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Policy Review: Has ESG lived up to its promise of a better society?



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1.Introduction


ESG stands for environment, social and governance. It is a framework of non- financial parameters used to evaluate organization behavior and to assess an organization's business practices and performance on various sustainability and ethical issues.


ESG was first mentioned in 2006 in the United Nations Principles for Responsible Investment (PRI) report consisting of the Freshfield Report and “Who Cares Wins'' wherein ESG criteria was required to be incorporated in the financial evaluations of companies.



2.ESG Financial Instruments


As ESG gains traction globally, it has brought with it a variety of financial instruments. Businesses globally have been taking concrete steps to enhance innovation in the capital markets driven by ESG. Financial instruments such as green, social, sustainable, and transition bonds and loans, have gained popularity. However, there remains a lack of consensus on what is defined as “green”or “sustainable” or “social” for financial products along with a variety of different criterias for measurement and reporting.


2.1ESG Bonds


They may also be called ‘social bonds’ or ‘green bonds’ and are one of the most common forms of ESG lending. These bonds inject funds into projects that will have a positive impact on combating environmental or social challenges. The financial risk and return characteristics are the same as traditional bonds, but the added ESG characterisation may help reduce the interest rates and thereby help raise more capital.


For instance, the IFC’s Green Bond Program combines an attractive investment proposition with an opportunity to support climate-related projects in developing and emerging economies and has consistently been triple-A rated. The green bonds are issued in several currencies, enabling investors to diversify their investments while helping to improve the visibility of domestic markets to global green bond investors. As of June 30, 2021, IFC had issued 178 green bonds in 20 currencies.


2.2Sustainability linked bond (SLB)


It is a borrowing instrument where financial and structural characteristics are target based i.e. whether the issuer achieves sustainability or ESG metrics within a given timeframe. If the company doesn’t meet those goals, there’s a penalty: higher interest paid to investors. This performance-based instrument allows issuers to commit explicitly to future improvements in sustainability outcomes while benefiting from discounted interest rates on the bond.


There is growing investor appetite for SLBs as they offer several advantages that green or social bonds do not. First, unlike green bonds, funds provided are not earmarked for specific purposes and can finance any corporate activities. Secondly, SLBs allow a wider array of issuers that are unable to access green or social bonds. Green bonds require heavy capital expenditures in the green areas such as renewable energy, utilities, or green buildings and are therefore inaccessible for most companies. Thirdly, SLBs allow more flexibility to issuers who may not want to issue green bonds due to lengthy ESG disclosure requirements and the higher amount of key performance indicators (KPIs) required.



2.3Green Loans


A green loan is a form of financing that enables borrowers to use the proceeds to exclusively fund projects that make a substantial contribution to an environmental objective. A green loan is similar to a green bond in that it raises capital for green eligible projects. However, a green loan is based on a loan that is typically smaller than a bond and done in a private operation. Green loans contribute to aligning lending and environmental objectives. To be called a green loan, a loan should be structured in alignment to the Green Loan Principles, which provide an international standard based on the use of proceeds, process for project evaluation and selection, management of proceeds and reporting.


2.4Sustainability Linked Loans (SLLs)


These are loan instruments and/ or contingent facilities which incentivize a borrower’s achievement of predetermined sustainability performance objectives. SLLs are also referred to as ESG (environment social governance) linked loans and are based on the Sustainability Linked Loan Principles (SLLPs) which have been issued under guidelines1 dated 19 March 2019 issued by Loan Market Association, Asia Pacific Loan Market Association and Loan Syndications and Trading Association.


There are also a number of other financial instruments also becoming more popular such as green insurance, micro credits for sustainable development and green investment funds.



3.Do these ESG- linked financial instruments actually create a positive impact?


ESG is moving from the periphery to the mainstream, transforming the capital and finance market. In 2021 alone, funds invested in sustainable and ESG-oriented funds increased globally by 53 per cent to US$2.7 trillion.


With sustainability-linked instruments, a company is essentially putting their money where their mouth is. The capital raised is designed to push the envelope when it comes to sustainability targets. Companies that issue a linked-bond or loan are making a very public statement about their sustainability ambitions and their intent to follow through on environmental or social commitments.


ESG-linked financial instruments incentivize a shift in behavior, whether it's lowering greenhouse gas emissions, decreasing wastewater usage, or improving diversity in senior management positions. By hitting those measurable, benchmarkable, and publicly disclosed targets, not only does the community and the environment benefit from those activities, the company is also pushed to do better.


An example of positive impact - Heathrow Airport recently issued a landmark sustainability-linked bond that ties the financial mechanism of the bond to a 15% reduction of absolute "in the air" scope 3 emissions by 2030.


