The ESG Impact: Redefining Business in the Modern Era

In a world increasingly driven by ethical considerations and sustainable practices, the concept of ESG – Environmental, Social, and Governance – has emerged as a critical framework for evaluating corporate responsibility and long-term viability. But what exactly is ESG, and why is it capturing the attention of investors, businesses, consumers, and legal counsel alike? In this blog article I explore the essence of ESG.

1. What is ESG?

Environmental, Social, and Governance (“ESG”) refers to the three central factors used to measure the sustainability and societal impact of an investment in a company or business:

• Environmental Criteria look at how a company performs as a steward of nature. They include a company’s energy use, waste, pollution, natural resource conservation, and treatment of animals. The criteria can also evaluate any environmental risks a company might face and how the company is managing those risks.
• Social Criteria examine how a company manages relationships with employees, suppliers, customers, and the communities where it operates. They include working conditions, health and safety, employee relations and diversity, human rights, and community engagement.
• Governance Criteria deal with a company’s leadership, executive pay, audits, internal controls, and shareholder rights. They include a company’s values and ethics, board structure, and transparency in accounting and business practices.

These criteria help to better determine the future financial performance of companies.

2. Why is ESG Important?

ESG is important for numerous reasons, some of which include:

• Risk Management: ESG factors can highlight potential risks that could affect a company’s financial performance. Companies that manage their ESG issues well tend to have fewer business disruptions, legal fines, and reputational damage.
• Long-term Value Creation: Companies focusing on ESG are often seen as more resilient and better positioned for long-term success. ESG strategies can lead to improved operational performance and potentially better financial outcomes.
• Investor Demand: There is a growing demand from investors for more sustainable and ethical investment options. ESG investing allows investors to align their portfolios with their values and societal expectations.
• Stakeholder Expectations: Consumers, employees, and other stakeholders are increasingly prioritizing sustainability and ethical business practices. Companies that ignore ESG risk losing trust and support from these crucial groups.
• Legal and Regulatory Requirements: Increasing regulations around the world require companies to disclose their ESG performance. Compliance with these regulations is essential to avoid legal penalties and to maintain a positive reputation.

Compliance with ESG factors offers additional cooperation opportunities with international partners and is becoming a key component for business survival and development. In the future, ESG compliance will transition from an advantage to a necessity.

3. Why is ESG Criticized?

Notwithstanding its unstoppable advance, it is good to be aware that ESG is by no means universally accepted. Some of the major criticisms are as follows:

• Greenwashing: Some companies may engage in greenwashing, where they overstate or misrepresent their ESG efforts to appear more sustainable than they are. This can mislead investors and consumers.
• Lack of Standardization: There is no universal standard for measuring and reporting ESG criteria, leading to inconsistent and sometimes incomparable data. This lack of standardization can make it difficult for investors to accurately assess and compare companies.
• Performance Trade-offs: Focusing too much on ESG factors can sometimes come at the expense of financial performance. There is concern that prioritizing ESG may lead to higher costs or lower returns.
• Complexity and Cost: Implementing comprehensive ESG strategies can be complex and costly, particularly for smaller companies. These costs may outweigh the perceived benefits, at least in the short term.
• Political and Ideological Bias: ESG investing is sometimes seen as driven by political or ideological agendas, rather than purely financial considerations. This has led to debate over whether ESG factors should play a significant role in investment decisions.
• Measurement and Impact: There is ongoing debate about the actual impact of ESG investing on achieving societal and environmental goals. Does ESG investing truly drive meaningful change or is it merely a marketing tool?

4. How have ESG Criteria been Integrated into European Legislation?

ESG Criteria have been – and are being – integrated into European legislation through several key pieces of regulation and directives aimed at enhancing corporate sustainability and transparency. Here are the main legislative frameworks:

• The Non-Financial Reporting Directive (2014/95/EU) (“NFRD”), adopted in 2014, requires large public-interest companies with more than 500 employees to disclose non-financial information. The directive mandates the reporting of environmental, social, and employee-related matters, respect for human rights, anti-corruption and bribery issues, and diversity on company boards.
• The Sustainable Finance Disclosure Regulation (2019/2088) (“SFDR”), effective from March 2021, requires financial market participants and financial advisors to disclose how they integrate ESG factors into their investment decision-making processes. It aims to enhance transparency on sustainability risks and impacts, promoting more sustainable investing.
• The Taxonomy Regulation (2020/852) establishes a classification system for environmentally sustainable economic activities. It provides clear criteria for determining whether an economic activity substantially contributes to environmental objectives, such as climate change mitigation or adaptation, while avoiding significant harm to other objectives.
• The Corporate Sustainability Reporting Directive (2022/2464) (“CSRD”) came into force in January 2023. It is part of the European Green Deal, which aims to achieve climate neutrality in Europe by 2050 and includes obligations for businesses to disclose social and environmental information. The CSRD is a revision and improvement of the NFRD, introduces more detailed reporting requirements, and covers a wider range of companies, including large listed companies and small and medium-sized enterprises (SMEs). The requirements of the CSRD are taking effect in a gradual timeline up to 2028, contingent on company classification.
• In December 2023, the Commission Delegated Regulation (EU) 2023/2772 (“CDR”) was published in the Official Journal of the European Union. The CDR sets out the first set of European Sustainability Reporting Standards (“ESRS”) under the CSRD.
• Most recently, the Corporate Sustainability Due Diligence Directive (“CSDDD”) was approved by the Council of the European Union on 24 May 2024. The aim of this Directive is to foster sustainable and responsible corporate behavior in companies’ operations and across their global value chains. The new rules will ensure that companies in scope identify and address adverse human rights and environmental impacts of their actions inside and outside Europe. For the first group of companies, the due diligence requirements may be applicable as soon as 2026.

