ESG has become a much mused over acronym in recent years, but what does it mean? In this short post I intend to sketch a few introductory remarks with a focus on why the topic may be of interest to environmental lawyers. What follows is taken from a paper I delivered at the FTB Quarterly Environment Update Seminar in May.
The three pillars are Environmental, Social and Governance and they signpost an approach to evaluating the extent to which a corporation or financial product directly or indirectly attains goals which are distinct from simply the profit motive. The aim is to capture some of the important non-financial risks and opportunities inherent to a company’s day to day activities. The over-arching objective is that by establishing a framework for public presentation of and discussion of these pillars, financial flows to sustainable development priorities may be increased (see definition provided by the UN Environmental Programme).
Although I shall focus on the “E” of ESG, it is worth pausing to note what is meant by “S” and “G”:
- Social includes matters such as employee development, labour practices, product liabilities including supply chain and health & safety standards, including issues around sourcing. It also includes consideration of access to and effect on underprivileged social group.
- Governance includes consideration of shareholders rights, board diversity, executive compensation and compensation alignment with sustainability performance. It also includes consideration of corporate behaviour, such as anti-competitive practices and corruption.
Scope of the “E”
This heading includes matters such as the use of energy, waste management, air/water pollution, deforestation issues, raw material sourcing, biodiversity practices on land and other actions around climate change issues. It also includes physical and climate change transition risks. The “E” of ESG is arguably broader than S and G, because it encompasses both the evaluation of activities that bear on the environment, and the resilience and risk exposure of undertakings’ activities to the effects of environmental issues such as climate change.
The need for regulatory action
ESG-friendly companies and financial products create the opportunity to attract a premium from investors. As with any other certification that leads to a market premium, there is a real risk of abuse, termed “greenwashing”, where the system of evaluation is not objective, thorough and consistent. It was recently suggested in the Financial Times that the “greenwashing” issue is a mis-selling scandal on the scale of the diesel emissions/PPI scandals of recent years. The particular problem identified there was retail investors investing in funds on the basis of claimed environmentally friendly credentials, only for the reality to emerge as quite otherwise. Indeed, in 2019, the UK’s Financial Ombudsman awarded an investor a small sum in upholding their complaint that their financial adviser had not followed their wishes and invested in ethical stocks, even though she incurred no financial loss. In recent weeks, the Wall Street Journal reported that the Securities and Exchange Commission is investigating Goldman Sachs over its ESG investment funds, and on 31st May, German police raided the offices of fund manager Deutsche Bank’s DWS in connection with an investigation of alleged “greenwashing”.
An emergent regulatory framework
Regulators are therefore responding by way of enforcement against the potential for market abuse. They are also responding – at the prior stage – through introducing standardised disclosure requirements. The difficulty is that the financial system is the high point of globalisation, and regulation in this area is currently fragmented across jurisdictions, often with little holding it together.
In 2015 Mark Carney and Michael Bloomberg founded the Global Taskforce on Climate-related Financial Disclosures (TCFD), and provided voluntary guidance on climate related disclosures. These recommendations formed the basis for UK requirements.
In 2021, in connection with the COP26 meeting, the International Financial Reporting Standards Foundation founded the International Sustainability Standards Board (ISSB), with the remit to develop a comprehensive global baseline of high-quality sustainability disclosure standards to meet investors’ information needs.
In April 2022 new UK corporate environmental disclosure standards came into force, amending the Companies Act 2006, for firms above a threshold (UK registered companies with securities admitted to AIM, with more than 500 employees, amongst other categories). The focus is on disclosures relating to “climate related risks and opportunities”, and it is perhaps less clear how these requirements bear on the impacts that a firm’s operation might cause on the environment. We are now several years into the Energy Savings and Opportunity Scheme Regulations programme (ESOS) which requires companies over a certain size to undertake an energy audit, and now into the third year of the Streamlined Energy and Carbon Reporting programme (SECR), requiring calculation and reporting of energy usage and greenhouse gas emissions. The ESOS programme is now at the phase where there is beginning to be enforcement against non-compliance, leading to some decided cases in the First-tier Tribunal.
In many ways the most advanced system yet developed is the EU’s “Taxonomy for Sustainable Activities”, a classification system which establishes a list of environmentally sustainable economic activities and a grading system. It identifies six environmental objectives:
- climate change mitigation;
- climate change adaptation;
- the sustainable use and protection of water and marine resources;
- the transition to a circular economy;
- pollution prevention and control; and
- the protection and restoration of biodiversity and ecosystems.
To be considered sustainable, an economic activity must contribute to at least one of these objectives, and do no significant harm to any of the others. There is mention in the literature that in the future there may be efforts to restrict public funding only to those firms classified as undertaking “sustainable activities”, as defined. Controversy has already arisen on this front, arising out of the Commission’s decision in February 2022 to approve in principle some specific transition energy activities – gas and nuclear – as falling within the environmentally sustainable classification.
