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 in-vogue 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 case-by-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.
Anita Anand is the JR Kimber Chair in investor Protection and Corporate Governance at the University of Toronto firstname.lastname@example.org.