These legislative frameworks collectively aim to enhance corporate transparency, promote sustainable investment, and ensure that companies operating within the EU adhere to high standards of environmental and social responsibility.

5. Applicability of ESG Standards in the Netherlands

As a member of the European Union, the Netherlands is subject to EU regulations and directives related to ESG standards. Here’s how these standards apply in the Netherlands:

• The NFRD was transposed into Dutch law, requiring Dutch companies that are large public-interest entities with over 500 employees to disclose non-financial information such as environmental, social, and employee-related matters, respect for human rights, anti-corruption and bribery issues.
• Dutch investment firms, asset managers, and financial advisers need to comply with the SFDR by providing detailed disclosures on sustainability risks and the impacts of their financial products.
• Dutch financial institutions and companies must use the taxonomy criteria to classify their economic activities and investments as environmentally sustainable.
• From 1 January 2024 all listed companies and large enterprises already subject to the NFRD have been obliged to report on sustainability policy and performance in terms of the CSRD. The CSRD applies to ‘large’ companies that meet at least 2 of the 3 following conditions: (i) net turnover of €40 million or more, (ii) total assets of at least €20 million, (iii) 250 or more employees. The mandatory reporting requirements in terms of the CSRD will apply to large companies that are not yet subject to the NFRD from 1 January 2025, and for listed SMEs and small and non-complex credit institutions and insurance companies from 1 January 2026. Medium-sized and small businesses are exempted from the CSRD until at least financial year 2026. However, they will have to deal with demands from their CSRD-compliant customers or suppliers.
• When implemented, the CSDDD will require Dutch companies to conduct due diligence on their supply chains to prevent human rights abuses and environmental harm.

In addition to the EU regulations, the Netherlands also has its own initiatives and standards promoting ESG practices, including the Dutch Corporate Governance Code, the Dutch Climate Agreement, and the Sustainable Finance Platform.

6. The Relevance of ESG to Legal Counsels

The relevance of ESG to legal counsels is immediately evident and increasingly critical as companies navigate the complex regulatory landscape and stakeholder expectations. Here are several key areas where ESG intersects with legal counsel responsibilities, and where legal counsels will be called upon to:

• Compliance and Regulation: Ensure adherence to national and international ESG regulations. Stay updated on evolving laws and advise on compliance actions.
• Corporate Governance: Advise on governance structures incorporating ESG principles. Ensure ethics and transparency through codes of conduct and policies.
• Risk Management: Identify and mitigate ESG-related risks. Develop strategies to protect against legal and reputational damage.
• Sustainability Reporting and Disclosures: Ensure accurate and compliant ESG disclosures. Prevent greenwashing by verifying ESG communications.
• Litigation and Disputes: Defend against ESG-related claims. Resolve disputes proactively to avoid litigation.
• Stakeholder Engagement and Communication: Advise on engaging with stakeholders on ESG concerns. Manage ESG-related crises.
• Contractual and Transactional Matters: Draft and negotiate ESG clauses in contracts. Conduct ESG due diligence in M&A.

Perhaps a future blog article warrants a closer look at these responsibilities, and particularly at the drafting and negotiation of ESG clauses in contracts.

7. Conclusion

ESG represents a significant shift in how companies and investors approach business sustainability and ethical considerations. While it offers numerous benefits in terms of risk management, long-term value creation, and alignment with stakeholder expectations, it also faces criticisms related to greenwashing, standardization, and potential performance trade-offs. As the field continues to evolve, addressing these criticisms will be crucial for the future credibility and effectiveness of ESG practices. Legal counsels play a critical role in integrating ESG principles into corporate practices, ensuring compliance, mitigating risks, and fostering sustainable business strategies.

Thoughts, comments or questions? Let me know!

Gundo Haacke, Interim Legal Counsel & Owner of Haacke Commercial Legal Services.
Blog article first published on 5 June 2024.
Image credit: Buro Happold.