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Introduction to ESG: Environmental, Social, and Governance

Updated: Jun 6, 2023

What is ESG?


ESG stands for “Environmental, Social, and Governance” and is an essential framework for assessing organisational sustainability and the sustainability/ethical impact of an investment or business decision. ESG helps businesses address urgent issues such as climate change, biodiversity loss, resource scarcity, social inequality, and financial risks, while also promoting sustainable business practices. ESG:


  • can be used to evaluate the impact of a company on the environment and on human health and society;

  • can be used to set organisational climate/environment/ethical targets;

  • can be used to consider the ethical implications of organisational practices;

  • includes an embedded regulatory function.


ESG principles are applied in business decision-making and investment but can also be applied more broadly across an organisation. It is most typically employed in the field of finance to assess non-financial metrics that may affect the risk profile of a company or investment. ESG principles are used to identify opportunities for business growth. Importantly, ESG is a tool that not only allows businesses to assess their impact on the environment, but also allows companies to assess and predict how the environment will impact their business activities, allowing for proactive action to mitigate risk.


ESG is data-driven, and requires robust datasets and data collection methods, analysis, and research to be effective. Though ESG sits within the financial sector the data is non-financial in nature. Therefore, what is interesting about ESG is that the data will be in many different forms across its three verticals, and part of the challenge is understanding those data.


ESG is complex and multi-faceted, and while the core principles of ESG remain the same, their implementation and significance can differ in interpretation and application depending on the sector in which you are in. The landscape is ever changing, dependent upon breakthroughs in environmental science, green technology, and sentiments among consumers and society. What is most important is that society, consumers and investors now demand more of business, and require organisations to meaningfully contribute to solving climate change and biodiversity loss. Hence, organisations are under greater pressure than ever before to evaluate and improve their environmental performance and social contribution. In addition, a large number of disclosure requirements are coming down the pipeline which will require businesses to disclose their sustainability performance across all ESG verticals. Hence, ESG frameworks are urgently required across all business/NGO/public sectors.


I will here first consider each individual vertical in ESG: Environmental, Social, and Governance.

Environmental

The “E” in ESG refers to the environment, how companies impact the environment, and how the environment impacts companies. We are in the midst of a climate crisis, where both rapid climate change (in this context referring mainly to carbon emissions) and biodiversity loss are increasingly recognised as going hand-in-hand. Natural resources are rapidly changing and disappearing, natural capital shrinking, and we are at risk of losing valuable ecosystem services and functions such as water supply, carbon storage, and food supply.

From an organisational perspective, environmental change can place urgent pressure on supply chains, leading to the scarcity and even disappearance of key resources. Water shortages, for example, can lead to the failure of water-intensive crops such as almonds, or shortages in the drinks industry with water being the core ingredient, for example, in beer. The concept of “Virtual Water”, which will be discussed in a later post, refers to the hidden water in commodities when traded from one place to another. Virtual water allows us to evaluate the environmental footprint of products, services, and commercial exchanges. It is a way of measuring indirect water use and can be used to assess water sustainability in supply chains. Water security is a key aspect of sustainable water management and is a key metric in ESG. Considering virtual water in ESG investing can help promote more sustainable water use, reduce water scarcity risks, and identify investment opportunities in companies that are working to improve their water management practices.


International and national targets with regards to climate change and environmental impact have been established and more continue to be developed and enshrined in law. To achieve these environmental targets, companies and organisations need frameworks to firstly account for their environmental performance, to locate and identify areas in which to make improvements, and methods to monitor and audit their environmental performance into the future. ESG tools can be employed for such a purpose.


Investors are increasingly interested in the environmental impacts of the companies they invest in. They demand more in terms of environmental sustainability which is increasingly recognised as not only a practical necessity, but as an intrinsic need. ESG frameworks can be used to communicate organisational sustainability and risk management efforts to stakeholders and investors.


Vitally, holding global temperatures at 2°C above pre-industrial levels will require a dramatic shift in both public and private investments from fossil fuels to renewable alternatives. Hence, responsible finance initiatives in the form of ESG scores are an attractive tool to set and align organisational sustainability goals.


From a practical perspective, the “E” in ESG considers factors such as a company's carbon emissions, resource usage, waste management, pollution control, and efforts to mitigate climate change. Companies that prioritise environmental sustainability may take actions such as implementing energy-efficient practices, adopting renewable energy sources, reducing greenhouse gas emissions, managing water resources responsibly, and addressing biodiversity conservation.


Social

The social, cultural and human health impacts arising from business behaviours are vital elements of sustainable development. The “S” in ESG is concerned with human health and human rights and recognises the need to meaningfully tackle issues such as exploitative labour, workplace and organisational diversity, gender equity, indigenous rights, and modern slavery. Global supply chains need to urgently address these issues, as well as issues such as employee wellbeing. The social element of ESG should, in my view, range from the global to the hyper-local, depending on the size of the organisation. Initiatives to improve global human health are essential, especially within a global company, but so too are smaller scale initiatives. Please see the following article on indigenous rights, the Just Transition, and risk exposure on this site's associated sister-website ecofooddev.com: https://www.ecofooddev.com/esg-natural-resource-management-amp-the-just-transition/


Social factors to consider in sustainable investing include a company's strengths and weaknesses in dealing with social trends, labour, and politics. Companies that prioritize social sustainability may implement policies and practices to foster employee well-being, support workforce diversity and inclusion, provide fair wages and benefits, ensure safe working conditions, and engage in responsible supply chain management. They may also contribute to community development through initiatives such as education and skills development programs, charitable donations, and volunteering efforts.


