Boards must deal with ESG issues as 'perfect storm' of activism gets underway: MLT Aikins lawyer

A “perfect storm” of environmental, social, and corporate governance activism is underway, says MLT Aikins lawyer Conor Chell. And corporate boards will need to understand, adapt, and embed an ESG strategy within their organization at all levels to ensure meaningful progress on these issues.

To avoid ESG activists, organizations “must take ESG seriously,” says Chell, who has developed expertise in areas of law related to ESG matters. This involves assessing their current strategy and performance and adapting their operations to achieve those goals.

Chell notes that it appears many boards do not understand the risk of ESG very well. According to Price Waterhouse Cooper’s 2021 Corporate Director survey, nearly 64 per cent of companies link sustainability issues to corporate strategy. However, a “whopping” 75 per cent of boards reported they do not understand ESG risk very well, nor do they have a good understanding of their company’s sustainability messaging.

However, Chell says this lack of understanding isn’t necessarily a result of a lack of expertise. Instead, it is a lack of awareness, he says, adding that “it is the duty of senior and executive management teams to educate and raise awareness of ESG matters for their boards, and it appears to date that hasn’t happened to the extent that it needs to happen.”

With many boards not fully understanding ESG risk, coupled with the “looming likelihood” of mandatory ESG reporting, the grounds are fertile for a significant increase in ESG activism.

Chell defines ESG activism as “an individual or group of shareholders in a corporation that are motivated primarily by ideological reasons, with little or no consideration of any other perspectives or rationale.” They are different from other shareholders who have diverse perspectives and views and are not motivated primarily by ESG-based ideology.

Chell points to the case of Engine No. 1 and its battle with Exxon as a cautionary tale for companies who may also soon become the target of similar ESG activism.

In May of 2021, an ESG activist investor group named Engine No.1 won a battle to install several directors on Exxon’s Board of Directors with the intent of forcing Exxon to tackle climate change in a more meaningful way.

Engine No 1.’s strategy resembled what academics refer to as “the market for corporate control,” buying and selling of shares of a targeted corporation to acquire voting control. However, rather than seeking control of a public company, a shareholder or group of shareholders can seek to correct managerial inefficiencies by acquiring enough shares in a target company to gain a significant (but not controlling) share in the company.

On May 26, 2021, with less than US $40 million worth of common shares in Exxon (approximately 0.02 per cent of Exxon’s shares), Engine No. 1 executed a proxy fight that resulted in its winning seats on the board of Exxon for three out of its four nominations.

Chell notes that Engine No. 1 had the support of large institutional investors, including BlackRock, Vanguard and State Street, who all voted against Exxon’s leadership and in favour of the activist group.

Before these events, Exxon faced significant shareholder dissatisfaction regarding the company’s climate change strategy. It resisted calls for investment into alternative energy such as solar and wind that were thought to offer less profit potential. Activist attention intensified when ExxonMobil posted a $22 billion loss. Exxon spent an estimated $35 million, not including the cost of management time, to defend against the proxy fight instigated by Engine No. 1.

Still, Chell says, Exxon has made some progress on ESG issues — one example is its recent public support for a pledge by the U.S. and EU to reduce methane emissions by 30 per cent below 2020 levels by 2030. “However, it will really come down to whether Exxon makes material improvement to its own ESG performance before we will be able to quantify any non-financial benefit derived from Engine No. 1’s ESG activism.”

Another example involves Shell and activist hedge fund First Point LLC, which recently purchased approximately US$750 million worth of Shell’s shares (or about 0.4 per cent of available shares). First Point LLC has written letters to Shell calling on the energy giant to split into two companies, reduce fossil fuel investments and pivot to renewable energy amid concerns about climate change.

Chell notes that Shell has previously been a target of ESG activism. In May 2021, a landmark ruling by the Hague District Court ordered the company to significantly accelerate cuts to carbon-dioxide emissions. The court concluded that Shell’s plan to reduce pollution was insufficient.

The success of Engine No. 1 was a “watershed moment” for the ESG activism movement, Chell says, and the Royal Dutch Shell case confirms the trend of growing ESG activism and how it will impact companies and their boards.

To date, Chell says ESG reporting has been largely voluntary. Companies have discretion in selecting the ESG frameworks and standards they rely on for reporting guidance and what ESG metrics they use and how they decide to communicate ESG information to investors and stakeholders.

But Chell says that the days of voluntary ESG disclosure and broad discretion companies have had are numbered. Momentum is growing, and many jurisdictions are moving towards mandatory ESG reporting, including the European Union, the United Kingdom, and the United States. Chell adds that in Canada, there also are “strong signals” that mandatory ESG reporting will likely not be a question of “if,” but “when.”

For example, a June 2019 report from the Expert Panel on Sustainable Finance recommends a “comply or explain” approach as part of the potential adoption of an ESG framework. And last month, the Canadian Securities Administrators published proposed disclosure requirements consistent with guidelines of the US-based Financial Stability Board’s Task Force on Climate-related Financial Disclosures.

While much of the ESG activism seen has involved the energy sector, Chell notes that many other aspects of ESG concerns — water use, biodiversity, racial and gender equality, for example — could also be targeted by activists.

One way of determining where ESG activism could go next is looking at the activities of the Global Reporting Initiative Sector Standards group. The GRI recently developed the GRI Sector Standard for the oil and gas industry and is working on similar standards for the following sectors: coal, agriculture, mining, textiles and apparel, forestry, and utilities.

Even private companies aren’t immune to ESG activism. “It is not difficult to imagine a scenario where an investor or investor group in a private company become dissatisfied with management’s ESG decisions,” he says. “Numerous avenues exist for such investors to take action, which could result in significant pain and disruption for a company’s management team and its board of directors.

Another trend occurring within ESG activism is targeting the supply chains on both the customer and supplier sides to improve overall ESG performance.

To ensure ESG activists do not capitalize on shareholder dissatisfaction in respect to ESG, Chell says companies should consider:

• Assessing the company against established ESG frameworks, standards, and metrics to identify material ESG risks and opportunities
• Communicating and reporting (both internally to boards and externally to stakeholders) on ESG issues
• Focusing on improving ESG strategy and performance by adapting operations to address key ESG issues
• Embedding ESG strategy into the organization at all levels to ensure that progress is made in improving the company’s ESG strategy
• Keeping an eye on future trends to analyze the company’s performance relative to other industries and peer groups

If companies want to avoid being the target of ESG activists, he says, they must “commit to continually improving ESG performance going forward and stay on top of new and emerging ESG trends.” This is an area that is “evolving at an incredibly rapid pace.”

He also suggests that ESG activism could lead to companies getting a leg up on novel ways of accessing capital as a result of making improvements. Many investors — individual and institutional - are actively seeking out investments that perform well from an ESG perspective, he says, and there is momentum for the development of ESG-focused investment funds.

“There are many innovative and new financing products that are being built with the improvement of ESG performance in mind,” he says, citing sustainability bonds as one example.

He also notes that a more all-encompassing idea of investing in ESG that does not screen out companies operating in particular sectors but allows for considering investments that are making strides towards meeting ESG goals.