What are the megatrends related to environmental, social, and governance (“ESG”) that will shape the corporate governance ecosystem and its key participants throughout the 2020s?
If the 2010s laid the groundwork for ESG corporate practices through debate and policy development, the 2020s will be about putting ESG into action. Our new decade is expected to see widespread adoption of ESG-related practices as the norm.
The 2010s: Building Momentum
To fully appreciate the shift from debate to action in ESG practices, it helps to look back at ESG developments during the past decade. While ESG efforts have existed for many decades — with considerable efforts dating as far back as the ’50s — it was around the 2010s that ESG became a mantra for most companies. At the start of the 2010s, market participants embraced corporate governance reform, focusing on restoring trust in the capital markets following the aftermath of the 2008 financial crisis. Laws, codes of best practice, investment stewardship efforts and company initiatives that were concentrated on board oversight and accountability firmly took root. These efforts included “say on pay,” which became standard practice in most major jurisdictions, as well as several regulatory and investor-led initiatives focused on board quality. Among these initiatives were board diversity, independence, refreshment and responsiveness to shareholders.
At the start of the 2010s, market participants focused on restoring trust in the capital markets following the aftermath of the 2008 financial crisis.
In the second half of the decade, environmental and social issues gained significant momentum. Several corporate crises affecting consumers, the environment and society at large (such as the Deepwater Horizon oil spill, Wells Fargo account fraud scandal, concerns over data privacy at Facebook, and the #MeToo movement) prompted calls to action for sustainable business practices.
In 2015, the United Nations Framework Convention on Climate Change (UNFCCC COP21) saw the first substantial private sector participation in international climate negotiations. The resulting Paris Climate Agreement boosted the ESG movement by creating urgency and a globally recognized framework of concrete objectives for addressing climate change risks.
Further, as asset managers and asset owners became signatories to the UN’s Principles for Responsible Investment (PRI) in record numbers, a corresponding surge in ESG-related investor activity gained momentum, including increased support for environmental and social shareholder proposals and capital inflows into ESG-themed investment products. The result was heightened pressure on companies to improve disclosures related to ESG.
The 2020s: ESG in Action
The developments during the 2010s paved the way for a more sophisticated ESG environment in this new decade, which is expected to foster widespread implementation of ESG-related practices. What follows are some of the key trends and issues likely to feature prominently in the actions of companies, investors and regulators in ways that will reshape the ESG landscape for years to come.
1. Climate Change: The Path to Net Zero
Climate change will be a dominant theme, as governments across the globe introduce more climate-related regulations. As a result, expect commitments to net-zero emissions by companies and investors to become standard practice by the end of the decade. All sectors — including those that are emissions intense that may have shown resistance in previous years — will participate in the transition to the low-carbon economy, because companies recognize the risks and opportunities linked to proactively addressing climate risks. Many firms will look to seize new business opportunities and position themselves as climate leaders. At the same time, investors will increase engagements around climate change and will likely begin to incorporate climate risk into their voting policies, going so far as to vote against the boards of laggard companies.
2. The Next Phase of Good Governance: Environmental & Social Issues
While traditional corporate governance will remain an area of focus — particularly around initiatives to improve board quality, shareholder rights and management incentive structures — the governance of environmental and social (E&S) issues will take center stage for investors and boards. The management of E&S risks will emerge as the new standard of comprehensive corporate governance practices. Expect the corporate social responsibility efforts of companies to move beyond simply “giving back to society” to also incorporate sustainability as a tool to systematically manage risk and create long-term shareholder value. Additionally, understanding a company’s impact on the environment and society will feature as essential expertise at the board level, with sustainability experts becoming key additions to many boards.
3. ESG Disclosures: The New Normal
Disclosures on ESG factors will become standardized and widespread by the end of the decade. As with corporate governance reform, intensified pressure from investors will serve as a major catalyst for change. Regulations will also play a critical role, with comply-or-explain codes of best practices potentially addressing E&S issues. Early signs of regulatory initiatives on corporate disclosures are already revealing themselves in some jurisdictions and may become more widespread. As noted earlier, corporate governance codes, executive compensation disclosures, say-on-pay and board-gender diversity mandates spread rapidly across the globe during the past decade as different jurisdictions learned about implementing governance standards from each other.
Existing reporting standards may serve as the blueprint for any mandated reporting, including reporting standards intended for the investment community (such as the Sustainability Accounting Standards Board and the Task Force on Climate-Related Financial Disclosures). Reporting frameworks addressing broader stakeholder audiences (such as the Global Reporting Initiative) also provide a clear roadmap. Verification and assurance will play an ever-increasing role in confirming the accuracy of these disclosures.
4. ESG Investing: From Stewardship to Integration
Expect asset managers to transition from ESG stewardship to ESG integration. Enhanced ESG disclosures will pave the way for investment professionals to better incorporate ESG risk assessments into their investment decisions. Engagement and proxy voting will move beyond the proposals listed on the meeting agenda as more investors systematically assess companies based on ESG risks. It remains unclear when or to what extent the inclusion of ESG risk assessments will impact capital flows. That said, the investment industry will need to address growing criticism over “greenwashing,” as new ESG products are brought to market by leading asset managers. Regulatory initiatives (such as the EU Action Plan) and market-driven solutions will likely play a significant role in creating standards for sustainable finance.
