There has been a sharp focus on Environmental Social Governance (ESG) aspects among stakeholders, including the investor community, who have become increasingly aware of the need to integrate ESG within their businesses and portfolio companies. This awareness has come in the context of several global events — a raging pandemic, and the worsening climate crisis, among others. This has brought into focus the tremendous strain and negative impact on global value chains. Furthermore, the lack of understanding of the intricate interconnections of the social and environmental fabric that binds the world has been brought to light.
The key question, then, is how can large organisations transition from good intentions to an action-oriented approach to well-integrated ESG systems within their business to mitigate and prevent harm to the community? More importantly, how can ESG be extended to their global supply chains, which include mid-market companies, in order to generate long-term benefits for organisations, customers, employees, investors, and the environment as a whole?
To put this into perspective, there are two major developments in the sustainable finance space that are heavily influenced by ESG. For starters, institutional investors’ approach to incorporating ESG into their investments has evolved, and the push is stronger than ever. According to Bloomberg Intelligence, global ESG assets under management (AUM) are expected to reach $53 Tn by 2025, accounting for nearly a third of the global AUM.
Investors are increasingly looking at ESG assessment as a tool for creating value for their portfolio’s long-term sustainable growth, both financially and in terms of positive environmental and social impact. Just last year, the number of new signatories to the Principles for Responsible Investment (PRI) increased by 42% over the previous year, bringing the total number of current signatories close to 4,000. This indicates a strong commitment from investment managers to integrate ESG within their investment process.
Second, large organisations around the world are rethinking current processes and actively working to incorporate environmental, social, and governance considerations into their functions. This step toward building resilient businesses has received significant support from both the government and investors. This will help companies in not only improving operational efficiencies, but also enabling diversity and inclusion policies and delivering on sustainable products and services.
Most importantly, they will be able to evaluate their supply chains to include mid-market companies as key stakeholders in their ESG assessments.
ESG thus requires an ecosystem-based approach. We cannot look at companies without considering the linkages of the supply chains or markets in which they operate. The increased regulatory requirements provide an opportunity for large organisations to reconsider their ESG approach to value chains. The true value addition of ESG for a business, however, would be the direct participation and evolution of mid-market businesses that are an integral part of their supply chain.
Many large corporations have established internal teams and processes, or have hired outside consultants, to assist them with ESG standards and disclosure reporting. Mid-market companies that are part of their supply chain will soon be forced to follow suit. This requires them to fully understand the implications of ESG and the impact this could have on their business.
The sustainability knowledge gap continues to be the greatest barrier to integrating ESG factors. There is also a general lack of direction and an incorrect understanding of how and where to invest resources to drive positive change.
Some of these mid-market companies have adopted ESG reporting and frameworks such as the Global Reporting Initiative (GRI) or the United Nations Sustainable Development Goals (SDGs) without fully understanding how this can create value for them. This may have negative long-term sustainability implications and may defeat the purpose of incorporating ESG for value creation. Thus, it’s crucial these mid-market companies look into the basics of using ESG as a value creation strategy.
Businesses should consider specific interconnected factors that could have a positive or negative impact on their operations. Identifying key E&S metrics that are closely related to the business model could be the first step in this direction.
For instance, consider a company that requires a significant amount of electricity to run its factories in a relatively power-deficient area. At various stages of the product lifecycle or operations, the company can capture metrics such as electricity use, cost per unit, and source and track work stoppages due to power outages. Tracking these metrics over time can provide insights into productivity loss, the impact on operating costs due to the use of diesel-powered generators, and the impact on the bottom line, among other things.
It can use these insights to implement renewable energy systems to improve operational efficiencies and productivity, among other things. While these ESG-related steps may increase their costs initially, the long-term benefits in terms of financial incentives, positive customer feedback, and overall environmental benefits would outweigh them.
Supply chains are critical for large organisations to achieve their sustainability goals and actions. Mid-market companies must therefore understand their position in these supply chains as well as the ESG requirements of their key stakeholders.
They can identify specific intervention areas, such as product certifications, better labour practices, or traceability. This will not only help them transition to a more sustainable business but will also enable financial value creation opportunities by attracting more buyers or customers.
ESG, as we all know, is a complicated topic. It includes a variety of frameworks and disclosure reporting options for businesses to choose from, as well as gradual adoption of mandatory regulation and increased investor interest. If we compared mid-market companies based on ESG factors, we would most likely find a patchwork of fragmented and ad hoc environmental and social initiatives. Identifying areas where peers are more advanced will help them benchmark their own ESG capabilities and shortcomings, as well as motivate them to invest in building their teams and processes.
Overall, integrating ESG means creating value for mid-market companies that are part of the global supply chain network, particularly in emerging markets. Although ESG adoption remains largely voluntary and flexible, early adopters may benefit from identifying key areas that are most important to them and their key stakeholders, enabling resilience and sustainable growth. Ultimately, mid-market companies that recognise and capitalise on ESG value creation opportunities will undoubtedly be tomorrow’s winners.
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