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7 January 202114 minute read

Beyond woke: Acting NOW on SESG

The Rule of Three - a guide for boards & businesses

In December 2019 I wrote a piece called "Twelve Days of Christmas", where each of the festive gifts symbolised a landmark of Sustainability and ESG (SESG), celebrating the good, acknowledging the bad and shaming one or two instances of the ugly. It illustrated the tremendous reach of SESG and put beyond doubt its immediate relevance to all businesses, in all sectors, in all geographies.

The feedback, which I appreciate greatly, noted that illustrating SESG in this way makes it too big to handle. Several contributors asked: Where do we start? or How do we make a difference? And one seasoned CEO counselled: "Keep it sharp & keep it real". Fair comment. This paper aims to respond to that feedback.

During 2020 consciousness of SESG developed rapidly, and there is a broad understanding of what it is and why it matters. No doubt the COVID-19 pandemic, the Black Lives Matter movement and Sir David Attenborough's "Witness Statement" have all helped. Providers of capital are making decisions based on SESG metrics and the court of public opinion factors ESG behaviour into its judgements. Companies are therefore under pressure to improve their SESG performance. To do that, awareness is not just a good thing: it is necessary, critical even, but it is insufficient to drive change. Awareness must be followed by action – prompt action. But that is not yet so much in evidence.

Why so? There is no shortage of data proving the financial merits and other business benefits of engagement with the SESG debate, and the urgency for such engagement. Especially in relation to climate change it is well understood that we are rapidly approaching a "point of no return" after which the goal of limiting the most severe consequences of the climate crisis will become unachievable. The timeframe is one of months and years, not decades or millennia. Businesses declare that they are variously prepared, willing or eager to take supportive or remedial action. But it's not happening.

Awareness must be followed by action – prompt action. But that is not yet so much in evidence.

Discussions with clients and other businesses indicate that the reason for this inertia is often profound uncertainty about what to do and how to do it. Boards need to be able to prioritise; to work out the actions that will have the biggest impact. Those actions must be formulated into an SESG response (a plan of action and measuring progress in achieving it) which is then communicated - honestly, carefully, consistently, and candidly.

This paper offers three core principles to help businesses understand the What? and How? of SESG, so they can deliver impactful change and enjoy the concomitant value enhancement and reputation dividend. Those principles – the Rule of Three mentioned in the title - are: Materiality, Advocacy & Authenticity. We'll look at each of these in turn.

Summary

During 2020 I've had client queries on the following lines: "We need to do something on ESG for our annual report/capital markets day – can you draft something?" That's a tough one. Every business has its own SESG story and there is small benefit in boilerplate, however elegantly worded.

As audiences, empowered by AI, become increasingly sophisticated in detecting standard wording its use risks a reduction in value rather than enhancement. Arguably it would be better to say nothing at all. To reap the potential returns businesses must first integrate SESG efforts into their strategy, and then they must operationalise that strategy. Once that's done, writing about it becomes relatively easy.

So the very first challenge for boards is this: identify the material SESG issues in your industry and develop initiatives for your business that set you apart from the competition. Focus on those that are hard to copy. Boards which eschew the materiality triage, and throw resource at anything with an SESG flavour will waste cost and in all likelihood experience reduced financial outcomes. An honestly written audit of such an approach will inevitably describe standardised and non-bespoke SESG behaviours.

Those behaviours may well be inherently virtuous and worthy from an ethical and societal perspective. They might make for a more fulfilled compliance function within the business. They might also help to preserve value. But they are unlikely to improve financial performance and generate the Alpha which is so coveted by CEOs. That reality – especially in a business world where competitive behaviours, like it or not, now have a distinct SESG dimension - paves the way to censure from stakeholders and potentially (see below) litigation.

It is the connection between effective SESG behaviour and financial outcome which is most interesting and on which businesses are being judged. To achieve that connection demands an SESG strategy in which material SESG factors are prioritised and non-material SESG factors are relegated. The strategy will have owners (and therefore accountability) at the highest level; it will be embedded throughout the business (and therefore become part of the business DNA) and it will be supported by remuneration (and therefore shape behaviours which sustain it). The strategy will then be used in the business, or "operationalised". Then it will drive results.

