By Lyndon Park
Over the past few years, there has been a dramatic transformation to Environmental, Social, and Corporate Governance (ESG) momentum.
Previously, ESG was a niche area with smaller activism-driven investors pushing companies to adopt ethical practices. They filed shareholder proposals, led divestment campaigns, and employed exclusionary and inclusionary tactics to their portfolio construction. While some investors continue to focus on thematic-based investments such as those aligned with climate change or other sustainability-related opportunities, ESG has grown and now encompasses a much broader range of investors, especially institutional investors. In fact, it’s becoming a moot distinction to use the term “ESG investor,” as nearly all investors now factor ESG into their portfolio decision-making. It is now mandatory for companies to consider how to integrate ESG within their overall strategies.
As boards and management teams face increased pressure from investors around ESG, there are several issues in particular that companies should consider.
The past 18 months have changed the conversation around ESG and diversity. While diversity has been an area of focus in many conversations around board composition or pay equity, it has now taken on a new, heightened level of interest. With an initial push for greater gender diversity, both investors and the market are focused on racial and ethnic diversity — not just among the board and management, but throughout the workforce.
Companies may face challenges as they address this particular topic, as it encompasses some deep-rooted societal issues that no one individual company can fix on its own. In addition, the SEC has not, at this point, provided detailed guidance around what it is expected in this arena.
With that in mind, investors have a general understanding that change in this area is not something that can happen overnight — but they do expect that this change will happen and will be reflected in companies’ actions and policies. A meaningful milestone is that starting 2022, Institutional Shareholder Services (ISS) will recommend against directors whose boards do not have at least one racially/ethnically diverse director, and investors have already adopted a similar policy.
Company leaders will often say, “People are our greatest asset.” During the COVID-19 pandemic, there were ample opportunities for companies to demonstrate what that means in practice and implication, and that will continue in the years ahead.
In the near future, companies can expect to engage with investors about the changes they made during the pandemic. What did the leadership team learn? In what areas did the company make changes to existing processes? What areas are returning or have already returned to normal, and how are you thinking about that strategically for the long term? How were you able to protect your people during the pandemic, and more importantly, how are you thinking about transitioning that as you look toward the future?
Increasingly, companies must be able to discuss their answers to these questions, specifically within recruitment and retention practices, training and compliance, benefits, and more.
Another focus area of ESG is climate risk. Some companies are more clearly and directly associated with climate change and climate risk, such as oil and gas companies. However, climate risk will affect nearly every industry in different ways — economic risk, regulatory risk, transition risk, physical risk, etc. Some may experience second- or third-order risk, but almost every company can, in very reasonable terms, understand how climate change could impact their business. As a result, investors now seek to understand how companies are managing that risk and how that risk is embedded in their strategic direction; many institutional investors now look for companies to disclose how they manage climate risks and opportunities using the Task Force on Climate-related Financial Disclosure (TCFD) Framework.
Given the growing importance of ESG, many companies are receiving increased pressure around disclosure — the reporting that explains a company’s actions and measured impact. However, that disclosure must also come with true integration of those practices and be aligned with investor expectations that such disclosure is pursuant to ESG frameworks that they adhere to, such as the materiality-driven framework recommended by the Sustainability Accounting Standards Board (SASB).
It can be easy for company leaders to look at their proxy statements and compare them to that of their peers, and begin to feel that they are lagging behind in some areas. And so, the pressure grows to focus on disclosure rather than creating and integrating practices that create the long-term ESG value. While investors are interested in disclosure, they also want to be sure that the company’s actions and impact will create lasting value.
In 2021, ESG issues will take center stage, so company leaders must be prepared to demonstrate how being a steward to the environment, customers, and communities can reap financial rewards. To learn more about these changes and what to expect, download our eBook, “ESG 2021: A Call to Action on Diversity & Inclusion, Climate Change and ESG Impact on Proxy.”