Environment, Social and Governance (ESG)
The ESG has three broad categories or areas, i.e., Environment, Social, and (Corporate) Governance, of interest for what is termed as Socially Responsible Investors. The investors consider the importance of incorporating their values and concerns (mainly the environmental concern) into their investments instead of simply considering the profitability and the risk presented by the investment opportunity.
The companies should focus on the three Ps to be sustainable and profitable. They are Profit, People and Planet as evolved into the ESG.
A brief description of each term of an ESG
A brief understanding of each term or element of the ESG, Environment, Social and Governance are as follows:
The E stands for the Environment; it includes the energy a company takes in and the waste it discharges, the resources it needs, and the consequences on humans and other living beings. E, also encompasses carbon emission and climate change. Simply, each company uses energy and resources, and each company affects and gets affected by the Environment.
It looks into the contribution of a company and its performance on the environmental challenges like pollution, waste, greenhouse gases, climate change, deforestation, etc.
The S stands for the social criteria; it addresses the relationship of the company with people and the reputation the company fosters with people and other entities or institutions in the area or community where it is conducting its business. S also includes the labour relations and the diversity. Each company operates in a broader and more diverse society.
It looks into the way a company treats the people, especially its own people. It focuses on human capital management, diversity and equal opportunity, the company's working conditions, health and safety of employees, misleading sales, etc.
The G stands for Governance, which means the internal system of practices, controls and procedures the company adopts in order to govern itself, comply with the rules and laws, make effective decisions, and meet the needs of the external stakeholders. Each company is a legal creation that requires Governance.
It looks at the management of the company, and it assesses the company's remuneration of the executives, tax practices and strategy, corruption and bribery, board diversity and the structure, etc.
In a company, each of these criteria, i.e., Environmental, social and Governance, overlap with each other in order to comply with the environmental laws and sustainability.
The ESG topics
The Environment, Social and Governance topics are:
The Climate Change and emissions
Air and Water Pollution
Audit Committee structure
Data Protection and privacy
Bribery and Correction
Gender and Diversity
Whistle blower scheme
MSCI ESG Rating
An MSCI ESG Rating is created or designed to measure the resilience of a company to long-term industry material ESG risks. A rule-based methodology is used to identify the industry leaders and laggards according to their exposure to the ESG risk and the management of those risks. The ESG risk and opportunities vary with industries or companies.
Steps for creating an ESG strategy for the business of a company
The ten steps for creating an ESG strategy for a company's business are:
- Focus on the best strategy
Initially, the company has to recognise that every business is different. Every business has different internal and external stakeholders, supply chains, locations/areas, budgets, aims, goals or objectives. The ESG strategy of the company must be particular for its own effectiveness.
- Establish the goal, from top to bottom
The establishment of an overall goal from the outset assists in defining the company's strategy and keeping the focus on streamlining. Engagement from the top executives/officials is crucial. Setting out what to achieve and keeping the goal broad in the initial stage is very profitable. After the conduct of a proper Audit, the targets and the goals are devised.
- Conduct a materiality analysis
The core of any business's ESG strategy is materiality analysis. It focuses on the issues which the businesses need to prioritise and identifies to invest time and resources through two lenses, the importance to external stakeholders and the importance to the business and its internal stakeholders.
- Use an objective third party.
It is always best to use a professional third party to conduct a materiality analysis or audit the company's ESG credentials for any other purpose. The third party is an unbiased perspective which legitimises the result.
- Engage with all stakeholders
The key part of materiality analysis is assessing the sentiment of a stakeholder. It is an important stage, especially when the governance criteria of ESG are considered.
Data is collected from all the employees. It also takes care of having structures in place that create feedback loops in a company from the bottom up, which can boost the company culture and shed light on the potential issues before they come to fruition. A good strategy results from a mixture of top-down and bottom-up approaches.
It is very important to push the external stakeholder collaboration. It is integral for a successful and fully informed analysis.
- Assess cost
Once a materiality analysis informs the business targets and the strategy, then the company starts considering its budget and lifecycle approach instead of viewing it as one upfront, substantial cost. The company should also assess the cost of inaction and the risk to its business.
- Construct an ESG team in the business of the company
The company hires professionals from the sustainability sector as it is essential for its business and its ESG output. Strategies need maintenance, and internal stakeholders offer this consistency during their hold of personal interest in the company they are employed. Hiring such sustainability professionals creates a strong governance structure.
- Ensure the third-party verification to demonstrate the robustness
- Manage the supply chain
When expanding the supply chain, it is important for a company to have a sustainable policy to make sure that ESG is embedded in the procurement process. Such policy needs to reflect the value of the company's business and includes a commitment to progressive improvement. A strong starting point is considered as existing frameworks such as UN Sustainable Development Goals.
- Recognise the dynamic process
Internal Audit plays a significant role in the ESG journey of the company. It may add value in the advisory capacity as it helps in identifying and establishing a functional ESG control environment. It also offers critical assurance support by providing an independent and objective review of the effectiveness of the ESG risk assessment, responses and controls.
