International: ESG takes the spotlight: What companies need to do to prepare
Shareholder activism resulting in unseating three directors at a Fortune 10 company. A key court decision on climate change. Progress on a sweeping EU Directive on Corporate Due Diligence and Corporate Accountability1, and new laws passed in Norway and Germany, addressing broad environmental, social, and governance ('ESG') and human rights mandatory due diligence and corporate accountability. Building on an ESG Task Force at the US Securities and Exchange Commission ('SEC') launched in March, legislation that just passed the US House of Representatives which, if passed by the Senate (challenging) and enacted, would increase public company ESG disclosures. Tara Giunta and Quinn Dang, Partner and Associate respectively at Paul Hastings LLP, unpack the evolving ESG landscape and considerations for organisations.
Even if legislators and regulators do not pass ESG legislation or impose ESG-related regulations, stakeholders - broadly defined as all interested constituencies including investors, shareholders, employees, consumers, and business partners - are increasingly prioritising ESG. As of 2019, 64% of consumers made purchasing decisions based on beliefs, and 88% of investors believe that companies that prioritise ESG initiatives represent better opportunities for long term returns2. Proxy advisory firms are demanding that companies in which they invest prioritise ESG as it relates to their business and operations. Companies that fail to meet ESG metrics are also being stripped from major stock indices.
Companies with large environmental footprints, particularly those in the extractive and oil and gas industries, should take note of two significant developments last month with respect to climate change risk.
On 26 May 2021, the Hague District Court ordered Royal Dutch Shell plc3 to reduce carbon emissions by 45% by 2030, compared to 2019 levels. The ruling was the first of its kind, adding increased pressure on oil and gas companies to take measurable, concrete steps to mitigate their impact on greenhouse gas emissions. The ruling could set a precedent in other countries, opening companies to new legal jeopardy on carbon and greenhouse gas emissions. Significantly, Shell will be required to reduce emissions during the pendency of its appeal, which means conducting business as usual during the legal appeal process is not an option.
The same day, Engine No. 1, a climate change-focused investment firm, successfully replaced three board members on Exxon's 12-member board of directors, despite holding just 0.02% of Exxon's outstanding shares. Engine No. 1 ran a platform that called for Exxon 'to implement a strategic plan for sustainable value creation […] (including more significant investment in clean energy)'4 and electing board directors with a track record of success in energy that can help the board adapt to changing industry dynamics. The firm received the backing of the three largest US institutional investors who own a fifth of Exxon, and three of the four nominees put forth were elected. Both the Exxon proxy fight and the Shell ruling signal that companies, particularly in the extractive and oil and gas sectors, are well advised to assess their climate and environmental and other ESG related risks and implement effective controls to address those risks.
Moreover, US public companies across the industrial spectrum need to understand their ESG risk profile, as well as the initiatives at the SEC to address ESG oversight. In March, the SEC announced the creation of a Climate Change and ESG Task Force focused on identifying material gaps and misstatements in issuer's disclosures regarding climate risks. Disclosure is also one of the key policy issues as the SEC engages in regulatory rulemaking on ESG, a process that was kickstarted by the Commission's opening of the notice and comment period that ended on 13 June 2021. A formal rulemaking proceeding is expected this fall.
Issue areas under the umbrella of ESG are wide ranging - from environmental pollution and climate risks, to human rights and modern slavery, to employee diversity, executive compensation, board oversight, and anti-corruption and cybersecurity. Over the years, compliance programs were established to address discrete areas, depending upon the industry, footprint and regulatory/compliance risks. As a result, oversight of many of the issues subsumed under ESG were often addressed in different silos, and spread across various compliance functions. With the emerging primacy of ESG today, the interconnectedness of risks as well as the risk exposure to companies has increased exponentially.
The proposals for a Directive on Corporate Due Diligence and Corporate Accountability ('the draft Directive') in the EU is instructive in how ESG is being considered by regulators worldwide, and it is sweeping in its coverage of ESG and human rights issues, as well as the obligations it would impose on companies not only organised and headquartered in the EU, but also those that access the EU internal market. Even though the draft Directive needs to move through a lengthy process, as noted above, certain Member States are already passing similar legislation.
