The Age of ESG

Jessica Strine is Managing Partner & CEO, Marc Lindsay is Managing Partner & Director of Research, and Robert Main is Managing Partner & COO at Sustainable Governance Partners. This post is based on a SGP memorandum by Ms. Strine, Mr. Lindsay, Mr. Main, and Amy Hernandez. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here).

Among the major developments in investment management over the past decade, the dawn of the Age of ESG—environmental, social, and governance factors—represents a true paradigm shift in the relationships between public companies and their investors. It is now common practice for shareholders to look beyond the traditional bottom line and evaluate how companies are performing in their stewardship of stakeholder resources, attention to environmental and social risks, and disclosure of sustainability strategies. This shift has been driven by a few important developments:

Ownership of public companies is increasingly concentrated among a handful of large institutions. Among them, index-based (or passive) investors are now the largest shareholders of most public companies in America. Given that these funds are required to track market indices, they do not have the freedom to increase or decrease position sizes in response to stock performance. As effectively permanent investors in a company, these investors are applying greater scrutiny to the governance and board oversight of companies in their portfolios.

Investors recognize that ESG factors can influence long-term business performance. As such, many investors now expect ESG factors to be integrated into a company’s strategy and disclosed in public reports. Passive investors are reviewing this disclosure as an indicator of governance quality. Active managers, under pressure to deliver alpha, are focusing on sustainability issues and variables beyond the financial statements in the pursuit of drivers of intrinsic value.

Purpose is power, and stakeholders matter. As company leaders wrestle with evolving demands from their investors, there is a renewed debate from many stakeholders – including regulators, employees, and communities—about the purpose of the corporation and whether shareholder interests should truly come first.

In this new paradigm, a public company’s ESG performance can weigh on or improve its valuation, can increase or decrease its cost of capital, and may ultimately influence shareholder voting outcomes. We believe there are important opportunities to mitigate risk and to drive long-term value by integrating material ESG topics into corporate strategies, elevating board acumen, improving governance quality, and enhancing communication with shareholders and stakeholders.

In this post, we discuss the themes catalyzing the Age of ESG, and outline some of the ways that companies can adapt and thrive amidst the confluence of demands they’ll experience in this new Age.

Institutional investors are increasingly concentrated … and increasingly focused on ESG.

On the heels of the global financial crisis, investors allocated to low-cost index-based funds in unprecedented proportions, and by late 2019, passive funds had surpassed actively managed funds’ aggregate assets under management (AUM) for the first time in history. As part of this shift, Blackrock, Vanguard, and State Street – “the Big Three”—now together hold about 25% voting power across the S&P 500, and about 22% across the Russell 3000. [1] Given their size, their views have significant influence on evolving corporate governance norms, and their decisions are of great importance to the outcomes of many shareholder votes. Recognizing that stewardship of investor assets is integral to their fiduciary duty, passive investors are investing more in analyzing portfolio companies’ board and governance quality, and they are thinking holistically about corporate governance and long-term value.

Whereas just five years ago, these three major investors employed small governance teams focused primarily on proxy voting, each has bulked up its ranks in an effort to apply more scrutiny to voting decisions, to better understand governance profiles, and to support their decision-making through more active engagement with portfolio companies. Some have tripled and quadrupled their ranks – as examples, BlackRock’s team has more than tripled from 13 in 2008 to 45 in 2019,2 and Vanguard’s stewardship headcount has risen from less than 10 to 35 [3] over the same time frame. In staffing up, the teams have focused on both the volume and the quality of their dialogue with portfolio companies, and are increasingly likely to engage with an independent director of the board. Whereas engagement with passive shareholders was once infrequent and relatively narrow—centering on executive compensation and shareholder rights—today these teams are delving into board composition, succession planning, risk oversight, ESG materiality, sustainability strategy, company purpose, reporting frameworks, and much more.

Sustainability and corporate governance issues are material.

Behind investors’ increasing focus on ESG is an evolving market perspective on materiality. A host of corporate and market sustainability factors, historically seen to be non-financial, are now viewed as material drivers of business performance. We have seen numerous recent instances of this across industries: climate change risks and the related costs to hydrocarbon producers; corporate culture pitfalls such as the series of #metoo incidents; data privacy concerns; changing requirements for reporting of wage equity or diversity & inclusion standards; supply chain issues… and the list continues to grow. Regardless of whether there is a near-term EPS implication, investors are mindful that these E, S, and/or G issues may have cost of capital or valuation implications that are well within their investment horizons.

Keying on the material upside and downside ESG risks to companies, fundamental active investors—driven by competition from index funds, increased client interest in ESG investing, and the search for additional sources of alpha—are ratcheting up their efforts to identify ESG leaders and laggards among public companies. While asset flows into sustainable funds have reached new highs in each of the last four years, perhaps the more significant trend has been the integration of ESG into mainstream investors’ investment processes. Sustainable investing assets now account for $12 trillion of the $46.6 trillion in professionally managed assets in the U.S., and the category is one of the fastest growing segments of the global asset management industry. [4] supply chain issues… and the list continues to grow. Regardless of whether there is a near-term EPS implication, investors are mindful that these E, S, and/or G issues may have cost of capital or valuation implications that are well within their investment horizons.

Looking ahead, companies can expect active investors to become increasingly focused and vocal on ESG, and to use their voice, vote, and investment decisions to influence public company practices. Likewise, investors are looking for more and better disclosure of ESG related information, and public companies should also expect mounting pressure to enhance the reliability and comparability of their reported data.