One of the strategies identified by the airport to achieve this target is the adoption of sustainable aviation fuels. This aims to contribute 7% towards its 2030 emissions reduction target.



4.Policy framework and regulations


Globally, ESG regulations have increased by 155% over the past decade, as the rapid growth of sustainability-based policy interventions continues to shape financial markets.


In India, the evolution of ESG regulations are still at a nascent stage, where so far the focus has been on providing protection regarding the environment or workplace conditions without incorporating the controls and disclosure that are a hallmark of contemporary ESG regulation.


The regulatory framework in India governing ESG issues is not codified under consolidated legislation but is captured by a plethora of laws addressing ESG-related matters that apply to the operations of corporate entities in India such as:


● environmental protection (eg, the Environment Protection Act, 1986; the Water (Prevention and Control of Pollution) Act, 1974);


● employee benefits (eg, the Factories Act, 1948; bonus and gratuity laws); and


● corporate governance (eg, the Prevention of Money Laundering Act, 2002; the Companies Act, 2013; the Securities and Exchange Board of India (SEBI) Act, 1992).


Notably, certain parts of the ESG framework – specifically, the laws relating to the environment – have not been periodically updated to reflect contemporary sustainability standards.


These are the current ESG regulations in India:


● The Securities and Exchange Board of India (SEBI), i.e., the capital markets regulator, made it mandatory for the top 1,000 listed entities by market capitalisation to include, in their annual report, a business responsibility and sustainability report (BRSR) describing the initiatives taken by the listed entity from an ESG perspective. The remaining listed entities may voluntarily submit such reports. The BRSR seeks disclosure from listed entities of their performance against the principles of the National Guidelines on Responsible Business Conduct, the Sustainable Development Goals (SDGs), and the United Nations Guiding Principles on Business and Human Rights.


Reporting under the BRSR format is divided into: general disclosures; management and process disclosures; and, principle-wise, performance disclosures. Reporting under each principle is divided into essential indicators which are to be mandatorily disclosed and leadership indicators which may be voluntarily disclosed.


The BRSR also provides for interoperability of reporting, i.e.entities that prepare sustainability reports based on internationally accepted reporting frameworks (such as the Global Reporting Initiative (GRI), Sustainability Accounting Standards Board (SASB)) may cross-reference the disclosures made under such frameworks to the disclosures sought under the BRSR.


● SEBI released the SEBI (Credit Rating Agencies) (Amendment) Regulations, 2023 making India the first country to regulate ESG ratings. This regulation will enforce greater ESG-related information disclosure by Indian corporations, compelling them to take action to mitigate their negative impact on the environment and society.


● The Ministry of Environment, Forest and Climate Change released a notification on the Green Credit Programme. The Programme establishes a domestic voluntary market mechanism where Green Credits can be traded. These credits act as incentives and will be available to various stakeholders, including individuals, private sectors, industries and cooperatives.



5.Comparing India’s regulations with that of developed countries


The disclosure requirements of the United States of America could be said to be similar to India’s. Currently, the Securities and Exchange Commission (SEC), the market regulator in America, requires all public companies to disclose information that may be material to investors, including information on ESG-related risks, and has issued guidance and rules setting forth its disclosure expectations. Other regulations are State specific such as, a dozen states have enacted requirements to enhance diversity on boards whereas a few states have leveraged regulation of their pension systems to advance sustainable investment.


Comparatively, the European Union’s regulations are wider in scope and depth with the aim to improve private sector transparency and accountability around ESG impacts and risks to promote sustainable economic growth and investment in the EU.


The EU Corporate Sustainability Reporting Directive is a policy requiring large companies and public-interest entities operating in the EU to disclose information on their ESG performance annually to improve transparency, credibility and accountability around corporate ESG performance. Companies will need to follow a “comply or explain'' approach, meaning they must disclose the requested ESG information or provide an explanation of why they are not able to do so. The companies will need to prepare a non-financial statement that discloses information on their policies, risks, impacts, and outcomes relating to ESG issues.


The EU Taxonomy is a classification system that defines what economic activities that can be considered environmentally sustainable. To qualify as being sustainable, an activity must contribute to at least one of the following six environmental objectives laid down and not significantly harm the other objectives.


The Sustainable Finance Disclosure Regulation focuses on the transparency of financial market participants, including banks, insurance companies, asset managers, and pension funds. It requires these organizations to disclose information about their ESG policies, risks, impacts and performance at both an entity (company) and product level. Financial firms with investment funds must also disclose what percentage of their products are in line with the EU taxonomy and for products that don’t meet the criteria, these companies must provide an explanation for why not.


On 13 June 2023, the European Commission unveiled its latest sustainable finance package. One of the key measures in the package is a proposed regulation seeking to address deficiencies in the operations of ESG ratings providers and enhance transparency around sustainability ratings and scores. A second part of the package expands the EU Taxonomy Regulation to include new criteria for economic activities related to environmental objectives.