Governance

Environmental regulation is increasing across the globe among calls for greater transparency with regards to environmental and social performance in business. Within the ESG framework, governance refers to the systems, processes, and practices that guide the way a company is directed, controlled, and operated. It focuses on the structures and mechanisms that ensure accountability, transparency, and responsible decision-making within an organisation. Governance factors encompass a range of considerations related to the company's leadership, board of directors, executive compensation, shareholder rights, ethical conduct, risk management, and compliance with laws and regulations. It also examines the company's approach to corporate governance, including the independence and diversity of the board, the separation of executive and board roles, and the effectiveness of oversight functions.


The EU has introduced several different ESG regulations in recent years, including the Sustainable Finance Disclosure Regulation (SFDR), Corporate Sustainability Reporting Directive (CSRD), and the EU green taxonomy.


The EU green taxonomy is a classification system that establishes a list of environmentally sustainable economic activities. It is designed to support the transformation of the EU economy to meet its European Green Deal objectives, including the 2050 climate-neutrality target. The EU taxonomy regulation and the Sustainable Finance Disclosure Regulation (SFDR) are implemented together to ensure equal competition and legal certainty for all companies operating within the EU.


The US has been slower than many other developed nations in implementing ESG regulations, but there has been significant progress in recent years. The U.S. Securities and Exchange Commission is poised to roll out ESG disclosure regulations on climate risk and human capital management.


Additional climate risk disclosures, such as those required by the Task Force on Climate-related Financial Disclosures (TCFD), are also becoming more common. The TCFD framework consists of voluntary recommendations that promote transparency leading to better climate risk management.


The TNFD (Taskforce on Nature-related Financial Disclosures) is an international cross-sector initiative that aims to provide a framework for organisations to report and act on evolving nature-related risks and opportunities. The TNFD framework will capture things that the TCFD does not, such as plastics in the oceanic food chain and loss of soil fertility caused by land use change. The full framework for market adoption will be in September 2023.


The TSFD is also now being developed, which will focus on social-related financial disclosures.


ESG regulations vary by country, and staying informed of and compliant across regional differences is critical for companies that do business internationally. The repercussions of non-compliance can be staggering, including large fines, poor reputation, and loss of business opportunities. ESG regulations are not just limited to the financial industry, but also include anti-money laundering regulations and US anti-trafficking laws.

This post aimed to provide a general overview of ESG and its context within business regulation. In upcoming posts I will delve more deeply into each of the three verticals, discussing the criteria for each, the practical implementation of ESG principles, ESG and its relationship to sustainability (and the Sustainable Development Goals), and I will continue on to discuss ESG metrics, dynamics, and reporting. I will also break down ESG by sector, such as food production, construction, property management, retail and more.

Key Takeaways

  • ESG is a framework for assessing organizational sustainability and ethical impact.

  • It helps businesses address urgent issues like climate change, biodiversity loss, and social inequality while promoting sustainable practices.

  • ESG evaluates environmental and societal impact, sets targets, considers ethical implications, and includes a regulatory function.

Environmental

  • The "E" in ESG focuses on environmental factors, including how companies impact the environment and how the environment impacts companies.

  • Environmental change can lead to supply chain pressures and resource scarcity, affecting industries such as agriculture and beverages.

  • ESG frameworks help companies account for their environmental performance, identify areas for improvement, and communicate sustainability efforts to stakeholders and investors.

Social

  • The "S" in ESG focuses on social impacts, including human health, human rights, and issues like exploitative labour, diversity, gender equity, and indigenous rights.

  • Global supply chains need to address social issues such as employee wellbeing and human rights.

  • Social sustainability considerations in investing include evaluating a company's approach to social trends, labour practices, and community engagement, such as promoting employee well-being, diversity, fair wages, and responsible supply chain management.

Governance

  • Environmental regulation and calls for transparency in environmental and social performance are increasing globally.

  • Governance in the ESG framework refers to the systems and practices that ensure accountability, transparency, and responsible decision-making within a company.

  • The EU has introduced ESG regulations, including the EU green taxonomy, Sustainable Finance Disclosure Regulation (SFDR), and Corporate Sustainability Reporting Directive (CSRD), while the US is making progress with ESG disclosure regulations. Additionally, climate risk disclosures and initiatives like the Task Force on Climate-related Financial Disclosures (TCFD) are becoming more common. The Taskforce on Nature-related Financial Disclosures (TNFD) and Taskforce on Social-related Financial Disclosures (TSFD) are also being developed. Compliance with ESG regulations is crucial for international businesses to avoid penalties and reputational damage.

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