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ESG and Compliance – An Action Plan

George Serafeim recently explored multiple issues relating to environmental, social and governance (ESG) in a Harvard Business Review (HBR) article, entitled “Social-Impact Efforts That Create Real Value”. Yesterday, I considered why ESG is something that every Chief Compliance Officer (CCO) and compliance professional needs to be aware of and move towards. Today, I want to lay out an action plan for ESG and one that compliance professionals should consider for their compliance regimes as well.

 

Companies need to understand that ESG, like compliance, is not a tick-the-box exercise but one that requires active monitoring and improvement. Indeed, that was one of the key themes from the 2020 Update to the Evaluation of Corporate Compliance Programs. The same is true for ESG. Serafeim believes that most corporations have treated ESG programs “like a cell phone case—something added for protection (in this case, protection of the firm’s reputation). Corporate leaders need to replace this mentality with an ambitious and differentiated ESG strategy if they want to see real financial dividends.”

 

He goes on to intone that “an ESG program may deliver efficiencies and other operational improvements—maybe even some that are necessary for corporate survival—but it will boost long-term financial performance only if it provides strategic differentiation from competitors.” Finally, just as his research into anti-corruption compliance demonstrated how companies with robust compliance programs outperformed on an ROI basis; (see his paper, of An Analysis of Firm’s Self-Reported Anti-Corruption Efforts, co-authored, with Paul M. Healy which demonstrated that companies with robust compliance programs do better financially in countries prone to corruption than companies with less effective compliance programs), “our research confirms that the adoption of strategic ESG practices is significantly and positively associated with both return on capital and market valuation multiples, even after accounting for a firm’s past financial performance.”

 

The implementation of an ESG strategy in a company involves large operational and strategic changes. As with compliance, ESG must start at the top with the Board and be diffused through the entire organization. Unfortunately, Serafeim has found that for “most companies the board of directors is far removed from the firm’s ESG efforts. This is a mistake. The board should be the entity that ensures that ESG metrics are properly considered in executive compensation and are adequately measured and disclosed as part of the audit committee’s work.” Moreover, there should be a systematic approach to sustainability governance.

 

As with compliance, a “top-down approach to sustainability and good governance is not effective if it is not supported from the bottom up by a culture that rallies around ESG initiatives.” Once again, Serafeim has found that “many strategic efforts fail because people further down in the organizational hierarchy don’t believe there is a true commitment to ESG goals or they lack clear direction for achieving them.” Similar to compliance, “Skepticism, even cynicism, leads such efforts to be sidelined or inconsistently implemented across functions, divisions, and business lines.”

 

But it is more than acceptance, there must be buy-in and participation within all the levels of an organization and indeed the stakeholders of a company. When you can link the purpose of ESG to your corporate strategy, you have a very powerful tool. (Think about that from the compliance perspective as well.) By telling your story around an ESG purpose to and with all stakeholders, Serafeim is seeing “more examples proving that a long-term trade-off between profits and sustainability is not necessary, given that companies can redesign how they generate revenue.” That sort of engagement can go a long way towards having everyone rowing in the same direction. The bottom line is that “Investors find value in information about [an ESG] purpose.”

 

However, having such a strategic view for ESG purpose, it can present new and different business opportunities. Serafeim pointed “to three key conditions: an intentional strategy to grow leaders within the organization, resulting in the promotion of internal candidates to the CEO role; fair compensation structures (in which the ratio of CEO pay to median worker pay is not extreme for the industry); and careful execution of mergers and acquisitions to avoid culture clashes. Though the reasons aren’t fully understood, the research suggests that externally hired CEOs and companies with more acquisitions need to work harder to create a sense of purpose.”

 

In his next section, Serafeim related what his research on firms that have successfully implemented an ESG strategy had yielded. He noted there were “three phases: efforts to reduce risk and ensure compliance with environmental regulations and other laws; efforts to improve operating efficiency; and efforts to innovate and grow.” Every CCO and compliance professional should study that progression and assess where their organization’s compliance, ethics and culture are based on that formulation.

 

Serafeim fleshed this out further by noting, “exemplary firms usually start by centralizing ESG activities, which is helpful for moving from a focus on risk and compliance to a focus on operating efficiency.” Yet to move to the “innovation and growth stage, companies need to decentralize ESG activities and empower corporate functions to take responsibility for them. This is true in terms of distributing power from the C-suite to middle management, but it’s also true at the board level. Initially a board needs to set up a separate sustainability committee. But at the third stage it will typically reallocate responsibilities to preexisting board committees.”Just as with compliance “many companies have failed to recognize that the functional role of ESG data has changed over time. Initially such data was used to judge a company’s willingness to avoid harm and do good. As a result, it was primarily an input to help form policies that signaled a firm’s commitment to achieving positive outcomes for the environment and society.” Yet now, as with compliance, the question has morphed into “whether it has the strategic vision and capabilities to achieve and maintain strong ESG performance.” This “means companies need to start measuring and reporting the results of their initiatives. Instead of communicating their policies for improving data privacy, water management, climate change mitigation, diversity, and other issues, they must communicate outcome metrics such as the number of customer accounts hacked, liters of water consumed per unit of product produced, carbon emissions saved, and percentage of women and people of color promoted internally to management positions.” Once again this sounds like something the Department of Justice (DOJ) would say about compliance programs.

 

Moving from intention to results is the next evolution for ESG. Serafeim ended his piece by stating, “The only way to outperform in this new era will be for companies to make material ESG issues central to their strategy and operations, to go above and beyond their competitors, and then to measure and communicate their superior performance. Global society faces enormous challenges. But if companies are bold and strategic with their ESG activities, they will be rewarded.”

 

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