The eras of ESG

Prior to the early 2010s, there was a limited number of companies that had explicitly and visibly incorporated sustainability into their company mission. These companies primarily adopted sustainability as a way to appeal to certain customers and employees, and differentiate themselves from competitors.

Following the launch of the UN Principles of Responsible Investment (PRI) in 2006, we began to see private equity (PE) firms identifying ways to think about and operationalise sustainability. Framing sustainability in terms of the pillars of environmental, social and governance and the growing use of the term ESG gave PE firms a more systematic framework for utilising ESG considerations as a way to manage risk.

Between 2010 and 2020, the number of PRI signatories tripled to over 3,000 and PE firms recognised that issues such as climate risk were important business considerations for assessing the resilience of their investments.

In addition to PRI, this decade saw the creation of the Sustainability Accounting Standards Board (SASB), the release of the UN Sustainable Development Goals (SDGs), and the launch of the Task Force on Climate-related Financial Disclosures (TCFD), all voluntary means of considering ESG matters within a business.

While many PE firms initially viewed ESG as a risk management tool, a growing number of investors also began to recognise performance in ESG topics as a means of adding value during the hold period, which further increased the incorporation of ESG considerations during the investment lifecycle.

In 2020, a number of high profile events shone a spotlight on ESG topics:

• The rise in climate-related environmental disasters, such as extreme heat, forest fires, floods, storms and hurricanes, continued at pace, challenging the perception that climate change is a distant future concern.
• The mistreatment and subsequent death of George Floyd and other people of colour and the Black Lives Matter movement raised awareness of racism issues, prompting numerous businesses to make public declarations on the topic of racial inequality and expand or create their diversity, equity and inclusion (DEI) programmes.
• The COVID-19 pandemic put a focus on ESG topics, in particular the management of human capital and supply chains. The pandemic was a test on how companies manage their workforce and support their customers and clients during tumultuous times. Companies also reexamined their supply chain practices, and those tied to single suppliers were forced to rethink their supply chains and develop contingency plans to manage these risks going forward.

These events resulted in many companies jumping on the ESG bandwagon. There was a flurry of activity on ESG topics as businesses made aggressive net zero commitments, pledged to have more people of colour in leadership positions and develop diverse talent pipelines, and adopted flexible work-from-home policies.

As the ESG bandwagon was reaching top speed, we started seeing an almost inevitable anti-ESG backlash. In the US, this was initiated by pushback from critics against ESG and anything seen as “woke”, with a resulting slew of legislation against the consideration of ESG factors in investments.

As the politicisation of ESG increased, we began to see examples of companies being sued or boycotted because of their climate goals or actions. Companies also began receiving heightened scrutiny and lawsuits for overstated sustainability-related claims or other instances of greenwashing.

Consequently, we saw a further decline in ESG commitments because of the greenhushing movement, with companies scaling back their ESG ambitions, opting to speak less openly about their efforts, and even deliberately using different language like “responsible investing”.

In 2023, the first major ESG-related regulations came into effect, the most prominent being Europe’s Corporate Sustainability Reporting Directive (CSRD). Others include the US Securities Exchange Commission (SEC) Climate Disclosure Rule (currently stayed), and California’s Climate Corporate Data Accountability Act (SB 253) and Climate Related Financial Risk Act (SB 261).

Across these four regulations, over 50,000 public and privately held companies could be subject to various reporting requirements related to ESG topics, including greenhouse gas emissions (GHG) and climate risk. Because GHG and climate risk disclosures were largely voluntary up to this point, these regulations essentially raised the floor on ESG disclosures by making GHG emissions and climate risk reporting mandatory for a large number of companies for the first time.

At the same time that regulations were raising the floor on ESG disclosures, there was a parallel effect on some companies that had already been proactively disclosing these metrics who then opted to align their disclosure practices with these new regulatory requirements, in some cases reducing the amount of data they reported. This was essentially lowering the ceiling on ESG reporting for those companies.

Is it inevitable that the rising floor and the lowering ceiling will result in a convergence in the extent to which companies will approach ESG disclosures? And what will keep the ceiling of ESG action from converging with the floor of regulation?

There are several trends working to counteract the decline:

• Many investors continue to require active integration of ESG considerations throughout the investment lifecycle, which includes doing more than merely complying with regulatory requirements. Investors still see ESG considerations as important for risk management and identifying value creation opportunities.
• Many companies have recognised that ESG can lead to operational efficiencies, lower costs, and reduced risk of business interruption with extreme weather events and supply chain disruption, resulting in more efficient and reliable operations for futureproofed companies.
• Many companies recognise that a proactive approach to ESG will help them attract and retain the best talent. Surveys indicate that many people would prefer to work for a company that shares their values, which often include stances on environmental and social issues.

The journey of ESG through a series of eras and the emergence of ESG regulations has had the dual effect of raising the floor on ESG action, such that a large number of companies are both compelled and required to focus on sustainability performance for the first time, while also lowering the ceiling for companies that adopt a more conservative or compliance mindset to sustainability and scale-back previous commitments.

However, we expect that other drivers for ESG performance – such as investor and stakeholder demands, operational efficiencies, the war for talent, and futureproofing – will keep the floor and ceiling far enough apart.