As we enter a new year, environmental and social responsibility becomes an ever brighter light on the radar of business. A series of diverse drivers have converged to ensure that ESG (Environmental, Social, Governance) has become or is fast becoming a top priority for businesses across the globe. For many the need to transition to new operating models incorporating greater ESG responsibility has already become an imperative. This transition will represent a complex challenge but also a significant opportunity.
This article looks at the background to the development of ESG as a commercial issue, why it matters and what steps businesses can take to keep pace with this fast-changing environment.
What is ESG?
ESG is a term used to refer to how a company manages its environmental, as well as social, aims and responsibilities. Originally used in the financial sector (particularly by pension funds and private equity houses) it is increasingly used by companies across the business community distinct from “corporate (social) responsibility” and “corporate governance”.
As a much broader concept, ESG has become an umbrella term for a broad range of environmental (e.g. pollution, waste and energy efficiency), social (e.g. diversity, equal pay, working practices and stakeholder engagement) and governance (e.g. executive pay, bribery, corruption and tax transparency) factors against which stakeholders can assess a business’s performance.
Why has ESG become important?
In addition to a fast developing regulatory framework there are a wide range of social, economic and commercial factors which mean that ESG will remain at the forefront of the corporate agenda for the foreseeable future:
Stakeholder awareness
Increasing environmental and social equity awareness amongst consumers, investors and other stakeholders are forcing organizations to address ESG issues both substantively and transparently. These pressures and influences - reinforced by the transparency afforded by the digital age - require businesses to put purpose at the core of their operations, demonstrating how they are addressing issues that concern their wider stakeholder communities.
The ESG research industry is flourishing with standards setters, data aggregators and rating agencies ranking businesses from an ESG perspective. Agencies are used – and ESG credentials are assessed - by a variety of entities from a business’s competitors to its investors, shareholders and customers. In particular, businesses should anticipate suppliers checking credentials as part of any tendering process.
Great expectations
In addition to increased awareness other factors are shifting perceptions and expectations amongst businesses in the ESG sphere. These include:
investor pressure (financial institutions themselves have come to better understand the risks to investments associated with ESG issues)
changes in marketplace behaviours
social issues and stakeholder activism
a desire amongst workers for their business to be seen to “do right” and not simply “do the right thing” (comply)
the Covid-19 pandemic which has led to an increased focus on business resilience - now inextricably linked with good ESG management – not to mention an increased sensitivity to worker well-being on the part of employers
Risk
ESG related issues pose a variety of risk to businesses and boards must understand how these might affect their business’s long-term resilience. These risks include:
Litigation: this can emanate from a multitude of sources e.g. a failure to manage climate change related events to supply chain related claims involving a supplier’s breaches of human rights or environmental compliance
Physical: flooding, contamination or health and safety
Commercial: loss of business and supply chain disruption
Reputational: this could be linked to any of the above risks. A negative ESG perception can have dramatic consequences - Boohoo experienced significant falls in its share price as a result of supply chain and working conditions related issues in 2020
Compliance
As we explain below, businesses live in a world where across jurisdictions rules and regulations are being implemented on a regular basis impacting the responsibilities and liability of corporates in the sphere of ESG.
Communication
Information flow and digital platforms will help maintain awareness of ESG-related issues. Businesses will need to be agile in responding to national and global issues and campaigns capable of impacting their stakeholders’ expectations. Similarly, businesses will need to be able to deal swiftly and transparently with any adverse publicity posing reputational risk.
Opportunities
Leaving aside the ethical and commercial imperatives there is significant evidence connecting sound ESG management and long-term value creation – an attraction for any business. Embedding ESG into its model will enable a business to protect and create value. It is well established that a focus on ESG issues can improve a business’s performance by enabling sustainable growth, recruitment and retention of talent, enhanced brand and reputation, access to wider and cheaper capital and business cost savings.
For businesses looking to raise finance the good news for those who are ESG-compliant is that they should enjoy lower costs of capital and access to greater choice. Conversely for non- ESG compliant companies access to capital is likely to become restricted and more expensive.
ESG is not a passing trend but rather a fundamental and permanent shift in the tectonic plates of commerce. ESG will continue to transform the business landscape driven by a broad and diverse range of socio economic issues and an increase in the awareness and expectations of their stakeholders.
ESG Drivers
A variety of events and issues have driven and will continue to power change in the ESG arena:
COP 26
For many professional observers, one of the key take-ways of the recent international climate change conference held in Glasgow was less the formal decisions made by nation states but rather the broad range of commitments made by the private sector outside the formal normal framework. The degree of engagement by businesses at senior level impressed many observers. Having made a range of commitments the next (challenging) step for many businesses will be developing the roadmap to achieve them.
