The combination of environmental,social and corporate governance factors has an important place in business today

Abstract

The combination of environmental, social and corporate governance (‘ESG’) factors has an important place in business today. These factors require businesses, among other things, to protect workers, incorporate environmental considerations, ensure consumer safety, increase health benefits for employees and perhaps reduce executive bonuses to help avoid layoffs. The ESG considerations have become relevant to business models, services and products of businesses and have become inherent in investment analysis and investment decisions. Corporate boards should take them on board in their decision-making process.

The ‘ESG’ combination has become one of the central concepts of the contemporary financial climate. ‘E’ stands for ‘environmental’, covering such issues as emission targets, carbon fuels, clean technology, climate change risk, renewable energy and waste management. ‘S’ stands for ‘social’, referring to such issues as workplace diversity, human rights, reduction of poverty and reducing tobacco and weapons production; ‘G’ refers to corporate ‘governance’ covering such issues as fair executive compensation, corruption, board diversity and accountability, and shareholder democracy.

The ESG combination challenges the classical theory of the firm on its deepest levels. Under this theory managers and directors run companies for the benefit of company owners, the shareholders. Acting on behalf of the shareholders, they should maximise a company’s profits and wealth. Accordingly, the purpose of the legal regime applicable to companies should aim to align the interests of the company’s actors (managers and directors) to that of the shareholders. ¹ While the potential misalignment of interests might be related to the diversity of the ownership structures ² and biases, ³ the basic idea remains that the ultimate purpose of a company is to serve the interests of its proprietary owners – the shareholders.

However, ESG challenges this classical theory. It says that the decision-making process of a company’s actors cannot be solely focused on maximising shareholders’ wealth; there are broader societal and environmental considerations that must be taken into account. Simply stated, there should not be profit without care for society and the environment. ⁴

This article engages with the ESG combination, then maps its inadequacies and makes concrete suggestions for the way forward. The topic may be new to the reader, so in many ways this article aims to serve as an introduction or ‘explainer’ about the subject.

First, the article makes an overview of the ESG, and illustrates its phenomenal success in many jurisdictions. Australia is no exception to this trend. As we will see, despite the somewhat scattered nature of the ESG provisions within Australia’s regulatory framework, ESG has become central to a company’s executive decisions and investment portfolios. Secondly, the article contemplates on the practical and conceptual difficulties of the concept. Thirdly, suggestions are made on the future conceptualisation, contextualisation and development of ESG. Finally, the conclusion provides a summary.

ESG

The ESG is evidently a successful enterprise. The public view ESG factors favorably. Research indicates that people prefer investing in sustainable financial products ⁵ such as ‘green’ loans and bonds which support green projects. The ‘impact investing’, alongside financial returns, aim to generate measurable social and environmental impact. ⁶ These products are in demand. ⁷ Since investors frequently lack information and expertise, the EU has moved towards a mandatory disclosure of sustainability-related information. ⁸ The current EU regulatory framework requires considering whether a given economic activity is of more benefit to the environment than harm. ⁹ The US moves in the same direction of disclosing, identifying and classifying corporate activity in light of the ESG framework. ¹⁰ Similarly, there is a strong call to accommodate sustainable goals within the classical vision of fiduciary duties, ¹¹ arguing, for example, that the trustees of pensions or charities can consider ESG factors as long as the trustee is reasonably convinced that the ESG investment will benefit the beneficiary. ¹² Similarly, some companies have linked executive compensation to ESG metrics. ¹³

The situation represents a ‘win-win-win’ scenario: ESG factors align with investors’ preferences for the underlying values of the companies in which they invest. This perhaps means a bright future for companies which promote green energy and lower carbon emissions. This may also, perhaps, signify a grim future for alcohol and tobacco companies.

