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What ESG is and what it is not
Increasingly becoming the flavour of the month in business circles and topping the agenda at most conferences, ESG is quite often misrepresented as a synonym for Corporate Social Responsibility (CSR) or a polite way of reminding us that we should print less and recycle more. But ESG is far greater than that and the purpose of this article is to shed some light on what ESG means in practical terms for Maltese issuers.
However, in order for one to understand the legal implications (of which there are several) of ESG, one must first understand what ESG is all about and, more importantly, what it tries to achieve, as it is only when one appreciates what ESG is that one can really begin to appreciate what its impact could be.
‘ESG’ is an acronym for ‘Environmental, Social and Governance’ and is generally used as an adjective to describe factors related to the way companies operate, which factors are increasingly becoming the main focus of investors and regulators alike. So called ‘ESG factors’ (which place added focus on matters such as climate change, proper working conditions and enhanced diversity on corporate boards) are, however, not just empty buzzwords, but are a means of reaching a desired end – more sustainable companies and resilient economies which can withstand shocks that will inevitably come their way. Perhaps there is no better illustration of the importance of achieving a more sustainable economy than the COVID-19 pandemic which has clearly shown that everything is connected to everything else, and that the stakes with continued unsustainability are high, because in an ever-connected world, the failure of one part of the economy can send devastating shockwaves throughout the entire system.
The European Union’s (EU) commitment to sustainability traces its roots to the EU Treaties. Sustainability is an overarching objective of the EU and meant to be the guiding principle for the EU’s policies and activities within Europe and in its relations with the rest of the world, to promote “peace, its values and the wellbeing of its peoples”, Treaty on the European Union (TEU), article 3(1). The values are set out in article 2 TEU: “respect for human dignity, freedom, democracy, equality, the rule of law and respect for human rights, including the rights of persons belonging to minorities”.
This said, it is amply clear that traditional approaches to encouraging corporate sustainability, such as self-regulation based on CSR or corporate stewardship codes, have yet to deliver sufficient improvements in, for example, human rights protections or mitigation of climate change, despite decades of attempts to do so.
Due to these shortcomings, and in light of the realisation that “it’s one minute to midnight on that Doomsday clock”, we are (finally) witnessing a paradigm shift in focus in global markets. Investors are increasingly shying away from investing in firms which merely aim to maximise their returns, without paying any attention to their impact on the environment and people’s lives, and are instead investing in firms whose business models are designed to be more sustainable – by properly regarding ESG factors and considerations in the course of their activities. Environmental considerations include climate change mitigation and adaptation, as well as the environment more broadly, for instance the preservation of biodiversity, pollution prevention and the circular economy. Social considerations refer to issues of inequality, inclusiveness, labour relations, investment in human capital and communities, as well as human rights issues. Governance considerations include proper management structures, employee relations and executive remuneration.
ESG therefore is not an off-shoot of CSR, or merely a synonym of “going green”. Rather it is a cultural shift away from the social norm of ‘shareholder primacy’, where directors are regarded as the ‘agents’ of shareholders and should maximise returns to shareholders, which norm is evidently not conducive to creating a sustainable economy. Rather, ESG signifies a cultural shift which rewards companies who pay due regard to environmental, social and governance issues in the conduct of their activities and shareholders are one of the main drivers of change – in fact, they are increasingly voting in favour of sustainable initiatives and are increasingly requesting ESG-related factors to be placed on AGM agendas.
Given the markets’ increased focus on ESG considerations, legislators and regulators alike have started legislating with a view to (primarily) increasing ESG-related disclosures. While the scope of a number of these laws is narrow (e.g. the Sustainable Finance Disclosure Regulation (SFDR), which requires financial market participants and financial advisers to disclose information about the sustainability risks they face and their principal adverse impacts), other pieces of legislation apply more broadly, including in respect of issuers.
The main laws which issuers ought to concern themselves with in terms of ESG regulation are the following:
Corporate Sustainability Reporting Directive
On April 21, the European Commission presented its proposal for a Corporate Sustainability Reporting Directive (CSRD), which aims to revise, broaden and strengthen the existing rules introduced by the Non-Financial Reporting Directive (NFRD) and to bring sustainability reporting on a par with financial reporting.
Under CSRD, all large companies, and all companies listed on EU regulated markets except listed micro-enterprises, would be subject to these reporting requirements and will have to report on (1) how sustainability issues affects their business, and (2) the impact of their activities on people and the environment.
Under CSRD, reporting would have to be in line with mandatory EU sustainability reporting standards that will be developed by the European Financial Reporting Advisory Group (EFRAG), the first set of which should be ready by mid-2022.
Reporting standards would include indicators that correspond to indicators in the SFDR and build on indicators in the Taxonomy Regulation (as explained below). In order to ensure proper reporting, CSRD also introduces an audit (assurance) requirement for reported sustainability information which will be a ‘limited’ assurance requirement to start off with.
If the EU Parliament and EU Council reach agreement by the end of 2022, the new rules under CSRD are expected to apply to financial years beginning on or after January 1, 2023. So companies would apply the standards for the first time to reports published in 2024, covering the 2023 financial year, while SMEs would have to comply from January 1, 2026.
Taxonomy Regulation
The Taxonomy Regulation establishes criteria for determining whether an economic activity is environmentally sustainable for the purposes of establishing the degree of environmental sustainability of an investment.