We shall also take a quick look at the ESG regulations in the emerging/ developing markets i.e. Brazil, Russia, China and South Africa:


Similar to India, Brazil has strong environmental and labour regulations in place. Other than these, the Securities and Exchange Commission of Brazil, requires listed companies to provide information on ESG practices and indicators under a “comply or explain” basis on an annual basis, and is subject to investigation and administrative penalties in case of misrepresentation. This resolution requires companies to explain: (i) where they publish their ESG matters; (ii) if such publications are audited by any independent advisor; (iii) the adoption of any (and which) ESG key performance indicators; (iv) greenhouse gas emissions; (v) business opportunities related to ESG; (vi) ESG risk factors potentially affecting decisions by the company investors; (vii) the role of managing bodies in ESG matters; (viii) the existence of internal channels permitting the flow of ESG information/complaints; and (ix) ESG elements affecting management compensation.


Additionally, Brazil’s Central Bank, requires the annual disclosure of a Social, Environmental and Climate Risks and Opportunities Report and aims at promoting transparency and market discipline to identify the level of commitment of institutions to a sustainable and inclusive economy.


The country also has certain voluntary ESG disclosures and guidelines in place to encourage companies to adopt transparency measures.


There is not a lot of data with respect to ESG regulations in Russia with the sustainable financial market said to be at a very early stage. While Russia may not have specific ESG regulations, it does have general environmental and social legislation that applies to various industries.


In China, a solid environment protection system has been established. In ESG- oriented regulations, the China Securities Regulatory Commission has made a series of regulations on environmental information disclosure for listed companies. The Asset Management Association of China released the Research Report on Chinese Listed Companies’ ESG and Green Investment Guidelines (Trial), establishing a core index system to measure listed companies’ ESG performance. In 2019, the Shanghai Stock Exchange issued the Listing Rules of the Shanghai Stock Exchange Science and Technology Innovation Board to clarify the information disclosure requirements for ESG.


However, at present, most Chinese enterprises still have low requirements for implementing ESG, and the disclosure of ESG data still lacks certain standards.


Regulation has been a key driver of ESG integration in South Africa.


● The Pension Funds Act, 1956 requires a pension fund, as well as its board to “before investing in and whilst invested in an asset consider any factor which may materially affect the sustainable long-term performance of the asset including, but not limited to, those of an ESG character. However, it does not prescribe what ESG factors must be considered.


● JSE-listed companies are subject to general continuing disclosure obligations under the JSE Listings Requirements, which apply to financially material ESG issues. JSE-listed companies have to annually report, on an “apply and explain” basis, the extent to which they have complied about how an organization’s strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value in the short, medium and long term.


Voluntary guidelines also supplement ESG-related regulation that seeks to guide institutional investors in developing and implementing sustainable and long-term investment strategies


In June 2023 the International Sustainability Standards Board (ISSB) issued its first two IFRS Sustainability Disclosure Standards, IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information and IFRS S2 Climate-related Disclosures.


IFRS S1 builds upon the Integrated Reporting framework and emphasizes the need for consistency and connection between financial statements and sustainability reporting. Users of the standards are expected to explain the linkages between information and use consistent assumptions. On the other hand, IFRS S2 incorporates the recommendations and guidance of the Task Force on Climate-Related Financial Disclosures (TCFD), covering governance structure, strategy, risk management, and metrics/targets related to climate-related issues.


While ISSB standards are voluntary, the possibility of jurisdictional adoption in specific regions may require firms to report in line with the new standards.


Sustainability is no longer about values. It is now about value.


That's what Emmanuel Faber mentioned, upon the launch of the IFRS Foundation sustainability standards. But how exactly does it work?


In essence, the IFRS sustainability standards ask companies to:


1. Disclose and assure their Scope 1, 2, and 3 CO2 emissions, targets, and progress

2. Highlight what parts of their balance sheet are at risk due to the effects of climate change (this is the "value" part)

3. Put appropriate governance in place to oversee the process


The framework is simple yet powerful. It comes down to measuring and disclosing CO2 emissions data and their relationship to the balance sheet. And powerful, because it speaks the language of accounting and investing, translating climate data into investor data.


Consider this example: California and the EU have, for the most part, banned internal combustion engines for new cars by 2035. Having a car company simply indicate their emissions, as has been the case up until now, wouldn’t be very meaningful as such, in the context of making sustainability about "value". But revealing what parts of their business are affected by these emissions will be a “game changer,” Faber said. You will now be able to compare car companies like for like, by seeing just how many of their current cars are "at risk" given the new regulation. And you'll see how much of their future business is at risk, based on their projections into the future. For investors, that's extremely "valuable" info.



