Societal need and business opportunity are coming together to transform the way companies craft strategy, drive performance, and report results.
Often heard in today’s boardrooms and C-suites and their virtual equivalents: a mixture of anxiety and enthusiasm about environmental, social, and governance (ESG) issues. “What risks are we sitting on?” leaders (and investors) are asking, as pressure for ESG disclosures mount. “How do we measure and manage them when there are no common standards? Where should we focus, when the list of potential issues is a mile long?” And, critically—which is where the enthusiasm comes in—“As we take a hard look at our business, what opportunities can we identify to solve big problems and create value in new ways?” The answers to these questions are interrelated, as are the initiatives those answers will motivate: reimagined reporting, strategic reinvention, and, ultimately, wholesale business transformation.
The underlying forces at work are well known. Investors, lenders, and rating agencies expect greater visibility of an ever-broader range of nonfinancial metrics to better understand diverse social and environmental risks. Governments’ ambitious, top-down commitments to limit carbon emissions are increasingly backed by new regulations and new taxes. More—much more—can be expected. Activist shareholders, among many other stakeholders, are advocating for net-zero policies and for tighter linkages between ESG targets and executive compensation packages. Socially conscious consumers are more inclined to vote with their wallets, encouraging businesses to reappraise their products and purpose, including their role as employers of diverse, engaged workforces. And the global pandemic has created significant additional momentum for change.
Against this backdrop, the ESG maturity level of companies varies widely. When PwC segmented executives responding to a recent survey according to their awareness and prioritization of ESG issues, their personal commitment, and their belief in the potential for business to positively impact society, it became clear that leaders in most organizations (nearly three-quarters) were in the early stages of their ESG journey. A few companies, though, have begun reorienting their business toward a value creation ecosystem that adds environmental sustainability, employee engagement, external partnerships, and broader societal impact to financial imperatives as measures of success. Companies that have earned top ratings on ESG indexes and that also produce solid investor returns include asset managers such as Norges Bank; tech companies such as Adobe, Salesforce, and Microsoft; and consumer-oriented firms such as Procter & Gamble and Best Buy.
Whatever the starting point for the ESG dialogue, the project will result in changes in all dimensions of a business, including strategic decision-making, implementation of the new direction, and reporting of progress and outcomes.
The three dimensions of the ESG revolution
Not only are those dimensions interdependent, but each of them can create momentum that helps fuel the others. In industries as varied as oil and gas, consumer goods, telecommunications, manufacturing, and hospitality and other services, companies are striving to build trust among, and deliver sustained outcomes to, their stakeholders. They are doing so by tackling these imperatives:
Reimagined reporting. The most immediate call for action often is some combination of heightened regulatory requirements, risk awareness, and demand for data and transparency to enable the management and disclosure of ESG factors. Everything from carbon emissions to racial and gender balance to the sustainability of sourcing strategies is under the microscope; investors, governments, and other stakeholders are interested in assessing whether businesses have identified and are managing ESG risks. As companies reevaluate what they report publicly, formal nonfinancial disclosures are starting to augment or replace nonbinding frameworks.
Strategic reinvention. In some cases, reimagined reporting will convince companies that to make progress against new metrics, they must rethink basic strategic questions about where and how to compete. In other cases, companies are moving aggressively to redefine their strategy with ESG at its core before grappling with changes in the reporting environment. Management teams are taking a fresh look at difficult strategic trade-offs in response to both new opportunities and external pressures, such as concerns about heavy carbon emissions (very much on the radar, for example, of energy companies and cement manufacturers) and about a range of social concerns, including health, race, gender, and inclusion and inequality. If its current strategic priorities are resulting in outcomes that are increasingly viewed as unsustainable (or even unacceptable), a business needs a strategy that addresses such concerns, exploits different opportunities, and, ultimately, redefines not only what the business does, but how it does it.
Business transformation. A business that begins to report against broader nonfinancial metrics will quickly find that it needs to define objectives to manage these metrics, and therefore to drive change—transformation—to achieve these objectives. Similarly, a business that has had to redefine its strategic priorities to ensure its sustainability and relevance will urgently need to transform if it is to deliver on the new strategic objectives. Either way, businesses will have to actively manage ESG outcomes by internalizing ESG into strategy, by transforming to implement the related change, and by reporting on both progress and outcomes. Senior leaders have a critical role to play in driving this agenda for transformation, which is not separate from ongoing digital transformations, but which will inform and build on them, redefining their context (and their purpose).
