The discussion around environmental, social and governance (ESG) issues is gaining traction – and will have long-term ramifications for the auto industry. ESG reporting considers risk factors beyond just a company’s financial metrics, such as their sustainability practices (as well as the practices of their suppliers), environmental risk-management strategies, stances on social issues and the make-up and effectiveness of their boards of directors. Here Y Nguyen, head of sustainable risk advisory and North American sustainable supply chains at BDO, a global accounting and financial-advisory company, takes a deep dive into this complex issue and offers some valuable insights and perspectives.
Environmental, Social and Governance:
How ESG can drive a company's long-term success
Q: Is public awareness of environmental, social and governance (ESG) investing where it needs to be? What does this term mean and what are the most important components?
Y Nguyen: The concept of ESG reporting originated from the investment community as a tool used by investors and capital markets to assess whether a company had long term investment value beyond its current year profits and losses. ESG reporting represented the non-financial metrics that gave investment managers insight into whether a company had good, long term hidden arbitrage value given its climate and environmental risk-management strategies, its resources, talent, labour, as well as the make-up and effectiveness of its board of directors (the G in ESG). Today, the concept of ESG has evolved into the larger umbrella of sustainability, which includes social responsibility, environmental stewardship, and fiduciary responsibility – the so-called “triple P:” people, planet, and profits. And ESG reporting reflects the metrics of those values that provide the biggest return for all shareholders and stakeholders, including investors, regulators, employees, consumers, and communities.
Q: Carbon-neutrality pledges, human-rights protections, fair operating practices, sustainable procurement, sourcing rare-earth metals – these are not exactly virtues we just discovered. Why is ESG suddenly so important?
Nguyen: These virtues are not recently discovered, but there is a movement and an expectation to capture more transparent accounting for them. The hardest part is how to measure non-traditional, non-financial metrics, such as carbon-emission footprints or long-term social-impact investments, and then assign values and/or costs to the risk of not managing these issues. The decades-long fallout of the financial crisis, coupled with the impact of climate and environmental changes, have intersected with the events in 2020 – the pandemic and the rise of social, consumer and investor activism. All these factors have crystallized into this new responsibility for all organizations – no longer just fund managers looking for arbitrage investments – to accurately identify and account for long-term value and long-term risks that traditionally have not appeared on balance sheets or income statements.
Q: ESG sounds good and feels good. But what are the actual benefits to a company? What is the business case?
Nguyen: One of the biggest ESG myths or misconceptions is that it is philanthropic in nature. But based on the United Nations definition of sustainable development, we consider sustainability as the intersection of people, planet and profits that meets the needs of the present, without compromising the ability of future generations to meet their own needs. Thus, the fiduciary responsibility of financial performance is still a very important value and the business case for sustainability is thinking about people and planet as resources to your organization – as inputs that create long-term value if properly managed. How can a company be successful in 5, 10 or 50 years, given that there are constraints on the environment, raw materials, on labour, people, and communities?
Q: Surveys suggest that younger generations are embracing ESG values. Is this what’s driving ESG? Is this then a strategy to not only appeal to customers, but also to talent?
Nguyen: The automotive industry is experiencing rapid changes coming from so many directions, so it is important to recognize that process innovation is just as important as product innovation. Companies need to strategically adapt to what their stakeholders value or risk becoming obsolete. Various surveys indisputably demonstrate the fact that each generation is increasingly embracing consumer, social and investor activism. Roughly 25 percent of Baby Boomers, 50 percent of Gen Xers and 65 percent of millennials prefer to spend money on products and companies whose values align with theirs, and this is expected to increase with Gen Z and Alpha generations. More people, whether they are employees, consumers, investors, or future investors, are more conscious of social issues such as climate change, social justice, modern slavery or diversity and inclusion. And they are voicing their opinions with their dollars. In today’s fiercely competitive environment, organizations need to manage this risk to not only attract, but also to retain market share.
Q: ESG is a new way to think, in that it combines financial and ethical values. The bottom line is no longer the bottom line. How do you change that mindset to accommodate ethics along with finances?
Nguyen: Yes, organizations must think about the top line, the bottom line and the “green line” (environmental impacts). But they are not mutually exclusive because sustainability management and ESG reporting are simply long-term returns and long-term risks captured in present-value reporting. Companies are seeing increasing reputational costs from their own operational failures, increasing third-party risks from unethical suppliers and outsourcers, as well as increases in investor lawsuits and in supply-chain disruptions. The benefits of striving for sustainable value chains and supply chains include built-in resilience, increased information and transparency and improved risk identification. Furthermore, risk-mitigation practices will only help an organization withstand disruptions and adverse events in the long term.
Q: How will we measure progress in ESG? How will we ensure companies keep their pledges while reporting transparently and authentically?
