It is vital that environmental, social and governance risk is addressed by directors and management in order to fulfil a duty to the company and society.

2020 taught all of us, including lawyers, several important lessons. One is the increasing importance of management of environmental, social and governance (ESG) risk by directors and management. Recent APRA and ASIC reports1 and the Hayne Royal Commission2 have increased focus on corporate governance and risk management. Despite this, 2020 saw several spectacular ESG failures by Australian companies with damaging fallout, including AMP with the promotion of a senior executive despite sexual harassment claims and Rio Tinto with the destruction of the Juukan Gorge caves. While these failures are problematic for the messages they send about attitudes to women, sexual harassment and Indigenous peoples, viewed more broadly, these failures led to reputational damage, embarrassing director resignations and reduced market value.

A recent trend in corporate governance has been the focus on directors recognising and overseeing so-called “non-financial risks” such as reputational risk. Poor ESG performance often results in reputational damage. But these risks are also financial risks because reputational damage can lead to consumers, investors and lenders turning away from dealing with the business. Directors are increasingly seeking to embed ESG as part of their corporate culture, and management of ESG risk is increasingly an issue in corporate finance, project finance and M&A due diligence.

The definition and development of ESG and its relevance to directors’ duties are considered in this article, and recent examples illustrate the importance of directors addressing ESG in order to comply with their directors’ duties.

What is ESG?

The concept of “corporate social responsibility” – corporations doing good in society – preceded the rise of ESG, which is a more specific set of issues within corporate social responsibility. The acronym, ESG, is often considered as being first used in the 2005 “Who Cares Wins” Report,3 but it is only in more recent times that ESG has become a real focus in Australia. The initiative was originally designed to find ways to integrate ESG into capital markets on the basis that this “makes good business sense and leads to more sustainable markets and better outcomes for societies”.4 ESG provides a response to changing social attitudes in the face of high-profile reports into corporate failures, with the consequence that directors and managers must consider issues and interests that they may previously have disregarded.

The “Who Cares Wins” Report outlined several areas within ESG as issues of concern:

Environmental issues

  • Climate change and related risks
  • The need to reduce toxic releases and waste
  • New regulation expanding the boundaries of environmental liability with regard to products and services
  • Increasing pressure by civil society to improve performance, transparency and accountability, leading to reputational risks if not managed properly
  • Emerging markets for environmental services and environment-friendly products.

Social issues

  • Workplace health and safety
  • Community relations
  • Human rights issues at company/suppliers’/contractors’ premises
  • Government and community relations in the context of operations in developing countries
  • Increasing pressure by civil society to improve performance, transparency and accountability, leading to reputational risks if not managed properly.

Corporate governance

  • Board structure and accountability
  • Accounting and disclosure practices
  • Audit committee structure and independence of auditors
  • Executive compensation
  • Management of corruption and bribery issues.5

This was a prescient list of issues given events in recent times. The report recognised that sound corporate governance and risk management systems were crucial pre-requisites to addressing ESG issues.6

Directors’ duties

Company law and the Corporations Act 2001 (Cth) (Corporations Act) do not explicitly address the question of the role of corporations and the role of directors in society and to how to take ESG into account. The Corporations Act does not take a prescriptive approach to any issues directors should focus on when fulfilling their director’s duties. We can compare this approach with the wide-ranging list of factors that UK directors must consider under s172(1) of the Companies Act 2006, which includes factors that fall within the ESG remit.7

The Corporations Act approach has traditionally led directors to focus on compliance with, and ensuring the legality of, their actions by reference to the duties under the Corporations Act and at common law. Primarily, the relevant duties tend to be seen as the duty to exercise care and diligence, the duty to act in the best interests of the company, and the duty to use powers for proper purposes.

In the past, directors often justified failing to consider ESG on the basis that they did not need to. They hid behind sentiments such as: “It is in the best interests of the company to make as much profit in the short-term as possible”, “Focusing on ESG is not profitable” or “It is not using our powers for a proper purpose to promote an ESG social agenda”. Over the past five years there has been a clear shift in directors’ attitudes to the role of ESG when complying with their directors’ duties, driven by changes in the attitudes of investors, consumers and other stakeholders, and high-profile reports into corporate failures.

