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The ABC of ESG – The Evolution, Drivers and the Next Phase

The Social Responsibility of Business Is to Increase Its Profits , a seminal piece by Milton Friedman was published on September 13, 1970. As the title suggests, it argued vehemently for businesses to focus on maximising profits for their shareholders. The article in today’s time would have been viral due it Mr. Friedman’s several twit-worthy retorts against ‘the social responsibility of business’.   But to be fair to Mr. Friedman, he has several nuances and assumed a perfect functioning market.

“What does it mean to say that “business” has responsibilities? Only people can have responsibilities.”- Milton Friedman

Half a century later,  it can be safely said that imperfect markets, greed, and our inability to price critical natural resources have made this planet unsustainable and almost uninhabitable for the underprivileged. And, businesses are now espousing a new commitment to environmental and social concerns.

We are at a juncture where almost every business is talking about its environmental, social and governance (ESG) responsibilities.  In less than 5 years, we are seeing terms such as ESG reporting, ESG investing, ESG Frameworks and Sustainability Reporting become part of mainstream business discourse. For some emergence of ESG is a new business opportunity; for some, it is the solution that will transform corporates into a benevolent, sustainability driving engine; and for some it is just a new fad. However, for a majority, this is one of the most confusing three-letter words that has occupied our mind-space.

What is ESG?

First thing first, the three letters E (Environment), S (Social) and G (Governance) are one of the most brutal simplifications of a complex set of variables that constitute these three dimensions. The table below gives what is generally represented by these three letters.

Once we look at the broad category of variables that come under the ESG, it is obvious that many of these have been covered under corporate, governance and sustainability best practices, and in many countries, a number of these variables are already under different legal and regulatory frameworks. In India, we already have The Forest Conservation Act, Environmental Protection Act, Air (Prevention and Control of Pollution) Act to just name a few. So what is so different about this ESG concept?

ESG : the Genesis, Rationale and Drivers

ESG appeared probably for the first time in the Global Compact’s report “Who Cares Win: Connecting Financial markets to a Changing World”. This endorsed by more than 20 leading global financial institutions highlighted that “in a more globalised, interconnected and competitive world the way that environmental, social and corporate governance issues are managed is a part of companies overall management quality needed to compete successfully.”

This report was significant as it change the discourse from business should care for society and the environment as good practices to being part of the business strategy and risk management. The report provided very succinct recommendations to investors, regulators, stock exchanges, financial institutions and companies on building a resilient investment market and contributing to the sustainable development goals. This report was just the beginning of the new discourse.

Since then gradually, Governments, investors/business shareholders and civil society have started demanding adherence to ESG reporting and compliance to the best practices. These stakeholders have different primary motives but align on the importance of ESG.

While investors and shareholders see ESG as a strategy for long-term risk mitigation and/or value creation, civil society and governments have been using this to make businesses more responsible and amenable to sustainable development goals. This has resulted in three broad areas and quite a diverse set of activities that we do which are driven by core ESG focus.

ESG Reporting: Today business stakeholders, investors and regulators are demanding that companies provide an assessment or report on how their businesses are operating in the context of ESG dimensions. There are principles, frameworks and standards that are guiding the ESG reporting. A majority of these reporting requirements are voluntary as of now but we are seeing several regulators coming up with their own standards and frameworks and making ESG reporting mandatory. Some of the guiding frameworks for ESG reporting are:

The above are just some frameworks that are globally in practice but depending on stakeholders and reporting format prescribed by regulators you have more than 100 ESG reporting formats. India has introduced its own Business Responsibility and Sustainability Reporting (BRSR) framework that is mandatory for top 1000 companies. These multiple frameworks have created a lot of confusions among companies about ESG reporting. To address this, there is a demand for universal sustainability accounting standards and already we can see some traction with the establishment of ISSB. The recent standards are also trying to address this challenge by integrating key framework recommendations in their reporting format. BRSR has aligned its reporting requirement to TCFD, GRI, CDP and SASB.

ESG Investing: Investors see companies that are scoring high on the ESG dimensions as long-term value creator and more resilient in dealing with risks originating from an increased focus on sustainable development and community welfare. ESG Investors believe that investing in these companies gives better economic results as it minimises long-term risks, however, this is not universally accepted. Very similar to ESG reporting, ESG Investing is also riddled with many challenges. A majority of fund managers rely on some type of ratings for exclusions or inclusion of companies for investment but these are very subjective and difficult to compare (Tesla was kicked out from Dow Jones ESG Indices and Philip Morris International – the leading cigarette manufacturer scored quite a decent ESG score!).

ESG Strategy and Implementation: This is the real crux of ESG focus. How to achieve ESG outcomes? And, this is an unsurprisingly complicated and herculean task for corporates. As we have seen with the wide range of issues being covered under the ESG frameworks, companies are suddenly looking for expertise and understanding of the topics that are not their forte. A mining company finding a way to do mining without causing biodiversity loss; a consumer goods company selling a zillion things in small plastic packets looking for reducing their plastic footprints or a fossil fuel company trying to achieve net zero emissions.. all of these are examples of ESG strategy and implementation focus. While ’S’ and ‘G’ are relatively easier to achieve; ‘E’ is quite complex and requires innovation in the way we do business and produce things and a deep understanding of a multitude of ‘E’ dimensions.

ESG is a step in the right direction but still, it is a work in progress.

While ESG focus is rapidly engulfing corporate and sustainability champions, we must acknowledge that it is not ‘the’ solution for sustainability challenges in the current form. ESG is too simplistic and it misses out on some of the key concepts that are core to sustainability discussion. Most of the ESG reporting frameworks and parameters do not focus on ‘contextualization’. In simple words, a fashion house can report or commit to reduced use of water for its jeans brand but to understand the real environmental impact of a pair of jeans you need to factor in where the water is being consumed and what is the ‘local ecological carrying capacity.

Similarly, many activities that are part of the usual business practices are now being ‘termed’ as ESG practices and yield no additional benefits.

To conclude, ESG as of now is a step in the right direction but it is a work in progress and would require a strong commitment to building on these existing initiatives to achieve the goals of social and environmental sustainability.

Some Recommended Reads for ESG Enthusiasts

Understanding Sustainability

ESG Reporting Frameworks

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