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What is environmental, social, and corporate governance (ESG)?
While financial institutions were once focused singularly on the creation of wealth, pressure to behave more ethically and responsibly has prompted firms to consider investments that serve environmental, social, and corporate governance (ESG) goals.
Since the 2008 financial crisis, public awareness of corporate financial behaviour has increased significantly. The integration of ESG in the corporate landscape has led to a culture of sustainable investing and products that are designed to meet sustainability goals, such as a reduction in carbon emissions and pollution, or the promotion of biodiversity.
With sustainable finance becoming a priority in jurisdictions around the world, many regulators are taking steps to add ESG factors to the financial compliance agenda. With that in mind, it is important that financial institutions understand and consider relevant ESG factors within their jurisdiction, and how they might affect their compliance obligations.
The evolution of ESG
Sustainable investment trends and their ESG considerations emerged from several 20th century trends. In the United States and other western countries, the 1960s and 70s saw a rise in philanthropic and socially conscious investment initiatives, promoting issues like affordable urban housing, access to healthcare, and Third World development. One of the most prominent examples of ESG-motivated investment was the global reaction to the South African apartheid regime: governments around the world mandated corporate disclosure of investment in South Africa, leading to mass disinvestment and calls for an end to the regime. In the late 20th century and the early 21st century, environmental factors gained greater corporate traction and led to the development of green investment products focused on addressing pollution, habitat destruction, and climate change.
As these factors have become more important on the financial landscape, their scope has expanded to cover a range of sustainability concerns. With that in mind, they may be defined in the following way:
- Environmental. The impact that a company has on the environment and on climate change, including its energy consumption, waste disposal practices, and carbon emission levels. Environmental issues such as the destruction of natural habitats, deforestation, and the treatment of animals are also relevant.
- Social. The promotion of inclusivity, diversity, and equality within a company, and the treatment and safety of employees. Social factors may include the impact a company has on the communities around it or in which it does business, and include volunteer schemes, sponsorships, and partnerships.
- Governance. The manner in which a company governs itself, makes ethical decisions, deals with conflicts of interest, meets the needs of stakeholders, and complies with the laws of its jurisdiction.
The criteria that define these factors are not hard and fast, and overlap in certain contexts: pollution and waste disposal may, for example, converge with community engagement concerns. Similarly, governance considerations call for firms to not only obey the letter of the law but its spirit, ensuring transparency and ethical practices, and the need to get in front of potential compliance violations before they occur.
Assessing ESG factors
ESG factors have traditionally been used to assess a company’s ethical performance although the assessment process may be inconsistent given the value placed on certain sustainability concerns by different stakeholders.
As sustainability issues have gained more importance in public and political discourse, and green investment products become more available, such factors have also become pertinent to financial performance: companies that engage in negative environmental practices, that fail to meet emissions standards, or that mistreat employees, often suffer significant financial consequences. Similarly, ESG-focused firms that disclose and promote their sustainability credentials and sustainable products may attract more interest in some segments of the market.
It is also important to remember that the significance of these factors varies by industry and expose companies to different types of sustainability concern. Financial services providers, for example, may be more concerned with business ethics and employee satisfaction than carbon emission levels and ecosystem preservation.
The rising public focus on sustainable awareness has prompted legislators to introduce mainstream ESG regulations in jurisdictions around the world. In addition to imposing sustainability standards and practices, most ESG legislation involves some requirement for corporate disclosure or record-keeping.
While global standards vary by country, the primary international ESG regulation remains the Paris Agreement (PCA) which was signed in 2015 by 197 countries, including the world’s largest economies. An EU initiative, the PCA specifically concerns climate change and commits signatory nations to reducing their carbon emission levels via domestic legislation.
The EU has become a world-leading jurisdiction in its implementation of ESG legislation. The EU’s Action Plan on Financing Sustainable Growth (2018) set out a framework for new regulations, while the subsequent EU Green Deal (2020) set out regulatory reforms in order to encourage EU firms to pursue sustainable business objectives. The EU has a number of reporting regulations that require firms to disclose their ESG credentials: the Sustainable Finance Disclosure Regulation and the Non-Financial Reporting Directive. Post-Brexit, the UK has introduced the Green Finance Strategy which broadly reflects the EU’s Action Plan.
Regulations in the US
While the US Securities and Exchange Commission (SEC) does not mandate corporate disclosure of ESG factors (with some exceptions), it has released guidance on how to handle the process as part of its existing disclosure framework. In more detail, the SEC recommends a principles-based approach to disclosure that emphasizes ESG issues a reasonable investor would consider pertinent and which reflect emerging sustainability issues.
The Securities and Exchange Commission recently proposed new ESG disclosure regulations. A SEC statement from 2021 outlined the importance of a standard metric for corporate ESG disclosures, and the need to be ‘adaptive and innovative’ to deal with the realities of climate risk. Accordingly, the proposed national system of effective ESG disclosure would consider the following questions:
- What types of ESG disclosure would be most useful for disclosure?
- How should the disclosure strike a balance between principles and metrics?
- How can ESG disclosure be standardised across industries?
- When should ESG disclosure standards be updated?
- How should US ESG disclosures be analysed against global data?
- How can companies use disclosure information with existing data to make decisions?
The SEC has invited public input on new ESG disclosure regulations with a focus on obtaining data to assess ‘the materiality of climate-related disclosures’. As part of its proposal, the SEC has asked for feedback on the effectiveness of a ‘comply or explain’ ESG disclosure framework (reflecting the existing disclosure framework). Under such a framework, companies would be required to either comply with their ESG disclosure requirements or, alternatively, explain why they have not.