Internal Control is a process which is affected by the company's governing body, management and other personnel, designed or created to provide a reasonable assurance related to the achievement of the objectives related to the operations, reporting and compliance. ESG reporting contains a wide variety of metrics; the company should establish the policies, processes, and internal controls that generate reliable and relevant information for decision-making and ensure the quality of data produced and reported.
The company should have a governance structure that executes the ESG strategy effectively. A good governance structure sees the accuracy of ESG data and the overall implementation of the ESG strategy. The Governance of a company should have an appropriate structure and process that enables:
- Accountability by a governing body through integrity, leadership and transparency to the stakeholders.
- Action by the management to achieve the goals of the company through the application of resources and risk-based decision making.
- The advice and assurance by any independent internal audit function to promote and facilitate continuous improvement through rigorous inquiry and insightful communication. It also provides clarity and confidence.
Internal Audit can recommend the frameworks to manage or mitigate the ESG risk, and it can also advise on developing the specific internal controls over ESG reporting.
Internal Audit provides insight into the kind of data that reflects the relevant sustainability efforts within the organisation.
It may provide guidance on ESG governance because of its proper understanding of risk across the company. It helps in identifying the roles and responsibilities, and it also provides training on internal controls.
As per the Institute of Internal Auditors, at a minimum, the internal audit function must provide the following assurance over the ESG reporting:
- A review of reporting metrics for relevancy, accuracy, timeliness and consistency
- A review reporting for consistency with the formal financial disclosure filings
- To conduct the materiality of the risk assessments on ESG reporting.
- To incorporate ESG into a regular audit plan.
The sustainability Reporting Frameworks to leverage
The followings are the sustainability Reporting Frameworks to leverage are:
- Global Reporting Initiative is designed for the disclosure of a wide range of the ESG issues and topics relevant to the stakeholders.
- The sustainability accounting standards board is more narrowly focused on the selected few disclosures relevant to a company's overall sector and is forwarded more towards an investor audience.
- Task Force on Climate-related Financial Disclosures (TCFD) was recently introduced for reporting the framework and is fixed on climate-related financial risk.
- The International Integrated Reporting Council (IIRC) supports the development of integrated reports on the strategy of the company and its Governance, performance and prospects in the context of its external environment.
Role of Internal Audit in ESG
The internal audit activity must go beyond identifying risks and include identifying the root causes, potential risk management strategies and preventive controls. It also ensures that the company's Governance, risk management, and internal controls are operating properly.
The internal audits examine aspects that define the company's ESG policy, such as the high-level oversight, awareness and implementation actions, risk assessment and due diligence procedures.
Internal Auditing Methodologies
The internal auditing methodologies include the following:
- Risk and opportunity assessment
- Regulatory requirements
- Review of new product
- Due diligence of the third party
- Definition of the ESG (Environment, Social and Governance)
- Mission, vision, values and strategy
- Top management's periodic review
- Context and stakeholder analysis
- Time, resources and budget
Policies and Procedures
- Entity wide policies and procedures on human rights, health and safety, etc.
- Existence of relevant processes such as supply chain, production, sales, etc.
- Consistency between the policy framework
- Policy management
Culture and Awareness
- Engage and create a dialogue with all the stakeholders
- Culture or tone of the ESG or sustainability and behavioural change
- Regular and Frequent training and communication
Tools and Data
- Technology to support the ESG Program like testing, training record, etc.
- The Predictive Measures, i.e., key risk indicators and key performance indicators
- The root cause analysis and tending
- Monitoring and tracking regulatory change
- Transactional, process and control testing
- Third-party and employee compliance due diligence and management
- Periodic Environment, Social and Governance (ESG) risk program evaluation
- Involvement of the second and third line
Issues management and investigation
- Issues or complaints management and remediation
- Responding to the government investigations, exams or inspections
- Response plan and the process for investigating alleged non-compliance
- The continuous improvement
- Reporting periodically to the management and remediation
- The mandatory regulatory reporting
- The external reporting to the stakeholders
- Keeping the records
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Frequently Asked Questions
ESG criteria is a set standard for the behaviour of a company used by socially conscious investors to screen potential investments.
The ESG Investing means investing in a company that scores high on the environmental and societal responsibility scales as set by the third-party, independent companies and the research groups.
The types of the ESG strategies are Environment, Social and Governance.
The MSCI ESG Rating is a comprehensive measure of the long-term commitment of a company to socially responsible and environmental effects in addition to financial gains.
The investment activity that focuses on the projects of the company that are committed to the conservation of natural resources is known as Green Investing.
The ESG Transparency tools are:
- ESG Rating and Climate Search Tool
- ESG Industry Materiality Map
- ESG Fund Ratings Search Tool
- Index Profile Search Tool
The ESG sets a vision for the companies that have environmental and social influence, providing both internal and external value. Establishing goals can have various positive impacts, such as reducing the carbon footprint, eliminating unnecessary waste, meaningful and diversified programs, enhancing the employee's health and safety, enhancing the board and business ethics, increasing stakeholder transparency, etc.
The SRI stands for the Socially Responsible Investing that looks for the investments that are socially conscious because of the nature of the company's business.
Impact Investing aims at the generation of specific beneficial social or environmental effects and financial gains.