Mark Kennedy explains how ESG strategies that combine uncertainty management with resilience can lead to a differentiated and sustainable market position.
There is an urban myth that COVID-19 has displaced the focus on sustainability issues as a significant concern of business leaders. The pandemic has certainly consumed much of our attention in the past six months but rather than replace the concern about sustainability issues, I would argue that COVID-19 has underlined in a profound way why businesses must engage with sustainability (or environment, social and governance (ESG)) issues if they are to achieve long-term success.
A strategic approach to ESG means engaging not only with climate change, but also with the range of societal and governance issues that relate to the risk profile of any business. This is a significant exercise and requires a full view of the business, its operations, and its positioning. The primary role of the leadership team, then, is to formulate strategy and create an environment in which the business can address ESG in a structured way while creating a longterm competitive advantage using ESG as a strategic vector. Such an approach requires boards to consider both the risks and opportunities presented by ESG issues.
THE THEORY OF THE BUSINESS
Peter Drucker, in his influential 1994 Harvard Business Review article ‘The Theory of the Business’, identified three parts to the theory or model that distinguished the successful business: 1 Assumptions about the environment. This included society and its structure, the market, the consumer, technology and so on. 2 Assumptions about the specific mission of the organisation. Here, many successful firms have defined themselves by a goal that reflects societal needs. (For example, Marks & Spencer aimed to be the “first classless retailer” in the 1930s while GM aimed to be the leader in “terrestrial motorised transportation equipment”.) 3 Assumptions about the core competencies needed to achieve that goal. A retailer may, in this regard, seek to be the best at pricing, or purchasing, or at customer experience – each setting a different strategic focus. Together, these assumptions drive almost all of the decisions that influence the success of a business. ESG may, for an individual firm, interact with each of these assumption sets.
RISK AND RESILIENCE
Risk and resilience Let us start with risk. Today, we acknowledge that the challenge of business risk management has been transformed in two ways. First, the level of uncertainty has changed. We recognise that unpredictability has increased and that the analysis of uncertainty is becoming a discipline in itself. Second, and perhaps conversely, we can know more about risks and their likelihood than ever before. Despite the feeling of shock we all experienced in relation to COVID-19, experts have been predicting a pandemic event for over a decade. Similarly, the impacts of an overly financialised economy and climate change have been flagged for many years. However, business leaders have not traditionally gathered the data and assessed the consequences of these types of events for their business.
Of course, ESG offers an opportunity for many, if not all, businesses. Some will benefit from a clear trend in consumer preferences. There is both a marketing and value advantage to firms positioning appropriately on the ESG issues that relate to their ‘theory of the business’. There are also profound advantages in taking a long-term view of strategic elements of a business, such as supply chain, resource management, financing and state aid, and fiscal policies. The EU Commission has supercharged this trend by creating the EU Green Deal, which provides for a radical reorganisation of economic incentives to support profound environmental action. There is also the unarguable benefit to any business of avoiding the worst consequences of crises. Writing about the improvements made to the resilience of financial systems over the ten years since the global financial crisis, Jon Coaffee noted that “the trick now is to ensure they are fit for purpose, and that means baking in flexibility and adaptability in a way that means they not only bounce back, but also bounce forwards when disruption hits”.
MAKING SENSE OF ESG
So, how does a business begin to address what could be a vast and confusing topic? Boards must consider five key issues to address ESG in a structured way.
1 Understand: the board must take a lead in understanding the ESG context. What are the elements? How do they relate to business? Which are relevant to the theory of business/ business model? As well as taking steps to understand the issues themselves, the board must also create a framework for the whole business to understand the context, and for all team members to understand why ESG is important and how it impacts their sphere of influence.
2 Analyse: data is king. We must understand the key assumptions that drive the business and results. We must also analyse carefully the impact of ESG issues on those assumptions. This is a significant exercise and leads to the development of key performance indicators (KPIs), which can steer the business effectively.
3 Plan for uncertainty: the management of risk and unpredictability has become a discipline in itself. Techniques such as forecasting, back-testing, crisis simulation, trend analysis and war gaming can form the basis for a board’s evaluation of the issues and possible solutions.
4 Execute: execution differentiates the successful. Change management, influencing behaviours, reporting, and governance are all essential elements of a successful ESG strategy.
5 Embed processes and strategies: finally, businesses must embed the ESG strategy, as they must any strategic component. This means building the key elements into our culture, infrastructures, feedback systems and reporting.
THE LINK BETWEEN ESG AND SDG
Environmental, social, and governance (ESG) refers to the three central factors in measuring the sustainability and societal impact of an investment in a company or business. There is mounting evidence that businesses which focus on ESG as a core part of their strategy outperform rivals in the medium-term and long-term. There are three pillars of ESG, which together form a framework for businesses to consider their strategic focus. They are economic, environment, and society. The ESG pillars are linked to the UN Sustainable Development Goals (SDGs), which provide a roadmap for society to address key sustainability challenges. The SDGs list 17 global goals, designed to be a “blueprint to achieve a better and more sustainable future for all”. Set in 2015 by the United Nations General Assembly and intended to be achieved by 2030, the SDGs are part of UN Resolution 70/1, the 2030 Agenda.
The Sustainable Development Goals are:
- No poverty
- Zero hunger
- Good health and wellbeing
- Quality education
- Gender equality
- Clean water and sanitation
- Affordable and clean energy
- Decent work and economic growth
- Industry, innovation and infrastructure
- Reduced inequality
- Sustainable cities and communities
- Responsible consumption and production
- Climate action
- Life below water
- Life on land
- Peace and justice strong institutions
- Partnerships to achieve the goal
For business leaders, the SDGs and the ESG pillars provide a template that allows businesses to consider their strategic position in an ESG context.
THE FOUR RS OF RESILIENCE
The four Rs of resilience Uncertainty management is a key concept in any strategic analysis. A second key concept might be resilience. Since the global financial crisis, we have progressively moved towards a more resilient financial system. If the COVID-19 pandemic has demonstrated anything, it is the need to embed resilience in businesses even more widely. What do I mean by resilience? In essence, it has four characteristics:
- Robustness: the capacity to withstand shock. In a business context, this might include the consideration of issues such as liquidity reserves, brand loyalty, and stock on hand. Resourcefulness: the availability of adequate resources to continue business during a period of crisis. This includes capital assets, financial capital (both equity and debt), operational assets, and people.
- Responsiveness: the ability to respond effectively during a crisis. This includes governance arrangements, communication technologies, and the processes to make them work.
- Redundancy: availability of alternatives where there is damage to, or failure of, a key business component. Can an alternate supplier be found? Have we more than one distribution channel? Can additional staff be sourced?
In combination, an ESG strategy that embeds both a sophisticated uncertainty management approach and a resilience model offers a business a differentiated and sustainable market position.
A LOOK AHEAD
We have seen how an event beyond our control – in this case, COVID-19 – can impact businesses and push them beyond the normal operating range. Indeed, we have seen businesses succeed – even in these circumstances. The ESG agenda sets out a template for considering both the risks and opportunities facing a business model. The importance of addressing these issues is also increasingly acknowledged by investors and authorities. In Europe, we will see the emergence of additional and more prescriptive nonfinancial reporting standards over the next two years. The UK, US and China are also working on these issues. This is forcing a change agenda on the business community and creating a situation where both public and private supports provided during the pandemic might be allocated in a more directed fashion. The science tells us that disruptive events will occur periodically, whether economic, financial, geopolitical or public-health. The question is: will your business be ready?
This article first appeared in Accountancy Ireland magazine October 2020