iIn his 2018 annual letter on corporate governance, Larry Fink, the CEO of the asset management firm BlackRock, stated that BlackRock would “increasingly integrate” into its investment process an assessment of a company’s leadership and responsiveness to environmental, social, and corporate governance matters. Fink minced no words:
Companies must ask themselves: What role do we play in the community? How are we managing our impact on the environment? Are we working to create a diverse workforce? Are we adapting to technological change? Are we providing the retraining and opportunities that our employees and our business will need to adjust to an increasingly automated world? Are we using behavioral finance and other tools to prepare workers for retirement so that they invest in a way that will help them achieve their goals?
This letter sparked considerable debate among the investment community, boards of directors and management teams, and the corporate bar. If the “public good” is a factor that should be considered by boards of a for-profit company, what weight should it be assigned in comparison with more traditional metrics used by boards, such as “enhancing the value of the enterprise” or “advancing the best interests of the company and its stockholders”? This is a spirited intellectual debate with potentially profound consequences as legal standards on the proper exercise of fiduciary duties by corporate directors and officers continue to evolve. However, while the jurisprudence will take time to develop, these considerations are already taking hold in the investment community. As we head into the next decade, an increasing portion of the investment community is taking into account an evaluation of a company’s ESG (environmental, social, and governance) profile in making their investment decisions. Industry-leading private and public companies are beginning to take these factors into account in building out their corporate governance profile and making business, management, and policy decisions. Companies in the energy, energy service, transportation, and heavy manufacturing sectors would be well advised to consider how their investors (and others with whom they do business) will look at their business, management, and policy decisions if they fail to adequately address ESG weaknesses.
What is ESG?
ESG factors are used as tools that evaluate the impact of ethical business practices on a company’s financial performance and operations. ESG encompasses a wide range of factors organized around the three prongs of environment, society, and corporate governance. The environmental assessment evaluates whether a company is sufficiently attentive to the potential environmental impact of its commercial operations and invested in taking appropriate steps to mitigate any negative effects, recognizing that the failure to do either could have an impact over time on the company’s reputation, financial performance, and ultimately, even its balance sheet. Elements considered in this assessment include the company’s impact on energy consumption, pollution, climate change, waste production, natural resources preservation, and animal welfare. On the social front, the assessment typically focuses on the company’s initiatives around and commitment to workforce and board diversity and human rights. The analysis will change from company to company, depending on the nature of its business, but will include matters such as the company’s record on human rights, child and forced labor, community engagement, health and safety, and stakeholder and employee relations. The key issue in the corporate governance assessment is how the company handles relationships with its own internal and external stakeholders, including whether there is transparency between management, employees, and shareholders. Among the factors included within the corporate governance metric are quality of management, board independence, conflicts of interest, executive compensation, transparency and disclosure, and shareholder rights.
Should both public and private companies be attentive to ESG?
While it would be foolhardy for a public company to ignore ESG today, even privately held companies that do not properly account for ESG run the risk of alienating financing parties and third-party contractors, which increasingly have their own reputational concerns about doing business with out-of-touch companies. Investors and others interacting with companies increasingly are using ESG to develop an overall investment suitability profile for a company. Since 2013, 70% of US investors have increased their allocation to ESG investments, according to reports from the investment firm Schroders.
Environmental factors are of particular concern for companies in the energy and energy service, transportation, and heavy manufacturing sectors. Shareholders are increasingly focused on the environmental impacts of the operations of the companies in which they make investments. Putting aside the need to comply with environmental laws, from an investor perspective, companies are expected to not only be fully aware of the environmental impact of their operations, but also to develop a framework to address those environmental effects (and take action to respond to those concerns). Several companies publicly share climate or sustainability reports detailing the environmental impact of their operations as well as the impact the environment and climate are having on their operations and their employees. For example, a hurricane season with several tropical storms and hurricanes in the Gulf of Mexico may slow business operations or even lead to oil spills or various types of pollution. Simultaneously, inland flooding from these storms may also prevent employees from traveling to work to assist with troubleshooting or even normal business operations. Or a vessel may be involved in a collision, resulting in the spillage of hydrocarbons or hazardous substances. These are not totally unexpected events or consequences, and shareholders expect companies to be out in front of these issues and consequences.
