Moving beyond ESG strategy and metrics
CEOs must account for ESG metrics, but thinking more broadly can both increase value as well as improve sustainability.
At the intersection of sustainability and strategy, many companies adopt an environmental, social and governance (ESG) strategy. In doing so, they can be strongly influenced by the external focus on third-party ESG metrics, which are framed as a way of measuring a company’s performance in ESG.
ESG strategies, which often aim to improve key metrics in a way that a firm finds acceptable or manageable, have given many businesses a pragmatic start toward becoming more sustainable. However, as a path to a better strategy, they have several drawbacks:
- ESG metrics are immature. Much work remains to be done to make them comparable, rigorous and transparent, especially as individual Environmental, Social and Governance scores are often combined to give a single composite measure.
- Managing to ESG metrics isn’t the best way to deploy sustainability as a driver of competitive advantage and value, or to hasten meaningful improvements in environmental and social outcomes. They can be poor inputs to decision-making.
- External ESG metrics offer an imprecise picture of the past, not a guide to the future. It’s difficult to gain competitive or strategic insight by benchmarking history. Given the significant differences between providers at this early stage of ESG maturity, using third-party metrics is unlikely to lead to the strongest future approaches.
- ESG metrics might identify issues, but they rarely point to solutions that lead to outperformance. Similarly, causal links between improving an ESG score and generating value are unclear — depending on the dataset, they fall between weak and non-existent. Focusing on metrics positions sustainability as a problem to fix, not an important part of a holistic strategy. And, as in any field, benchmarking against other firms is unlikely to identify a path to market-beating performance.
- Company performance, not metrics, enables long-term sustainability improvements. Investors support genuine gains in sustainability but, in the long term, won’t tolerate strategies that do not deliver economic value. They may accept lower short-term performance but only if it is explicitly framed as part of a longer-term improvement strategy. CEOs understand this: firms that communicate and deliver both impact and financial performance secure higher investor support for long-term investments, including those to improve sustainability.
For these reasons, with the way ESG and ESG strategies are framed currently, the evidence for a link between economic value and ESG ratings is modest at best. While ESG metrics are closely observed, financial performance remains much more important in corporate valuations.
Organizations should, of course, take seriously the issues underlying ESG metrics; this is an important contribution to preserving the environment and improving other key dimensions of the working world. But a focus on ESG metrics is unlikely to lead to the best combination of increased value and improved sustainability.
Joining sustainability and strategy will evolve both
A strategy refresh driven through sustainability principles should promote a healthier environment as well as a more sustainable business.
Treating sustainability as a new theme to be integrated into corporate strategy development and implementation across all functions of a company is a more effective path. The alternative –addressing sustainability issues through a dedicated function — is at best a stepping-stone, as sustainability considerations are then often seen by core business functions as an add-on.
The question for CEOs is whether their strategy makes the most of the market, technology, customer and regulatory trends created by sustainability imperatives: this approach will find and deliver new sources of value and advantage.
A sustainability-driven strategy refresh should enable both a healthier environment and a better, more resilient business. To achieve this, CEOs need to combine the art of crafting superior strategies with an in-depth understanding of how sustainability factors will change the way businesses prosper or fail. Joining sustainability and strategy development is the next evolution of both.
There are three major ways to trigger this evolution:
1. Reframe business-defining questions with an integrated sustainability lens
CEOs must think about updated variations on classic, top-level strategy questions:
- Is my purpose the best possible fit with competing stakeholder demands?
- How will current and adjacent value pools evolve as customers and suppliers increase their focus on sustainability?
- How will my competitive position change as externalities are priced into the economics of our business, and that of our competitors?
- As sustainability plays out in my industry, how should I position my strategy and portfolio for maximum advantage?
- Which set of strategic initiatives, and therefore investment focus areas, generate the right balance of financial, social and other outcomes to deliver on stakeholder expectations?
- How do I make sure these choices are integrated into my organization, making my choices stick?
CEOs may find some of these questions easier to answer than others, but ultimately they need to fit together in an internally consistent way. They also need to be adapted into specific versions for business units or sectors within a portfolio.
2. Test key choices top-down and bottom-up
CEOs can also ensure strategic choices explicitly include sustainability imperatives. Both bottom-up and top-down approaches can help here.
From the top down, it can be helpful question to ask: “How will increased sustainability modify or create new strategic drivers?” Rather than treating sustainability as a separate strategic theme, CEOs can test existing strategic themes for compatibility with increased sustainability.
