Interplay between ESG and Corporate Governance: Outlines

17th September, 2024 - 12:55 pm Categories: Environment Law Practice 0 Comments

INTRODUCTION

Environmental, Social, and Governance (ESG) considerations have shifted in the modern business environment from a mere nicety in business strategies to its mandate. This change is part of a more general process that acknowledges that the sustainable management of a firm is both the right thing to do as well as being financially advantageous and protective of a company’s future performance. This has seen stakeholders today, such as investors, regulators and consumers, raise concerns on the compliance of companies to ESG and this sees corporate giants grappling with the complicated laws that exist in these fields.

Where corporate governance once concerned itself with holding managers and corporations to account, or of promoting equity and fairness within them, it must now do so with the additional context of sustainability. The emergence of ESG factors in corporate governance is changing the nature of organisations, the way business strategies are formulated, down to the senior management and all the way to supply chain decisions. Therefore, compliance has emerged as a key theme in ESG, as organisations have to navigate an ever-increasing body of law and regulations requiring sustainable business practices.

This blog focuses on taking a closer look at issues to do with corporate governance, ESG and pushing forward the legal angle of transitioning to sustainable business models. By reviewing the historical background of ESG, the current state of affairs, and the future trends, we want to present the most objective view of ESG’s impact on the corporate world and the way business organisations are changing to achieve both profit and sustainability goals.

HISTORICAL PERSPECTIVE ON ESG IN CORPORATE GOVERNANCE

The use of ESG principles as part of the approach to corporate governance is a comparatively new phenomenon, but its foundation can be linked to the development of a wider process of corporatisation of responsibility and social responsibility. ESG has therefore evolved over the years to become a more sophisticated approach to corporate governance moving away from a strictly monetary motives of business organizations to their social responsibilities to the society and the natural environment.

Corporate Social Responsibility – The Global Trend

The idea that now forms the bedrock of ESG practices was rooted in the idea known as Corporate Social Responsibility (CSR) that emerged in the middle of the 20th century. It has been noted that the philosophy of CSR appeared as the level of people’s concern with the effects of corporate operations on society and the natural environment increased. Business use in business began to emerge in which enterprises’ functions were not only to generate revenues but also to contribute positively to the society and the environment. There was the appearance of superadded proposals at this time as companies engaged in limited ethical sourcing, community participation, and environmentalism.

The Globalization Era: Towards a Theory of Corporate Social Accounting

In the last decades of the twentieth century, globalisation increased the scale of operations of transnational corporations through acquisitions of companies across frontier national frontiers, thus raising an outcry on how they were run. The expansion of businesses across the global borders occasioned a search for guidelines that could be parametered to offer ethic knowledge that can work well different parts of the world. During this period, many global codes designed to govern corporate conduct began to be developed, including the United Nations Global Compact (2000) and the Organisation for Economic Co-operation and Development’s Guidelines for Multinational Enterprises (1976). It was these initiatives that promoted the contestable business practices that would complement the international human rights, labour, and environmental standards.

This was also the time where the idea of the ‘Triple Bottom Line’ or ‘the economic, social and environmental profits and losses’ was a growing idea to undertake reporting besides the profit. This formed the basis for what the world came to know as ESG, which is a more legal form of the framework.

Experiencing Financial Crisis of 2008: Trigger for the Integration of ESG Factors

It can be argued that the 2008 global financial crisis was the starting point for credit and corporate governance as well as ESG integration. Relying on the ‘shareholder value’ model the crisis unveiled a major failure of the Anglo-American approach to corporate governance including excessive short-termism and reckless risk-taking in pursuit of short-term stock value increases. As it was seen during the crisis, observers are demanding that sound corporate governance must require consideration of ecological and social impacts to avoid future occurrences.

Costs, risks and benefits associated with corporate social responsibility increased the expectations of regulators, shareholders and other interested parties, and introduced ESG factors into mainstream corporate reporting. The crisis laid bare the links between the financial and social and the firm was compelled to take on the natural world.

The Modern Era: Integration of ESG Concerns into Legal and Regulatory Instruments

In the last decade only, ESG has shifted from being a nice to have concept to a compliance-based norm. Globally, governments and regulatory bodies have provided new laws and guidelines that make companies report on their ESG activities and outcomes. For instance, the European Union’s Non-Financial Reporting Directive (2014) requires companies reporting their non-financial information on dealing with social and environmental worries.

On the other hand, with the increase of the practices of responsible investment, more pressure is being applied to companies on ESG factors. Today, institutional investors develop policies that may follow the guidelines suggested by the UN’s Principles for Responsible Investment (PRI) and integrate the ESG factors into the investment decisions. This has turned ESG compliance into legal compliance and into a necessity to gain access to capital markets as well.

ESG COMPLIANCE CONCERNS NUMBER OF ISSUES AND RISKS

With the growth of Environmental, Social and Governance (ESG) initiatives forming a pivotal component of modern corporate governance systems, organisations have to deal with the broad spectrum of issues and operational risks associated with their conformity to these standards. There are also key challenges including: The constantly changing regulatory environment, particularly in areas of ESG reporting; expectations from stakeholders and; the challenge associated with the integration of ESG in operational activities. These concerns are not only threatening to a company’s supply chain and revenue figures but are also unlawful and can have enduring repercussions.

Regulatory Uncertainty and Complexity

On of the biggest hurdles to ESG compliance which has been identified is the fact that the regulatory landscape governing ESG is quite convoluted and sometimes patchy. For multi-SLOs, it is challenging to create a unified ESG regulation since they differ from one place to another. One key issue is that global regulation is somewhat inconsistent, so by law firms have to deal with the local laws that apply to the country the firm is based in, global guidelines issued by global professional bodies that sometimes differ, and also industry regulations that are often industry-specific. This is a problem since it gives raise to compliance risks since firms may not be aware of the changes in the regulatory landscape or interpret the rules correctly.