Communication is an essential aspect of the deployment of strategy which should not be overlooked. Publicly setting goals creates a sense of commitment and ownership, as does reporting progress against those goals, but it needs to be done carefully and with awareness of the challenges for the unwary, all of which are discussed in further detail below.

Materiality

Data capture and analysis in relation to SESG is becoming a science. We now understand much better that there is a difference between SESG factors which, regarding financial outturn, are incrementally improving and those which have a very significant positive impact. That is a significant prize, and one that is worth having. But it does require an approach which is ambitious rather than defensive.

Unfortunately there is evidence of a significant amount of "convergence" in the SESG universe, in which many companies copy each other's efforts and "do similar things well". The risk is that such behaviours become viewed as hygiene factors, like brushing teeth or eating a balanced diet, rather than competitive and strategic differentiators. That is not to say that such things should not be done at all – they are important for overall corporate health – but they should not be regarded as the endgame: they will not achieve Alpha.

The hallmarks of Materiality
It is acknowledged that "not all SESG issues are created equal." While SESG is relevant to all industries, certain aspects of it are more impactful to some sectors than others. For example, pharmaceutical and drug development companies have to demonstrate the environmental integrity of their manufacturing process, their philosophy on patient access and (as seen in the current developments around COVID-19 vaccines) their readiness to collaborate with competitors, not for immediate profit but for the greater good of humankind. For energy and utilities companies a core focus needs to be on decarbonisation. For financials and information technology the emphasis is on the development and safeguarding of human capital (the S in ESG).

This isn't just an assertion. Harvard Business School-led research, which looked at 2,000 US companies over two decades, found that those that invested in material ESG issues did significantly better than their competitors, while those that invested in immaterial ESG issues did worse. Evidently SESG can be a value creation opportunity, but it can equally well be an excuse for window dressing. Bearing in mind the more vocal demands from investors for businesses that "walk the talk", and taking into account the technology available to help such investors in their identity parade, a board that develops an SESG response without a prior materiality assessment is likely to miss that opportunity.

Of course, the G in ESG – the governance of a business's environmental and social strategy – must underpin that strategy and is critical to ensure that it is effectively implemented, maintained and improved over time. The theory and practice of good governance is well understood (albeit not always observed) and so the concepts of initiation at the highest level within an organisation ("tone from the top"); ensuring that governance is cascaded throughout the organisation ("embedding"); and using compensation structures to drive behaviours which reflect and realise that strategy, are not new to SESG. The challenge for innovation is the development of key ESG performance metrics, showing executive leadership what it is managing towards and showing the board what it must supervise and oversee.

Advocacy (The Power of Purpose)

Another feature of 2020 has been the debate around the purpose of the corporation. This is actually the foundation stone for the SESG debate, because the question "how do we go about it?" (strategy) can only be asked once we first have an answer to the question "what are we here to do?" (purpose). Although it had occupied academia for a number of years the discussion of purpose gained legitimacy in boardrooms following the 2019 signposts of the "Fink Letter" at BlackRock and the summer statement from the US Business Round Table. In response to those signposts much has been written about whether the declared investor position is genuine, or whether in reality the short, medium and long term focus of investors remains profit maximisation.

The 2020 proxy season is cited as evidence for that, although it is probably misleading to look at the statistics alone. SESG related voting interventions may have been the exception rather than the rule at the AGMs held in 2020, but it would be wrong to assume that this indicates complacency or duplicity: it is much more likely to be an acknowledgment that that investors realise the implementation of an effective SESG strategy takes time. If in 2021 there is still no tangible progress towards such a strategy then the general meeting season may not be plain sailing for the companies concerned.

A strong culture cannot be bought, nor can it be achieved overnight.

Alongside purpose and SESG strategy we have also learned about the importance of culture and values. The larger and more complex a business organisation the greater the distance between the relevant actors and the greater the importance of a culture that reflects and supports corporate purpose and business strategy. We know that businesses with a strong sense of culture do better than their peers. A strong culture cannot be bought, nor can it be achieved overnight. It depends a clear articulation by leadership of their carefully developed SESG strategy, expressed so as to be readily understood and repeated by all levels within the organisation and by the outside world. This articulation and expression is what is meant here by Advocacy.

