It is strategically important for companies to understand the distinction between “ESG” (Environmental, Social and Governance) and “CSR” (Corporate Social Responsibility). In simple terms, ESG is a sub-set of CSR factors that are financially material and of interest to investors and other capital markets participants (see A Material Difference: The Distinction between CSR and ESG).
To Understand ESG, Start With the “G”
In exploring the scope of ESG, it helps to start with the Governance “G”, because this provides context for the Environmental and Social “E&S”.
What Is Included in the “G”?
We can distinguish two aspects of governance in the ESG context: the “traditional G” and the “G of E&S”.
“Traditional G” considerations (such as board quality and independence, shareholder rights, and holding executive management accountable for performance) have long been important aspects of good corporate governance and are foundational to investors’ assessments of ESG performance. Alongside these considerations, increasingly investors expect directors to provide effective oversight of material environmental and social risks and opportunities, in addition to the financial and operational issues that they have always been expected to oversee – this is what we refer to as the “G of E&S”.
An important distinction between G and E&S is that good governance is a baseline expectation for all companies, whereas a company’s E&S factors that are likely to be financially material vary widely from sector to sector and company to company. While a few E&S factors, such as climate change and human capital management, are almost universally material (see It’s Never Too Early to Start Thinking About an ESG Strategy), a notable characteristic of E&S factors is how rapidly they can evolve to become financially material.
The need for boards to provide oversight of material E&S factors is changing the face of “traditional G” governance. Increasingly, the capital markets are recognizing that material E&S risks should be considered alongside traditional financial risks (for example, Larry Fink of BlackRock’s 2020 letter to CEOs stating that climate risk is investment risk). There are increasing expectations that the directors on a quality board should have appropriate E&S expertise and education, that boards should be able engage effectively with shareholders on E&S issues, and that executive compensation should integrate strategic E&S performance metrics, where relevant.
Starting With the “G” Also Helps Issuers to Respond to Investor Expectations
For issuers seeking to respond to capital markets expectations on ESG, it would be prudent to give early and close attention to the “G of E&S”. Institutional investors getting started with ESG often begin the journey by intensifying their focus on governance, then building out their capacity to integrate E&S factors to investment decision-making.
Effective governance is vital to support consistent performance in addressing material E&S risks and opportunities. Embedding these E&S factors into a company’s governance structures and processes ensures that they receive appropriate attention and oversight, and that the sustainability programs through which they may be managed are no longer siloed or sidelined, as they have often been in the past.
The “G” may come at the end of the term “ESG” – but it should certainly not be an afterthought.