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G: The Intersection Between E and S

Ariel White-Tsimikalis, Partner, Bryan Cave Leighton Paisner, explains how governance reforms are placing ESG at the top of the agenda for UK boards and investors.

ESG has morphed fairly quickly from a buzz word into a concept firmly being embedded in the minds and strategy of a growing number of corporates and their boards as well as the investor community more broadly.

Sustainability, once seen as the key (if not sole) externality on the minds of corporates and their investors, has evolved into a broader conversation under the auspices of ESG. It has branched out from E-centric issues to include more focused conversations around S – which caught up quite impressively during the course of 2020 – and, critically, has been anchored and fortified by a growing body of global and domestic legislative and regulatory reporting and governance frameworks under G.

ESG is a fast-paced area and is evolving practically on a daily basis. So where are we currently on the G front specifically and what is coming down the pipeline that asset managers and the broader investor community need to look out for?

Key trends dominating the UK corporate governance narrative

The ESG tidal wave is currently at a pivotal moment – as we seek to find our feet and (re)define ourselves as a nation, as an economy and capitalist system and as a community in the wake of a sea of change caused by climate change, the pandemic, Brexit and the Black Lives Matter movement. How we invest, how we run businesses, how we regulate, how we look after our employees, how we treat our environment and how we consider the communities in which we live are all being (re)tested and seen through a new lens.

The challenges of the past year have blown strong wind into the sails of ESG and given it new speed, fortitude and urgency to fill some of the gaps exposed in our existing frameworks and, in some cases, provide a means to addressing certain shortcomings. Already this year major strides have been made on the G front which will affect public interest entities and the investment community particularly when it comes to assessing ESG credentials and driving change through stronger ESG investment strategies and board agendas.

UK corporate governance reform

In March 2021, the UK Government published its long-awaited White Paper setting out a package of measures aimed at improving the UK’s audit, corporate reporting and corporate governance systems in the wake of recent accounting and corporate governance scandals. It represents possibly one of the most significant shake-ups in the UK’s corporate governance framework in recent times. A whole raft of changes are being proposed with three in particular relevant to the broader investment community.

Firstly, the Government is proposing to expand the scope of companies that qualify as a public interest entity (PIE), whose audits are subject to additional regulatory requirements, in order to provide an added layer of protection to investors and the public in light of recent accounting failures within non-PIEs. The current scope of PIEs captures credit institutions, insurance undertakings and companies with securities admitted to London’s Main Market, and the Government is seeking to bring certain large private companies as well as AIM companies with a market cap of €200m or greater (currently around 105 AIM companies) into scope. Overall, up to 2,000 additional entities could be brought into scope depending on the ultimate definition of PIE adopted following the consultation – a notable increase from the approximately 2,000 which are caught by the current definition and significant expansion of the investment pool.

Secondly, the pandemic has clearly accelerated investor appetite for fuller disclosures by companies about how they are planning for potential future challenges and business risks. The UK Government is therefore proposing that premium listed PIEs publish an annual ‘Resilience Statement’ setting out how directors are assessing the company’s prospects and addressing challenges to its business model (including risks posed by climate change) over the short, medium and long-term, and an ‘Audit and Assurance Policy’, whereby directors explain how they are seeking to obtain internal and external assurance of the information being reported to shareholders (over a three year rolling period).

The Audit and Assurance Policy would be subject to an advisory shareholder vote at the time of publication. Whilst initially both these statements would only be required of premium listed companies, the plan is to extend these requirements to other PIEs over time. These proposals firmly plant ESG matters within the purview of board strategy and decision-making, wrapped in a blanket of additional director accountability, and will give investors better insight into the non-financial reporting metrics and organisational resilience of corporates.

Thirdly, in putting forward its preferred ‘Sarbanes-Oxley lite’ option, i.e. not formally mandating external attestation of the effectiveness of a company’s internal controls, it is clear the UK Government understands there is a careful balance to be struck at a time when the UK listing regime is being revamped in order to attract more capital to London. It will be interesting to see how market practice develops as regards external attestations based on what market participants, particularly institutional shareholders, investors and financial advisers, may require or like to see. It might be that we end up at a Sarbanes-Oxley standard for listed companies through the back door in any event which will be a significant shift from where we are today. The investment community therefore is likely to play a key role in defining the direction of travel and ultimate destination of this significant proposal.

