Environmental, social and governance (ESG) frameworks have over the years become significant to assessing an organisation’s business practices and performance on sustainability and ethical issues. They also provide a way to measure business risks and opportunities in social and environmental performance. This is often critical in the extractives sector because of the magnitude of their operations on the environment and host communities.
In other words, ESG is designed to measure the impact (both positive and negative) that a business has on the environment and on society – including an assessment of the governance practices (or lack thereof) which impact all stakeholders (including shareholders and host communities). Generally, investing in businesses that embrace ESG is often referred to as sustainable investing, responsible investing, impact investing or socially responsible investing (SRI).
First coined in the groundbreaking report of 2004 ‘Who Cares Wins’ (a collaboration of the UN Global Compact, the International Finance Corporation, and the Swiss Government), ESG comprises financial and non-financial environmental, social and governance factors into corporate reporting. Initially used to aid investment decision-making, ESG now increasingly influences the decision-making of employers, employees, customers and host communities.
The foundation of best practice ESG reporting is an assessment of ESG performance against environmental, social and governance criteria. Improved ESG performance is achieved by establishing good corporate governance practices that effectively identify, manage and mitigate the social and environmental risks of a business. Undoubtedly, improved ESG performance makes a business more sustainable, strengthens wider capital markets and leads to better outcomes for society and the environments on which the business entity depends for the right to operate and succeed.
Assessment of ESG
Presently, there isn’t a globally accepted standard, assessment methodology or checklist to measure the ESG performance of a business. In practice, however, all ESG performance assessments attempt to measure the impact operations of a business have on the environment and society – including an assessment of how well a business is governed to manage those impacts. There are three critical aspects of ESG – Environment, Social and Corporate governance.
The environmental aspect assesses the impact a business has on the natural environment and should include the impact from production, use, transportation and disposal of a business’s products or services. Environment should include an assessment of:
- Natural resources sourcing, use, management and conservation
- Impact on biodiversity and the treatment of animals
- Air pollution – especially greenhouse gas (GHG) emissions and carbon footprint
- Waste management and discharges into land and water
The use of toxic chemicals and management of hazardous waste
- Energy use and conservation
- Environmental risks and how well those risks are managed (contaminated land, natural disasters, climate change, etc.)
- Compliance with environmental regulations
The social aspects assess impacts a business has on society and the relationships it has with its stakeholders – including employees, consumers, suppliers and the communities in which they have the social licence to operate. The social components similarly include societal impacts associated with the full life cycle of a business’s product or service delivery. The fundamental aspects include an assessment of:
- Respect for and observance of human rights
- Working conditions and fair labour practices – including those of suppliers and the supply chain
- Hiring practices, employee engagement, equal opportunity, gender, diversity and inclusion
- Occupational health and safety management
- Community relations, initiatives and engagement
- Customer satisfaction
- Social risks and how well they are managed.
- Social licence to operate (SLO) and meeting the expectations placed on a business for societal acceptance.
Governance assesses how well a business is governed, the composition and transparency of its Board of Directors and the degree to which governance practices identify, manage and mitigate the environmental and social impacts of a business. Governance issues should include an assessment of:
- Board structure, diversity, experience and independence
- Executive selection (including conflict of interest), committees and compensation
- Board transparency and shareholder rights
- Board understanding of and commitment to ESG
- Corporate codes of conduct, procurement practices, business ethics and values (including bribery, fraud and corruption)
- Lobbying and political contributions
- Data protection, privacy and security
- Corporate risk management and how well risks are managed (actual and potential lawsuits, supply chain interruptions, natural disasters, regulatory change, loss of reputation and brand value)
- Compliance with financial regulations, accounting standards and disclosure requirements
Significance of ESG to Companies and Boards
- Improved Access to Capital
ESG is a product of the 2004 collaborative initiative between the UN Global Compact and CEOs of more than 20 major financial institutions with assets under management (AUM) of over US$6trillion. The initiative establishes that integrating environmental, social and governance issues into investment decision-making – and thus capital markets – reduces business risk, improves long-term corporate performance, strengthens financial markets and delivers more sustainable outcomes for society. In 2021, ESG AUM was US$37.8trillion and ’are on track to exceed US$53trillion by 2025 – representing more than a third of the US$140.5trillion.
The notion is that businesses with better ESG performance tend to be more sustainable, provide better long-term returns to investors, and will have greater access to the ever-growing pools of ESG capital. Conversely, businesses with a poor ESG performance – or those that do not incorporate ESG factors into corporate performance reporting – will increasingly be seen as riskier, less sustainable; and will be less able to access capital. This means that the responsibility of corporate management does not stop at getting profit. Corporate leaderships have an equal responsibility to their stakeholders. As such, corporations – especially those in the extractives industries – have external social, environmental and ethical goals, and not just internal business goals. Organisations must therefore consider other stakeholders in their decision-making.