6.ESG- Success or Failure?


ESG has become increasingly important to investors and consumers alike. From reducing Carbon Emissions to promoting diversity and inclusion, ESG practices have a significant impact on the bottom line of businesses. Let's look at some success stories of ESG Impact:


1.PATAGONIA


Referred as ESG’s Golden Child, Patagonia is envisioned not only as a retail Clothing line brand, the brand is an ode to social goodness. As counterintuitive as it sounds, a fashion company – conventionally synonymous with levels of high pollution – may have proved the impossible possible: planet and profit can coexist.


From animal welfare protection programs and migrant worker support to supply chain transparency, it covers all aspects of ESG. In 2020, the ownership of Patagonia was transferred to the Patagonia Purpose Trust (a uniquely curated trust) and Holdfast Collective (a non-profit). This ensures that the company’s profits of around $100 million per year are dedicated to combating ecological crises such as biodiversity loss and climate change.


2.IKEA IWAY


IWAY, the IKEA way of responsibly procuring products, services, materials, and components. It is a Code of Conduct for Suppliers and IKEA’s Value Chain to meet certain environmental and humanitarian qualities to work with.


IWAY focuses on four key areas: positive impact on the environment, decent and meaningful work for workers, promotion of children's rights, and animal welfare. A due diligence process, including verification by approved auditors, is embedded in the value chain to identify and minimize risks. In fact, IWAY has evolved over time. In 2020, IKEA introduced a new generation of requirements and ways of working to reflect the changing world.


By prioritizing sustainability, diversity, and ethical sourcing, these companies have created a brighter future for their employees, customers, and the planet, but also gain the rewards of increased value and success.


While the intentions behind ESG investing are good, this risks leading to greenwashing, a practice of companies that use marketing to convince the public that their products and business operations are environmentally friendly. And it may well be that the lack of a coherent and agreed-upon definition has encouraged those views.


Here are some of the adverse impact stories of ESG:


1.TESLA


Despite Tesla being a vertically integrated sustainable Energy Company aiming to transition the World to Electric Mobility, it was cut from S&P 500 ESG Index released in May 2022. The official statement read, “Tesla’s “lack of a low-carbon strategy” and “codes of business conduct,” along with racism and poor working conditions reported at Tesla’s factory in Fremont, California, affected the score.” While Companies like multinational Oil and Gas Exonn and tobacco making Company Philip Morris were included in the list.


However, Tesla made back into the list in 2023.The back-and-forth over the index changes reflects a wider debate about the metrics used to judge corporate performance on environmental, social and governance (ESG) issues, a growing area of investing.


2.H&M


The fast-fashion brand, H&M, faced accusations of greenwashing for misleading consumers with its Environmental Scorecards. To offer consumers information about its Conscious Choice collection, H&M used a fashion industry metric called the Higg Sustainability Profile.


However, more than half of H&M's scorecards overstated their respective products' environmental soundness, according to Quartz. In one example, a scorecard for a garment that required 20% more water to create than average said the garment required 20% less water. H&M said a technical error caused this discrepancy.


Many others like Volkswagen, Coca Cola, Walmart have faced accusations of Greenwashing in the past. As a result, some Companies shy away from marketing their ESG efforts due to fear of Greenwashing claims. Even Customers trust in Sustainability initiatives seems to be worn down. Further let us look at the position of ESG at present.



7.CURRENT STATUS OF ESG


7.1Environmental Aspect


As humanity grows and expands its footprint through the 21st century, we are changing the world in unprecedented ways. Human impact on the physical environment is becoming increasingly evident. Overpopulation, pollution, burning of fossil fuels and deforestation have all contributed to climate change, affecting worldwide ecosystems that we, and all species, depend on.


Businesses are transitioning to sustainable practices and deploying positive change in the Supply Chain, the market, their policies and the culture. For example, Ford and Nike are two of many companies that manufacture their product from recycled materials. Consumer interest in sustainability is growing, and we are seeing evidence of mass behavioral change, like the meteoric rise of electric vehicle sales. Consumers aren’t afraid to call out and scrutinize companies on their environmental pollution, which we saw in response to businesses that failed to reduce their plastic consumption.


"Surveys suggest that Customers have a clear sense of personal responsibility, want to make the world a better place, and when asked, an increasing majority says they are willing to pay a premium for sustainability. They want to purchase green products, reduce their energy usage, buy second-hand, pay for fair trade and donate to charities” - DELOITTE


Additionally, in 2020, over 330 enterprises, including Adobe, Microsoft and VISA, called on a “bipartisan group of federal lawmakers to build back a better economy by infusing resilient, long-term climate solutions into future economic recovery plans.” This new type of business leadership is helping the world transition toward a sustainable economy.


