Reporting on the environmental, social, and governance (ESG) elements of an organization's performance has been a growing focus of corporations, investors, and regulators globally. From the U.S. and Europe to Asia, net-zero emissions pledges, regulatory moves toward global sustainability reporting standards, and industry-level initiatives are gaining pace ahead of the 2021 United Nations Climate Change Conference in November. "The first half of 2021 has featured a flurry of regulatory activity in both the U.S. and Europe, as major financial markets come to terms with how to standardize ESG risk reporting and the practice of integrating ESG into investment practices," begins a recent article in InvestmentNews.
Yet, to relegate ESG to the realm of compliance is short-sighted, according to Edward Olson, leader of advisory firm MNP's Environmental, Social & Governance practice and based out of Kelowna, British Columbia. He says ESG has true potential for long-term value creation, including economic benefit. Indeed, he proposes that the organizational perspective must shift from ESG as compliance to E2SG — economic, environmental, social, and governance — a recognition of the strategic and economic benefits of ESG that will position the organization for the future. "Internal audit departments need to add value, which means looking beyond compliance-based, historically focused transactional auditing," Olson says. "Understanding how ESG generates value and the mechanisms a company will use to achieve desired outcomes should be the priority."
Companies taking the lead on ESG issues can gain strategic advantages through enhancing brand trust and reputation, ensuring access to capital, reducing waste and cost, and better positioning themselves for the future. By recognizing these advantages and familiarizing themselves with E2SG, internal auditors can help support organizational efforts in this rapidly evolving area.
Performance and Trust
Recent research supports the notion that ESG boosts financial performance. The NYU Stern Center for Sustainable Business and Rockefeller Asset Management conducted a meta-analysis of more than 1,000 research articles between 2015 and 2020. The researchers found a positive relationship between ESG and financial performance for 58% of the corporate studies that focused on operational metrics. Among studies that focused on sustainability-linked portfolio investments, 59% showed similar or better performance relative to conventional investment approaches.
Of the many reasons for a positive relationship between ESG and financial performance, the most essential may be consumer trust, according to the 2021 Edelman Trust Barometer Special Report: Trust, The New Brand Equity. Tapping into 14,000 consumers in 14 countries, this year's survey concluded that consumer expectations of brands extend beyond transactions to now serve the "societal we." Nearly two-thirds of respondents, 63%, "want brands to focus on making the world a better place," Edelman reports. Brands are expected to consider their purpose and how they can effect change in society, with almost 86% of respondents expecting brands to take one or more actions like giving money to good causes, addressing societal challenges, and supporting local communities.
From Reputation to Strategy
While brand trust may sometimes be linked only to reputational risk, ESG is becoming part of the larger strategy for many organizations. For example, Volvo Cars has been reporting on the environmental, health, and safety aspects of its automobiles and production processes since 2000, after the company signed the United Nations Global Compact. More recently, the company committed to reduce its life cycle carbon footprint per car by 40% between 2018 and 2025, to be fully electrified by 2030, and to be completely carbon neutral by 2040.
"It's more important than ever for all companies globally to walk the talk," says Louise Nihlén, internal audit director at the Volvo Cars' global headquarters in Sweden. "In the beginning, the audits were performed based on a reputational or brand risk perspective. Now the sustainability strategy is fully incorporated into the corporate strategy, so it is very high on the agenda of the board of directors and executive management team." Volvo Cars' internal audit activity, composed of 11 auditors, completed its first full audit of sustainability in 2015, focusing on the set-up and governance structure needed to assure proper reporting.
Volvo Cars recognized the essential need to be responsive to its consumers and to take the lead, explains Jan Holm, a senior business auditor for the company. The company's 2020 annual and sustainability report notes the share of its electric models more than doubled last year and reached more than 30% of its total sales in Europe, while helping the company and its sister company Polestar beat their joint European Union carbon dioxide emissions target. "Sustainability is a clear part of our long-term strategy … to be fully electric and technically advanced and to have direct consumer relationships," Holm says. "While safety has been Volvo Cars' top priority since the company's inception in 1927, the company's current tag line — 'freedom to move in a personal, sustainable and safe way' — places sustainability on par with safety."
