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ESG CRITERIA AND FINANCIAL PERFORMANCE: THE MEDIATING ROLE OF CORPORATE GOVERNANCE

Publications, Research paper

ABSTRACT

Environmental, Social and Governance (ESG) is a measure of how businesses integrate environmental, social and governance practices into their operations and the overall impact and sustainability of the business model. In recent times, ESG compliance has become an essential paradigm for efficient corporate management as well as managing regulatory frameworks and stakeholders’ expectations. It is no longer just a voluntary action but is increasingly being mandated by the investors as well as by law. This paper primarily aims to understand the link between ESG criteria and the financial performance of a company, with special emphasis on the role of corporate governance. Drawing upon the recent Indian and global legal developments and regulatory frameworks, this paper argues that robust corporate governance is indispensable for efficiently translating ESG outcomes into sustainable financial outcomes.

KEYWORDS

ESG, Compliance, Performance, Relation, Framework, Financial, Mediating, Disclosure, Corporate Governance

INTRODUCTION

The concept of ESG was introduced for the first time in a report published by the United Nations Principles for Responsible Investment (UNPRI) in 2006. It was proposed that responsible investors should thoroughly consider the impact of ESG factors on investment value. This view has now increasingly been accepted on an international level. The environmental component encompasses resource efficiency, pollution control, and climate change mitigation. The social dimension of ESG primarily includes labour practices, community engagement and human rights. Similarly, the governance dimension of ESG refers to the process of decision-making, reporting, and the logistics of a business. It keeps an eye on a company’s transparency with its stakeholders and its ethical actions.

The past decade has seen a tremendous shift in the manner in which companies are evaluated, with non-financial factors such as Corporate Social Responsibility (CSR), environmental stewardship, social responsibility, and quality of governance taking precedence. Technological advancements, economic frameworks, and global sustainability initiatives have necessitated companies to develop strategies that lie at the interface of conventional stakeholder-oriented management and sustainable business practices. As a result, investors, regulators, and consumers have increasingly started demanding accountability from the corporations regarding the environmental and social concerns associated. Adapting an ESG framework can have several benefits for a company, including improving company reputation, reducing overall costs, attracting customers, securing investments, etc. 

External factors like corporate governance can mediate the complex relationship between ESG criteria and financial performance, as the governance structure of a corporation plays a key role in determining the formulation as well as implementation of ESG policies. This paper aims to investigate how ESG initiatives impact the profitability and firm value of a company, and the mediating role which corporate governance plays in this relationship, along with emphasising the legal frameworks and practical challenges.

RESEARCH METHODOLOGY

This research primarily makes use of a mixed-method approach, which consists of doctrinal legal analysis as well as a review of empirical studies. Examination of statutes and regulations governing ESG disclosure as well as corporate governance in India and other major jurisdictions such as the UK, European Union, and the US has been carried out. Other methods employed include review of industry reports on the relationship between ESG performance, governance, and financial outcomes, which have also been published in reputable journals and websites. Primary sources of information for this paper include legislative texts, regulatory frameworks, and reputable websites. Secondary sources of information include industry reports and academic articles. Together, this methodology combines legal interpretation and comparative analysis to highlight the role of corporate governance in the effectiveness of ESG criteria in overall financial performance.

REVIEW OF LITERATURE

  1. ESG Compliance and Financial Performance

 THEORETICAL FOUNDATIONS

  1. Stakeholder Theory

The Stakeholder Theory asserts that firms must balance the interests of multiple stakeholders, i.e. investors, employees, customers, communities, and regulators, to sustain long-term performance. One of the most prominent ways in which ESG criteria can operationalise this theory includes embedding the environment-friendly and long-term beneficial interests of the stakeholders into corporate strategy. Companies that are involved in ESG actively contribute to the relationship with shareholders by minimising conflicts, building trust and enhancing transparency. 

  1. Resource-based View

The Resource-based View proposes that companies can achieve a competitive advantage through the possession of resources that are rare, valuable and inimitable. Corporations which tend to invest in environmental innovation, social welfare, and ethical corporate governance structures often result in long-term benefits such as cost savings and brand differentiation and end up being inimitable for other companies. Intangible assets such as brand reputation and stakeholder reputations-enhanced by ESG initiatives, yield superior financial performance. 