Purpose and profits, on the same plane.

Industry influencers and key stakeholder groups have thrust ESG and a corporate commitment to ‘multi-stakeholderism’ into the headlines. Last year, the Business Roundtable moved away from the concept of shareholder primacy and issued a statement signed by 181 high-profile CEOs committing to lead their companies for the benefit of all stakeholders—customers, employees, suppliers, communities, and shareholders. [5] Investors have been similarly vocal. Blackrock’s CEO Larry Fink has driven headlines with annual letters to CEOs that link purpose and profit inextricably, calling on businesses to embrace purpose and make “a positive contribution to society.” [6] The other members of the Big Three, together with many of the world’s largest institutional investors, have conveyed similar sentiments. These trends are even more pronounced outside the US. Recent EU regulatory efforts have focused on building ESG considerations into their financial policy framework, and the World Economic Forum’s recent “Davos Manifesto 2020” defined a corporation’s purpose as engaging “all of its stakeholders in shared and sustained value creation.” [7]

Receptivity to these ideas has run the gamut, with multi-stakeholderism and corporate purpose seen as impractical idealism in some board rooms, and as well-worn best practice in others. Increasingly, however, investors and business leaders are recognizing that, in order for companies to maximize long-term value for investors, they must also serve a beneficial purpose for the stakeholders throughout the company’s value chain. This means integrating long-term sustainability—material environmental and social issues—into a company’s strategy. It means building a board and governance profile that support long-term shareholder and stakeholder success. And it means communicating all of this effectively to multiple audiences.

Best practices in the Age of ESG:

This paradigm shift comes with a clear message for companies: oversight of ESG issues is integral to a company’s governance profile from the view of passive investors, and to a company’s investment case from the view of active investors. As such, the stakes are high at both the ballot box, and on the trading floor. However, balancing the pursuit of long-term value with the quest for governance leadership is by no means easy. As a starting point, though, we see a few best practices emerging:

  1. Proactive shareholder engagement: A proactive shareholder engagement program enables a public company to understand the issues most important to its institutional investors, including its passive It is no longer enough to center investor outreach around quarterly results and the buy-side/sell-side teams that track them. Shareholder communications should be responsive to the changing investor base and the increased focus on long-term value, including ESG matters. These shareholder engagements, built over years of discussion, are essential to understanding voting policies and expectations, shaping sustainability disclosure, and building a company’s activism preparedness.
  2. Embrace sustainability—integrate ESG into corporate strategy: The enhanced focus on sustainability and ESG is a priority for many investors and other Leading companies will ensure that sustainability topics relevant to their business are not only on the board’s agenda but integrated into company strategy. Successful companies will embrace material environmental and social issues as part of creating a sustainable business strategy, and integral to their governance profile. Similarly, companies should understand how they compare to their peers and investor expectations. Just as well-governed companies have long prepared ‘vulnerability assessments’ for shareholder activism, companies should now also focus on their ESG vulnerabilities.
  3. Build a ‘fit for ESG’ board: The job of a director has never been more challenging and time consuming, particularly with the emergence of sustainability and ESG as top Companies need an engaged, ‘fit for purpose’ board of directors with the expertise and perspectives to provide appropriate oversight, ask difficult questions, and engage with institutional investors during both good and challenging times. It is crucial that boards have the breadth of backgrounds, range of capabilities and adequate capacity to execute their fiduciary duty. Likewise, it is imperative that companies clearly communicate the strength of their board’s skills, experiences, and processes.
  4. Enhance your internal ESG governance. Sustainability governance should not be limited to the boardroom, and a well-designed ESG program must embed sustainability-focused controls, key performance indicators (KPIs), and reporting throughout the organization. All levels of management must be involved in incorporating sustainability into the company’s day-to-day activities. This requires a company culture where sustainability and purpose is not an afterthought, but core to the company’s existence.
  5. Tell your sustainability story. It is no longer the norm to categorically dismiss queries related to sustainability, in any industry. The question now is how to respond, and it is imperative that public companies proactively enhance their disclosure rather than let third-party ratings providers control the narrative. Since there is not yet a regulatory mandate or other universally accepted disclosure standard for sustainability data, crafting this disclosure remains a challenge. However, investors continue to coalesce around the merits of industry-specific standards issued by the Sustainability Accounting Standards Board (SASB) and the climate-related disclosure recommendations of the Task Force on Climate-related Financial Disclosure (TCFD). [8] Companies should look first to these frameworks as they map out their sustainability journey.


1Lucian A. Bebchuk and Scott Hirst, “The Specter of the Giant Three”, Boston University Law   Review (May 2019). (go back)

2Blackrock, 2019 Investment Stewardship Annual Report.(go back)

3IPE, “ETFs for ESG: The ESG governance challenge”, ETFs Guide 2019.(go back)

4The Forum for Responsible and Sustainable Investment, “US SIF Trends Report 2018.”(go back)

5Business Roundtable, “Statement on the Purpose of a Corporation.”(go back)

6Blackrock, Larry Fink’s Letter to CEOs, “A Fundamental Reshaping of Finance.”(go back)

7World Economic Forum, “Davos Manifesto 2020: The Universal Purpose of the Corporation in the Fourth Industrial Revolution.”(go back)

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