Introduction
Throughout modern history of corporate governance, the world has witnessed countless episodes of corporate fraud and financial greed, unfettered with any remorse or responsibility whatsoever. The response has often oscillated from intense criticism to moderate policy action. Calls around the world from the society are made towards the companies for being more responsible. Among all the hullabaloo, a word “ESG” rings in our ears. But what is ESG? Environmental, Social, and Governance (ESG) is an approach to evaluating the extent to which a corporation works on behalf of social goals that go beyond the role of a corporation to maximize profits on behalf of the corporation’s shareholders. Typically, the social goals advocated within an ESG perspective include working to achieve a certain set of environmental goals, as well as a set of goals having to do with supporting certain social movements, and a third set of goals having to do with whether the corporation is governed in a way that is consistent with the goals of the diversity, equity, and inclusion movement.
ESG, is a stakeholder-centric approach towards business. This is a form of corporate governance practised by business concerns who consider it important to incorporate their values and concerns (such as environmental concerns) into their selection of investments instead of simply considering the potential profitability and / or risk presented by an investment opportunity. While discussing ESG, there are various concepts which we will discuss as we attempt to dilute the entire dogma.
More recently the term ESG has become more fashionable internationally when talking about a company’s environmental, social and governance activities. The term ESG was first coined in 2005 in a study, ‘Who Cares Wins’, conducted in response to Kofi Anan, the then Secretary-General of the UN, asking financial institutions to partner with the UN and the International Finance Corporation to Identify ways of integrating environmental, social and governance concerns into capital markets
The Meteoric Rise of ESG
When we integrate ESG factors into investment processes and decision making, we come across a term known as “Responsibility Investing”. ESG factors cover a wide spectrum of issues that traditionally are not part of financial analysis, yet may have financial relevance. This might include how corporations respond to climate change, how good they are with water management, how effective their health and safety policies are in the protection against accidents, how they manage their supply chains, how they treat their workers and whether they have a corporate culture that builds trust and fosters innovation. The idea that investors who integrate corporate environmental, social and governance risks can improve returns is now rapidly spreading across capital markets on all continents.
The rise of ESG investing can also be understood how markets and societies are changing and how concepts of valuation are adapting to these changes. The emerging challenge for most entities is to adapt to a new environment that favours smarter, cleaner and healthier products and services, and also to leave behind the tenet of the industrial era when pollution was free, labour was just a cost factor and scale and scope was the dominant strategy. For investors, ESG data is increasingly important to identify those companies that are well positioned for the future and to avoid those which are likely to underperform or fail. For individuals, ESG investing offers the opportunity to vote with their money. And for policy makers, it should be a welcome market-led development that ensures that the common good does not get lost in short-term profit making at any cost.
Criteria for ESG
The traditional form of corporate governance in India has always been focused on earning profits for the shareholders. But here, taking the principles of ESG into account, we attempt to provide a roadmap for every company in India to adopt ESG practices in their corporate houses to achieve a sustainable future.
We will dissect the term ESG before moving ahead. Every entity is deeply intertwined with ESG concerns. It makes sense, therefore, that a strong ESG proposition can create value – ergo, this article tries to provide a framework for understanding the five key ways it can do so. But first, let’s briefly consider the individual elements of ESG:
- The E in ESG, environmental criteria, includes the energy your company takes in and the waste it discharges, the resources it needs, and the consequences for living beings as a result. Not least, E encompasses carbon emissions and climate change. Every company uses energy and resources; every company affects, and is affected by, the environment.
- S, social criteria, addresses the relationships your company has and the reputation it fosters with people and institutions in the communities where you do business. S includes labour relations and diversity and inclusion. Every company operates within a broader, diverse society.
- G, governance, is the internal system of practices, controls, and procedures your company adopts in order to govern itself, make effective decisions, comply with the law, and meet the needs of external stakeholders. Every company, which is itself a legal creation, requires governance.
Just as ESG is an inseparable part of how business is done, its individual elements are themselves intertwined. For example, social criteria overlaps with environmental criteria and governance when companies seek to comply with environmental laws and broader concerns about sustainability. Our focus is mostly on environmental and social criteria, but, as every leader knows, governance can never be imperviously separate. Indeed, excelling in governance calls for mastering not just the letter of laws but also their spirit – such as getting in front of violations before they occur, or ensuring transparency and dialogue with regulators instead of formalistically submitting a report and letting the results speak for themselves.
