Chapter 1
Why today’s ESG isn’t enough
Investors, regulators and leaders want more comprehensive disclosure than ever before, but the picture is incomplete.
ESG factors, from agricultural stewardship to working conditions, pose material risks to business. Mike Lee, EY Global Wealth & Asset Management Leader, describes the expectations of investors: “Institutional clients are demanding ESG-related investment options. Assets allocated to ESG strategies have grown rapidly and 75% of wealth clients look to integrate ESG parameters into their portfolios. Investors also have a growing appetite for better information and for transparency on risk and ethics in their investment decisions.”
ESG-friendly flows
$53tProjected assets under management with a focus on ESG by 2025. The figure already stands at $37.8t, up from $22.8t in 2016.
Despite growing rapidly, the ESG ecosystem is still immature. The marketplace for impactful investment products has been flooded with “green” funds, many of which ask investors to take them at their word; assets under management focused on ESG are projected to reach a value of US$53t by 2025.1 Many companies can report selectively to cast themselves in a favorable light, while some conform more closely to consistent market practices than others. This is not sustainable, with many fearing a backlash from confused investors and other stakeholders with accompanying accusations of greenwashing.
The intent of ESG to help stakeholders understand more about an organization's broader commitments, performance and impact is very commendable. Yet there is an urgent need for ESG to mature to the same level as financial disclosure - for society and for business. Many industries face a “burning platform” of constricted investment flows, shareholder activism and shifts in consumer preference; the EY Future Consumer Index has recently shown that 43% of global consumers want to buy from businesses that benefit society, even at a higher cost.
Financial services firms also need to be able to rely on more accurate and consistent information to minimize high-carbon portfolios, maximize greener options or work with companies to lend or insure more equitably across all communities.
This is the moment for ESG — particularly for leadership on environmental factors in the year of COP26, the upcoming UN Climate Change Conference — to measure what matters, inform capital allocations, empower investors, drive innovation and support the transition through adaptation and mitigation.
Widespread adoption of many of the recommendations by the Task Force on Climate-related Financial Disclosures (TCFD) shows that the international community is closer to agreement on standards for reporting climate-related “E” metrics within ESG. The urgency of the climate crisis is the driver for this. In a consultation paper, the International Financial Reporting Standards (IFRS) Foundation proposes a “climate-first approach” that recognizes the growing importance of the environment as a factor in financial risk.8
However, in the past year, social issues from diversity and inclusion to wage equality have become even more important to all stakeholders — governments, regulators, investors, customers and employees. And while still a work-in-progress, the approach being taken to align on “E” could inform a way forward for “S.”
Neither can the “G” be neglected. Good governance has always been a key issue, not least because it encourages ethical and effective action across an organization. Research has found that companies with strong shareholder rights — a key measure of the quality of corporate governance — have higher value and better yearly returns.9
According to a Russell Investments survey, 82% of asset managers said governance led their ESG-related decisions in 2020, while 13% said environmental and 5% said social.10 From now on, board oversight and governance throughout an organization for E and S will need to match the rigor we see today around financial management. Businesses should take a proactive role in embracing every letter of ESG, using recent progress on environmental standards as a roadmap.
Immaturity, inconsistency and imbalance across the many factors that comprise ESG form a significant case for change. The current state of ESG is not always robust or mature enough to inform decisions by the financial services industry, enable investment, give confidence to consumers or help businesses to plan strategies for the future. But more rapid evolution is possible.
Chapter 2
Four stages to realize ‘FESG+’
With support from stakeholders, ESG can be transformed to realize its full potential.
To realize the potential of “FESG+” — financially integrated ESG, with the ability to add new factors — we see four steps that need to be taken now:
- Convergence — because common standards will reduce complexity and provide even more clarity in disclosures.
- Adoption — because peer-to-peer comparison and continuous evolution through experience are both best served by widespread adoption.
- Assurance — because non-financial reporting, like financial, needs to earn and inspire trust.
