Before the global COVID-19 pandemic, the debate around environmental, social and governance (ESG) factors as drivers for long-term shareholder value was underway in earnest. Those discussions have continued with even more vigor since. The debate is anchored in demonstrating how seemingly non-financial drivers are financially material to a company. As businesses emerge from the pandemic with some long lasting changes, the debate continues but with a greater focus on the “S” and refining the business case for how ESG factors are financially important to a company’s long-term sustainability.
Larry Fink’s 2019 Annual Letter to CEOs elevated purpose with profit – demanding businesses lead in a more holistic way. The Business Roundtable followed with its August 2019 modernized Statement on the Purpose of a Corporation, signaling a shift from a shareholder, profit-only purpose to a multi-stakeholder focus that considers a company’s impact on its entire value chain of customers, employees, supplier relationships, communities and shareholders.
Shortly after 2020 began, the pandemic disrupted global supply chains, exacerbating risks of labor trafficking and modern slavery, and put human capital management front and center. Taken together, these events have reverberated globally and have uprooted long ignored systemic social issues. Social uprisings on racial and social inequality have also evoked an across-the-board corporate response at an unparalleled breadth and level with specific calls to action to dismantle systemic racism and rebuild systems that create actual diversity, equity and inclusion.
Both the pandemic and the racial inequality crises reveal that one company’s resiliency depends upon another company’s resiliency. In this context, the ESG discussion is much more about long-term sustainability and action instead of solely ‘feel good’, performative corporate social responsibility.
While ESG has been primarily a profit and arguably purpose aligned investment approach, it can also serve as a framework for businesses to build resiliency. However, the sustainability ecosystem is complex, confusing and fragmented, with no common metric or disclosure system for comparison by disparate stakeholders. As such, company ESG disclosures are often met with skepticism as to the authenticity of the information (also known as greenwashing).
This four-part legal alert series:
Unpacks some common misunderstandings about ESG and differentiates it from other investor and business approaches,
Provides a roadmap to navigating the variety of ESG disclosure guidance and rating and ranking systems,
Addresses the current landscape of legal risks, and
Discusses governance structure and oversight, and how executive compensation is and can be used as a way to incentivize ESG strategies.
ESG Categories: In broad terms, ESG factors are premised on elements of good corporate citizenship and, for many factors, financial relevance. They generally cover the following:
What are the natural resources a company uses in business operations (e.g., energy, water, land use, chemicals and plastics)
How does a company’s use of natural resources impact the environment or climate
How are employees (aka human capital) treated, taking into account, among other things, well-being, fair and equitable pay, health and safety, talent management, inclusion, equity and diversity
Supply chain management
Human rights and labor standards, including the prevention of forced labor, both within a business’s own operations and those in the supply chain, and generally keyed to international standards or laws
Data Privacy & Cybersecurity
Board structure and independence
Companies currently address some of these factors through processes and policies, such as anti-discrimination/harassment policies, codes of conduct, and supplier codes of conduct. However, responsibility for implementation and execution of the factors can be siloed and not well integrated across the organization and into the supply chain.
Integrating ESG factors is a call for companies to treat the factors as relational, keyed to international principles and holistically embeded into the operations. The challenge, among many others, is that ESG is multi-disciplinary and must be driven by the board and senior management given the disparate aspects of ESG and the need to assess the materiality of the various factors to the industry and business.
The “E” often dominates the conversation, particularly in the US. Now, the global COVID-19 pandemic can somewhat be credited with increasing the focus on the “S” as well. Nevertheless, many other events and crises have fallen under the “S” umbrella, creating tremendous reputational risks for companies. These include the Me Too movement, the heightened focus on human rights at the international level and modern slavery legislation. See links here or here.
Sustainable or Socially Responsible Investing Morphs into ESG
ESG is simple in concept, but complex and nuanced in implementation and execution. It’s development has led to confusion about whether ESG, in its current state, is pecuniary or not. Shaped by the investor and international communities, investors use ESG factors to align investments and values and to evaluate a company’s long-term sustainability, which is expected to return higher financial performance. Boards and senior management can use ESG factors as a roadmap to a more long-term sustainable and resilient business. The latter is the investor community’s expectation.
The term ESG was coined in a 2005 report published by the United Nations (UN) Global Compact called “Who Cares Wins” following a 2004 study intended to provide recommendations on integrating ESG factors. A look at how ESG principles of today have evolved from social responsibility investing is helpful to dispel some myths around what is ESG.
ESG investing has its origins with religious groups, including Methodists, Quakers and Muslims, that sought to make investments aligned with their religious beliefs. The groups typically used an exclusionary or negative screening approach to eliminate investments in certain products like alcohol, tobacco and weapons. For Muslims, this approach allows for compliance with Sharia or Islamic law.
As time developed, ESG moved from religious or socially driven investments to a means towards good corporate citizenship and sustainability for the long-term.
Social activism against the Vietnam War and use of chemical weapons led to an exclusionary investment approach to avoid investing in companies that contributed to the Vietnam War.
Two United Methodist ministers launched the Pax World mutual fund considered to be the first sustainable mutual fund and still traded today.
Shareholder concern for business’ environmental practices gave rise to the Coalition of Environmentally Responsible Economies (Ceres), made up of businesses, investors and public-interest groups to develop sustainable business practices and move towards a low-carbon economy.
Some 26 sustainable funds with approximately $1.9 billion of assets under management.