Also, as the governments and regulatory authorities are extending and polishing the ESG standards, the companies have to learn how to work through the changing standards indefinitely. Otherwise, a company may be subjected to fines, receive enhanced attention from the regulatory authorities and, lastly, investors’ confidence may be eroded.

The most highlighted difficulties or barriers to data collection and reporting involved in this research include the following:

What is vital along with performing and compiling full compliance is something else that is quite complicated for organizations: ESG reportage. Gathering, evaluating and disclosing ESG information involves systems and procedures, which can be expensive and take a lot of time to put in place. Several firms suffer from the absence of benchmark measures and reporting structures, which causes variations in the outlining of ESG data.

It is especially acute where information gathering entails numerous tiers in the supply chain and third-party accreditation, for example in the spheres of environmental influence and corporate social obligation. There are not only risks to the ESG strategy and achievements but also legal risks: accusations of the company’s actions can cause reputational damage and even be based on inaccurate or incomplete data.

Managing Profitability While Pursuing ESG Mang Coleman & S Knight

There is also a potential relationship between short-term corporate financial performance and long-term ESG objectives, which forms an enormous challenge to corporate compliance with ESG standards. Thus, the integration of ESG factors into business operations to achieve sustainable value creation is a task that in the process of its implementation still involves high investment costs, including invested in the use of efficient environmentally friendly technologies, the modernization of labor relations, or the strengthening of governance. These investments might not generate value which is realised in terms of direct financial measure, this creates conflict of interest between profitability and sustainable development goals or ESG initiatives.

There are some problems here that cut to the heart of modern business, especially for bosses and for directors, who often find that in order to meet numbers on their financial bottom line, they have to take actions that are at worst dubious on the ESG front and at best borderline. Firms that are not able to strike this balance may well find that they lose the confidence of investors, come under pressure from activists, or suffer the same stigma.

Litigation and Regulatory Scrutiny

The more ESG becomes incorporated as a governing factor in organizations, organizations are at higher risk of lawsuits and regulatory actions. Due to legal standards, proper implementation, and failure in the management of ESG issues, Companies undergo legal risks such as ESG regulation compliance and ESG risk disclosure and failure to address stakeholder expectations. For instance, it may involve legal risks such as environmental legal risks, personnel legal risks, and governance legal risks in which business undertakings could be subjected to penalties and sanctions due to legal infractions and in the process be badly reputed.

Another implication arising from the growth of shareholder activism is that legal claims on ESG matters have also become more prone to litigation. In the case of an issue like ESG, claims are increasingly brought in legal processes to force management changes or to demonstrate to directors that ‘no’ is not an acceptable answer. Furthermore, regulatory authorities start strengthening the obligations of organizations – in some regions, it is even prohibited to fail to meet ESG requirements.

Implication 3: Reputational Risks coupled with Stakeholders’ Pressure

For the modern generation of factory managers, legal risks connected with ESG non-compliance are as pernicious as reputational. Businesses and corporations are under pressure from investors, customers, employees, and other interest groups in the society and all these groups expect the best in ESG standards. The failure in this respect is costly since it is accompanied by severe reputation loss, lack of consumer confidence, and decreased investment appeal.

The use of social media and the utilisation of news around the clock makes it even harder for ESG related firms to manage their reputations. The risks of ESG violation are high because even minor violations or discrepancies in ESG standards, policies, or operations can attract exposés, protests, or campaigns for boycotts and divestment that escalate the consequences of ESG noncompliance.

Day to day Operational and Supply chain Issues

Yet another challenge is the integration of ESG practices in the processes of the company and its supply chain. Corporations need to guarantee that their supply and service chain is ESG-compliant, which is challenging to implement because, for example, some members of the supply chain are in countries with immature legislation on the issue. This is even more complicated due to the fact that compliance needs to be observed, monitored, audited, and reported all along the supply chain and this can be time consuming and costly.

Another set of issues is also related to the integration of ESG factors into various business activities. This may mean changes in the product offering, embracing of new technologies or systems, and commitment to sustainability, all of which force new major changes in the organization and on senior management’s balance sheets. These operation alterations can cause an interruption to business and lead to short term cash flow problems.

CONCLUSION

There is confirming evidence that the concepts of Environmental, Social, and Governance (ESG) as part of the corporate governance agenda is no longer an option but a requirement for efficiency and sustainability of organizations. As the rules and standards develop and the expectations of the shareholders grow, more obstacles and threats arise to achieve the ESG standards. Speaking of challenges, one should mention regulatory concerns and problems with data collection and harmonization, the question of ESG profitability and reasonable compromise, and risk of ESG reputation.

Yet these are also opportunities! Addressing ESG issues in advance enables organisations to strengthen their competitive edge, as well as improve and protect their reputations, and, therefore, their financial stability in the long term. The mitigation of the risks of ESG compliance is all about having effective governance mechanisms in place, and using solid reporting systems, the promotion of a positive corporate culture in relation to sustainability as well as profitability.

Given the rising expectations from the stakeholders who are now not just evaluating companies purely on their profits but also on the climate change policies they support, ESG if implemented effectively has become a legal prerequisite but more of a competitive necessity. Therefore, those firms that accept the new trends and endeavour to overcome such emphases will be suitable to meet the dynamics of a changing world market.

Author: Kaustubh Kumar, in case of any queries please contact/write back to us via email to chhavi@khuranaandkhurana.com or at  Khurana & Khurana, Advocates and IP Attorney.