What is ESG?
Written by Tim Greenhalgh
ESG provides a framework for socially-conscious investors to look beyond the financial metrics of business and make better investment decisions. It has evolved over the past 20 years in particular in response to growing awareness of the implications of a company’s actions for business performance.
What does ESG stand for?
ESG stands for Environmental, Social, and Governance and it’s a means of providing ways to measure the level of sustainability and social responsibility within a company.
An ESG framework provides criteria for investors to measure in an effective way with some precision the impacts a company’s operations have environmentally and socially. The three elements help investors to understand more fully a company’s business strategy and helps to give stronger data on future performance.
The criteria around environmental engagement look at how a company impacts on nature and ways it manages this relationship. The data could, for example, include the company’s energy use and its methodologies for waste disposal and levels of pollution it generates. Other factors might include treatment of animals and conservation of natural resources.
Data provided in any ESG evaluation could also be useful in highlighting the potential environmental risks that a company might have to manage, including full compliance with official regulations and ongoing challenges such as safe disposal of toxic by-products to containment of hazardous emissions.
ESG criteria will also provide detailed information on broad social performance, how effectively a company manages relationship internally with its employees and externally with customers, suppliers, partners and the wider community.
The data will give clear indications of the “social health” of a business, from the way it chooses to work with suppliers that hold similar values, to how it interacts with all stakeholders. The information will advise on how it treats employees, the style of human resource management, and health & safety policies, as well as the ways it encourages community engagement in its workforce.
ESG data on governance will give details on the business’s leadership team, its pay and what internal controls are in place, as well as the auditing processes and the engagement with shareholders, along with their voting rights.
This information should reveal whether a company is operating fully within the law, and that it has taken steps to ensure that there are no conflicts of interest in the choice of board members. The data should show the ways it might engage with the political sphere through financial contributions and the degree to which it has clear and precise accounting methodologies.
Why ESG is important
ESG frameworks have developed out of the culture of corporate social responsibility and in doing so, have extended the scope beyond the ethical sphere to focus on a view of business that accepts the wider implications for sustained success. A company can be extremely profitable and fulfil shareholder obligations in the narrowest sense, but whether it can survive in the long term is determined, to a greater extent by ESG performance.
ESG and responsible funds have grown rapidly in the past few years with younger investors focussing on sustainability. The Investment Association reports that responsible funds have taken £6.7 billion of investment in the first half of 2021 – £2.4 billion more than the previous year.
It’s also true that in the UK, the government is in the process of developing strong ESG regulations to support its vision of a green industrial revolution, fulfilling the 2050 net zero target and ensuring a robust and sustainable economic recovery from the COVID-19 pandemic.
The ESG regulatory framework will also be underpinned by legislation that should match or improve on human rights standards and sustainability covered by European Union laws and globally.
Currently, the UK does not have a comprehensive piece of legislation governing ESG but there are sets of regulations that do cover elements of best practice that businesses may need to comply with These are contained in a number of legislative sources and official guidance, including:
- Disclosure Guidance and Transparency Rules
- UK Stewardship Code 2020
- UK Corporate Governance Code 2018
- Modern Slavery Act 2015
- Climate Change Act 2008
- Companies Act 2006
- Bribery Act 2010
ESG reporting is largely not mandatory at the moment but this will change. But some companies do have to measure and report on some elements within ESG frameworks, including greenhouse gas emissions, energy use, gender pay gap, and prevention of modern slavery.
In the absence of comprehensive ESG legislation, some companies, notably Marks & Spencer and Lloyds Banking Group have taken steps to develop their own comprehensive frameworks for reporting on environmental, social and governance strategies.
Most other companies are to a greater or lesser extent, engaging with ESG practices, driven in part by the growing number of investment funds that seek this level of detail.
With the COP26 climate summit in Glasgow (November 1-12), minds are focussing on sustainable, environmentally conscious business. The Task Force on Climate-Related Financial Disclosure (TCFD) has gained some traction in the UK with the Chancellor alerting companies that mandatory reporting of climate-related financial information in accordance with the TCFD guidelines will be implemented across the economy by 2025.
With the G7 also reported aiming to back mandatory climate disclosures, the impetus for companies to fully embrace ESG frameworks is growing rapidly.
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