The presence of investors representing £trillions in capital reinforced the net zero commitment and delivered the clear message that longer-term value creation will acquire a greater focus in future investment processes.
Capital Markets
In addition to The London Stock Exchange’s ESG reporting guidance, the final report of the Financial Stability Board’s Taskforce on Climate-related Financial Disclosures (TCFD) set out information that companies should disclose to enable investors to better understand how companies oversee and manage climate-related financial risks. The UK’s Financial Conduct Authority has made reporting in line with the TCFD recommendations mandatory for listed companies (in the case of standard listed companies for accounting periods beginning on or after 1 January 2022).
The UK government is consulting on draft regulations which will amend the UK Companies Act and require UK-incorporated large companies to include TCFD climate-related disclosures in their strategic reports.
The FCA published its ESG strategy on COP26’s finance day reaffirming its commitment to existing enhancing climate-related financial disclosures and transparency.
The 50% surge in Tesla’s share price in 2021 was due to more than supply chain issues affecting the rest of the automotive sector. Investors increasingly look beyond the balance sheet to how companies integrate ESG into the core of their business. Investor need for quality and comparable ESG data to distinguish between companies will continue to drive reporting standards and transparency – adding further pressure for businesses to integrate ESG policies into their working practices and management reporting.
EU legislation
The Commission has established an EU framework placing ESG at the heart of the financial system to help transform Europe’s economy into a greener and more resilient system. The EU has recently sought to address the inconsistencies in sustainability-rating schemes by the introduction of new labelling system (“Taxonomy”) which will sift economic activities by environmental sustainability – clarifying what counts as “green”. This is intended, amongst other things, to help investors and businesses disclose with greater consistency what share of their activities or investments are “green”.
Whilst there has not been a comprehensive onshoring of these regulations as part of the Brexit process, nevertheless the UK government has committed to matching the EU’s sustainable finance action plans ambition and is expected to adopt similar principles. (See references elsewhere in this briefing to TCFD and the UK government’s recent green finance policy paper.).
UK legislation
Recent changes in domestic UK law have also increased the requirements on companies across different ESG areas. Examples include:
UK climate change legislation.
In 2019, the UK set itself a statutory net zero carbon target for 2050. Key areas of regulation to drive progress towards that target include the EU Emissions Trading System and UK Emissions Trading Scheme, the climate change levy, climate-related disclosures (in particular, as mentioned above increased alignment with the TCFD recommendations), the Energy Savings Opportunity Scheme and energy efficiency in buildings and products.Modern Slavery.
The Modern Slavery Act 2015 includes an obligation on large commercial organisations that carry on business in the UK having a turnover of £36m or more to publish an annual modern slavery statement on what action they have taken to ensure their business and supply chains are slavery free.Gender pay.
The Equality Act 2010 provides that large employers (at least 250 relevant employees) are subject to mandatory gender pay gap reporting.Anti-corruption and bribery.
The UK Bribery Act 2010 prompted commercial organisations to assess whether they have adequate procedures to ensure that they are not involved in bribery and corruption. Most major companies already have in place an anti-corruption policy that should be reviewed regularly to ensure that it is fit for purpose.
As mentioned the UK government is following fast in the EU’s “green” tracks. In June 2021 the UK government announced the establishment of the Green Technical Advisory Group which will provide independent non-binding advice to the government on the development and implementation of a UK green taxonomy. This was followed in October by the UK government policy paper “Greening Finance: A Roadmap to Sustainable Investing” which amongst other things sets out the government’s ambition to green the financial system and align it with the UK's net zero commitment.
In addition, there are non-statutory codes and various UK Companies Act provisions which may have direct or indirect ESG application and to which larger and listed businesses need to have regard including the UK Corporate Governance Code and UK Stewardship Code.
The UK’s current legislative framework is inadequate for its international and domestic carbon targets. Consequently, more legislation in the ESG arena is likely to be both inevitable and swift meaning the level and pace of change required could be extremely disruptive to UK businesses. Regardless, commercial imperatives will help ensure that ESG compliance becomes increasingly mandatory.
Impact of ESG for businesses
The ESG lens will force companies to better understand their key value drivers and adapt their business models to the realities and demands of the ESG sphere. Businesses will need to be agile and embrace accountability and transparency - these businesses are likely to be both more viable and valuable in the long term. These factors raise a number of issues and considerations for businesses:
Executive remuneration
As ESG issues become prominent in companies’ relationships with stakeholders, executive remuneration is being adapted to align with expectations in this area. Companies are increasingly incorporating the management of material ESG risks and opportunities into their long-term strategy and incentive plans.
Core Metrics
Businesses will need to identify a range of performance measures – from governance to people and prosperity - as part of any ESG disclosure exercise and consider what is achievable (not least from the perspective of generating the relevant data).