The ASX Corporate Governance Council (CGC) periodically releases its views on best practice for listed companies and is often seen as setting the governance bar for all Australian companies. In “Corporate Governance Principles and Recommendations” (4th edn) released in 2019, the CGC’s recommendation 3 was to “Instil a culture of acting lawfully, ethically and responsibly”.8 The CGC referred to the interim report of the Hayne Royal Commission:

“. . . The duty [to pursue profit] is to pursue the long term advantage of the enterprise. Pursuit of long term advantage (as distinct from short term gain) entails preserving and enhancing the reputation of the enterprise . . . And, lest there be any doubt, it also entails obeying the law. But to preserve and enhance a reputation . . . the enterprise must do more than not break the law. It must seek to do ‘the right thing’”.9

Both the CGC and Commissioner Hayne recognised that acting lawfully is just one part of the equation for directors and acting ethically and responsibly – “doing the right thing” – are key parts as well. There is a shift from analysing directors’ duties through a legalistic prism to considering whether their actions promote positive ESG outcomes. It is a move from “Can we legally do this?” to “Should we be doing this?”

Consumers, investors, providers of debt, and activist shareholders are forcing directors to embrace ESG. Directors now understand that consumers won’t buy their products if they come from a company with a bad ESG record; investors won’t invest in or provide finance to a company with a bad ESG record – they will “vote with their money”;10 and companies that have a bad ESG record won’t attract the best employees.

Environmental

There are various environmental issues that either have or are coming to the fore – primarily climate change but others, such as elimination of single-use plastics, are also becoming important. For many companies/directors, the 2020 bushfires were a tipping point making climate change impossible to ignore.11 The bushfires may turn out to be a “road to Damascus” moment for directors, but the need to consider climate change as part of fulfilling directors’ duties has been building ,albeit slowly. In 2016, N Hutley SC and S Hartford Davis gave a well-publicised opinion that: “Directors can, and in some cases should be considering the impact on their business of climate change risks, to the extent that they intersect with the interests of the firm”.12 They concluded that those directors who failed to consider climate change risks could be found liable for breaching their duty to exercise care and diligence.

By 2019, Hutley and Hartford Davis gave a more emphatic opinion: “It is increasingly difficult in our view for directors of companies of scale to pretend that climate change will not intersect with the interests of their firms”,13 meaning that directors of all large companies must take into account climate change. They have reiterated their views in their Further Supplementary Memorandum of Opinion this year.14 However, it is not just large companies that are affected by the impact of climate change. For business, climate change poses physical risks, economic risks and potentially reputational risk (for contributing to, or failing to deal with, climate change). In order to make proper business decisions, directors need to consider whether these risks associated with climate change will adversely affect their business.

Moreover, more regulators, such as ASIC and APRA,15 now require certain entities to report on climate change risks, giving increased transparency to shareholders, consumers and investors about business performance in relation to these risks. ASIC recently wrote to many listed companies to remind them of their obligations.16 More companies are now voluntarily reporting on climate change under the Taskforce for Climate-related Financial Disclosure framework.

Increasingly, shareholder activists are targeting annual general meetings with questions about action on climate change and other ESG issues. For example, in 2020 AGL, Santos and Woodside faced climate change-based shareholder resolutions, and BHP faced a resolution to stop supporting business associations that oppose the Paris climate accords. While these resolutions are not usually passed, they put significant pressure on directors to act. Interestingly, this year Rio Tinto’s board supported two activist-led resolutions on climate change that were overwhelmingly passed by shareholders.17

It is not just companies that now face activist members. While many superannuation funds adopt ESG investment policies to guide their investment decisions, such funds are not themselves immune from activism. A member sued the Retail Employees Superannuation Trust (REST) in 2018 over climate change disclosures and its handling of climate change risk,18 alleging breached duties of care and skill, duties to exercise powers and duties in the beneficiaries’ best interests and for failure to allow access to certain documents. REST settled the litigation in 2020 by agreeing to take steps to ensure that financial risks posed by climate change and other relevant ESG risks were measured, managed, reported on and disclosed to members. REST also agreed to use a variety of mechanisms to assess and, if necessary, take steps to improve its investment managers compliance with climate change and other ESG risks.19

Social

Recently, several social movements have been sweeping the world including the #MeToo and #BlackLivesMatter movements.20 These social movements are also driving changing attitudes to corporate governance with directors and management recognising the risks to their businesses from not addressing them. Directors and managers who ignore the implications of these movements do so at their peril, and failure to act damages both directors and their companies. As advisers to directors and managers, lawyers must also understand the implications.

