Five no regrets actions companies can take amid ESG whiplash

From the rise of the ESG movement to the subsequent criticism, where does that leave companies? We lay out the practical path forward.

In brief

• In response to the impacts of global climate change there has been rapid, cross-industry coordination towards ESG action. 
• Resulting backlash to the ESG movement has questioned the increasing dominance of ESG factors in corporate decision-making.
• As governments and companies continue to drive momentum in the ESG movement, there is an increased emphasis on accountability and ESG fiscal policy.

Challenges to the ESG movement

ESG has been growing with such popularity that perhaps unsurprisingly, it has drawn backlash centered on the increasing dominance of ESG factors in corporate decision-making. The underlying theme is that the ESG landscape is nascent, and despite being in its infancy, it has already exerted considerable influence. Challenges to the ESG movement have questioned the definition of sustainability, the quality of ESG data and conflicts of interest.

The clear definition of sustainability — or lack thereof — has sparked considerable debate. The terms “sustainability” and “ESG-aligned” often refer to socially and environmentally responsible corporations, but there is no common definition. For example, four leading ESG rating agencies – MSCI, ISS, Sustainalytics and Moody’s – each has its own set of criteria for assessing top-rated companies. An example analysis of correlation among these four providers for the automotive industry found correlations values ranging from 0.39 to 0.82.ᵛᶦ Many would question those correlations below 0.5. The EY Enough reportᵛᶦᶦ highlights this issue, suggesting that misconceptions about what constitutes a sustainable corporation distracts us from understanding the true extent of the problem, which is that we must operate within our planetary boundaries. The multiple, sometimes competing, definitions of sustainability could potentially lead to ineffective or misguided sustainability strategies.

The reliability of ESG data has also been called into question, given processes to develop the data are often new, with limited oversight in place. Yet this data is increasingly used to drive business and investment decisions. Of the 494 companies in the S&P 500 that disclose ESG information, 320 companies (65%) received some form of verification. Sixty companies, (19%) selected the same auditor the Audit Committee selected for financial statement assurance.ᵛᶦᶦᶦ The remainder use various providers to obtain ESG verification according to various standards. In unaudited reporting, it is common to see significant changes in year-over-year reporting without explanation. Skeptics argue that without high-quality controls or audit, ESG data may be inconsistent, inaccurate and unreliable. This could potentially lead to false evaluations of a company’s sustainability performance. As taxes and executive incentives are increasingly tied to this information, real dollars may be misused.

A third challenge to the ESG movement is the potential for conflicts of interest in the evolving business landscape. There are instances of a single entity offering ESG ratings, ESG indices, credit ratings and ESG consulting services. Corporate clients look with raised eyebrows when an agency provides them with a poor ESG rating followed by an offer to help them improve their score for a fee. Some argue that this arrangement could compromise the objectivity of the ESG ratings that shareholders are basing investment decisions on.

Current state of ESG

With this push and pull as a backdrop, we are seeing governments and sustainability leaders driving the momentum in the ESG movement. The current direction emphasizes transparency, accountability and ESG fiscal policy.

The shift from voluntary to mandatory ESG reporting continues to rapidly evolve. Regulatory bodies have been enacting sustainability-related legislation across the globe, pushing for targeted and standardized ESG disclosures subject to assurance, addressing a major concern for skeptics.

• The European Union’s (EU's) Corporate Sustainability Reporting Directive (CSRD) requires large companies with operations in the EU to disclose their governance, strategy, risk management and metrics associated with material sustainability topics, in line with the European Sustainability Reporting Standards framework.
• In India, companies must comply with mandatory sustainability disclosures in accordance with guidelines issued by Securities and Exchange Board of India.
• Climate reporting, including climate risks and greenhouse gas emissions, is becoming the global baseline, with legislation coming from various corners of the planet including the UK, Japan and California.

As more companies embark on their ESG reporting journeys to meet voluntary and mandatory requirements, a significant portion of large, publicly listed companies across various industries now discloses climate targets. Greenhouse gas reduction ambition continues to grow, with the last decade seeing companies move from goals without context to science-based targets. The number of companies across the globe with net zero targets has more than doubled in a little over two years.ᶦˣ Transition plans are lagging, however, with only 5% of FTSE 100 companies having disclosed credible plans to transition to their net zero targets.ˣ We believe transition plans are next – and will be pivotal in addressing skepticism on accountability in meeting ambitious goals.

Finally, governments are continuing to play their role in addressing the climate crisis, using carrots and sticks in fiscal policy to drive change.