The ESG combination is a winning formula. Initially introduced in 2004 in the UN document Who Cares Wins, ¹⁴ ESG became one of the trendy aspects of the worldwide financial arena. In 2020, assets under the management of ESG funds reached USD1.7 trillion globally ¹⁵ and are expected to reach USD53 trillion by 2025, ¹⁶ making the ESG framework, if not the most then, one of the most important aspects of current and future financial activity.

Some scholars argue that Australia lags behind the world in its ESG reporting obligations, ¹⁷ pointing out that ‘ESG research is in its infancy’ in Australia. ¹⁸ The regulatory provisions related to the ESG combination are scattered across the various sectors of the Australian legislation landscape. Thus, the Prudential Practice Guide requires companies to specify the climate change impact that their activities create. ¹⁹ Corporate Governance Principles and Recommendations ²⁰ requires companies to disclose board gender diversity ²¹ and any activities that involve ‘environmental or social risks’. ²² The Corporations Act 2001 (Cth) s 299 (1)(f) requires disclosing performances that concern environmental issues. ²³ The provisions of the Modern Slavery Act require companies that meet a certain threshold of income to disclose risk in relation to such issues as human trafficking and child labour. ²⁴ As can be seen, ESG’s legal framework in Australia lacks unity and cohesiveness. ²⁵

However, similar to the rest of the world, the ESG is clearly advancing in Australia. Thus, Freeburn and Ramsay have demonstrated growing shareholder activism with respect to ESG issues. ²⁶ This study focused on shareholder resolutions, as a mechanism available to shareholders to uphold their rights in extraordinary circumstances through the amendment of a company’s constitution. ²⁷ It showed a particular interest by the shareholders with respect to the ‘E’ – that is, ‘environmental’ – component of the combination. ²⁸

Another study has demonstrated that 75 per cent of ASX companies clearly defined an ESG strategy. ²⁹ At the same time, only 30 per cent of those companies established clearly identifiable key performance indicators (KPIs) for measuring ESG performance. ³⁰ Similar to the study that dealt with shareholder activism, this work has also noticed the focus on the ‘E’ component in the ESG combination, coining environment as ‘the first area of focus’ and a ‘frontrunner’. ³¹

Interestingly, Tianyu Cai et al found a link between the sociological factor of managers’ backgrounds (such as military or non-for-profit experience) and the ESG practices. ³² Finally, recent work by Gholami, Sands and Shams has illustrated the significance of the industrial context. ³³ Investigating corporate disclosure among a large number of listed Australian companies from 2007–17 has shown a general correlation between ESG practices and corporate financial performance. ³⁴ However, the findings varied greatly across different industrial sectors. Companies representing sectors such as energy and communications were more prone to improving their performance based on ESG factors. ³⁵ These findings support the point about the significance of the specific sphere of economic activity in measuring ESG impact.

The ESG share of the Australian financial market is clearly growing. ³⁶ Australians want their superannuation portfolios and other investments to be within the ESG narrative. ³⁷ Similar to comparative literature, the empirical studies point to a correlation between ESG portfolios and financial performance, ³⁸ or at least suggest that ESG does not scarify performance. ³⁹ At the same time, scholars have called for the establishment of clear benchmarks in measuring ESG framework compliance, ⁴⁰ calling for further elucidation of the internal components within the combination ⁴¹ and greater enhancement of the empirical studies on ESG factors, ⁴² and expressing concern about data manipulation. ⁴³

The difficulties

The ESG framework is not free from difficulties. As mentioned earlier, it could be that ESG undermines the classical notion of corporate governance which focuses exclusively on shareholder primacy and wealth maximisation. ⁴⁴ This notion exists in opposition to the incorporation of social and environmental considerations into business models, strategies and the daily operation of companies, perhaps representing a foreign, disruptive ideology to the classical model of the firm. ⁴⁵ Critics say that ESG factors place an unjustified and undemocratic burden on the shareholders, ⁴⁶ doubting whether the mandatory ESG disclosure requirements confirm the classical disclosure rationale of protecting investors. ⁴⁷ Critics also argue that ESG politicises corporate activity, providing corporate boards and executives with the leeway to pursue their own ideological agendas and therefore increase agency costs borne by the shareholders. ⁴⁸

