ESG Explained

Background:

On April 21st, 2021, the European Commission adopted a sustainable finance package introducing the Corporate Sustainability Reporting Directive (CSRD). This directive significantly expands the scope of mandatory ESG reporting compared to previous requirements. As a result, nearly 50,000 companies in the EU will be required to report on ESG factors starting in 2023.

Recognizing this evolving landscape, the Hungarian Stock Exchange (BÉT) recommends all issuers develop ESG reporting roadmaps by year-end. To help companies navigate this process, we'll publish a series of articles exploring ESG and practical approaches.

So, what is ESG?

ESG stands for Environmental, Social, and Governance. These pillars represent the core areas companies report on within ESG frameworks. The goal is to capture non-financial risks and opportunities inherent in a company's operations.

Why is ESG here to stay?

Our world faces pressing challenges like climate change, transitioning to a circular economy, and social inequalities. Investors, regulators, consumers, and employees increasingly demand that companies go beyond financial stewardship: they expect them to be responsible stewards of environmental and social capital, with strong governance frameworks to support this.

Many investors now integrate ESG factors into their decision-making, making ESG crucial for securing both debt and equity capital.

What falls under the Environmental Pillar?

This pillar focuses on aspects like:

• Emissions: Greenhouse gases, air, water, and ground pollution.

• Resource use: Use of virgin vs. recycled materials, and maximizing product lifecycles to minimize waste.

• Water management: Responsible stewardship of water resources.

• Land use: Deforestation and biodiversity considerations.

• Positive sustainability impacts: Initiatives that create long-term business advantages.

Reporting on the Environmental Pillar is often the most complex.

What falls under the Social Pillar?

Companies report on:

• Employee development and labor practices.

• Product liabilities: Safety and quality of their products.

• Supply chain standards: Labor practices, health & safety, and ethical sourcing.

• Accessibility: Providing products and services to underprivileged communities (where relevant).

The Social Pillar focuses on a company's social impact and responsibilities.

What falls under the Governance Pillar?

This pillar covers:

• Shareholder rights.

• Board diversity.

• Executive compensation: How pay is structured and aligned with sustainability performance.

• Corporate behavior: Anti-competitive practices and corruption prevention.

The Governance Pillar emphasizes responsible leadership and ethical business conduct.

What's relevant for your company?

Not all sectors face identical ESG issues. For example, greenhouse gas emissions are less significant for banks compared to energy companies. This industry-specific context is called materiality. Companies report on material issues, which are those with potential financial impact (e.g., unexpected costs, fines, brand value loss, revenue decline due to competition from sustainable alternatives).

A growing trend is double materiality, acknowledging the importance of both financially and socially material issues.

How do you report?

While ESG is often seen as a reporting framework, it originally emerged as a tool for evaluating listed companies' sustainability disclosures for investors. With rising demand for ESG information, the framework has become synonymous with reporting.

There's no single standard ESG framework yet, but there's broad consensus on the covered issues. Differences may exist at the data point level. Companies rely on sustainability reporting standards to determine how and what they report.

Common reporting frameworks include:

• Global Reporting Initiative (GRI)

• Sustainable Accounting Standards Board (SASB)

Companies typically report through sustainability reports or increasingly, by showcasing ESG performance on dedicated webpages alongside traditional reports.