What is ESG and why is it important?

NED Capital Knowledge Centre  |  Adrian Lawrence FCA, Founder

ESG — environmental, social and governance — refers to a framework of non-financial criteria through which a company’s behaviour and performance across three distinct dimensions is assessed, reported and increasingly regulated. ESG analysis is used by institutional investors to evaluate investment risk and alignment with sustainability objectives, by regulators to set disclosure requirements for large companies and by boards to structure their oversight of a growing range of corporate responsibilities that extend beyond financial performance alone.

For company boards and non-executive directors, ESG is not primarily a public relations concept — it is a governance accountability framework with real regulatory requirements, real investor expectations and real legal risk for directors who treat it as a compliance exercise rather than a substantive board responsibility. This guide explains what ESG means for boards, what the UK regulatory requirements are, how institutional investors use ESG data and why ESG expertise has become a specific NED appointment criterion for many organisations.

What ESG Stands For

ESG is an acronym with three distinct components, each covering a different dimension of corporate responsibility.

Environmental (E) covers the company’s relationship with the natural environment — its carbon emissions and climate impact, its energy consumption and efficiency, its water usage, its waste management and its approach to biodiversity. In governance terms, the environmental dimension requires boards to assess and oversee the company’s climate risk exposure, to set and monitor commitments for reducing environmental impact and to disclose environmental performance in the company’s reporting.

Social (S) covers the company’s relationships with people — its employees (pay, working conditions, health and safety, diversity and inclusion), its supply chain (labour standards, ethical sourcing), its customers (data protection, responsible marketing, fair treatment) and the communities in which it operates. The social dimension requires boards to oversee the company’s policies and performance on workforce matters, supply chain due diligence and community impact.

Governance (G) covers the structures and processes through which the company is directed and controlled — board composition and independence, executive remuneration, shareholder rights, anti-corruption compliance, transparency and accountability. The governance dimension is the area in which non-executive directors have the most direct and immediate responsibility — governance is the board’s primary function, and the G in ESG is essentially a summary of what effective board governance requires.

The three components are not equally weighted in all ESG assessment frameworks, and the relative importance of each varies by sector, geography and the specific investor or rating agency applying the framework. Climate and carbon emissions have received the most regulatory attention and public prominence; the social and governance dimensions have historically been less systematically measured but are receiving increasing focus from both regulators and investors.

The UK Regulatory Framework for ESG Reporting

ESG reporting for UK companies is governed by a growing and increasingly specific set of regulatory requirements that have materially expanded over the past five years. Understanding what is legally required — as opposed to voluntary best practice — is a governance responsibility for NEDs on the boards of companies caught by these requirements.

Task Force on Climate-related Financial Disclosures (TCFD). The TCFD framework requires companies to disclose information about their climate-related risks and opportunities across four areas: governance (how the board oversees climate-related risks), strategy (the actual and potential impacts of climate-related risks on the business), risk management (how the company identifies, assesses and manages climate risk) and metrics and targets (the data used to assess climate performance). TCFD-aligned disclosure is mandatory for UK premium listed companies, large UK-registered companies and certain financial services firms, with the requirement extending progressively to mid-market and smaller companies. For NEDs, the governance pillar of TCFD is directly relevant — the board’s oversight of climate risk must be described and disclosed.

UK Sustainability Disclosure Requirements (SDR). The FCA’s Sustainability Disclosure Requirements framework — published in 2023 and phasing in from 2024 — regulates sustainability claims made by asset managers and investment products. SDR creates specific anti-greenwashing obligations for the financial services sector and is part of the UK’s broader effort to align ESG disclosure with international standards.

ISSB Standards. The International Sustainability Standards Board (ISSB), established in 2022, has published two initial sustainability disclosure standards — IFRS S1 (General Sustainability-related Disclosures) and IFRS S2 (Climate-related Disclosures). The UK Government has committed to endorsing ISSB standards and they are expected to form the basis of future UK mandatory sustainability reporting requirements. NEDs at companies approaching the size thresholds for these requirements should be aware that the direction of travel in UK ESG regulation is toward more comprehensive, standardised and auditable sustainability disclosure.

Section 172 and the Companies Act. Directors’ ESG accountability in the UK has a statutory foundation in Section 172 of the Companies Act 2006, which requires directors to have regard to the interests of the company’s employees, the need to foster business relationships with suppliers and customers, and the impact of the company’s operations on the community and the environment. This is not an ESG reporting requirement but an ESG governance requirement — directors are legally obliged to consider these stakeholder interests in their decision-making, not merely to report on them.

