ESG is one of the biggest talking points in the business sector at the moment: as of July 2020, the value of ESG-related assets has exceeded USD 40 trillion. Several law firms have established dedicated sustainability practices. So, what is ESG and why is it quickly becoming too big to ignore?
What is ESG?
First coined in the landmark study entitled ‘Who Cares Wins’, the term ESG (‘Environmental, Social, Governance’) refers to sustainability objectives which companies aim to meet. Examples of ESG-related issues include: climate change; creation of markets for environmental services and environment-friendly products; workplace health and safety; human rights and slavery; disclosure practices and board structure. The aim of such policies is to contribute towards an improved society.
Why should companies care?
The days of companies solely thinking about financial performance – following traditional profit-seeking models – are over. Held accountable for their actions, they will need to demonstrate that they are a ‘force for good’. Both Covid-19 and social movements, notably the Black Lives Matter movement, have acted as ‘accelerants’, shining a brighter light on ESG as a whole (‘S’ in particular). Consequently, consumers are increasingly seeking to support businesses promoting general welfare, boycotting those who do not. For instance, the skincare powerhouse L’Oréal faced severe backlash for referencing the terms ‘whitening’ and ‘fairness’ in an assortment of their skincare products.
Investors are also taking action. Many now recognise that ESG information about companies is necessary to understand their purpose and strategy, in addition to the management quality of the companies. Indeed, there is a large amount of empirical data supporting a correlation between companies that perform well on ESG criteria and those that perform well financially: a recent Morningstar survey found that ESG funds have demonstrated more stable financial performance and resilience in the face of the Covid-19 pandemic. This trend has led corporate and individual investors to perform sustainability screenings before deciding to invest in a company.
Along with the pressure exerted on companies by stakeholders, governments and other legal authorities (such as the EU) are also taking action. To ensure carbon-neutral targets are met, for instance, the FCA have required premium listed companies, from the beginning of this year, to more accurately disclose how climate change affects their business. To promote general welfare, the EU have also published a set of reforms targeting sustainability. Of particular note is the Non-Financial Reporting Directive (2014, subsequently revised). This requires large ‘public interest entities’ to disclose their compliance towards ESG criteria, namely the environment and climate change, human rights and slavery and corporate governance. A ‘public interest entity’ is defined as any financial business (such as credit institutions) and businesses with more than 500 employees alongside either a balance sheet greater than EUR 20 million or a net turnover greater than EUR 40 million. For means of transparency and consistency, there is also a Taxonomy that aims to provide a unified classification system for such activities under this regulation.
In the face of these expectations and mandates, it is clear that companies need to consider their compliance to ESG sustainability criteria. Enter the role of the law firm.
What are the legal challenges?
Ensuring and maintaining compliance with ESG sustainability criteria leads to many legal challenges.
First, companies will need practical guidance in disclosing their ESG-compliance. This includes informing them on their obligations to report on climate change, human rights, corporate governance and structure in their Non-Financial Statement. Allen & Overy, for instance, conducted such a report on a renewable energy company.
Second, due diligence will need to be conducted on behalf of companies with regards to ESG. This includes checking whether human-rights and slavery violations are being committed and investigating environmental performance within the supply chain.
Third, companies will need advice and assistance in sustainable finance. Notably, law firms are helping with the issuance of social bonds and financing of renewable energy projects: Clifford Chance recently advised EDP on its USD 750 million hybrid-bond issuance.
Finally, companies face the legal challenge of designing contractual agreements to mitigate the risks of ESG-related violations such as corruption, money-laundering and human rights violations. In cases where these violations are found, legal assistance in the form of dispute resolution will be necessary.
How will this affect law firms?
Beyond the legal issues mentioned above, law firms themselves face challenges. Clients will only want to work with firms that themselves have proven to be ESG-compliant. A firm’s direct CO2 emissions are a client’s indirect emissions. Consequently, there are increasing calls to combat climate change within the legal space. In 2018, for instance, Clifford Chance managed to halve its carbon footprint in three years. In order to ensure a law firm’s values echo that of its clients, companies are increasingly requesting to work with diverse and inclusive groups. There is also an expectation that ESG-compliance will be monitored, so as to inform companies of future legislative risks. As a result, several primers are now being produced on the topic.
To conclude, as society is becoming conscious of the environmental and social impact of their actions, ESG has established itself as a force that has permanently changed the commercial industry. The legal challenges facing companies as they transition from the old profit-maximising model to a welfare-promoting model are significant. Law firms themselves have to rise to the challenge by maintaining disclosures, ensuring diversity and inclusion and publishing environmental data for their clients. With the growing sense of collective social responsibility and accountability alongside government commitments to net-zero carbon goals, ESG is becoming a force too big to ignore.