Legal perspectives on ESG and director duties

In today’s rapidly changing business landscape, the concept of Environmental, Social and Governance (ESG) factors has emerged as a guiding framework for companies seeking to thrive in the long term. From small startups to multinational corporations, businesses of all sizes are recognising the importance of integrating ESG considerations into their strategies, operations and culture.

Understanding ESG

ESG encompasses a broad range of criteria that measure a company’s impact on the environment, society and corporate governance. It is therefore an umbrella term of factors relating to the decisions and behaviour of an organisation in the context of social responsibility. It is also the term used by the investment world when using these types of factors to assess corporate behaviour, evaluate the future financial performance of companies and to manage risk.

The Environmental factor assesses a company’s efforts to minimise its carbon footprint, conserve national resources and mitigate climate changes. The Committee on Climate Change reported that the UK can end its contribution to global warming within 30 years by setting a net zero target by 2050. The Climate Change Act 2008 (2050 Target Amendment) Order 2019 came into force in 2019 and changed the UK’s 2050 net greenhouse gas emissions reduction target under the Climate Change Act 2008 to 100% (it was previously 80%). This is known as the UK’s net zero emissions target, and organisations are now setting net zero targets to accomplish this goal.

Social factors evaluate a company’s treatment of people. These could be the company’s employees, customers and communities, and takes into account the company’s equality, diversity and labour practices.

Governance factors focus on the company’s leadership, transparency and accountability, ensuring ethical behaviour and effective risk management.

Why ESG matters

Integrating ESG considerations into business practices is no longer just a moral imperative; it is increasingly becoming a strategic necessity. Consumers, investors and regulators are placing greater emphasis on sustainability, social responsibility and ethical conduct. Companies that prioritise ESG factors not only enhance their reputation and brand value, but also reduce risks, attract investment, and drive innovation.

ESG-aligned companies are better positioned to navigate regulatory changes, anticipate market trends and build resilience in the face of global challenges.

Some key ESG-related legislations are:

• The Environmental Protection Act 1990
• The Water Resources Act 1991
• The Companies Act 2006
• The Climate Change Act 2008
• The Equality Act 2010
• The Bribery Act 2010
• The Modern Slavery Act 2015
• The Environment Act 2021

Some legislative provisions are more relevant to companies in certain industries, for example the Environmental Damage (Prevention and Remediation) (England) Regulations 2015 will be relevant to companies which have contaminated land, or are at risk of damaging the environment, or are at risk of, or engage in, polluting water.

Some sectors are also more exposed to ESG risks. These include technology hardware, automotive and transportation sectors.

Director duties

The directors of a company have a responsibility to oversee company risk, ensure material risks are identified, assessed and mitigated. Sections 172 and 174 of the Companies Act 2006 are particularly relevant in the ESG context.

Section 172 imposes on company directors a duty as follows: “a director of a company must act in the way he considers, in good faith, would be most likely to promoted the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to:

(a) the likely consequences of any decision in the long term,

(b) the interests of the company’s employees,

(c) the need to foster the company’s business relationships with suppliers, customers and others,

(d) the impact of the company’s operations on the community and the environment,

(e) the desirability of the company maintaining a reputation for high standards of business conduct, and

(f) the need to act fairly as between members of the company.”

This duty carries a subjective test, as the director’s conduct needs to be other than in good faith. Whilst this duty is owed by directors to the company and so is not directly enforceable by stakeholders such as employees, it does, to an extent, codify the concept of ‘enlightened shareholder value’, which is that directors should have regard to stakeholders and the impact of their decisions in the long-term whilst working for the benefit of shareholders.

Section 174 on the other hand, requires a director to exercise the reasonable care, skill and diligence that would be exercised by a reasonably diligent person with both:

• The knowledge, skill and experience that might reasonably be expected of someone carrying out those functions (objective test);
• The knowledge, skill and experience that the director actually has (subjective test).

Embracing ESG across industries and sizes

While the specific ESG priorities and challenges may vary across industries and company sizes, the fundamental principles remain consistent. From technology startups to traditional manufacturing companies, businesses must assess their environmental impact, promote social equity and uphold strong governance practices.

Large corporations with extensive resources and often a long supply chain are particularly at risk. Such corporations often have more advanced ESG programs and dedicated sustainability teams as a result. Small and medium-sized enterprises can also make meaningful strides by integrating ESG into their day-to-day operations, supply chains and stakeholder engagements.

Embracing ESG is not merely a trend; it is a fundamental shift in how businesses operate and create value in the 21^st century.

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