5. ESG Engagement: Asset Managers Take the Lead
Despite recent U.S. regulatory actions that may make it more difficult for shareholders to file resolutions, ESG-related shareholder activism will continue to rise in the 2020s. For decades, shareholder resolutions have served as a mechanism by which investors could identify and vet governance issues (including the governance of E&S), leading to reform in corporate practices and the adoption of standards (e.g., annual director elections and proxy access, among many other topics). Until recently, asset managers had largely participated in driving change to corporate practices by reacting to shareholder proposals or proxy advisor policies.
However, in the past five years, many large and prominent asset managers shifted to a more proactive stance, leading policy initiatives focused on board refreshment, board gender diversity and director over-boarding. Recent letters penned by the CEOs of BlackRock and SSGA signal further leadership from asset managers in introducing reforms and holding boards accountable to a higher standard of ESG practices. Despite this, shareholder resolutions will continue to play a major role in driving change, even if the proposal filing process becomes more challenging for proponents.
6. Economic Activism: Governance as a Driver for Change
Expect corporate governance factors to feature more prominently in proxy fights, as activists attempt to build a case for the replacement of board members. The view that improved governance can enhance long-term shareholder returns is resonating with a growing number of large asset managers (including prominent index funds), indicating that good financial performance alone will not be enough to shield companies from economic activism. Financial factors that make companies vulnerable to activism will continue to drive the main arguments. However, expect activist campaigns to focus on corporate governance as a means to further unlock superior returns. Poor oversight of environmental and social issues that have a material impact on businesses may also be used against management in contested situations.
7. Data and Technology: Smarter Analytics Drive ESG Practices, Protocols
Data and technology will drive significant changes in our ability to measure, calculate and monitor ESG factors and assess their materiality and impact on long-term value creation. Better visibility on challenging metrics like resource consumption and biodiversity will likely allow for the creation or enhancement of international frameworks and targets on several key issues, mirroring the Paris Climate Agreement. Improved and standardized disclosures will give investors the ability to assess the impacts of ESG factors on valuations. Expect artificial intelligence to play a major role in identifying patterns linking economic performance to ESG factors. In addition, companies that can better measure their ESG impacts and risks will be better positioned to make improved capital allocation decisions.
8. Diversity and Inclusion: Beyond Boardroom Diversity
In addition to boardroom diversity, the focus for companies and investors will shift toward diversity across the organization, from the C-suite to the general workforce. Policies on equal pay, equal opportunity and corporate culture will also come under more intense scrutiny. Expect U.S. boards to cross the 30 percent threshold of female participation in the early part of the decade, edging closer to gender parity near 2030, and especially so at larger firms. The number of top female executives will more than double by the end of the decade, despite starting from a shallow base. (Currently, women make up only about 6 percent and 5 percent of U.S. company CEOs and board chairs, respectively.)
9. Executive Compensation: Increased Focus on Metrics and Goals (including ESG)
The trends seen in the 2010s will continue, with a greater proportion of incentive awards becoming performance-based instead of time-based and the use of restricted stock continuing to outpace the use of stock options. Expect large investors to refine their executive compensation assessment methodologies separate and beyond existing evaluation benchmarks set by proxy advisors and other third parties. This trend may lead to increased opposition to executive pay programs at say-on-pay votes and emphasize the transparency and appropriateness of performance metrics and the robustness of targets even more.
As ESG considerations gain prominence, more companies will link executive incentives to ESG-related metrics. The appropriateness and robustness of ESG metrics and targets linked to executive compensation will become a potential topic of contention, especially if such measures are used to drive higher compensation while financial performance and shareholder returns disappoint.
10. Political Impacts: Geopolitics and Public Pressure
Politics will play an ever-increasing role in shaping the ESG landscape as geopolitical tensions, trade wars and populism directly and indirectly influence corporate behavior. In the energy, technology and industrials sectors, national security concerns may affect business partnerships and mergers and acquisitions, as was the case in the Qualcomm-Broadcom deal, which was blocked on such grounds by a presidential executive order in 2018. The Carlos Ghosn saga (former CEO of Renault and Nissan, a fugitive as this article was completed) also demonstrates how politics at the national level can have a direct impact on corporate governance. Sanctions against individuals and companies of specified countries are likely not going away. Further, public pressure — and very often, populist rhetoric on a wider range of social and environmental issues — may put additional regulatory pressure on companies and their shareholders in relation to ESG issues.
Seizing the ESG Moment
While the foundations have been laid for many of the trends and issues highlighted above, we expect to witness the widespread implementation of ESG-related practices across industries and jurisdictions in the next 10 years. Companies, investors and governments who fail to act on ESG will likely face greater risks and miss significant opportunities compared to ESG leaders in many key areas, ranging from better access to capital to operational improvement and pursuing new business ventures.
Demonstrating leadership in ESG will ultimately become a differentiating factor for entities in the public and private sectors, and market participants have much to gain from embracing ESG stewardship as part of their competitive advantage.