ESG fac­tors and how cli­mate change af­fects busi­ness

The Globe and Mail (Ottawa/Quebec Edition) - - OPINION & ANALYSIS - ANITA ANAND

The JR Kim­ber Chair in In­vestor Pro­tec­tion and Cor­po­rate Gov­er­nance at the Univer­sity of Toronto

The At­tor­ney-Gen­eral of the State of New York re­cently sued Exxon Mo­bil, al­leg­ing that Exxon de­frauded share­hold­ers by omit­ting to pro­vide ma­te­rial in­for­ma­tion in its pub­lic dis­clo­sures about how cli­mate change might af­fect its busi­ness. The case raises the is­sue of en­vi­ron­men­tal and so­cial gov­er­nance – known as “ESG.” From cli­mate-change ac­tivism to di­ver­sity in lead­er­ship po­si­tions, boards of di­rec­tors and as­set man­agers are faced with the in­vogue ques­tion of the ex­tent to which – and how – they take ESG fac­tors into ac­count.

But should we re­ally lump all rel­e­vant fac­tors un­der the rubric of “ESG”? Given the vague­ness of the term, it makes more sense to dis­cuss “ESG” is­sues on a caseby-case ba­sis and per­haps dis­pense with the acro­nym al­to­gether. This ap­proach does not mean that we think that ESG fac­tors are unim­por­tant, only that we rec­og­nize the dan­gers in­her­ent in broadly ap­plied la­bels.

What dan­gers? A fail­ure to ob­serve ESG fac­tors can lead to risk, in­clud­ing rep­u­ta­tional risk, for the pub­lic cor­po­ra­tion and for as­set man­agers. Aca­demic re­search sug­gests that tak­ing into ac­count ESG fac­tors in­creases firm value. Other re­search sug­gests that the pres­ence of in­sti­tu­tional own­er­ship is causally re­lated to a firm’s en­vi­ron­men­tal and so­cial per­for­mance. In­deed, as Rot­man School of Man­age­ment Pro­fes­sor Alexan­der Dyck et al find, in­sti­tu­tional in­vestors, in ag­gre­gate, use their own­er­ship to pro­mote ESG prac­tices around the world. One can rea­son­ably con­clude, there­fore, that tak­ing ESG into ac­count is good for busi­ness.

Dis­clo­sure is cen­tral to un­der­stand­ing a firm’s obli­ga­tion to keep up with ESG think­ing. A cor­po­ra­tion’s an­nual in­for­ma­tion form must dis­close risk fac­tors in­clud­ing in­for­ma­tion that would be likely to in­flu­ence a rea­son­able in­vestor’s de­ci­sion to buy, sell or hold the cor­po­ra­tion’s se­cu­ri­ties. On a close read­ing of Cana­dian se­cu­ri­ties law, how­ever, this is not the le­gal test for the sub­stan­tive con­tent of an is­suer’s dis­clo­sure. Rather, the test is whether the piece of in­for­ma­tion would rea­son­ably be ex­pected to have a sig­nif­i­cant ef­fect on mar­ket price or value of the se­cu­ri­ties. If an item is ma­te­rial in this sense, it must be dis­closed.

And so there is a gap. Share­hold­ers may rea­son­ably care about an is­sue, such as cli­mate change, and be­lieve that the is­sue is cen­tral to the cor­po­ra­tion’s busi­ness, but that does not mean that boards will take cli­mate change into ac­count in the con­text of their le­gal duty to act with a view to the best in­ter­ests of the cor­po­ra­tion. In other words, cur­rent le­gal obli­ga­tions do not en­sure that boards will fully ad­dress the in­ter­ests and con­cerns of all of their stake­hold­ers.

This gap gives rise to the ques­tions: When does an ESG fac­tor en­gage the “best in­ter­ests” of the cor­po­ra­tion? When does an ESG fac­tor be­come “ma­te­rial” un­der the law? The re­sponse to th­ese ques­tions is neb­u­lous be­cause ESG fac­tors them­selves dif­fer widely in terms of sub­ject mat­ter and im­port in any given sit­u­a­tion. It is dif­fi­cult to imag­ine how “ESG fac­tors” could be placed on a cor­po­ra­tion’s risk heat map with­out more speci­ficity; some ESG fac­tors will be riskier than oth­ers in a given cor­po­ra­tion de­pend­ing on the cor­po­ra­tion’s busi­ness, among other fac­tors.

Still other ESG fac­tors will be univer­sally im­por­tant. For ex­am­ple, the #MeToo era has il­lus­trated that boards are well ad­vised to en­sure that a sex­ual-ha­rass­ment pol­icy is in place in the cor­po­ra­tion and that it is un­der­stood and ad­hered to by all board mem­bers, se­nior man­age­ment and em­ploy­ees. But what hap­pens when, as in the re­cent CBS net­work case, the board chair and CEO po­si­tions are oc­cu­pied by the same in­di­vid­ual who is the one ac­cused of sex­ual ha­rass­ment? Boards need ob­jec­tive ad­vice from un­re­lated par­ties on best prac­tices and pro­ce­dures be­fore such sen­si­tive sit­u­a­tions arise. The CBS case has taught us that pro­ce­dure mat­ters and that if re­cusal does not oc­cur, re­moval may be the next best op­tion.

Also stick­ing out like a sore thumb in Canada’s ESG dis­cus­sions is the ques­tion of cannabis le­gal­iza­tion. Now, pub­lic com­pa­nies whose busi­ness in­volves cannabis are iden­ti­fy­ing their tar­get con­sumer base. Are they also con­sid­er­ing the so­cial harm that may oc­cur from the use of cannabis, es­pe­cially among those who are deemed to be un­der age? In a boom­ing in­dus­try, the in­ter­ests of vul­ner­a­ble pop­u­la­tions may be sub­or­di­nated to con­cerns about cor­po­rate growth. Th­ese risks are mag­ni­fied as le­gal­iza­tion ratch­ets up com­pe­ti­tion while reg­u­la­tions are still nascent and untested. For cannabis cor­po­ra­tions that do not wish to cede prof­its or mar­ket share while the le­gal regime takes shape, such con­cerns likely do not have prac­ti­cal im­port de­spite the fact that they are in­te­gral to th­ese com­pa­nies’ risk pro­files.

Some may say that th­ese are not new is­sues: Boards and as­set man­agers have al­ways as­sessed risk, in­clud­ing in the con­text of ESG. But at this mo­ment in time, partly be­cause of a heated po­lit­i­cal en­vi­ron­ment and sci­en­tific ev­i­dence about the dire ef­fects of global warm­ing, the pres­sures to un­der­stand and to con­sider ESG fac­tors are some­what un­prece­dented. In re­sponse, boards of­ten make ref­er­ence to ESG with vague rep­re­sen­ta­tions that they are ob­serv­ing cor­po­rate cul­ture, pri­or­i­tiz­ing risk, and en­sur­ing that they have com­pre­hen­sive in­ter­nal poli­cies. But given their lack of speci­ficity, th­ese state­ments hardly con­sti­tute use­ful guid­ance for in­vestors or “best prac­tices” for boards.

ESG is use­ful be­cause it mo­ti­vates boards to think more broadly about the risks that they face and im­pose. But the term “ESG” is overly broad. Boards and as­set man­agers would do well to de­velop a prag­matic ap­proach, one that does not sim­ply group all “ESG” fac­tors to­gether but teases them apart and treats them as sep­a­rate is­sues, i.e. po­ten­tial risks, in their own right. In this way, the rel­a­tive im­por­tance of is­sues lumped un­der the ban­ner of “ESG” will be clearer for all to see.

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