Helping entities achieve Sustainability using ESG
Paying attention to ESG concerns does not compromise returns – rather it does quite the opposite. As mentioned above, we have five key ways to foster positive value creation and sustain results for the entity. These five ways are discussed below:
- Top Line Growth: A strong ESG proposition helps companies tap new markets and expand into existing ones. When governing authorities trust corporate actors, they are more likely to award them the access, approvals, and licenses that afford fresh opportunities for growth.
- Cost Reductions: ESG can also reduce costs substantially. Among other advantages, executing ESG effectively can help combat rising operating expenses, which popular research has found can affect operating profits by more than 50 per cent. The same report disclosed a significant correlation between resource efficiency and financial performance.
- Regulatory and Legal Interventions: A stronger external-value proposition can enable companies to achieve greater strategic freedom, easing regulatory pressure. In fact, in case after case across sectors and geographies, we’ve seen that strength in ESG helps reduce companies’ risk of adverse government action. It can also engender government support.
- Productivity Uplift: A strong ESG proposition can help companies attract and retain quality employees, enhance employee motivation by instilling a sense of purpose, and increase productivity overall. It is no secret that employee satisfaction is positively correlated with shareholder returns.
- Investment and Asset Optimization: A strong ESG proposition can enhance investment returns by allocating capital to more profitable and more sustainable opportunities. It can also help companies avoid stranded investments that may not pay off because of longer-term environmental issues.
Foresight trickles down to the bottom line, and it results into handsome positive value addition that enhances sustainability of the entity in the society. Following the ESG principles helps us achieve this goal.
A comparison of how a strong ESG proposition is linked with value creation is tabled below:
| Strong ESG Proposition | Weak ESG Proposition | |
| Top-Line Growth | Able to customers and clients with more sustainable products by achieving strong community and government relations. | Lose customers through poor sustainability practices or perception of unsustainable products. Poor labour and community relations. |
| Cost Reductions | Lower energy consumption through reduced water intake and less pollution. | Generation of unnecessary waste and payment related to waste disposal costs. |
| Regulatory and Legal Interventions | Achieve greater strategic freedom through deregulation, subsidies and government support. | Suffer restrictions by regulators by incurring fines, penalties, enforcement and litigation actions. |
| Productivity Uplift | Boose employee motivation and attract better talent through greater social credibility. | Deal with social stigma which restricts talent pool and lose existing skilled talent. |
| Investment and Asset Optimization | Enhance investment returns by better allocation of capital for long term. Also, avoid investments that may not pay off due to environmental costs. | Suffer stranded assets as a result of poor investment decisions and premature write-downs. High environmental costs involved which throttles revenues. |
Allied Concepts in relation to Achievement of Sustainability using ESG
Apart from the measures discussed above, there are more key measures and metrics, the concepts of which we need to be discuss to show how ESG can help an entity achieve sustainability. These measures are listed as below:
Triple Bottom Line
In 1994, John Elkington – the famed British management consultant and sustainability guru –coined the phrase “triple bottom line” (TBL) as his way of measuring performance in corporate America. The idea was that a company can be managed in a way that not only makes money but which also improves people’s lives and the well-being of the planet.
In finance, when speaking of a company’s bottom line, we usually mean its profits. Elkington’s TBL framework advances the goal of sustainability in business practices, in which companies look beyond profits to include social and environmental issues to measure the full cost of doing business. Triple-bottom-line theory says that companies should focus as much attention on social and environmental issues as they do on financial issues.
TBL theory also says that if a company focuses on finances only and does not examine how it interacts socially, it is not able to see the whole picture and therefore cannot account for the full cost of doing business.
According to TBL theory, companies should be working simultaneously on these three bottom lines:
Profit: This is the traditional measure of corporate profit—the profit and loss (P&L) account.
People: This is the measure of how socially responsible an organization has been throughout its history.
Planet: This is the measure of how environmentally responsible a firm has been.
Profits do matter in the triple bottom line – just not at the expense of social and environmental concerns.
Green Economics
Green economics is a methodology of economics that supports the harmonious interaction between humans and nature and attempts to meet the needs of both simultaneously. The basis for all economic decisions should be in some way tied to the ecosystem and that natural capital and ecological services have economic value.
