From aspiration to accountability: ESG for boards

When the COVID-19 pandemic took hold in early 2020, many thought that climate agendas and other ESG concerns might be put on the back burner. In fact, the opposite occurred.

Climate action intensified, and social issues moved to the forefront with global outcries against racial injustice, a spotlight on worker safety and the experience of the disproportionate impact of the pandemic on minorities and women.

ESG issues are being advanced in many ways—through new legislation and enhanced disclosure requirements, investor ESG criteria and performance standards, ESG ratings agencies and peer comparisons, proxy advisors’ guidelines, increasing stakeholder activism and litigation, and political agendas. 2020 brought intensified scrutiny and criticism from shareholders, employees, communities and other stakeholders where companies were deemed to have fallen short on their stated commitments to sustainability, diversity and other socially-responsible practices. This manifested not only in public reproach and reputational damage, but also in more formal actions against companies in the form of divestments, shareholder proposals, proxy fights and litigation.

ESG’s prominence in the boardroom is evolving at an accelerating pace. Boards and management teams are recognizing ESG as integral to their core business, enhancing their operational and financial performance. ESG is increasingly seen by companies not only through a risk management lens, but through a strategic lens as an opportunity to innovate, differentiate and create value. ESG-competent management teams and boards that can demonstrate a well-integrated ESG strategy are attractive not only to investors and capital providers, but also to partners, dealmakers, regulators, employees and other stakeholders, as they show their commitment to both financial performance and social purpose.

Dimensions of ESG accountability for management and boards

While many companies have embraced the ESG mindset and value proposition and are demonstrating strong ESG performance, for others that have fallen behind, the pressure for ESG accountability is advancing on a number of fronts from a number of different players.

Legislation and mandatory requirements. Increasing regulation and mandatory disclosure requirements are being implemented in many jurisdictions, and ESG matters are increasingly significant and under the watch of securities regulators. Companies need to stay on top of the changing regulatory landscape and trends in order to demonstrate compliance and strong ESG governance.

Investors. Investors have increasingly expressed the importance they place on ESG and climate action. They are taking action on their ESG objectives in various ways—raising the bar on performance and disclosure expectations, capital allocation, divestments, shareholder proposals, voting decisions for directors, proxy fights and litigation. Investors are demanding better ESG disclosure and requiring companies to provide consistent and complete information under various endorsed frameworks and are increasingly relying on ESG ratings in making their investment and lending decisions. This is not just a box-ticking exercise: investors expect meaningful action, progress and integration of ESG practices and performance across their organization. Companies falling behind on ESG criteria will face growing barriers and increasing costs of capital.

Proxy advisors. Proxy advisors have also underscored their focus on the board’s role in ESG oversight, with both ISS and Glass Lewis stating that that they will tie voting recommendations to how directors oversee climate change and other environmental and social issues. Under its discussion of “egregious actions” by directors, this year ISS added “demonstrably poor risk oversight of environmental and social issues, including climate change” to its list of examples of failure of risk oversight (in the same list as bribery, serial fines or sanctions, significant adverse legal judgments and hedging of company stock). In situations where Glass Lewis believes that a company has not properly managed or mitigated environmental or social risks to the detriment of shareholder value, Glass Lewis may recommend that shareholders vote against the members of the board who are responsible for oversight of environmental and social risks. Proxy advisors have also stated they will tie their voting recommendations to their stated policies on diversity expectations.

Shareholder activism – shareholder proposals and proxy battles. ESG has become a key component of the dialogue with shareholders, and the universe of shareholder activism has grown to include activists focused on climate action and other ESG objectives. There has been a growing number of climate-related shareholder proposals in the U.S. and Canada over recent years, and diversity and social proposals have been increasingly prominent. These proposals are often revisited over multiple years and, if progress is not made to resolve the underlying concerns, they can progress to voting action against directors, proxy battles or other action.

