The way companies manage their environmental, social and governance (ESG) responsibilities is increasingly influencing the way they are viewed by investors, customers, regulators, employees and other key stakeholders. ESG has steadily become a framework of behavioural standards used to assess the quality of a company’s management, its exposure to business risks and its ability to leverage opportunities. Focus has predominantly been on companies on the London Stock Exchange’s (LSE) Main Market, but companies operating on the Alternative Investment Market (AIM) are increasingly coming under scrutiny too.
What is ESG?
The three ESG pillars are interdependent because activity in one area can affect performance in another, but they cover a multitude of issues. A focus on strong environmental standards can include corporate policies addressing climate change, use of sustainable natural materials, lowering the company’s carbon footprint and positive action to achieving net zero emissions; social standards determine how a company manages its relationships with employees, suppliers, customers and the local community, and its policies advancing diversity, inclusion and equality; and ethical governance standards define how the company is run, and how it measures on anti-corruption, anti-slavery, senior executive remuneration and shareholder rights.
In practice, factors such as a company’s size and sector will determine its areas of ESG focus, but stakeholders are increasingly demanding positive action in all areas and that companies be held accountable for their actions and ESG impact.
The growing importance of ESG
The ability of stakeholders to monitor and measure companies’ actions and activities more easily has placed companies under greater scrutiny and reinforced stakeholder expectations of how companies should act. Companies are increasingly being assessed on their environmental and social impact, not just on their profitability.
Stakeholders value transparency because it enables them to make informed choices. It has become vitally important for companies to be able to demonstrate and communicate excellent ESG performance, not only from a desire to be doing the right things but also to meet the expectations of key stakeholders: to secure investment, retain and grow their customer base, attract talented employees and meet regulatory requirements. A recent survey found that 75% of investors think ESG issues should be at the forefront of a company’s business strategy regardless of the impact they may have on the company’s profitability, and 80% of investors include ESG considerations in their decision-making process.
In line with the demands of other stakeholders, regulators are increasing pressure on publicly quoted companies to produce clear, transparent, and comparable ESG disclosure alongside their financial reporting. Steps are also being taken to prevent exaggerated claims and ‘greenwashing’ to attract investors and customers.
The increasing scrutiny investors place on ESG performance also affects companies preparing for an IPO as much as for public companies. A positive, clearly articulated ESG strategy alongside transparent disclosures can increase a company’s chances of attracting investment in a competitive market and prepares the company for operating on the Main Market or on AIM.
Mandatory and non-mandatory ESG Reporting
Currently there is no overarching legislative framework that encompasses all ESG factors. Companies are required to comply with legislation that covers various aspects of ESG and are obliged to adopt the most appropriate non-mandatory framework for the company’s business sector which also focus on different ESG areas.
ESG legislation that companies must comply with include The Climate Change Act 2008, Bribery Act 2010, and the Modern Slavery act 2015. Companies’ ESG disclosure requirements are determined by the UK Corporate Governance Code 2018, the Companies Act 2006 and the FCA’s Disclosure Guidance and Transparency Rules. The non-mandatory guidelines include the Task Force on Climate-Related Financial Disclosure (TCFD), Sustainability Accounting Standards Board (SASB), Carbon Disclosure Project (CDP), International Integrated Reporting Framework (IIRC), and Global Reporting Initiative (GRI). Companies can adopt more than one non-mandatory framework.
The assortment of legislation and non-mandatory frameworks can be confusing in regard to how and what companies need to monitor and report on, and how stakeholders assess and compare companies’ performance. The likelihood of more numerous and demanding ESG regulations in coming years may require clearer guidance and commonality of approach on ESG performance.
AIM companies and ESG disclosure
The regulatory requirements affecting AIM companies are less prescriptive than on the Main Market in order to give emerging AIM companies the opportunity to grow. However, despite AIM companies being generally newer the government’s direction of travel can be seen in the recent amendment to the 2006 Companies Act, which took effect from April 2022. The amended legislation requires all companies trading on a regulated market, including AIM, with more than 500 employees, to disclose climate-related information in their Annual Reports. This information must conform with the TCFD’s four recommendations concerning governance, strategy, risk management and metrics and targets.
This brings AIM companies that fit the criteria within the scope of mandatory disclosure requirements for the first time. Previously only AIM companies preparing to move to the Main Market were required to make these disclosures. In-scope companies are required to state in their Annual Reports whether their disclosures are consistent with TCFD recommendations, or to explain why not.
There are several aspects of disclosure. These include: a description of how companies identify and assess the principal climate-related risks and opportunities of their operations; how these might impact the company’s business model and strategy; the governance arrangements for assessing and managing them; an analysis of the company’s resilience in various scenarios; and the key performance indicators for assessing progress against targets.
This development in making AIM companies more compliant with ESG mandatory requirements follows an amendment to the rules on corporate governance for AIM companies by the LSE in 2018. Under AIM Rule 26, AIM companies are required to comply to a recognised corporate governance code. This places the onus on AIM companies to detail the corporate governance code they are following, how they comply with that code, and instances where the code has not been followed with an explanation why. This information must be annually reviewed.
The Rule amendment reflects the LSE’s aim that developing AIM companies should follow good governance practice. The LSE doesn’t advocate a particular code although it does point to the UK Corporate Governance Code (UKCGC) and the Quoted Companies Alliance Code (the QCA code) as established benchmarks. Both codes focus on engagement between the company, shareholders and stakeholders, the efficiency and diversity of the board, an appropriate balance between executive and non-executive directors, and supporting the board with knowledgeable committees.
Despite AIM companies being generally smaller and less developed than Main Market companies, ESG compliance and initiatives can equally enhance their reputations and credibility from the perspective of key stakeholders.
Consumers and investors are leading the drive for companies to disclose their ESG impact and performance in their Annual Reports and in other ESG reporting. Regulators are responding to this desire for transparency and clarity by putting pressure on company boards to comply. Listed companies will be increasingly accountable for their actions and performance whichever market they operate in.
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