What is ESG?
ESG, which is an acronym for Environmental, Social, Governance, is a measure of how well a business integrates with society and the environment, as well as its transparency to its shareholders.
The environmental considerations for businesses may include, but are not restricted to, reducing energy consumption and moving to renewable energy sources, minimising waste and encouraging recycling, incorporating corporate climate policies, and converting to greener products.
The social aspect focuses on business relationships (particularly those relating to employees, clients, and suppliers) and their impacts on society.
Lastly, governance looks at the management of businesses, its diversity, the ethical considerations factored into decisions, and the accuracy and amount of reporting produced by the company.
ESG in light of Covid-19?
ESG has grown exponentially in the past few years, with ESG-focused institutional investment expected to reach US33.9 trillion by 2026.
Covid-19 played a significant role in increasing the focus on ESG. The widespread lockdowns during the pandemic, which restricted travel and economic activity, caused a world record reduction in greenhouse gas emissions and air pollution and exacerbated social inequality on a large sale. For the first time, the public was clearly able to see the impact that companies had been having on the environment around them.
Interestingly, ESG focused funds and companies fared better during the pandemic, dispelling the belief that incorporating ESG factors into a business model is a performance trade off. It is no wonder that ESG is now a metric commonly used on exchange traded funds (ETFs) to inform investors about their investment decisions.
In the past two years, those EFTs that carry an ESG label has doubled. The concern is that it is up to the EFTs themselves to determine the level of sustainability of their own investment funds, leaving the investor to do their own due diligence as to the true nature of the classification. The Financial Conduct Authority (FCA) has warned of the "subjective nature of ESG factors and how ESG data and ratings are incorporated into benchmark methodologies". It asserted that there are "widespread failings" with the ESG benchmark that guides sustainable investment and that this is leading to a growth in greenwashing.
Greenwashing
Greenwashing is the practice of making unsubstantiated claims about how environmentally friendly a company is. Numerous high-profile companies have been discovered trying to persuade stakeholders that they are more ecologically friendly then they are. For example:
- In 2019, McDonalds introduced paper straws to replace their plastic ones in an effort to become more "eco-friendly". The irony was that, as it turned out, these paper straws were largely non-recyclable, whilst the plastic straws has been recyclable in the UK.
- In 2015, it was discovered that Volkswagen had been fitting various vehicles with software that would reduce emission levels during emissions testing. Some of these vehicles were emitting up to 40 times the legal limit of nitrogen oxide pollutants.
- H&M advertised clothes in their "Conscious Choice Line" as being a made with "a little extra consideration for the planet" even though some of the clothes in this line were made up of 100 percent polyester which is not biodegradable, evidently misleading consumers. In fact, in 2021, Changing Markets Foundation found that 96% of H&M’s sustainability claims were misleading or false.
Restricting the use of sustainable terms
In an effort to combat greenwashing, the FCA has proposed implementing restrictions on the use of sustainability related terms, such as "green", and to require companies to back up the sustainability claims that they make. The government has also suggested expanding the FCA’s remit to those who provide ESG ratings.
Whilst improved regulation of those advertising themselves as being "sustainable" will help curtail greenwashing, this only encapsulates those already purporting to be "green" rather than all companies. As a consequence, campaigners are calling for a more drastic approach which would have a much wider remit.
The Better Business Act
The Companies Act 2006 currently includes paying regard to "the impact of the company’s operations on the community and environment". However, The Better Business Act campaign looks to extend this further. The campaign proposes an amendment to section 172 of the Companies Act to empower directors to "exercise their judgment in weighing up and advancing the interests of all stakeholders" rather than purely the shareholders.
There are four principles that are reflected in the amendments (as set out on The Better Business Act website):
1. Aligned interests
The interests of shareholders are now advanced alongside those of wider society and the environment. This establishes a new principle of fiduciary duty within Section 172 of the Companies Act.
2. Empowering directors
This change must empower directors to exercise their judgment in weighing up and advancing the interests of all stakeholders.
3. Default change
This change must apply to all businesses by default. It must no longer be optional to benefit wider stakeholders beyond shareholders.
4. Reflected in reporting
Following this change, businesses must report on how they balance people, planet and profit in a strategic report or impact report, where one is currently required.
These principles supersede the theory of shareholder primacy, which currently exists, and will ensure that all UK companies take ownership of their environmental and social impact.
The campaign is a coalition of over 2000 companies, led by B Lab UK, who provide the certifications for companies know as B Corporations. These are companies which are certified as meeting certain standards of social and environmental performance, transparency and accountability. This proposed reform reflects this successful business model, which is already employed by over 1200 companies in the UK.
The Parliamentary Reception for the Better Business Act is taking place on 26 April 2023. It will provide parliamentarians and stakeholders the opportunity to discuss and reflect upon the proposal. You can stay up to date on the campaign here.
Even though the proposed amendments to section 172 are significant, they do not create new rights for stakeholders to hold the directors accountable. The reason for this is partly the fact that the risk of third party claims against directors would be overwhelming if all stakeholders had rights to pursue directors, leading to a very cautious and risk-averse approach being taken by directors in their decision making.
However, the current proposal would leave stakeholders reliant on the company (and possibly the shareholders) to hold the directors to account. There are limits on when an individual (rather than the company) can bring a claim against the directors for breaching their duty, an example being when a shareholder brings a derivative action claim on behalf of the company, but such claims are rare in practice and the court must grant permission.
Next steps?
It is widely accepted that current legislation and regulation is not effective at curtailing greenwashing. Whilst improved oversight from the FCA may help reduce greenwashing, it will only impact those claiming to be sustainable. Consequently, a more drastic change to legislation is required to have a greater impact. It will be interesting to see whether the proposed changes to s172 of the Companies Act are implemented.
Rebecca Sutcliffe