In March 2021, the EU introduced the Sustainable Finance Disclosure Regulation. The Regulation requires investment products to be characterised as dark green, light green or non-sustainable. It relies upon the criteria used to define sustainable activities within the Taxonomy. There are criticisms: although the criteria for “dark green” is rigorous, that for “light green” is considerably less so.
Here in the UK, the government produced in October 2021 a Greening Finance Roadmap to Sustainable Investing. This document recognises the need for a common taxonomy to establish “what counts as green or sustainable”, and notes this is still a work in progress. We can expect to see further development of this in the near future, through work undertaken by the Treasury’s Transition Plan Taskforce.
Difficult questions abound including how transition technologies will be defined; the extent to which deep and unknown supply chain impacts can and will be incorporated (e.g. deep sea mining where impacts are sometimes simply unknown); and whether off-setting (e.g. through a purchasing of land for habitat restoration) may be taken into account when classifying a firm’s operations as a whole.
The London Stock Exchange (LSE) has grasped the nettle by introducing the Green Economy Mark, a type of certification recognising London-listed companies and funds deriving more than 50% of their revenues from products and services that are contributing to environmental objectives. The mechanism involves an application process including disclosures followed by a panel review, and a decision within 28 days. Once obtained, the Green Economy Mark can be used in marketing, and the issuer will be identified in a public list of Green Economy Issuers on London’s markets. The list of issuers will be reviewed annually. The objective is to attract green technologies to list in London, where the Green Economy Mark will give them greater prominence in the markets. In 2021 an LSE report confirmed over 100 issuers (5% of total issuers on the LSE) with combined market cap of £149bn, have been recognised with a Green Economy Mark.
Were such a system to be rolled out on a broader basis, there are questions as to who would be best placed to undertake the assessment of firms’ activities, and whether there might be a role for the Environment Agency, in the same way as it oversees enforcement of the ESOS regime (Energy Savings Opportunity Scheme Regulations 2014).
How might lawyers find themselves involved?
ESG raises a potential host of legal issues in multiple practice areas, and in these early years there will be a need for joined up thinking and pooling of legal resource. Some of the avenues which may be of relevance are these:
- Liability for sanctions for breaches of disclosure requirements, pursuant to the Companies Act 2006 (at present). This raises issues likely to be within the milieu of financial regulatory compliance lawyers.
- Litigation instigated by activist investors, who could seek to exploit ESG disclosure and information issues to further other aims in relation to an undertaking. Misrepresentation and misstatement claims may be mounted in relation to what undertakings have said to their investors about their activities (in 2018 the New York’s State Attorney General commenced proceedings against Exxon Mobil on exactly this basis). Similarly, litigation could follow where investors suffer financial loss consequent upon ESG-related disclosures made to the market, causing the share price to plummet – investors may well comb-through ESG disclosures to find statements which were untrue or misleading and which have a causative link to their loss. Liability here may arise in consequence of sections 90 and 90A and Schedule 10 A of the Financial Services and Markets Act 2000.
- The proper exercise of fiduciary and trustees’ duties in relation to how an investment is carried out and whether pursuing ESG objectives rather than maximising shareholder value is satisfactory. At the very least, advisors and fund managers will need to be crystal clear – in terms of ESG – with investors as to the basis on which they are being advised and their interests pursued. Similar issues may arise in relation to trusts and charities, as recently demonstrated in the case of Butler-Sloss & ors v Charity Commission  EWHC 974 (Ch) concerning the scope of trustees’ ability to adopt an ESG focused investment policy that excludes many potential investment opportunities on account of their not according with environment focused charitable purposes.
- Direct challenges to administrative decision making such as the decisions to draw up schemes of sustainability classification/taxonomy, and challenges to the individual decisions classifying an undertaking as sustainable or otherwise. One can for example envisage the potential for challenges to be brought by environmental charities in relation to decisions to classify as sustainable undertakings with activities that are questionable from a sustainability perspective, or from market competitors where decisions appear inconsistent or contrary to the evidence and confer a benefit on a rival.
- Finally, broader potential legal challenges relating to claims against parent companies of foreign subsidiaries (see for example, Lungowe v Vedanta  UKSC 20; Okpabi v Royal Dutch Shell  UKSC 3), and challenges to export financing (see: R (Friends of the Earth) v Secretary of State for International Trade & Ors  EWHC 568 (Admin).
ESG, or at any rate “E”, presents itself as an area of likely considerable future interest for environmental lawyers, and those working in other specialist areas of the law who will need to grapple with environmental matters. It is therefore an area that will repay careful attention in the coming years as a regulatory framework and body of decisions emerges.
Jonathan Welch is a barrister at Francis Taylor Building specialising in environmental, planning and public law.
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