ESG: key concepts for businesses and investors

A company that considers government policy directions in its activities is familiar with the terms “ESG concept,” “ESG factors,” “ESG criteria,” “ESG principles,” “ESG risks,” etc. Open sources, expert discussions, and industry publications provide a general idea of ESG. However, determining the first step can be challenging because of the vast amount of information available, and it requires time and effort to separate key issues from minor ones.

The ESG concept combines Environmental, Social, and Governance areas. There is currently no single generally accepted definition of this term. Therefore, ESG could be considered:

• as an independent concept of assessing the company’s activities or investments under three areas of ESG factors (environmental, social and governance) and in accordance with ESG criteria;
• taking into account ESG principles – the fundamental principles of the ESG concept;
• by identifying ESG risks in the investments or the company’s activities.

ESG factors

Via the ESG factors, the three main components of sustainable development – environment, society and corporate governance, are revealed. However, there is no single definition and list of ESG factors, which makes it difficult to understand and manage them consistently. According to the Report of the European Banking Authority (the “EBA Report”), organisations generally rely on various international systems and standards for ESG factors, which could be combined for the industrial sector as follows:

• Environmental: consumption of resources (energy, water, etc.); pollution (air, water, etc.); production and management of waste and wastewater; protection of biodiversity; research and development in low-carbon and other environmental technologies.
• Social: quality and innovation in customer relations, customers’ right to gain information on environmental issues; human rights; labour practices (human resource management, employee relations, diversity, gender equality, health and safety); access to credit and financing; personal data security.
• Governance: rules or principles that define the rights, responsibilities and expectations between different stakeholders in the governance of an entity; remuneration of senior management; independence of the Board of Directors, its composition and structure; rights of shareholders (owners of a share of the authorised capital); internal audit; compensation; bribery and corruption; integrity in corporate conduct/framework of conduct.

Thus, ESG factors are non-financial indicators (characteristics) of a company’s activities or investments in the environmental, social or governance areas that may have a positive or negative impact on the financial performance of investments or activities of a company.

The EBA Report also emphasises the two-way connection between the company’s operations and ESG factors. Thus, companies can influence ESG factors (the “inside-out” perspective), and influence in the opposite direction is also possible when ESG factors influence the company’s activities (the “outside-in” perspective). As an example, the mutual influence of the company’s activities and the ESG factor “climate change” is analysed: the company may influence climate change through CO2 emissions (inside influence), while “climate change” with extreme weather conditions may have a physical impact on the company’s assets (premises) (outside influence).

In addition, under the EBA Report, ESG factors could also be divided into:

• those which resulted from the company’s own fully controlled activities and management tools (the “inside-out” perspective); such factors should generally be identified and taken into account through the company’s risk management and internal governance systems, i.e. the company has more control in determining these factors and timely implementing measures to minimise their negative effects;
• ESG factors impact a company through its counterparties and invested assets (the “outside-in” perspective); these factors are crucial because they relate to the company’s core business and directly affect its financial performance and solvency.

At the same time, it is also worth considering that it is now at an inflexion point due to failed attempts to combine diverse and heterogeneous areas, factors, and issues of the concept and the lack of specific, measurable goals and indicators.

ESG criteria

Although the terms “ESG criteria” and “ESG factors” are sometimes used interchangeably, it is helpful to distinguish them.

ESG criteria are a set of standards (recommendations and/or requirements) that an activity/asset/counterparty, etc., must meet, and based on which the screening is performed on how ESG factors are implemented in the company’s activities or investment assets. In other words, ESG criteria provide a framework of acceptable measures/standards for a comparative assessment of investments/companies’ activities regarding ESG factors.

ESG principles

In a narrow sense, ESG principles are used in close connection with and sometimes interchangeably with the terms “ESG criteria/standards.” They set general requirements and corrective recommendations for a company’s investments and activities in ESG areas. Therefore, ESG principles are divided into environmental, social, and governance.

The list of relevant ESG principles depends on the company’s area of investment or activity, but it generally focuses on responsible business conduct and reducing negative environmental impact.

For example, the following ESG principles in the investment and financial sector are defined: the Principles for Responsible Investment (PRI), the United Nations Environment Programme Finance Initiative (UNEP FI) Principles for Responsible Banking, the Equator Principles, etc.

In the broader framework of considering ESG principles, it is worth considering the principles of sustainable development and responsible behaviour of companies and institutions which consider the impact of their activities on the environment and society, in particular:

• Ten Principles of the UN Global Compact.
• The OECD Due Diligence Guidance for Responsible Business Conduct.
• The OECD Guidelines for Multinational Enterprises on Responsible Business Conduct, etc.

These principles have progressively shaped the ESG concept and remain the guiding principles for developing an ESG agenda.

ESG risks

ESG risks are identified as the probability of negative events or consequences due to an ESG factor’s impact on the company’s operations/invested asset or due to the aggravation of an ESG factor caused by the company’s operations/invested asset.

ESG factors, which are indicators that can have a positive and negative impact on a company, are interrelated with ESG risks, which are the negative materialisation of ESG factors that should be avoided or at least mitigated.

ESG risks are divided into the following areas:

• environmental risks – which are risks from environmental factors (climate change, air and water pollution, freshwater shortages, land pollution, deforestation, as well as corrective regulatory measures aimed at eliminating such factors); they are divided into physical risks arising from the physical effects of climate change and environmental degradation, and transition risks, which relate to uncertainty on timing and speed of transition to an environmentally sustainable economy, and could be influenced by three factors – policy, technology and consumer preferences;
• social risks usually relate to a company’s relationship with its employees, as well as with the communities in which the company operates or with which it interacts;
• governance risks relate to the company’s management process, decisions made, and actions taken on behalf of the company. In general, governance risks could be independent (closely associated with management competencies, e.g., the level of tolerance to corruption violations) or could be shaped by environmental or social risks (e.g. considering the impact of climate and environmental changes and related physical and transition risks in company’s activities is a sign of good governance, which also covers management decisions to ensure and improve the level of protection of employees’ rights, etc.).

ESG risks materialise through the traditional categories of financial risks (credit risk, market risk, operational and reputational risk, liquidity and funding risk).

ESG risks are specific to a company or business direction and depend on a list of relevant ESG factors.

ESG risk identification aims to identify challenging areas of a company’s activities that may have or already have a negative impact according to ESG criteria, determine preventive actions, and reduce or avoid the risks’ negative consequences.

We appreciate your attention and would be happy to hear questions and comments on your experience interacting with the ESG concept.

In the following publications, we will continue our exploration of ESG and discover whether the concept is officially enshrined in the law. We will also identify the correlation between the ESG concept and sustainable development, provide arguments why it is worth considering not only the profit component in the company’s activities but also developing the ESG direction, and finally, evaluate the legal justification for the relevance of ESG.

If you would like to discuss the issues raised in this paper in more detail, please contact the SK team.

Information contained in this legal alert is for general informational purposes only, does not constitute legal or other professional advice and should not be relied upon as a substitute for specific professional advice adapted to the specific circumstances.