EMPIRICAL RESEARCH

Empirical research consistently finds a positive relation between ESG compliance and financial performance. Studies conducted on corporate organisations and firms also demonstrate that firms with a high ESG score exhibit superior profitability, measured by metrics such as Return on Equity (ROE) and Return on Assets (ROA). A few of the key findings of empirical research conducted include:

  • Risk Management: Companies complying with the ESG guidelines tend to experience lower volatility and reduced exposure to regulatory, reputational and operational risks. They also suffer from fewer instances of corruption and fraud.
  • Cost of Capital: Firms with a strong ESG profile also enjoy lower costs of capital, as the investors perceive them as being more sustainable.
  • Operational Efficiency: In addition to reducing costs, ESG measures also boost operational efficiency.
  • Market Access: Strong ESG practices can improve company reputation as well as attract investors and increase stakeholder confidence, resulting in greater market reach and potential new partners in the markets.
  1. Legal Standards for Corporate Governance

The set of policies, guidelines and practices that govern a company in the best way possible can be termed as ‘corporate governance’. The Companies Act, 2013, is the primary law which is responsible for governing corporate governance in India. Other such laws and regulations in place include Corporate Governance Voluntary Guidelines 2009, Insolvency and Bankruptcy Code 2016, SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015, National Guidelines on Responsible Business Conduct, etc. Some of the existing legal framework for promoting ESG principles, as well as recent legal developments which have taken place include:

  • The Companies Act mandates that companies with a certain net worth establish a committee to oversee Corporate Social Responsibility (CSR) initiatives. It also mandates a female director to be appointed in certain kinds of businesses.
  • The Securities Exchange Board of India changed Regulation 34 of the LODR regulations in 2023 to allow for BRSR (Business Responsibility and Sustainability) Core and BRSR Core for the value chain framework of the company. It required board-level oversight of ESG risks, and that the top 1000 listed companies disclose the ESG policies and practices they follow.  
  1. The Mediating Role of Corporate Governance

The integration of ESG principles into overall corporate governance represents the shift in how companies and firms are expected to carry out their business. Corporate governance, which traditionally focused solely on the financial performance of a company, has now extended its purview to include broader responsibilities. The board members of a company play an essential role in determining and assessing the opportunities and dangers related to ESG. Similarly, the stakeholders also actively engage in the oversight of ESG activities, hence acting as stewards of the company’s interests. Hence, it can be said that corporate governance and ESG are intertwined. While corporate governance establishes the framework for ethical conduct, ESG further enhances its implementation by incorporating measurable and stakeholder-oriented criteria. 

  1. Enabler of ESG Integration

Robust corporate governance structures are crucial to effective ESG integration. It ensures that the existing framework and criteria regarding ESG are not merely symbolic but also embedded in proper strategy, risk management, and performance evaluation.

Through the interconnected processes of organisational, operational, and strategic integration, businesses can incorporate sustainability and other associated ESG factors into their corporate plans. Establishing sound governance practices is essential to integrating ESG leadership and accountability across the entire organisation, and all the parties involved – the board, management, and staff – have a part to play.

  • Role of management: The management of a company should be actively involved in communications with the stakeholders, as well as the customers, investors, employees and the board members in order to reinforce accountability structure, which is a precondition for good ESG governance. 
  • Role of board members: The board members are primarily responsible for overseeing strategy and reporting, as well as ensuring that the management team is setting up clear and time-bound goals in order to address the ESG priorities. The board is also responsible for keeping the management team accountable by requesting regular updates and communication regarding the progress.
  • Role of employees: The process of incorporating ESG aims and considerations across the entire organisation depends heavily on its workforce. They must possess a clear understanding of the goals and objectives associated with the ESG strategy, as well as proactively engage themselves in participating and contributing towards the efforts.
  1. Empirical Evidence: Governance as a Mediator

A substantial body of research has consistently found a positive relationship between ESG compliance and financial performance. Empirical studies also suggest that the positive effects tend to be significantly enhanced in companies with strong governance. According to Saini et al. (2023), businesses are better equipped to turn ESG initiatives into profitability when their governance frameworks are stronger. Businesses with a stronger governance structure are better equipped to invest in long-term sustainability plans and have the right systems in place to make sure that their ESG efforts complement their long-term financial objectives.

