ESG has risen to become a dominant issue over the last two years. This has been driven by many factors including greater transparency; the growing demand for climate action; increasing regulation; and the need for companies to demonstrate a clear licence to operate. However, there has been very little analysis of how ESG is influencing the behaviour of mid and small cap companies. Most of the debate and commentary concentrates on large, global companies. Does this mean that the capital markets are not engaging with these companies about their ESG performance? Are the senior management of these companies ignoring their environmental and social responsibilities? Our recent research shows that the short answer is “NO”.

SIFA Strategy conducted research which sought to understand what pressure mid- and small-cap management teams are facing on ESG; where that pressure is coming from; where they see it impacting their businesses in the future; and how far they have developed their ESG programmes. The findings show that the momentum in ESG is building for these companies. Increasingly the leadership teams see ESG as having a significant impact on their business strategy in the future. However, the levels to which these companies are adopting ESG best practice and embedding it into their business processes varies considerably. Some companies have a long journey ahead to maximise the value creation and resilience that fully embedding ESG can offer.

ESG is becoming more closely aligned to shareholder returns.

The recognition that ESG and shareholder returns are related is fast gaining traction. 56% of respondents see ESG performance and financial returns as being ever more closely aligned. However, this is a relatively new phenomenon. Many senior leaders admitted they would have seen ESG and financial returns as separate issues only two years ago. As ESG increasingly gains acceptance as having a direct commercial and financial impact, so its implementation is becoming more complex. In the future we will see ESG evolving from what for many companies is a narrative based approach, to one that is more quantitative and linked to financial materiality. This evolution of ESG is going to catch some companies out. 20% of respondents, or 1 in 5 management teams, still see ESG as having little or no alignment to shareholder returns.

The capital markets are placing the most pressure on companies to implement ESG. But take note of your customers and supply chain.

Over three quarters of respondents see the capital markets as driving the demand for ESG implementation, reflecting the closer link to financial materiality. This confirms research we undertook in 2018 with the UK’s leading fund managers which highlighted investors were intending to increase the level of questioning to senior management on ESG issues. Today, our research reaffirms that senior managers expect the level and detail of ESG questioning to increase, though not only from the capital markets. Greater inspection is also anticipated from regulators and companies are witnessing increasing levels of scrutiny and information demands from their position in the supply chain and their customers. There is a growing realisation that ESG performance indicators, how these are reported, and how ESG is built into the corporate narrative and brand will be an important driver and protector of reputational value.

The environment has the most potential impact on valuation. But understanding your social impact will also be key.

The environment is seen as the most pressing concern for the majority of companies, with 57% seeing it as having a very significant or significant impact on their business in the future. This compares with only 9% seeing it as having little or no impact. As the climate crisis becomes ever more apparent and Governments set net-zero strategies, the double materiality of the environment on companies is going to increase. Companies are also going to have to become far clearer on their social impact. A quarter of companies already rate social issues as having a very significant or significant impact on their valuation over the next decade with 51% seeing social issues having a greater impact in the future. Some companies believe that social issues will be on the same level as the environment within five years. This is going to place greater pressure on companies to understand and measure their social impact and value in the future. This will create a number of challenges as companies are struggling with quantifying their social non-financial drivers.

ESG as a management discipline is at a very early stage.

Despite the level of influence placed behind ESG, its implementation as a management discipline has a long way to go. Only 6% of our participants believe they have fully embedded ESG into their business. 42% admit it remains at a much earlier stage. Though over three quarters of respondents say that ESG is now on the Board agenda, the range of ESG issues covered by the Board and the level of information being given to the Board varies considerably. 57% do not have KPIs and targets relating to ESG in place. 74% do not yet link leadership remuneration to ESG performance.

Conclusion

In conclusion, it is clear that mid- and small-cap companies recognise the clear momentum behind ESG. Senior management are also beginning to plan for its long-term influence. However, the broad adoption of best practice has a long way to go.

To receive a copy of the research ESG Momentum is Building or to learn more about SIFA Strategy, please do not hesitate to contact us.