How corporate governance factors drive ESG integration

In a recent lead article, The Economist gave a blistering critique on environmental, social & governance (ESG) issue and how companies are addressing them. The article stated that lawmakers and market participants should deprioritize the social (S) and corporate governance (G) factors and concentrate sole on environmental factors (E). The article also stated that emissions are the only relevant metric to pursue, and as a result the letter E should stand for emissions and not environment.

Climate-related risk is of a different magnitude than other risk factors measured in ESG, such as unlawful human rights practices in supply chains, which fall under the S category. As greenhouse gas (GHG) emissions are the most important metric to reduce in order to help mitigate climate change, those emissions should be measured on a stand-alone basis.

However, to focus on emissions alone would not confer enough importance on their contributing factors — such as energy efficiency metrics, or the creation of a diverse board to make better decisions, or in relation to the massive risk that climate change creates.

Governance is just as important as the S and E factors

Good corporate governance plays an important role in implementing successful strategies to reduce emissions and facilitate the transition to a low-carbon economy. According to a global study conducted by the CFA Institute, 67% of respondents said they consider governance factors when making investment decisions. Thus, to create good corporate governance, factors such as shareholder rights, leadership effectiveness, and board independence and expertise are critical to success.

The ways in which governance helps mitigate climate-related risks and ultimately reduces emissions depends on the influence that asset owners and asset managers have on corporate boards. Their engagement with boards is a form of active stewardship because it influences corporate strategy at the board level.

Indeed, the UK Stewardship Code of 2020 has played an important role in providing guidelines for asset owners in the United Kingdom. The Code is a globally recognized framework that investors and investor associations use to guide their engagement strategies with their portfolio companies’ corporate boards. Not surprisingly, the Code includes ESG as a principal component and has been adapted in other countries. In fact, the Japanese Governance Code goes even a step further by suggesting that ESG should be included in every asset class, not just equities.

Governance codes are generally not mandatory around the world. However, the European Union implemented a mandatory approach through its Shareholder Rights Directive II, which strives to increase shareholder activity and transparency between companies and their shareholders for certain key activities, such as monitoring, voting, cooperating, and communicating.

Also not surprisingly, corporate engagement and shareholder action is the third largest ESG investment strategy overall, which indicates that the implementation of ESG factors within the investment community is well established.

Role of asset owners in influencing the G

Asset owners have influenced corporate boards in various ways; and collaboration campaigns with the largest asset owners are often used today to exercise such influence, particularly in identifying climate risks.

Engine 1 — The little engine that could

Engine No. 1, a small hedge fund, implemented one of the most stunning forms of engagement that influenced good governance. Despite owning just 0.02% of the company shares of Exxon Mobil, Engine 1 convinced the company’s largest asset owners — Blackrock, State Street, and Vanguard — to back its plan and vote for a new board composition that added three new board members.

The focus of Engine 1 was not on environmental issues (which are often the main reason for shareholder activism), but rather on a risk assessment that indicated that excessive exposure to fossil fuels would threaten shareholder value. By focusing on protecting the company from the risks of huge exposure to fossil fuels, Engine 1 argued that Exxon Mobil was simply not doing enough to reduce climate risks.

The collaboration of asset owners is supported by organizations such as Climate Action 100+, which is comprised of more than 700 global investors that represent $68 trillion across 35 markets. This is probably the most prominent example of an organized collaborative approach that uses companies’ own corporate strategy to effect transformational change. The goal of Climate Actions 100+ is to cut emissions to net zero, improve governance, and strengthen climate-related financial disclosures.

To this end, Climate Action tracks net zero initiatives by the largest emitters. Currently, 166 focus companies are part of its 2022 initiative, accounting for up to 80% of global corporate industrial GHG emissions.

While there are ample cases in which a more direct engagement strategy, such as the one practiced by Engine 1, can successfully influence the adoption of more sustainable business models, there are also examples in which ESG activism has not been successful. The research firm Insightia stated in its 2022 annual report on ESG activism that only 55% of global activism campaigns featuring board representation and ESG demands were successful, a decline from 60% compared to the previous year.

Those opposed to ESG use governance to influence outcomes

Despite the influence that asset owners and asset managers have on engagement strategies, there are few examples of asset owners taking a reverse approach and actively undermining the integration of ESG factors into the investment process. For example, state treasurers in Florida, Texas, and Missouri have mandated public pension funds to sell funds from asset managers such as Blackrock and Credit Suisse largely because of their ESG stances.

However, integrating ESG into investment decisions does not mean that asset managers are unable to own equities from utilities or fossil fuel companies. In a recent statement to a British parliamentary committee, Blackrock stated that it will not stop investing in coal, oil, and gas, as it has a fiduciary duty to its clients in transitioning to a low-carbon economy. In fact, the Blackrock Global Allocation Fund has invested in 77 fossil fuel stocks. A combination of ESG metrics and financial metrics may drive the criteria that Blackrock uses to select these stocks and may explain why it prefers one fossil fuel company over another.

Good governance, as brought about through shareholder action, is one powerful way to influence corporate boards’ decision-making when boards fall short on their responsibilities, particularly as those responsibilities relate to climate risk.