What Is ESG – Environmental, Social, and Governance – and where did it come from?

The recent COP27 conference has been another reminder of the importance to us all of sustainability and the drive to net zero. That makes it an appropriate opportunity to look at ESG standards – ESG meaning EnvironmentalSocial and Governance. For business, much focus in the sustainability space has been linked to the development of ESG policies.

In today’s world, with such significant concern about climate change, the focus with ESG often seems to be the E – environmental. However, it must be looked at as much wider in scope to include the S and G as equally fundamental considerations.  

The move from purely environmental concerns – and the wish by campaigners to make businesses take responsibility for the detrimental impacts of their activities – to the wider ESG agenda today has been taking place over decades. These attitudes broadly start with the development of the importance of “sustainable” development, into the EU driven Corporate Social Responsibility (CSR) strategies, and on to the more widely defined ESG approach today.

The development of ESG has been driven largely by the financial sector. This approach was developed as part of the sector’s demonstration of “responsible investment”; this was based in part on the presumption that businesses that do deliver good performance in relation to ESG, and demonstrate that they are good corporate citizens, will increase shareholder value.   

The support for promoting ESG is that properly developed policies which are well delivered by a business will help it to develop sustainably, as these policies will help to identify, assess and manage risks (including protecting against action from regulators) and assist in developing new markets. This drives company value, both because the business can be seen to be reducing risks which should benefit its longer-term growth and from the reputational and brand benefits of being seen to be acting sustainably and ethically. The focus placed on ESG by financial institutions and investor pressure has led to ESG policies spreading into the wider business community. 

How do ESG policies work in practice?

Examples of what the different strands of ESG should (or could) measure are:

Environmental – the impact of the business on the natural world, and vice versa.  This could include carbon footprint, pollution, waste and impacts on biodiversity, use of water and energy efficiencies.

Social – the managing of the relationship with customers, the communities in which the business operates and its workers, health and safety, human rights, diversity and inclusion.  

Governance – anti-corruption and bribery, board diversity, audit and compliance, internal business controls and shareholder rights. 

The protections that flow from a developed ESG strategy are seen as both operational and strategic. This developed approach should provide security against litigation, or regulatory action against breaches of its obligations by the business, help reduce operating costs by focussing for example on resource efficiency, allow better dialogue and relationships with shareholders, workers and customers, ensure a valuable assessment of likely business disruptions and protect the business from reputational harm.

ESG – should you/must you report on what you are doing? 

Some businesses in the UK must report on ESG under mandatory reporting requirements. The UK government and financial sector regulators have clearly been looking to expand the obligations for businesses to report on climate related risks, with the increased requirements to report under the Task Force on Climate Related Disclosures (TCFD) in the UK coming into effect most recently in Spring 2022. It is therefore vital that businesses know, and keep under review, the specific regulatory requirements that mandate reporting by it in relation to ESG issues.  

Even if not obligated to report, many other businesses will be expected to report by virtue of contractual commitments imposed on the business, and some simply choose to report. As well as being required by business relationships (such as insurers and investors), there appears to be growing demand from customers and workers for the businesses they engage with or work for to demonstrate their commitment to environmental, ethical and sustainable standards. For this reason, the relevance of ESG is not just for large businesses. 

Does ESG add value? Does it bring benefit or risk?  

We have talked about ESG driven from the investment world, where the key benefits can include 

  • enhancing investment opportunities
  • reducing legal or regulatory actions against the business
  • helping to identify business savings by moving to reduce waste and overheads, such as energy. 

For individuals – your customers and employees – because ESG attracts significant public attention it can be seen as a positive draw to a particular business.      

Customers choose who to buy from based on many different factors, but a business’ stance on ESG is growing in cultural importance and can be expected to sway some customers in their choices.    

With recruitment proving a challenge for businesses, ESG can be one element of a positive People Culture, inspiring people to join, or stay with, a business. ESG is therefore seen by many businesses as an important part of their strategic development, even if they are not yet required by regulation to report. 

