ESG Explained | Article series exploring ESG from the very basics | #1 What is ESG? (2024)

Background

On April 21st 2021, the European Commission adopted the sustainable finance package which includes the proposed CSRD¹ which reforms and greatly increases the scope of reporting required compared to the NFRD² disclosure requirements. The increase in scope means that from2023 almost 50,000³ companies in the EU will now have to report on ESG issues

The Hungarian Stock Exchange (BÉT) has issued a recommendation to all issuers that they develop an ESG reporting roadmap by the end of the year. In order to assist with this task we have decided to publish a series of articles exploring the topic of ESG and how to approach it.

What is ESG?

ESG stands for environmental, social and governance. These are called pillars in ESG frameworks and represent the 3 main topic areas that companies are expected to report in. The goal of ESG is to capture all the non-financial risks and opportunities inherent to a company's day to day activities.

Why is ESG here to stay?

Our world faces a number of global challenges: climate change, transitioning from a linear economy to a circular one, increasing inequality, balancing economic needs with societal needs. Investors, regulators, as well as consumers and employees are now increasingly demanding that companies should not only be good stewards of capital but also of natural and social capital and have the necessary governance framework in place to support this. More and more investors are incorporating ESG elements into their investment decision making process, making ESG increasingly important from the perspective of securing capital, both debt and equity.

What falls under the Environmental Pillar?

Emissions such as greenhouse gases and air, water and ground pollution emissions. Resources use such as whether a company uses virgin or recycled materials in its production processes and how a company ensures that from cradle to grave the maximum material in their product is cycled back into the economy rather than ending up in a landfill. Similarly, companies are expected to be good stewards of water resources. Land use concerns like deforestation and biodiversity disclosures also fall under the Environmental Pillar. Companies also report on positive sustainability impacts they might have, which may translate into long-term business advantage. From a reporting perspective this is the most complex pillar.

What falls under the Social Pillar?

Under the Social Pillar companies report on how they manage their employee development and labour practices. They report on product liabilities regarding the safety and quality of their product. They also report on their supply chain labour and health and safety standards and controversial sourcing issues. Where relevant companies are expected to report on how they provide access to their products and services to underprivileged social groups.

What falls under the Governance Pillar?

The main issues reported under the Governance Pillar are shareholders rights, board diversity, how executives are compensated and how their compensation is aligned with the company’s sustainability performance. It also includes matters of corporate behaviour such as anti-competitive practices and corruption.

What is relevant from all this for your company?

Of course, not all sectors of the economy face the same ESG issues. For example in the case of banks, greenhouse gas emissions (more precisely scope 1 and 2) are not as important as they are in the case of energy. These differences in what matters to a particular sector from an ESG perspective is called materiality. Companies report on issues that are material to them. Typically materiality is determined based on what ESG issue is considered financially material in a given industry. Financially material issues are those that can impact a company's financial performance (e.g.: unexpected surplus costs, fines, loss of brand value, loss of revenues due to consumers choosing more sustainable alternatives). Increasingly double materiality is being recognised as an important concept in choosing what is considered material by a company. Double materiality means alongside financially material issues, socially material issues are also treated as material.

How do you report?

ESG today is broadly thought of as a reporting framework, however originally it was a framework developed for evaluating the sustainability related disclosure of listed companies for investors. Now with demand for ESG related information on the rise, the ESG framework has become synonymous with reporting. There is no standard ESG framework (yet), only a broad consensus on the issues covered by it; there can be numerous differences at the data point level. For this reason, companies rely on sustainability reporting standards to determine how and what they report.

Reporting is typically done by applying one or more frameworks. The 2 most commonly used reporting frameworks are the Global Reporting Initiative (GRI) and the Sustainable Accounting Standards Board’s standards (SASB). ESG reporting is typically done by publishing a sustainability report although more and more companies are disclosing data through webpages that showcase the companies ESG performance in addition to a more standard report.