The Evolution of ESG: from Convention to Mandate - Daniel Park

Introduction


In recent years, ESG has become a hot topic of increasing prevalence in the commercial world. But as a concept it remains nebulous, leading to various misconceptions regarding its substantive nature and impact. In this article, I aim to explain ESG from the perspective of macroeconomic, political, and regulatory developments in the past two decades, demonstrating its rapid evolution from an altruistic convention to an enforceable mandate. In doing so, I highlight the impact of the growing legal and commercial imperative of ESG on law firms and their clients, and how they can proactively mitigate ESG risks in an ever-changing regulatory landscape.


Definition of ESG


ESG (Environmental, Social and Governance) represents the three key factors used to assess the impact of business investment in terms of sustainability and ethics. First, the ‘E’ aspect considers how well a company safeguards the environment in its decision-making and policies. Then, the ‘S’ aspect asks us to critically examine the impact of a company’s practices both within the workplace and on society more widely. Finally, the ‘G’ aspect scrutinises the logistical, reporting, and decision-making aspects of a company, and assesses whether it is behaving ethically and with transparency towards its stakeholders.


The macroeconomic backdrop


In a recent article, Martin Lipton, a founding partner of the law firm Wachtell, Lipton, Rosen & Katz, argued that the rising prevalence of ESG should be situated within the broader shift in view of the purpose of corporations. The traditional narrative was that the exclusive purpose of corporations was to maximise profits for their shareholders, exemplified by Milton Friedman’s 1970 article ‘The Social Responsibility Of Business Is to Increase Its Profits’. The Friedman doctrine, however, came into doubt with the 2008 financial crisis, which Lipton argues 'expos[ed] the reality that an exclusive focus on short-term maximization of shareholder value came at the expense of sustainable growth and innovation'. The shareholder-centric view has gradually shifted to a broader stakeholder-centric one, espousing the long-term value of accounting for various stakeholder interests (which still, importantly, include shareholders as a primary stakeholder group). Both the World Economic Forum’s Davos Manifesto 2020, and the rejection of the long-standing shareholder-centric tradition by the Business Roundtable in 2019, exemplify this shift. For Lipton, considering the interests of stakeholders inherently involves 'ensuring that a company avoids ESG blindspots' and managing ESG-related risks that can negatively impact a company’s strategies, reputation, and key stakeholder relations in the long-term. The modern purpose of corporations, in holistically assessing stakeholder interests, thus requires that ESG risks form part of several fundamental considerations to be balanced by a company to ensure its long-term sustainability and prosperity.


The business Implications of this shift have manifested in three primary ways. Firstly, the reliance of businesses on consumers as primary stakeholders, coupled with a younger and more sustainability-conscious consumer base, has produced additional demand for companies to fundamentally alter their practices. In addition, investor appetite for companies with sustainable products and ESG credentials is growing, partly due to a greater availability of data permitting heightened ESG scrutiny. Finally, green financing has become more widely available, for example with banks increasingly offering environmental and sustainability-linked debt financing (like ‘green bonds’) to fund projects involved in the energy transition.


These trends illustrate the demand for sustainable corporate practices, which have also had a positive influence on businesses. Findings from the European Securities and Markets Authority (ESMA) show that UCITS funds (Undertaking for Collective Investment in Transferable Securities) with an ESG strategy objectively outperformed their non-ESG peers and were cheaper overall.


The 2015 Agreements


Two of the most prominent events in relation to ESG have been the Paris Agreement of 2015 and the Sustainable Development Goals (SDGs) set by the United Nations General Assembly in 2015. Their impact explains the evolution of the ESG regulatory regime today.


The Paris Agreement set a long-term temperature goal of limiting global warming to below 2 degrees Celsius, preferably 1.5, compared to pre-industrial levels. It also set the goal of reaching net-zero by the middle of the 21st century. The Agreement signified to stakeholders across the world that a paradigm shift was occurring in global policy which specifically addressed climate change, one of the most prominent aspects of ESG.


The UN SDGs aimed to put sustainability at the centre of global economic development. The 17 goals, intended to be achieved by 2030, are broad and interconnected. They include eradicating poverty, achieving gender equality, and building sustainable cities and communities. In 2017 they were refined by the General Assembly, which identified specific targets for each of the goals as well as progress-measuring indicators.


Both of these developments have received criticism. Environmentalists have criticised the Paris Agreement for being insufficiently binding and clear, in terms of the measures necessary to implement climate action globally. The SDGs have been criticised for overlapping and lacking coherence, as well as for providing little practical guidance. Their impact has also been said to be very difficult to track. These criticisms, though harsh, raise valid concerns of greenwashing, or even ‘SDG-washing’. This refers to the worry that the unclear goals of the SDGs and conventions like the Paris Agreement can be utilised by companies in their ESG commitments for reputational and financial gain, but with little intent to act on them in the long-term.