Social Audit
A social audit is a formal review of a company’s endeavours, procedures, and code of conduct regarding social responsibility and the company’s impact on society. A social audit is an assessment of how well the company is achieving its goals or benchmarks for social responsibility.
The scope of a social audit can vary and be wide-ranging. The assessment can include social and public responsibility but also employee treatment. Some of the guidelines and topics that comprise a social audit include the following:
- Environmental impact resulting from the company’s operations
- Transparency in reporting any issues regarding the effect on the public or environment.
- Accounting and financial transparency
- Community development and financial contributions
- Charitable giving
- Volunteer activity of employees
- Energy use or impact on footprint
- Work environment including safety, free of harassment, and equal opportunity
- Worker pay and benefits
- Non-discriminatory practices
Diversity
A company’s board of directors plays a critical role in making decisions relating to strategy, and growth. The role of the board and its impact on corporate performance has been well studied; however, the diversity of the board of directors and the corresponding correlation to the level of corporate innovativeness has not been previously investigated.
Board diversity matters but concentrating on only one form of diversity isn’t enough. Our interviewees suggested that social diversity (e.g., gender, race/ethnicity, and age diversity) and professional diversity are both important for increasing the diversity of perspectives represented on the board. Diversity doesn’t matter as much on boards where members’ perspectives are not regularly elicited or valued. To make diverse boards more effective, boards need to have a more egalitarian culture — one that elevates different voices, integrates contrasting insights, and welcomes conversations about diversity.
Diversity of Perspectives vs. Diversity of People: Discussions over diversity often focus on women, independence and ethnicity. Choosing board directors solely because someone fits into one of those categories, or because the appointment appeases regulatory bodies, isn’t enough on its face.
Productive board discussions require a breadth of perspective that is also diverse. Boards that choose directors based on filling a category to meet the desired composition without considering whether the director can fill the need for varied perspectives lose a prime opportunity for robust discussions and well-rounded decision-making. Such a dynamic is increasingly important because of the complex issues today’s boards are facing.
The essence of a quality board is not only appointing board directors who appear diverse, but selecting board directors who are capable of thinking and communicating diverse thoughts and opinions. Beyond seeking people who truly lend diversity to board discussions, board directors should be chosen because they positively impact the chemistry and dynamics of the current board.
Most board directors are well aware that the changes they bring to the organization are often lasting, whether the changes are positive or negative. On the whole, board directors believe that diversity nets better decision-making because of the weight of the decisions they regularly make.
If all board directors were always on the same page, there would be no need for a board at all. Board directors are keenly aware that they perform at their very best when cultural diversity, diversity of thought and diversity of perspectives are rampant around the board table. Changes in the economy and with technology make it increasingly difficult to navigate the web of risks their corporations face. The experiences of a diverse board help bring discussions to the boardroom to help board members identify and deal with negative forces in the corporate world.
A boardroom filled with multiple perspectives lets creativity rule the day and doesn’t make room for groupthink. Great ideas emerge when disrupting the status quo. This environment fosters a dynamic that generates comprehensive oversight.
There is, however, no uniform definition of board diversity. Traditionally speaking, one can consider factors like age, race, gender, educational background and professional qualifications of the directors to make the board less homogenous. Some may interpret board diversity by taking into account such fewer tangible factors as life experience and personal attitudes.
In short, board diversity aims to cultivate a broad spectrum of demographic attributes and characteristics in the boardroom. A simple and common measure to promote heterogeneity in the boardroom – commonly known as gender diversity – is to include female representation on the board. For everything else, a mixture of board members from different ethnicities, races, age groups and backgrounds will contribute positively in the growth of management and growth of the company.
Carbon Disclosure Rating
A carbon disclosure rating is a measure of the environmental sustainability of a company, based on voluntary disclosures by the company itself. The practice is intended to help investors who wish to incorporate ESG factors into their investment decision-making process.
The most widely used carbon disclosure ratings are administered by CDP, a United Kingdom-based non-profit organization formerly known as the Carbon Disclosure Project.
The basic framework involved in generating carbon disclosure ratings is the use of questionnaires administered by CDP. Companies participating in this program submit responses on an annual basis to a series of questions tailored depending on the company’s industry. The responses are then analysed, graded, and made available to institutional investors and other interested parties.
CDP’s metrics separate companies based on their understanding and application of climate-related changes.