Every company is uniquely situated, and so is the scope of change it needs. Regardless of the motivations—an ambitious emissions target that inspires strategic reinvention; deals to exit or restructure businesses that are unsustainable; ambitious diversity, equity, and inclusion (DEI) priorities; or supply chain overhaul—the resulting ESG agenda will eventually encompass reporting, strategic, and business transformation initiatives. It all adds up to a new equation for business: behaviors based on purpose and trust that create value by finding solutions to the challenges society is facing.
If you spend much time in management reviews or board meetings these days, you’ll probably be presented at some point with a lengthy description of ESG issues, initiatives, and metrics that someone is tracking. Unfortunately, it’s rarely clear what the objective of each initiative is, let alone how far the organization is from that goal, or how all the parts add up to an overall aspiration or value creation goal. One result: endless discussion of which benchmarks to use, instead of where the company wants to go on its ESG journey.
Part of the challenge is the proliferation of ESG ratings and risk assessment metrics, which largely were developed in silos. Scoring is opaque and noncomparable because the ratings are based on different criteria plucked from frameworks set out by multiple standard-setting bodies. Not surprisingly, “lack of reporting standards” was cited as a top barrier to ESG effectiveness by executives in a recent PwC survey.
To be sure, ESG standards are winnowing as the mandatory assurance of corporate nonfinancial statements comes into effect. It’s happening first in the European Union, for both asset managers and larger companies, as part of the European Green Deal. The US SEC is considering following suit, a move that would be consistent with a May 2021 executive order from President Biden on climate-related financial risk. In the near future, it won’t be enough simply to have ESG targets on DEI or emissions reduction; they’ll need to be benchmarked, measured, disclosed, tracked over time, and assured.
Urgent as the need is for common, external reporting standards to guide corporate disclosures, each business will also need to identify and then manage the critical factors that are most relevant for that particular business. This requires a rigorous approach to understanding and defining the critical metrics for the business, establishing a baseline, and enhancing measurement and reporting for management purposes.
Establishing a baseline
Any kind of rigorous reporting regime needs a baseline. The farther businesses get from traditional financial targets—for example, if they start mapping the carbon footprint of an office building or a supply chain, or assessing whether a manufacturing facility or crops are vulnerable to flooding or droughts—the more difficult it can be to define relevant baselines. Breakthroughs are possible, though, if you gather the right data.
Regulatory targets in British Columbia, Canada, for example, led an energy supplier to set an ambitious midterm climate goal: a 30% reduction in emissions by 2030. The first step was to identify the measures that could contribute to significant emissions reductions. Then the utility created a governance and reporting structure that provides senior leadership with oversight and the ability to communicate progress toward the target. The company will be tracking activities through a series of milestones on the way to achieving the target over the next ten years. It now has a narrative that regulators and stakeholders can assess, and checkpoints along the way that help ensure it is on track. Those milestones build confidence to make decisions about capital expenditures, invest in training, and approach the capital markets in the future.
Carbon footprinting, though complex, is becoming more common, of necessity, just as valuing stranded assets such as coal or oil in the ground is now well understood. Across sectors, companies will have to measure and report on their impact in an abundance of areas that are far from obvious. Consider these examples:
- A telecom company has begun forecasting and reporting the financial impact severe weather could have on its business operations a decade from now, to inform long-term capital expenditure decisions for itself, its customers, and its investors.
- A beverage company is undertaking research on the degree to which teenagers who attend lectures on the effects of binge drinking change their attitude toward alcohol use and abuse. The goal is not only to encourage responsible drinking—which helps the company’s brand—but also to collect auditable data that shows it is taking action to mitigate potentially dangerous behavior with social consequences.
- When it was applying for permission to build an offshore wind farm as part of its transition out of fossil fuels, an energy company was pushed by local authorities and residents to address and quantify the environmental effects of overground versus underground electricity transmission.
All these assessments, and many more, will show up on nonfinancial statements. In 2019,90% of the constituents of the S&P 500 published sustainability reports; 29% had some kind of assurance review. Not surprisingly, the process of gathering, verifying, and presenting this data is having profound effects. Companies providing information to rating agencies need specific, granular data to feed into the ratings algorithms that determine membership in ESG-branded stock indexes. In turn, the expanded outlook of stakeholders is forcing leaders to reassess their strategies and capabilities as they address issues that were not on the radar a decade ago.
