The acronym ESG is short for environmental, social and governance. ESG is a process of quantifying an organisation’s commitment to social and environmental factors. It uses specific metrics related to the intangible assets of an organisation that are applied to tabulate a score of the level of this commitment. That is, a corporate social credit score.
The Genesis of ESG in the 1960s: A Turning Point in Corporate Accountability
The genesis of ESG lies in the early 1960’s with the publication of the book The Silent Spring which documented the adverse environmental effects caused by the indiscriminate use of pesticides (in particular, DDT). This was the beginning of the environmental movement seeking to make corporations accountable for the detrimental effects of their activities on the environment and human health.
Key Milestones in the ESG Journey: From the Brundtland Commission to CSR
In 1987, the Brundtland Commission of the United Nations – aka World Commission on Environment and Development (WCED) – was convened to help direct the nations of the world towards the goal of sustainable development. It promoted the decoupling of environmental degradation and economic prosperity. In doing so, it introduced and defined the term sustainable development as development “that meets the needs of the present without compromising the ability of future generations to meet their own needs.”
In 1992, the United Nations Environment program (UNEP) issued the Statement of Commitment by Financial Institutions on Sustainable Development which became the original backbone of the UNEP Finance Initiative (UNEP/fi) when it was created in the wake of the Rio Earth Summit in 1992. By signing up to the Statement, financial institutions openly recognised the role of the financial services sector in making our economy and lifestyles sustainable and commit to the integration of environmental and social considerations into all aspects of their operations.
In 1994, John Elkington introduced the concept of The Triple Bottom Line (TBL) as a sustainability framework that balances the company’s social, environmental and economic impact. Its underlying purpose was to help transform the current financial accounting-focused business system to take on a more comprehensive approach in measuring impact and success. TBL was a practical approach to sustainability in that companies needed to adopt socially and environmental responsible behaviours that could be positively balanced with its economic goals.
In 2001 the European Commission presented a paper called Promoting a European framework for Corporate Social Responsibility, derived from social expectations and concerns about the environmental impact of economic activities. This was the first time the concept of corporate social responsibility (CSR) was presented as a distinct strategy. The strategy included the promotion of the concept that enterprises are responsible for their impacts on society with an outline of how those enterprises should meet that responsibility. CSR is however, a business model for individual companies without a common set of criteria for measurement of corporate achievement.
The Birth of ESG: Who Cares Wins Report and Its Global Impact
The term ESG was coined in a 2004 milestone report called Who Cares Wins. The report was the result of a joint initiative of financial institutions which had been invited by United Nations Secretary-General Kofi Annan to develop guidelines and recommendations on how to better integrate environmental, social and corporate governance issues in asset management, securities brokerage services and associated research functions.
Twenty financial institutions from 9 countries with total assets under management of over 6 trillion USD participated in developing the report. The initiative was supported by the chief executive officers of the endorsing institutions. The U.N. Global Compact oversaw the collaborative effort that led to this report and the Swiss Government provided the necessary funding.
The institutions endorsing the report were convinced that, in a more globalised, interconnected and competitive world the way that environmental, social and corporate governance issues are managed is part of companies’ overall management quality needed to compete successfully.
The presumption was that companies that perform better with regard to these issues can increase shareholder value by, for example, properly managing risks, anticipating regulatory action or accessing new markets, while at the same time contributing to the sustainable development of the societies in which they operate. Moreover, these issues can have a strong impact on reputation and brands, an increasingly important part of company value.
The Who Cares Wins report recommended that analysts better incorporate environmental, social and governance (ESG) factors in their research where appropriate and to further develop the necessary investment know-how, models and tools in a creative and thoughtful way.
At about the same time the UNEP/fi published the Finance Initiative Innovative Financing for Sustainability Report which showed that ESG issues are relevant for financial valuation. This report and the Who Cares Wins report formed the backbone for the launch of the Principles for Responsible Investment (PRI) at the New York Stock Exchange in 2006 and the launch of the Sustainable Stock Exchange Initiative (SSEI) the following year.
The purpose of PRI is to understand the investment implications of ESG factors and to support its international network of investor signatories in incorporating these factors into their investment and ownership decisions.
SSEI is a peer-to-peer learning platform for exploring how exchanges, in collaboration with investors, regulators, and companies, can enhance corporate transparency – and ultimately performance – on ESG issues and encourage sustainable investment.
ESG has come a long way since 2006 with ESG on track to reach US$53 trillion in assets under management (AUM) for 2021. While Europe accounts for half of global ESG assets, the U.S. has the strongest expansion this year and may dominate the category starting in 2022.
