What is ESG and where did it originate?

The term ESG took hold following a report commissioned by the United Nations in 2004 entitled “Who Cares Wins” which stated “Companies that perform better with regard to these issues can increase shareholder value by, for example, properly managing risks, anticipating regulatory action or accessing new markets, while at the same time contributing to the sustainable development of the societies in which they operate.”

This contrasts with the ideas of Milton Friedman (summarised in his article in the NY Times in 1970) who suggested that the responsibility of the corporate executive is to maximise profit for the shareholders with matters such as ESG being a matter best left to legislators.  

Environmental, Social and Governance is not a new concept.  Many historic laws and regulations can be grouped under ESG principles.

Examples –

• Laws on pollution
• Equality & Diversity
• Employee Rights
• Health & Safety. 

In fact, the U.K. Government has a rather better track record on ESG than it is given credit for.  Laws have recently been introduced on minimum wage, eradicating modern slavery from supply chains, bribery, gender pay disparity and topical and well-publicised net-zero carbon emission targets (which are world leading).  

ESG and UK listed companies

Directors can be put under considerable pressure to anticipate and apply new ESG standards before they become obligations. However, it is arguable that the whilst directors of UK companies should plan for future standards they should only adhere to binding obligations.

Fiduciary duties

The Companies Act 2006 codified directors’ fiduciary duties and introduced a new concept of acting in the best interests of the company and taking account of wider interests.   

Specifically, Section 172(1) of the Companies Act 2006, requires a director to “act in a manner which he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to —

• The likely consequences of any decision in the long term,
• The interests of the company’s employees,
• The need to foster the company’s business relationships with suppliers, customers and others,
• The impact of the company’s operations on the community and the environment,
• The desirability of the company maintaining a reputation for high standards of business conduct, and
• The need to act fairly as between members of the company.”

Section 172 (2) goes on to state that “Where or to the extent that the purposes of the company consist of or include purposes other than the benefit of its members, subsection (1) has effect as if the reference to promoting the success of the company for the benefit of its members were to achieving those purposes.”  

In other words, the matters set out in section 172(1)(a) to (f) are subservient to the primary duty to promote the success of the company for the benefit of its members as a whole.

The Companies (Miscellaneous Reporting) Regulations 2018 amended s. 414C of the Companies Act to provide that a strategic report for a financial year of a company must include a statement which describes how the directors have had regard to the matters set out in section 172(1)(a) to (f) when performing their duty under section 172.  

So directors cannot just promote the success of the company for the benefit of its members as a whole without at least reporting on the matters set out in section 172(1)(a) to (f).

There has been no specific case law on how this balance between the interests of members and these wider considerations should be struck.  The attainment of ESG objectives must therefore be carefully calibrated to align with shareholder interests.

Directors of UK listed companies, Corporate Governance and Reporting Requirements

Under the 2018 FCA Corporate Governance Code, a UK listed company must set out a statement articulating its purpose, values and strategy, and ensure its culture and behaviour are aligned.  Shareholders can hold directors responsible for meeting these standards.

From 1st January 2021, UK incorporated and overseas commercial companies with a premium listing are required by the FCA Listing Rules to state in their annual financial report whether they have made disclosures consistent with the recommendations of the Taskforce on Climate related Financial Disclosure (TCFD) or explain if they have not done so. This helps to assess listed companies on environmental aspects of ESG.

In addition (and although not legally binding), the London Stock Exchange has issued guidance with recommendations for good practice in ESG reporting (endorsed by the PRI) for all companies with securities listed on markets operated by the London Stock Exchange, i.e. including AIM.  

UK listed companies may feel pressure to report on compliance with even more exacting global ESG standards. 

This pressure can come from asset managers and the proxy advisory firms.  By way of example, the International Business Council of the WEF recently published a draft discussion paper in conjunction with the big four accounting firms to create non-financial reporting standards against which major corporations can report.  The report states that 140 CEO’s of major global corporations support this approach which advocates that “society is best served by corporations that have aligned their goals to the long-term goals of society” using the UN Sustainable Development Goals as the roadmap for that alignment.  Of course, the accounting firms have a vested interest in promoting these standards which they will then assist companies to report on.

Also, given the adoption of EU SFDR – and the future implementation of the Taxonomy Regulation (see below), EU listed companies will be increasingly expected to provide information to EU asset managers to enable asset managers to correctly characterise their investment portfolio and investment products.  The EU also intends to adopt a Corporate Sustainability Reporting Directive which is likely to align corporate reporting with indicators which align with the SFDR and Taxonomy Regulation.  The UK is likely to take a similar approach so reporting requirements are likely to converge.

Proxy advisory firms ‘guide’ many asset managers on how to exercise their influence over listed companies and publish their ratings which directors will feel pressure to respond to. 

