Common Pitfalls in ESG Development
These poor practices can result in superficial approaches to risk management, leading to missed opportunities as companies seek to adopt robust ESG strategy
By Kosmas Papadopoulos and Rodolfo Araujo, FTI Consulting
A growing number of companies are recognizing the opportunity for long-term success that results from an effective environmental, social and governance (ESG) strategy. Rising expectations from stakeholders, including investors, customers, employees and communities, indicate that high ESG performance may translate to better access to capital, talent and business opportunities.
While companies are eager to improve their ESG position, some find it difficult to create a plan of action. The term “ESG” may appear somewhat nebulous, and it is sometimes interchanged with other similar, yet varied, terms like sustainability and corporate social responsibility. Further, ESG issues cover a wide variety of topics, making it challenging for companies to understand and prioritize key issues. Some companies are not able to take decisive action and may try to address ESG issues through incremental steps, which leaves them lagging behind their peers. Other companies may fail to see results or recognition despite significant efforts.
To successfully navigate the complex and evolving ESG landscape, companies must avoid approaches that may lead to missed opportunities. This article discusses a few such misguided approaches, the seven sins of ESG management. These are common mistakes companies make when attempting to deal with ESG issues. At best, they can result in failure to receive credit for their efforts and, at worst, can leave the company exposed to significant risks.
Defining what ESG means for a company
The term “ESG” has become widely used by the investor community to broadly capture a wide set of issues that extend beyond the standard business and financial risks facing the corporation. For companies, an ESG program refers to the policies, management systems and processes the organization has in place to manage material environmental, social and governance risks that are specific to the organization.
As with any type of material risk, the responsibility for ESG risk sits with the board, while the executive team is responsible for implementing the board’s ESG strategy. Environmental and social issues may vary by industry and may even be company-specific, depending on the exposures to specific risks, while corporate governance practices tend to be the same across industries.
It is critical for companies to regularly conduct an ESG materiality assessment. This helps to organize and prioritize relevant ESG factors based on their level of impact to the business and key stakeholders. When identifying material issues, companies should consider a long-term approach, which allows them to consider both direct and indirect financial impacts that may stem from social or environmental risks and opportunities. In this approach, companies may consider the long-term effects of potential regulatory developments, industry norms, stakeholder concerns, as well as opportunities for innovation.
Once the company identifies and prioritizes its material issues, it may set objectives and strategies for achieving its goals. The establishment of ESG programs for the implementation of the company’s strategy can become a source of innovation and industry collaboration. Companies should avoid a static approach that may focus on adhering to minimum regulatory requirements. Instead, the dynamic management of ESG risks and opportunities entails continuous improvement and the use of recommended best practices in a methodical and cost-effective manner. Further, the effective implementation of the ESG program requires regular monitoring and assessment using key performance indicators.
The development of an effective ESG program requires a conscious effort that is led by the board and management and transpires to the entire company.
This systematic approach to ESG using a risk management perspective is in direct opposition to perceptions of ESG programs as company efforts linked to non-business activities for improving the company’s image through charity, philanthropy and marketing. While social investment, community relations, green initiatives and corporate communications may be part of the company’s ESG program, these efforts should not be misunderstood as representing the full scope of the company’s approach.
The 7 sins of ESG management
The following are a few of the most common misconceptions and problematic practices among companies when dealing with the management of ESG issues, which can lead to significant pitfalls. The common element in several of these practices is the lack of a purpose-driven strategy that focuses on company-specific material issues and is fully integrated with the business objectives of the organization. As discussed above, the development of an effective ESG program requires a conscious effort that is led by the board and management and transpires to the entire company.
- Excessive focus on ratings. Some companies consider the improvement of their ESG standing as an improvement of their ratings by ESG rating agencies. A company approach that focuses exclusively on improving the company’s rating is at risk of allocating more resources to “checking boxes” instead of developing a strategy that is tailored to the company’s unique outlook and exposure to risk.
ESG ratings can be helpful for companies to understand potential perspectives of material issues, but they represent only specific viewpoints by third parties. In fact, the multiple rating methodologies available on the market make it almost impossible to satisfy all viewpoints.
Positive ratings can indeed help a company gain recognition, but they should be viewed as only the outcome of the company’s efforts. It is important for companies to focus on their own perspective on how to manage their material ESG risks and opportunities and to use third-party views as inputs, not as ends in themselves.
- Treating ESG solely as a communications effort. Companies sometimes make the mistake of attempting to improve their image by focusing only on their communications and public relations strategy, thus “putting the cart before the horse” in their ESG efforts.
Communications can help the company amplify its messaging, but they cannot substitute for a robust management system that addresses material risks. Investors and other stakeholders can see through messaging that does not correspond to significant action (often referred to as “greenwashing”).
More importantly, by focusing on the messaging and not on the management of ESG issues, the company remains exposed to significant risks.
- Lack of board and management oversight. Some companies delegate ESG or sustainability responsibilities to individuals or departments within the firm, without the involvement of the board and senior management. However, the company’s ESG management strategy should be positioned as a core part of the company’s vision and values. Therefore, it is imperative that the board and senior management not only oversee but also drive the company’s ESG strategy, bringing it to full alignment with the broader business strategy.