FRC Corporate Governance Code. The 2024 revision of the FRC UK Corporate Governance Code strengthened expectations on boards to engage with and report on their stakeholder responsibilities — including environmental and social matters — in their governance reporting. The Code’s culture provisions require boards to assess and monitor the company’s purpose, values and strategy to ensure these are aligned with the company’s sustainable long-term success.

The Board’s ESG Governance Responsibilities

The board’s ESG governance role has three dimensions that NEDs should understand clearly.

Oversight of ESG strategy. The board is responsible for setting and overseeing the company’s ESG strategy — ensuring that the company has identified its material ESG risks and opportunities, that it has a credible plan for managing them and that management is accountable for delivering against that plan. This does not mean the board develops the ESG strategy itself — management does that — but the board challenges, approves and monitors it. A board that has approved a net zero commitment without challenging the credibility of the pathway to achieve it, or that has endorsed a diversity and inclusion strategy without monitoring its implementation, has not fulfilled its ESG governance responsibility.

ESG risk oversight. Climate risk is now regarded by the FRC, the FCA and the Bank of England as a material financial risk that boards are required to assess and disclose. The physical risks of climate change (damage to assets, supply chain disruption, insurance costs) and the transition risks (regulatory carbon costs, stranded assets, changing consumer preferences) are potential sources of material financial loss that boards must evaluate as part of their risk governance function. A NED who does not understand their company’s climate risk exposure cannot fulfil the risk oversight function that their governance role requires.

ESG reporting integrity. The board — specifically the audit committee — is responsible for the integrity of the company’s ESG disclosures. As ESG reporting becomes more standardised and more subject to external assurance, the risk of material misstatements in sustainability reporting — whether through greenwashing or through inadequate data governance — becomes a governance risk that boards must actively manage. The FCA’s anti-greenwashing rule (in force from 2024) creates specific legal risk for any company making sustainability claims that are not substantiated.

ESG and Institutional Investors

Institutional investors — pension funds, asset managers, insurance companies and sovereign wealth funds — collectively hold the majority of shares in UK listed companies and have become significant actors in ESG governance. The growth of ESG-focused investment — funds that screen investments based on ESG criteria, or that engage with boards on ESG matters — has created direct governance pressure on listed company boards from their major shareholders.

ESG ratings agencies — MSCI, Sustainalytics, Bloomberg ESG and others — assess and score companies against ESG criteria. Poor ESG scores can affect a company’s inclusion in ESG-focused indices and its attractiveness to ESG-mandated investors. Institutional investors increasingly integrate ESG ratings into their investment and voting decisions — a board that receives a poor governance score from a major ratings agency should expect investor engagement on the specific governance issues the rating has identified.

The UK Stewardship Code — published by the FRC — sets standards for how institutional investors exercise their ownership responsibilities, including engagement with boards on ESG matters. Investors who are signatories to the Stewardship Code are expected to engage with the companies they invest in on governance, environmental and social matters and to report on how they have done so.

The Debate About ESG

ESG has become genuinely contested in a way that was not the case five years ago, and an honest governance guide should acknowledge this rather than treating ESG as an unambiguous good.

The primary criticisms of ESG in its current form are: that ESG ratings are inconsistent (the same company can receive dramatically different ESG scores from different ratings agencies, calling the objectivity of ESG assessment into question); that ESG investment approaches are not consistently delivering better risk-adjusted returns than conventional approaches; that ESG has been used for marketing purposes by asset managers and companies in ways that amount to greenwashing; and that ESG’s broadening scope has created governance obligations that are difficult to define, measure and fulfil without becoming a compliance burden that distracts from substantive governance.

In the United States, ESG has become politically polarised — several US states have passed legislation prohibiting public pension funds from applying ESG criteria in investment decisions, and several major US financial institutions have quietly withdrawn from net-zero alliances while publicly maintaining ESG commitments. The UK governance environment has not followed the same political trajectory, and TCFD-aligned climate disclosure remains mandatory for large UK companies. But the ESG backlash in the US is a governance reality that UK NEDs with US parent companies or US investor bases should understand.