- Innovation — because new strategic thinking is required to embrace and stay ahead of change, and to meet future stakeholders’ information needs more quickly.
1. Convergence
Common language equals consistency of action. At the moment, the language is not closely shared.
For “FESG+” to emerge, sustainability reporting must learn an important lesson from financial reporting: it must achieve the same degree of consistency, robustness and comparability at an international level. Standards-setters need to embrace processes that will make them more agile in the future because the current ESG approach is still evolving and will need to evolve further.
For example, as the level of reporting and the capital demands of transition to net zero accelerate, standards-setters will have to integrate more material information and move faster to develop robust guidance. They must consolidate terminology, definitions and disclosure practices that can be applied consistently around the world. “Common language equals consistency of action. At the moment, the language is not closely shared,” says Keiichi Ushijima, EY Japan Climate Change and Sustainability Services Leader.
There are multiple standards, but investors do not necessarily agree on their usefulness.
Global efforts to improve ESG reporting standards are under way:
- The merger between the Sustainability Accounting Standards Board (SASB) and the International Integrated Reporting Council (IIRC) to form the Value Reporting Foundation is an example of the positive steps required to simplify the disclosure process and achieve global sustainability standards.
- In March 2021, IFRS trustees agreed to form a working group tasked with naming a new board, the International Sustainability Standards Board (ISSB), to represent all its participants ahead of COP26.
- The International Federation of Accountants opted into IFRS standard-setting in March 2021.
- The World Economic Forum (WEF) and the UN Department for Economic and Social Affairs (UN/DESA) called for global standardization and coordination in ESG reporting in April.
- The Finance Ministers and Central Bank Governors of the G7 offered support to the IFRS and TCFD in their June 2021 communiqué, welcoming their efforts to establish global standards.
- The EU is moving further ahead with the proposed Corporate Sustainability Reporting Directive (CSRD) and the EU Taxonomy Climate Delegated Act, alongside 6 amendments to acts on investment, insurance and fiduciary duties to address sustainability issues. These measures are intended to support sustainable investment and provide more clarity on which economic activities will contribute towards the EU’s environmental goals.
There is a risk that global standards, if they are overly rigid, will lock in a lowest-common-denominator approach to reporting that could harm transparency in the long run. Private sector initiatives such as the WEF IBC Metrics (pdf) whitepaper, and its support for the IFRS Foundation, can be highly impactful in ensuring that standard setters are informed by best practice, address current issues, provide workable guidance on implementation, and encourage flexible and innovative standards for the future.
2. Adoption
“To shift whole economies down new capital pathways takes a long time,” according to Mat Nelson, EY Global Climate Change and Sustainability Services Leader, “and market forces alone can’t deliver on the potential of ESG or bring about the transformation to ‘FESG+’.”
There is a prominent role for self-regulation, investor demand and consumer pressure in encouraging the adoption of standards. The financial services industry, in pricing products and services, can also steer businesses towards adoption. But governments may need to legislate for compliance and transparency, especially to ensure and accelerate adoption by significant companies not listed on the capital markets.
To shift whole economies down new capital pathways takes a long time.
EY research in 2021 has shown that institutional investors view the integration of material ESG opportunities into strategy as more important than innovation or research when it comes to measuring and predicting a company’s success.14
Leaders can view full adoption of the ESG approach as a positive catalyst to rethink their purpose and strategy and consider who they exist to serve. As Reto Isenegger, EY EMEIA Sustainable Business Services Leader, says “this conversation should go beyond the sustainability department. COOs, CFOs and CEOs should be viewing sustainability as a main topic, to protect and create value, now more than ever before.”
Businesses that resist this trend and approach adoption with the bare minimum of procedural commitment will risk finding themselves on the wrong side of impending legislation, and open to pressure from activist investors.
Governments should see their role as incentivizing the integration of ESG into strategy and target-setting. Regulation can also bring much-needed stability and certainty to ESG reporting. The adoption of TCFD recommendations by both regulators and companies in multiple jurisdictions shows this process in action.