In 2000, the Global Reporting Initiative (GRI) released its first framework for standards of sustainability reporting.
The UN Global Compact created as a global initiative to use business as a force for good, led by then UN Secretary General Kofi Annan.
The UN Global Compact’s 10 principles reflect a multi-stakeholder view of business, integrating international principles related to human rights, labor, the environment and anti-corruption into business strategies. Currently, 11,017 companies have committed to adhere to these principles.
As the ecosystem for ESG disclosure, ratings and rankings becomes more crowded and complex, there is a push towards a common and core set of metrics (discussed in the next alert). In this push, industry groups are returning to these international principles as the foundation for ESG considerations and implementation.
While the ESG ecosystem has evolved, other investor and business approaches have as well, causing some confusion around defining and understanding ESG. It’s worth noting that terms like sustainability, ESG, impact, and purpose are not necessarily mutually exclusive in this space. Ultimately, each company needs to define impact and purpose for itself.
ESG vs. Impact Investing
Beginning in the 2000s, the notion of impact investing was also introduced and somewhat attributed to the launch of the Global Impact Investing Network (GIIN). There is no one definition of impact investing. However defined, impact investing focuses on using investments in mission-driven companies seeking to influence a positive outcome on society and/or to address and remediate a societal issue (e.g., business models that address elimination of poverty, recidivism reduction, and economic and women empowerment). In contrast, consideration and integration of ESG factors is viewed, primarily by the investor community, through a lens of both good corporate citizenship and contribution to long-term financial performance. Distinctions aside, the approaches can be combined to achieve sustainability and resiliency while also creating impact if a business wants to achieve both, as discussed in this insightful article co-authored by the CEO of Impact Engine, a leading investment venture fund.
ESG vs. Certified B Corporations
Currently, there are over 3,000 certified B Corporations (B Corps) that aim to balance purpose and profit. B Lab, a third party entity, certifies companies as B Corps using an impact assessment that holistically considers five dimensions of the business: governance, employee workforce, customers, environment and community.
At a macro level, B Corps and companies integrating ESG factors into their business strategy do intersect. Because of the mission-based ethos and nature of B Corps, B Corp certification is much more about identity and purpose. The dimensions evaluated by B Lab are very relational and are not profit or financial metric driven. Rather, being a certified B Corp is about a way of building trust across the value chain and doing well by doing good, which is reflected in the structure, standards and policies of a certified B Corp.
B Corps have largely been the domain for private companies. As a condition to the certification, the company must reincorporate as a benefit corporation if the state law where the company is domiciled allows for this type of legal entity. While more than 36 states offer a benefit corporation as a legal entity, Delaware is the most notable as it allows for incorporation as a Public Benefit Corporation. Any company who incorporates as a benefit corporation under the relevant state law can identify purposes, such as environmental and social, other than maximizing shareholder profits. This allows some legal protection for boards of directors.
Because of the need for, and cost associated with, a shareholder vote to reincorporate an entity, among other reasons, this can be a practical barrier to B Corp certification for public companies. Notwithstanding, B Corps are slowly making their way into the public company space - with Danone North America leading as the world’s largest B Corp. At this juncture, the few other public B Corps were certified before becoming public.
Incorporating ESG factors and being a B Corp are not exclusive. A company can do both. In this regard, the impact assessment tools and guidance available through B Lab are a useful resource for companies seeking to heed the Business Roundtable’s 2019 call to action, to align progress of its business practices to the UN Sustainable Development Goals and as a reference point for potential changes to environmental and social policies.
ESG vs. the US Department of Labor
As of March 31, 2018, US retirement assets totaled $28 trillion. Fiduciaries appointed with investment oversight have a duty to manage the assets prudently and for the exclusive benefit of participants and beneficiaries using the fiduciary duty principles of the Employee Retirement Income Security Act of 1974. Over the years, the US Department of Labor has expressed its views on the degrees to which fiduciaries, as investors, can consider ESG factors when making investment decisions. The DOL published its latest guidance on June 23, 2020. Please see our alert discussing the guidance.
The DOL has largely discouraged ESG-driven investments in retirement plans despite the investment and international communities moving towards them. While the DOL’s latest guidance is significant in its own right and outside the scope of this alert series, it’s worth noting that the DOL’s chilling effect on ESG related investments will shape the investment of a significant amount of US assets. The DOL’s focus, however, is on retirement plan investors and not on a company's evaluation and incorporation of ESG from the perspective of creating long-term multi-stakeholder value and a resilient business.
Stakeholder Capitalism – Everyone Has a Say or View
The shift to stakeholder capitalism - a term now top of mind for business -- is premised on the theory that maximizing shareholder value as a company’s sole focus has largely failed. It’s encapsulated within The Davos Manifesto issued earlier this year. While the stakeholder capitalism theory is appealing and gaining traction in the current climate, moving into practice is another challenge altogether. Development and implementation of ESG factors is the main path for traditional, for-profit companies (i.e., non-B Corp and non-impact focused companies) to shift towards stakeholder capitalism.
The ESG ecosystem continues to grow and mature. The tides are moving towards companies using a more holistic approach to assess and communicate their environmental and social risks and opportunities across the value chain. This trend is reflected in voluntary disclosure frameworks. As a result, it’s especially important for senior management and boards of directors to identify gaps in awareness, implementation and execution through effective governance structure and oversight.
In the next alert, Getting into the ESG Disclosure, Rating and Ranking Game, we provide a roadmap to making sense of the ESG ecosystem and the challenges.