Besides the public’s interest in ESG investing, the asset management industry is also increasingly attracted by it, since selling products that are billed as “environmentally friendly” or “green” is often a way to charge consumers higher prices.


While this is one side of the coin, the other includes rising claims of accusation of Greenwashing, Greenhushing, a practice of companies that use marketing to convince the public that their products and business operations are environmentally friendly. For Example, misleading messages like H&M uses sustainability claims as “CONSCIOUS CHOICE” and Decathlon uses “ECODESIGN”.


7.2Social Aspect


As the business environment continues to evolve, so must corporate policies, especially when it comes to safeguarding stakeholders. Just as the internet changed the way businesses operate, companies worldwide have had to reassess how to handle and protect their data. The General Data Protection Regulation (GDPR) is now a fundamental legal component of business.


A growing number of investors are basing their investment decisions on ESG factors, as companies with strong ESG performance are more likely to provide better financial returns and reduced risks. Social factors investors use to assess corporate social performance can include concepts such as providing its employees with a safe and healthy working environment, how it invests resources in the communities in which it operates and general business ethics.


“In most organizations, sustainability is now generally acknowledged as both a valuable risk-management tool and a long-term contributor to the bottom line… However, one strong value proposition associated with sustainability is still waiting to be consistently integrated into most corporate strategies. And that is the potential for leveraging customer engagement through sustainability." -Deloitte


Companies that drive positive social impact are more attractive to investors. Such actions can include hiring a local workforce, offering competitive employee benefits, or helping communities tackle challenging social issues, such as sustainable farming or affordable housing. Furthermore, companies that are inclusive in their hiring culture tend to have a more positive outlook on society, and people tend to see them more positively.


Research by the Harvard Business Review confirms that, “the adoption of strategic ESG practices is significantly and positively associated with both return on capital and market valuation.”


ESG initiatives are synonymous with corporate strategy, and companies with long-term objectives are adopting ESG practices. Larry Fink, CEO of BlackRock, the world’s largest asset management firm, wrote in a 2020 letter that, “a company cannot achieve long-term profits without embracing purpose ... a strong sense of purpose and a commitment to stakeholders helps a company connect more deeply to its customers and adjust to the changing demands of society.”


7.3Governance Aspect


By examining a company’s internal procedures, leadership structure and potential conflicts of interest, good governance policies can help keep you out in front of potential violations or sanctions.


The financial crisis that struck world markets in 2008 was the most devastating economic disaster since the Great Depression, according to many economists. While numerous factors contributed to the recession, it could be argued that poor corporate governance and oversight played a major role, citing an overemphasis on short-term profits, excessive pay and greed at the expense of long-term sustainable growth. Poor corporate governance practices have often times been the foundation of some of the biggest corporate scandals and controversies.


For Example, failure of Silicon Valley Bank is a Governance component failure of ESG. It was flagged for a lack of board-level risk management expertise since 2016 and a lack of industry expertise on the audit committee since 2021. The company did not have a Chief Risk Officer – a highly specialized role specific to just a few industries, including banking in 2022.


The Global Reporting Initiative – a global standard setter for impact reporting – provides helpful guidance to consider. GRI requires disclosure of reporters’ governance structure and composition, the role of the “highest governance body” (often the Board) in setting purpose, values and strategy, in risk management, in sustainability reporting, in evaluating performance, member competencies and performance, remuneration and incentives.


Composition factors include membership in underrepresented groups, gender and other factors that have new prominence today. For example, S&P Global Market Intelligence research revealed that companies with better female representation within corporate boards and C-Suite positions experience greater financial performance and profitability than companies with lower gender diversity.


The study found that, “in the 24 months post-appointment, female CEOs saw a 20% increase in stock price momentum, and female CFOs saw a 6% increase in profitability and 8% larger stock returns.” The analysis found that the driving force for the superior results was due to female executives being held to a higher standard.



8.STRATEGIC IMPLICATIONS


The uncertainty faced by the World now has required businesses to deploy long term sustainable solutions. Corporate ESG policies and practices are closely watched by investors, employees, customers, government officials and other stakeholders. That makes an effective ESG strategy underpinned by strong management processes increasingly important to long-term business success.


Studies show that most large companies have ESG programs. In a report published in October 2022, consulting firm KPMG said its research found that 96% of the world's 250 largest companies by revenue report publicly on ESG or sustainability matters. A strong ESG proposition correlates with higher equity returns, from both a tilt and momentum perspective.


Better performance in ESG also corresponds with a reduction in downside risk, as evidenced, among other ways, by lower loan and credit default swap spreads and higher credit ratings.


