The First 25: Why every company should put sustainability at the heart of its strategy
It’s been a long road for sustainability to make it into the boardroom, but the crucial next steps require dynamic scenario planning and integrating ESG into operational processes.
With ESG (environmental, social and governance) factors now firmly on the corporate agenda, sustainability strategies are increasingly at the heart of the way companies do business, while being placed front and centre in communications.
The latest edition of the First 25, Navigating the sustainability odyssey – Emperor’s annual review of corporate reporting suites – finds many companies considering sustainability on a par with ‘traditional’ business strategy, at least in terms of prominence in disclosure. A strong indicator is the level of focus placed on it by boards, with over half (52%) of companies now having a dedicated sub-committee for sustainability in place.
But why are companies finally putting sustainability at the heart of their strategy? A key driver in promoting this shift is the concept of ‘double materiality’ (graphic from the European Commission):
The long and winding road of sustainability
In the past, companies have pursued corporate social responsibility (CSR) strategies and disclosed impacts on external stakeholders because of compliance requirements such as the Non-Financial Reporting Directive (NFRD), which is currently being revised by the EU and will be called the ‘Corporate Sustainability Reporting Directive’ (CSRD). This included disclosure on issues such as human rights, diversity, and environmental issues, explaining any material impacts that the company’s activities had on the external environment (covered by ‘Environmental and Social Materiality’). However, these disclosures did not cover the financial materiality of such issues, by considering the forward-looking impacts on the company’s strategy and financial position. As the potential impact on the company’s financial performance remained unquantified, many boards did not consider them material to the financial performance of their businesses.
The Task Force on Climate-related Financial Disclosures (TCFD), became the first methodology that requires companies to carry out scenario planning to understand the medium to long-term impacts of climate change on their business; and in doing so, consider how climate issues impact financial materiality. What this means is that companies need to increasingly take into account external forces as the global economy goes through a fundamental shift towards sustainability.
These trends are, in part, driven by the necessity to reduce carbon emissions drastically (45% by 2030, according to the 1.5C special report by the Intergovernmental Panel on Climate Change known as the IPCC) so the world can keep within the temperature targets set by the Paris agreement and avoid the catastrophic impacts of climate change. This is going to lead to the introduction of various climate policies, such as carbon pricing ($75 per tonne of emitted CO2 as proposed by the IMF), a carbon border adjustment mechanism (CBAM) proposed by the EU, or banning the sales of new petrol and diesel vehicles from 2035 onwards. All of these policies will put a price on the results of business activities considered to be externalities that previously were not be valued, and consequently will have a direct impact on a companies’ bottom line.
But another factor is the clear social trends that point towards a demand for low-carbon products and services, and increasing evidence of legal liabilities (for companies in certain carbon intensive sectors to begin with), which also brings fiduciary duty into play. Investor groups such as the Institutional Investor Group on Climate Change (IIGCC) are increasingly becoming sophisticated around these issues and introducing various frameworks, such as the Paris Aligned Investment Initiative (PAII), which will increase pressure on companies to disclose on these issues if they are considered financially material.
Although climate change is one of the most pressing issues from an ESG perspective, other issues such as biodiversity and nature loss are also rapidly rising up the agenda, demonstrated by the official launch of Taskforce on Nature-related Financial Disclosures (TNFD) on 10 June 2021.
There are immense opportunities available for companies to adapt their business models in line with this tectonic shift towards a sustainable and low-carbon world, but time is of the essence. As ever, early-movers are likely to create competitive advantage for themselves and leave others wanting.
How can you plan and prepare for a very different future?
That brings us to 2021, where we find ourselves in a wildly different place. The pandemic, and resulting lockdown, has further accelerated many of these conversations and brought them into crystal clarity.
For businesses, understanding the medium to long-term impacts of these externalities and issues – which go beyond the usual planning horizons – requires the use of scenario planning as a strategic tool.
Companies need to construct alternative plausible futures and narratives to understand the strategic and financial materiality of these issues. This requires an organisational effort given the level of uncertainties involved, making this process challenging but extremely valuable and relevant. To that end, the FRC is currently undertaking a survey of FTSE 350 companies with a specific focus on scenario planning, as it recognises that this is one of the key gaps in companies’ skillsets, which may prevent them from produce meaningful metrics and targets for climate risks and opportunities.
The issues highlighted around ESG are also incredibly dynamic, so it’s imperative that they are embedded within companies’ strategic and operational risk management processes and part of business-as-usual activity. For this purpose, it would be advisable for companies to integrate sustainability matters with Enterprise Risk Management (ERM) and other governance processes, such as performance metrics and targets.
Many companies are considering these issues from a compliance and disclosure perspective, which is a good start. But more importantly, for sustainability to become truly synonymous with strategy, they must be considered from a strategic perspective and discussed at the board table. The first step towards success is setting up governance processes to ensure these topics are being appropriately managed and monitored by the right stakeholders. This is critical given the implications on strategic matters, such as, access to, and cost of, capital.
Anj Chadha is Chief Executive at Top Tier Impact Strategies Ltd, a global ESG advisory firm.
For more insight on sustainability and strategy, and much more, you can download the complete First 25 research: Navigating the sustainability odyssey.