We use the term R-ESG to emphasize the importance of Resilience (R) along with the three ESG factors: Environmental (E), Social (S) and (Governance). We encourage others to approach Sustainability and ESG in the same way.
We recommend an expansive approach to integrating Sustainability/ESG into a business. The idea is to increase and/or protect corporate value, directly or directly, by:
- increasing resilience,
- pursuing ESG-related opportunities,
- minimizing risks within the firm and throughout its value chain, and
- communicating effectively with stakeholders.
Traditional Compliance Obligations
Traditionally, businesses have had to comply with:
- the laws of each jurisdiction in which they operate,
- duties they agree to — notably contractual, and
- duties owed to shareholders.
New Kinds of Compliance Obligations
As Bob Dylan said, “The times, they are a-changin’,” and they have been for some time. Companies are finding themselves subject to new categories of expectations and to new kinds of laws.
Meeting Stakeholder Expectations
In the latter half of the 20th Century, the idea of Corporate Social Responsibility gained a foothold and created a new category of expectations. The people associated with those expectations, along with a company’s owners, came to be called “stakeholders”. They include employees, suppliers, investors, lenders, and people in the communities in which the companies operate. Specific items of concern to these stakeholders are often referred to as “ESG factors”.
Because most of ESG is not yet required by law, ESG is sometimes called “soft law”. Expectations may be low, or they may be high. Businesses increasingly believe they have to satisfy stakeholders’ expectations or suffer adverse consequences.
Some ESG factors have been incorporated into laws, or have been otherwise baked into governmental, commercial or financial regimes that can be quite coercive. This is a major trend, “soft law” becoming “hard law”, which is happening in country after country,
Broadly speaking, these laws place two kinds of duties on companies:
- laws that require disclosures of information to third parties, especially investors, about companies’ ESG risks and what they are doing about them, and
- laws that mandate ESG behaviors, for example, the new German Supply Chain Due Diligence Act and the impending European Union Corporate Sustainability Due Diligence laws. We call these “Value Chain Sustainability” laws (“VCS” laws). They are paradigm-shifting in many ways; for example, they make companies accountable for the ESG behaviors of their supply chains. This is closely related to third-party risk management (“TPRM”) and should be managed accordingly. (See our blog posts.)
VCS laws are mainly intended to prevent harm to human rights and to the environment. (In fact, VCS laws are sometimes called Human Rights and Environmental Due Diligence or “HREDD” laws.)
ESG Is Somewhat Different for Investors than for Operating Companies
ESG refers to a kind of investing. It also refers to the conduct of operating businesses. ESG investors and companies that use ESG principles may embrace the theory of “stakeholder capitalism” (recognizing obligations to people who are not shareholders) — or they may not — but they share a belief that their decisions should take account of considerations and metrics not reflected in traditional financial statements.
Investors and operating companies often have different perspectives on ESG:
- ESG investors demand that issuers of securities be responsive to ESG considerations. The historical background of ESG is “socially responsible investing” or “SRI”. Over time, much of the “beyond the financials” thinking, and the terminology used, came to be called “sustainable investing” or “responsible investing”. For such investors “ESG” is now the semi-official term of choice and the relevant unifying concept.
- On the other hand, beginning in the second half of the last Century, social and political reformers developed and advocated for the concept of “corporate social responsibility” or “CSR”, and the related terms “stakeholder capitalism”, “conscious capitalism” and “sustainable business” came into usage. All of these denote “beyond the financials” values and thinking. The uptake of these concepts by the business community has moved from antagonism or cautious approval to a much broader and increasing acceptance. This has been accompanied by an almost general understanding of the concept and general outlines of ESG.
Sustainability/ESG as a Functional Area
Sustainability/ESG is in the early stages of becoming a functional area of an organization. Chief Sustainability Officer is a new, increasingly common executive title.
Unlike traditional functions, like finance or manufacturing, ESG is inherently cross-functional and is one way in which companies dissolve the barriers between functional “silos”.
Examples of ESG Factors
A consistent characteristic of ESG is the grouping of what we call “factors” into three categories: environmental, social and governance. Here are some, but not all, of the factors:
In the environmental category, :
- Climate change and carbon emissions, which may result in
- assets becoming impaired, and
- adverse consequences to contributors to climate change
- Utilization of “natural capital” (such as biodiversity and raw materials sourcing)
- Pollution and waste management
- Energy efficiency
- Use of green technologies and renewable energy
- Air and water pollution
- Habitat degradation
- Water scarcity
In the social category:
- Health, safety, and human capital development
- Product and consumer safety
- Community relations
- Social opportunities
- Customer satisfaction
- Data protection and privacy
- Diversity and inclusion
- Employee engagement
- Human rights, including opposition to slavery/quasi-slavery
- Labor practices
And in governance:
- Regulatory compliance
- Board and executive oversight
- Board independence
- Shareholder rights
- Internal controls
- Transparency and ethics
- Board composition
- Audit committee
- Bribery and corruption
- Business model resilience
- Data privacy
- Executive compensation
- Political contributions
- Whistleblower schemes
We see all these as risk factors, and believe they should be managed accordingly.
In our opinion, a company’s risk management — including compliance management — is another factor in the Governance category, perhaps the most important of all.