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What is the G in ESG? Unveiling the critical role of governance

28 February 2024

George Lampridis, Senior Associate

While environmental and social considerations often take the spotlight, governance remains the unsung hero of the ESG revolution. It serves as the foundation for the delivery and monitoring of ESG, akin to a ‘sandwich analogy for ESG’. This article delves into the multifaceted role of governance in ESG, highlighting compliance and the financial value of ESG-driven investments. Navigating challenges to establish a future-proof governance framework is crucial for sustainability in today's rapidly evolving landscape.

ESG discussions often focus on environmental and social aspects, somewhat sidelining “G” for governance. While global initiatives like COP27 and COP15 address environmental and social concerns, regulatory attention is broadening to include the social pillar, as evident in the EU Social Taxonomy. However, we see no governance taxonomy on the horizon.

The Task Force on Climate-related Financial Disclosures (“TCFD”) exemplifies a framework linking the environmental and governance aspects. It recommends clear governance structures for overseeing climate-related risks and opportunities, representing a departure from traditional non-financial reporting.

Governance, previously perceived as a checklist task, now demands significant investments in controls, systems, and personnel. The EU Taxonomy introduces pillars for environmental and social aspects, yet governance, while mentioned as an obligation, is vaguely defined. Nonetheless, connections between taxonomies and governance are evident, especially in the environmental taxonomy's governance safeguards. Recent directives like the Corporate Sustainability Reporting Directive (“CSRD”) strive to clarify ESG governance requirements, yet concerns persist about the risk of reducing the role of governance to a mere checkbox exercise, potentially leading to governance-washing.

On January 22 2024, the Financial Reporting Council released the revised UK Corporate Governance Code, highlighting transparency, accountability, and adaptability. It now places more focus on culture, diversity, and risk management, including detailed reporting on malus and clawback provisions. These changes reflect the evolving corporate governance landscape, aiming to strengthen board oversight of company operations.

A sandwich approach

In the evolving landscape of ESG frameworks, corporate governance often takes a back seat to its flashier counterparts—environmental and social considerations. But what if we told you that governance is the unsung hero, the glue holding the entire ESG journey together?

Imagine a new ESG framework, not as a rigid pillar but as a sandwich. A framework where environmental and social aspects are the juicy middle, cushioned by two slices of governance. 

Governance sits at the top, setting the rules for ESG integration. This upper layer shapes the ESG strategy, making it the guiding force behind seamless progress. Beneath this, there is a lower layer where tools and processes come into play, designed and implemented by dedicated roles within the governance model. These tools are not static but dynamic gears driving the monitoring, assessment, and continuous improvement of ESG integration.

Acknowledging governance’s multifaceted role in ESG underscores its importance as a cornerstone for sustainable business practices. It extends beyond mere compliance to strategic positioning. With ESG regulations tightening, compliance is non-negotiable. It is not just about ticking boxes, rather preventing the risks associated with greenwashing—the real deal or no deal.

Building a brand known for sustainability not only attracts top talent but also sets the stage for acquiring like-minded companies. Investors are also nodding in approval. As they increasingly embrace ESG integration, companies’ ability to attract capital becomes effortless. This is a win-win scenario for all parties involved.

But here is the kicker: financial value creation. Investing in companies without ESG motivations might pose regulatory and reputational risks. However, by flipping the script and investing in ESG-motivated companies, suddenly, you are looking at higher profits and promising returns during the exit phase.

From helicopter view to powerhouse

Having elucidated the elevated spirit and essence of governance in ESG, and the pivotal role it plays, let's now delve into design and implementation. Here, the collaborative efforts of the Board of Directors merge with the dynamic execution prowess of the ESG team, driving the ESG journey forward.

Similar to the people, process, and tools model, the focus is on designing efficient company structures to guide the ESG journey.

The designated teams will have the responsibility to craft policies and processes that shape the operations of a company in the ESG trajectory. Following new directives from the European Financial Reporting Advisory Group (“EFRAG”), companies must grasp and implement the concept of double materiality, integrating ESG factors into investment decisions for social, environmental, and financial benefits. Additionally, the ESG team ensures the implementation of tools for managing ESG adaptation, facilitating internal and external disclosure for reporting, regulatory compliance, and financial purposes.

Navigating the complexities of future-proof governance

In establishing a future-proof governance for sustainability, key areas must be addressed, including the Board of Directors, the ESG company framework, and the role of the Chief Sustainability Officer (“CSO”). An elevated role of CSO is crucial and is needed in most companies. Subsequently, inquiries arise concerning the ESG team’s qualifications and responsibilities, KPI selection, regulatory compliance, policy formulation, process execution, and ESG integration into due diligence and investment strategies. The resolution of these challenges is an ongoing process, subject to debate and refinement, with no one-size-fits-all solution. Decisions regarding company structures, reporting lines, and responsibilities (i.e., centralised or decentralised models) depend on each company's unique traits, preferences, and regulatory environment. The imperative lies in crafting an adaptive and tailored governance framework aligned with the company's vision, appetite for sustainability, and industry best practices.

The next time someone diminishes the significance of governance in ESG, highlight that it goes beyond a mere checklist item. It stands as the unsung hero, sculpting the story of sustainable practices through each meticulously crafted governance model. Step into the ESG revolution, where governance assumes the forefront!