As Michael Jansen, one of the central figures of the classical theory of the firm put it:

Companies that try to [incorporate sustainability factors] either will be eliminated by competitors who choose not to be so civic minded, or will survive only by consuming their economic rents in this manner. ⁴⁹

Along similar lines, other scholars have identified the ESG combination as being ‘driven in part by politically motivated decisions to invest in particular industries or to use particular private managers’. ⁵⁰ The concerns here are brutally simple. The sustainability factors appear to be negative externalities at odds with the classical model of the firm.

This points to the significance of robust empirical studies. If one could demonstrate an empirical link between ESG portfolios and financial performance, this would undermine the core argument of critics. If ESG improves performance (return of investment, return of equity and return on assets), it does not undermine the classical model of the firm, but rather serves it. The argument here is ‘doing well by doing good’. ⁵¹

Unfortunately, the empirical research is somewhat mixed on this point. On the one hand, some studies suggest that ESG portfolios and ESG disclosure improve performance. ⁵² Others, such as Chang et al are more skeptical. These have expressed doubts whether ESG-based funds are performing better that their conventional counterparts, ⁵³ pointing to the lack of sufficient data and making a call for increased comprehensive empirical work of the field. ⁵⁴

Beyond the acute need for empirical studies, the conceptual and doctrinal challenges of the ESG combination are significant. First, there is the question of the relation between the ESG framework and related concepts such as ‘corporate social responsibility’ (CSR) and the UN’s 17 Sustainable Development Goals (SDGs). CSR is a relatively old concept. As early as 1953, US economist Howard Bowen commented about the ‘obligations of businessmen ... to follow these lines of action which are desirable in terms of the objectives and values of our society.’ ⁵⁵ From this perspective ESG is by no means a new concept, epitomising largely a re-branding of the older CSR notion. Indeed, it is hard to draw a sharp line between the two. Many scholars use ESG and CSR interchangeably, ⁵⁶ pointing to the historical relation between the two. ⁵⁷

On a similar note, there is a question of the interrelationship between ESG and the newer concept of the SDGs. ⁵⁸ Adopted at the UN Sustainable Development Summit, these goals aim to globally uphold such values as reduction of inequality, economic growth, quality education, clean energy and reduction of poverty. Comparatively to ESG, the SDGs put forward a broader agenda, both in terms of the issues covered and universal inspirations. ⁵⁹ One would doubt the doctrinal stability and applicability of the ESG framework without clarifying the relation between it and the related concepts of CSR and SDGs.

Second is the question of context. It seems clear that incorporation of the various factors cannot be executed in the same manner across all industries. The operation of the factors differs across jurisdictions and within particular spheres of economic activity. As Elizabeth Pollman recently noted:

[T]he combination of E, S and G into one term has provided a highly flexible moniker that can vary by context, evolve over time, and collectively appeal to a broad range of investors and stakeholders. ⁶⁰

Issues such as corruption appear to be more central to developing countries. Again, much demarcation and elucidation is required in order to sustain a meaningful operation of the ESG concept.

Thirdly, there is the problem of information manipulation and selective disclosure. ⁶¹ In 2021, the UK's Financial Times quoted the portfolio manager of one of Europe's best-performing sustainable funds saying ‘many of the funds that use the ESG label … are not as sustainable as they appear. Several popular ESG funds, for example, invest in the world’s largest carbon emitters’. ⁶² Particularly troubling is the phenomenon of so-called ‘greenwashing’ which relates to situations when companies create a formal façade of sustainability while operating in a manner that undermines it. This represents the difference between ‘looking good’ instead of ‘being good’. ⁶³