- Improved Risk Management
As the world is rapidly changing, environmental and social factors increasingly and irreversibly impact the lives of both rich and poor. The externalities of businesses (environmental and societal impacts of a product or service) are increasingly being seen or assessed for what they truly reflect, which is a risk to the sustainability of a business. In other words, ESG is the new lens by which investors, employees, and society at large view the companies they host, invest in, work for and buy from. The assumption is that businesses which incorporate ESG best practices into their governance, operations, mindset and ethos will be incorporating best practice risk management into their business.
- Better Financial Performance
In a more ‘globalised and competitive world’, the improved management of environmental, social and corporate governance issues will ‘increase shareholder value’ and ‘have a strong impact on reputation and brands, an increasingly important part of company value’.
Furthermore, by incorporating ESG-thinking into governance and management, a business regularly and systematically assesses both financial and non-financial factors that could affect its long-term sustainability. ESG-led businesses thus have a wider and longer-term view of the risks and opportunities that could impact their operations. It presupposes such companies are better-armed to identify risks sooner, manage them better and simultaneously recognise opportunities to take advantage of them. In a rapidly changing world, ESG provides a business with the framework for better risk management, improved social and environmental sustainability, and better overall financial performance. Doing what is right, fair and just is expected of responsible corporations.
Consequences of non-compliance
As the world is rapidly changing, so too is investors’ tolerance toward businesses with poor governance practices and unsustainable environmental or social impacts. Today, corporate ESG leaders are enjoying access to, and inclusion in, an ever-increasing pool of ESG funds. Conversely, companies with poor ESG performance are being excluded from this growing volume of ESG funds, and some – in the case of companies associated with deforestation and environmental degradation across the world – now face disinvestment from the portfolios of reputable asset management firms. Thus, businesses that ignore ESG and human rights violations do so at their peril.
Just as there is no single standard assessment methodology for ESG performance, there is no single reporting format for ESG transparency and reporting…for now. There are, however, several reporting standards that, if used, will deliver what could be considered ‘best practice’ ESG reports. The upsurge and adoption of social media has increased a bottom-up, democratised flow of information on the lack of or misreporting on ESG. The power of ordinary people to expose corporate poor performance has a tendency to undermine corporate brands.
Global Reporting Initiative Universal Standards
Over the years, concerns about corporations’ social performance have been reflected in the notion of triple-bottom-line of economic prosperity, environmental quality and social justice. Subsequently, a variety of global standards for non-financial reporting and principles have been developed. Some of the key initiatives are the Global Reporting Initiative (GRI) and UN Global Compact. Established in 2009, The Global Reporting Initiative (GRI) is an independent, international organisation founded to help businesses (and other organisations) take responsibility for their social and environmental impacts. The GRI aims to provide ‘a global common reporting language’ to communicate those impacts. The GRI reporting standards are recognised as ‘the world’s most widely-used standards for sustainability reporting’ and comprise 45 Universal Standards. The standards uphold that it is in the best interests of an organisation to behave ethically. This perspective is one of enlightened self-interest and represents the business case for corporate social responsibility (CSR).
Beyond financial incentives, having a good reputation as an ethical organisation represents an asset that enables premium pricing and is attractive to potential and existing employees. The growing importance of ESG reporting and the ever-increasing and significance of GRI and the UN Compact make a compelling case for businesses to think beyond financial incentives. Corporations, especially those in the extractive sector, must become moral agents with a commitment to improving community well-being through the equitable distribution of a corporation’s profits.
Challenges to implementing ESG
Some of the factors which may hinder an ESG policy include regulatory obstacles (e.g., narrow interpretation of fiduciary duty); low buy-in from critical stakeholders (e.g., politicians); lack of portfolio diversification; and weak institutional capacity.
Implementing ESG in investment approaches presents four main challenges. First, a uniform definition of ESG is still lacking as investors consider many factors under the broad term ESG. Second, investors lack consistent accounting frameworks and disclosures – constraining their ability to compare and assess investments across all areas of ESG. Third, empirical research on the impact of applying ESG on financial returns is still inconclusive, especially in the fixed-income space. Fourth, measuring whether impact investment achieves its desired effects is difficult.
These challenges, notwithstanding environmental and social factors, increasingly and irreversibly impact our lives. This makes it moral and business sense for corporations to regularly and systematically assess both financial and non-financial factors that could affect their long-term sustainability. This is in tandem with Principle 7 of the UN Compact, “Businesses should support a precautionary approach to environmental challenges”.