What was the origin of ESG?
Back in July 2000, the United Nations launched an initiative called the Global Compact, which aimed to get businesses to adopt a set of principles which would drive more civilised corporate behaviour. These ten principles covered human rights, labour practices, environment and anti-corruption, and were collectively referred to as socially and environmentally responsible behaviour and sustainable strategies.
This initiative led to the adoption a few years later of what was called the Principles of Responsible Investment, which stated:
“As institutional investors, we have a duty to act in the best long-term interests of our beneficiaries. In this fiduciary role, we believe that environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios (to varying degrees across companies, sectors, regions, asset classes and through time).”
How has ESG evolved?
In the past few years since our first article specifically on the subject in 2017, there have been several strands of development:
Index providers and rating agencies
Index providers and rating agencies have introduced monitoring of ESG in listed companies. For example…
The standout is MSCI, global provider of equity, fixed income, real estate indexes, multi-asset portfolio analysis tools, ESG and climate products, which has made ESG monitoring a growing and increasingly significant element in its service offerings.
And the largest of the Big Three credit rating agency, S & P, came out with its first ESG version of its S & P 500 index.
Investing institutions
Investment companies have introduced funds linked to ESG…
One of the largest, BlackRock, not only has created products like its sustainable fund range, but through its CEO Larry Fink, has made ESG and sustainability principles a very public part of its investment philosophy.
Investment bank, JP Morgan, has introduced what it describes as a broad range of sustainable investment funds under an encompassing frame of ESG.
Investment giant Vanguard says it provides the options of an index fund which excludes certain companies operating in sectors like weapons or tobacco, or an actively managed fund that selects companies which meet certain ESG criteria or excludes companies which engage in controversial activities.
Leading Sovereign Wealth Fund, Norway, quickly adopted ESG principles which led it to disinvest from companies which operated in sectors which rated badly in ESG terms, such as tobacco and certain arms suppliers.
Activist fund, TCI, started exerting pressure for companies to improve disclosure of their environmental performance.
Reports appeared finding that good ESG scores reduced the cost of capital compared with companies with poorer ESG scores, possibly resulting from higher profitability due possibly to lower risk.
Regulators etc
Regulatory bodies and other interest groups have started to create reporting standards. Amongst the bodies and initiatives concerned are the following:
- UNGC (UN Global Compact)
- CDP (Carbon Disclosure Project)
- GRI (Global Reporting Initiative)
- TCFD (Taskforce on Climate-related Financial Disclosure)
- SDFR (sustainable finance disclosure regulations)
- CSRD (Corporate Sustainability Reporting Directive)
International accounting bodies
International accounting bodies have been creating councils and boards with the objective of establishing international financial reporting standards governing ESG and related topics….
- SASB (Sustainability Accounting Standards Board)
- IIRC (International Integrated Reporting Council)
- IFRS (International Financial Reporting Standards)
- ISSB (International Sustainability Standards Board)
Politicians and climate scientists take an interest
Politicians have been concerned with social and governance issues for some time, and also environmental damage resulting from pollution and activities such as mining. More recently, they and climate scientists have focused particularly on developing climate monitoring standards, for instance…
- The Paris Agreement, adopted by the United Nations Climate Change Conference COP21 in 2015
- The Glasgow Climate Pact, signed at the COP26 conference in 2021, when the “Paris Rulebook” was also agreed
Parties potentially adversely affected
However, parties potentially adversely affected by these processes have started to group together to raise objections, for instance…
- Political factions, particularly in the Republican Party in the United States, challenging what they see as culture wars and excessive state interference
- Business sectors affected, such as oil and gas
What are the most advanced current regulations?
The European Union, in January 2023, adopted the Corporate Sustainability Reporting Directive (CSRD). This applies to companies resident in the EU and those with subsidiaries and activities covered by the Directive in the EU, mandating annual sustainability reports in addition to financial reports. These reports have to comply with the European Sustainability Reporting Standards (ESRS), which are much more extensive than current ESG reporting requirements generally.
