Beyond the Bottom Line: an holistic approach to ESG
Alea acta est. As the Latins would say, the die is cast and the game must be played. Regulations are coming into effect for companies, investors, ESG rating agencies in Europe, depicting a new scenario for a sustainable single market. [1]
Companies are subject to a double handling requirement concerning their disclosure and reporting systems. Investors are subject to product transparency and disclosure as well with the SFDR (i.e. Sustainable Finance Disclosure Regulation). Finally, the last piece of the puzzle: ESG Rating Agencies are about to be required to observe stringent rules in the EU market concerning conflicts of interest management, transparency and integrity. India, where hard regulation is in place, is a practical case-study worth to consider at this stage. [2]
Now that some background has been explained, let’s try to delve into this four-fold policy framework.
While the Corporate Sustainability Reporting Directive will require undertakings to adopt financial and impact materiality at the same time [3], they will be also asked to track, monitor and further control their supply chains and value chains, considering the impact of the Corporate Sustainability Due Diligence Directive (i.e. CS3D). Together, and by encouraging transparency, accountability, and innovation in a gradually gold standard way for the ESG World, offering a win-win situation for both shareholders and stakeholders.
Sustainability investment products and services are progressively being subject to supervision and regulatory pressures. First, the Sustainable Finance Disclosure Regulation (i.e. SFDR) has established a classification of funds. Then, ESMA – the European authority supervising financial markets – has given even more insight into tracking and “labelling” ESG funds to pre-empt greenwashing risks. [4]
Here's the crux of the issue: current ESG ratings primarily rely on compasses pointed towards E and S factors. These are undoubtedly important destinations, but without a skilled captain steering the ship – a strong "G" – a company's sustainability voyage risks getting lost at sea.
Imagine a powerful ship stocked with the latest eco-efficient technology and a crew passionate about sustainability. Yet, without a captain at the helm – someone charting a course, ensuring smooth sailing, and making sound decisions in rough weather – the ship could easily flounder. It might have the potential for a sustainable journey, but without proper leadership, it could end up causing social damage or neglecting its environmental targets.
Current ESG ratings, or opinions regarding an entity, issuer, or debt security's impact on or exposure to ESG factors, alignment with international climatic agreements or sustainability characteristics, issued using a defined ranking system of rating categories, [5] with their often overemphasis on E and S factors, risk creating a similar scenario. They paint a picture of a company's sustainability efforts, but fail to assess whether the company has the leadership and internal controls (the captain and crew) to navigate towards lasting environmental and social change.
So, how do we safeguard a safe and sustainable voyage? Sure, an ESG analyst should ideally consider all three aspects of ESG (Environmental, Social, and Governance) in their analysis – but how? The dialogue balancing process between the three factors makes it even clearer: if an undertaking achieves all the environmental targets, missing the social targets – then strengthening corporate governance could be the solution. [6] If a company achieved all its social targets, missing the environmental ones - then better governance would still allow it to improve. But if, on the other hand, a company achieved a very bright environmental strategy and definitely consolidated its social targets - without good governance it would not be able to stay on course – as it happened in the past. [7] In a nutshell, while every ship can set sail with a helm, it cannot get in first course without a good crew and without a good captain. This also applies to ESG Ratings and making sense of them in this way is essential.
References:
[1] Clifford Chance “CSRD, CS3D & SFDR: what companies need to know”. Available at: https://paperjam.lu/article/csrd-cs3d-sfdr-what-companies-
[2] Business Today India “The ESG rating providers now have a big task at hand; here's what is going on”. Available at: https://www.businesstoday.in/magazine/the-buzz/story/the-esg-rating-providers-now-have-a-big-task-at-hand-heres-what-is-going-on-431026-2024-05-27]
[3] LSE Grantham Institute on Climate Change and Environment ‘Double materiality’: what is it and why does it matter? Available at: https://www.lse.ac.uk/granthaminstitute/news/double-materiality-what-is-it-and-why-does-it-matter/]
[4] ESMA Final Report Guidelines on funds’ names using ESG or sustainability-related terms. Available at: https://www.esma.europa.eu/sites/default/files/2024-05/ESMA34-472-440_Final_Report_Guidelines_on_funds_names.pdf.
[5] Wikipedia Regulation of ESG rating in the EU. Available at: https://en.wikipedia.org/wiki/Regulation_of_ESG_rating_in_the_European_Union#:~:text=Defining%20the%20basics,-Finding%20a%20clear&text=%22ESG%20rating%20means%20an%20opinion,ranking%20system%20of%20rating%20categories.%22
[6] Cimpanelli G. Repubblica “La sostenibilità comincia dalla “G” di governance”. Available at: https://www.repubblica.it/dossier/economia/affari-e-finanza-idee-per-la-crescita/2024/05/27/news/la_sostenibilita_comincia_dalla_g_di_governance-423093529/
[7] Morello M. (2021) Sustainability cannot go ahead without governance – the Danone’s case shows why. CSRNatives Blog. Available at: https://www.csrnatives.net/post/sustainability-cannot-go-ahead-without-governance-the-danone-s-case-shows-why]
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