For UK boards, the governance-appropriate response to the ESG debate is neither to dismiss ESG as a passing fashion nor to embrace it uncritically as an unambiguous governance good. It is to engage with ESG governance requirements on their specific merits — addressing the regulatory requirements that apply, meeting the legitimate investor expectations that are genuinely material to the company’s capital access and cost, and doing so on the basis of substantive action rather than reputational performance.

ESG and Non-Executive Director Appointments

ESG expertise has become a specific NED appointment criterion for listed companies and large private companies as ESG governance obligations have grown. Boards that lack directors with genuine ESG expertise — specifically expertise in climate risk assessment, sustainability reporting or stakeholder governance — face challenges in fulfilling their ESG oversight responsibilities with the credibility that regulators and investors expect.

The most commonly sought ESG NED profiles reflect the specific ESG governance gaps that boards are trying to address. Climate and environmental expertise — a director who has managed or governed a business through a significant energy transition, who understands physical and transition climate risk at an operational level, or who has specific expertise in sustainability reporting — is the most consistently requested ESG-related NED criterion. Diversity, equity and inclusion expertise — a director who has governed or implemented significant D&I programmes — is increasingly specified for nomination committee roles. Supply chain sustainability — a director with specific experience of managing social and environmental standards in complex supply chains — is sought by retailers, manufacturers and companies with international sourcing exposure.

See our page on ESG Board Chair Recruitment for more on ESG-specific board appointments, and our NED Recruitment Agency page for how NED Capital approaches ESG capability as a board composition criterion.

ESG in Private Companies and PE-Backed Businesses

ESG governance is not exclusively a listed company concern. Private equity investors have developed their own ESG expectations for portfolio companies — driven partly by the LP (limited partner) expectations of the PE funds themselves, partly by increasing regulatory requirements (the EU’s SFDR creates significant ESG disclosure obligations for PE funds marketing to European investors) and partly by the recognition that ESG risks in portfolio companies represent value risks that affect exit outcomes.

Many PE investors now require portfolio companies to complete an ESG baseline assessment at investment and to develop a programme for addressing material ESG risks during the hold period. The independent NED on a PE-backed board may be specifically assessed for ESG governance capability as part of the investor’s portfolio governance framework. For companies considering PE investment, demonstrating credible ESG governance is increasingly part of the investment readiness story alongside financial performance and management capability.

Large private companies — those with more than 500 employees and £500 million in turnover — are progressively caught by mandatory sustainability reporting requirements that have historically applied only to listed companies. Boards of large private companies should assess their ESG reporting obligations proactively rather than waiting for regulatory requirements to crystallise into compliance deadlines.

Practical ESG Governance for Boards

For boards at the early stages of developing their ESG governance approach, five practical steps provide a substantive starting point.

Materiality assessment. Identify the ESG issues that are materially relevant to your specific business — the environmental risks that affect your operations, the social issues that affect your workforce and supply chain and the governance gaps that affect your accountability to shareholders and stakeholders. Not all ESG issues are equally relevant to all businesses, and a materiality-based approach focuses governance attention where it matters most.

Baseline reporting. Establish a baseline for ESG data — carbon emissions (scope 1, 2 and where material, scope 3), workforce diversity metrics, governance structure description — before committing to targets. Boards that set ESG targets without reliable baseline data are setting commitments they cannot verify or manage.

Board competency review. Assess whether the current board has the ESG expertise to fulfil its oversight responsibilities — specifically in climate risk assessment and sustainability reporting. If gaps are identified, address them through NED appointment, director training or both.

Integrate ESG into board reporting. ESG should be a standing board agenda item — not a once-a-year sustainability report review but an integrated part of the board’s ongoing risk governance and strategic oversight. The board that only sees ESG data in the annual sustainability report is not exercising meaningful ESG oversight.

Avoid greenwashing. The most significant legal and reputational risk in ESG governance is making claims about environmental or social performance that are not substantiated by evidence. The FCA’s anti-greenwashing rule creates direct regulatory risk for companies making sustainability claims in financial products and communications. The board’s ESG governance function includes ensuring that the company’s ESG communications are accurate and defensible.

Related guides: What Is Corporate Governance?  |  What Is a Board Meeting?  |  NED Knowledge Centre

NED Capital places non-executive directors with ESG expertise for boards across the UK. Call 0203 137 2496 or see our NED Recruitment Agency page to discuss a board appointment.