Nguyen: What gets measured, gets managed, but also garbage-in-garbage-out. Leading organizations must develop good governance, good data management, strong monitoring controls and verifiable and auditable data to ensure value creation and risk management is measurable and reportable. The role of auditors is changing to include closer scrutiny of non-financial risks and regulators and regulations are evolving to demand more transparency and accountability in qualitative metrics.
Make no mistake, green PR and “greenwashing” are very real things as more and more companies get called out in very public headlines when they fail to live up to their public sustainability commitments. A couple automotive brands made headlines this summer – one related to repeated violations of child labor laws at their United States subsidiaries and one related to climate-change lobbying and lingering emission-testing scandals. The reputational costs have become increasingly high as more investors and consumers want to spend their money with companies that they believe align with their values.
Q: What advantages do Canadian companies, or the Canadian economy have in embracing the ESG ethos in their corporate culture and operations?
Nguyen: One of the key advantages of Canadian companies and the Canadian economy is that we have a very strong labor force – workers who are educated and experienced in the skilled trades. A strong ESG ethos in corporate culture and operations promotes talent retention and organizational resilience. Innovation, whether it involves deploying technology or enhancing operations, will help to withstand some of the global and cross-border supply shocks now experienced by many companies. Organizations need people and robust processes to power innovation and success.
On the other side, Canadian companies must also recognize they are part of a global supply chain and an international market, and therefore must be prepared to better understand their relationships and their vulnerabilities outside the Canadian borders. An increasing number of major U.S. companies are demanding that their suppliers, vendors, outsourcers, and business partners operate sustainably, track their carbon emissions, and obtain an ESG-rating certification to continue to do business with them. The new normal is changing too rapidly and is expected to keep changing. Canadian automotive companies of all sizes must be able to correctly scan the horizon and be prepared for what is likely and probable and minimize the impact of these changes. Companies that hold obsolete inventory run the risk of being off-side, falling behind or holding obsolescent – and it can happen quite quickly.
Q: What are the most important actions that companies can take now as the auto industry gradually embraces ESG principles?
Nguyen: Companies must be able to assess upcoming risks and evaluate if they are able to properly address those risks and succeed. And if they cannot, they must act today. If you look at emerging regulation trends, whether it is disclosure requirements for financial statements related to carbon-emission footprints in a value chain or regulations evolving out of Europe, particularly in Switzerland and Germany, more regulators are moving towards the idea that companies need to be held accountable at the top of the supply chain. This means there will continued, downstream pressures and a cascading effect on all companies, whether they are parts manufacturers or automotive retailers. Companies are increasingly held accountable for ethical and safe labor practices, enforcing anti-bribery and anti-corruption governance, and improving their environmental and climate impact.
Because standards for net-zero emission requirements and human-rights violations are not yet universally adopted, many companies do not have the mechanisms to track and assess this data. To determine so-called “Scope 3” emissions outside their own organizations, or to monitor ethical supply chains, many organizations must map out their supply chains to gain a clearer line of sight into their third-party relationships.
Many companies are surprised that a supplier’s code of conduct is not sufficient to identify and deter forced labor and child labor in their supply chains. To move toward a sustainable solution to these issues, organizations first need to build those transparent reporting mechanisms.
Q: Given that the pressures on the auto industry are imposed by short-term thinking (think monthly sales reports), how does the industry adapt to a long-term initiative like ESG?
Nguyen: By reframing sustainability as long-term value creation, it becomes clear that short-term reporting needs and long-term planning do not have to be mutually exclusive. An organization can ensure long-term success by incorporating long-term targets and monitoring progress in the short-term. Companies must rethink how they operate and shift from reacting to remediating. Operational efficiencies, operational excellence, risk management and technology transformation are the “hows” of managing sustainability issues and driving better performance and returns.
Nguyen: Governments and regulators are notoriously slow to move. In fact, multinational organizations have the resources, geographic footprints, and de facto power greater than any single government or non-government organization. Multinational brands and U.S. supply chains are at the forefront of the sustainability and ESG movement that will impact Canadian companies. We can forever motivate a donkey to move forward by hanging a carrot in front of it. If the donkey still refuses to move, we might urge it forward with a stick. The primary point of this article is that companies must rely on the power of the sustainability and ESG “carrots” – value-creation, risk mitigation and long-term success – rather than wait for the “stick” of regulatory enforcement and cooperation.
ABOUT THE PANELIST
Head of Sustainable Risk Advisory and North American Sustainable Supply Chains at BDO
Y Nguyen, CPA, CA, CIA and CSSCP, leads sustainability enablement and business resilience for BDO and specializes in bespoke and value-added sustainability risk-advisory solutions for clients of all verticals.