A step-by-step guide for directors to raise ESG score

ESG has become increasingly prominent, and environmental campaigners more assertive. Environmental issues were behind Mike Canon-Brookes’s involvement with AGL. Activists have attempted to hold Shell’s directors personally liable over the company’s climate transition plans. 

This has created a predicament for company directors and officers. It raises the question of how exactly they must approach ESG. 

So, let’s look at some concrete steps that directors should take when analysing ESG, and especially environmental and social issues.

Step 1: Deconstruct ESG

The first step is to be specific about what exactly is “ESG”. It relates to environmental, social, and governance factors and these are different. 

Good corporate governance should, by its very nature, benefit shareholders. It is something that directors should strive towards. There is a debate over precisely what constitutes good corporate governance. However, in theory, there is no cost to shareholders from improving corporate governance.

Environmental and social factors can be more complex. Oft-times these factors can involve expenditure. They can also run counter to the firm’s current business operations. For example, an oil refiner would have a stronger environmental score if it stopped refining oil, but that would also undermine the company’s present business case. 

A strong ‘social’ score also need not increase shareholder wealth. Corporate philanthropy can be positive PR. Improving employee satisfaction can improve corporate performance. However, pursuing social objectives can also reflect managers using shareholders’ money to fund pet projects and personal passions.

The differences between the E, S, and G create significant problems in reported ‘ESG’ indexes. The ESG indexes differ significantly in what they measure, how they measure it, and the weight they assign to those measurements in an aggregate index. This means the same company can receive markedly different ESG scores between index providers. 

High ESG indexes are also not necessarily associated with better stock returns. The empirical literature suggests firms with better ESG indexes experience lower stock returns, especially when there is more certainty about the firm’s ESG level (i.e., the indexes agree with each other). These lower returns might imply a lower realised cost of equity. However, given evidence that investors often over-pay for environmental impact, the negative returns could also reflect a natural adjustment down from over-hyped prices or simply worse performance.  

The first step is thus to eschew ESG indexes in favor of focusing on precise ESG related steps, ensuring those activities are evidence backed, and appropriately measuring both the commercial and ‘ESG’ impact of those measures. 

Step 2: Consider Directors’ Duties

Company directors and officers must comply with their duties. It is illegal to do otherwise, even if the directors think that they are ‘doing good’. 

There are several duties that are particularly relevant to ESG. 

Duty of loyalty and good faith

Company officers and directors must act in good faith, for a proper purpose, and in the best interests of the corporation. To be clear, the legislation around this duty specifically requires the officers and directors to act for the corporation rather than for other third parties. Outside interests and considerations are relevant only to the extent they affect the corporation’s value.  

This duty has clear implications:

1. Officers and directors can properly consider ESG factors. 
2. When considering such factors, they must consider whether pursuing it is in the best interests of the corporation. Thus, to use our oil refinery example, shutting down the oil refinery might not be in the best interests of the corporation. In this way, ESG considerations are much like any other consideration: they must be assessed through a financial lens. Pursuing ESG factors can be good PR but officers and directors must quantify this. 
3. Officers and directors do not have authority to pursue causes that they believe in or support if those causes do not enhance shareholder wealth. 
4. Officers and directors act for all shareholders, not merely the largest or loudest shareholder. Thus, even if an activist amasses a large block of shares, officers and directors cannot merely defer to that activist. Rather, they must consider what is in all shareholders’ best interests. 

Duty of care 

Under this duty, officers and directors must exercise the ‘degree of care and diligence that a reasonable person’ would exercise in the circumstances. The director will ordinarily be deemed to do so if their actions are done in good faith, for a proper purpose, rationally believed to be in the company’s best interests, and are appropriately informed. 

The duty of care sits alongside the duty of loyalty. That is, if the officers or directors worked carefully to expropriate money from the company, they would still violate their directors’ duties. Or, if officers and directors worked carefully at an oil refiner to eliminate oil refining while paying little heed to the financial impact, they would also violate the duty. The objective directors carefully pursue must be a legitimate purpose.

The duty of care implies that officers and directors must diligently assess the business case for any ESG proposal. Officers and directors cannot pursue environmental proposals if they reduce shareholder wealth. In this respect, ESG proposals are much like any other business proposal. However, this does not mean that environmental and social factors are irrelevant.

Environmental and social factors can influence business operations. It is beyond the scope of this article to discuss all such implications. However, environmental and social action (or lack thereof) can precipitate regulatory intervention. They can also have a public relations element. Further, these factors can influence employee satisfaction, which can influence corporate performance. There is also evidence that some shareholders and lenders might appreciate environmental and social action. This might lower the cost of capital. However, the evidence is relatively nascent. And, it is necessary to consider whether the cost of capital would in fact fall if environmental and social factors harm the firm’s operations. In all cases, decisions should be based on quality evidence and should focus on what is best for the corporation.

The duty of care also implies that officers and directors must consider climate change and environmental factors, rather than simply ignoring them. However, the focus should be on how those environmental and social factors affect the corporation. Climate change could disrupt some business operations and/or result in government intervention. Thus, it is prudent to consider it. Indeed, if directors ignore regulatory or business threats, directors would likely violate their duty of care. 

Use of position 

Thirdly, officers and directors must not “improperly” use their position to “gain an advantage” for themselves or others, or to “cause a detriment” to the corporation. The advantage can be pecuniary or non-pecuniary. 

This duty implies that officers and directors must not use their position to force the company to pursue a personal agenda or cause, especially one that harms the corporation. This can be difficult to prove, especially when the ‘advantage’ is non-pecuniary or merely involves promoting a personal cause. 

In our oil refinery example, if an environmental activist entered the board and ceased all production in order to promote their personal agenda, this director would have improperly used their position to both harm the corporation and gain a non-pecuniary advantage for themselves. 

What then must officers and directors do?

Officers and directors must consider each environmental and social factor on its merits. Simply deferring to ESG indexes is inadequate. ESG indexes aggregate myriad factors and these factors do not necessarily  increase shareholder wealth. And, the ESG ratings differ significantly between indexes. The indexes thus fail to consider whether pursuing a policy increases shareholder value. 

Governance initiatives enhance shareholder wealth, at least in theory. Good governance is about ensuring officers and directors act in shareholders’ best interests. There is some disagreement about precisely which initiatives do achieve this goal. However, governance initiatives all have this goal in mind. Thus, for governance, officers and directors must keep up-to-date with empirical evidence and literature to ensure that governance proposals are evidence based. 

The appropriate way to consider an environmental or social factor is to assess – and quantify – the precise way in which it influences cash flows and/or the cost of capital. This can then allow a company to assess whether the environmental or social initiative will result in positive value overall.