The foundation that binds the E and S in ESG is Governance

The importance of Governance in ESG

Based on the World Economic Forum's Global Risks Report for 2024, risks connected to Environmental, Social and Governance (ESG) have consistently been the most prominent risks over the past ten years. This is because organisations are facing growing demands to identify, analyse and address ESG-related challenges. If organisations do not respond to these ESG-related risks, there is a possibility of facing negative consequences from stakeholders, including investors.

As organisations assume responsibility for their ESG initiatives, the ESG-related concerns that are currently prominent and trending in the news encompass:

Material misrepresentation of ESG performance

According to the 2022 Global Economic Crime Survey, 8% of organisations that were victims of fraud also experienced fraudulent reporting of their ESG performance. The manipulation of ESG data is becoming more prevalent, since it involves the deliberate use of unbalanced reporting, intentional misreporting or distortion. The financial ramifications of this are catastrophic as organisations now face substantial fines and, with an increase in litigation cases.

The risk of greenwashing has become significant

Regulatory authorities are now taking supervisory measures against organisations that deceive customers, investors, and other important stakeholders regarding the sustainability of their products or plans for transitioning to more sustainable practices. Instances of greenwashing encompass the deliberate manipulation of:

ESG performance measures and metrics to falsely demonstrate compliance with specific requirements included in Sustainability Linked Loans or to artificially boost the company's stock value by aligning its values with ESG measurements.
Attainment of ESG-related goals, key performance indicators and targets for management and executive compensation incentives for their personal gain.
Sustainability programme data and information in order to earn ESG credits or obtain certificates of compliance with pollution management standards.

Reputational damage

Organisations presently are confronted with the risk of irreparable harm to their reputation and, in extreme cases, the revocation of their social license to operate due to the dissemination of unsupported assertions regarding their ESG performance.

Investor funding

Sustained investor funding risk due to penalties imposed on organisations for ESG misstatements.

The aforementioned ESG-related risks can ultimately be attributed to deficiencies, inadequacies or breakdowns in governance, since the leadership's ethical culture sets the precedent for how organisations address significant inaccuracies in ESG accomplishments, deceptive environmental claims and resulting harm to reputation. Governance concerns serve as the foundation for business failures, substantial regulatory sanctions or penalties, trust erosion and reputational harm. The sufficiency and efficiency of governance structures, systems, and processes are crucial for maintaining the Environmental (E) and Social (S) aspects of ESG practices, and for ensuring the long-term viability and adaptability of the organisation.

Definition of Governance

Corporate governance is defined by the UK Corporate Governance Code (the Code) as "the system through which organisations are supervised and directed." Governance of organisations falls under the purview of the Boards of Directors, and they should ensure that a suitable governance framework is established. The concept of corporate governance, as defined in the King IV report on Corporate Governance for South Africa in 2016, refers to the ethical and efficient leadership demonstrated by the governing body in order to attain desired governance outcomes. This includes the establishment of an ethical culture, strong performance, effective control and legitimacy. According to the King IV report, corporate governance is a matter of leadership; therefore ethical and effective leadership is necessary to establish an ethical organisation. Foundational to governance are a number of critical components, each of which contributes to the direction of an organisation's success.

The governance (G) element of ESG refers to the procedures and structures through which organisations are supervised, regulated and held responsible. This may encompass details like business ethics, the composition and inclusivity of the board of directors, executive remuneration, corporate adaptability, rules and procedures concerning bribery and corruption.

How governance influences ESG

Governance, as defined, functions as an umbrella term encompassing both the 'E' and 'S' components of ESG. It is a fundamental prerequisite and enabler for the effective implementation of policies and measures aimed at tackling environmental and social issues. Given the intricate and interconnected nature of risks, effectively managing ESG related risks necessitates a governance-focused approach. ESG risks and opportunities encompass all governance matters that fall under the purview of Boards of Directors. In the absence of efficient and well-established governance processes the 'E' and 'S' will not be successfully implemented. When integrating ESG risks into risk management frameworks, a holistic approach can be achieved by approaching them through the lens of governance. This process entails the modification of risk appetite statements and business and risk strategies, as well as the assurance that all three lines of defence have complete transparency regarding roles and responsibilities.

By drawing upon the control environment component of the Internal Control Framework established by the Committee of Sponsoring Organisations (COSO) and the COSO ERM Framework (Enterprise Risk Management—Integrating with Strategy and Performance), the role of Governance in ESG requires the leadership of the Board of Directors which:

Demonstrate commitment to integrity and ethical values to manage ESG risks. Leadership that embodies integrity, competence, responsibility, accountability, fairness and transparency, in addition to the establishment of an internal ESG culture that is congruent with the ethical culture of the organisation, will guarantee that the manner in which risks, opportunities, and reporting are managed is consistent with the ethical culture of the business.
Exercise oversight responsibility in respect of the organisation's ESG strategy and risk management processes, ensuring that the business operates in the best interest of all stakeholders. In addition, the Board fulfils its oversight duty by ensuring that the business strategy and its response to existing ESG challenges and risks are in line, as well as by collaborating with senior management to identify sustainable opportunities and threats and defining the Board's mandate accordingly. This practice guarantees that the overarching business strategy and sustainability priorities remain in perfect alignment.
Ensure transparency and accountability in ESG performance and reporting, as well as to support the implementation of the ESG strategy, establish governance structures with designated authority and responsibilities. In addition to overseeing and ensuring controls over sustainability information, data governance and reporting, the existence of effective governance structures reduces the instances of scandals or fines that may result from misrepresentations of sustainability performance. The King IV report provides support for ESG-related risk governance with regard to governance structures. This is achieved through the implementation of stakeholder management, the establishment of a Social and Ethics Committee, and the identification and integration of risks and opportunities into strategic planning processes.
Exhibit a steadfast dedication to proficiency by guaranteeing that the organisation possesses the requisite expertise, skills, knowledge and aptitudes to operationalise and steer the ESG strategy and corporate governance of the organisation. Internal evaluation of ESG reporting metrics against a consistent framework for completeness, accuracy, and comprehensibility requires the necessary talent and expertise.
Maintain a system of accountability regarding ESG reporting and the sustainability programme. The Board upholds accountability by ensuring that the establishment of executive compensation incentives (both explicit and implicit) is not linked to ESG performance, but rather aims to promote positive behaviours and attitudes rather than heighten pressures for unethical reporting.

The ability of the Board of Directors and executives to harmonise ESG objectives with other business goals is enhanced when governance is central to ESG. This empowers organisations to generate long-term value for investors and other stakeholders through differentiation and enhancements. This requires the creation of a governance framework that categorises ESG-related risks into fundamental domains.

To Conclude

Given the risks associated with ESG initiatives, organisations that effectively manage the governance pillar are better equipped to foster a culture of responsible decision-making, accountability and transparency throughout the implementation and reporting of ESG programmes. This is accomplished by integrating ESG-related risks into the governance structures, systems and procedures. Effective governance safeguards an organisation's long-term success and fosters confidence among its stakeholders, in addition to assisting it in achieving its ESG objectives. Internal auditors, as the overseers of governance, have a crucial role in helping their organisations enhance their ESG initiatives and practices. They accomplish this by offering both assurance and advisory services, which encompass a wide array of ESG-related risk assessments and verification of sustainability data for comprehensiveness and accuracy and assisting with development of competitive, compliant and sustainable ESG Frameworks.