What is ESG?
Prior to delving into Environment Social Governance (ESG) it is first important to understand the difference between Corporate Social Responsibility (CSR) and ESG as they are often being confused and used interchangeably. Although it is appreciated that ESG's growth is in fact rooted in CSR they are not at all interchangeable. CSR aims to make organisations conscious of their responsibility within a community through, inter alia, voluntary services, donations, and fundraising - activities that are often linked to the organisation's marketing. On the other hand, ESG is an umbrella term comprising of three key factors, Environment, Social and Governance, each used as part of a framework to facilitate an organisation's transition to a circular and sustainable model as well as to provide investors with a means of measuring the transition or legitimacy of the organisation's sustainable and ethical impacts.
The ESG framework allows investors to evaluate the performance and behaviour of a company and in so doing, to determine whether they are investing in companies that are integrating ESG considerations, thus minimising their investments' negative impact or maximising their positive impact on society and the environment. Contrary to CSR, ESG provides investors with quantifiable considerations that disclose and report on how companies manage their supply chain, respond to climate change, and increase diversity and inclusion within their company, allowing them to screen potential investments or assess the risk in investment decision making.
What is the "E" in ESG?
The focus of this article is to provide a general understanding of the 'E' (Environmental) in ESG and how this is reflected in recent legislative and regulatory initiatives. Environmental considerations determine the extent to which the organisation is acting as the steward of the environment, focusing on, amongst others, waste pollution, deforestation, climate adaptation, climate mitigation and its overall utilisation of natural resources as well as the effect of its operations on the environment.
In the context of the EU's policy, integration and adopting of ESG considerations is understood as sustainable finance, that is, a process of taking due account of ESG considerations when making investment decisions in an effort to support economic growth. In terms of Environmental considerations, this is aimed specifically at: reducing pressures on the environment; addressing greenhouse gas emissions and tackling pollution; and minimising waste and improving efficiency in the use of natural resources. All this whilst increasing awareness of, and transparency on, the risk that may have an impact on the sustainability of the financial system and taking into account social and governance aspects. Moreover, sustainable finance is aimed at achieving the objectives of the European Green Deal, namely channelling private investment towards an equally economic and climate-resilient economy in juxtaposition with public expenditure to facilitate the transition to a green and inclusive economy, all the while being competitive.
The EU Legislative Package i.e. the Taxonomy Regulation, the Sustainable Financial Disclosures Regulation (the "SFDR") and the Low Carbon Benchmark Regulation (the "Benchmark Regulation") are each aimed at enforcing and facilitating the integration of ESG considerations into the investment and advisory process in a harmonised manner. The Taxonomy Regulation established the framework for the EU taxonomy by setting out the following six environmental objectives:
- Climate change mitigation;
- Climate change adaptation;
- The sustainable use and protection of water and marine resources;
- The transition to a circular economy;
- Pollution prevention and control; and
- The protection and restoration of biodiversity and ecosystems.
(together referred to as the environmental objectives)
For the purpose of establishing the degree to which an investment is environmentally sustainable in terms of the Taxonomy Regulation, an economic activity shall qualify as environmentally sustainable where that economic activity: contributes substantially to the environmental objectives; does not significantly harm the environmental objectives; is carried out in compliance with the minimum safeguards in alignment with certain international guidelines including but not limited to the OECD guidelines and the United Nations Guiding Principles of Business and Human Rights; and complies with technical screening criteria that have been established by the European Commission.
The SFDR imposes disclosure requirements on certain financial market participants to increase transparency towards the end-investor, facilitate the comparability of different financial products and services, and contribute to the objective of fighting "greenwashing1". It lays down sustainability disclosure obligations on the environmental and social impact of an entity's investment decisions, and requirements on how to present the characteristics of green investment products. The SFDR sets out different requirements and implementation timeframes in respect of disclosures on websites, in prospectuses and in periodic reports.
On the other hand, the Benchmark Regulation introduces a regulatory framework that lays down minimum requirements for EU climate transition benchmarks and EU Paris-aligned benchmarks at the EU level, to ensure that these benchmarks do not significantly harm other ESG objectives.
This transition from the soft laws of the United Nations Sustainability Goals (the "UNSDGs") and the Paris Agreement objectives to the hard laws of the Legislative Package, is a clear commitment by the EU to align financial flows with a pathway towards low-carbon and climate-resilient development, with the ultimate aim of making Europe the first climate-neutral continent by 2050.
This commitment can also be seen in the banking sector. The European Central Bank (the "ECB") has published its "Guide on climate-related and environmental risks - Supervisory expectations relating to risk management and disclosure" in November 2020. This Guide describes how the ECB expects significant banks to consider climate-related and environmental risks as drivers of existing categories of risk when formulating and implementing their business strategy and governance and risk management frameworks. It further explains how the ECB expects institutions to become more transparent by enhancing their climate-related and environmental disclosures.
A Bank's management body ( the "Board"), for example, is expected to consider climate-related and environmental risks when developing the institution's overall business strategy, business objectives and risk management framework, and to exercise effective oversight of climate-related and environmental risks. Institutions are also expected to explicitly include climate-related and environmental risks in their risk appetite framework, and to assign responsibility for the management of climate-related and environmental risks within the organisational structure in accordance with the three lines of the defence model. They are also expected to incorporate climate-related and environmental risks into their existing risk management framework with a view to managing, monitoring and mitigating these over a sufficiently long-term horizon. Institutions are hence expected to identify and quantify these risks within their overall process of ensuring capital adequacy. It is interesting how:
- in their credit risk management, institutions are expected to consider climate-related and environmental risks at all relevant stages of the credit-granting process and to monitor the risks in their portfolios.
- institutions are expected to consider how climate-related and environmental events could have an adverse impact on business continuity and the extent to which the nature of their activities could increase reputational and/or liability risks.
- institutions are expected to monitor, on an ongoing basis, the effect of climate-related and environmental factors on their current market risk positions and future investments, and to develop stress tests that incorporate climate-related and environmental risks.
There is no doubt that the environment, and ESG generally, will continue to feature high on the agenda of consumers, investors, regulators, policymakers, corporates and businesses alike, and in case of the latter irrespective of size, profits or impact. Ultimately, it is hoped that the integration of ESG considerations into one's business practice and decision-making strategy will contribute to the transition to a low carbon circular economy and in turn to the establishment of a more resilient economy which has recently proven to be even more necessary and is also the focus of the European Green Deal. Moreover, ESG considerations, whether from a soft or hard law perspective, should continue to instigate change in the culture and approach of Boards and management in general. This is critical in achieving the goals and objectives set out in the UNSGs as well as in the Paris Agreement.
1 Greenwashing is used to describe the practice of companies launching adverts, campaigns, products etc. under the pretence that they are environmentally beneficial, often in contradiction to their environmental and sustainability record in general. https://www.ethicalconsumer.org/transport-travel/what-greenwashing
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