ESG-focused disclosure for listed companies

In December 2020, the UK Financial Conduct Authority (FCA) released a technical note in which it stated that climate-related risks as well as other ESG-related risks may be financially material to issuers’ assets and therefore need to be carefully considered when determining what should be disclosed under the various disclosure regimes applicable to issuers listed in the UK. The key message from the FCA: listed companies need to carefully consider ESG matters when determining what should be disclosed under existing applicable disclosure regimes. These obligations apply to any issuer on a regulated exchange (so not just premium listed companies, but would not capture AIM companies) and took immediate effect.

What is perhaps most significant regarding this edict from the FCA is how broadly it applies. In scope UK listed companies should be considering their disclosure obligations across a wide array of disclosure documents including prospectuses, shareholder circulars, management reports and section 172 statements in annual reports and even when considering whether to disclose inside information under the UK Market Abuse Regulation – all now need to be filtered through an ESG lens. This broad brush shift is more seismic than it appears on the surface. In one fell swoop, ESG has been embedded throughout the entire UK disclosure framework for in scope listed companies.

Diversity on boards

The S and G have intersected quite dynamically in the recent period with the targets set by the Hampton-Alexander Review which recommended that FTSE 350 companies aim for a minimum of 33% female representation on boards and executive committees (and their direct reports) by 2020. In its final report published earlier this year, it was reported that around 65% of the FTSE 350 have met the target of at least 33% of their board positions being held by women and there are no longer any all-male boards in the FTSE 350. This is a significant improvement on recent years. However, the work is not done.

More progress remains to be made when it comes to women in executive roles. There are only 17 female CEOs in the FTSE 350. And, critically, just 2.9% of board positions are held by women of colour according to the 30% Club even though the Parker Review recommends there should be one director of colour on each FTSE 100 board by the end of 2021 and one on each FTSE 250 board by 2024.

Climate-related financial reporting

In December 2020, the FCA introduced a new rule in the FCA’s UK Listing Rules requiring climate-related financial disclosures in issuers’ annual financial reports. The disclosures are to be made against the recommendations and the recommended disclosures set forth by the Taskforce on Climate-related Financial Disclosures (TCFD) which was established by the G20’s Financial Stability Board off the back of the Paris Agreement on climate change. The new rule is designed to help users of financial statements, particularly investors and shareholders, understand how an issuer is managing climate-related risks.

The new disclosure obligations apply to all commercial companies with a premium listing, wherever they are incorporated and applies to financial years beginning on or after 1 January 2021. The FCA, however, is expected to consult later this year on extending the new Listing Rule to a wider list of companies, with standard listed companies likely to be targeted in the first instance. Moreover, the UK Government published a consultation in March 2021 with proposals to mandate the inclusion of climate-related financial disclosures by UK-incorporated large private companies, AIM companies (with more than 500 employees) and limited liability partnerships in the non-financial information statement which forms part of the Strategic Report in their annual financial reports.

Measurable reporting, disclosure and governance requirements

In summary, legislative and regulatory frameworks are boldly anchoring ESG through tangible and measurable reporting, disclosure and governance requirements. G is intersecting with E and S and paving the way to a more integrative reporting framework and, at the same time, is levelling the playing field across the various components of ESG. Shareholders, asset managers and other members of the investment community are increasingly having more tools than ever before to drive change in the companies in which they invest.

Much of the progress made by G has been driven by the growing interest (and expectations) from the wider investor community for whom ESG has cemented itself in firms’ investment strategies. We are already seeing a growing number of companies with requisitioned climate change resolutions at their AGMs this year. And as we move towards a more harmonised ESG benchmark framework, it will be increasingly easier for the investor community to measure, assess and hold corporates to account for their ESG credentials and aspirations. At the end of the day, what gets measured gets done.

Those corporates who still think ESG is fluffy nice-to-have corporate social responsibility mumbo jumbo will be left behind in a plume of dust. The G is driving board effectiveness by focusing the minds of directors on these issues. ESG needs to be top of the agenda not just for internal operations, risk management and compliance heads and human resources teams, but right up at the top of the organisation – the board agenda and, more critically, the board’s overall long-term strategy. Those who get that, will flourish. Those we are still educating themselves on ESG, need to move into fifth gear. And those who still have no idea what this is all about, will miss out on a significant opportunity to create sustainable companies with strong stakeholder relationships and investors who will help them flourish for the long term.


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