The acronym ESG has recently become more and more common in business circles. Therefore, we have decided to write up this short article to help you understand what ESG is and what it means for business relationships.
The acronym ESG (Environmental, Social, and Governance) refers to the new requirements in the field of social responsibility, corporate governance and environmental sustainability. ESG is de facto an assessment of a company's social responsibility in the area of social and environmental factors. These three broad categories are used to define "socially responsible entrepreneurs", i.e. entrepreneurs who consider the inclusion of their values and concerns important (such as environmental protection, corporate governance or community interests).
PRACTICAL IMPLICATIONS FOR COMPANIES
Financial institutions, investors, business partners, other stakeholders, and the public correctly view ESG as a potential risk for companies that may not comply with these standards. The legal, financial and reputational risks and negative impacts associated with non-compliance with these standards can in many cases complicate the situation not only for the company that does not follow them in a sufficient manner, but also for other companies with which they do business.
We have recently come across specific ESG requirements, particularly in the area of public procurement, where our clients, especially those based in western Europe, have increasingly started to require some form of ESG certification or proof of sustainability risk management of service & supply providers.
What are then the areas of ESG? ESG is comprised of three main categories, which are further divided into sub-categories.
E – Environment. Evaluation criteria targeting environmental topics, including, for example, what resources are used - raw materials, emissions, level of innovation. The company's environmental impact.
S – Social. Criteria focusing on assessment of the level of social responsibility of a given company. These criteria include, for example, an assessment of working conditions, how the company approaches respect for human rights, the impact of the company's production on society.
G – Governance. A criterion targeting the way a company is governed, emphasizing internal controls and procedures (usually established by various standards, such as ISO, and their implementation), the responsibilities of suppliers and the management of the company as a whole.
So, what are the main factors that tend to be taken into account when assessing a company's ESG criteria? In our experience, they comprise primarily (but not exclusively) from the following areas
- Carbon footprint
- Environmental sustainability
- Water consumption
- Respect for human rights
- Consumer protection
- Animal welfare
- Equality – discrimination
- Management structure
- Employment relations
- Employee remuneration
- Management remuneration
- Investment strategy
- Investor structure
- Principles of responsible investment
- Data protection
ESG ON THE EUROPEAN MARKET
The first legislative steps on ESG at the European level are already about to come into effect. On November 28, 2022, the Council of the European Union finally approved the Corporate Sustainability Reporting Directive (“CSRD”). This Directive amends the 2014 Non-Financial Reporting Directive (“NFRD”) and introduces uniform and specific EU standards for non-financial reporting and expands the scope of persons affected by the requirements.
Businesses will now have to disclose both the positive and negative impacts of their activities on the environment and society as a whole. They will also have a duty to report on so-called ESG risks and opportunities affecting long-term sustainability of their business activities and to disclose strategies to ensure or improve sustainability.
Although these areas are relatively new in Central Europe, they represent a new global reality that companies can utilize for new business opportunities; the earlier companies start applying ESG principles, the more of a competitive edge they will gain over their competitors. Moreover, it cannot be ruled out that the ability of companies with a low ESG rating to acquire loans, subsidies or incentives will be limited in the future or that their participation in public procurement might be limited.
The rules contained in the CSRD will apply from 2024 in four main phases:
- In 2025, for the first time, selected companies will be obliged to publish reporting for 2024. This obligation will apply to companies already subject to the above-mentioned 2014 NFRD;
- in 2026, the obligation to publish 2025 reporting will also apply to large companies;
- in 2027, small and medium-sized enterprises admitted to trading on a regulated market will have a duty to publish their 2026 reporting for the first time, with the possibility to use a two-year exemption from this obligation if they fulfil certain conditions;
- in 2029, reporting for 2028 will also be required for third-country companies that generate a net turnover in the EU of more than €150 million and have at least one subsidiary or branch in the EU above the thresholds.