These five links to Value Creation are a way to think about ESG systemically. Incorporating ESG framework in the Corporate Strategies not only provides Competitive Advantage but also increases financial and non-financial performance.




9.How does ESG support Risk Management?


Risk Management strategies are designed to help organizations deal with a wide range of risks. In the past, this range mainly consisted of financial, compliance, or operational risks.


A new class of risks has emerged in recent times and is known as ESG risks that address environmental, social and governance issues. ESG Risk Management has emerged as an important aspect of risk analysis and management for any company or organization. A 2023 IBM IBV study showed that organizations that are seen as ESG leaders are 43% more likely to outperform their peers on profitability.


ESG risks fall into three pillars, and each organization will face issues specific to its industry and operations.


1. Environmental Risks


These risks include environment-related issues such as Greenhouse gas emissions (GHG), deforestation, pollution, water usage, biodiversity, waste, etc.


2. Social Risks


These include factors such as customer relations, human rights, labor rights, employee relations, occupational safety and health, supply chains, diversity, inclusion, etc.


3. Governance Risks


These risks include issues such as succession planning, board management practices, executive compensation diversity among board and management, corruption, fraud, data hygiene, security, equity, etc.


Companies must navigate compliance and regulations specific to their industry, take the board of directors’ oversight of risk management policies into account, develop reliable risk management systems and internal controls, decide what information must be disclosed to the public and investors, and provide guidance for prudent decision-making and efficient resource allocation.


ESG data is essential for assisting businesses in engaging in effective risk management because it enables them to plan for compliance, enhance voluntary disclosures, and develop risk mitigation roadmaps to handle threats in advance.



10.Challenges & What can be done better : A Corporate View


10.1Seeing ESG as a Compliance Activity


When companies perceive ESG as a compliance activity, they tend to approach it as a box-ticking exercise rather than a strategic priority. To address this challenge, companies should:


a.Foster a culture of sustainability: Promote a mindset shift that views ESG as a strategic imperative rather than just a regulatory requirement. This can be achieved by integrating sustainability into the company's mission, values, and overall strategy. Tesla, an electric vehicle and clean energy company, has revolutionized the automobile industry with its focus on sustainability. Their mission is to accelerate the world's transition to sustainable energy. Tesla's electric vehicles and energy storage products aim to reduce reliance on fossil fuels and combat climate change. They also promote renewable energy adoption through initiatives like solar panel installations and battery storage systems.


b.Communicate the business case for ESG: Clearly articulate the value proposition of ESG, emphasizing how it aligns with long-term business resilience, reputation, and stakeholder expectations. This helps employees and stakeholders understand the strategic importance of ESG beyond compliance.


For example, Unilever has been proactive in communicating the business case for ESG. The company's Sustainable Living Plan serves as a clear framework for its sustainable business practices. Unilever communicates the financial benefits of its sustainability initiatives, emphasizing cost reductions achieved through waste reduction, energy efficiency, and sustainable sourcing. They also highlight the positive impact on brand equity and customer loyalty.


10.2Lack of Clear Ownership and Success Metrics:


Without clear ownership and well-defined success metrics, companies may struggle to set and achieve their ESG goals. To address this challenge, companies should:


a.Assign dedicated ESG roles: Appoint individuals or teams responsible for driving ESG initiatives, ensuring accountability and coordination across the organization. This includes establishing a clear reporting structure to ensure ESG efforts are integrated into decision-making processes. The number of Chief Sustainability Officers (CSOs) at corporations globally is skyrocketing. According to a May 2022 study in Reuters, the number of CSOs holding an executive level position increased to 28% in 2021, more than tripling from 9% in 2016.


b.Define measurable and meaningful metrics: Establish key performance indicators (KPIs) that reflect the company's ESG priorities and are aligned with industry best practices. These metrics should be regularly tracked, reported, and integrated into performance evaluations and executive compensation. The vast majority of S&P 500 companies are now tying executive compensation to some form of ESG performance—growing from 66 percent in 2020 to 73 percent in 2021. The most significant increase was found in companies’ use of diversity, equity & inclusion (DEI) goals, rising from 35 percent in 2020 to 51 percent in 2021, as investors and other stakeholders continue to focus on diversity—making it a priority for companies as well. And as a result of the ever-growing attention to climate change, the share of S&P 500 companies that tied carbon footprint and emission reduction goals to executive pay also grew considerably, from 10 percent in 2020 to 19 percent in 2021.


