What Does the ‘G’ in ESG Mean?

When it comes to corporate governance and investment, the term ‘ESG’ stands for Environmental, Social, and Governance. ESG has gained substantial attentionin recent years, especially among different stakeholders of an organisation, including investors, employees, customers, and even regulators. In fact, investors are increasingly looking at the non-financial factors of a company as part of their investment analysis process to explore growth opportunities.

Along with the environmental and social factors, the governance aspect of ESG also plays a critical role in ensuring that an organisation maintains its sustainability goals as well as ethical integrity. It should be noted that in India, no single law covers ESG. Instead, it is covered separately and primarily under the Companies Act 2013 and SEBI’s LODR (Listing Obligations and Disclosure Requirements) Regulations, 2015.

Let’s understand what is the meaning of the ‘G’ in ESG and how it impacts an organisation:

Understanding the Governance Factor in ESG

Governance in the context of ESG refers to how a company is managed and controlled. It includes all the rules, practices, and processes that guide and oversee a company's operations. Good governance helps ensure that a company is run effectively and ethically. Here’s a simplified explanation of the key components of good corporate governance:

Board Composition and Function: The board of directors is crucial in setting a company’s direction and management. An organisation’s board should have members not only with the right mix of skills but also from diverse backgrounds. In fact, as per Section 149 of the Companies Act, certain defined classes of companies are required to have a female director.This diversity helps the board make better decisions and guide the company through complex challenges.

Executive Pay: It is important that the pay for company executives is linked to the company’s long-term goals. This means that their earnings should reflect how well the company is doing in achieving these goals. In recent years, corporate India has witnessed quite a few associations and boards directing it to apply ESG goals in terms of its executive pay. For example, the National Stock Exchange(NSE) requires all the companies listed on its index to disclose how their executive pay is linked to their ESG agenda.

Audit Policies for Risk Management: Companies need strong systems in place to handle risks and to ensure that their financial reporting is accurate. This involves regular checks (audits) to make sure that everything is running as it should be and that the company is following all the necessary laws and regulations.

Rights of Shareholders: This aspect covers shareholder rights. Shareholders of a company should have a say in important company decisions and should be kept well-informed about how the company is doing. This includes having the right to vote on major decisions and receiving regular updates about the company’s performance.

Why is the Governance Factor Important?

Good governance is important for any company because it ensures that the business is run effectively, ethically, and in a way that benefits everyone involved—from shareholders and employees to the wider community. Here are some of the main reasons why good governance is crucial:

Transparency: When a company has clear governance structures, it means that its decision-making process is transparent. This helps investors and other stakeholders like customers and employees see how decisions are made by the board, thus building trust in the organisation’s ability to sustain itself. Alternatively, it also makes it easier for the stakeholders to hold the company accountable for its actions, as they can see what the company is planning to do and why.

Accountability: Strong governance ensures that everyone in the company, especially those in high positions, is responsible for their actions. This accountability is crucial because it prevents individuals from taking advantage of their positions for personal gain, which can lead to corruption. When leaders know they are accountable for their decisions, they are more likely to act in the best interests of the company. This not only helps in maintaining a good reputation but also boosts confidence among investors and the public.

Management of Risk: Having an effective governance and audit process involves having systems in place to identify potential risks to the company—whether financial, ethical, or legal. Once these risks are identified, good governance helps ensure that they are dealt with before they can cause serious problems. For example, regular audits and checks can uncover issues that might otherwise lead to financial losses or legal troubles.

Long-term Sustainability: Lastly, good governance impacts a company’s ability to be sustainable over the long term. This includes not just environmental sustainability but also economic and social sustainability. Governance practices ensure that a company’s activities are aligned with legal and ethical standards.

What are the Specific Governance Disclosures Required for ESG Ratings?

As discussed above, in India, companies are required to adhere to several governance-related disclosure norms primarily governed by the Companies Act, 2013, and the Securities and Exchange Board of India (SEBI) regulations, particularly under the Listing Obligations and Disclosure Requirements (LODR).

Below is a table highlighting key governance-related disclosures that companies in India are expected to make:

What Are the Challenges in Implementing Effective Governance?

Implementing good governance practices in a company can, of course, be challenging. While the benefits of adhering to ESG criteria are significant in the long term, in the short term, there are several obstacles that can make it difficult for companies to establish effective governance.

Here are some of the main challenges:

Resistance to Change: One of the biggest hurdles in the governance front of implementing ESG is the inherent resistance to change that exists within most organisations. When new governance practices are introduced, they can disrupt the way processes took place earlier. This can be particularly challenging if the changes affect the interests of board members or senior executives who may have been following certain practices for a long time.

Cost Barrier: Improving governance definitely requires a significant investment. This can include the costs of hiring new staff with the right expertise, training current employees, updating systems to improve transparency and accountability, and conducting regular audits. For many companies, especially smaller ones, these costs can be a substantial barrier.

Different Cultures and Norms: For companies that operate in multiple countries, different cultural expectations and legal requirements can complicate governance efforts. Different countries may have different norms and regulations regarding corporate governance, which can require companies to adapt their policies in various ways. This can be challenging to manage, especially for global companies that need to maintain consistency in governance standards while also respecting local practices.