With apologies to Raymond Carver, when we talk about ESG (environmental, social, and governance) we often find that although we think we all are talking about the same thing, there is little agreement about the proper scope and role of ESG.

Depending on who is doing the talking, ESG may refer to very different things with very different meanings, very different expectations, and very different impacts. Ostensibly ESG refers to a bundle of environmental, social, and governance-related priorities and objectives intended to provide a lodestar helping to guide corporate decision-makers as well as a framework for evaluating corporate responsibility. It is generally assumed that a corporation that acts consistently with ESG principles is a sound investment and has a favorable risk profile.

However, beyond anodyne statements that corporations should be law-abiding and responsible, there is much uncertainty and controversy about, among other things, the specific issues and concerns that make up the constituent elements of ESG, what makes an entity successful from an ESG perspective, how material progress toward the achievement of ESG principles is measured, and whether there is any correlation between successful engagement in ESG initiatives and profitability or reduced corporate risk. There is also uncertainty about the makeup of the regulatory and litigation risks associated with ESG. Given the ambiguities and uncertainties that are inherent in a discussion of ESG, it may well be an impossible task to satisfy every constituency or interested set of stakeholders.

Whose ESG?

ESG has become something of a buzzword in the corporate and investing world. Shareholders and activist investors demand that corporations adopt ESG practices and goals. Corporations are eager to publicize their good citizenship by adopting aspirational ESG goals. Investment advisers and managers continue to roll out funds and other investment vehicles targeting climate-friendly or other ESG-focused companies. Pension and retirement fund managers include ESG responsibility as a factor in their selection of investments. Analytical firms include ESG factors in their evaluations and ratings. Securities regulators have launched ESG task forces charged with developing ESG-related reporting requirements. With this background, ESG initiatives have become a factor in assessing a corporation’s reputation and value.

But the question remains, what is everyone talking about when they talk about ESG? The generic answer is that ESG is shorthand for a collection of factors—E (environmental), S (social), and G (governance)—that are instructive when making investment decisions or evaluating corporate performance and risk. A brief review of publicly available materials from the webpages of several large investment managers that offer ESG-focused funds demonstrates the challenge of finding clarity when discussing ESG. Following is a compendium of the factors included under the ESG-oriented investment umbrella by three investment managers:

E: environmental biodiversity loss, climate change, renewable energy use, reduced carbon emissions, green building, deforestation, native title, pollution, reduced waste, and natural resources

S: social diversity, inclusion, race, gender, human rights, modern slavery/trafficking, supply chain standards, antidiscrimination, bullying, harassment, First Nations people, cultural heritage, health and safety, data privacy, labor management, human capital development, employee relations, and conflict/blood resources

G: governance risk mitigation, shareholder activism, antibribery, anticorruption, accountability, board independence, board diversity, transparency, leadership, corporate governance, executive pay, business ethics, board structure, tax strategy, donations, and political lobbying

The breadth and diversity of issues that can be characterized as ESG priorities pose a host of challenges for corporate boards trying to determine how to respond effectively to the call for greater ESG responsiveness.

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No “Good” Deed Goes Unpunished

It appears to be a common viewpoint that ESG initiatives eventually will equate with a reduction in corporate and management risk because they demonstrate responsible leadership. This may prove to be the case once the meaning and content of ESG become better defined and ESG goals become reality and not merely promises. At present, however, with the uncertainties surrounding ESG initiatives, ESG is often a source of additional risk and new litigation. To date there has been little litigation against perceived ESG laggards. Defying expectations, much of the ESG-related litigation has been brought against entities that have undertaken ESG initiatives. The sources of ESG-related litigation have included controversial ESG actions that allegedly harmed the corporation’s share price and reputation, ESG actions that allegedly restrained trade or interfered with shareholder rights, and ESG-related representations and claimed benefits that allegedly exceeded actual performance.

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To date, so-called greenwashing and similar claims have been the predominant category of claims arising out of ESG efforts. These claims typically concern an alleged discrepancy between a corporation’s public statements concerning ESG activities and the corporation’s actual actions. The relevant discrepancies can be the result of alleged misrepresentations or misstatements, overly optimistic goals, or the inadequate execution of policies and/or inadequate oversight and supervision.

“Greenwashing” refers to the subset of situations in which an entity exaggerates or paints an overly rosy picture of its environmental initiatives or accomplishments. These claims typically are brought as shareholder or regulatory proceedings. The experience of Wells Fargo Bank with the failed execution of its diversity in hiring initiatives is a prominent recent example of the risks that result when there are discrepancies between aspirational policy statements and actual corporate practice. Wells Fargo announced a broad diversity and inclusion in hiring initiative. After the initiative was launched, reports of fake interviews and the doctoring of interview records began appearing in the media. After initial denials, Wells Fargo acknowledged that fake or back-dated job interviews had been reported in order to satisfy the bank’s diversity in hiring requirements. Shortly thereafter, Wells Fargo was sued in a shareholder claim, alleging that Wells Fargo made statements that were materially false and misleading, Wells Fargo failed to disclose that it had misrepresented the extent of its diversity efforts, Wells Fargo conducted fake job interviews in order to feign compliance with its diversity in hiring requirements, Wells Fargo’s conduct exposed it to potential enforcement actions, and Wells Fargo’s share price and reputation suffered as a result of the bank’s actions. Instead of minimizing risk, ESG initiatives, if rolled out poorly, create a new category of potential risk.