In Hong Kong, climate-related disclosures aligned with TCFD will be mandatory across relevant sectors by 2025. In the UK, the department for Business, Energy & Industrial Strategy (BEIS) has encouraged all public interest entities to use TCFD guidelines in line with the government’s Green Finance Strategy, and has taken consultation on mandatory disclosures by 2025. The government of New Zealand has mandated disclosure in line with TCFD for financial services organizations and all equity and debt issuers listed on the NZX. Internationally, asset managers view TCFD disclosure as a key priority.
3. Assurance
Trust in ESG needs to be protected by the same approach used to prevent financial misreporting — a combination of corporate governance, regulation and statutory audit.
At present, the level of assurance on sustainability information varies internationally, and across different sources. The International Federation of Accountants recently published that 51% of companies that report on sustainability information provide some level of assurance on it, with 63% of those assurances being provided by Audit or Audit-affiliated companies.23 Although taken on a smaller sample, recent analysis of a subset of global companies by the World Business Council for Sustainable Development found that rates of assurance on sustainability information were higher, at 84%, and had climbed year on year.
The EU Commission recently adopted the proposed Corporate Sustainability Reporting Directive (CSRD). This signals that assurance of reported sustainability information will soon become widespread. The CSRD would mandate EU-wide audit under a “limited assurance” requirement, in line with the current capacity of the market to generate ESG information.24 As other jurisdictions adopt similar or parallel policies, the market for external assurance services providers specializing in ESG will develop at pace.
Initial progress towards robust sustainability assurance has been made based on the International Auditing and Assurance Standards Board’s (IAASB) Extended External Reporting Assurance guidance — intended to improve the reliability of assurance and help assurance practitioners respond to new reporting regimes. But further change is still on the horizon.25 In ESG, as in financial reporting, the audit profession must take responsibility for trustworthy conduct, but independent oversight will also be needed.
4. Innovation
The ESG approach is itself a recent innovation in the world of corporate disclosures. It must continue to evolve. The combination of reporting convergence, fuller adoption and greater assurance to build trust would position ESG as a powerful strategic enabler for financial and nonfinancial parties alike to make more informed decisions.
Not only can future sustainability reporting converge and come closer to matching financial reporting for structure and stability, it can also more accurately reflect risk and thereby price a truer cost of business into decisions. It can integrate environmental and social data in a financially relevant way. The long-term value and impact of a business can be understood as part of a more coherent whole.
The concept of “FESG” recognizes that financial and non-financial information must be connected to shape strategy and allow interested parties to assess sustainability in the context of both financial performance and financial consequence. Traditional financial accounting has allowed interested parties to evaluate a business’s activities, but without always factoring in the impact of environmental, social and governance factors, the picture has always been incomplete.
Efforts to achieve greater alignment between financial and sustainability reporting have gained momentum in recent years. Looking ahead, more businesses will strive to express environmental and social impacts in the form of comparable financial data; about 15% are already doing so, according to the Climate Risk Disclosure Barometer 2021.26 However, new methodologies need to be developed to fully incorporate sustainability into strategy, capital allocation and operations, and to enhance ESG with greater financial relevance.
The Harvard Business School’s Impact-Weighted Accounts initiative is worth monitoring, as a growing number of companies are using it to address the challenge of aligning a firm’s “overall value to society” with its financial data.27 Similarly, the Value Balancing Alliance is seeking to “create a way of measuring and comparing the value of contribution made by business to society, the economy and the environment.”
An accepted method of monetizing sustainability will emerge from this innovative process to measure an organization’s net value contribution (positive or negative). Cross-sector accounting initiatives that can price the total impact of companies, therefore, are on the horizon. The realization of “FESG”, through the convergence of reporting standards and increased financial relevance, will allow companies to demonstrate environmental and social impacts in a way that is transparent, comparable and reliable.