- Disconnect from business strategy. An ESG strategy cannot be thought of separately from the company’s business strategy. An ESG strategy that does not consider the company’s strategic objectives and does not inform the main corporate strategy fails to serve its purpose. Such disconnects may stem from potential misperceptions about the purpose of the ESG program, lack of board and management oversight, or a failure to conduct a thorough materiality assessment.
- Compliance-oriented approach. Some companies may present their ESG program by making references to compliance with rules and regulations regarding environmental, labor practices, health and safety, and other key issues. This approach may appear reactive and indicate a reluctance to go above and beyond minimum requirements.
To position themselves as leaders, companies would need to illustrate that they proactively establish best-in-class programs that exceed minimum requirements as part of a deliberate ESG strategy. At the same time, in jurisdictions with robust rules and regulations, it is important for companies to fully explain their practices, so that they get full credit for their efforts. Otherwise, their audience may not fully appreciate that the company is operating at a high standard.
- Inconsistencies across the firm. As a result of a lack of a companywide strategy and coordination, or operations in disparate jurisdictions, geographies or business segments, some companies may end up adopting different standards in different divisions without a clear reasoning for the discrepancies in business practices. Such an approach leaves significant gaps in the company’s ESG management programs, with potential exposures to risk.
In such instances, companies should map their policies and programs across business units and geographies and harmonize efforts across the company to have a consistent approach with equivalent practices on how to address material risks.
- Lack of assessment and monitoring. The collection of data and information to monitor performance on key ESG issues constitutes a significant challenge for companies in the implementation of their ESG programs. Lack of effective monitoring of ESG performance impedes the company’s ability to make progress and receive full credit for its ongoing initiatives through reporting.
The creation of the mechanisms and methodologies for collecting the appropriate information for monitoring performance may take significant effort at first. However, such a process can become instrumental in establishing a successful program.
In addition to a review of the data, the monitoring process should include continued assessment of the effectiveness of the company’s programs, so that systems can be adjusted to achieve continuous improvements.
ESG considerations for the oil and gas sector
Oil and gas companies are subject to many of the pitfalls described above and may face some risks in their management of ESG issues that are more specific to the industry. The management of climate change is a good example of a challenging issue facing the industry. There is a growing expectation, especially among investors, for companies to explain how they manage climate change risks and opportunities, including a transition to a low-carbon economy.
Each oil and gas company’s circumstances in relation to climate change risk may be unique to its geographic location, its cost structure and its assets. As some companies attempt to address the risks and opportunities in their disclosures, much of the information they provide may raise more questions than address potential concerns.
Below, a couple types of responses to climate change risks that oil and gas companies make in their disclosures are highlighted to illustrate some of these pitfalls.
Mechanical application of climate change reporting frameworks.
The Task Force on Climate-Related Financial Disclosures (TCFD) and the CDP (formerly Carbon Disclosure Project) are the two most widely used reporting frameworks for disclosing company approaches to managing climate change risks. Other reporting frameworks, such as the industry-led IPIECA guidelines for sustainability reporting, the Sustainability Accounting Standards Board (SASB), and the Global Reporting Initiative (GRI), also include climate change elements in their guidelines.
The use of such frameworks for reporting can prove invaluable for firms, as these frameworks may help companies structure their thinking and organizational response to climate change risks. Companies should view these frameworks as tools and opportunities for organizing their approach to climate change risk. They should avoid treating the use of such frameworks as a compliance exercise, whereby they mechanically respond to a list of questions to satisfy the demands of external stakeholders.
It may be preferable for companies to delay public disclosure in accordance to a framework and instead use the framework as a reference point internally, in order to organize their risk management and strategy approach to managing climate risk.
Repositioning legacy approaches without having conducted a risk assessment.
In some company responses to climate change risks, it becomes evident that the company has not fully considered risks and opportunities and potential scenarios to evolve its position on climate change. Instead, the company may present and reposition its legacy approach as its governance, risk management process and strategy on climate change issues.
This tactic may appear as disingenuous to outside parties, and, more importantly, it may represent a missed opportunity for the company. It is very likely that, after conducting the risk assessment and the scenario analysis, many firms may end up in the same position in terms of their strategic responses to addressing climate-related risks and opportunities.
However, it is important for companies to go through the process of evaluating potential issues. The scenario analysis may illuminate concerns that the board and management may not have previously considered, and it is worth conducting, even if it is only for internal purposes.
From an investor perspective, it is more important to demonstrate that the company has a clear-eyed perspective on these key issues and is forming a strategy to address potential future risks, rather than the company positioning itself as having found the answers to all the questions.
The sins of ESG management outlined in this article may not necessarily qualify as deadly sins for companies, but they can prove very dangerous as they may lead to poorly managed or superficial approaches to risk management. By adopting a comprehensive ESG strategy that focuses on material issues, companies can take full advantage of the opportunity offered by a sound ESG management system to address risks and protect long-term shareholder value. DC
The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, its management, its subsidiaries, its affiliates, or its other professionals.
