ARTICLE ESG principles and their impact on corporate world

      Article 74 (3) of the Constitution of the Republic of Serbia stipulates that Everyone will be obliged to preserve and improve the environment. 
In the wake of all events happening around the world and severe climate impact of such events, but also keeping in mind the fact that many businesses rely on traditional corporate models, three letters have risen to prominence – ESG.
These three letters seem to be setting the course of the future of this planet, and in this article we will provide a general outline of the phenomenon.

ESG – What it stands for
ESG stands for Environmental, Social, and Governance. These are key factors when evaluating the existing operations and practices of a company in terms of sustainability, and ethical impact of its business. The “sustainability of business” has been a hot topic for a while and these three words are the reason for it.

E – Environmental

This category encompasses the impact  that any company activity has on the natural world, such as climate change, pollution, resource depletion, and waste management. A company with good environmental performance is one that takes measures to minimize its environmental footprint and reduce the negative impact on the planet. The following factors, among others, are in focus:
•    Climate change and CO₂ emissions;
•    Biodiversity;
•    Air and water polution;
•    Waste management;
•    Deforestation.

S – Social

The impact a company has on society is being observed in a social context, including factors such as 
•    Labor practices, 
•    Human rights, 
•    Employee diversity and inclusion, 
•    Community engagement, 
•    Product safety, 
•    Data protection and privacy, etc. 

The companies that prioritize social responsibility aim to create positive outcomes for all stakeholders, including employees, customers, and wider community. 

G – Governance

Focuses on the management and decision-making processes, including the work of the board of directors, executive compensation, transparency, and accountability. Strong governance practices are crucial for maintaining the trust of stakeholders and ensuring long-term sustainability. Therefore some key factors are: 
•     Structure of the Board of Directors;
•     Bribery and corruption;
•     The whistleblowers policy.

The ESG has gained importance as investors and consumers have become more aware of the impact that corporate practices have on the world around us. Companies that prioritize ESG are often seen as more responsible, trustworthy, and sustainable, and may be more attractive to those investors looking for long-term value.

Regulation of the ESG
In a transition to a better, greener and more transparent environment key national and international players started adopting regulations that tend to encompass such principles. One to mention is the commitment of the United Nations to define the Sustainable Development Goals - a set of 17 targets created to lead to peace and prosperity - as part of the 2030 Agenda, which influences the promotion of environmental and social responsibility.

Other binding acts:

1. - EU Sustainable Finance Disclosure Regulation (SFDR): This regulation, which came into effect in March 2021, requires financial market participants to disclose information on how they integrate ESG factors into their investment decision-making processes. It also establishes a classification system for sustainable economic activities (EU Taxonomy) and requires companies to disclose the proportion of their revenues that come from environmentally sustainable activities. 
2. - Corporate Social Responsibility laws (France): In 2017, France passed this law requiring companies with over 5.000 employees to implement a CSR plan that includes measures to reduce their environmental impact, promote social responsibility, and improve their governance practices.

These acts, and many others, are not equally binding on all subjects and their implementation depends on the jurisdiction, yet they do pose an obligation of submitting ESG reports. It is worth mentioning that there is no universal “ESG Act“.  These principles are rather scattered in multiple individual acts which, among the key topic they regulate, contain some or most of these principles.
Such task is not an easy one either, due to the fact that the ESG principles are not standalone principles, capable of being strictly divided, but are intertwined and interconnected. Therefore, it is very challenging when trying to report business results and activities related to ESG in terms of the metrics and evaluation methodology.
The best take to this day might be the White Paper on Stakeholder Capitalism Metrics created by the “Big Four” (four biggest consulting companies in the world - PwC, EY, KPMG, Deloitte) in cooperation with the World Economic Forum. This White Paper offers solution for standardization of ESG principles, where some of the metrics are Stakeholder engagement, Ethical behavior, Nature loss, Health and well-being, and so on.

An interesting take on this matter are Sustainability linked bonds (SLBS) where the issuer commits to meeting certain ESG targets or performance indicators in given timeframe. If the company fails to meet the target metrics, higher interest must be paid to the investors. It is a binding financial instrument that can play a crucial role in encouraging companies to make sustainability commitments. 

Pros and cons
With all said above, we can now create a list of pros and cons that ESG principles bring to the table.

The pros are:

• •    Improved sustainability - ESG encourages companies to reduce their environmental impact and create more sustainable business practices, which can help protect the planet and ensure resources are used more efficiently;

• •    Better stakeholder relations - prioritizing social responsibility and good governance can help companies build trust with stakeholders, including customers, employees, and investors;
• •    Risk mitigation - by considering ESG factors, companies can better identify and mitigate potential risks, such as supply chain disruptions or reputational damage;
  •    Increased responsibility, trustworthiness and overall brand reputation.

 

The cons are:

• •  Lack of standardization – there is currently no standardized framework for ESG, which can make it difficult to compare companies or evaluate their performance in a meaningful way (except the stated Stakeholder Capitalism Metrics);
• •  Greenwashing – in connection to the previous drawback, some companies may engage in "greenwashing" or "ESG-washing" by making exaggerated or misleading claims about their environmental or social performance without actually implementing significant changes to their practices - companies can define their own ESG strategy through easily achivable KPIs;
• •   ESG are not binding on businesses – they are voluntarily accepted standards;
• •  Lack of human capacities – since the ESG standards are being implemented all around the world in a stunning speed and under pressure of environmental activists, a need for specialists in this field is rising. However, there are yet no adequate courses and the companies resort to school its internal personnel. The courses are taken usually by financial analysts in a sped up manner and they obtain the certificates, but if there is a true knowledge gained remains a mystery.

 

Concluding remarks

Bearing in mind all of the above, it is obvious that further steps need to be taken for a more efficient implementation of the ESG principles. Even with all the drawbacks, these flaws can be solved with adequate involvement of all key political, commercial, environmental and other factors.
At the World Economic Forum 2023, held in Davos, the President of the EU Commission Ursula von der Leyen presented the EU's Green Deal Industrial Plan, which aims to help Europe become a leader in green technology and achieve carbon neutrality. An important regulatory part of such Plan is the Net-zero Industry Act which aims to reach the set-out goals.

Therefore, even though these standards are not binding per se, they do play an important role when investors seek investment opportunities and support companies and their businesses, while customers tend to select the companies that are more ESG-oriented. The steps to formally binding ESG are already undertaken and in the future our markets are expected to be transformed significantly, while the countries are expected to support companies following ESG principles by providing incentives and advantages.

 

Authors:

Miloš Vučković, Senior & Managing Partner

Aleksandar Čermelj, Associate

 

*The information in this announcement does not represent legal advice and is provided for general informational purposes only.

**Partner, Senior Associate and Associate refers to Independent Attorney at Law in cooperation with IVVK Lawyers.