A and A- | Leadership level
B and B- | Management level
C and C- | Awareness level
D and D- | Disclosure level
F | Failure to provide sufficient information to be evaluated
One criticism of the carbon disclosure rating process is that its scores do not necessarily reflect the actions a company takes to mitigate its impact on climate change or to offset its carbon footprint. Rather, a score may simply reflect that the company failed to promptly or fully disclose information with CDP.
However, an “F” does not mean the company has failed to reign in its carbon footprint. Rather, it means that the company has failed to provide enough information to CDP to receive an evaluation. As a result of this, another criticism of the process is that the ratings are inconclusive, as many companies do not provide information to the CDP on what actions they’ve taken to limit how they impact climate change.
Data Protection and Privacy
Larger companies, in particular the companies doing business globally, need an elaborated compliance management which covers all relevant business processes. To ensure the trust of their clients and employees, and in order to mitigate liability risks of their directors and officers, the design and the implementation of companywide compliance and data-management processes have to be in line with cross-border legal requirements, in particular with data protection law and works council constitution law. Loss of private data can endanger sustainability of the entity. In this area, employment law and data protection law are closely linked. Few areas where the corporates can work on data privacy and data protection to enhance corporate governance and further in their ESG objectives are as follows:
- Surveillance of employees
- Monitoring of internet communications
- Advice on data protection in the workplace
- Proper storage and usage of personal employee data
- Draft on data protection compliance
- Cross-border data flows
- Corporate governance
- Professional ethics guidelines, code of conduct
- Safeguard of customer and client data
India Inc. is taking steps to enact a data protection framework which incorporates many elements of the GDPR law in the EU. The new law, the Personal Data Protection Bill (PDP), is currently in front of parliament and was proposed to effect a comprehensive overhaul of India’s current data protection regime, which today is governed by the Information Technology Act, 2000.
The PDP Bill includes requirements for notice and prior consent for the use of individual data, limitations on the purposes for which data can be processed by companies, and restrictions to ensure that only data necessary for providing a service to the individual in question is collected. In addition, it includes data localization requirements and the appointment of data protection officers within organizations.
India has not yet enacted this specific legislation on data protection. However, the Indian legislature did amend the Information Technology Act, 2000 to include Section 43A and Section 72A, which give a right to compensation for improper disclosure of personal information.
Regulatory Aspects of ESG
India Inc. has introduced regulations on ESG which are effective on corporate entities. However, nothing in the law restricts other smaller corporate entities or non-corporate entities to adopt ESG practices.
Business Responsibility and Sustainability Report
The Securities and Exchange Board of India (SEBI) has decided to introduce new requirements for business sustainability reporting by listed entities. This new report will be called the Business Responsibility and Sustainability Report (BRSR) and will replace the existing Business Responsibility Report (BRR).
SEBI, in 2012, mandated the top 100 listed entities by market capitalisation to file Business Responsibility Reports (BRR) as per the disclosure requirement emanating from the ‘National Voluntary Guidelines on Social, Environmental and Economic Responsibilities of Business’ (NVGs). In 2019, the Ministry of Corporate Affairs revised NVGs and formulated the National Guidelines on Responsible Business Conduct (NGRBC). In December 2019, SEBI extended the BRR requirement to the top 1000 listed entities by market capitalisation, from the financial year 2019-20.
BRSR, which is from an ESG perspective, is intended to enable businesses to engage more meaningfully with their stakeholders. It will encourage businesses to go beyond regulatory financial compliance and report on their social and environmental impacts. The BRSR will be applicable to the top 1000 listed entities (by market capitalization), for reporting on a voluntary basis for FY 2021 – 22 and on a mandatory basis from FY 2022 – 23.
Sustainability Reporting is the disclosure and communication of ESG goals – as well as a company’s progress towards them. The benefits of sustainability reporting include improved corporate reputation, building consumer confidence, increased innovation, and even improvement of risk management.
ESG goals are a set of standards for a company’s operations that force companies to follow better governance, ethical practices, environment-friendly measures and social responsibility. Environmental criteria consider how a company performs as a steward of nature. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights.