10.3No Immediate ROI or Link to Company Performance:


ESG initiatives often require upfront investments without immediate financial returns, making it challenging to prioritize them over other business activities. To address this challenge, companies should:


a.Develop a long-term perspective: Recognize that ESG goals may have intangible benefits that translate into long-term value creation, such as enhanced brand reputation, improved stakeholder relationships, and reduced regulatory risks. Communicate this perspective to shareholders and investors to garner support. As a pioneer in the ESG space, Schneider Electric has been able to address these kinds of challenges much earlier than most — and is already on the way to ensuring sustainability is a shared priority among employees, vendors, customers, and other stakeholders. Leading by example, Schneider Electric is helping other companies to achieve their net-zero goals too.


b.Explore innovation opportunities: Encourage innovation and research and development (R&D) efforts focused on ESG. Identify areas where ESG considerations can lead to new market opportunities, cost savings, or operational efficiencies. Demonstrating the potential for innovation-driven ROI can help secure resources for ESG initiatives. Google (Alphabet Inc.) has made significant investments in ESG-focused innovation and R&D. Through its initiatives such as Google Sustainability Labs, the company explores cutting-edge technologies and solutions to address environmental challenges. Google supports research and development in areas like renewable energy, circular economy, sustainable agriculture, and climate change mitigation.


10.4Lack of Integration into R&D Portfolio Planning:


Companies often overlook the integration of ESG considerations into their research and development (R&D) portfolio planning, missing opportunities for sustainable product and process innovation. To address this challenge, companies should:


a.Integrate ESG into innovation frameworks: Incorporate ESG criteria, such as life cycle assessments, eco-design principles, and stakeholder input, into R&D processes. This ensures that ESG considerations are embedded from the early stages of product or service development. Philips, a multinational technology company, incorporates ESG criteria into its R&D processes for healthcare products and solutions. The company utilizes lifecycle assessments to understand the environmental impacts of its products and services. Philips applies eco-design principles to develop energy-efficient and environmentally friendly healthcare technologies. Stakeholder input is sought through collaboration with healthcare professionals, patients, and experts to address social and ethical aspects of product development.


b.Foster collaboration: Encourage cross-functional collaboration between R&D teams, sustainability experts, and business units to identify and prioritize ESG-related innovation projects. This collaboration helps align ESG goals with overall business objectives and facilitates knowledge sharing.


10.5Limited Employee Engagement and Understanding:


For effective implementation of ESG initiatives, it is crucial to engage and educate employees at all levels. To address this challenge, companies should:


a.Communicate the purpose and impact of ESG: Educate employees about the importance of ESG, how it aligns with the company's values and mission, and the positive impact it can have on stakeholders and society. Use various communication channels, including training programs, internal newsletters, and town hall meetings.


b.Foster employee involvement: Encourage employee participation in ESG initiatives by creating channels for feedback, idea sharing, and volunteering opportunities. Empower employees to contribute their expertise and passion to drive ESG-related innovation within their respective roles.


c.Provide training and resources: Offer training programs and resources to enhance employees' understanding of ESG topics and their integration into business operations. This helps build a shared knowledge base and ensures a common understanding of ESG goals and strategies.


Charise Le, Schneider Electric's chief human resources officer, identified three ways in which HR can ensure the success of ESG strategies.


First, own the people, strategy and connection to ESG. "Our people strategy supports business growth, our culture, and leadership transformation," she said. "By 2025, we commit to creating equal opportunities by ensuring all employees are uniquely valued in an inclusive work environment, and by fostering learning, upskilling, and development for each generation."


Second, use ESG as a motivational catalyst through incentive plans which highlight the importance of sustainability performance. For example, Schneider Electric has incorporated sustainability performance criteria in the short-term incentive goals for employees since 2011. Additionally, a portion of the award under the long-term incentive plan is subject to meeting sustainability objectives.


And finally, be an advocate, continuously engaging employees in everything in the ESG space. "HR can help connect employees to our ESG goals by promoting diversity, supporting professional development, and ensuring safe, healthy working conditions," Le said.


By addressing these challenges and implementing the suggested actions, companies can overcome barriers to focusing their innovation efforts and resources on ESG goals, leading to more effective and impactful ESG integration within their operations.



11.Why should Governments care about ESG?


1.Protection of People, Society, and the Environment: ESG aligns with the government's responsibility to safeguard the well-being of its citizens, social structures, and the environment. Legislation, regulations, and policies governing emissions, water use, waste management, health and safety, gender equity, and corporate governance have direct implications on companies' ESG performance and the overall reputation of the jurisdiction.


2.Business and Investment Attraction: Global investors increasingly consider ESG factors when making investment decisions. Governments that promote clear ESG disclosure and strong ESG performance enhance their investment and procurement competitiveness. By supporting sustainable practices, governments improve the jurisdiction's appeal to businesses and foreign direct investment, facilitating economic growth and job creation.


3.Impact on Credit Rating and Borrowing Costs: ESG considerations not only apply to companies but also extend to jurisdictions. Credit rating and investment research agencies now incorporate ESG factors in their risk assessments of governments at various levels. Positive ESG ratings can directly influence the government's credit rating, borrowing capacity, and borrowing costs, highlighting the financial implications of prioritizing sustainability.