Finally, the interplay between the three factors is troubling. One may argue that the three factors could not be easily reconciled without some tradeoffs. Their co-existence may lead to internal tensions that cannot be easily resolved. ⁶⁴ While the Who Cares Wins report says that the three factors are ‘closely interlinked’, ⁶⁵ it does not explain how they relate to each other. ⁶⁶ While some say that all ESG factors are equally important, ⁶⁷ others strongly doubt this and refer to the ‘E’ factor as more important than S or G. ⁶⁸ There are also those who say that the E and S could be combined under the ‘social’ grouping, while the ‘G’ factor is grounded on different considerations. ⁶⁹

The way forward

What does the ESG future hold for Australia and the world? We can safely say that this future is bright, both in Australia and globally. However, much further work is required. The ESG factors link together a broad range of values, principles and concepts. Their internal interplay requires careful elucidation through empirical, doctrinal and conceptual work.

First, the ‘environmental’ factor appears to be more important than others. It has deep roots within the traditional corporate law literature and practice. The 2021 IPCC Sixth Assessment Report established a solid causal link between human activity and climate change. ⁷⁰ This suggests a need for a solid economic analysis of each of the ESG factors and their combination.

Second, the ‘social’ factor deserves attention. Does it refer to a particular state and, if yes, how does it refer to the state sovereignty principle? Furthermore, does the concept of ‘society’ focus on the ‘immediate society’ or does it also include justice and benefits for future generations? ⁷¹ This point is important. Without determining the specific parameter of the inquiry, a meaningful analysis of the factors and their interplay is questionable.

Third, some of the concepts within the ‘G’ factor require special treatment and contextualisation. Take, for example, the ‘corruption’ concept. It has been argued that within the context of Chinese cultural relativism and economy, this concept should be analysed through a dramatically different conceptual lens than those of Western scholars. ⁷² Perhaps a related point applies to the notion of executive compensation. Scholars have shown the complexity of this notion in a diverse economy, corporate ownership structures and performance incentive mechanisms. Within this context, it is apparent that this dimension of financial activity should be predominately assessed through the framework of the classical economic theory of the firm. ⁷³

Fourth, the various components of the ‘S’ factor require elaboration. Consider the well-known concept of ‘human rights’. ⁷⁴ It has been argued that the number of values which represent ‘human rights’ is much higher than one might think. ⁷⁵ This may involve normative work on the hierarchy of human rights and clarifying their transnational aspects. A related point applies to the concept of ‘equality’. While representing a key concept in moral and legal philosophy, it is highly complex and requires much doctrinal and conceptual work. ⁷⁶

Finally, there is a deep question about the very nature of the firm. ⁷⁷ There is a direct connection between the various theories of the firm and the ESG. For example, the ESG may be incorporated relatively easily within the state-based theory of a firm. ⁷⁸ Thus, if a corporation owes its existence and incorporation to the will of a state, this theory can explain the correlative duty of the corporation to support the societal goals of that state. Other theories of the firm, such as corporate personality and web of contracts, may encounter significant difficulties in incorporating an ESG combination within their conceptual bases or it may impose significant limitations on operational scope. In other words, it is likely that, before delving into the question of the nature and application of ESG factors, one may need to comprehensively answer a preliminary and important question about the very nature of a firm.

Conclusion

ESG is a global success, and Australia is no exception to this trend. True, ESG is not free from difficulties. It has been argued that ESG undermines the classical model of the firm. Additional conceptual and doctrinal work is required to clarify the internal interplay and priority (if any) between ‘E’, ‘S’ and ‘G’ factors and their application to specific industries. The relation of the ESG combination to older CSR and newer SDG concepts requires qualification as well. The lack of comprehensive empirical studies and the troubling phenomenon of the concept’s manipulation do not contribute to public trust and doctrinal stability.

This does not mean that ESG’s future for Australia (and beyond) is not bright. Perhaps the opposite will prove true. However, as has been argued, the combination raises a multilayered set of empirical, conceptual and doctrinal questions that require answers. Without such an interdisciplinary exercise of investigation, conceptualisation and contextualisation, the doctrinal purity of the ESG combination and its operational mechanics will remain latent.