Environmental, Social and Governance (ESG) evaluates how a business integrates these three pillars into its operations, ultimately affecting its long-term financial performance and stakeholder relations.
So, what do the three elements of ESG mean and how can they affect – and benefit – corporate performance?
Environmental
This focuses on the effect a company’s activities have on the environment. Environmental concerns have come to the fore in recent years, and businesses, by virtue of their size, will have a greater effect on the environment than individuals. Therefore, they will be held to a higher standard of behaviour and scrutiny, meaning their response to environmental issues must, perforce, be greater too. Energy efficiency will also have beneficial effects on a company’s bottom line with the significant increase in energy costs in the past few years.
Environmental issues don’t just cover the business’ products and services; they also apply to the supply chain, where monitoring at all stages is crucial to maintain environmental probity.
Examples of practices which fall under the Environmental element of ESG include:
- reducing energy usage and prioritising renewables to become a net zero organisation
- developing greener products and services
- switching to zero-waste products or sustainable packaging
- changing to LED lighting and switching lighting off when not in use
- reducing the amount of waste destined for landfill by encouraging recycling and segregation of waste.
It’s also worth bearing in mind that regulatory action can be taken against companies who breach environmental standards and fines as a result of that action can be significant indeed. It make sense, therefore, to get compliance right as part of an overall environmental strategy.
Another area where companies need to pay attention to their ESG responsibilities is overseas contracting, where issues such as the avoidance of child labour in supply chains and the use of Fair Trade initiatives can prove delicate areas to navigate successfully.
In recent years, investors have responded to the increased awareness of – and interest in – green issues by concentrating their investments in environmentally friendly businesses and sectors; in some instances, they are turning their backs on companies who have been accused of “greenwashing” – the practice of making dishonest or cynically misleading statements about how beneficial for the environment a product can be, while at the same time pursuing environmentally damaging practices or processes.
For such companies, the consequences of not being genuine about their environmental credentials can be significant; not just loss of investment capital but a hit to their profitability and reputation damage, a serious matter when environmental activism is on the rise and predominantly online.
Social
A business can’t exist in isolation and the way it interacts with its employees, customers, suppliers and the communities in which it operates will significantly affect its commercial performance.
Subjects like labour practices, human rights and diversity will fall under the category of Social. For many companies, there is an incentive to future-proof their approach to diversity and go further than the law requires, although this means that a finger needs to be kept on the pulse of public opinion to ensure the business doesn’t suddenly find itself out of step.
As with environmental aspects of a business’ operations, the social aspects will apply to the supply chain, emphasising the degree to which no business is an island in today’s interconnected world.
Social and ethical practices that companies can follow include:
- ensuring the safety of products
- making sure that customer data is secure
- providing training and supporting health and safety, and wellbeing
- promoting diversity and inclusivity policies in the workplace
- investing in local community projects
Governance:
This assesses a company’s leadership, executive pay, audits and shareholder rights, focusing on board structure, transparency and ethical conduct. It’s a response to corporate governance scandals of the past and is the subject of official and regulatory codes of conduct, including
It should be noted that the first of these only applies to listed (public) companies, not private limited companies, although the latter can follow it if they wish – but they are not obliged to do so.
Corporate governance controls are often a requirement for investment and shareholders will also be keen to ensure that companies are behaving in a transparent and ethical way. With the rise of the internet and social media, it’s become increasingly difficult to conceal corporate wrongdoing and reports of scandal, even unevidenced, can have a detrimental effect on a company’s reputation.
Practices that will improve and enhance governance practices include:
- accurate reporting to stakeholders on financial performance, business strategy and operations
- ensuring business leaders and managers are accountable for risk and performance management
- undertaking business ethically, such as preventing bribery
- ensuring diversity in any leadership team
- being open about executive pay.
What is the difference between ESG and Corporate Social Responsibility?
