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The true cost of ESG

Environmental, social and governance (ESG) criteria are moving to the forefront of corporate strategies, in part because of investor, customer and regulator expectations. The COVID-19 pandemic has heightened this trend and the role that companies are expected to play in helping safeguard employees, customers and society as a whole.

Research by Bank of America in 2019 revealed that S& P 500 companies that had suffered ESG-related controversies since 2014 have seen their stock market values drop by approximately USD 534bn in total. Climate change scandals, sexual harassment claims and major data breaches are just some of the ESG cases that have negatively impacted corporate valuations.

While ESG failures or difficulties can directly affect overall business performance, there are elements, such as reputation where it is considerably harder to evaluate the impact on a business. From a recruitment perspective, for example, candidates may have previously prioritised working hours and vacation allowance, but today there is much greater interest in a business’s efforts to reduce global poverty and carbon emissions. To attract millennials and younger generations, businesses must have ESG criteria at the centre of their corporate strategies.

Optimising the value of companies

Today, businesses need to consider the interests of a broader suite of stakeholders, moving away from the traditional primary focus on shareholder value. The investment community increasingly recognises that a company’s value cannot be optimised without recognising environmental, social and governance factors.

A shift in the funds landscape

More than ever, fund managers are focusing their attention on a variety of ESG strategies, from ‘doing no harm’ at one end of the scale to ‘making a positive impact’ at the other. Initially borne out of market demand, this shift is now also a result of EU regulation, which will require funds to report on, amongst other things, how ESG factors and risks are integrated into their investment processes. When implementing ESG strategies, funds will be looking at all underlying asset classes – not only equities but fixed interest, real estate and infrastructure. 

Laura Houët, a partner in the London-based Financial Services & Products Group, says, “Businesses should therefore be more alert to how they are presenting  themselves to the world and to potential investors.

If companies do not have the correct social policies in place, if they do not consider their own environmental footprint, if they are not concentrating on providing good governance, then they will not be attractive to funds over the long term. There is an acceptance that any successful long-term fund strategy must now be transitioning to one which has ESG at the heart of every decision.

Ethics in the workplace

ESG has both internal and external elements. Corporate governance, for example, has evolved enormously since the 2008 financial crisis, and this has been given additional impetus by other worldwide factors such as the #MeToo movement. 

In the workplace, ensuring the rights of whistleblowers is fraught with difficulty. While whistleblower systems have been established across all industries, in practice it is hard to encourage people to come forward. In France, for example, data protection rules mean that anonymity is compromised. 

Caroline Froger-Michon, the Paris-based Co-Head of the CMS Employment & Pensions Group, says, “Whistleblower hotlines are rarely used in France.” 

She says that HR departments are focusing more on training managers and encouraging certain behaviours in the workplace, 

Management skills training is becoming a major tool used by HR teams to regulate the workplace and to avoid any harassment and discrimination issues.

Whistleblower structures require an overhaul to encourage greater usage, according to Martin Lützeler, a CMS Employment Law partner in Cologne. Often the lack of anonymity limits the effectiveness of hotlines, and he believes that this creates a disincentive for businesses to invest in whistleblower systems. 

He says, “It is also problematic that whistleblowers are still considered by some to be nest-polluters, even though they report actual incidents and even crimes that harm companies and society.

Contributing to society

Tax structuring is another area where some businesses have been attacked over ethics. A number of global technology businesses, for example, have suffered reputational damage caused by their efforts to minimise tax liabilities. 

Björn Demuth, a Stuttgart-based Tax partner at CMS, states, “While these structures are entirely legal, they can be viewed as ethically sensitive in some quarters, particularly when businesses are expected to provide a ‘fair’ contribution to the tax revenues in the countries where they operate.

The power of social media to impact reputations is an additional factor that businesses must take into account when trying to minimise their tax liabilities. 

The steady creep of technology, including artificial intelligence (AI), into various industries is also raising some difficult ethical questions in the area of tax. Björn Demuth poses the idea that if human labour is replaced by robots and AI, there may come a point where these technologies will have to be taxed to fill the gap created by lower income tax revenues. 

Ensuring fair competition

Additionally, AI could potentially impact consumers negatively with smart pricing based on an individual’s wealth, interests and other factors. Moreover, it has the potential to commit antitrust offences. Where intelligent technologies interact over pricing, and costs artificially increase, the operators of these systems could potentially become liable, says Michael Bauer, Head of the CMS Competition & EU Group at CMS. 

The interesting question is how human beings can be held liable if machines decide by themselves.

Competition concerns pose further obstacles to the ESG movement. While competition authorities strive to take sustainability considerations into account, according to Michael Bauer, there have been instances where sustainability initiatives have run into trouble. For example, in 2015 the Netherlands Authority for Consumers and Markets ruled that the ‘Chicken of Tomorrow’, a sustainably sourced chicken, was not exempt under the Dutch Competition Act and was effectively restricting competition in the Dutch market since it would have caused prices higher than consumers would have been prepared to pay.

What is clear is that businesses will take time to adapt existing cultures and practices so that they can achieve the ethical standards that the public, investors and regulators expect. The ESG movement is evolving rapidly and individual businesses must keep a close eye on these mounting priorities. 

Key contacts

Caroline Froger-Michon
Co-Head of the CMS Employment & Pensions Group
T +33 1 47 38 43 03
Dr. Michael Bauer
Rechtsanwalt | Head of the CMS Antitrust, Competition & Trade Group
Brussels - EU Law Office
T +32 2 6500 420
Laura Houët
Co-Head of ESG
T +44 20 7367 3582
Dr. Martin Lützeler
Rechtsanwalt | Fachanwalt für Arbeitsrecht (Certified lawyer for labor and employment law)
T +49 221 7716 305
Dr. Björn Demuth
Rechtsanwalt, Tax Adviser | Fachanwalt für Steuerrecht (Certified lawyer for tax law)
T +49 711 9764 488