This can be achieved by:
- Moving from climate scenarios that capture climate risk to embedding climate elements in strategy scenarios
- Scanning for sustainability-driven product innovation as part of competitor, or other strategic, diagnostics
- Tailoring customer research agendas to test hypotheses about critical sustainability issues and solutions
- Understanding how increased sustainability is being applied as a driver of innovation approaches
Answers to these questions can provide insights as to how industry value chains or ecosystems are likely to evolve as sustainability has greater influence.
Case Study: Using scenario analyses to improve organizational buy-in
One of EY-Parthenon’s clients struggled to assess the impact of the net-zero transition on its portfolio, determine how to set an ambitious and realistic target, and form a view on sustainability-related opportunities while transitioning its business. Our client, a leading global player in agricultural, energy and metals commodities finance, engaged EY-Parthenon teams to help inform key choices and design a product plan for future growth.
How EY-Parthenon teams helped:
Our teams performed top-down and bottom-up scenario analyses. We worked with the client’s executive teams to co-design a set of top-down scenarios aimed at achieving net zero, while assessing them against the strategic ambition of the client’s bank. At the same time, from the bottom up, we measured the greenhouse gas (GHG) emissions at client level, introducing them to the credit portfolio management approach and embedding them into the capital allocation process and broader strategic decisions.
What we can learn from it:
Testing key choices through both top-down and bottom-up approaches gives executives more confidence in making informed decisions on portfolio composition and gets indirect buy-in from the organization before implementation even starts.
From the bottom up, a helpful question would be: “Which specific sustainability concerns will our strategy need to accommodate?” The focus here is on identifying areas where a significant impact is both possible and likely to be rewarded. Three interrelated qualifiers can help identify these:
- Future prominence for stakeholders: A direction of travel may have already emerged for many stakeholder groups. Competitor actions or regulatory positions also have broad, understandable trends. Accountability for embedded emissions is perhaps the most obvious example of an issue with increasing prominence for consumers. Expected future viability of major current customers as they deal with a changing world (and more extreme climate change) is another important aspect to consider — will a shift in the future customer portfolio require a revamped strategic positioning?
- Uniqueness of contribution: Issues with high or increasing importance will require some kind of contribution. Assessing the uniqueness of the contribution is an important guide to whether an issue can be used to create a competitive advantage, or whether any response is more likely to be seen as meeting the industry standard.
- Size of business value, net of investment: It generally makes sense to focus first on business value. Stakeholders might value making unique contributions to important issues but factors central to the business’s economics or strategy will merit more attention and investment — particularly if additional value could be created.
This analysis helps rank issues. Prominent issues where businesses are seen to have unique contributions to make — good or bad — require close attention, as there’s likely to be an expectation of action.
Portfolio composition is an example of how these two processes can come together. Some CEOs may find very attractive businesses are not well positioned to respond to the (top-down) sustainability-driven changes in industry structure, the (bottom-up) sustainability imperatives of stakeholders, or the sustainability initiatives of competitors. Deciding on the role of these companies or business units may depend on the economics of increased sustainability, as well as the position of the portfolio as a whole. This can reveal potentially attractive, complementary acquisition targets, as well as the need to divest parts of the current portfolio.
Case Study: How a fashion retailer embedded ESG goals into its strategy
A leading global online fashion retailer had recently refreshed its ESG strategy, recognizing that the original strategy was too broad to be embedded in its business strategy and operations, and that progress varied across its initiatives. EY-Parthenon teams were engaged to provide an overall maturity assessment of its ESG agenda and support the development of an ESG roadmap as well as a business case to deliver its ambitions.
How EY-Parthenon teams helped:
Drawing on their extensive experience, EY-Parthenon teams identified the key areas of focus. These focus areas could embed the ESG program into the heart of the business, make it core to operational and strategic decision-making, and help the business make key commercial trade-offs.
EY-Parthenon professionals facilitated a series of workshops to help the ESG team articulate the key enablers and risks, plus develop a pathway to help deliver the goals. These informed a program-level roadmap from which leadership teams could model alternative scenarios, as they move toward their ESG goals.
What we can learn from it:
C-suite decision makers require clarity on the size of their ESG investment and the key business changes and trade-offs required, along with the optimal timing, to deliver publicly committed goals. Understanding how an ESG strategy and individual initiatives can deliver value to stakeholders, along with recognizing the imperative for ongoing strong financial performance, supports investment decisions.
