What boards should know about balancing ESG critics and key stakeholders

Maria Castañón Moats is Leader, Paul DeNicola is Principal, and Matt DiGuiseppe is Managing Director at the Governance Insights Center at PricewaterhouseCoopers LLP. This post is based on their PwC memorandum. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) by Lucian A. Bebchuk and Roberto TallaritaDoes Enlightened Shareholder Value add Value (discussed on the Forum here) and Stakeholder Capitalism in the Time of COVID (discussed on the Forum here) both by Lucian Bebchuk, Kobi Kastiel, Roberto Tallarita; and Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock (discussed on the Forum here) by Leo E. Strine, Jr.

Environmental, social and governance (ESG) topics are often discussed as if there is a collective understanding about what they mean. But company leaders, regulators, investment analysts, portfolio managers, activists and retail investors may use the ESG acronym to talk about everything from investment strategies and investment vehicles to corporate social responsibility (CSR) and shareholder proposals. Put them all in a room together and they will quickly realize they may not be on the same page.

The use of ESG as an umbrella term for so many topics has led to misperceptions and, at times, controversy about whether focusing on certain risks and opportunities violates duties to investors. Activist investors, environmental groups and others have challenged companies to do more to combat climate change. On the other hand, various state attorneys general have raised concerns about how ESG factors, like climate, are used by asset managers in the proxy voting process, by pension plan managers when making investment decisions and in financial institutions’ lending to the energy sector. As companies come under greater pressure to provide ESG disclosures, the information they publish and the story they tell has, in some cases, been conflated by some to assume that those companies “have an agenda.” This has been an area of concern in some boardrooms.

Sustainable value

“ESG” is an umbrella term that can mean many things to different people. We like to think about it as building “sustainable value” through strategy, investment and oversight. Sustainable means “built to last.” Sustainable value is value that will last over time.

The key insight we take from our market experience is that “sustainability” and “value” are not separable from each other. To build value in the business, a company has tothink about how to build it to last. And to last, a business has tobuild economic value —if it isn’t profitable, it isn’t sustainable. At the same time, a business won’t last if it doesn’t build resilient relationships with stakeholders. Nor can any business thrive over the long term if its business model degrades and depletes the natural and social environments in which the business operates.

It’s important that directors consider both sides of the ESG debate. Certain environmental, social and governance issues may impact a company’s ability to be successful in both the near and long term; others might not. For instance, product safety is paramount for consumer product companies, but is less important in business services. As such, there isn’t a singular approach to ESG that works for every company; which ESG issues are most important will vary by company size, industry, maturity and a multitude of other factors. Two key points may be getting lost in the debate:

  • At its core, ESG is about companies developing long-term strategic plans, identifying and mitigating material risks, recognizing emerging growth opportunities to their businesses and their boards’ oversight of all of it.
  • More robust ESG data, not less, could lead to companies making more informed decisions and to better public policy.

Directors should also take the opportunity to move beyond the rhetoric and consider two key catalysts behind the calls for greater ESG disclosures —(1) professional investors who are using ESG data to inform decisions about whether to buy or sell your company’s shares and (2) ESG fixed income and equity investment funds that allow millions of retail investors to marry their financial goals with their values. We don’t anticipate these two catalysts losing strength any time soon.

The value of ESG investing

A 2022 global PwC surveyof the asset and wealth management industry showed an unprecedented acceleration towards ESG investments in markets around the world. Nearly eight in ten institutional investors responded that they plan to increase their allocations to ESG products over the next two years.

ESG-oriented funds can be a key growth driver for asset management firms. At a time when fees on traditional investment products have been pushed lower, the survey found that more than three-quarters of asset managers believe investors would be willing to pay higher fees for ESG funds —at least for now. To meet the demand, more than 75% of respondents said they are retrofitting existing funds to be ESG compliant. A much smaller percentage said they were launching a new suite of funds.

While ESG funds did experience periodic outflows in 2022, PwC estimates that, based on demand and beneficial economics for asset managers, ESG-aligned assets under management (AUM) will grow faster than the total asset management market, accounting for nearly one-fifth of all assets by 2026. In the US, AUM could hit $10.5 trillion in 2026, up from $4.5 trillion in 2021. We do not expect that this trajectory will change even if the criticism of ESG persists.

Investment strategies built on ESG factors

In a separate 2022 PwC GlobalInvestor Survey, respondents said they want companies to focus on innovation and financial performance. They ranked those as their two highest priorities for business, with reduction in greenhouse gas emissions coming lower. Over the next five years, however,

investors expect the threats stemming from climate change and cybersecurity to rise.
We believe professional investors want transparency because they are increasingly using ESG data as inputs in their models as they seek to get a holistic view of a company’s strategic opportunities and risks. The 2022 Asset and wealth management survey found that:

Time to focus on ESG reporting

So, what does this mean for corporate directors and their companies?

In the short term, directors will need to balance the potential for their actions to address ESG risks and opportunities to be misconstrued —and the reputational risks that follow —with this increasing market demand and the evolving regulatory disclosure requirements. In the US, the SEC is widely expected to finalize new rules for climate disclosures in early 2023. (The agency is also expected to propose requirements that address sustainability issues more broadly through a proposal for enhanced disclosure of human capital.) Globally, the European Financial Reporting Advisory Group is developing new, expansive ESG reporting requirements under the Corporate Sustainability Reporting Directive and other markets are producing their own new regulations. Even if a company isn’t required to make ESG-related disclosures, its business partners are likely to ask them to share data.

Directors should also look at this as an opportunity to refine their company’s story and build brand health —with both critics and key stakeholders. Our research indicates that investors largely think that companies should take steps to address risks and opportunities associated with climate change, but they are not operating on blind faith. PwC’s Global Investor Survey found that 87% of investors think corporate reporting contains unsupported sustainability claims (i.e., some degree of greenwashing), and a similar majority wants corporate reporting to provide the business rationale and financial implications of ESG initiatives. Further, 75% of investors said they would have greater confidence in corporate sustainability reports if the information was assured by an independent auditor.

To build trust, companies must collect, analyze and report robust, auditable ESG data. The company should present the data to tell a true story of how the company is mitigating risks and taking advantage of opportunities. These are management responsibilities. Boards should have in place appropriate processes to get the right information and exercise their oversight responsibilities. Boards need to be able to assess whether investments of time and money toward sustainability are accretive to long-term value. More simply, boards need to ask whether management is setting the right priorities, making the right promises to stakeholders and keeping those promises. Companies may not be able to mute all oftheir critics, but being proactive on ESG reporting can help them distinguish themselves from peers and potentially take advantage of the ESG asset flows.

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