ESG will become more dynamic and continue to develop. Businesses have the opportunity to harness this development. The G7 Finance Ministers and Central Bank Governors’ support for the newly launched Taskforce on Nature-related Financial Disclosure, as well as the upcoming UN Convention on Biological Diversity, suggests that biodiversity will soon be a main reporting topic.28
“Water, land use, biodiversity; all complex and multifaceted forces that will be critical in climate action, but difficult to capture in the current conception of ESG,” according to Deborah Byers, EY Americas Industry Leader. Standards-setters have been found to be relatively static and reactive until very recently. Business leaders can be more proactive in determining the factors that will make their organization stand out, embedding them into their strategy, operations, products and services, and communicating them through “FESG+”.
Water, land use, biodiversity; all complex and multifaceted forces that will be critical in climate action, but difficult to capture in the current conception of ESG… these cannot be missed.
These are just two innovative steps that would help to unlock the full potential of “FESG+”. More will also be required from the financial service sector, investors and governments.
As Gillian Lofts, EY Global Financial Services Sustainable Finance Leader put it: “Financial services need to take a leading role in the safe and effective climate and sustainability transition. Understanding and pricing the risks, meeting regulatory requirements for greater transparency and innovating to meet consumer and corporate demands are all essential. They cannot fulfil these needs without improved ESG reporting and disclosures.”
The financial services industry as a whole has a sizable role to play in innovating to deliver ESG objectives. The ability to meet client demand for ESG transparency will hinge on the types of data captured, reported and analyzed by financial institutions. 59% of banking firms surveyed in the Annual IIF/EY Global Risk Management Survey identified the lack of necessary data as a limiting factor in pursuing ESG-related opportunities.29
For example, in managing its own exposure to sustainability risks, the industry can create a massive downstream effect on the behaviors of businesses. Another role for the industry is in the creation of new products to boost the appetite for green assets. The full market potential of green bonds, infrastructure financing, ESG funds and sustainability-linked loans have yet to be fully explored.
The formation of groups like the Glasgow Financial Alliance for Net Zero signals a broader initiative to make lending, investing and ensuring more sustainability. EY research has shown that 42% of UK small and medium sized businesses would be interested in an insurance product that was discounted based on lower emissions.30
Insurers, in particular, need to focus on leveraging ESG information into better management of risk; environmental exposures are only the beginning. The rollout of climate scenario planning — for example, the Climate Biennial Exploratory Scenario by the Bank of England, which will test the resilience of the UK’s financial system against the physical and transition risks of climate change — signals the emergence of underwriting on the basis of comprehensive ESG information.31
Recent stress tests suggest that insurers are moderately exposed to climate change risks. The insurance industry, as experts in current risk management and future risk identification, have a pivotal role in leading the transition and in building new forms of risk management, risk transfer and supporting adaptation to the future threats.
Investors should be able to rely on comprehensive ESG disclosures to inform their strategies. Some may move beyond tolerating minimum performance against consensus ESG benchmarks and propose that companies accelerate to best-in-class ESG policies. (See TPI framework and further reading.32)
While the IEA has called for an end to new coal, oil and gas developments this year in order for the world to reach net-zero carbon emissions by 2050 and investors have focused on oil and gas majors, pressure is likely to affect other sectors too.33 Climate-conscious investors have expressed an interest in engaging fossil fuel-dependent companies, from building materials to mining.34
Governments could base policy on comprehensive ESG reporting to prevent emissions leakage and meet their net-zero commitments. Regulatory measures like the Carbon Border Adjustment Mechanism depend upon an accurate view of domestic emissions, as well as other sustainability information. The EU could use its leadership, for example via the CSRD, which requires large corporations to report on ESG based on a “comply or explain” principle, to encourage other jurisdictions to follow suit.