Ensuring Future Access to Capital
While consumer responsiveness must align with organizational strategy, so must access to capital, Olson notes. Sustainable finance through green, sustainable, and ESG bonds and loans has grown rapidly in recent years as banks and investors strive to achieve their own ESG goals. In April 2021, S&P global ratings analysts predicted that "global issuance of sustainability-linked debt instruments will likely surpass $200 billion this year" to become "a new asset class." ESG-linked loan issuance alone hit $87 billion during 2021's first quarter, triple the amount over the same period last year, according to a Reuters report in June.
ESG-linked loans and bonds create alignment between sustainable finance and corporate sustainability commitments. Financial institutions are able to influence change while offering interest savings when companies achieve embedded sustainability targets. Borrowers often benefit from reduced interest costs in return for meeting targets linked to ESG goals. According to Reuters, average savings range between 0.05 and 0.15 percentage points if the targets are met, while costs rise if the targets are missed.
While ESG-linked financing has many benefits, companies need to plan well for growing investor and regulatory scrutiny, according to PwC's article Sustainable Bonds and ESG Strategy. Holm agrees: "The need for transparency increases because we are committing to use those funds in a specific way, and we need to report that back to the stakeholders."
Balancing Cost, Quality, and Sustainability
Looking strategically at business development from the perspective of sustainability means positioning the organization to consider not just short-term risks and opportunities but also to lead by considering long-term value creation, nature-related dependencies, and climate-related exposures; accounting for the risks those bring, Olson advises.
For Volvo Cars, that meant implementing a life cycle analysis, which helped the company prioritize supply chain sustainability as a top risk. The company considers the sustainability of materials, from sourcing through production and reuse or remanufacturing — all elements of a circular economy. Sustainability is an equal part of the procurement equation, on par with cost and quality, according to Holm, who acknowledges the difficulty of measuring those elements comparably.
"Accurately measuring ESG and developing meaningful key performance indicators requires new ways of thinking," Nihlén says. "Sustainability starts with the design of the products. It also requires investments in digital tools to measure and monitor those indicators."
Costs Versus Investment
When considering the circular economy, the business model changes. Instead of factoring in waste, companies must consciously seek out ways to conserve resources and reuse components. While enhancing ESG should result in long-term declines in materials used, which eventually reduces costs, those cost reductions may take some time to realize. Setting up new processes first requires a commitment of resources to create new infrastructure and a system of monitoring. Yet, the risks and costs of not implementing ESG strategies are greater, notes Holm, because Volvo Cars' stakeholders feel the company's purpose should include sustainability.
Volvo Cars also seeks suppliers that fulfill its ESG criteria, and the company works with existing suppliers to encourage their evolution in that direction. In its 2020 annual and sustainability report, Volvo Cars acknowledges that it identified "high-risk raw materials" — those that are "of pivotal importance from a production perspective" and also may be "associated with negative ESG impacts." These must be handled with "enhanced due diligence and increased supply chain transparency and traceability," the report says.
Thus, implementing ESG practices also increases the need for talent with new competencies, Nihlén explains. "To make well-informed decisions that take into account the intricacies of sustainability in balance with cost and quality requires people with wide range of competencies," she says. Internal auditors likewise must know which questions to ask and how and where to get the information they need to verify the company's ESG statements and work closely with experts in second line roles to achieve this.
Proactive and Future-focused
As a stakeholder group, employees are becoming more focused on ESG issues as well. A 2020 study by professional services firm Marsh McLennan, which analyzed ESG as a workforce strategy, found that top employers, as measured by employee satisfaction and attractiveness to talent, have significantly higher ESG scores than their peers. The study asserted that ESG performance will become increasingly important to attracting and retaining talent from the Millennial and Gen Z generations, which will comprise 72% of the world's workforce by 2029.
One of The IIA's Core Principles for the Professional Practice of Internal Auditing is to be proactive and future-focused. Proactive planning around ESG gives organizations a competitive edge in terms of fulfilling stakeholder expectations, attracting and retaining talent, and positioning themselves as a leader. Internal auditors should be well-versed in leading practices, metrics, regulations, and strategies related to ESG and sustainability so they can help lead organizations into the future.
"A growing body of evidence suggests the long-term benefits of ESG initiatives far outweigh the initial costs," Olson notes. "Since many of the advantages accumulate as ESG initiatives mature, the real risk is not getting initiatives underway as soon as possible. And remember E2SG — there is economic value in ESG. Internal auditors should know where to find that value and help their companies maximize it."