What are the Risks of ESG Governance?

Environmental, social and corporate governance (ESG) – like climate change and environmental justice – has been a hot topic of discussion in the early days of the Biden administration. Illustrating the interconnectedness of the trending issues, climate change and environmental justice are pillars of ESG.

The ESG-related activity at the federal government is just getting started. The US Securities and Exchange Commission (SEC) announced the creation of a Climate and ESG Task Force to “develop initiatives to proactively identify ESG-related misconduct” with a focus, in part, on “material gaps or misstatements” in disclosure of “climate risks.” The SEC also raised the concept of developing a universal reporting framework and acting Chair Allison Lee explained that the SEC has “begun to take critical steps toward a comprehensive ESG disclosure framework.” The SEC is also signaling it may “consider the broader array of ESG disclosure issues,” beyond climate change (e.g., workforce diversity). The US Department of Labor (DOL) announced it would not enforce two Trump administration rules that – at least implicitly – could limit investments based on ESG. The DOL explained the rules appeared inconsistent with Executive Order 13990, “Protecting Public Health and the Environment and Restoring Science to Tackle the Climate Crisis,” and, practically, the DOL had heard “from stakeholders that the rules, and investor confusion about the rules, have already had a chilling effect on appropriate integration of ESG factors in investment decisions.”

While this post focuses on the ESG risks and opportunities in the US, there are ESG developments happening globally. In Europe, for example, aggressive actions are being taken on ESG-related obligations as part of the European Green Deal, and to facilitate the continent’s alignment with Paris Agreement climate targets and the European Union’s commitment to adopt the United Nations Sustainable Development Goals. The core of Europe’s ESG efforts include the Non-Financial Reporting Directive (requires certain companies to publish data on corporate activities and impacts on ESG factors), the Taxonomy Regulation (establishes a sustainability classification system), and the Sustainable Finance Disclosure Regulation (establishes an obligation on fund managers, financial advisers and other regulated firms to disclose information on various ESG considerations).

As ESG takes global center stage, there are practical questions being raised regarding what are the quantifiable risks associated with a company not addressing ESG. For public companies in the US, one clear risk is the increased likelihood the Biden administration’s SEC will pursue enforcement under existing authorities for company disclosures that, for example, fail to meaningfully identify material issues or quantify impacts or risks associated with climate change. Another risk doesn’t come from the federal government, but rather from institutional investors and shareholders. Much is made of the “shareholder primacy” theory in corporate governance and its requirement that board members act in a manner that maximizes value of shareholders ahead of other stakeholders (e.g., employees, society, local communities, and consumers). But the view of delivering value to shareholders has been argued to include long-term value, which would require consideration of ESG-related issues. A board of directors considering ESG, the argument goes, can preserve the company’s reputation by creating long term value for stakeholders and concomitantly avoiding the potential destruction of shareholder wealth. There are an increasing number of ESG rating agencies that provide “scorecards” or otherwise identify company-specific ESG issues (e.g., Sustainalytics, MSCI), which are designed to help identify long-term corporate value and risks.

Earlier this year Blackrock explained in the Our 2021 Stewardship Expectations statement that it “expect[s] companies to demonstrate how climate and sustainability-related risks are considered and integrated into their strategy” and “[i]f a company does not provide adequate public disclosures . . . to assess how material risks are addressed, we will conclude that those issues are not appropriately managed and mitigated.” The expectation is the 2021 corporate annual general meetings will see significant developments related to ESG, with resolutions voted on for some of the world’s largest companies focused on climate, human rights, biodiversity, employee issues, and racial equality.

“ESG” means different things to different people. Often ESG is simply associated with public company disclosures and sustainable investing. What about private companies that do not publicly disclose to the SEC and do not need to answer to shareholders? What ESG risks do they face? The importance of ESG – to date – has been less about ESG-specific laws or regulations mandating corporate action, but broader risks associated with the reputational, financial, and legal impacts of handling ESG issues poorly. Below are some of the risks that companies – including private companies – should consider as they think strategically about internal policies and resource allocation focused on ESG.

• Risks to Corporate Reputation. Social media and other electronic information sharing plat­forms have dramatically increased visibility and scrutiny of corporate activity. Images of oil spills, employee claims of harassment or discrimination or unequal pay, allegations of ecosystems and indigenous com­munities impacted by extractive industry projects, a company cyber security breach that exposes customer data, or stories of child labor can all go viral and circle the globe in hours. For companies, the implications can be significant: such a scenario can damage corporate profits and career prospects of executives and board members; jeopardize supply agreements and consumer loyalty; and amplify risk of government investigations, enforcement, and litigation.

• Risks to Project Financing. Many of the world’s major financial institutions have committed themselves to assessing and managing environmental and social risks associated with project financing via the Equator Principles. The Equator Principles oblige financial institutions to make informed investment decisions and withhold or withdraw financing on projects or assets not conforming to “good international industry practice.” The Equator Principles incorporate, for example, the International Finance Corporation’s Environmental and Social Performance Standards, which include standards similar to ESG metrics (g., Performance Standard 1: Assessment and Management of Environmental and Social Risks and Impacts). A company that ignores ESG considerations may be neglecting the types of standards that are necessary to obtain or retain financing for projects and operations.