Regulatory reform in the EU and the US


Regulators have responded to these criticisms of a lack of clarity, transparency and effective enforcement mechanisms. Sustainability and ESG-related measures have now transitioned from altruistic thought leadership and unclear commitments to substantive legal standards, enforceable by authorities.


The European Commission laid out the Sustainable Finance Action Plan in early 2018. Aimed at encouraging sustainable investing, the plan included the implementation of two key ESG-focused regulations: the EU Sustainable Finance Disclosure Regulation (SFDR), implemented in March 2021, and the EU Taxonomy Regulation, implemented in January 2022. The SFDR creates classification rules for funds regarding sustainability and ESG-linked investments, essentially imposing enhanced disclosure and reporting obligations in order to attain the ESG credentials that a company has promoted. The Taxonomy, on the other hand, seeks a consistent lexicon to conclusively determine when an economic activity, such as an investment, can be classified as ‘sustainable’. This trend of facilitating sustainable investment through regulation has also reached the UK, where the government has committed to devising their own derivative UK Green Taxonomy in line with the EU.


In the US, the Securities and Exchange Commission (SEC) in May released proposed rules to mandate transparency and disclosure on ESG-related matters. The main rules concerned climate-related disclosures, disclosures by certain investment advisers and investment companies about ESG investment practices, and changes to prevent deceptive or misleading fund names. The SEC wasted no time in enforcing the spirit of these rules, using its existing regulatory regime. For instance, the SEC charged a registered investment advisor in May 2022, who agreed to pay a $1.5 million penalty for misrepresentation on ESG-related reviews. Likewise, the SEC investigated Goldman Sachs’ asset management division in June 2022 over the accuracy of certain ESG claims made by its funds.


The overriding theme of all these regulations is to ensure transparency and clarity. Regulators want to standardise definitions of E, S and G globally, which currently seems to be the most effective approach of bringing about substantive change. In particular, standardisation of S and G, which have been overshadowed by environmental considerations, will be increasingly targeted. For example, the German Parliament passed the Supply Chain Act in 2021, which imposed S-related obligations on companies to establish procedures that are compliant with human rights in their supply chains.


The consequences for businesses


Businesses will need to be more conscious of ESG in their risk management, since failure to comply with these new standards creates significant risks of investigation and litigation and the consequent reputational and financial damage. For example, we have seen a rising tide of climate litigation being levied against companies by NGOs on behalf of consumers, and on the basis of misstatement, increasingly succeeding. In July 2022, groups of NGOs filed a lawsuit against KLM for greenwashing in advertisements - the first of its kind against the airline industry.


However, returning to the holistic stakeholder view of corporations discussed at the beginning of this article, it is important to resituate ESG risks and concerns once more within the context of a balancing act that companies undertake. Corporations must balance the demands and interests of different stakeholders to make informed strategic decisions, and ESG considerations are but one component of that formula, albeit an increasingly more important one. The increased focus on ESG by regulatory authorities should not be exaggerated such that ESG is perceived as the single most important metric or factor in the decision-making process of companies: rather, it should be seen as a positive development enabling a holistic approach to dealing with ESG-related matters on balance.


Nonetheless, the new regulatory reform agenda will undeniably pose obstacles for companies and will require them to pre-emptively act to mitigate potential ESG-related risks. As these standards and risks are relatively new, businesses will have to devise innovative solutions to facilitate the process of analysing ESG-related risks or even opportunities, which will be interesting to follow in the years to come. A recent example of innovation comes from JP Morgan, which recently worked with software firm Datamaran to create an AI data analysis tool that helps clients gauge the risks that their assets both face and pose to the wider world.


The role of law firms


In this evolving regulatory landscape, what can law firms do to align themselves with the growing imperative attached to ESG?


First, firms should consider that clients are altering their business practices, not just because they are legally required to, but also because it is in their best interest to promote long-lasting and sustainable business. Because of this integrated approach, clients are increasingly demanding that the law firms they work with share a commitment to the same values and standards. Therefore, law firms must demonstrate robust practices to their clients (such as a strong commitment to diversity and inclusion and pro bono work), or they will increasingly find themselves falling behind competitors in an ESG-conscious market. Indeed, clients have begun to ask law firms upfront to provide their ESG credentials.


Firms will also have a growing role in advising clients across a broad spectrum of ESG issues, on regulatory, contentious, and transactional matters. On the regulatory side, clients will look to law firms to help them understand the implications of new frameworks like the EU Taxonomy Regulation. Clients will also want to ensure that they are resistant to ESG risks that arise in the future. Climate litigation or ESG-related investigations (particularly in the US, given the SEC’s aggressive approach to enforcement) may also present opportunities for law firms to provide contentious expertise for clients through the lens of ESG. Moreover, transactional teams will be able to help clients navigate the enhanced ESG due diligence, reporting and disclosure obligations in the deal-making process. Because of the multifaceted nature of ESG risks and issues, law firms will need to take a cross-disciplinary approach, and we are increasingly seeing the creation of in-house decentralised ESG practices which cover all of their practice areas.

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