The four lenses of governance, strategy, risk management, and metrics and targets.
There is increasing pressure for organisations to demonstrate their sustainability credentials. Therefore, CFOs, finance functions and finance professionals must step define, enable, shape and tell their organisations’ ESG stories. When thinking about business resilience and ESG, a great place to start is with the four lenses of governance, strategy, risk management, and metrics and targets. These lenses come from the TCFD framework recommendations for evaluating and reporting climate-related risks. If you take out the specific climate references from their recommendations, they still provide a broad framework for working with any of the core elements of sustainability, whether environmental protection, social inclusion or governance.
In the 2019 white paper, Re-inventing finance for a digital world: The future of finance, we explored the role of the finance function and its primary activities. These are the primary activities of information, insight, influence and impact. Whether you are assessing risks, reconciling accounts or compiling management information reports, the process activities remain constant. By overlaying the four sustainability lenses to the basic finance activities, we can understand where to focus our time and resource.
By focusing across these four areas, the finance function’s basic activities are:
Assembling information for sustainability metrics and targets
Analysing for insight to build sustainability issues into risk management processes
Advising on sustainability risks and opportunities to influence organisational governance
Applying for impact by building sustainability into strategy and organisational control systems.
Governance What is the organisation’s governance around the ESG risks and opportunities?
Governance boards have an important role to play, and to be effective, as Carney highlights, it is essential that, ‘Every board committee should have the relevant ESG factors integrated into their work, and the full board should be informed on how ESG issues affect the company’s risk management.’46 Finance functions have a crucial role to play. They must produce assessments for boards that, ‘aim to reduce the ignorance of the decision-makers.’47 This can then be enhanced by finance functions and boards engaging with scientists and academics, ‘to verify the technical and scientific legitimacy of any action’.48
Boards must then spend more of their time engaged in robust discussions and oversight making more informed investment decisions for their organisations. This oversight includes reviewing strategy, risk management policies, business plans and performance systems and making sure there is a balance across the environmental protection, social inclusion and governance pillars.
In an organisation’s journey to ESG maturity, the governance structure (of boards and committees) must adopt a ‘stakeholder perspective’ and be moving towards a ‘systems value perspective’, focused on the long horizonal view. For some organisations, this will be a challenge, especially where financial incentives are used to continue with ‘business as usual’.49
Strategy What are the actual and potential effects of governance risks and opportunities on the organisation’s business model, strategy and financial planning?
A key governance theme is an organisation’s purpose. Once agreed, the purpose must be built into its strategy and at its business model core if it is to be viewed as authentic.
It is also important that once articulated, a balance of environmental protection, social inclusion and governance mitigations are embedded into the control systems of an organisation. These systems include strategic planning, budgeting, performance measures and performance reviews. Here, an integrated thinking and a systems value approach will help.
Stakeholders will want to understand the resilience of an organisation’s strategy and how it considers the different ESG risks and opportunities. This includes future product and service innovation, and, reassurance that when issues of materiality arise there are reporting processes in place.
Finally, it is important to demonstrate to stakeholders how an organisation’s strategy contributes to society.
Risk management How does the organisation identify, assess and manage governance risks?
An organisation needs to be transparent and able to articulate its processes for identifying, assessing and managing ESG risks. This should include stress-testing and scenario planning to identify trade-offs that then inform strategic and business model decisions.
When thinking about the risks and opportunities to your organisation, an excellent place to start is with the WEF Global Risk report 2021. There are nine global societal risks that ‘if it occurs, can cause a significant negative impact for countries or industries within the next 10 years.’50 They could challenge the effective management and leadership of any organisation:
Collapse or lack of social security systems
Employment and livelihood crises
Erosion of social cohesion
Failure of public infrastructure
Infectious diseases
Large-scale involuntary migration
Pervasive backlash against science
Severe mental health deterioration
Widespread youth disillusionment.
It is about translating these risks into a language your organisation understands and debating strategy and business model implications.
Metrics and targets How are metrics and targets used to assess and manage governance risks and opportunities?
The problem for many organisations, when it is thinking about metrics and targets, is achieving a balance between short-term and long-term governance factors. Just adopting ESG metrics alone will not simply fix short-termism. Henderson highlights, Many ESG metrics remain hard to construct, rarely comparable across firms and often difficult to audit, and even those that are well thought through are insufficient to capture the universe of useful nonfinancial factors that may drive performance.51
When organisations are focused in the short-term around maximising profits and metrics purely focused on outperforming their competition, there are negative long-term implications. Most institutional investors are focused almost entirely on outperforming their competition, and they are judged against their benchmark on a quarterly or monthly basis. They want the companies they own to hit their targets today, even if it might be bad for those companies in the long term. These institutional investors care more about the short-term performance of their portfolios than about building long-term corporate value.52
How do finance functions shift the balance to include metrics that communicate the value of the intangibles driving long-term value and sustainability for organisations?
When Paul Polman joined Unilever as its CEO in 2009, one of his first actions was to inform shareholders that it would stop quarterly annual company reports. He cited, that it was driving the wrong behaviour, and was at odds with a sustainable, long-term value creation model.53
Investors and analysts increasingly need complex sustainability data to make more informed investment decisions. This usually involves organisations providing metrics that answer difficult questions. However, there is a tendency to not answer the difficult questions and substitute them with metrics that are more easily collected, yet lack strong causality. The substitution for an easier metric or target, ‘will lead to an answer that does not give different aspects of the evidence their appropriate weights, and incorrect weighting of the evidence inevitably results in errors.’54
Authors Carl Bergstrom and Jevin West point out that we must understand the difference between correlations and causation when using metrics and targets. We must all watch out for evidence of correlation being miscast as evidence of causation.55 To tell an honest story, it is not enough for numbers to be correct. They need to be placed in an appropriate context so that a reader or listener can properly interpret them. One thing that people often overlook is that presenting the numbers by themselves doesn’t mean that the numbers have been separated from any context. The choices one makes about how to represent a numerical value sets a context for that value.56
A final lesson, again from Bergstrom and West (above), is that just producing metrics and target data on governance factors are not helpful on their own. Finance functions and finance professionals must also provide context.
