To the surprise of many, the pandemic accelerated interest in ESG (Environment, Social and Governance) issues in 2020.
As BlackRock pointed out in its last CEOs’ letter, ‘From January through November 2020, investors in mutual funds and ETFs invested $288 billion globally in sustainable assets, a 96% increase over the whole of 2019.’ There is a valid financial reason for this: sustainable corporations provide better risk-adjusted returns to investors; moreover, the global transition to a net zero sustainable economy represents a big investment opportunity. Indeed, as noted by State Street, the Covid outbreak has demonstrated that ‘[c]ompanies with strong ESG characteristics experienced less negative stock returns during the market collapse’.
From a corporate law perspective, the attention to ESG factors can also be characterised as a consequence of the shift from the dominant model of shareholder primacy, focused on financial risks and short-term returns, to a stakeholder capitalism model, based on a collaboration among corporations, shareholders and other stakeholders to achieve long-term sustainable value.
With regards to the ‘G’ factor, the evolution of corporate governance codes around the world in the last twenty years led to global convergence towards international best practices supporting the revelation of a good degree of information about the governance structures of listed companies. For years, issues around board composition and remuneration, as well as committees and internal controls, have been emphasised in the dialogue between companies and investors. In the wake of Covid-19, resolutions about dividend payments and share buy-backs have gone under the spotlight. Companies are generally required to inform the market about their governance practices and about non-compliance with any recommendation of the applicable code (‘comply or explain principle’) but investors and proxy advisors may require additional disclosure and/or recommend different practices.
Some complexity indeed arises from the multitude of voting guidelines adopted by institutional investors and proxy advisors, as well as the rating methodologies from ESG rating agencies, which often vary depending on the preferences and weights of the constituting factors. For instance, on the subject of overboarding—ie the number of board positions that a director can hold—approaches range from principles generally stating that a director must devote sufficient time to the task (G20/OECD Principles of corporate governance), to sector-specific provisions (CRD IV), to detailed provisions on the precise numbers of mandates depending on the role (whether executive or non-executive) of the director (eg ISS proxy voting guidelines).
The ‘E’ factor climbed up the agenda after the 2015 Paris agreement to tackle climate change: since then, the transition to a net-zero economy by 2050 at the latest—both an imperative of science and an item of growing public pressure—has become a policy target in more than 125 countries.
The financial sector is expected to collect and distribute large amounts of funds to finance such transition. According to the IEA, the average yearly spend for investments related to the energy transition will increase threefold in the next 20 years, leading to an average value of $2.6 trillion per year, allowing renewables, infrastructure and all services related to a more efficient use of energy to be future proof for the change to occur.
In order to help identify and disclose the information needed by investors to appropriately assess and price climate-related risks and opportunities, in June 2017 the Task Force on Climate-related Financial Disclosures (TCFD), established by the G20’s Financial Stability Board, published several recommendations, which are widely recognised as authoritative guidance on the reporting of the financial implications around the climate-related aspects of an organisation’s business. However, as it stands, there is no global benchmark to judge how ‘green’ a project or economic activity is, and the lack of a classification system increases the risk of ‘greenwashing’.
The EU’s Taxonomy Regulation, aimed at creating the world’s first-ever ‘green list’—a classification system for sustainable economic activities—intends to create a common language that investors and businesses can use when investing in projects and economic activities that have a substantial positive impact on the climate and the environment. Nevertheless, the legal framework is not complete since several technical screening criteria are expected to be specified in delegated legislation. Similar initiatives are under consideration in the UK.
Finally, the ‘S’ factor—which ranges from the protection of health, safety and economic stability of workers to enhancing a resilient supply chain and treating local communities fairly—has strongly emerged during the pandemic as a factor that profoundly affects the business and competitive environment.
The EU Non Financial Reporting Directive—which requires large European companies to include non-financial statements in their annual reports—identifies several social and employee-related matters to disclose, eg actions taken to ensure gender equality, working conditions, social dialogue, health and safety at work and the dialogue with local communities, and/or the actions taken to ensure the protection and the development of those communities. It also recommends the inclusion of information on due diligence processes implemented in supply and subcontracting chains, an area on which there are discussions about the need to introduce stricter reporting requirements or a legal standard of care (mandatory due diligence).
The ‘S’ factor may prove quite hard to measure and this increases the need to rely on non-financial reporting standards that may assure relevant, faithful, comparable and reliable information. Currently, metrics and standards used by companies to showcase their sustainability efforts vary considerably and are not always comparable, so that the press labels them as an ‘alphabet soup’. Among the wide array of reporting frameworks and standard setters are the initiative by the International Financial Reporting Standards Foundation, the ESG reporting framework proposed by the World Economic Forum’s International Business Council, in collaboration with the Big Four accountancy firms, and the cooperation among five renowned standard-setting institutions (CDP, CDSB, GRI, IIRC and SASB) to develop a global reporting system. The European Financial Reporting Advisory Group (EFRAG) has recently laid down specific recommendations to describe the scope and structure of future sustainability reporting standards that contribute to the achievement of the EU’s policy objectives.
Standardisation is important, although each company is required to identify its own ‘material’—ie reasonably likely to affect its value—sustainability matters. Moreover, under the so-called double materiality perspective, companies should disclose not only how sustainability issues may affect the company, but also how the company affects society and the environment. Against this backdrop, and with a view to encouraging the development of market best practices, my firm, Enel Group, has recently published a suite of key performance indicators, targets and principles—inspired by ICMA and LMA principles—that support the Group in integrating sustainability across all its financing tools, beginning with green bonds and now focused on sustainability-linked financial instruments that are tied to the UN Sustainable Development Goals.
By selecting specific and measurable KPIs (such as greenhouse gas emissions (measured in grams of CO2 per kWh) or the ratio of renewable energy installed capacity to total installed capacity), regularly reporting on them and issuing bonds whose terms provide for an interest rate increase if the company fails to meet them, Enel has pioneered a concrete way to measure the sustainability improvement of the company and to grasp the value associated with sustainability.
To sum it up, though the scope of ESG and the associated transparency obligations are wide and complex, and though the reporting framework is yet to be fully developed, there have already been valuable private and public initiatives aimed at achieving comparable and reliable information. Interestingly, as recognised by EFRAG, there is a significant and increasing expectation that ESG reporting adopts not only a backward-looking perspective but also a forward-looking one. Extended planning horizons, ie up to 10 years—such as the recent Enel’s 2030 vision—may prove very useful to concretely show how to run a company with a long-term perspective.
Michele Crisostomo is the Chair of the Board of Directors and of the Corporate Governance and Sustainability Committee of Enel S.p.A. This post is based on a Senior Practitioner Lecture given by the author to students on the MSc in Law and Finance program in the Law Faculty at Oxford.