Development Goals in their marketing materials. This is representative of the market movement away from shareholder capitalism (the social responsibility of business is to make a profit) and towards stakeholder capitalism (companies have an economic, environmental, and social duty). Companies are left with a choice to join the movement to transparently report on their impact, or to fall behind their competitors.
“ESG cannot be an afterthought, it must be an integral part of corporate strategy. Demonstrating ESG commitment and performance also requires a holistic approach to reporting, with sustainability, risk, and financial reporting teams working together… To meet the demands of investors, companies need to take their ESG-related performance as seriously as they do all of their business and financial metrics.” – Emma Cox, Global Climate Leader, PwC UK
Reporting on ESG seems like a no-brainer. Why aren’t all companies doing it?
With the increasing momentum to report on ESG impact, it seems like a no-brainer that every company should be reporting on environmental and social metrics alongside their traditional financial metrics.
Without a common set of standards and with more than 614 potential reporting requirements and frameworks to choose from, starting out with ESG reporting can be daunting. Companies that have never reported on ESG encounter many questions, including:
• Which framework should I start with?
• What should I measure?
• Who is responsible for reporting?
• Who should pay for the ESG reporting solution?
• How do I interpret data once it’s been collected?
• How will ESG reporting benefit my company?
For small business and early-stage companies that lack existing in-house ESG expertise, recruiting new talent or hiring an external consultant may be too costly or infeasible. The pressure of manually reporting on ESG may add undue burden to an already-busy team.
“These concerns — that ESG measures can obscure important insight into processes, misdirect our attention away from systems, and dangerously misrepresent broader values — don’t mean that companies shouldn’t measure. They should. But they need to do more.” – Jennifer Howard-Grenville, Diageo Professor of Organization Studies, at the Cambridge Judge Business School.
Where do we go from here?
Investors play a critical role in supporting their portfolio companies on their journey to measure, monitor, and manage their ESG performance. In the second article in this series, we will provide a guide to messaging the business benefits of ESG measurement to portfolio companies. Then in the third article of this series, we will provide a practical case study and advice for talking to portfolio companies about ESG measurement and management.
Proof is committed to supporting our clients on their journey to understand and improve their ESG performance. Whether your company is just beginning to report on ESG criteria or looking to gain deeper insights from existing ESG data, Proof will provide the resources to help your business succeed and enhance your impact.
• Follow Proof on LinkedIn to access our next article in the series on how to set your ESG strategy.
• Build your ESG strategy with Proof. To start your ESG reporting journey, reach out to us via our website.