Insights

The term ‘ESG’ (environmental, social and governance) and the broader area of sustainable finance has lately been heavily mentioned across various platforms and, while such topics have been discussed for several years, interest and related activities are now gaining traction, with discussions being regularly brought up in company board meetings.

Historically, ESG-related issues weren’t seen as being within the purview of the board of directors but fell within the ambit of ‘corporate social responsibility’ and were considered as being separate and distinct from the business of generating revenue and profits. These issues were not considered by directors but rather by specific teams who discussed topics and organised initiatives that could provide public good and were completely irrelevant to shareholders.

Initial notions of ESG include ideas such as diversity, sustainability and ethical-based decisions being undertaken by a company. However, given the heightened interests from various stakeholders (including investors, shareholders, employees, consumers and suppliers), directors are now more than ever required to know that ESG entails.

Directors need to realise that integrating ESG-based decisions is not a window-dressing exercise but rather an exercise for a company to seize on valuable opportunities ‒ through the design and implementation of long-term sustainable policies and practices ‒ that can contribute to its long-term success and growth.

Legislation

The general duties of directors arise out of their juridical position under general principles of law. Directors are duty bound to act with loyalty and care/skill as codified in the Companies Act of Malta.

The duty of care requires directors to exercise the diligence and skill that a reasonably prudent person would exercise in comparable circumstances – this duty of care fundamentally requires that a director must be well informed when making corporate decisions. Should such decisions relate to the setting and implementation of the company’s long-term business strategies, the board may well be required to ensure that it has all the relevant information at its disposition regarding ESG-related risks and opportunities the company faces or could face.

When discharging their duty of loyalty, directors must determine what is in the company’s best interest. To do so, they may (and should) consider various stakeholders. Thus, with the ever-growing interest from company stakeholders requiring that companies integrate ESG matters in their day-to-day business, directors will definitely need to be well informed on such a topic.

We are also seeing a growing school of thought whereby the concept of a stakeholder goes beyond human, political or economic considerations and the environment considered to be a stakeholder, given that the company’s activities may affect the environment, which in turn may affect the company’s operations (such as climate change); therefore, the company has a moral obligation to safeguard the environment.

Furthermore, the duty of good faith requires that the directors are aware of any legal/regulatory violations or other harm being caused by a company. This requires that directors are aware of any ESG-related laws/regulations in place to ensure that the company is abiding by its legal/regulatory obligations. This also ties in with recent ESG specific regulatory proposals issued by the European Commission which require entities to adapt to ensure they are in line with ESG-related laws and regulations.

Purpose and strategy

A starting point for the board is to take advantage of its unique vantage point, by determining whether it has clearly articulated and defined its purpose and to assess whether such purpose is linked to overall

strategy. In undertaking such an evaluation, the company’s stakeholders need to be properly identified and considered in a comprehensive manner.

In defining such purpose and strategy, the board is to consider, identify and understand the potential impact and related risks of ESG factors in relation to the company’s operating model.

While this can be seen as a challenging task, whereby the board has to collectively address matters from a vast array of fields regarding various ESG factors in light of the company’s operations, strategy and risk profile, this can be seen as an opportunity for the board to leverage ESG for the long-term success of the company, its stakeholders and society in general.

The board of directors should consider implementing an ESG oversight structure that ensures their decision-making process is adequate and will withstand the various parameters they take in the ordinary course of business. Such oversight should ideally be performed by directors from diverse backgrounds and who have the appropriate skill set to do so. This notion is being given more importance by supranational bodies when providing guidance on the composition of the board of licensed entities, and it is expected that this will trickle into other industries in the very near future.

Companies may view ESG integration as necessary to ensure a strong reputation and limit reputational risk with stakeholders. Managing ESG risks and opportunities therefore becomes an important part of managing brand and reputational value.

Remuneration

One way the board may seek to promote ESG initiatives within a company is by initially identifying the relevant ESG factors and then including ESG objectives in execu­tive compensation.

A growing trend among stakeholders is to push for ESG achievements to be included in more traditional key performance indicators in executive compensation. Linking non-financial metrics, such as ESG, with executive pay, presents an opportunity to incentivise desired behaviours and to further show to stakeholders a concrete commitment to ESG priorities.

The European Commission seems to be making headway when incorporating remuneration factors into ESG laws, through the introduction of a number of initiatives and regulations.

The new proposal relating to the Sustainability Reporting Directive, which will eventually replace the Corporate Sustainability Reporting Directive, introduces a number of reporting requirements relating to equal opportunities, such as gender equality and equal pay for equal work. Further reporting requirements include those related to working conditions, such as secure and adaptable employment, wages, social dialogue and involvement of workers.

We have also seen new proposals relating to pay transparency. Ensuring equal pay between men and women and addressing the gender pay gap has always been on the European Commission’s agenda, and such proposal seeks to address this lack of transparency.

As a result of these new proposals, companies will need to adapt swiftly in order to keep up with this ever-changing environment.

First published in the Times of Malta, this article is the first of a two-part series. The second article, being published next week, will focus on the current ESG-related reporting and disclosure requirements and further risk mitigation mechanisms that can be adopted by the boards of various companies.