• Legal Liability Risks. Neglecting ESG considerations can result in litigation risk – at least the need for companies to defend themselves in court against perceived or alleged neglect. For example, ESG includes a focus on raw material sourcing and supply chain risks, with an emphasis on human rights, child labor, and other considerations. Cobalt is a key input for batteries used in electric vehicles – the center piece for decarbonization of the transportation sector – and other products, but more than half of the world’s cobalt is found in the Democratic Republic of the Congo (DRC), where child labor in artisanal mining is estimated to account for approximatively 20 percent of cobalt exports. Using cobalt as an example, there are supply chain-focused tools and organizations focused on minimizing risks associated with the extraction and utilization of cobalt in downstream uses by companies. However, it is up to downstream users to take steps to appropriately mitigate risks as part of corporate ESG policies. Technology and automotive companies, for example, are currently defending a class action lawsuit brought by plaintiffs representing parents of children killed or maimed at cobalt mining operations in the DRC. Jane Doe 1 et al. v. Apple Inc. et al., 19-CV-03737 (D.D.C).

• Risks Associated with Lack of Diversity, Equity, and Inclusion. The events of the last year have been pivotal in motivating a concerted focus on diversity, equity, and inclusion issues, including expectations concerning board and workforce racial and gender diversity. There are significant potential downsides, reputational and otherwise, from having workforces that substantially diverge from the customers and communities corporations serve. Some companies are linking executive compensation to meeting certain ESG metrics, including diversity metrics. However, this is an illustrative example of where companies must be strategic and thoughtful about ESG policies and associated implementation to avoid unintended consequences. Employment laws generally prohibit the consideration of protected characteristics, including race and gender, in any employment decision. This means programs that give preferential treatment to a protected minority group in the terms and conditions of employment can create legal exposure if they are not carefully designed and implemented.

• Risks Based on Lobbying. We are seeing increased focus from governments, investors and NGOs on the lobbying positions of trade associations and how those positions align with the statements of member companies. Earlier this year, for example, companies were questioned via Congressional inquiry on their interactions with trade associations and the groups’ positions on climate change. On this issue, from the investor perspective, BlackRock explained that “we expect companies to monitor the positions taken by trade associations of which they are active members on such issues for consistency on major policy positions and to provide an explanation where inconsistencies exist.” CERES, an influential NGO that makes the “financial business case for sustainability,” in an open letter to corporations called on them to “[a]lign your trade associations’ lobbying with a path to net zero by 2050” and correspondingly “[a]llocate your spending on lobbying and other channels of political influence in ways that advance and do not obstruct, a path to net zero by 2050.” As part of implementation of ESG policies, companies will want to monitor closely the advocacy of their trade associations given this increased scrutiny.

• Risks from Lack of Corporate ESG Coordination. Most public companies have multiple divisions and operating units. There may be risks if a public company is not coordinating across its divisions and operating units on ESG-related implementation. This is particularly true if a public company is factoring the operations of private subsidiaries into, for example, public reporting or sustainability reports. Often different components of a multinational corporation will have different leadership, organization, work cultures, and other distinctions that can make coordination and alignment on ESG issues difficult. The ESG priorities of the Biden administration and institutional investors and the associated risks noted above may also be relevant and indirectly applicable to private companies that are subsidiaries of public companies and illustrates the importance of ESG risk management even for private companies.

• Risks Associated with Lost Opportunities. ESG is not just about managing risks, but also about seizing opportunities. Managing ESG issues well can enhance corporate value and performance and create competitive advantages against industry peers that could otherwise go uncaptured. In an economy dependent on international trade, global supply chains and diverse workforces, public and non-public companies alike should explore opportunities not only with environmental issues, such as climate change, but also issues like product safety and stakeholder relationships with regulators and the communities in which they operate. Recent studies conducted on ESG related issues in the wake of the Covid-19 pandemic indicate that companies are better positioned to withstand the consequences of unexpected shocks if their management strategies account for the macro-effects of so-called societal “megatrends,” such as diversity and inclusion and climate change. Companies that invest first in new technologies, for example, to mitigate climate change, or prioritize a diverse workforce, can set themselves apart from their peers and seize unrealized value. Given the opinions of Gen Z and Millennial workers, corporate embrace and management of ESG issues can also add value to workforce strategies. In the global competition for talent necessary to drive future corporate growth, ESG issues can be a competitive advantage to attracting and retaining talent.

We expect significant additional developments on ESG-related issues in the short-term – at the same time there are once-in-a-generation movements on issues like climate change, environmental justice, racial equality, and the role of corporations in society. New risks and opportunities will emerge and corporate strategies will need to adapt to identify opportunities and mitigate risks.