What is ESG? Ten takeaways for directors and c-suite executives

In brief - ESG relates to environmental, social and corporate governance factors. It goes beyond specific existing legal requirements and sits on the border of ethics, politics, law and public relations. 

This article contains 10 takeaways from a recent presentation on ESG given as part of our Director Relationship series.

1. Investors are flocking to the theme

International capital markets are responding. Rivers of money are moving into investment funds with an ESG purpose. 

As a consequence, companies are looking to attract these funds by demonstrating ESG characteristics.

2. Banks will continue to change their behaviour

Many banks are adopting transition plans to net zero which requires them to consider exposure to emitting industries. They are also facing ongoing protest votes being raised at Annual General Meetings against lending to fossil fuel projects.

3. Reporting initiatives will expand

Reporting initiatives are on the horizon, particularly in Europe and lobbyists of all persuasions are circling the Australian Accounting Standards Review Board raising the question, should accounting standards deal with ESG matters?

4. Insurance companies are incorporating ESG into their risk models

Insurance companies are definitely looking at this. Particularly through the lens of risk which is their main business. In some areas, we are seeing insurance premiums explode.

5. Shareholder activism will increase

ESG is partly about politics. Shareholder activism is politics at the company level in the sense of influence on decisions and pressure on company behaviour through legal, political and public relations levers. 

6. Activists will use traditional corporate influence levers

The recent activity relating to AGL is a fascinating example of how traditional corporate influence levers can be used. AGL had been making plans to split the company into a clean energy entity and a fossil fuel entity.

• Seeking Board support for a deal: Mike Cannon-Brooks saw an opportunity to both make a financial gain from AGL’s transition to a clean-fuel energy company and speed up the utility’s plans to shut down coal-fired power stations. Grok, Mike Cannon-Brooks' company, teamed up with Brookfield on a joint bid to acquire AGL and transition it to a private company. Their approach was rejected by AGL.
• Lobbying shareholder voting behaviour: The plan then became to spoil the demerger; Grok used derivatives to buy a blocking stake of 11.28%, ensuring Grok did not pay a premium for the shares, and converted the derivatives into shares in time for the AGL vote. Grok launched the “Keep it together Australia” campaign. 
• Studying the share register: AGL knew immediately that it had a fight on its hands; for a demerger that they thought uncontentious, but reliant on the support of mostly passive institutional investors and a big retail share register.
• Utilising PR techniques: A PR battle began and ended when the proxy adviser to AGL's 4th largest shareholder advised it would vote against the proposal with Grok. Shortly thereafter, the Chair, CEO, and two non-executive directors resigned.
• Appointing Board Directors: The saga continues with Grok seeking support for the appointment of four new directors to the board. AGL supports one but is urging shareholders to vote against the other three.

7. ESG will drive M&A Activity

ESG will drive transaction activity when: 

• A company wants to rebalance its portfolio of business. This would be for a number of reasons including public relations, attracting better ESG assessments from global investors and thereby facilitating capital flows; or to hedge risks of further regulation.
• Acquirers see opportunities to buy something from an ESG perspective and improve it to add value. This could be a variant of the house sellers strategy of giving it a lick of paint and putting in new gardens to attract a higher price. This is likely to drive future M&A activity if the market devalues companies with low ESG characteristics.
• Companies looking to divest negatively perceived assets. For example, AGL's attempt to create a fossil fuel AGL and clean fuel AGL.

8. Include ESG factors in your due diligence processes

Regardless of your view on the importance of different ESG items, acquirers should understand what is happening in the target and go in with their eyes open. You can then weigh such factors in the mix with other conventional due diligence matters when considering whether to proceed.

Due diligence processes should include consideration of:

• supply chain inputs: For example, consider application of modern slavery regulation;
• whether the business being acquired has parts that don't accord with the acquirer's profile and how it presents itself. Are you buying into a public relations problem?

9. Directors' duties and ESG

Directors have a duty of care and diligence and must act in the best interests of the company. But there is no prescriptive list of issues that directors must consider. 

To understand directors' duties in the context of ESG, directors need to understand what the hot ESG topics are in their industry. Examples include:

• energy or automotive companies - it is likely to be environmental factors; 
• tech companies - it is likely to be cyber and privacy concerns; and
• manufacturers - labour conditions in the supply chain and the impact of Modern Slavery laws may be a key focus.

There is a debate about how much directors can take third party non shareholder interests into account, but the courts have acknowledged that directors can take a broad and long-term approach to the interests of the company as long as there is a rational basis.

10. ASIC is watching this space

ASIC has expressed concern about the practice of greenwashing, where companies raise money on exaggerated claims of being ESG-friendly to attract investment monies.

ESG should not be treated as a marketing exercise. There are rivers of money that are going into ESG. Capturing them can be tempting but public commitments must be supported by objectively reasonable grounds to avoid risking greenwashing. 

In particular, ASIC has warned against making misleading and deceptive statements in the context of raising funds and say that they will target greenwashing.