Innovation must go beyond a focus on climate change to realize the full potential of ESG. Yet here, as with initiatives to drive convergence around common standards, the degree of focus and collaboration across key stakeholder groups shows what is possible. Initiatives by banks in the US to increase lending to minority groups is just one example of that.35
Chapter 3
Five actions to take, based on better information
Informed action by all stakeholders will realize the full potential of ‘FESG+’.
“Without standardization, ESG is problematic. But even with convergence of standards, more will need to be done to embed ESG solutions to global challenges” as Meg Fricke, EY Partner Climate Change and Sustainability Services, explains. To date, ESG has been focused on disclosures. But now, action is needed to enable outcomes.
Without standardization, ESG is problematic. But even with convergence of standards, more will need to be done to embed ESG solutions to global challenges
To develop solutions and differentiate from competitors, there are five key areas in which leaders should challenge their organizations to take action and incorporate the “FESG+” framework into their strategy for the future.
1. Engage with stakeholders, from consumers to regulators
Consumers are developing an appetite for change, not just transparency. Regulators are also outcome oriented. This represents a strong case for businesses to take action now.
Past research has found that pressure from stakeholders (including customers, employees and activists) boosts the transparency of sustainability reports, but action and tangible change are in increasing demand as well.36 The EY Future Consumer Index has shown that 68% of consumers believe companies themselves need to drive positive social and environmental outcomes.
Non-governmental organizations are also gaining traction in lobbying for change. The Green Technical Advisory Group (GTAG) which will advise the UK government on the creation of a “green taxonomy” is just one example of how external stakeholders will shape the business environment around “FESG+.”
The SEC in the US is holding similar consultations with market participants on the adequacy of sustainability disclosures, and in Japan a “council of experts” has published a consultation on potential revisions to Japan’s Corporate Governance Code regarding ways to increase attention to ESG matters among Japan's listed companies.37 Businesses should actively understand and engage with these processes, staying on top of the evolving perspectives that will shape their market.
- Do you understand how your stakeholders' expectations about your social and environmental performance are changing?
- How are you incorporating new expectations into every aspect of your business, from strategy to operations, from the development of new, affordable, sustainability-led products and services to manufacture and distribution?
2. Engage with investor pressure
Similarly, investors are increasingly impatient in demanding strategic change. For example, 89% of institutional investors across major markets say companies with strong ESG performance deserve a premium valuation to their share price. 90% agree that companies that prioritize ESG initiatives represent better opportunities for long-term returns than companies that do not.38
EY research has found that 91% of investors now view nonfinancial performance as “pivotal” in their investment decisions.39 The UN-backed Principles of Responsible Investment are considering stronger measures, including third-party assurance, to build confidence in data reported by signatories and drive impactful investment.40
Worldwide, 78% of high net worth (HNW) individuals now have goals related to sustainability in their lives, and this figure increases with the level of wealth held by these individuals (93% of ultra HNW).41
A major reallocation of investments is clearly on the cards, with 76% of HNW clients believing it is important to integrate ESG parameters into their portfolios. Companies will need to consider how they incorporate FESG+ into their decision making.
- What kinds of new information are investors demanding, and how well prepared are you to access and disclose the relevant data?
- How are you incorporating FESG+ factors into your assessments of both risks and opportunities, and how is this informing the development and execution of your strategy?
3. Own your “FESG+” narrative
Companies can prepare for the types of disclosure that will be required and for those that will best serve their stakeholders. A range of new factors pertinent to a company’s future success will emerge in the years to come, and the established disclosures supported by the WEF IBC initiative are a good starting point.
Companies also have the opportunity to target, measure and report on factors that go beyond net zero commitments as part of their unique narrative. Employee mental health, now an area of increased scrutiny, is just one additional factor that companies could choose to focus on to differentiate themselves and transform ESG into a distinct narrative for all stakeholders. Other areas, such as gender pay gaps or incidents of discrimination or harassment, might also be used by companies to set themselves apart.
- How well do your current ESG disclosures communicate your purpose and ambition to your employees, customers and investors?