However, a 2020 study by MIT Sloan School of Management entitled “Aggregate Confusion – The Divergence of ESG Ratings” shows that ESG ratings can diverge significantly. It is hard to find consistency when the various agencies rank companies in such different ways. 

Pressure from asset managers

Asset managers generally attract investors into their funds on the basis of their ability to increase the value of the assets under management.  Some funds are marketed on the basis of expressly promoting ESG, esp. to help meet the challenge of climate change. Funds are increasingly holding investee companies to ESG standards but it is not clear what standards actually apply.    

Many asset managers are signatories to the Principles of Responsible Investment, (the “PRI”), a network of international investors (generally Western) working together to put the PRI into practice. The PRI works in partnership with the United Nations Environment Programme Finance Initiative and UN Global Compact.   Non-signatory asset managers are including ESG priorities in their own investment model.  

Blackrock’s updated engagement priorities for 2021 asserts that management of climate and natural capital “can be a defining feature in companies’ ability to generate long-term sustainable value for shareholders”. Meanwhile, many traditional UK long only investors and alternative investment funds are promoting their individually curated ESG principles.  It can be hard to follow such disparate standards but companies must be mindful of what their members are requiring of them.

In the EU, the Sustainable Finance Disclosure Regulation (SFDR) will require asset managers to report on how sustainability risks are integrated into their investment-making decision process, consideration of the impact and sustainability of the investments and – if the product is being marketed as having ESG characteristics (Article 9 products under the draft Taxonomy Regulation)  – various product level disclosures.  The first level requirements apply from 10 March 2021 and additional implementation will follow.

The territorial scope of SFDR is ambiguous and as Brexit occurred before the main obligations came into force, its application to UK asset managers is unclear.  However, it is likely that the UK will implement similar measures and may well replicate the EU provisions to make the reporting easier.  Large UK asset managers with investee companies in the EU as well as the UK will likely put universal reporting processes in place.

As long as funds prioritise ESG rated stocks, these stocks will rise and the capital appreciation will look favourable, but what about profits and the payment of dividends?  Will there be an ESG bubble?

In this regard, it is significant that the United States Department of Labour recently adopted amendments to the investment duties of ERISA plan fiduciaries to make clear that such managers are required to select investments and investment courses of action based “solely on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course of action”.  In essence, non-pecuniary factors (such as ESG) must be tied to the retirement security of plan participants to be ERISA compliant.  

So, an asset manager which markets a green energy fund might legitimately invest in the Norwegian green hydrogen company Nel Hydrogen. It is seemingly well run and may yet play a commendable role in energy storage solutions and decarbonising energy intensive manufacturing industries and the promotion of hydrogen powered vehicles. However, it is yet to turn a profit and is not suitable for income investors like ERISA plan fiduciaries. 

By contrast, asset managers managing money for pensioners who need a high yielding stock will need to invest in shares of UK listed companies which pay regular dividends, and many of these will be in areas of the economy which may not be regarded as ESG standard bearers.

Examples –

• Oil & gas
• Coal mining
• Tobacco
• Weapons Manufacturers
• Gambling Companies  

However, these UK listed companies will often have better ESG records than non-UK listed companies and these sectors will be with us for some time so is divestment really the responsible course to take? After all, the UK will continue to need oil & gas, minerals and commodities in its domestic economy and asset managers would do better to hold these companies to best in class ESG standards rather than import products from foreign owned corporations with lesser ESG standards.   

Conclusions

Democratic elected governments should decide what industries citizens should subsidise and which should have extra taxes imposed upon them.  U.K. state subsidies continue to propel the development of renewable energy whilst petrol, tobacco, gambling and tobacco are highly taxed. This is a compact which the UK electorate supports. 

UK companies should pause before changing their business model to meet global standards promoted by unelected bodies like the WEF and UN unless they are adopted in the UK. In particular, directors of UK companies should not lose sight of the need to balance basic fiduciary duties to members with the requirement to consider the impact of the company’s operations on the community and the environment in Section 172(1)(e) of the Companies Act.  

UK Companies will increasingly need to provide information to asset managers to enable them to report on how they will be characterised in their investment products (e.g. under SFDR).  Asset managers will increasingly market products according to their ‘sustainability’ and investors can then select the products they want according to whether they prioritise ESG over income (assuming such distinction actually exists).  Such transparency is welcome although will add an administrative burden to companies and asset managers.

Multinational companies in the FTSE100 like Anglo American may feel they need to aim higher due to their global impact but they must do so in a measured manner.  Anglo American has chosen to demerge its coal mining business in part to meet ESG pressure. Coal mining won’t stop because this business has been demerged and the investor base of the two legacy companies will no doubt diverge but will the new RSA listed coal company feel the same pressure to meet high ESG standards when it is no longer part of Anglo American?  Germany retired its nuclear power stations but imports gas from Russia. Is Gazprom a global ESG standard bearer?  These and other awkward questions must be answered.

Published – 29/04/21