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ESG – An Evolution for Corporates

Introduction

In November 2021, Prime Minister Boris Johnson that “It’s one minute to midnight on that Doomsday Clock and we need to act now”. He was rather stating an issue that the whole financial and corporate world has been grappling with. As to how to create a sustainable world for our future generations while at the same time satisfying our own present needs.

Environmental, Social, and Governance (ESG) is a major discussion point in boardrooms worldwide. The pressure to include climate-based actions and social initiatives in the overall governance of the company is constantly rising. To stay ahead of the curve, it is important for companies to continuously evolve their ESG strategies.

A comprehensive ESG strategy should consider all aspects of the business, from operations to supply chain to product development. It must also consider the company’s impact on different stakeholders, including employees, customers, suppliers, and investors. Companies that adopt ESG can reap several benefits. Companies should have a defined plan for integrating ESG into their strategy and disclosures.

Building a National Strategy

The United Kingdom (UK) government has been rather forceful and articulate in pushing forward the ESG agenda amongst the financial markets as well as making it a central theme amongst the corporates. UK’s Financial Control Authority (FCA) has built the ESG strategy among the five following saliencies:

Transparency

Promoting transparency on climate change and wider sustainability along the value chain

Trust

Building trust and integrity in ESG-labelled instruments, products, and the supporting ecosystem

Tools

Working with others to enhance industry capabilities and support firms’ management of climate-related and wider sustainability risks, opportunities, and impacts

Transition

Supporting the role of finance in delivering a market-led transition to a more sustainable economy

Team

Developing strategies, organizational structures, resources, and tools to support the integration of ESG into FCA activities The rising pressure from FCA and other governing authorities including the Institute of Directors in the UK have been constantly pushing for fairly stringent guidelines to ensure that both the investment funds and the companies build ESG into their business plans and undertake concrete steps to tackle issues related to all the three elements of ESG.

Corporate Matters

According to a report published by Harvard Law School for Corporate Governance, areas that need focus in the coming short and medium term are:

Remuneration

Continuing to implement remuneration guidelines issued during the COVID-19 pandemic, investors increasingly focus on companies’ remuneration policies. To remain eligible to receive funds, the management should substantiate the coverage of environmental risks in their remuneration structures and performance metrics. To engage investors, they must present quantifiable data linked with value creation while maintaining transparency.

Flexible working

The idea of a flexible work schedule is gaining popularity as people continue to feel the effects of the pandemic. They prefer flexibility in working hours and even look forward to an additional day off in the four-day work week. The four-day work week is proving to be a win-win situation for both employers and employees. It increases productivity and facilitates employee retention. Helping employees maintain their work-life balance gives the companies a competitive edge, even when hiring.

Rise of ESG activism

These deal with the corporate policies related to gender parity, skill set diversity, pay parity, LGBTQ+ related policies and issues. Pressure from activist investors was the driving force behind major changes that led to more gender equality. They targeted “Big Oil” and “Big Tech” companies like Shell and ExxonMobil to effectively achieve their goals. In response to the aggressive campaigns, companies had to make structural changes in their board to ensure gender parity. Big technology companies have even paid attention to LGBTQ+ rights, while data privacy concerns are still under consideration.

Technology to play a broader role

The role of technology in corporate has assumed a higher significance in the post-pandemic world, with remote/hybrid working becoming the norm than an exception. Consequently, there are issues related to data security and reskilling of employees. However, what is also becoming apparent is the loss of social equity, which was one of the critical features of the collegial nature of the workplace. This is reflecting on the mental health spectrum of the employees. The UK National Health Service (NHS) offers government funding to develop long-term plans to address mental health. Data from the U.K. Centre for Mental Health showed that mental health issues are costing UK businesses £34.9 billion a year.

Regulation for Growth

While the above issues are being dealt with at a regulatory level in the UK and a behavioral level by the corporates, another bigger issue that the FCA is dealing with is the management and growth of the ESG funds themselves.

Pensionage.com had pegged the UK’s ESG-related investments at GBP 6.44 trillion in 2020 with a projected growth of around 10.5%, higher than the European Union (EU) growth of 9.3%. Consequently, the current ESG assets under management (AUM) in the UK would be closer to GBP 7.86 trillion. However, in the recent past, there have been several questions related to the definition of these ESG funds and whether many of them even meet the basic criteria for qualifying to be called an ESG fund. It was rather revealing when Morningstar culled around 27% of the funds it recognized as sustainable, cutting assets worth close to $1.2 trillion in a reclassification as not meeting the criteria of being included in the category of ESG funds.

Popularly called Greenwashing, this is a direct result of a lack of transparency and the absence of any specific standards for classification as an ESG fund. As a result, both investors and regulatory bodies alike have pressured them in providing proof. Companies must abide by the standard principles to receive any further funding or be trusted by stakeholders in their industry space. The pressure from ESG investors and regulators is leading companies towards more accountability in their environmental practices.

UK is leading the way in terms of creating a regulatory framework for businesses concerning their ESG initiatives. In March 2022, the House of Commons passed two laws that cover all UK companies and Limited Liability Partnerships (LLPs). As a consequence, the companies must mandatorily streamline their environmental risk reporting and publish Sustainability Information Statement that outlines the environmental risk as perceived by the business and how they plan to manage the same in addition to integrating the environmental risk into the overall business risk.

On the positive side, a survey by EY reveals that –

  • UK asset managers lead all other major global markets for incorporating E, S, and G activity into operations and disclosing ESG metrics – far outstripping the U.S.
  • Larger UK asset managers significantly outperform boutique firms in conducting and reporting ESG activity
  • UK asset managers rank highly at a global level for having fair and competitive remuneration packages

Conclusion

The integration of ESG into reporting and disclosure continues to progress rapidly. As a result, companies will increasingly need an established plan to integrate sustainability considerations into their business model. Companies use their understanding of the environment to optimize their operations and increase profits. The growing scrutiny from stakeholders has led companies toward more rigorous ESG governance.

ESG matters must become a regular agenda for audit meetings in 2022. Regular assessments will ensure the company’s disclosure process is robust enough for the management to make informed decisions. Besides impacting financial statements, it also ensures that management is aware of all the risks involved and integrates ESG into its core business strategies.

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