You may have heard the term “ESG” before. It has been used with increasing frequency for a few years, but the term and ESG-minded business practices have gained more traction over the last year or so. ESG stands for three factors—environmental, social, and governance. The ESG factors can be broken down to a set of non-financial metrics and standards that a company’s operations try to achieve and that socially conscious investors use as a framework to identify material risks and growth opportunities, and to screen potential investments based on sustainability and ethical practices. After many recent years of environmental disasters, corporate scandals, and public health concerns, achieving ESG metrics is now a critical and expected piece of corporate performance and responsibility.
ESG metrics are often interconnected across the three factors, and there is no single, agreed upon list. Many can be measured either monetarily or in other ways, while others cannot. Below are just some examples of the metrics that investors and other stakeholders are taking into consideration today.
- Environmental (Is the company a good steward of the environment regarding compliance with environmental regulations, natural resource conservation, climate change and carbon emissions, air and water pollution, deforestation, energy efficiency, waste management, water scarcity and conservation, and ethical treatment of animals?)
- Social (How does the company manage its business relationships, customer satisfaction, data protection and privacy, workplace policies, gender and diversity inclusion, employee engagement, community engagement and service, volunteer work and donations, human rights, labor standards, and employee health and safety?)
- Governance (How does the company handle its transparency, leadership structure, internal controls, executive pay, lobbying, political contributions, whistleblower schemes, board composition, and shareholder rights?)
These metrics are constantly evolving, and it is increasingly crucial for companies to adapt their thinking, their operations, and their outreach to address each. It is also imperative that companies get ahead of the curve and begin to create their own metrics, those that will drive their performance and social responsibility.
Why Should Companies Focus on ESGs?
ESG metrics began as a way for investors to align their investments with their values. While this is still true, many investors are beginning to recognize that ESG metrics have another purpose—helping maximize their investment profitability by avoiding investing in companies whose practices pose an unacceptable risk. Many point to several examples of events over the last few years that resulted in billions of dollars of losses for companies and severe declines in stock prices. If ESG metrics had been evaluated, many believe that maybe these risks could have been identified and mitigated.
Investors are also looking to ESG-minded companies because investors feel that factoring in these metrics is simply the right thing to do and that these companies have stronger leadership. Investors believe that leaders who prioritize ESG risks are also likely to manage these risks better and deliver greater long-term shareholder value. There is even a growing body of data showing that the stocks of ESG-minded companies are performing as well as or better than companies that don’t make ESG a priority. All of these represent a competitive strength to investors.
Outside the world of shareholders and investments, other stakeholders are also considering ESG in their decision making. Current and potential employees, participants in the supply chain, and members of the community are also asking how companies are measuring and addressing these factors. Just like access to capital, these stakeholders can have an impact on a company’s performance and bottom line.
What Are the Risks of Reporting ESGs?
ESG investing is growing exponentially. Once thought to be solely the investing approach by younger investors, many more participants in the market are looking to ESG metrics for guidance. Because of this, publicly traded companies are facing increased pressure not only to develop ESG measurable scoring metrics and achieve these milestones, but also to publish those goals.
But beware, there are no universal reporting requirements or standards. ESG metrics are currently not included in mandatory financial reporting, although many organizations and institutions are working to formalize disclosures. There was even an effort in Congress last year to require the Securities and Exchange Commission (the “SEC”) to formalize a framework. Although the Corporate Governance Improvement and Investor Protection Act (H.R. 1187) passed the House of Representatives in June 2021, it hasn’t made much headway in the Senate.
According to the Wall Street Journal and other media outlets, the SEC announced recently that the agency will “propose rules mandating disclosure from publicly traded companies about climate change and associated risks” on March 21, 2022. Although a move forward, the proposed rules will be subject to public comment before the rules are voted on by the SEC commissioners and will most certainly face legal challenges if approved. Until then, there are many third parties that have filled the gap to provide guidelines; however, without a universal and formalized framework, it is difficult for investors and for companies to compare metrics and performance.
Despite the lack of conformity, many companies track ESG metrics and include ESG disclosures in their annual report and SEC filings or in an independent ESG report. Since no mandatory disclosure requirements exist, companies must carefully evaluate these disclosures to determine whether the benefit of the disclosure outweighs the potential risk. Companies must be careful to understand and use widely accepted standards and be cautious not to make inaccurate statements. There is a developing litigation trend where consumers and shareholders are challenging a company’s ESG statements as misrepresentations, unfair and deceptive trade practices, and securities fraud. Companies need to be extra vigilant that they are making accurate and supportable statements regarding their ESG disclosures.
Establishing, tracking, and reporting ESG goals and metrics will soon be the norm for companies, if it is not already. Investors are regularly looking for these measures and incorporating them into their investing strategies. Companies, however, should not make these disclosures lightly and should establish the correct internal controls and reporting standards.
If you need assistance with establishing ESG initiatives or reporting ESG metrics, or if you need assistance defending your ESG reporting, please contact any of the attorneys on this post. We’re working alongside our clients as they navigate sustainability and ESG challenges, serving as their trusted business advisor and helping them uncover opportunities they have to make change, all the while remaining equally committed to further developing our own internal programs.
We understand that clients operating in different industries face unique sustainability and ESG opportunities and challenges. Our proactive, industry-focused approach is intended to assist clients as they navigate the myriad of sustainability and ESG topics impacting their businesses. Future blog posts will dig deeper into these industry-specific issues, and we welcome your feedback as we continue to develop this series.
Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. The author has provided the links referenced above for information purposes only and by doing so, does not adopt or incorporate the contents. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.