Plastic pollution is a more recent concern for shareholders. This past spring, both Chevron Phillips Chemical Co. and Exxon Mobil announced that they would begin to issue reports on plastic pellet spills from their chemical plants in 2019. Pellets are used to manufacture plastic products and are considered a major source of pollution in oceans.
Many companies are in industries where some form of environmental impact is unavoidable, but even there, shareholders are expecting companies to take steps, where possible, to minimize their environmental impact. An example of this can be found in the transportation industry, where European airlines including KLM, Air France, and Lufthansa have recently announced partnerships with passenger rail companies to encourage passengers to replace short-haul flights with train travel. These airlines see not only the environmental upside, but also a commercial one, because the change frees up gates at busy airports that can be used for more profitable long-haul flights. While longer distances and travel times in the United States may make this alternative less workable (except in densely populated, heavily traveled corridors), we note that United Airlines has developed a partnership with Amtrak to allow customers to collect mileage points while using the train system in the Northeast.
Another transportation segment with a significant environmental impact, the cruise industry, is likewise becoming more conscious of greener fuel alternatives by looking to liquefied natural gas (LNG) as an alternative fuel. Cruise ships typically use heavy fuel oil or marine gas oil. As of January 1, 2020, these fuels may be used only on ships that have installed scrubbers to lower harmful emissions, as mandated by the International Maritime Organization (IMO 2020). But as early as 2015, the cruise industry began to look for cleaner alternatives, such as LNG, which is odorless, colorless, nontoxic, and noncorrosive. LNG is also cheaper. To date, Carnival Corporation has 10 LNG ships on order, and Royal Caribbean has three new LNG ships, the first of which is to be delivered in 2022.
Public and private companies are also concerned with social factors and are making decisions to further improve diversity at the management and board levels. Gender diversity has reached record highs, but ethnic diversity is growing at a slower pace. In 2019, women filled 20% of all Russell 3000 board seats, compared with 10% in 1996. In contrast, only 10% of Russell 3000 directors currently belong to an ethnic minority group. In addition to financial motivations by investors, legislation is also driving the diverse composition of boards and management. In 2018, California passed a law requiring that public companies with principal executive offices in California have at least one woman on their board by the end of 2019, and by December 31, 2020, this minimum will be raised to two female directors if the corporation has a five-director board and three female directors if the corporation has at least a six-director board. Illinois, Colorado, Massachusetts, and Pennsylvania all have enacted nonbinding board diversity legislation to encourage diversity of boards.
A poor ESG profile may also affect a company’s ability to qualify for loans and financing. Credit ratings have traditionally considered sustainability risks. Recently, however, credit rating agencies are becoming more transparent in how ESG factors are analyzed when credit ratings are assigned. In January 2019, Fitch Ratings issued a new integrated scoring system to show the impact that ESG factors have on individual credit rating decisions. Investors want ESG factors to be integrated into credit scores, and credit rating agencies are responding.
In conclusion, and consistent with Fink’s proclamation, investors consider companies with strong ESG factors to pose less of a long-term financial risk. Future investment attractiveness is being increasingly tied to ESG, and if they haven’t already done so, companies should work to improve their profiles on the transparency, diversity and corporate governance fronts.
What are the legal implications of ESG?
As noted at the outset, where corporate jurisprudence will eventually assign a place to ESG among the factors to be considered by corporate fiduciaries is still a bit unclear. One could make a compelling argument that appropriate attention to ESG is fully consistent with the exercise of fiduciary duties because it helps protect the value of the enterprise. However, what weight to assign to ESG compared with more traditional metrics is as yet unknown. What is known, however, is that from the perspective of powerful voices within the investment community, taking steps to ensure the sustainability of an enterprise is something investors expect of management.
Finally, a word about ESG and deal-making. ESG assessment has had, and will continue to have, an effect on transactional due diligence. Due diligence is evolving to include a nonfinancial risk analysis in addition to the financial and legal risk analyses, which have traditionally focused on financial risks and exposures and legal compliance. Diligence efforts are now expanding to focus on ESG factors. Potential liability will always be the key concern, but companies that are thinking about a potential sale should be aware that questions regarding sustainability efforts and business operations encompassing ESG will be asked. The inability to answer these inquiries well may have an impact on investor interest or even valuations.
