In recent years, with increased awareness of the impacts of human activities on the environment and society, there has been a growing interest in investing in sustainable projects. One of the main conceptual frameworks that have taken center stage is the acronym ESG (Environmental, Social, Governance).
This article focuses on the different concepts in the ESG acronym and their meaning in the context of sustainable investment.
“E” for environmental impacts
Environmental criteria also referred to as environmental factors, which are hidden under the letter “E”, are one of the three basic categories of ESG criteria or factors and, together with social and governance, form the basic frame of reference for non-financial reporting.
The area addressed by the environmental criteria is the environmental impact of the resource consumption and activities of the company subject to ESG reporting. Whether this is to reduce the impacts of climate change or to reduce as much as possible the pollution that occurs as a result of the company’s activities as a whole, i.e. also throughout the supply chain.
The objectives that companies should pursue are, in particular, the reduction of greenhouse gas emissions (reduction of the carbon footprint), the efficient use of energy and the maximum use of clean energy sources, the streamlining of waste management, and the disposal of packaging materials.
Why track environmental impacts?
Evaluating environmental criteria is an important part of ESG reporting and, in particular, of investing or accessing investment capital. Environmental analyses allow investment managers and investors to assess the environmental impact of a company’s business and how the company is working to reduce its environmental footprint. Businesses that monitor environmental factors and actively work to reduce their emissions and environmental footprint, and where these activities are reportable through ESG reporting, are more likely to succeed in the long term and are more attractive to investors.
“S” for social
The social factor (“S”) refers to social factors such as employee rights, health and safety standards, gender equality and pay equity – issues that can harm society. It also examines internal policies relating to issues such as inclusion, and the company’s relationships with employees, customers, and other stakeholders. Product safety and quality and consumer protection are other of the many social indicators taken into account. It should be stressed that monitoring these (and the following) indicators not only aims to improve working conditions for employees and relations inside and outside the company but also, and for some businesses in particular, to improve the overall performance and profitability of the company, as well as to improve the company’s image to business partners and consumers.
As part of ESG reporting, companies are obliged to monitor these parameters and social phenomena and include relevant information and analysis in their reports. Mandatory so-called indicators include, for example, (i) engagement process and grievance mechanisms for own workers, (ii) description of own workers (by time and relationship, gender and region), (iii) OSH indicators, (iv) gender pay gap and overall, and (v) serious incidents related to labor and human rights.
The importance of social factors for business activity
The financial performance of a company can be affected by several social factors that can cause short-term as well as long-term problems. So why not underestimate the monitoring of social factors?
- The demands and composition of the company’s workforce may present challenges in the future. Employee strikes or consumer protests can directly affect a company’s profitability by causing a shortage of qualified employees or controversies that damage the company’s reputation.
- Companies that ensure that their products and services do not pose security risks and/or minimize exposure to geopolitical conflicts in their supply chains typically experience less volatility in their business.
- Long-term changes in consumer preferences are influenced by complex social dynamics, ranging from surges in public opinion on the internet to physical strikes and boycotts of companies by various groups. Decision-makers, or investors directly, may see them as important indicators of a company’s potential.
- ‘Sustainable’ investors will seek to minimize the risks that social factors pose to returns. As with investing in ESG as a whole, showing a preference for companies that pay attention to these social issues can be a way for investors to reflect their values when investing while leading to higher and more reliable returns over the long term.
“G” for corporate governance
The governance aspect of ESG deals with corporate governance and transparency concerning shareholders and other stakeholders such as business partners, investors, and employees. ESG governance sets structures and protection schemes and provides important rules for everyone and the company to follow, such as a company-wide code of conduct for employees. When you see a company involved in a scandal or having bad media publicity because of internal misconduct, it is usually the result of a failure of ESG governance.
Key ESG governance topics include shareholder structure, board or management diversity, executive compensation, corporate policies, business ethics and conduct, tax and general financial transparency and strategy, risk management, non-competitive practices, data protection, privacy and cybersecurity, defined ESG decision-making structure, and many others.
ESG governance refers to the implementation of decision-making, board oversight, rules, policies, and procedures across the enterprise relating to ESG. Businesses with strong ESG governance practices typically have accountable owners and leadership teams, clear ESG accountability structures, and structured controls over internal company processes and procedures.
When a company wants to streamline its governance mechanisms and bring them into line with ESG legislation, it usually takes constructive steps in one or more of the above areas. Using independent auditors, diversifying governance bodies, implementing data protection measures, improving the accountability of managers, or developing, updating, communicating, and training employees on important ESG principles are examples of ESG governance in practice.
Why is ESG governance important?
Investors, regulators, and customers are looking for companies that demonstrate sound financial decision-making and business performance while making a positive contribution to the environment and society. ESG governance encompasses, among other things, risk management and is considered by many investors and analysts as a proxy for overall governance quality. Because corporate governance has been around longer than most environmental and social practices, there is a wealth of historical data and research that points to the success and long-term value of good governance. It should be seen by corporate governing bodies, executives, and investors not only as a method of risk prevention and control but also as a source of opportunity and competitive advantage.
The acronym ESG has become a key concept in the world of investment and business, with environmental, social, and governance aspects becoming an integral part of the evaluation of sustainable investments. Current trends indicate the growing importance of ESG factors and their integration into investment decisions. For investors and businesses themselves, ESG standards present new challenges and opportunities. The importance of these aspects in investment decisions brings opportunities for financial gain while contributing to a better world in which we feel good.
Given the growing awareness of ESG factors, their importance, and the obligations arising from ESG legislation, it is crucial that we continue to explore and develop these concepts. Only in this way can we ensure a lasting positive impact on our society, the environment, and future generations.
If you have any questions regarding legal issues on the topic of ESG, please do not hesitate to contact us.
Ráchel Kouklíková, legal assistant – email@example.com
Mgr. Jakub Málek, managing partner – firstname.lastname@example.org
Mgr. Kateřina Roučková, junior lawyer – email@example.com
31. 07. 2023