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Time for change — insights into environmental, social and governance

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ESG is an umbrella term for a broad range of environmental, social and governance factors against which investors and other stakeholders can assess the behaviour of the entities they are considering for investment.

ESG refers to the decisions and behaviour of a company or financial organisation in the context of social responsibility or ethical corporate behaviour. It is used to determine whether (based on different criteria and metrics) the companies in which financial organisations invest are adhering to a standard of behaviour that they deem to comply with their relevant ESG goals. This includes whether those companies will subject their investors to too much risk or create opportunities and achieve an operational improvement with a benefit to the environment or society and potentially to the organisation’s financial performance.

Crucially, ESG is not simply about seeking compliance with current regulations. It also entails instilling a cultural commitment in a company to improve the key ESG factors associated with its activities. This is irrespective of whether or not that company is heavily regulated. ESG focuses on the potential for a company to have a more positive impact on the world alongside seeking to make a financial return.

Is ESG a new idea?

ESG is increasingly becoming the preferred term for concepts that revolve around business integrity and corporate ethical behaviour. Similar concepts were previously referred to as corporate responsibility (CR) or corporate social responsibility (CSR). ESG has now largely replaced CSR as the term used most often (although the terms ESG and CSR are sometimes used interchangeably). The shift is driven by the fact that ESG appears to be the term of choice for investors, which in turn has been passed on to businesses.

What are the different elements of ESG?

The environmental aspect of ESG measures a company’s impact on the natural environment. It takes into account factors such as climate change, biodiversity, use of resources and management of waste, and pollution of air, water, and land.

The social aspect of ESG measures how a company treats employees, customers and the wider communities in which it operates. It includes diversity and inclusion (D&I), equal pay, human rights (including modern slavery and child labour) and stakeholder and community engagement.

The governance aspect of ESG measures how a company operates in terms of audits, board diversity, internal controls and shareholder rights. It includes bribery and corruption, executive pay, board independence, diversity and structure, and conflicts of interest.

Taken together, these factors help investors and other stakeholders to measure the performance and ensure the accountability of companies. The factors that are relevant to a particular business will differ depending on the sector and the countries in which the business operates and its supply chain.

What is ESG investing?

ESG investing is investing that takes ESG factors into consideration, in particular, managing risks that could decrease returns and seeking to achieve a superior return in the long run. It could also include a specific decision to exclude certain types of investment (for instance excluding investments in organisations involved in tobacco). An investor who is only concerned with financial return might also decide to exclude investments in specific sectors that it perceives as high risk.

How has ESG become important?

One of the key drivers for the rise in ESG has been increased public concern for the environment and for social equity. This is reflected in pressure for investments to be made ethically (especially in relation to pension funds). Pension funds are significant investors in public companies, real estate, and private equity, and they have been increasingly willing and able to take positive steps via their direct investments, attaching ESG conditions or influencing behaviour through their voting rights.

Financial institutions are engaging closely with the risks to investments associated with ESG issues. Climate change is one of the most urgent ESG issues, and recognition of the severity of the risks from climate change has grown exponentially over recent years. International initiatives such as the UN’s Race to Zero and Net Zero Asset Owner Alliance, and the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD) have gained traction and are setting new benchmarks for investor expectations from companies.

Is it all good news?

There are several challenges to ESG implementation:

  • Providers of ESG data and ESG ratings are largely unregulated, leading to lack of transparency, risks of inconsistent or conflicting data, gaps in data and loss of confidence.
  • High costs are involved in aggregating data, producing ESG reports, benchmarking performance, producing profiles and creating new sustainability-based products.
  • ESG factors are complex (in particular social factors) and there is no definitive, industry-wide definition.

Many commentators have serious concerns about greenwashing, that is, where companies exaggerate their green credentials or make misleading green claims. EU and UK work on sustainable finance seeks to address the risk of greenwashing, but the complexity of ESG issues and measurement, and the lack of unified frameworks for assessing and comparing risks bring significant challenges.

Recent criticism goes even further and argues that ESG investing risks harming, rather than helping, the causes that it purports to support (not least because it creates a distraction from effective action on these issues). Critics also suggest that there is less overlap between ESG purpose and investment profit than proponents for ESG investment claim, in part because ESG issues are often very long term and so are not relevant to the short timelines of many investment strategies.

Despite these concerns, investment funds that focus on ESG issues are growing in popularity. Companies expect climate and ESG issues to continue to gain traction and are addressing pressure from investors through a range of measures, including their governance structures, stakeholder engagement, public disclosures and specific targets and strategies.

What next?

ESG-related regulation is increasing apace. The UK government is rolling out mandatory TCFD reporting by large companies and financial institutions across the UK economy by 2025. The Environment Bill 2021-22 includes clauses seeking to prevent illegal deforestation by controls on the UK’s international supply chain. The Pension Schemes Act 2021 includes provisions regarding UK trustees’ governance duties in relation to climate change risk. The package of EU sustainable finance regulation seeks to integrate ESG considerations into the investment and advisory process in a consistent manner across sectors, and the UK government and regulators are working on similar legislation and regulation post-Brexit. The European Commission is developing a sustainable governance initiative that could include duties on companies to address human rights and environmental due diligence in their supply chains. The US Securities Exchange Commission is working on enhancing disclosure requirements to include material ESG factors.

What does this mean for law firms and their clients?

Lawyers need to understand what the growth in ESG means for their clients and for the way they run their own practices. Many large firms have already pivoted to form practice groups focussing on ESG advice and are reporting very strong client demand for these services from corporate and financial clients.

Law firms are also being asked about their own ESG credentials when pitching for business, responding to supply chain questionnaires, or when recruiting talent, which leads them to look at their own environmental policies and diversity and inclusion metrics. As a result, firms must examine their own processes, including staff training and recruitment, travel policies, and procurement, as they transition to meet best ESG practice.

In future articles, we will be taking a closer look at how ESG issues affect different sectors and organisations, such as corporates, banks, private equity investors and professional services firms.

Authored by Senior Editors in the Practical Law Team

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