ESG is a structured approach used by investors when considering a business’ approach to ethics, sustainability and the way that it manages risk. It tends to focus on creating long-term value. It examines how effectively a company can respond to environmental challenges, social responsibilities and the standards set out in governance regulations. ESG is highly data-driven and is increasingly regarded as an essential feature of business strategy.
Corporate Social Responsibility describes voluntary efforts by companies to make a positive contribution to society and build goodwill. This is often attempted through community-level projects but tends to have mostly short-term benefits, and ones that can’t be objectively quantified. While ESG serves as a framework for investor analysis, CSR centres on socially responsible activities that are not always linked to financial performance.
Examples of CSR initiatives include cutting carbon emissions, improving waste disposal systems, and supporting charitable causes, which may be related to employee concerns and interests.
The benefits of ESG policies
Whether a company has evolved its ESG policies over the course of several years, or whether they’ve been drafted from scratch with industry best practice in mind, strong ESG practices can help to mitigate risks associated with environmental regulations, social unrest and governance failures.
The diversity factor
Earlier, we mentioned diversity and it will have escaped nobody’s attention that DEI (Diversity, Equity and Inclusion) has become a social and political hot potato in recent years. No company wants to get involved in the culture wars, but behaving decently towards all its customers, employees and investors will have commercial and social dividends. Customers are less loyal to a brand – and more socially aware and active – than they used to be, and will often vote with their feet and wallets if they feel that a company’s values (or lack of them) don’t match their own. Similarly, companies who want to attract the widest range of talent to give them that commercial edge will find the pool from which they draw that talent a wide, deep and diverse one. Anything that reduces the attraction of their company to sections of the population will limit their ability to recruit key personnel. Again, the reach of social media means that companies who walk the walk as well as talking the talk will reap the benefits; those who just pay lip service to the notion of diversity and inclusion will find they are swiftly found out.
Who is responsible for ESG reporting?
The larger the company, the more responsibility attaches to any ESG reporting role. For SMEs, it may be a job that the CFO (or equivalent) can handle, but for larger companies with more employees and higher turnover, it may make more sense to appoint an ESG Controller, whose dedicated job it is to stay up to date with relevant requirements and regulations and report directly to the board on progress, compliance and further corporate commitments.
The Corporate Sustainability Reporting Directive
On 5th January 2023, the EU’s Corporate Sustainability Reporting Directive (the CSRD) came into force.
https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32022L2464
The Directive requires qualifying companies to report on how their activities affect the environment and society.
It might be thought that UK firms won’t be affected by this directive, but that’s not the case, as companies based outside the EU will need to follow its requirements if they fall into any of the following three categories:
- Companies with securities, such as stocks or bonds, listed on a regulated market in the EU
- Companies with annual EU revenues over €150 million and an EU branch with net revenue in excess of €40 million
- Companies with annual EU revenues greater than €150 million and an EU subsidiary that is a large company; i.e. meeting two of these criteria: 250+ EU-based employees, €20+ million balance sheet or €40 million local revenue
Not just for the big boys
Although we’ve outlined the benefits of ESG for larger companies, it can also have big benefits for businesses of all sizes, particularly SMEs. It can improve a company’s reputation, underlining its commitment to the environment, diversity and ethical business practices. In an economic environment where every client needs to be won and retained, anything that gives a business an edge could be crucial to their survival and success.
We’ve mentioned above the effect that ESG measures can have on reducing costs for businesses, particularly with waste, packaging and energy usage, and this holds true even more with smaller firms where the margins are that much tighter.
For many smaller companies, finding the right employees at the right time can be the key difference between success and failure and a working environment in which diversity is recognised and championed can be a big advantage when it comes to recruitment initiatives.
How can we help?
If you’re faced with the prospect of drafting ESG policies and practices, it can be a bit daunting. The risk of getting it wrong isn’t something that many businesses want to contemplate, so it makes sense to bring in the experts. Our Business Crime and Regulatory, Employment and Corporate/Commercial teams have wide experience in the varied aspects of ESG and DEI and can walk you through how to ensure your policies and procedures are adaptable and robust enough to benefit your organisation, now and in years to come.