• The EU Green Deal pledged $1 trillion in investments that support the transition towards a greener economy.ˣᶦ
• The US Inflation Reduction Act includes over $350 billion in funding for clean energy-related projects.ˣᶦᶦ
• As of the beginning of 2023, 23% of global emissions are subject to a carbon pricing mechanism,ˣᶦᶦᶦ with that number set to increase as carbon board adjustment mechanisms (CBAM) in Europe, Australia and elsewhere take hold.
• The EU CBAM will put a price on carbon emissions produced during the manufacturing of carbon-intensive goods imported into the EU. According to S&P analysis, cost for S&P 500 companies could amount to as much as $1.3 trillion from various 2030 carbon prices.ˣᶦᵛ

The path forward: immediate no regrets next steps for large and mid-size companies

Whiplash in the ESG movement allows for companies to pause and objectively assess focus areas and how they will create shared value. Given the current state of ESG, there are immediate no regrets next steps for large and mid-size companies alike.

Pursue “win-wins”

When in doubt, companies should consider investing first in ESG projects that offer a strong return on investment. This involves determining operational and capital expenditure costs, cost savings and the emissions-reduction potential for operational and value chain decarbonization projects that can be implemented at a wide scale across the business. For example, adopting electric vehicles for their reduced total cost of ownership and using energy-saving building appliances. Additionally, companies that engage in activities aligned with public policy goals can take advantage of available tax credits and incentives to subsidize spending on energy efficiency and sustainability. When considering cost, extend the consideration to risk as well. Also manage ESG risks as the business risks they are. ESG risks pose threats to businesses now with the rise in extreme weather events, but as we approach and surpass certain environmental tipping points, these risks are certain to become even more significant to businesses, potentially costing millions of dollars in damage and recovery.

Innovate products that are desirable and sustainable

Executives on earnings calls are appropriately excited about sustainability tailwinds. As more people, businesses and governments prioritize sustainability, the demand for sustainable products and services is growing rapidly. Achieving the United Nations’ Sustainable Development Goals is expected to open up at least $12 trillion of market opportunities.ˣᵛ Companies that align their product strategy to this rapid growth of end markets exposed to sustainability trends stand to not only join a global movement but also stand to profit from it. For example, in the agriculture and food sector, the rise in vegan consumers presents a market opportunity for plant-based meat substitutes and increased profitability for producers of such goods. Similarly, manufacturers producing less water-intensive inks, like those used in digital textile printing, can conserve water and reduce air pollution, making their products more attractive to customers. Overall, this can lead to the development of new markets and opportunities for businesses that align their focus accordingly.

Transform businesses to take advantage of circular economy models

Businesses can leverage the principles of the circular economy to transform their operations and drive growth. This involves designing products for disassembly and reuse, which extends the product’s lifecycle and reduces waste. Developing reverse logistics networks is another key strategy, enabling businesses to reclaim products and materials, further minimizing waste and maximizing resource efficiency. Implementing quality-control programs to certify refurbished or remanufactured products increases customer trust and satisfaction, while also contributing to sustainability goals. Moreover, these refurbished or remanufactured products can increase the per-unit margin due to a lower overall cost of production. Adopting circular models not only allows businesses to increase revenue but also reduces supply chain risk and addresses resource scarcity, making it a win-win solution for the economy and the environment.

Prepare for ESG regulations

Regulations including the CSRD, the California climate laws, CBAM and others require companies to shift from a voluntary reporting mindset, propelled by sticky notes and spreadsheets, to a mandatory reporting environment. While penalties for non-compliance are not yet clear, they may be associated with strict financial repercussions. As a result, for important data points, focus on robust processes and controls, and get automated. You may find yourself one day saying, “We should have standardized years ago. This is much easier now.”

Integrate social inclusion into your ways of working

Companies are experiencing seismic shifts in their workforce, with Generation Z and millennials set to comprise the majority by 2030. Engaging in pressing social issues, living your employee value proposition, supporting the communities impacted by your business and fostering inclusion within your company are strategic means to attract and retain the incoming generations. This often starts at the center of your business — articulating a clear social impact mission. Not only can your business benefit from inclusive products reaching new markets, but your talent pipeline depends on it.

When assessing the above five no-regrets actions, consider taking a holistic approach to sustainable transformation to advance sustainability programs in alignment with business strategies. A robust transformation places focus on the development of a business case and measurement of economic, environmental and social outcomes. By taking a proactive approach to sustainable transformation, you should be better positioned to navigate the ongoing evolution of the ESG landscape – mitigating risk, meeting new and emerging regulations and reaping financial rewards.

Sharmen Hettipola also contributed to this article.

The views expressed by the authors are their own and not necessarily those of Ernst & Young LLP or other members of the global EY organization. Moreover, they should be seen in the context of the time they were made.

Neither EY nor any member firm thereof shall bear any responsibility for the content, accuracy or security of any third-party websites that are linked (by way of hyperlink or otherwise) in this article.