"Finance function can play a pivotal role in integrating ESG goals into a company’s overall strategy and operations."
The importance of ESG has never been this much of an interest of wider audience as it has been in the last decades. The recent ESG failures like of the Volkswagen’s Dieselgate scandal in 2015 and BP’s Deepwater Horizon spill in 2010 have certainly activated a wave of awareness and alert across wider stakeholders. These types failures not only affect businesses' bottom lines in the form of heavy penalties such as the 31.3 billion Euro and 20.8 billion USD paid by VW and BP, but also the long lasting negative impacts on their brands.
For companies, having an appropriate ESG strategy in place is increasingly becoming important as part of their overall business strategy.
What is ESG?
ESG stands for Environmental, Social, and Governance. It’s a framework employed to assess the sustainability and ethical impacts of an organization and investment.
Environment factors assess how a company manages its impact on the environment, such as its carbon footprint, use of renewable energy, and waste management, while Social factors look at how a company treats its employees, customers, vendors, and communities. This includes areas like labor practices, gender equality, and community engagement. Governance factors examines the companies’ leadership, board structure, and corporate policies, ensuring they align with ethical business practices.
Recent Momentum in ESG
ESG has gained significant momentum in business and finance world in the recent years all over the world. Organizations are increasingly committing to become responsible corporate citizens. According to a recent study by McKinsey, over 90% of S&P 500 companies have now committed to ESG[i]. This is a significant increase from just a few years ago, and it reflects the growing importance of ESG issues to investors and consumers. Several key developments have significantly contributed to this high level of commitment from the companies all around the world. Increased investor interests, corporate failures, climate change awareness, stakeholders pressure and regulatory initiatives are few to mention.
Investor Interests
ESG is becoming increasingly important to investors. Institutional investors, such as pension funds and endowments, are increasingly allocating their assets to companies that are committed to ESG. As per a recent report by PwC, ESG focused institutional investment expected to grow by a soaring 84% from US$18.4tn in 2021 to US$33.9tn in 2026[ii]. This is expected to lead to a growing demand for jobs in the field of ESG analysis.
Roles of Finance function in incorporating ESG?
As more and more companies are increasingly committing to ESG, the finance function within the companies can play a crucial role in help integrating those ESG goals into the overall strategy and operation while ensuring compliance with ESG regulations and disclosures for maintaining transparency. Below are some of the specific areas where Finance function can involve and contribute to their success.
I. Reporting and disclosure
Accurate and transparent reporting is essential for maintaining regulatory compliance. Finance function can significantly contribute to the production of sustainability report and ESG disclosures for different stakeholders. Finance need to be on continuous update as such disclosure requirements are continuously evolving. Following the adoption of European Sustainability Reporting Standards (ESRS) by European Union in mid of 2023, ESRS will standardize how companies within EU report climate change and other ESG related actions, which is set to go into effect on 01st January, 2024.
II.Capital Allocation
As part of their existing responsibility for allocating the financial resources within the company, finance function may incorporate in their financial planning, the ESG activities and prioritize funding based on their priority. This will involve two key steps. First is to establish a capital allocation framework which is basically a criterion for evaluating and prioritizing investment opportunities that may include ROI, risk assessment, and ESG consideration. Once the framework established the second steps is to evaluate and prioritize each potentials candidates of project against the framework. The projects that turns out have met the criteria will be prioritized for capital allocation.
III. Risk Assessment
Assessment of the risks associated with ESG factors is critical when managing ESG related risks. These assessments can look into how the ESG related risks like resource scarcity, community risks, and ethical practices could impact company’s financial performance and reputation. Regulatory disclosure wrong doings from companies can attract hefty fines from regulators. However, the financial losses from the reputational damages that follows the fine can make the fines look insignificant compared. The quantum of fines issued by the regulator is equal to 0.045% of market cap on average, and the average value of reputational losses which equaled 5.49% of sample firms’ market cap. This equates to £1.15 billion worth of value loss for the average FTSE 100 firm[iii].
IV. Sustainability financing
Finance function can explore and secure green financing options such as sustainability linked loan. It’s paramount to build and nurture relationships with financial institutions and investors who have the same interest of supporting the sustainable initiatives. Some existing and emerging finance instruments include, green bond, green equity funds, green leasing, transition or sustainability bond, and Islamic finance (interestingly climate change mitigation strategies and consistent with the principles of Sharia finance)
V.Cost saving and efficiency
Energy efficiency projects, waste reduction efforts, and supply chain improvement can also bring the company’s financial benefits in the form of savings. Implementing energy-efficient technologies in lighting, heating, cooling, and manufacturing processes can lead to reduced energy consumption costs. Same applies to waste reductions, reducing wastages can lead to lower disposal costs and reduced material procurement expenses. Streamlining supply chains and improving overall operational efficiency can lead to reduced transportation costs.
Finance functions can drive such projects, from starting with ROI calculations to quantifying these gains. Even though such project may require higher initial investments, in the long terms, the benefits in the forms of cost saving can outweigh those initial costs.
Equipping Finance for a sustainable future.
To equip finance and other profession with relevant tools to carry out their roles in ESG areas, multiple institutions have come up with varying ESG related qualifications. Some of these qualification include the GRI Standard certification offered by Global Reporting Initiative, the CSR-P certification by the center for Sustainability and Excellence (CSE), and FSA Certification in Sustainability Accounting by the Sustainability Accounting Standards Board (SASB). These qualifications can add substantial value to the skill set that they already have to become partners in their organization’s effort toward ESG.