#MeToo has directly led to a focus on sexual harassment as a workplace health and safety issue and on removal of sexism and misogyny. In this context, a clear failure was AMP’s promotion of a senior executive to chief executive of its offshoot, AMP Capital in 2020. The promotion came after settling a claim of sexual harassment against him by a more junior employee. AMP said the harassment was “at the lower end of the scale”. The AFR reported that the executive was promoted because “he made a lot of money for the company”.21 Even though AMP had the claim externally investigated, AMP’s handling of the complaint and the promotion of the executive, led to investor and shareholder pressure for him to be removed. As result, the executive was demoted, AMP’s chair resigned, AMP’s reputation was tarnished, and AMP Capital suffered a 7 per cent decline in assets under management.22

In Australia, the #BlackLivesMatter movement translates as preventing discrimination and racism, and improving Indigenous engagement and advancement. Another example of absolute failure to recognise societal shifts in attitude was Rio Tinto’s destruction of the 46,000 year old Juukan Gorge caves, against the wishes of the traditional owners, the PKKP. The subsequent outcry led by shareholders such as AustralianSuper and Hesta resulted in a parliamentary inquiry, and the resignation of the chair, CEO and other senior personnel. It is not just listed companies that are affected by these societal changes – note the resignation of Eddie McGuire due to his statements at the press launch of the Do Better Report into racism at Collingwood Football Club and the subsequent acknowledgements by coach Nathan Buckley.23

Governance

The third limb of ESG is governance – the rules and systems by which companies are governed and make decisions, and manage risks to the business. Good governance aims to foster the long-term growth of the business because consumers, shareholders and other stakeholders trust the business and its processes, products and services.

Rio Tinto’s Juukan Gorge destruction can also be seen as a failure of governance. Rio Tinto’s internal processes led to the wrong decision being made. Rio Tinto had obtained lawful authority to destroy the caves – it had asked the question “Can we legally do this” but it evidently did not ask the question “Should we do this?”. If it did ask that question, Rio Tinto’s decision-making processes failed to answer it by taking into account the importance of the views of key stakeholders: the PKKP, investors and the wider community. At the very least, it failed to properly take into account reputational risk.

How governance works in practice is often a reflection of the culture of the business. Often, these types of governance failures are a result of a corporate culture that sees managing risk as merely a process and a “tick the box” exercise (ie, has someone “ticked the box” that they had considered the relevant risk, rather than engaging with that decision). Rethinking how risk management needs to be embedded in the business’s culture also gives the business opportunity to embed ESG considerations as part of asking “Should we do this?”. A company’s governance systems need not only produce directors and managers that ask the question “Should we do this?”, but also have the tools to answer that question appropriately.

ESG Credibility: Measurement of performance

Directors and managers are increasingly aware of ESG, but turning that awareness into a plan of action and measuring progress and success can be difficult. ESG performance can be harder to measure than more objective matters such as financial loss. How well directors and management are dealing with ESG issues material to their businesses is sometimes called the “Responsibility Factor” or the “R Score”. There are diverse approaches to how stakeholders and investors measure ESG, but there is an increased importance of third party ESG ratings and benchmarking against externally created standards, such as those developed by the Sustainability Accounting Standards Board. Given the difficulty in measurement of ESG performance, communication with stakeholders about the business’s engagement with ESG is critical. To inform those communications, directors need audits and reviews of their ESG performance.

How does this all play out?

Businesses are led by the “tone from the top” – what employees see the directors and senior managers prioritising. The more that directors cascade responsibility for ESG within their business processes and culture, and use remuneration structures to reward implementation of their ESG strategy, the better ESG risks will be managed by the business. Not only will they be “doing well by doing good” but it should lead to fewer problems being identified in finance and M&A due diligence and to better ESG scores from third parties.

Increased communication via Twitter, Instagram and TikTok means increased public awareness of ESG failures by directors and management – this is not going away. There is nowhere to hide for directors who fail to address ESG issues and who fail to embed into their management of risk, and into the company’s culture, a clear focus on ESG.

This article was initially published by Gerry Bean in the Law Institute of Victoria’s Law Institute Journal – July 2021.