The philosophy of responsible business is based on the principle of business being accountable to all its stakeholders towards global developments which are increasingly seeking businesses to be responsible and sustainable towards their environment and society. In light of ever-increasing global challenges relating to climate change, environmental risks, growing inequality, etc., business leaders have been compelled, and have also found it to be in their interest, to reimagine the role of businesses in the society and not view them merely as economic units for generating wealth. The performance of a company must be measured not only on the return to shareholders, but also on how it achieves its environmental, social, and good governance objectives.
United Nations Principles for Responsible Investment
The UN Principles for Responsible Investment (PRI) is an international organization that works to promote the incorporation of environmental, social, and corporate governance factors (ESG) into investment decision-making.
The core philosophy behind the organization is that environmental and social considerations are relevant factors in investment decision-making and should therefore be considered by responsible investors. For example, supporters of the PRI argue that it is both financially and ethically irresponsible to not consider the environmental impact of a company when assessing its merits as an investment. By contrast, many investors have historically viewed environmental and social impacts as negative externalities which can be ignored for purposes of investment decisions.
To combat this long-prevailing attitude, the PRI put forward six core principles, to which signatory companies must agree to commit themselves. As expressed on the organization’s website, these six principles are as follows:
- Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.
- Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.
- Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.
- Principle 4: We will promote acceptance and implementation of the principles within the investment industry.
- Principle 5: We will work together to enhance our effectiveness in implementing the principles.
- Principle 6: We will each report on our activities and progress towards implementing the principles.
Stakeholder Capitalism
Any entity cannot sustain for long without ignoring the interests of their stakeholders. Stakeholder capitalism is a system in which corporations are oriented to serve the interests of all their stakeholders. Among the key stakeholders are customers, suppliers, employees, shareholders and local communities. Under this system, a company’s purpose is to create long-term value and not to maximize profits and enhance shareholder value at the cost of other stakeholder groups. Supporters of stakeholder capitalism believe that serving the interests of all stakeholders, as opposed to only shareholders, is essential to the long-term success of any business. Notably, they make the case for stakeholder capitalism being a sensible business decision in addition to being an ethical choice.
Conclusion
An honest appraisal of ESG includes a frank acknowledgment that getting it wrong can result in massive value destruction. Being perceived as “overdoing it” can sap a leader’s time and focus. Underdoing it is even worse. Companies that perform poorly in environmental, social, and governance criteria are more likely to endure materially adverse events. Just in the past few years, multiple companies with a weak ESG proposition saw double-digit declines in market capitalization in the days and weeks after their missteps came to light. Leaders should vigilantly assess the value at stake from external engagement and plan scenarios for potential hits to operating profits. These days, the tail events can seem to come out of nowhere, even from a single social media post. Playing fast and loose with ESG is playing to lose, and failure to confront downside risk forthrightly can be disastrous.
However, being thoughtful and transparent about ESG risk enhances long-term value even if doing so can feel uncomfortable and engender some short-term pain. The linkage from ESG to value creation is paramount. Three words environment, social, governance, across the bottom and top lines, can be difference makers. In a world where environmental, social, and governmental concerns are becoming more urgent than ever, leaders should keep those connections in mind.
The emerging ESG mandate in corporate governance presents a new challenge for companies in India. In a stakeholder-driven approach, the ESG requirement for each company is different and must be fine-tuned to suit stakeholders with whom a company interface. The Indian Government is also stressing upon the need to adopt ethics, transparency and accountability among businesses to promote responsible business practices. Such an increased focus on ESG would allow more companies to be ESG-compliant, ultimately leading towards sustainable growth for future generations and contributing towards value creation for the companies as well as their stakeholders.
Bibliography
ESG and impact investing: Dual drivers of sustainable development; Financial Express
ESG (Environmental, Social and Governance); Corporate Finance Institute
The Remarkable Rise Of ESG; Forbes
Five ways that ESG creates value; by McKinsey.
IPCC. “AR6 Climate Change 2021: The Physical Science Basis”
International Chamber of Commerce. “10 Conditions for a Transition Toward a Green Economy”
United Nations Environment Programme. “Green Economy”
Harvard Business Review. “25 Years Ago, I Coined the Phrase ‘Triple Bottom Line’; Here’s Why It’s Time to Rethink It.”
PRI Association. “Enhance Our Global Footprint”
Principles for Responsible Investment. “Home, https://www.unpri.org/.”
GRI. “About GRI, https://www.globalreporting.org/about-gri/.”
CDP. “Companies scores, https://www.cdp.net/en/companies/companies-scores.”