Currently the European Union also prepares legislation in the form of a directive on corporate sustainability due diligence. A proposal for this Directive on Corporate Sustainability Due Diligence and amending Directive (EU) 2019/1937 ("CSDD Proposal") was published on February 22, 2022 and it introduces, among other things, a human rights and environmental due diligence obligation for certain companies and a civil liability for failing to exercise due diligence.
Obligated entities under the CSDD Proposal are:
- EU companies withmore than 500 employees on average and a net turnover of more than EUR 150 mil;
- EU companies with more than 20 employees on average and a net turnover of more than EUR 40 mil, provided that at least 50% of the net turnover was generated in one or more of the so-called high-impact sectors such as agriculture, textiles, clothing, fishing, extraction of mineral resources etc.;
- Non-EU companies in the EU with a net turnover of more than EUR 150 mil;
- Non-EU companies in the EU with a net turnover of more than EUR 40 mil, provided that at least 50% of the net turnover was generated in one or more of the high-impact sectors.
The CSDD Proposal establishes a corporate due diligence duty (especially with regard to the supply chain of companies). In order to act with due diligence, a company must incorporate due diligence into its policies, be able to identify actual or potential adverse human rights and environmental impacts, be able to prevent, mitigate or eliminate those potential adverse impacts and minimize the extent of actual adverse impacts, establish and maintain grievance procedures for those affected by adverse impacts, monitor the effectiveness of its due diligence policies and measures, and ensure public communication of due diligence. All of this must be done by the company in accordance with the provisions of the CSDD.
It must be noted that the CSDD Proposal is not the only legislative measure adopted by EU Member States in this regard. Effective from this year, Germany has already passed its own supply chain due diligence act.
EUROPEAN SUSTAINABILITY REPORTING STANDARDS
After a public consultation period, the European Financial Reporting Advisory Group prepared the first set of draft European Sustainability Reporting Standards (“ESRS”). These standards will become part of the CSRD as they outline detailed reporting requirements. The final draft version was published on 16 November 2022 and the standards are now awaiting approval by the European Commission, which is expected by 30 June 2023.
In the first phase, two sets of cross-cutting standards and ten sets of topical standards have been prepared, the latter divided into three groups in accordance with the ESG acronym. Their aim is to ensure that companies will report all relevant and important data in a structured and comprehensible form.
The second set of draft ESRS will include sector standards and standards for small and medium-sized enterprises, and these are expected to be adopted by 2024.
ESRS sector standards will be created for companies operating in specific sectors, such as agriculture, coal mining, energy production, and road transport. One of the reasons for the different regulation is that these specific sectors are strategic and there is great potential for change, especially in sectors that are of national security and political importance. Different rules will also apply to small and medium-sized enterprises to minimize their administrative burden.
LAW FIRMS AND ESG
An example of how ESG works in the legal profession can be the activities of PRK Partners under the so-called practice group, where an interdisciplinary approach is applied to help clients to understand this new phenomenon and thus mitigate the risks associated with insufficient reflection of the ESG requirements and to explore new opportunities offered by ESG. Legal advice provided by PRK Partners in this area takes into consideration insights from other relevant areas and respects the clients and their specific needs. Briefly put, PRK Partners helps clients to define the easiest and the most economical way ofbecoming ESG compliant as required by public authorities, shareholders, clients, business partners or financing entities, investors, financial institutions and ever more so often – our clients themselves.
PRK Partners ESG practice group currently provides legal advice in the following areas:
- Reviewing the company's and group's fundamental documents, rules of procedure and signature rules and their structure in order to comply with the ESG regulations in the corporate, labour and finance areas;
- Assisting in the identification and assessment of strategic risks;
- Finding opportunities related to the EU Green Deal (public aid, funding resources);
- Advice on creating ESG-compliant corporate culture;
- Training in ESG-related areas;
- Preparation of ESG documents for financial due diligence and M&A transactions;
- Carbon footprint calculation;
- Renewable energy projects;
- Supply chain management and circular economy strategies, including whistleblowing compliance;
- ESG issues related to finance;
- Compliance with environmental regulations;
- Sustainable funding.
By Jaroslav Seborsky, Asociate, PRK Parnters