While shareholder proposals often have low levels of voting support, we may see increasing support for those driven by ESG objectives. Even if ultimately unsuccessful, they bring attention and focus to the company’s ESG performance and can be a catalyst for change as we saw with “Say on Pay” proposals. In Canada, there were over 35 ESG-related shareholder proposals in 2020, including proposals related to:

• ESG performance criteria in setting executive compensation;
• adoption and disclosure of climate targets consistent with Paris Agreement and other environmental objectives, including quantitative targets and annual progress reports;
• assignment of specific responsibility for human rights risk assessment, mitigation, and reporting;
• oversight of workforce practice and policies, including corporate culture, diversity, and health and safety; and
• particular pressure on financial institutions to address a number of topics:
  • targets and reporting on efforts to reduce GHG emissions associated with underwriting and lending activities,
  • targets for female Board representation of more than 40% over the next five years,
  • evaluation of funding recipients’ policies and practices for human and Indigenous people’s rights, and adoption of policies and
  • strategies addressing current or historic gender pay gaps.

As these trends progress, we may see more regular “Say on Sustainability” or “Say on Climate Change” advisory votes for shareholders in the future.

When shareholder engagement strategies fail and activists are not satisfied with progress and performance on the ESG front, they may take the step of nominating directors, particularly where a company is believed to be underperforming in other areas. Perceived ESG deficiencies add another tool to the toolbelt for activists in a proxy battle and can help garner more shareholder support.

Litigation. There has also been a rise in claims in the U.S. and in Canada against companies and boards under the broad umbrella of ESG-related litigation. These claims come in various forms, including breach of fiduciary duty claims against boards, claims against companies for climate, environmental and social impacts, corporate disclosure litigation for securities fraud and false advertising, claims against parent companies for subsidiaries’ activities, challenges to permits and regulatory proceedings. Some notable examples of ESG litigation include:

• several high-profile diversity litigation cases in the U.S. were brought in 2020 in conjunction with the racial inequality activism (e.g., against Oracle, Facebook, Cisco, Qualcomm, Norton LifeLock, Monster Beverage, Danaher). These cases claim securities fraud on the grounds that companies failed to appoint racially diverse officers and directors while publicly declaring their commitments to diversity, and breach of the directors’ fiduciary duties and the duty of oversight for failing to appoint diverse officers and directors;
• in December 2020, a lawsuit was filed on behalf of current and past black federal employees, claiming systemic racism and discrimination against the Public Service of Canada. The claims include wrongful failure to promote, intentional infliction of mental suffering, constructive dismissal, wrongful termination, negligence, violations of employment law and human rights law, and Charter breaches; and
• with respect to Canadian companies’ conduct abroad, Canadian courts have been a friendly forum for litigation claims against parent companies for human rights and environmental actions of their subsidiaries operating overseas, with courts receptive to claims based on overcoming corporate separateness or direct liability for parent entities on the basis that they directed or controlled their subsidiaries’ actions.

D&O insurance. The D&O insurance market has tightened globally with many companies facing reduced coverage at higher cost, in part due to insolvencies and business failures as a result of COVID-19, but also as a result of continued activism and litigation against directors. ESG is a major topic for D&O underwriters and they are actively monitoring board oversight and responsiveness to ESG factors and comparing the company’s ESG performance to that of peers. Underwriters are focussed on employee health and safety concerns, resiliency and general preparedness for future risks, board oversight of cybersecurity risks, and the evaluation and management of climate-related risks and sustainability initiatives, all of which fall within the broad scope of ESG. In the face of increased activism and litigation, D&O underwriters want to understand how companies are preparing for and identifying issues that might attract activists’ attention, how recent trends are changing priorities and expectations for stakeholders, and whether boards have a good defense-preparedness plan if an activist launches a campaign. In certain high-risk sectors, insurers may request ESG interviews with management to address concerns on particular ESG risks.

Executing ESG priorities: the opportunity to differentiate

Canadian corporate law, with its stakeholder model, enables directors to focus on ESG concerns when making decisions and determining what is in the best interests of the company. Against this legal backdrop, there is growing opportunity for boards to differentiate themselves and create value and fulfill broader social purpose through strong ESG performance. To do this effectively, boards should establish an ESG mindset in their organizations whereby ESG is embraced as integral and central across the business. In evaluating board and management performance of their ESG-related duties, investors and other stakeholders generally will not demand perfection, but expect companies to make honest and credible ESG commitments and show meaningful progress toward those objectives. Boards and management may want to improve their internal expertise to understand and guide their evaluation of ESG factors, and may need to engage outside ESG experts and independent evaluations to ensure they have an accurate and well-informed picture of the company’s ESG landscape that includes considerations, opportunities and risks across the organization¹. ESG is broad reaching, covering a wide range of disciplines and expertise, and the assessment of ESG priorities must be carefully tailored and integrated throughout a company’s operations, workforce and the broader supply chain. Companies that are focusing on the right mix of ESG priorities that are most relevant to their business are showing strong financial performance, achieving lower costs of capital and attracting and retaining top talent and customers (read more in “Purpose and profit: ESG and the path forward”).