  1. Legal Implications

The legal requirements discussed above, such as SEBI’s BRSR framework mandating board-level oversight, underscore the importance of the role of corporate governance as a mediator. Failure to integrate ESG into governance structures can not only result in companies getting exposed to loss of investor confidence and reputational harm but also result in legal liability.

  1. COMPARATIVE ANALYSIS: INDIAN FRAMEWORK V. GLOBAL PRACTICES
  2. Indian Framework

India’s regulatory framework for ESG is considered to be one of the most progressive ones among the emerging global markets. The mandate for Corporate Social Responsibility and the BRSR framework are some of the guidelines which have successfully created an ecosystem for effective ESG integration. However, businesses still encounter obstacles when attempting to incorporate ESG principles. Some of the most common challenges faced by Indian companies concerning ESG integration include:

  • Lack of Standardisation: The lack of consistency or a standardised form of ESG reporting makes it difficult for a person to compare the performance of an ESG-driven company with the performance of other companies and make an informed decision regarding investments.
  • Inadequate Disclosure: Adequate ESG disclosure is not provided in the companies’ annual reports, which makes it difficult for investors to decide on or evaluate the ESG performance of a particular company.
  • Limited Awareness: Many Indian investors as well as businesses possess very low levels of awareness regarding ESG. This has resulted in a lack of demand for ESG-driven investments as well as reluctance for long-term sustainable business practices.
  • Lack of Expertise: The knowledge and abilities needed to effectively apply ESG practices are in short supply. This results in failure to address to identify and address the associated risks accordingly. 
  • Cost considerations: Complying with ESG criteria can result in a short-term financial burden for companies. ESG practices can be particularly expensive to implement for companies with limited financial resources. This makes it difficult to prioritise ESG considerations, especially in the beginning stages.
  • Short–term vision: Many Indian companies, as well as investors, seek short-term profitability and are reluctant to invest in initiatives with long-term payoffs. As a result, they are hesitant to invest in ESG. 
  1. Global Practices

Some of the legal provisions which exist with regard to ESG include:

  • Corporate Sustainability Reporting Directive (CSDR): A Comprehensive mandatory framework devised by the European Union and effective from January 2025. ESG disclosures must be comprehensive and are based on the 12 European Sustainability Reporting Standards (ESRS). Climate change is one of the many ESG subjects it covers.
  • Sustainable Finance Disclosure Regulation (SFDR): Introduced by the European Commission and effective from March 2021. It imposes mandatory ESG disclosure obligations for the asset managers as well as financial market participants in order to ensure that ESG factors are being integrated both at the entity and product level.
  • Australian Sustainability Reporting Standards (ASRS): ASRS mandates large Australian companies, which meet certain financial and operational criteria, to disclose all financial consequences associated with climate change and their responses to such risks. 
  • Sustainability Disclosure Requirements (SDR):  Mandatory ESG regulations are being considered by the UK government, with the legislation potentially being implemented beginning from or after 1st January 2026. Large UK-listed companies, asset managers as well and financial institutions will be mandated to report sustainability-related information.
  • The United States has no explicit provisions or a unified ESG reporting framework. However, recent developments such as the Securities and Exchange Commission (SEC) proposing and finalising to formulation of climate disclosure rules amidst increasing regulatory pressures for standardising ESG reporting, are a testament to the fact that the country is moving towards greater regulatory oversight.

Some of the common challenges faced by the global companies in terms of ESG integration include:

  • Presence of multiple reporting frameworks: Adherence to multiple reporting frameworks proves to be a hindrance for multinational companies from complying with ESG guidelines. 
  • Lack of clear definition: It is difficult to define ESG precisely, as well as calculate risks quantitatively. This turns out to be a challenge for companies to create a robust legal environment for ESG integration. 
  • Complex data management: Gathering data which encompasses everything from diversity initiatives to environmental issues can be both financially as well as mentally exhausting for group leaders. This is further aggravated by the lack of consensus on terminology and various other matters.

