ESG and businesses

Answer

What’s ESG?

In November 2020, the Financial Times released an opinion piece – ESG: a trend we can’t afford to ignore. The article argued that sustainable investing is no longer a fantasy but is already here. Environmental social and governance (ESG) has emerged as an umbrella term for a range of factors against which investors or lenders can assess an entity’s behaviour when considering whether to invest.   

ESG is a broadly similar concept to corporate social responsibility, and encapsulates issues such as modern slavery, human rights, data protection, employee relations, climate change, environmental issues and supply chain sustainability. It’s emerged as a key topic in the legal sector, as businesses grapple with what ESG means for them and what they can do to improve their ESG credentials.  

The commercial impacts of ESG

Until now, the climate crisis and a wider public awareness of environmental and biodiversity-related issues meant that the focus for businesses has predominantly been on the ‘E’ in ESG. However, as the recent introduction of the Modern Slavery Procurement Practice Note (PPN) by the Cabinet Office suggests, the ‘S’ and ‘G’ are also beginning to receive more attention. Further, the PPN demonstrates that ESG remains a key consideration for both public sector organisations and private companies bidding for public sector work. 

There are a large number of areas in which ESG intersects with businesses but this article will briefly consider a couple of them. This article will also touch on the considerations that businesses may consider when making ESG-related decisions and the commercial and legal issues that can arise when doing so. ESG pervades a wide range of sectors and can incur criminal and regulatory sanctions in some contexts. These sanctions will not be considered further within this note, but for some topical examples have a look at this UK Finance article.

Supply chain management

One element of ESG that can prove a particular challenge for larger businesses is supply chain management. Following recent and significant growth in ESG awareness, investors and stakeholders are starting to expect businesses to look beyond their own internal operations and consider whether the activities of their supply chain are ESG-compliant. 

UK legislation includes a range of ESG and supply chain obligations, including:

• environmental – for example, the Environment Act 2021 introduced new framework provisions to make it illegal for larger businesses operating in the UK to use key forest risk commodities produced on land being illegally occupied or used; 
• modern slavery – the Modern Slavery Act 2015 places obligations regarding modern slavery on businesses over a certain size and, as set out above, this is also the subject of UK government guidance; and
• directors’ duties – the Companies Act 2006 requires directors to promote the success of the company, and sets out a number of factors that directors must have regard for when doing so; the factors include fostering the company's business relationships with suppliers, customers and others and considering the impact of the company's operations on the community and the environment.

Supply chain management can be difficult from a practical perspective, particularly if businesses have a very large or multi-tiered supply chain, or where parts of their supply chain are based abroad. It can be time-intensive and potentially costly (both financially and from a resource perspective) to establish ESG-compliant supply chain policies and track that compliance through. However, companies must weigh these considerations against the dangers of not doing so. Suppliers expose businesses to the greatest ESG compliance risks. Having limited visibility over the activities of its supply chain or failing to ensure compliance within the supply chain with ESG-related factors can open businesses up to a range of risks, including reputational damage, litigation and supply chain disruption. 

Sustainable finance

Sustainable finance and green finance are examples of the push to facilitate sustainable economic growth by incorporating ESG considerations into investment decisions. 

The UK regulates sustainable finance in a variety of ways:

• The UK green taxonomy – the UK government is expecting to implement a UK green taxonomy that will set out the criteria that specific economic activities must meet to be considered environmentally sustainable. It’s intended to, among other objectives, improve understanding of companies’ environmental impact.  
• Financial Conduct Authority (FCA) initiatives on climate change and sustainable finance. This includes the FCA’s ESG strategy, which includes the principles of promoting transparency on climate change and wider sustainability and supporting the role of finance in delivering a market-led transition to a more sustainable economy.

Green finance initiatives can be difficult for businesses to understand or engage with given the number of options available and the wide range of parameters that are currently taken into account when considering whether finance is ‘sustainable’ or ‘green’. The UK green taxonomy will aim to tackle this issue by creating clarity and consistency for investors and providing a reference point or performance target for companies. However, businesses will also be mindful of the benefits of engaging with ESG to attract investment and the risks of being left behind if they do not do so. Further, companies involved in activities such as greenwashing (ie, the act of “making people believe that your company is doing more to protect the environment than it really is”) can suffer reputational damage and could, in some cases, be subject to litigation.

ESG-related risks

This article has briefly touched on several of the ESG-related risks that businesses can encounter when grappling with ESG. One of the key risks to businesses in the context of ESG is reputational damage, which could have a lasting impact on a business’ performance in the market and (depending on the nature and scale of the issue) potentially affect its ability to raise finance in the future.

In addition, ESG litigation is a growing area of law. Causes of action can be identified in a wide range of existing legislation, while other more novel ideas of where we might see ESG litigation develop in the future have also been mooted. Examples include as follows:

• Breach of contract – where ESG-related duties or obligations are owed under a contract, the failure to comply with those provisions could give rise to a breach of contract claim. This commonly leads to a remedy of damages. 
• Nuisance – commentators have noted that historically, this was the tort that was historically most associated with claims regarding environmental concerns. Remedies could include damages or an injunction to either stop a party from taking or compel a party to take certain action.
• Negligence – in order to successfully show negligence has occurred, claimants must prove that a duty of care has been breached, leading to a recoverable loss or damage. Other factors including causation, foreseeability and mitigation will also be relevant to a successful claim. Negligence claims could arise in relation to negligence affecting the environment, harm to individuals, companies and property or as a result of poor governance.
• Breach of directors’ duties – although not yet fully tested in the courts, there could be the potential for company directors to be personally affected if they’ve breached the ESG-related elements of their directors’ duties in failing to carry out proper supply chain management. A recent real-life example of this kind of action is ClientEarth’s derivative claim against Shell’s directors. ClientEarth claims that Shell’s 11 directors breached their legal duties under the Companies Act 2006. In particular, it claims that Shell’s board has mismanaged climate risk by failing to prepare properly for the energy transition to net zero, and by failing to adopt and implement an energy transition strategy that aligns with the Paris Agreement.

ESG is here to stay

It’s clear that ESG is now a key consideration for businesses and can have a wide range of both positive and negative impacts. Failure to manage ESG-related risks can be costly to businesses in a number of ways. However, if businesses can successfully manage those risks – and support by specialist ESG legal advisers can help them do this – they’re more likely to survive and thrive in the future. 

Helena Sewell is a trainee solicitor at Burges Salmon LLP.