12.How can Governments contribute to the success?


Governments can take several actions to maximize the benefits of robust ESG performance:


1.Support Strong and Consistent ESG Reporting: Governments can play a role in establishing and promoting standardized ESG reporting practices across companies, sectors, and industries. By providing a shared language and framework for reporting, it becomes easier for businesses and government departments to communicate and tell a common ESG story. This consistency fosters transparency, comparability, and accountability in ESG practices, enabling better decision-making by investors and stakeholders.

A recent INSEAD survey of Limited Partners (LPs) found that only 45 percent of general partner (GP) investors report any ESG or impact metrics, and most of them focus only on positive stories. The survey also found that less than one in six GPs report granular impact data. A recent report from BlueMark reviewed 31 impact reports from existing impact investors. It showed that fewer than half used standardized indicators cited any sources or defined their metrics, limiting the comparability of reported data. Given this poor track record, the consensus is growing that private equity funds could and should take the lead in first standardizing ESG and impact accounting and then embedding those standards and metrics into their daily operations.


2.Raise the Bar for ESG Performance: Utilizing data and policy, governments can incentivize high ESG performance among companies and jurisdictions. By offering incentives and creating favorable conditions for sustainable practices, governments encourage businesses to prioritize ESG considerations. Sending strong signals about the importance of continuous improvement in ESG performance further drives positive change.


3.Communicate the ESG Story: For strong ESG performance to yield benefits, the government must ensure that ESG-related data and information are easily accessible to interested audiences. Providing accessible and user-friendly platforms for sharing ESG data enhances transparency and empowers stakeholders to make informed decisions based on sustainability criteria.


4.Provide Clarity for Investors: Governments have a role in setting clear rules and regulations related to ESG claims, similar to other financial aspects. By providing clarity and guidance, government agencies boost investor confidence and attract more investment into sustainable businesses and projects. Clear ESG guidelines help investors evaluate the risks and opportunities associated with sustainable investments.


By implementing these actions, governments can effectively promote and support ESG practices, leading to a more sustainable and responsible business environment, benefiting both the economy and society at large.



13.Concluding thoughts


As the world faces a number of global challenges including climate change, transitioning from a linear economy to a circular one, increasing inequality, there is an increasing expectation from not only investors and regulators but also from consumers and employees that organizations should not only be good stewards of capital but also of natural and social capital and have the necessary governance framework in place to support this.


As we moved along looking at various financial Instruments of ESG to know about the evolution of policy frameworks and regulations in emerging countries like BRICS nations and developed nations like the European Union, the US, we could look at the success and failures examples in the field. We also analyzed the current status of ESG and the strategic implications it entails assisting the companies in risk management and asset optimization. Lastly, we charted out the challenges arising in the corporate sector and what more could be done by the corporates and Governments to support the implementation of ESG metrics to ultimately ensure sustainable growth.


Though ESGs are considered to be non- financial performance indicators, they ensure implementation of systems and processes and accountability for the same to manage an organization’s impact such as carbon footprint, treatment of employees and regulatory compliance and risk management initiatives. ESG initiatives also contribute to broader business sustainability efforts that aim to position companies for long-term success based on responsible corporate management and business strategies.



Meet The Thought Leaders



Subham Rajgaria is a mentor at GGI an undergraduate from IIT Kharagpur. He is an incoming MBA candidate at HBS. He has worked at legacy firms such as Westbridge Capital and Mckinsey & Co.








Meet The Authors (GGI Fellows)




Isha Tambakuwala is a Commerce graduate from Lady Sri Ram College, Delhi. She is passionate to find a niche in the Impact sector by bridging the gap between Business and Social Impact/Impact Investment.

She is also an Artist who likes to express herself and social agonies through her artwork. Also, she is a fitness enthusiast who participates in annual treks and marathons.





Jahnvi Jethanandani is a Strategy consultant based out of Dubai and an ex-founder of a renewable energy-based startup in the PPP model in India. She is an MBA from IIM Shillong. She is keenly interested in exploring Sustainable growth models for Organizations and Nations.







Shweta Bhatia is working as a legal and compliance associate for an incubator & accelerator for start-ups in Mumbai. She has done her Law and is a Company Secretary. She is interested in working in the impact space to build solutions for vulnerable communities and assist in strengthening linkages between sectors.





If you are interested in applying to GGI's Impact Fellowship program, you can access our application link here.


 

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https://corpgov.law.harvard.edu/2022/11/27/linking-executive-compensation-to-esg-performance/


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https://www.impactphl.org/news-archive/perspectives/vol65

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