Other voluntary frameworks such as the International Integrated Reporting Council, Sustainability Accounting Standards Board (SASB) and Global Reporting Initiative (GRI) have also played a key role in providing industry-specific standards in order to provide ESG disclosures. Additionally, the Carbon Disclosure Project (CDP) has assisted investors in integrating sustainable investment techniques and ESG indicators into their investment portfolios.

METHOD

  1. Doctrinal Legal Analysis

Key laws and statutory and legal developments about ESG and corporate governance in nations including the UK, USA, India, Australia, as well as the European Union, have been the subject of legal analysis for this paper.

  • India: The Companies Act, 2013, SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015, National Guidelines on Responsible Business Conduct, Business Responsibility and Sustainability Responsibility (BRSR) Framework
  • Australia: Australian Sustainability Report Standards
  • UK: Sustainability Disclosure Requirements
  • European Union: Corporate Sustainability Reporting Directive (CSDR), Sustainable Finance Disclosure Regulation (SFDR)
  • USA: Securities and Exchange Commission (SEC) Disclosure Rules
  1. Data and articles published in reputed sources have been collected through their websites, such as KPMG, Springer, British Business Bank, BLANCCO, Director’s Institute, etc. 
  2. A study of the empirical research conducted by bodies, focusing on the:
  • Relationship between ESG and financial performance
  • Role of corporate governance in the aforementioned relationship
  • Effect of strong corporate governance procedures on the favourable correlation between financial performance and ESG factors. 

          have been carried out, the results of which have been suitably mentioned and footnoted.

  1. A comparison has been drawn between the framework and guidelines persisting in India and those existing globally. The comparison focuses on the impact of regulatory differences as well as the challenges which the companies generally face in terms of integrating ESG principles.

SUGGESTIONS

  1. Strengthening of Legal Frameworks
  • There must be an introduction of a standardised form of ESG reporting, as the lack of it has resulted in reduced interest in investing in ESG-driven companies. Mandating ESG disclosure requirements as per global standards (GRI, SASB) can help build trust and reliability, as well as attract investors.
  • Board oversight must be strengthened, with mandatory inclusion of individuals with high ESG expertise on corporate boards being prioritised. 
  • Periodic board-level meetings or review of ESG-related risks, as well as progress, must be legally mandated.
  • Legislative bodies can also take a proactive approach by incentivising good ‘ESG-integrated’ governance practices of companies. Examples will include providing tax incentives or public recognition for ESG compliance.
  • Appropriate regulators must be empowered to investigate any cases of ESG-related misconduct and uphold as well as safeguard market integrity.
  1. Capacity building and increasing awareness
  • Training and awareness programs must be conducted in order to make companies and investors aware of the basic principles of ESG, the benefits of ESG compliance, as well as the risks associated with it.
  • Company employees as well as executives must be trained about the risks, opportunities and legal obligations associated.
  1. Increased involvement of stakeholders
  • Formal mechanisms must be established to ensure thorough stakeholder engagement.
  • Investors must be encouraged to actively engage with boards on ESG-related issues as well as exercise their voting rights in order to ensure enhanced accountability. 

CONCLUSION

With the evolving legal and financial landscape, it has become necessary for all responsible firms and companies to take long-term, sustainable initiatives into account. While various research and empirical evidence indicate a positive relationship between ESG compliance and the financial wellness of a company, strong corporate governance practices have been shown to play a crucial and equally significant part in the positive relationship between ESG criteria and financial performance. Effective governance structures act as a pillar and effectively mediate the translation of ESG initiatives into the successful financial performance of a company. Given the increasing legal obligations and accountability demands from investors, all companies must also prioritise governance reforms to ensure the credibility and effectiveness of their ESG commitments. Other adequate policy changes in corporate governance, such as harmonising ESG-reporting standards, cultivating a thorough accountability culture for all stakeholders, and mandatorily strengthening board oversight, are imperative in order to realise the potential of ESG compliance in improving the financial performance of a company to the fullest extent.

Submitted by: –

Anabil H Kashyap

Manipal University Jaipur

Dehmi Kalan, Off Jaipur-Ajmer Expressway

Jaipur, Rajasthan-303007