To identify these priorities and develop their ESG strategy, companies should conduct a materiality assessment on different factors under each of the environmental, social and governance categories to evaluate and determine those most relevant to their business and identify a set of immediate focal points and actions, as well as longer-term objectives. Boards should ensure that they have meaningful and regular oversight for the most significant ESG priorities and the plans to address them. There is no one-size-fits-all governance model, but rather it should be adapted to the particular management and board structure to ensure the wide range of ESG priorities have the appropriate degree of prominence in the organizational setting. Companies should consider the proportionality of the ESG considerations and measures to be implemented and allocate capital and resources accordingly. ESG issues and stakeholder sentiment are dynamic and can evolve and become increasingly material over time, so management and boards should try to anticipate and monitor emerging issues and trends.  The COVID-19 crisis has exposed certain weaknesses and systemic threats to some businesses and provided greater insight into supply networks and other outside factors influencing operations, causing boards to think more broadly about their business environments and ESG priorities and strategies.  

After evaluating and developing ESG priorities, boards should ensure proper communication and accountability for its ESG strategy and commitments, including considering the following elements:

• Disclosure – telling the company’s ESG story: companies should seek to communicate their ESG priorities through credible and measurable objectives, including tailored qualifiers and cautionary statements, and should provide regular reporting on progress under a consistent and recognized framework. Often ESG matters are being addressed well by functional units within the organization, but companies are not telling their stories in a coordinated and coherent way that conforms to disclosure frameworks. The board should carefully review the company’s ESG disclosure and how the commitments, targets and priorities are being characterized, avoiding blanket statements and overstating their commitments (“green-washing” and “social-washing”).
• Integration, execution and monitoring – walking the talk: the board must ensure the organization broadly embraces its ESG philosophy, culture and strategies and adopts a process for executing and delivering on its commitments. To achieve proper integration and accountability, there should be a governance model with clearly articulated roles and responsibilities within the different board committees and across management, tailored to the business and organizational structure. ESG factors and practices should be broadly integrated into corporate policies, the enterprise risk management framework and training programs. The board and its committees should receive regular reports on material ESG matters to allow them to monitor and measure progress. The company’s ESG priorities need to be addressed and aligned not only in the existing operations and business, but also when considering and diligencing M&A transactions, new projects, new partners and others in the supply chain. As organizations progress in their cultural ESG shift, ESG teams and considerations should not be siloed and separate, but rather have prominence at a strategic level and be centrally integrated across the business and a driving criteria in decision-making.
• Budget and capital commitments: the board must allocate resources and capital and align budget planning to achieving the ESG commitments over targeted timelines. 
• Performance and compensation criteria: corporate performance indicators and scorecards must be consistent and reflect measurable objectives and targets, and ESG-related performance indicators should be considered across various performance criteria and may need to be rebalanced and upweighted. Boards should adopt the same rigour in assessing these criteria as they do other metrics, and thought should be given to how these criteria and compensation philosophies will be disclosed in proxy materials.
• Defense-preparedness and record-keeping: boards should consider the increasing risk of ESG related activism, assess their vulnerabilities, refresh their stakeholder engagement strategies and develop a tailored defense preparedness plan. They should also ensure there are well-documented minutes and corporate record supporting their actions and thoughtful deliberations and decision-making.

Conclusion

Boards and management teams are evolving and advancing their ESG journey with increasing speed. The leaders who are successfully adopting an ESG mindset in their organizations and integrating ESG considerations as a central feature across their business are differentiating themselves by achieving social purpose, financial performance and stakeholder satisfaction.

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¹ The Canadian Coalition of Good Governance’s Directors’ E&S Guidebook provides a number of recommendations for boards to guide their oversight and monitoring of environmental and social matters and related disclosure.