Commentary

ESG’s Fab Five

Rajiv Jalim, Director of Solutions Engineering at FigBytes, highlights five essential ESG metrics to help investors track sustainability progress at portfolio companies.

One of the most common questions I hear when I talk to private equity, venture capital firms and other ESG-centered investors is pretty basic: Where do I start?There are a puzzling array of hundreds of metrics these investors can use as key measuring sticks. So it’s a daunting task to choose those that are most relevant to your portfolio’s key attributes, whether that’s sector, geography or regulatory environment. Daunting, but not impossible if you know what questions to ask.

I would start with the purpose of the metrics. It isn’t to check a box or stake a claim to a meaningless ESG ‘badge of honour’ that gets included in a prospectus. The metrics are there to create a true culture of sustainability within the companies that use them, so if you are trying to determine which companies are ‘true green’ while others may be greenwashing, ask whether the metrics they follow are driven by that culture of sustainability.

I’ve picked out a ‘Fab Five’ of useful metrics groups below that are worthwhile for any company to consider. But the important caveat is that the final list of metrics should undergo a materiality review. That’s an important exercise in which a company brings internal and external stakeholders together to decide what sustainability issues are most relevant, and what actions are likely to have the most impact on the company’s footprint. Those two factors – relevance and likely impact – will ultimately narrow your list down to something manageable.

As an investor you may want to check whether any sort of materiality review has even been done. If not, you may want to ask, why not?

Regulatory and compliance requirements, which can vary wildly between industries and countries, will also guide where companies invest precious sustainability resources. Recent regulatory developments, notably in Europe, are highlighting the importance of carrying out full impact assessments to detail impacts on a variety of issues, including human rights, environmental pollution, deforestation, or bribery and corruption within an industry.

While the topics below represent groups of metrics, I will mention a few of the most important ones within each group and how they can be useful.

Environment

Carbon emissions get all the attention on the environmental front, but it’s not the only place you should be looking for impact. Companies often measure carbon intensity, or carbon emissions produced per unit of activity. That activity could include producing a product, producing electricity, or economic activities such as dollars spent. Reporting total electricity purchased and carbon intensity are a good start, but of course you can always go further and ask, “What other direct and indirect emissions are coming from operations that can’t be measured on an electricity bill?” Scope 3, or emissions that come from indirect sources like supply chain partners, can be considered the “next level up” once you have a handle on basic Scope 1 and 2 metrics.

But environmental measures should have a focus that goes beyond emissions or clean energy reporting. In the next decade, given the intense climate change effects we’re already seeing, water will become the ‘new carbon’, an essential element in business strategy that must be closely monitored. Businesses will struggle with water resource management and stewardship, and they will need robust data to make smart and ethical decisions about it.

Social Issues

The ‘S’ in ESG – which is often less developed in North American countries compared to Europe – covers a broad array of issues, but you can narrow the issues down if you remember that the metrics should have their roots in your company values. Organisations developing ‘S’ initiatives should look to their materiality assessments or industry-specific frameworks like SASB, which calls out ‘S’ under its Human Capital dimension, for guidance on relevant metrics for monitoring. They act as lighthouses for companies that simply don’t know where to start.

Asking key values questions in your assessments will help you determine which material metrics to focus on in this category: Do you value having a diverse workforce, representing many cultures and a reflection of the society the company works in? Does your company work in an industry like construction, where health and safety might be a priority for those working in potentially dangerous environments?

Key metrics under this category could include:

  • Diversity, Equity, and Inclusion (DEI): While you can measure this through simple numbers (gender and racial minorities in senior management, different nationalities present across regions), you can also use regularly obtained employee engagement data to understand whether employees feel this value is reflected in everyday interactions.
  • Employee engagement – Do employees feel engaged at work and have good work-life balance? Do they feel career development opportunities and room for growth are readily available? These are also data that can be collected through regular employee listening programmes. I’m not suggesting the run-of-the-mill annual census to take a temperature. Feedback loops should be quarterly and regularly monitor important variables like relationships with managers and whether employees feel fully supported.

Governance

The common metric that falls under the ‘G’ in ESG is the percentage of employees fully trained on the company Code of Conduct, as well as ethics policies that cover bribery and corruption. I have also seen companies measure the number of committees across the company that have formal responsibility for reaching sustainability goals. The same principle that I mentioned in incentivizing management applies here – if it’s not written down as something to be accountable for, it will get lost in the paper shuffle.

Key metrics under this category could include:

  • Sustainability goal incentive plans – What percentage of C-suite executives, top directors and senior employees have sustainability objectives integrated into their variable or long-term incentive plans? Is executive pay anchored to some sustainability goals for the company or each executive’s unit? It’s pretty simple – company values mean very little if you aren’t incentivizing managers to practice them.

Community and society 

Community initiatives often get lumped together with general social issues of the day, but how a company interacts with the society it’s embedded in is a crucial set of metrics that should operate separately. Here are a few key indicators:

  • Percentage of employees that participate in philanthropic projects or initiatives to support the local community.
  • Total company financial contributions to selected philanthropic projects.
  • Social outcomes and impacts of each program. Outcome data is difficult for any community-oriented project, but not impossible. If there’s a mentoring program for young unemployed people, how many get jobs, and how fast? How many partnerships with other social stakeholders are there, and what are the positive outcomes of those partnerships?

Supply chain and value chain

Though these two things might seem as separate categories – the product you make or service you provide, versus the partners you work with to get you there – I think together they are arguably the most important metric of all. In short, you’re measuring where sustainability meets your core business. To be sure, the supply chain metrics might feature a lot more prominently for a Walmart, Amazon or other retailer that relies on a vast network of supply chain partners. But every company has a value chain – the activities that focus on more internal value-adds like product testing, innovation, research and development and marketing – and sustainable practices can be ingrained in that process if you choose the right metrics. Here are a few examples of metrics companies might choose from this category:

  • The percentage of suppliers that have received and signed the company’s Supplier Code of Conduct or a relevant industry Code of Conduct.
  • The percentage of suppliers that have set and reached targets for the reduction of greenhouse gas emissions – for example, net zero emissions programmes or designing energy efficient technologies.
  • The number of suppliers who have a declared human rights policy or stance, or who are taking steps like providing a living wage to promote those objectives.

On the value chain side, it’s all about measuring direct impacts. For example:

  • Clear KPIs that account for known negative impacts – though most companies measure emissions impacts of production, there are other social and cultural impacts that often get left off the table.
  • Documented efforts to lower those negative impacts over time.
  • Accounting methodologies that attempt to put impacts, both positive and negative, in monetary terms that go into an annual financial report.

Suppliers may be required to report any or all of the above metrics to the company they supply, so data collection must happen at the supplier and supply chain owner levels.

There is a lot to digest when you scan the ‘Fab Five’ metric groups. Keep in mind that these five (like the classic ESG framework) often overlap. There are no black-and-white boundaries between some of them – for example, sustainability goals for individual executives could fit into a social or governance category.

While I consider these the foundation of a good sustainability plan with measurable outcomes, I think it’s important not to let the perfect be the enemy of the good. In other words, if you are putting together a portfolio of companies focused on sustainability, or if you’re a venture capital firm ensuring your existing portfolio of companies is working toward their sustainability goals, you don’t need to track all five groups to have a ‘fab plan’. I advise companies to start with two core metrics and build every year toward a Fab Five plan – even that means progress. Judging from recent global climate change metrics, we could all use some progress these days.

 

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