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From A Financial To An Entity Model Of ESG

Iain MacNeil
Irene-marie Esser[1]

(December 2021)

The 2030 Agenda for Sustainable Development, adopted by all United Nations Member States in 2015, provides a shared blueprint for peace and prosperity for people and the planet. It makes provision for 17 Sustainable Development Goals (SDGs), which are an urgent call for action by all countries – developed and developing – in a global partnership.[2]. On 11 December 2019, the European Commission presented the European green deal, a growth strategy aiming to make Europe the first climate-neutral continent by 2050.[3]Under the UN Guiding Principles on Business and Human Rights (‘UNGP’s’) companies have a responsibility to undertake human rights due diligence.[4]This is all in an effort to have more sustainable companies, in the context of environmental, social and governance concerns.

Sustainability is a key theme in corporate and financial law. It has many strands but one of the key overarching themes is a focus on how corporate governance and financial regulation might contribute to resolving or mitigating externalities. Corporate governance and financial regulation have a role to play in the transition to a sustainable economic model, especially in a global context. This is already happening through voluntary action driven by global guidelines, policies and principles as well as national, self-regulatory codes of best practice. Some of these soft law recommendations are also starting to be framed as harder obligations mandating responsible behaviour from companies through, for example, reporting requirements. The latest announcement that the UK will make it mandatory for Britain’s largest businesses to disclose their climate-related risks and opportunities, in line with the Taskforce on Climate-related Financial Disclosures (TCFD) recommendations, is an example in point. On 10 March 2021, the European Parliament also approved an outline proposal for the EU Directive on Mandatory Human Rights, Environmental and Good Governance Due Diligence, this legislation is expected to be approved in 2022. After this, the EU member states will be given time to include it in their national legislation.[5]

Prof Iain MacNeil and Professor Irene-marie Esser of the School of Law at the University of Glasgow recently explored this issue by proposing an entity model of ESG investing, from a corporate law perspective, which should promote sustainability and the protection of stakeholder interest more effectively.[6] ESG investing evolved over time from the earlier concept of CSR. The process of evolution moved the focus from the external impact of corporate activities to the risk and return implications for financial investors of failing to address ESG issues in their portfolio selection and corporate engagement. The bridge between the two approaches was the framing of sustainability in the early part of the millennium as an overarching concept that could be mapped on to the supply of capital and the techniques employed by institutional investors. The financial model of ESG investing is now the standard approach around the world and is reflected in ESG ratings, codes and guidance and regulatory rules. It focuses on the role of capital and investors in driving change in sustainability practices and pays much less attention to the role of board decision-making and directors’ fiduciary duties. In our research, we trace the origins and trajectory of this change in emphasis from CSR to ESG and attempt to explain why it occurred. We identify shortcomings in the financial model of ESG investing and propose an alternative ‘Entity’ model, which we argue would more effectively promote sustainability in the corporate sector around the world. In this blogpost we discuss some of our findings and observations.

As a starting point it is important to be clear on the meaning and scope of CSR within this context. For our purposes, sustainability is the overarching concept, with CSR and ESG as sub-sets that operate within the corporate and financial domains respectively. Sustainability is focused most explicitly on externalities and, from a corporate governance perspective, on how the de facto norm of shareholder primacy has limited the internalisation of externalities through a focus on shareholder interests. The ethical foundation of CSR means in principle that the focus is on doing the right thing in the context of the operational setting of the business. In that sense the ethical choice is not framed as an instrument for improving financial performance, albeit that the expectation might be that observance of ethical standards would, in the long term, have that effect. ESG is focused on financial risk and return and therefore integration of ESG factors into the investment process has the primary purpose of improving returns over the long term by mitigating the risks associated with those ESG factors. The early development of CSR was marked by a focus on ethics and accountability, sustainability then focused on externalities and stakeholders, while the advent of ESG focused attention on adjusting the supply of capital to reflect risks to portfolio returns.

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