Introduction – ESG
ESG is widely understood to stand for ‘Environmental’, ‘Social’ and ‘Governance’ and covers a vast array of often inter-linked issues. For any business, it is important to understand, plan for and, as necessary, leverage or mitigate material issues. Given the breadth of issues encompassed by the initialism ‘ESG’, it is important to identify which of these potential issues are, or may be, material to a particular business.
Materiality can manifest in different ways. For example, a business may be accused of a particular transgression which can have a direct impact on the company’s share value. Equally, many clients, in particular those in the financial services industry, now expect their service providers to have policies and procedures in place to deal with these issues. If they do not, then their business may go elsewhere. The same applies to employee attraction and retention. From a business’s perspective, all of these angles are important – from redefining how capital allocation decisions are made, to impacting on human capital management.
In this section, we consider ‘social’ issues in the context of human rights, as well as diversity, equity and inclusion.
One such issue relates to the fact that companies are perceived to have a level of responsibility for the suppliers they contract with, in part due to their ability to influence those suppliers. Companies are also evaluated more carefully by their clients and employees, both current and prospective, in terms of how they
- treat their staff,
- reflect the societies within which they operate and the array of clients they serve, and
- consider and approach different societal issues.
As to the first topic, an increasingly well-known issue is in respect of modern slavery. Where modern slavery is discovered, or even alleged, to exist within a company’s supply chain, the company itself is often held ‘responsible’ by investors and consumers. There have been a number of high-profile examples of this, with the potential for significant value to be wiped from a company’s market value. One’s first instinct should be that modern slavery is abhorrent in and of itself. The possibility of rapid, global coverage of any suggestion of worker exploitation is now an accepted adjunct of the digital and social media age, which can represent a major financial and reputational risk.
In terms of diversity, equity and inclusion, companies also need to take care to not just consider, but take positive steps to understand and appropriately address such issues. The context of these issues can vary. On one hand, where incidents occur (some of which evolve into global movements), companies may need to consider whether, and on what basis, to react. Any reaction, or non-reaction, can be compounded by exposure across social media. Being ready to understand, process and make an informed and justifiable decision in such circumstances is important. A key part of this is ‘authenticity’, which takes time and care to establish.
Indeed, how a company approaches diversity, equity and inclusion amongst its own workforce goes to the heart of a company’s culture and image. How employees feel about working there, and how that culture is perceived by third parties has rightly become of critical importance. If a company is unable to attract and retain a bright, diverse workforce, this can affect performance. Furthermore, clients are becoming increasingly willing to tie the winning of their business to such ‘social’ factors. Taking these factors seriously can provide companies with a material competitive edge. It follows that failing to do so can leave you at a real disadvantage.
Finally, and importantly, geo-political events are also falling into this area. In some contexts, employees and the public have looked to the leaders of businesses to make a choice about where they operate, and with whom they do business. In turn, this can require business leaders to re-think their approach to traditional corporate values and drivers. Furthermore, sanctions introduced by governments have introduced a web of compliance requirements with serious consequences for breach. The failure to manage the risks that accompany these rapidly changing circumstances – both legal and reputational – could have a serious and lasting effect on a business.
It is widely recognised that effective governance is critical in terms of running a successful business. Of the three ‘ESG’ factors, ‘G’ is arguably the most well-established in the business world. There is longstanding research that considers the relationship between a company’s governance and its value or returns for investors.
Traditionally, issues that come to mind are around protecting against bribery and corruption, dealing with AML and KYC, as well as setting out how board decisions are made, ensuring that appropriate checks and balances are in place.
However, governance is a broad umbrella, and as the regulatory landscape changes at pace, including in respect of various ‘E’ and ‘S’ factors, an open and deliberate approach is required to ensure that appropriate policies, procedures and structures are in place to deal with the increasing variety of issues that can be material to a business.
For example, executive compensation can now be a focus not just internally, but also externally for activist investors who may capitalise on media exposure of challenges to compensation packages. Policies that ensure a more transparent and consistent approach to recruitment, pay and promotions across a business are now expected as standard. There is a wide-spread desire to ensure that minority groups are better represented in leadership teams. The value and benefit of moving beyond diversity to achieving a truly inclusive business culture is becoming ever-more demonstrable and, therefore, in demand.
All of these issues are now rising to, or have reached, the top of board agendas. Transitioning from talk and ideas towards action can be challenging. Overseeing the evolution of traditional views and forms of governance to encompass not just modern modes of thinking and values, but in some instances even cutting edge climate science, can require boards to step carefully and yet with purpose.
Those leading businesses should be in no doubt that these issues are increasingly under the spotlights of customers, regulators, investors and employees.
In our next article, we will look at issues around ‘measurement’ in the context of ESG.