3. Ensure common assessment methods for sustainability and other strategic initiatives
Investments to improve social impact can appear to have negative or hard-to-estimate financial returns. It can be tempting to let such investments slide through to approval because, for example, they improve ESG metrics. This misses the opportunity to increase meaningful impact.
Investments with negative value should not generally proceed or be accepted as part of the price you pay for better ESG performance. They indicate that a firm may not have identified the best levers. Even investments to comply with current or future regulation, commonly thought of as cost, have real and very direct value when appropriately assessed.
While some investments with unclear links to value may be pragmatic — for example, as controlled experiments or to avoid reputational risk — CEOs should expect the number of initiatives with negative or unquantified value to decline over time.
Applying the same assessment methods to sustainability and commercial initiatives alike helps to embed sustainability in strategy. Many strategic initiatives — particularly those with long-term payoffs and/or in new or innovative areas — can, and even should, be assessed with “error bars” around their economics. Excluding sustainability initiatives from this discipline misses an opportunity to increase confidence in them belonging in a firm’s strategic agenda. This undermines the commitment to change.
Most firms can do more to use the data or connections they need to estimate business impacts. There are at least two major sources of relevant information:
- Data on current stakeholder attitudes. This includes insights on customer preferences, product performance and investor attitudes, as well as information on the “competitive frontier” of sustainability activities for key issues.
- Data on future economic impacts, including identifying the chance that regulatory change or community expectations will lead to sustainability issues being “priced into” costs or revenues.
Few firms find such business data is perfect, but in many cases it’s enough. And it has to be: the competition and regulators will not wait for perfect data. As most sustainable investment activity is very recent, and the underlying technology and market conditions are changing, few long-term case studies proving viability do not yet exist.
Deliver through the business, not around it
Sustainability initiatives need to be captured in the strategic ambitions of the whole business.
Delivering strategic initiatives with greater effectiveness is a common business goal. Many firms already maintain and sustain effective mechanisms to drive strategy. Isolating sustainability activities in a sustainability team or chief sustainability officer (CSO) avoids these mechanisms, by design.
Sustainability initiatives can and should be executed with the same rigor as traditional strategic initiatives. Sustainability objectives and initiatives will only reach their full potential if they are captured in the scorecards of key business functions, such as a consumer goods business’s supply chain director, and measured with the same attention as other commercial initiatives.
EY clients identify the lack of data to measure progress against key sustainability initiatives as a common challenge. Typically, the necessary data is not captured by legacy processes and systems. CEOs need to identify early the new internal business and impact data they will use to create a true measurement of progress and achievement. The digital technology to continuously monitor performance — such as supply chain carbon emissions or plastic use — is often not just a goal in itself but a condition for successful execution.
Case Study: How market-leading investors approach investment opportunities
One of EY-Parthenon’s clients, a leading global private investor (credit and equity), is multiplying its efforts to invest in sustainable opportunities. The client recognizes that companies’ valuations and ability to create value do not only relate to the commercial and financial dynamics of the business but also on the alignment with sustainable targets. As such, it engaged EY-Parthenon teams to develop an ESG framework to guide its investment decisions in line with its sustainability objectives.
How EY-Parthenon teams helped:
We defined the metrics and methodologies to identify the most material ESG themes across all industry sectors; recommended a structured approach to define relevant ESG key performance indicators to link to individual transactions, along with traditional financial metrics; and redesigned the investment process to embed such metrics into strategic decisions.
What we can learn from it:
Sustainability investment must be driven in a focused and highly sector-specific way, with clear alignment between financial targets and ESG metrics. Achieving material improvements in key sustainability areas is paramount strategically as it puts companies in a stronger competitive position, leading to better valuations.
Confusing the means with the end is a cardinal error in strategy. The end in sustainability is increasingly clear: to focus on meaningful action that delivers value for a firm’s chosen stakeholders, which in today’s world includes society, the planet and others, alongside shareholders. For CEOs, the challenge is to avoid processes that stop before this end is reached, leaving behind a set of issues that, while worthy, remain outside the organization’s mainstream strategy.
The steps above can give meaningful sustainability actions greater prominence in a CEO’s long-term agenda, with better outcomes. Our research shows this is the best way to achieve a business that — over time — will have the financial means and investor support to create a more sustainable future.
Andrew Hearn, Global Development Lead for Strategy at EY Parthenon, contributed to this article.
Investors want businesses to deliver market-leading returns while also performing sustainably. CEOs can achieve these dual goals by integrating their corporate and sustainability strategies so that their companies, and all their stakeholders, come out on top.