Many smaller businesses providing goods or services to larger businesses may also find that the supply chain requirements will involve ESG reporting. Collating information to report on ESG can be resource heavy. That can be a significant disadvantage for smaller businesses because of the administrative time taken up. Particularly in the currently very difficult economic climate for businesses, the additional load on a small team of complying with complex reporting required by a customer or supplier could make a difference to the viability of a commercial relationship.  

There are dissenters to the view that ESG is unreservedly “a good thing”. Even in the investment world there are commentators that say that the idea that pushing ESG investment will solve the long-term, significant problems that we face like climate change exaggerates the possible effects of ESG focussed investing. The simple mismatch between the usual timetable for investment (short term) and the immense time it will take to “solve” climate change demonstrates the likely limited effect. The lack of standardisation and regulation in the reporting of ESG also leads to questions as to whether the investment sector is delivering the positive impacts from ESG that are claimed.   

Another key problem with ESG is that there are not comprehensive and objective sets of criteria and rules measuring ESG and delivery against ESG policies. Although steps are being made (such as with the TCFD reporting requirements aiming to provide consistent information on the material financial impacts of climate change), each company’s decisions as to its wider ESG policy objectives, how it delivers and measures the success of those objectives are unique to it. That can make a proper interpretation of a company’s ESG behaviour difficult to assess and opaque. It makes it harder to compare different businesses activities and their claims as to their aims and achievements.  

The development of common definitions, methodologies and metrics for ESG standards would increase transparency and bring increased trust in the data being delivered by businesses. That lack of transparency and consistency is one reason for the growing concerns about greenwashing.  

What is greenwashing?

Greenwashing, put very simply, is where actions are presented as environmentally sound, green, sustainable or ethical when the balanced reality is different. Evidence is growing that individuals (customers) are seen positively to value those businesses that make a commitment to act ethically. That means that there could be a disadvantage to business caused by a competitor’s over-egging (or misleading) as to its ESG performance.    

Reputational harm for getting ESG wrong – whether greenwashing or otherwise – must be seen as a significant risk of harm to reputation.  

As well as the negative PR that could follow claims of greenwashing, it is also clear that regulators take this seriously. To demonstrate, the US SEC set up a greenwashing task force as part of its enforcement activity; in May it was reported to have issued a significant fine ($1.5m) against a division of BNY Mellon in response to allegations of misstating and omitting information in prospectuses and other documents about ESG investment considerations for its managed mutual funds. Although with a lower financial consequence, the UK’s advertising regulator, the ASA, recently banned HSBC advertisements because they found that the ads were “misleading” about the bank’s work to tackle climate change.  

What does ESG mean to your business?

It is important to consider ESG through the lens of positive engagement. If a business is to start to develop ESG strategies, the business case for the choices made needs to be considered carefully. What is the benefit to the business in what is being proposed? What are you trying to achieve? What are the risks to the business of over-scoping, and then under-delivering, or failing to achieve your aims? A link between an ESG strategy and the core business aims will normally help with delivery because of the effective tie to your business activities. 

The three strands of ESG cover very different elements, some of which will almost certainly be being done by the business under a different guise (eg health and safety issues). As a smaller business, consider starting by selecting certain limited areas that can it objectively impact and measure and look to develop wider strategies from there.  

The wider benefit of ESG is almost certainly not being seen as the means for a business simply to ensure compliance with its obligations. Its benefits instead flow from the demonstration of a cultural commitment of the business to having a positive impact. That positivity becomes increasingly important to businesses in a world where the reputational harm which can follow from individual customer, employee or stakeholder pressure can quickly magnify.     

Key takeaways for your business?

  • Have a transparent, honest approach to showing how your business deals with ESG  
  • Know your reporting obligations
  • Set your ESG agenda and policies with care and consideration
  • Understand your business reasons for your ESG strategy
  • Don’t over-promise
  • Don’t under-deliver
  • Don’t mislead

How Moore Barlow can help

John Warchus is a partner in the Moore Barlow Commercial and Technology team, providing advice to business clients across a broad spectrum of commercial matters, including commercial contracts, data protection, IP and IT. John works to provide the pragmatic commercial advice that the business needs to develop and thrive. If you would like to contact our commercial team with regard to your business needs, we will be delighted to speak with you.