Meaning of ESG

Environmental, social and governance (ESG) has been the topical buzzword in boardrooms, corporate governance reports, webinars, research, and blogs – emerging as a focal point at the 2023 United Nations Climate Change Conference (COP28) recently held in Dubai. ESG refers to a framework or set of standards used by investors to assess a company’s performance and behaviour in relation to environmental sustainability, social responsibility, and corporate governance practices.

In other terms, ESG is used as a tool to measure the sustainability and ethical impact of investments and business practices by potential investors. For instance, investors utilize the following in ESG: (a) the environmental criteria to evaluate a company’s impact on the environment and natural resources; (b) the social criteria to examine the methodology a company utilizes in managing relationships with its employees and customers; (c) the governance criteria to assess the company’s leadership and internal controls.

Two cardinal factors characterize ESG. Firstly, incorporating responsible and ethical investing whereby ESG factors influence investment decisions to align with sustainability goals and ethical considerations. Secondly, given that ESG is used as a yardstick by socially conscious investors to screen potential investment, it takes the holistic view that sustainability extends beyond environmental issues and encompasses social and governance matters as well.

Pre-ESG

Prior to the incorporation of ESG factors in business and investment decisions, the primary emphasis was on financial performance and profit maximization. This is evident in the 1960s and 1970s when economists such as Milton Friedman gained notoriety for endorsing financial performance in investing as opposed to social responsibility. Consequently, this perspective gained prominence throughout the 20th century.

Companies typically paid minimal attention to their environmental footprint, social obligations, or governance standards beyond those mandated by law. Environmental issues were frequently disregarded, resulting in pollution of the environment, ecosystem degradation, depletion of resources, destruction of habitats and gradual contribution to climate change. Social concerns such as labour conditions, human rights, and community involvement were frequently overlooked, resulting in the prevalence of exploitative work environments and the perpetuation of social disparities in specific instances. Governance practices commonly exhibited a deficiency in transparency and accountability, consequently fostering instances of corporate misconduct and unethical behaviour. Generally, the business landscape prior to the integration of ESG principles was marked by a narrow focus on financial metrics, without much consideration for the broader societal and environmental implications of business operations.

The rise of ESG

The early stages of ESG can be traced to the 1970s when opposition to South Africa’s apartheid regime led to selective disinvestment based on ethical considerations. This was endorsed by  Reverend Leon Sullivan who formulated the Sullivan Principles in 1977 to guide business dealings with South Africa, resulting in reports that prompted significant disinvestment by United States companies, increasing pressure on South Africa to end apartheid.

This pressure on ethical investing intensified in the 21st century, with environmental groups urging companies to incorporate investment approaches that encompass environmental and social factors in decision-making, citing benefits such as improved recruitment and brand reputation. Consequently, major banks and investment houses, such as Unibanco in Brazil and Jupiter Fund in London, responded to this growing trend.

ESG issues would then, for the first time, be formally addressed in the 2006 United Nation’s Principles for Responsible Investment (PRI) Report which encapsulated the 2004 United Nations Global Compact “Who Cares Wins” Report and subsequent reports from Freshfields, Bruckhaus, Deringer International Law Firm including several financial institutions.  These reports offered solutions to the investment landscape with the aspiration of integrating environmental, social, and governance considerations to foster the development of sustainable investments.

Over the years, there has been a surge in evidence that suggests a correlation between ESG considerations and financial performance. The recognition of long-term sustainability in investments, combined with fiduciary duty, has elevated the importance of ESG factors in the investment market.

Current practice of ESG in Kenya

The focus on ESG in Kenya is escalating as significant institutional investors demand greater commitment to ESG criteria from the companies in which they invest.

ESG in Kenya is characterized by disclosure and reporting obligations where investors are demanding disclosure and reporting on standardized data pertaining to environmental impact, social practices, and governance: prompting regulatory bodies to enforce mandatory reporting standards. In turn, regulators such as the National Environment Management Authority (NEMA) have implemented legislation that mandates disclosures  – such as Section 68(3) of The Environmental Management and Coordination Act (No.8 of 1999)  which requires premises owners or project operators who have conducted an Environmental Impact Assessment (EIA) to maintain records and submit annual reports to NEMA. Further, Section 57 of EMCA and the Environmental (Impact Assessment and Audit) Regulations 2003, along with the 2012 National Guidelines for Strategic Environmental Assessment in Kenya, require strategic environmental and social assessments for all projects and programs to prevent adverse impacts. Additionally, the 2015 Code of Corporate Governance Practices for Issuers of Securities sets minimum standards for stakeholders of publicly listed companies. It requires Boards of such companies to adopt formal strategies for sustainability.

In the banking sector, the Central Bank of Kenya (CBK) has issued a Guidance on Climate-Related Risk Management (GCRRM) for commercial banks to guide the development and implementation of climate-related strategies and mitigate climate-related risks. Mandatory reporting began in September 2022, which saw the banking sector, through its industry association the Kenya Bankers Association, launch a Climate-Related Financial Disclosures Template on September 7, 2023. The template aims to facilitate compliance with the GCRRM by all licensed commercial banks. Further, the ESG Guidance Manual, released by the Nairobi Securities Exchange (NSE) in November 2021, mandates listed firms to publicly disclose their ESG performance, both positive and negative, on an annual basis.

Listed companies such as Safaricom PLC and KCB Group PLC have also taken proactive steps to voluntarily report on ESG and sustainability issues to their stakeholders. This pre-emptive adoption of voluntary disclosures by industry leaders indicates a growing recognition of the strategic importance of responsible and environmentally sustainable business practices.

Challenges of ESG in Kenya

Given the nascent stage of ESG operationalization in Kenya, the governance structure remains underdeveloped while standardized reporting frameworks are lacking. There is a need for consistent and standardized frameworks for ESG reporting across industries. Moreover, there are notable gaps concerning compliance and enforcement that need to be addressed by regulators.

Given ESG’s recent emergence, there is a notable lack of awareness and understanding surrounding ESG principles among various companies and stakeholders. Thus, there is a necessity for heightened awareness efforts.

Integration of ESG into business strategies remains a challenge. The incorporation of ESG considerations into core business strategies and decision-making processes can be complex for companies transitioning to ESG-focused practices. Therefore, further research and elucidation of ESG practices in this area are warranted.

Conclusion

In closing, the future of investing increasingly hinges on Environmental, Social and Governance principles, underscoring the imperative for investors to prioritize ESG factors when prospecting investments to maximize financial performance and long-term societal and environmental well-being.

By: Stephen Mallowah (Partner) and Pressy Akinyi (Trainee Advocate)

For more guidance on ESG practices in Kenya, contact smallowah@tripleoklaw.com