M&A
As part of their due diligence exercises, buyers are taking an holistic approach to targets and their stakeholders focussing on potential supply-chain related issues. Due diligence needs to be bespoke and adapted to the specific circumstances of the target and its businesses and operations. A thorough understanding of suppliers and customers and where potential ESG risks might arise becomes essential - particularly where those entities are located in sensitive industries. Similarly, the form of contractual protection sought by buyers needs to be tailored to address those risks.
Corporate Group Liability: Multinationals
The increased complexity of ESG compliance has led inevitably to increased litigation risks for companies. This has become particularly relevant to companies with overseas interests. While previously the English courts were reluctant to take jurisdiction over claims involving overseas activities and entities, recent cases including a 2019 case (Vedanta Resources) have demonstrated that an English parent company may be liable for the activities of its overseas subsidiaries where its oversight has been negligent.
Businesses are increasingly expected to identify, manage and remedy any adverse ESG impacts of their activities across the group’s value chain. Those operating across borders must consider the risk of the ESG impact of their subsidiaries’ operations - local communities, the environment and human rights – and take steps to mitigate risks.
Private Equity: Investor expectations
In the last couple of years vast sums have been raised by investors and ear-marked for businesses which score well on ESG metrics. Private equity institutional investors have over recent years become very alert to ESG matters. These influence not merely the investment decision but also the conduct of the investee during ownership and preparation for exit.
The link between ESG compliance - management of non-financial risk - and superior long-term financial performance is well established. In short, ESG compliance has in many respects become synonymous with effective management - ESG factors can have a material impact on returns.
Many investors integrate sustainable investment practices across their investment process and most have detailed ESG policies setting out their ownership and governance strategy.
ESG has become a specific non-financial portfolio review issue for many investors. As with capital markets this in turn has led to an increase in the quality and quantity of ESG-related data required by private equity investors. PE backed businesses are expected to demonstrate not merely an understanding of their ESG risks but also how they will identify them, manage the risk and to provide data in support.
Stakeholder Engagement
It is essential for businesses to understand what matters to their lenders, investors customers, workers, business partners and wider communities - and their expectations. Surveys and data indicate an awareness and concern amongst workers and job seekers about a business’s ESG activities. Add to this the fact that the digital era can throw a bright – and immediate - light in the corner of any facility anywhere in the world and the need to facilitate an open dialogue with stakeholders in the widest sense becomes clear.
As part of any ESG roadmap businesses will also need to understand their supply chains and identify steps to address any weaknesses or risks from an ESG perspective.
Business Adaptation
Businesses will need to understand their carbon foot-print and identify what is possible for them to change. Similarly, stakeholder pressure will require businesses to be able to explain their purpose beyond the economic and engage with employees and other stakeholders. Recruiting and retaining talent is also likely to be affected by a business’s purpose and ESG awareness. Business is likely to experience a significant increase in the creation of “green” jobs and the up-skilling of workers and management in matters ESG.
The ability of a business to transition to the new low carbon economy operating model will be key to its future success. That transition will encompass a range of factors impacting not just how a company does business but where and with whom. It will also involve a review of corporate practices, policies and strategy across multiple fields as part of the business’s review of core ESG metrics referred to above.
Businesses need to rethink their priorities and wider purpose in society while considering their broader impact on their communities and beyond. Central to this exercise is the need for reflection by corporates on their “purpose” – identifying, and perhaps redefining, their priorities, targets and objectives to ensure that ESG is integrated into their business model and strategy.
How we can help
For many businesses the development of ESG-related policies and strategies and associated road- maps may be well in hand. For those who are closer to the start of the process the prospect, and knowing where to start, can be forbidding. In practice, the materiality of individual ESG factors will differ by company, sector and territory. There is no ‘one size fits all’ approach to an assessment of materiality of ESG issues which should be tailored to the circumstances of the particular business.
The development of an ESG action plan and roadmap will be more efficient if part of a holistic review of the business’s wider risk and compliance. Delegating the exercise to a person (or more likely, team) will help – the work involved should not be under-estimated. Any strategy will need to involve the fundamental question of its corporate purpose, relevant metrics (what data do you measure?), risks and opportunities, goal-setting and how performance will be reported. Engagement – within and outside the business – will also be key.
As explained there are a multitude of factors and risks falling within ESG. We can help your business manage these risks by providing support in a variety of areas including:
Risk assessment across ESG policy areas
Regulatory compliance
Opportunities for relevant ESG related certifications
Management training and awareness
Supply chain due diligence (including a review of procurement policies)
ESG strategy and related policies and procedures (a comprehensive ESG strategy will help a business to assess risks and opportunities)
M&A support including due diligence
ESG disclosure
ESG related litigation
If you would like to discuss anything arising from this briefing please get in touch.