At the core of the Taxonomy Regulation is the definition of a sustainable economic activity. In order for an economic activity to qualify as sustainable, it must (a) contribute to at least one of six environmental objectives listed in the Taxonomy Regulation; and (b) do no significant harm to any of the other objectives, while respecting basic human rights and labour standards.
The six environmental objectives are: (i) climate change mitigation; (ii) climate change adaptation; (iii) sustainable use and protection of water and marine resources; (iv) transition to a circular economy; (v) pollution prevention and control; and (vi) protection and restoration of biodiversity and ecosystems.
While the Taxonomy Regulation is primarily a classification tool, it has other functions. For example, it requires entities falling within its scope to disclose information concerning the degree of alignment of their activities with the Taxonomy Regulation. Accordingly, under the Taxonomy Regulation, issuers will need to disclose how, and to what extent, their
activities are associated with ones that are considered as environmentally sustainable, and will need to disclose (a) the proportion of turnover derived from the Taxonomy Regulation activities; and (b) the proportion of their capital expenditure and operating expenditure associated with certain activities defined under the Taxonomy Regulation.
This is known as ‘article 8 disclosure’ and it will also apply to the expanded list of entities captured by CSRD (i.e. all large companies, and all companies listed on EU regulated market except listed micro-enterprises). Article 8 will begin to apply in two tranches: (i) from January 1, 2022, as regards the first two environmental objectives (that is, climate mitigation and climate adaptation); and (ii) from January 1, 2023, to the other four environmental objectives (water, pollution and control, circular economy, biodiversity).
Proposed directive on corporate due diligence and corporate accountability
On March 10, 2021, the European Parliament voted in favour of a resolution to recommend the drawing up of a directive (which will also apply to entities listed in the EU) on corporate due diligence and corporate accountability. The proposed directive will impose an obligation on undertakings to take all proportionate measures and make efforts within their means to prevent adverse impacts on human rights, the environment or good governance from occurring in their value chains and to address such impacts when they occur.
In practice, the proposed directive will require undertakings to devise processes which can identify, assess, prevent, mitigate, cease, monitor, communicate, account for, address and remedy the potential and/or actual adverse impacts on human rights, including social, trade union and labour rights, on the environment, including the contribution to climate change, and on good governance, in its own operations and its business relationships in the value chain.
At present, the proposed directive is still in its inception, and there is no concrete date of applicability as yet.
Soft laws and other initiatives
Apart from hard laws such as the CSRD and the Taxonomy Regulation, there are also a multitude of so-called ‘soft’ laws published by entities such as the Task Force on Climate-related Financial Disclosures, which has developed a framework to help public companies and other organisations more effectively disclose climate-related risks and opportunities through their existing reporting processes.
Although not technically law in the traditional sense, the recommendations of the Task Force are widely recognised as authoritative guidance. In fact, a number of governments and financial regulators around the world have expressed support for the recommendations and are integrating them into their guidance and policy frameworks.
Another example of a soft law is the science-based targets initiative (SBTi) which a partnership between CDP, the United Nations Global Compact, World Resources Institute and the World Wide Fund for Nature. Among other things, SBTi defines and promotes best practice in emissions reductions and net-zero targets in line with climate science.
The Maltese government is also taking its own initiatives in the field. For example, earlier on this year, the Ministry for Energy, Enterprise and Sustainable Development launched a project to gather ESG-related information from (equity) issuers listed on the Malta Stock Exchange, and this with a view to creating an ESG scoreboard which will serve as a reference for investors who wish to invest in Maltese issuers shares by applying a sustainable business model that is sustainable.
Next steps
While it is clear that issuers need to start thinking about the obligations to which they will become subject when the above-mentioned laws begin to apply, they also ought to start taking a proactive approach to ensure that their business models are ESG-oriented.
Over time, all companies will need to demonstrate that they carefully consider the risks and opportunities they face in the light of ESG concerns. Like cyber security or data privacy a few years ago, this is an emerging risk which should be included in the company’s governance, strategy and enterprise risk management.
Boards will need to identify any transitional risks posed to businesses as well as assessing their resilience to the materialisation of ESG risks (for example, the physical effects of climate change), whether these are direct or indirect. They must scan the horizon for any effects, such as regulation, which may require major or minor adjustments to existing business models or strategy.
Accordingly, issuers would do well to keep their boards briefed regularly on the topic to ensure that they are comfortable with the subject before they have to take any decisions about the future of the company.
Likewise, ESG considerations should be embedded across the business through cross-functional teams, and issuers should avoid situations where such considerations get trapped in a “sustainability silo”.
In practical terms, it may be advisable for boards to consider how to integrate ESG factors into its structures and processes. If the company has a particular exposure to these ESG risks, it may be appropriate to set up an advisory committee, or to bring climate change issues within the remit of a board committee, to ensure that a close eye is kept on the area.
Conclusion
To confine ESG considerations to the sidelines and relegate them to marginalised CSR committees would be detrimental to issuers and to the market alike.
Issuers should have realised by now that we are witnessing a huge cultural change that will have a significant impact on the way we do business in the short, medium and long term. Apart from issuers’ impending obligations as a result of new laws being enacted, attitudes are changing rapidly, and if issuers don’t adapt to this cultural shift, they are destined to become irrelevant before they know it.
ESG factors, therefore, are no longer a gentle breeze that can easily be navigated; rather, they are fast becoming a strong wind that can either blow a ship off its course or propel it on its journey towards new horizons. Whether issuers win or lose with ESG is up to them – all they need to do is adjust their sails.