The first set of reporting standards under ESRS for those companies affected was adopted in July 2023.
There are ten ESG topics where reporting is required under the ESRS, and in due course reporting standards will be issued for various industry sectors, SMEs and non-EU parent companies.
Companies covered by CSRD will be expected to:
- Apply a materiality assessment on each sustainability topic using the double materiality principle to report appropriate information
- Report on the material impacts, risks and opportunities (IROs) identified in the company’s own operations, those of its group and those of its upstream and downstream value chain
- Show metrics and targets for material sustainability topics and how these link to their financial reports
- Subject their disclosures to third-party audit before filing.
Problems of definition of ESG?
ESG reporting requirements are effectively a framework aiming to capture all the non-financial risks and opportunities inherent to a company’s day to day activities.
The ten ESG topics listed in the ESRS reporting standard are:
- Environmental
- Climate change
- Pollution
- Water and Marine resources
- Biodiversity and ecosystems
- Circular economy
- Social
- Own workforce
- Workers in the value chain
- Affected communities
- Consumers and end users
- Governance
- Business conduct
As mentioned above, the reporting standards will be progressively extended and elaborated to address specific sectors and companies in the months ahead.
These reporting standards already differ from other existing global guidelines on ESG reporting, such as those issued by the USA’s SEC, and others aiming for compatibility with frameworks such as the Global Reporting Initiative, Sustainability Accounting Standards Board or Taskforce on Climate Related Disclosure.
One particular aspect is materiality, and the issue of double materiality (how sustainability issues might create risks for the company’s activities plus how the company’s activities impact people and the environment). Double materiality is part of EU CSRD regulations, but is not currently recognised by the ISSB (International Sustainability Standards Board) which has ruled out the concept. The IFRS International Financial Reporting Standards which created the ISSB says it is working with the GRI (Global Reporting Initiative) and the EU to achieve inter-operability.
This issue is controversial as it has been presented as a questionable decision by the ISSB to adopt materiality, which only addresses how events affect a company’s financial prospects, whereas double materiality addresses how corporate actions affect society, the environment and other companies.
There are even discussions about triple or context-based materiality, which looks at impacts of ESG in an even wider context, for instance how climate or bio-diversity changes might affect a company’s entire supply chain or business ecosystems.
By way of comparison with the EU’s ESRS reporting standard, the UNPRI website lists the constituent issues of ESG as:
- Environment
- Sustainable land use
- Biodiversity
- Circular economy
- Plastics
- Water
- Fracking
- Methane
- Social
- Cobalt and the extractive industry
- Clothing and the apparel supply chain
- Human rights
- Modern slavery and labour rights
- Covid 19
- Just transition as the world responds to climate change
- Diversity, equity and inclusion
- Decent work
- Governance issues
- Tax fairness
- Responsible political engagement
- Cyber security
- Executive pay
- Corporate purpose
- Anti-corruption
- Whistle-blowing
- Director nominations
Then again, MSCI lists the following in its Materiality map
- Environment
- Carbon Emissions
- Product Carbon Footprint
- Climate Change Vulnerability
- Financing Environmental Impact
- Water Stress
- Biodiversity & Land Use
- Raw Material Sourcing
- Toxic Emissions & Waste
- Packaging Material & Waste
- Electronic Waste
- Opportunities in Clean Tech
- Opportunities in Green Building
- Opportunities in Renewable Energy
- Social
- Labor Management
- Health & Safety
- Human Capital Development
- Supply Chain Labor Standards
- Product Safety & Quality
- Chemical Safety
- Consumer Financial Protection
- Privacy & Data Security
- Responsible Investment
- Community Relations
- Controversial Sourcing
- Access to Finance
- Access to Health Care
- Opportunities in Nutrition & Health
- Governance
- Governance
- Ownership & Control
- Board
- Pay
- Accounting
- Business Ethics
- Tax Transparency
Some regard the European stance on ESG investing as longer term than the US stance and hence superior.
What are the objections being raised?
Criticisms of ESG can be grouped into three broad categories.