- What opportunity might there be to differentiate your organization from the competition by defining new factors and using them to inform the strategic choices you make?
4. Understand your data
Just as demands for the independent assurance of non-financial data grow, so will the need for companies to improve the way they collect, aggregate and take management responsibility for their own data. For larger companies the collection of this data, using a consistent enterprise wide taxonomy, presents a real challenge. If the data is going to be used in formal dialogue with investors and other interested parties, or in the assessment of executive compensation, its veracity becomes even more important.
While many companies have strong taxonomies in place for financial information, including robust and documented underlying processes, together with the added assurance of multiple management signoffs, these processes are often more basic for their non-financial information. Many companies will have to work harder to ensure that the assurance of the non-financial information is accurate, while being watchful about the additional costs and bureaucracy that can sometimes accompany such endeavors.
Companies can begin by ensuring they have the right data experts, equipped to handle current and emerging reporting requirements, and with a clear understanding of how data will be interpreted by third party organizations. The data challenges of the changing ESG landscape are not trivial; it’s time to get ahead of the curve. The EY Global Climate Risk Disclosure Barometer confirms that data quality is a key challenge for business.
Only 41% of businesses currently conduct scenario analysis in relation to climate change, and fewer still (15%) feature climate risk in their financial statements.43 This must change. Analyzing current disclosures and comparing them to proposed standards is an important step towards understanding what data requirements might emerge. Finance professionals must get involved in sustainability, leveraging their skillsets in collecting, processing and reporting data.
- How can your organization bring the same degree of rigor and confidence around financial reporting to the information provided on ESG?
- How prepared are you to engage with standard setters early and then respond to new ESG regulations as they emerge, including outputs from COP26?
5. Embed ESG more widely than just a sustainability team
Many businesses still need to embed strategic thinking about “FESG+” more widely than just their sustainability team. Boards and executives need to place sustainability at the core of strategic concerns and ensure a close connection between the finance function, the sustainability team and executive leadership.
To successfully embed “FESG+” factors into decisions across every part of the organization, from strategy development to execution, from new product innovation through to manufacture and distribution, will require new leadership models that allow businesses to embrace the complexity of the challenge ahead and respond to it effectively.
- Are your sustainability efforts still siloed, or are you prepared for a fully integrated approach to “FESG+”?
Addressing these five areas will take time and the external landscape will continue to evolve. The priority for business leaders is to start now to build the necessary expertise across the organization. This includes further professionalization of ESG and working with standard setters to define generally accepted ways of linking financial and nonfinancial information. CFOs and financial controllers need to offer visible leadership on sustainability and ESG reporting, with systems of internal controls on the data and judgments on ESG that match the approach they take to financial obligations.
Chief Technology and Data Officers will need to enhance their functions to track and deliver the insights required to make decisions. If the board or workforce diversity of a business, for example, is going to match the society in which it operates, the data needs are significant.
Executives also need to provide more visibility of ESG performance to board members to help them to make decisions and take action, from capitalizing on emerging trends and attracting long-term investment to securing shareholder support in the short-term; “FESG+” is a critical framing.
Conclusion
Today’s ESG approach does not serve businesses or their stakeholders as well as it could, often lacking the degree of comparability, adoption and assurance required to make fully informed decisions. As well as fixing these issues, ESG needs to evolve through innovation – connecting ESG reporting with financial reporting and ensuring the agile adoption of future “+”-factors. The opportunities and rewards for organizations that position themselves to realize the full potential of embedding “FESG+” are substantial — and so are the potential benefits for all stakeholders. This is a crucial moment of change and now is the time to position your business for “FESG+”, in terms of strategy, innovation, execution and disclosure.
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Summary
This is the decade for action, and creating a more inclusive form of capitalism. ESG can help, and it is increasingly important to investors, financial institutions, customers, employees and leaders. We can set an agenda for integrating financials, adopting standards and driving value-led decisions.
