ESG: Why does it matter?

ESG has started to have a meaningful impact on the way business is done

Although some companies may consider it a tedious task of box-checking, ESG (an acronym for environmental, social and governance coined in 2005) has started to have a meaningful impact on how business is done.

The criticism of ESG is well known. After all, businesses exist to make money within the limits of the law, not to promote social values. To the extent a company does promote social values, this may be seen as part of its corporate brand but not meaningful to the fundamental way it operates. Hence, research has noted the absence of correlation between profitability and ESG performance. A company may be good at ESG and bad at business, or vice versa.

"What we sometimes narrowly see as formal ESG compliance is actually being driven by real and pressing social goals that businesses must meet to remain relevant."

The changing role of business

Since business is carried out in a social environment, it obeys social norms, which ESG has largely become (many expect the acronym to change soon and encompass even wider social goals). People have started to expand their notion of the role of business, which now includes serving the greater good and living up to social expectations. To that end, companies are feeling the need to make multiple stakeholder groups happy. Shareholders, naturally, but increasingly employees and consumers too. Many companies today are making major decisions based on social values alone. Over 1,000 companies have discontinued or curtailed operations in Russia, others have made protecting the natural environment part of their core mission.

Who are the people who dictate the ESG requirements to businesses? Narrowly speaking and most ostensibly from the companies' point of view, these are the financing institutions, the banks and investment funds who promote the ESG requirements to their investees. Next come financial reporting watchdogs. In August 2022, the International Financial Reporting Standards (IFRS) completed its consolidation with the Value Reporting Foundation, formalising the new International Sustainability Standards Board (ISSB). Thus, accounting requirements will go hand in hand with ESG measuring and reporting. Implementation is usually done via listing standards on stock exchanges, which serve as gatekeepers to a large investor base. As a result, those reporting a low ESG score will have more limited access to capital.

People power

While financing institutions, gatekeepers and watchdogs are relevant to ESG implementation, the actual driver is elsewhere. There is growing evidence that the pressure to focus on ESG originates largely from employees and consumers, or from society as a whole, while investors are following this social trend. Many employees now want the company they work for to take a strong position on social issues. Consumers are also making choices in the marketplace based on purpose and sustainability. Both groups are backed by science-based goals and school education which instil social values.

So what we sometimes narrowly see as formal ESG compliance is actually being driven by real and pressing social goals that businesses must meet to remain relevant.

author: Ilko Stoyanov