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It’s Only a Matter of Time Before Regulators Have Their Say

The ESG-related hazards confronting corporations are not limited to market pressures and litigation risks. Federal regulatory agencies have begun weighing in concerning the role of ESG in corporate disclosures and bringing enforcement actions involving allegedly inaccurate or misleading ESG statements.

The SEC has established an ESG task force that is preparing rules governing climate change disclosures. The proposed final rules were scheduled to be released in the fourth quarter of 2022 but have been pushed back until the first quarter of 2023 at the earliest due to recent Supreme Court rulings limiting the scope of agency rule-making powers.

The SEC’s ESG task force is also charged with bringing ESG-related enforcement proceedings. The ESG task force is focusing initially on material misstatements concerning climate risks under existing rules. The SEC is particularly concerned with investment advisers that are branding and marketing their funds and investment strategies as ESG directed. It is the SEC’s stated intention to hold investment advisers that market their funds as ESG-focused accountable if they do not accurately describe the application of ESG factors in their investment processes. To date, the SEC has brought enforcement actions against a number of advisers and asset managers for marketing funds as ESG focused without adequate policies and procedures in place to ensure that the investments were indeed ESG directed. In a similar vein, the SEC has commenced enforcement proceedings against securities issuers that have announced ESG initiatives but have failed to follow through on those initiatives.

Additionally, the Department of Labor has issued rules permitting ERISA plan fiduciaries to consider ESG factors when selecting investments for retirement funds or exercising shareholder rights such as the authorization of proxy votes. These rules reverse the approach of the previous administration that forbade plan fiduciaries from considering ESG factors when investing plan funds.

To date regulatory enforcement actions have not been focused on corporations or investment managers that failed to undertake any ESG initiatives. Enforcement actions largely have been brought against enterprises that have overstated their ESG achievements or have had poor execution of their ESG initiatives. Although the SEC has yet to promulgate rules providing for ESG-related disclosures, it is clear that the SEC will look askance at allegedly misleading or inaccurate statements concerning the fulfillment of ESG goals or the utilization of ESG factors in making investment decisions.

Watch Out for Cross-Currents

Based on the foregoing, there are:
(1) Definitional issues surrounding ESG initiatives.
(2) Inconsistencies in the evaluation of ESG performance. (3) Disagreements about some of the more controversial expressions of ESG goals.
(4) Concerns about potential discrepancies between ESG promises and performance.

Nonetheless, there is vague general consensus that it is appropriate for corporate boards and management to identify ESG priorities and for investors to include ESG factors in the process of selecting investments. We may not be able to define or evaluate ESG with precision, but generally we know it when we see it.

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There Are No Clear-Cut Answers When We Talk About ESG

The assumption that companies that are taking ESG initiatives are good risks assumes that the corporate embrace of ESG is an indicator of corporate success or of reduced liability and regulatory risk. Ultimately, that assumption may prove to be accurate. But that conclusion is not clear-cut at present. ESG initiatives may be a magnet for litigation due to controversial choices or unmet goals. Corporate boards and investment managers also must balance the risk of being viewed unfavorably if they do not adopt ESG measures against the risk of disinvestment if they run afoul of investors and state fund managers that view ESG as inappropriate.

Companies eager to demonstrate their ESG bona fides have to beware exposing themselves to accusations that they are exaggerating their ESG accomplishments. Optimistic goals to reduce emissions may be viewed as a material misstatement by regulators or investors if goals are not met. ESG should not just be a marketing tool. If a corporation or fund presents itself as ESG oriented, it is necessary to actually be ESG oriented.

The process of making ESG decisions, the complexity of evaluating the level of commitment to ESG initiatives, and the risks that are associated with ESG initiatives may be more challenging and nuanced than often is assumed. A clear-eyed approach and careful analysis in adopting appropriate ESG goals, as well the commitment to fulfill stated goals, are the bare minimum of a successful ESG program.

There is no guarantee that there will be immediate payoffs or that realistic accomplishments will be viewed favorably by analysts or the investment market. If there is a payoff to ESG initiatives, it most likely will come in the form of leaving an entity better prepared to meet future challenges as the by-product of careful planning and the commitment to continual improvement. In other words, an ESG-friendly culture is not much different than the kind of corporate culture that responsible and healthy boards always have fostered. It may be difficult to define or measure ESG precisely. The definitional and methodological sloppiness associated with much of the current discussion is unfortunate, but a board that is prepared to adapt to ESG demands is one that is prepared for the vicissitudes and changing circumstances that face any business enterprise.

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