Complexity
The sheer number of elements involved causes:
- Unacceptably large workload: it has been estimated that S&P’s Global’s Corporate Sustainability Assessment, a road map of what it assesses runs to 253 pages.
- Incoherence: the challenge is compounded by the difficulty of weighing so many disparate qualitative factors against each other.
- Lack of overall standards: notwithstanding current discussions, there is still no agreement on a global standard, while the depth and breadth of existing standards is increasing all the time.
Subjectivity
The built-in subjectivity of judgements results in:
- Inconsistencies: notorious examples are Boohoo, rated highly by MSCI on social grounds but later severely criticised by a study which condemned the company’s poor working practices, and Tesla, criticised for its poor governance, while leading the world in the introduction of electric cars
- Greenwashing: the dressing up of funds as ESG compliant has been quite widely criticised, and the German regulators have recently brought cases against asset managers
- Impact washing: beyond greenwashing, accusations have been made of responsible investment funds being marketed as focusing on E and S, while having little prospect of achieving improvements in their investee companies, hence impact washing.
Political involvement
The increasing attention of social commentators and politicians has raised issues of:
- Woke capitalism: believers in so-called free market liberalism regard the vogue for ESG as simply an example of wokeness, which should be treated as the enemy of shareholder capitalism and resisted
- Executive pay: in recent months, examples are emerging where executive pay has been linked to ESG performance, with the criticism that the woolliness of the targets has been used to deliver unwarranted bonuses
- Extraterritorial impact: the extension of the EU’s new rules has been criticised in the USA for its potential impact on investment companies which can have little influence over data over which they have little control, but which could give rise to potential liabilities.
What is the current purpose of ESG and what’s the way forward to ensure ESG meets its goals?
ESG can broadly be described as an attempt to get companies to better meet the requirements of society at large. This is generally accepted both in the political field and in the wider business community, notwithstanding the long-held views of free market shareholder capitalists.
So, if we ask the question who is it for, we can, perhaps summarise it as being:
- for the benefit of investors who are concerned about these things
- to help protect employees
- to help protect wider stakeholder groups who may be affected by the company’s activities.
At the heart of current concerns is the way in which ESG should be incorporated into a company’s goals, its strategy to achieve these goals and the resulting detailed business plans. And here, we have to reiterate that the purpose of a business is to deliver goods or services to customers that they value, in such a way as to constitute a viable operation.
The role of the board (as made clear in the UK Companies Act 2006), is to ensure that the executive delivers this objective in a way that takes account of the wishes of the key stakeholders and reflects the current views of society regarding culturally acceptable standards. Failure to do this will result in failure of the business.
So, unless promoting ESG is the goal of the business, it simply represents some of the factors that the business has to take into account, and give an appropriate weighting, in planning its strategy and implementing its business plan.
More importantly, its current focus on (single) materiality for investment purposes (the impact of ESG issues on the company), appears, especially from a holistic corporate governance perspective, to be the tail wagging the dog: the primary driver is to minimise the impact of ESG issues on the company and boost investment attractiveness, instead of ensuring the company has a healthy culture and viable business model and therefore performs well on these issues.
So far from dismissing ESG’s importance, our approach at ACG has always been that these issues will naturally be addressed in applying holistic corporate governance and are an integral part of the board’s and management’s responsibilities. It should, as a business leader said recently, be seen not only as a solely PR issue, as perhaps it once was, but in in terms of competitive adaptation and the real possibility of board directors exposing themselves to accusations of breaches of duty and claims against them for misleading & deceptive conduct.
Recognising the current lack of globally agreed definitions and standards, companies must therefore do their best to incorporate the standards appropriate to the countries in which they operate and put in place measurement systems through which they can report on performance to the relevant authorities.
While execution of these standards is a management issue, its direction, as always, must be set at board level in a way consistent with its legal obligations under the Companies Act, that is, with the ongoing viability of the company being the focus. This will ensure ESG issues and their materiality are addressed at the right level and in a strategic way, rather than slipping into a distracting side issue.