There are as many audiences for external advocacy as there are stakeholders in a business. But the focal audience is and remains investors, bearing in mind that enduring access to capital is the oxygen without which no business can survive and prosper. Again this is not limited to the field of SESG, but it is important that due weight is given by boards to ensure that their communications with investors embrace SESG too. So far it isn't clear that this is happening. There are various reasons for that, some well founded and others less so. Misconceptions include that investors place little value on corporate communications.

We know that the opposite is true, but only for communications that are honest, transparent, relevant and specific. Boards that invest solely in securing SESG ratings are unlikely to hit the spot as far as investors are concerned. The science behind this is very similar to that which applies to corporate governance ratings and other metrics which depend upon "at a distance" or desktop analysis of generic data. It shouldn't come as a surprise. A further misconception is that investors operate largely objectively and are typically unresponsive to interactions with management.

We know that businesses that invest in stakeholder engagement on a continuous basis, rather than to coincide with particular events in their financial calendar and/or their corporate development programme (including their M&A activity), enjoy greater support from their owners and are better protected against the risk of shareholder activism.

Authenticity: aligning words and actions

This is actually the most important of our three principles. If there is not a close and continual association between (i) the declaration by any businesses of its purpose and SESG strategy; and (ii) its behaviour in manifesting those things, then the value of its efforts in relation to SESG will be severely and rapidly undermined; its resilience in the face of business risks eroded and its reputation diminished. There will be practical consequences of these things in reducing its access to financial and human capital and ultimately in its market access and licence to operate. Those are big statements to make and they are inconvenient truths for boards to accept, but the evidence to support them has become very substantial. As SESG grows in importance, so does the data, big and small, which provides a window on the way in which businesses develop an effective SESG response, or fail to do so. The authenticity of that response is the way in which the winners and the also-rans will be categorised in the future.

It is important to understand that in pursuit of SESG authenticity it is not necessary for businesses to be "best" or even "best in class". There are various examples – of which Unilever is often cited – where boards have publicly acknowledged that there is room for improvement in material aspects of their SESG performance. Those acknowledgements are associated with positive share price movements rather than downturns, inviting the conclusion that what matters here is transparency and candour (yes, certainly coupled with a clear strategy for remediation and a belief that management can and will deliver) rather than a counsel of perfection.

Authenticity is a critical business discipline to avoid accusations of "greenwashing". Greenwashing is often used to describe a situation where a business deliberately describes an SESG output which is not reflected by reality. It is a deception, and an intentional one. But greenwashing can in fact occur in any situation where a company's declaration of SESG aspiration and achievement don't match up – that can arise even when motivated by the best of intentions with no desire to mislead.

The lack of a consistent standard for SESG disclosures is a reality at the current time despite a number of high quality initiatives, some with a global reach, to correct that situation. Why does that matter? Because the fact/description disparity of which greenwashing is one instance is a litigator's charter and the business risk which that represents to management is much leveraged by the prevalence of third party litigation funders who offer the prospect of financial gain on a win/win basis in which the expenses of an unsuccessful challenge are absorbed by the funder at no cost to the plaintiff. Together with a piecemeal SESG regulatory landscape, that creates an environment in which the disciplined application of the principles of Materiality, Advocacy and Authenticity become non-negotiable risk mitigation tools for any business leadership team.

Conclusion

As the velocity of change in the SESG arena increases, it is no longer attractive or interesting for a business to show awareness and intention – or even just written processes and protocols. Such a business will need to demonstrate an SESG strategy which is: consistent with its corporate purposes; focuses on issues material to the business; is underpinned by its culture and values; and is resilient to competition and replication.

The leadership of that business will also need to show that it can deliver. This will inevitably require the production of very specific, time-linked and measurable objectives and regular communication of progress – at all levels within the organisation – towards the achievement of those objectives. Boards must be brave enough to extend that advocacy externally, not just within the business, and it must be protected by verification to prove its accuracy and also by the authenticity that makes it truly useful to investors.

On the SESG journey 2021 is a year to move from awareness to action and from action to results. That is the challenge for businesses in pursuit of Alpha. It is an easy challenge to state, but a demanding one to implement, especially where time is of the essence and the need for focus is paramount. An optimal response will be greatly facilitated by the principles within the Rule of Three: Materiality, Advocacy and Authenticity. Boards which need to make a difference should keep them close at hand.

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