Although subject to change as it moves through the approval process, the draft Directive would require that a company:
- identify and assess actual and potential impacts on ESG and human rights issues;
- institute measures to prevent and mitigate harms;
- monitor the implementation and effectiveness of remedial measures; and
- publicly report on the process; the requirements apply not only to the company's own operations, but also to those of its business partners, which means upstream (supply chain) and downstream (customers and product usage).
It is expected that the European Commission will submit a final proposal to Member States and the European Parliament by the end of 2021. Member States then would need to adopt implementing laws within two years from adoption. The mandatory due diligence law is expected to add significant 'teeth' to human rights due diligence. Companies breaching due diligence rules could face civil liability unless they show they have acted with all due care. Competent authorities may impose sanctions calculated based on a company's turnover, and may include temporary or indefinite bans from public procurement or state aid, asset seizures, or other administrative sanctions.
Given these developments, companies - including their corporate counsel and boards of directors - should take action to the extent they have not already done so. Businesses will also need to prepare due diligence and risk assessments and identify where their companies, affiliates, and suppliers can address ESG risks. Failure to take immediate action could leave companies vulnerable to costly proxy fights and reputational damage. For public companies in particular, such actions will need to be corroborated with supporting documentation or they could otherwise be subject to greenwashing concerns. Inaccurate and misleading reporting could be subject to forthcoming SEC actions on sustainability reporting. We expect to see more SEC action as the SEC Climate and ESG Task Force continues it work to proactively identify ESG-related misconduct and identify material gaps or misstatements in ESG-related disclosures.
Given this climate of corporate accountability as to ESG, companies are advised to conduct a gap assessment of systems and processes, including identification of ESG vulnerabilities and implementation of a two to three year action plan to address those risks. To ensure that compliance programs are reasonably calculated to address the company's evolving risk profile, periodic risk-tiered risk assessments should be conducted throughout the company's value chain, upstream and downstream, as well as the full span of company operations, functions, and business relationships. A significant part of this risk assessment will include supply chain due diligence regarding exposure to products and goods sourced from regions known to deploy forced labor. Based on that assessment, companies will need to develop a comprehensive strategy for mitigating and managing the risks of forced labor. Practical measures include reviewing and strengthening third-party due diligence, contract clauses, supplier codes of conduct, and heightened monitoring to align with the entity's human rights strategy and approach. More and more, companies are also harnessing technology to aid in supply chain tracing.
Moreover, companies must ensure that there is effective management of ESG and human rights risks by reviewing and, as appropriate, enhancing their compliance and risk governance function - at the management and board levels. There must be meaningful board engagement, as well as assignment of day-to-day responsibilities to a senior officer with adequate staffing and resources to effectively manage those risks. Boards should have systems in place where they receive reports from management on mission-critical risks, which includes ESG risks. Boards must also have sufficient ESG fluency and expertise to ensure effective oversight of management regarding ESG related risks. More recently, institutional investors are looking for boards to formally vest oversight of ESG issues in at least one board-level committee.
External pressure is mounting on companies to address ESG issues in actionable and measurable ways. Requirements from legislators and the courts, as well as demands from outside investors, mean that perfunctory check-the-box exercises will leave companies exposed to legal and regulatory risks, as evidenced by significant developments in the recent months with respect to climate change and mandatory due diligence.
1. Available at: https://www.europarl.europa.eu/doceo/document/TA-9-2021-0073_EN.html
2. Special Report: Brand Trust in 2020, Edelman Trust Barometer 2020 (2020).
3. Available in Dutch here: https://uitspraken.rechtspraak.nl/inziendocument?id=ECLI:NL:RBDHA:2021:5339
4. Available at: https://reenergizexom.com/materials/engine-no-1-to-nominate-four-highly-qualified-independent-director-candidates-to-exxonmobil-board/