Whether the cause is new disclosure requirements, stakeholder scrutiny, climate risk, or green growth opportunities, at some point, ESG issues will bring leaders to the heart of their strategy—their blueprint for where and how to compete that reflects their view of the future, the opportunities and threats they face, and the capabilities they can bring to bear. In practice, that might mean moving from carbon mapping and greenhouse gas reduction to creating a product road map for new, low-carbon products.
Strategic dialogue may start with questions of ambition: What must we do? What should we do? What could we do? The answers to these questions help define a company’s degrees of strategic freedom, and must reflect an informed sense of the risks and opportunities that face the business in the short, medium, and long term. Given the long time frames associated with some of the fundamental shifts an ESG strategy requires (transitions from fossil fuels, supply chain overhauls, investing in upskilling), the ability to fine-tune forecasting is crucial. Interestingly, the CEOs in PwC’s 24th Annual Global CEO Survey whose companies have set formal decarbonization targets through the Science Based Targets initiative (SBTi) of the World Resources Institute have significantly greater confidence in their organization’s revenue-forecasting capabilities than do a control group of CEOs in the survey matched for country, industry, and company size.
Although it’s still early days for most companies’ strategic reinvention, one message is already clear: as the context within which business operates changes rapidly, so too must the strategic journey. Leaders need to establish a constantly iterating process, underpinned by high-quality data, to assess, adjust, and flex strategic priorities and milestones that ensure resilience and success in a highly dynamic world. To bring that dynamism to life, we’ll describe the experiences of a chemicals company and an industrial company that have been revisiting their strategies with ESG in mind.
Reformulating a chemicals company’s product portfolio
Over the course of a decade, a global chemicals company changed many of its products and operations following the realization that its processes, which are carbon intensive, and its products—literally thousands of chemical components—could end up being outlawed or shunned by customers, even though the bulk of what the company produced was beneficial to society. (One example: biodegradable and bio-based packaging for consumer products.)
To reformulate its strategy in the face of this threat, the company undertook a massive product portfolio review with several purposes: to establish where it was hurting the environment and what needed to change, to identify which products to reengineer, and to pinpoint where it was adding the most value and how it could remain competitive in its field.
As a means of better informing strategy formulation, the company now uses an impact assessment tool that brings together tailored economic and operational data to determine the effects of a decision—such as its product portfolio changes—on ESG criteria including pollution outputs, CO2 emissions, labor practices, social welfare, and more. This creates the kind of granularity that helps leaders make strategic decisions, understand trade-offs, identify opportunities, and tell their story to all their stakeholders. The tool has also enabled the company to develop and regularly refine a road map for refocusing R&D, overhauling operations, changing incentives, and evolving hiring practices.
Resetting an industrial company’s carbon strategy
Consider next the experience of an industrial company that has begun taking far-reaching steps to put itself on a more sustainable trajectory. The company began by defining a clear ambition centered on bold targets, initially aiming for short-term operational emissions reduction and becoming a net-zero company by 2050. To achieve these goals, the organization elevated sustainability to a strategic priority and identified a set of supporting management interventions, starting with a revamped planning process with sustainability at its core.
To inform its strategic priorities, the company studied new energy technologies in areas such as wind, solar, batteries, and hydrogen, along with emissions reduction technologies such as carbon capture. Using the insights from those findings, the company developed a portfolio strategy out to 2050, showing the rate at which it would need to divest traditional businesses and power sources, and how quickly it would need to replace those with greener options. Then, to generate early options, the company created a venture fund that could identify and invest in promising technologies, through straight investments or joint ventures with others.
Next, the company began applying a sustainability lens to future capital investments. For example, before constructing a new facility, the organization had previously used traditional financial analyses such as net present value to determine whether that facility represented the best use of capital. In that analysis, the carbon component was relegated to an afterthought (an internal carbon-pricing mechanism). The company realized that this approach was no longer sufficient to deliver on its strategic goals. When it began to factor in carbon in a more explicit way, the company actually changed the design and construction methods for new sites, expressly to reduce emissions. As it reallocates capital as a result, the company is evolving its strategic commitments.
An ESG transformation can flow from a new strategy, from changed reporting requirements, or from ongoing efforts to rewire processes or data-informed decision-making. ESG transformation isn’t distinct from, but rather should inform and extend, digital transformation efforts that have been a critical area of focus for many companies in recent years. The business transformation also can extend beyond a company’s borders to its broader ecosystem. Below, we’ll look in more detail at ESG-flavored ecosystem and digital transformations for the chemicals and industrial companies we just described—and at the role of senior leadership in company-wide transitions.