The Evolution of ESG Metrics and Reporting Standards
Earlier we referred to The Triple Bottomline concept, a framework that balances a company’s social, environmental and economic impacts. Its underlying purpose was to help transform a financial accounting-focused business system to a more comprehensive approach in measuring impact and success.
The three-pillar concept includes:
- Environmental preservation measures such as good waste management, abating pollution, reducing GHG gas emissions, preserving biodiversity, protecting forests etc.
- Social equity measures such as enhancing gender parity, fair wages for employees, creating opportunities for disadvantaged groups etc.
- Economic development including the ability of generations to meet their own needs through maintaining a viable economic society today.
ESG has adopted those three pillars of sustainability, with the notable variation to the third pillar. Economic development is replaced with the word governance and hence, the “G” in ESG. The G word refers to governance factors of corporate decision-making from policy-making through to the adequacy of ESG reporting itself.
Some of the metrics used for ESG performance are:
ESG development started slowly with players limited to those wanting to do good. In the last 6 years however, the player numbers have increased exponentially as it dawned on investment analysts that ESG methodology is an effective way reduce costs, generate revenue growth and mitigate risk.
Unfortunately, that accelerated interest in ESG has led to an uncoordinated development of the discipline characterised by an alphabet soup of standards, frameworks (globally over 125 of them) and agencies that rate corporate ESG performance (globally over 600 of them) using many and varied metrics for ratings assessment. To add to the confusion, the ESG space is mostly voluntary with different frameworks designed for specific core outcomes.
The good news is that there are movements afoot to consolidate disparate standards and frameworks. Five of the most prominent frameworks and standards are leading the charge. An extract from CDP at https://www.cdp.net/en/articles/media/comprehensive-corporate-reporting reads:
“Transparent measurement and disclosure of sustainability performance is now considered to be a fundamental part of effective business management and essential for preserving trust in business as a force for good. Yet, the complexity surrounding sustainability disclosure has made it difficult to develop the comprehensive solution for corporate reporting that is urgently needed.
In response to this, five framework- and standard-setting institutions of international significance, CDP, the Climate Disclosure Standards Board (CDSB), the Global Reporting Initiative (GRI), the International Integrated Reporting Council (IIRC) and the Sustainability Accounting Standards Board (SASB), have co-published a shared vision of the elements necessary for more comprehensive corporate reporting and a joint statement of intent to drive towards this goal – by working together and by each committing to engage with key actors, including IOSCO and the IFRS, the European Commission, and the World Economic Forum’s International Business Council.
GRI, SASB, CDP and CDSB set the frameworks and standards for sustainability disclosure, including climate-related reporting, along with the Task Force on Climate-Related Financial Disclosures (TCFD) recommendations. The IIRC provides the integrated reporting framework that connects sustainability disclosure to reporting on financial and other capitals. Taken together, these organisations guide the overwhelming majority of sustainability and integrated reporting.”
TCFD is an organization that was established in December 2015 with the goal of developing a set of voluntary climate-related financial risk disclosures that would ideally be adopted by companies to help inform investors and other members of the public about the risks they face related to climate change.
The Future of ESG: Regulatory Developments and Global Trends
From a regulatory point-of-view, there is movement afoot too. The Sustainable Finance Disclosure Regulation (SFDR) was introduced by the EU in March this year imposing mandatory ESG disclosure obligations on asset managers and other financial markets participants alongside the Taxonomy Regulation and the Low Carbon Benchmarks Regulation as part of a package of legislative measures arising from the European Commission’s Action Plan on Sustainable Finance.
The SFDR aims to bring a level playing field for financial market participants (“FMP”) and financial advisers on transparency in relation to sustainability risks, the consideration of adverse sustainability impacts in their investment processes and the provision of sustainability related information with respect to financial products. The SFDR requires asset managers to provide prescript and standardised disclosures on how ESG factors are integrated at both an entity and product level.
The UK Government confirmed on 29 October that it will make it mandatory for large companies to disclose information in alignment with the recommendations of the TCFD from April 2022. This makes the UK the first G20 country to enshrine the mandate into law, subject to Parliament approval. More than 1,300 of the largest UK-registered companies and financial institutions will have to disclose climate-related financial information on a mandatory basis – in line with the TCFD.
Meanwhile, in New Zealand, beginning in 2023, new laws will require financial firms to explain how they would manage climate-related risks and opportunities with disclosure requirements based on the TCFD standards and the standards of New Zealand’s independent accounting body the External Reporting Board (XRB).
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