We recently published research into the current status of ESG within UK mid- and small-cap companies, supported by Peel Hunt, which highlighted that the influence of ESG on performance and valuation is becoming increasingly understood and influenced by a broader set of stakeholders, despite the current economic challenges.

Based on the research, and our continuous dialogue with stakeholders across the ESG spectrum, we have identified six areas of ESG which management teams should consider throughout the coming year and beyond:

• The relevance of climate change will increase and will not be delayed by economic challenges. Corporates will be expected to continue to take seriously their approach to net zero, energy transition, and environmental responsibility. While there were mixed results and reviews of COP27, it reaffirmed the need for stronger cooperation on corporate net zero commitments. Companies must start to understand and tackle the challenge of their Scope 3 emissions if they have not already done so and upgrade their TCFD disclosures to include financial impacts. We will also see greater scrutiny of the use of carbon offsets and credits. As it appears worryingly clear that the world will miss its 1.5°C climate target, we expect to see greater investor, regulatory, consumer and supply chain pressure to focus on climate adaptation and emissions reductions strategies.
• As well as the focus on climate change, companies should start to properly consider their approach to nature. The role of natural capital and preserving the world’s finite natural resources is becoming more important and will be reflected in everything from policy changes to corporate reporting. Water health, air quality, land quality and biodiversity will continue to rise up the agenda, in part supported by developments such as the Taskforce on Nature-related Financial Disclosures (TNFD) which is publishing the final draft version of its framework (v0.4) in March, with final recommendations being published in September 2023.
• The relevance of a company’s social influence will require greater management consideration. The workforce, consumers, customers, suppliers, and society in general are all impacted by a company’s actions. They also have a growing expectation for corporates to be part of the solution to the many social and environmental issues facing the world. As the UK and European economies continue to navigate challenges such as the cost-of-living crisis, it will become increasingly important that a company is seen to actively consider and deliver a positive social impact. As an example, 65% of companies in our recent research recognised that a company’s commitment to ESG issues is now an important factor in employee attraction and retention. As the influence of ESG expands, management will have to devise better ways to understand and measure the expectations of a broader set of stakeholders.
• Management teams will need to demonstrate greater understanding and measurement of their environmental and social impact. 80% of managers interviewed in our research now view ESG as aligned with corporate performance and valuation, up from 54% in 2021. This trend is the reason why understanding ESG materiality and influence will evolve to become a more detailed data driven approach. For many companies this is going to require a fundamental change to how they view, measure and report on the materiality of ESG, as well as how they adopt and manage their programmes.
• ESG will become a more defined management practice, led by the CEO, with a closer link to executive pay. With the increasing recognition of how ESG can have an impact on the performance and valuation of a company, ESG will mature to be a senior management responsibility with proactive Board oversight, requiring different executive and Board expertise. Driven by improving data and metrics, how ESG is linked to remuneration will also become clearer. The transparency of the link to pay and how far down it is taken within the business will become a test as to how developed ESG is as a management and operational discipline. Our research highlighted the challenge in this area with only 13% of companies believing that ESG had been fully embedded within their business, and 8% saying that remuneration was fully linked to ESG performance.
• Increased standardisation in setting sustainability goals, reporting guidelines, and disclosures related to ESG will be a focus in 2023. In a continued effort to identify greenwashing, and improve the regulatory and reporting burden on corporates, standard-setting bodies will be working hard to address the issue of corporate and investor accountability and setting a baseline that is consistent across sectors, market capitalisations and countries. Despite it being unlikely that a true global standard will be created in the near term, management teams should keep an eye on the International Sustainability Standards Board (ISSB) and its take on sustainability disclosure and how it is integrating with existing reporting such as TCFD and CDP.

In conclusion, ESG will continue to grow in influence over the next year, despite the economic outlook which might provoke more short-term thinking. Companies will need to have a greater understanding of ESG materiality; be able to measure a broader set of stakeholders; and create metrics and targets linked to remuneration set over the longer-term that also take into account their licence to operate and reputational value. This will not all be accomplished in 2023, however the year will be an important part of ESG’s continued evolution.