Ecosystem evolution, digital transformation
Let’s return to the chemicals company, whose reinvention effort caused it to look beyond its own four walls. One example: the promotion of sustainable use of plastics, a significant opportunity for the company to transform toward a more circular business model characterized by recyclable design, use of alternative raw materials, and remanufacturing in a new value ecosystem.
Such initiatives can lead to innovative collaborations born of the need to improve processes and outputs. In the case of the chemicals company, this happened with the polymers it supplies to carmakers, which can now be recycled. To maximize circular opportunities, those carmakers have to know when the car is at the end of its life cycle, which could be more than ten years from manufacture, and must have a way to retrieve the plastic. These car companies have teamed up with dealers, recyclers, and others in the value chain to make this happen.
The industrial company, too, is working more closely with its suppliers to push the net-zero agenda out across its entire network. This step is critical because for this industrial company, as for many other large organizations, the bulk of the carbon footprint is in the supply chain, not within the boundaries of the company itself. Digital transformation is enabling this ecosystem effort: one of the company’s business units recently put its entire supply chain on a cloud-based ERP system—an important first step in helping suppliers track, report, and reduce their carbon impact.
Already, the industrial company has good news to report: it is a year ahead of schedule in achieving its short-term operational emissions targets. Those successes have heartened executives, employees, and other stakeholders directing their energies toward the next wave of progress and more ambitious targets. To cement those goals in the minds of executives, the company set aside millions of dollars in management incentives, linked to sustainability performance. It is now creating a similar incentive structure for the full workforce.
Leading the transformation
The far-reaching effects of ESG transformations mean their success is heavily dependent on the focus and drive of senior leaders. In many organizations, the needed leadership is still emerging. “Lack of attention or support from leadership” ranked high on the list of barriers to ESG effectiveness in PwC’s recent executive survey.
In our experience, committed leaders can make an enormous difference by focusing on two priorities. First, leaders need to be able to connect ESG initiatives with the organization’s overall direction. For example, a large asset manager is undertaking a set of pilot projects to encourage the decarbonization of three portfolio companies. It would be easy for three small experiments to get swallowed up or fall by the wayside but for the fact that they connect with a much bigger aspiration: to focus the asset manager’s entire investment portfolio on companies whose operations are consistent with limiting global warming to 1.5 degrees Celsius above pre-industrial levels. In short, the pilots—which are running simultaneously with a full program to assess emissions across the portfolio—have a purpose that extends beyond their individual results. The senior team is staying close to those outcomes, which are creating energy for deeper transformation.
A second critical priority for leaders is to back up their ESG initiatives and aspirations with real resources. This is easier said than done in most organizations because budgets are sticky, there’s considerable competition for capital and the best people, and it’s easy for here-and-now priorities to trump ESG investments. The executives surveyed by PwC called out “balancing ESG with growth targets” as the top barrier to ESG effectiveness; “difficulty quantifying potential ROI” wasn’t far behind. Strong leaders can help change the conversation, though. The CEO and COO of a North American utility, for example, developed and frequently repeated a simple slogan to describe the (costly) shift they envisioned from coal- and gas-powered plants to wind- and solar-powered ones. Not only has this helped galvanize the organization, it’s also supported their efforts to educate the investor community about the long-term financial benefits of their strategy as alternative energy economics improve—which, in turn, has helped keep the needed capital flowing their way.
When leaders connect ESG with their strategy—as opposed to having it be a “bolt-on” set of initiatives—and focus intently on ESG resourcing, they’re better able to develop a true agenda for ESG transformation. Such an agenda can be invaluable for leaders as they seek to make the right trade-offs between compliance and ESG leadership, to capture the imagination of stakeholders, and to maintain focus in busy organizations that frequently are trying to transform in other ways, too.
The impetus for business to address ESG issues and opportunities is likely to continue to grow, spurred by investors and shareholders, governments and policymakers, employees, suppliers, customers, and citizens more broadly. There is a heightened awareness of the risks that need to be identified and managed, but there is also a growing sense of the huge opportunities offered by the scale of the transformation society is now facing. Whether your journey starts as a response to a new reporting requirement or reflects a top-down strategy refresh, it will lead to a pervasive reappraisal of operations, activities, and (especially) outcomes throughout the business. It will also create opportunities to identify and realize significant new sources of value creation.