ESG is getting in the way of SMEs’ ability to innovate, argues Frank Verhage.
ESG (Environmental, Social, Governance) is synonymous with sustainable, social and fair corporate governance. The concept is based on the recognition that it’s not only important for companies to be economically successful but also to protect the environment, assume social responsibility and make company decisions transparently comprehensible. In practice, however, ESG is simultaneously becoming the epitome of sprawling bureaucracy.
While global ESG orientation was previously only mandatory for international corporations, it’s now also highly important for medium-sized companies because their supply and distribution chains usually also have global reach. This cripples the economic and innovative power of SMEs.
The term and concept of ESG criteria were first introduced by the United Nations in 2004. Behind it is a set of standards based on the UN’s “Six Principles for Responsible Investment” (PRI). These principles are aimed at company owners and managers, as well as investors, and impose a set of voluntary commitments, ranging from including ESG considerations in investment analyses, decision-making processes and corporate policies to reporting on the progress made on implementation.
The six UN principles have given rise to numerous legal frameworks, including the Corporate Sustainability Reporting Directive (CSRD), the Non-Financial Reporting Directive (NFRD) and the EU Taxonomy Regulation. While the NFRD only applies to large, publicly traded companies with more than 500 employees, the CSRD significantly expands the scope of companies that must disclose information on how they address issues such as environmental protection, human rights and diversity by removing capital market orientation as a criterion. Over time, ESG legislation will affect more or less all types and sizes of companies. And this is a huge problem.
The taxonomy requirements alone are laid down in a 600-page set of rules. A specially appointed Technical Expert Group (TEG) has spent two years deliberating on these regulations. But a startup or small or medium-sized company with perhaps 100 or 500 employees is required to understand, master and follow them.
The European Union doesn’t make things any easier. For example, companies operating in multiple countries must deal with a variety of national regulations and standards that may differ from the CSRD guidelines. This makes reporting more complicated and potentially inconsistent.
As bureaucracy grows, so does market pressure. More and more customers, B2B and B2C, as well as employees, shareholders and other stakeholders, consider ESG compliance a given. As a result, it’s becoming essential for companies to undergo ESG screening. Sustainability and ESG have ceased to be a niche topic and are now an important part of any corporate strategy. Banks and investors already expect a convincing and sustainable business model including ESG. This certainly also applies to the public. A company that’s caught by the press blatantly violating ESG criteria has to fear a considerable loss of image.
This poses immense challenges for many not-so-large companies. The beneficiaries are the numerous ESG consultants. Since the companies themselves can hardly manage the enormous ESG bureaucracy, they hire consultants in droves to take care of it. This incurs enormous costs, which ultimately weaken innovation and the productivity of the economy. The danger that ESG will weaken Europe’s ability to innovate is very real.
All complaining doesn’t help. The best thing for management to do is to see this change as an opportunity and quickly adapt to the ‘new normal.’ The train is unstoppable anyway. So it’s better to jump on and steer with it than to let it roll over you. And hire the right ESG consultant before it’s too late. Every entrepreneur and every business decision-maker should prepare for this in good time.