The global COVID-19 pandemic is driving even greater scrutiny of environmental, social and governance (“ESG”) topics that have gained prominence in recent years. In particular, proxy advisors and shareholders—both index funds and active managers—are emphasizing employee health and welfare, risk oversight, succession planning, capital return decisions and executive compensation constraints to reflect the COVID-19 environment.
These evolving priorities align with those of the “Big 3” index funds, who in the early days of 2020 laid out their most prescriptive set of ESG expectations ever. More recently, the index funds have acknowledged the near-term implications of COVID-19 but have affirmed their heightened expectations of boards and management teams with regards to ESG.
Against this backdrop, investor support for ESG-related shareholder proposals has increased in recent years, and the convergence of ESG into shareholder activism and M&A continues.
On balance, ESG appears likely to continue to rise in significance, with implications for boards and management teams beyond the immediate public health crisis, through the rest of 2020 and beyond.
Sharpening focus on the “S” in ESG
While the “E” in ESG – environmental issues including climate change – has garnered relatively more attention in recent months and years, expect COVID-19 to also solidify the “S” agenda going forward.
Business continuity, employee health and welfare and long-term strategic planning have been key areas of concern for corporate boards, particularly during the crisis. We expect that shareholders and proxy advisors are likely to critically assess boards’ performance on these issues, including human capital management, risk oversight, succession planning, capital allocation and executive compensation. For example, proxy advisors have recently highlighted the importance of succession planning, given the potential impact of COVID-19 on individual leaders. And governments and shareholders alike will be scrutinizing judgments made around tradeoffs involving furloughing and workforce reductions versus executive compensation and return of capital.
The “Big 3” Index Funds Raise the Bar on ESG
In Larry Fink’s annual CEO letter in January, he placed sustainability at the center of BlackRock’s investment approach and mandated a year-end deadline for companies to align their ESG reporting with SASB standards. BlackRock subsequently released an updated set of proxy voting guidelines that add teeth to its ongoing engagement priorities, and then reported an intensive effort to engage companies on their responses to COVID-19. While BlackRock acknowledges that companies may need to reallocate resources to address immediate priorities in the near-term, they have signaled that they expect a return to focusing on sustainability reporting in due course.
In particular, in 2020 BlackRock will vote against directors for reasons that include failing to identify which independent director(s) are accessible to shareholders, making inadequate disclosures on sustainability issues, failing to align pay outcomes with long-term performance metrics and failing to disclose the board’s role in overseeing the company’s human capital practices.
State Street Global Advisors will also now be voting against nominating and governance committees at companies where SSGA has had board gender diversity concerns over four consecutive years without “productive” engagement. SSGA also plans to vote against directors at large-cap companies that are deemed laggards relative to peers on SSGA’s proprietary ESG scores (“R-Factor”, which relies on the SASB framework). These expectations appear to persist in the COVID-19 environment – SSGA reiterated in a recent note related to the crisis that “we continue to believe that material ESG issues must be part of the bigger picture and clearly articulated as part of your company’s overall business strategy.”
Further, Vanguard has enhanced its call for clear, comparable, consistent and accurate environmental and social disclosures in the context of a board’s risk oversight process — essentially SASB-aligned reporting. Vanguard also will vote in favor of ESG shareholder proposals that address perceived shortcomings relative to market norms and key competitors’ practices, reflect an industry-specific, materiality-driven approach and are not overly prescriptive. As the pandemic unfolded, Vanguard publicly recognized the need for companies to balance short- and long-term considerations – and also affirmed that it remains “keenly focused on risks …that can erode a company’s value over time, such as social and environmental risks. In particular, climate change presents a pressing and concerning risk to long-term shareholder value.”
Active Managers Weigh In
The index funds are not the only investors highlighting ESG in the face of the global pandemic. Prominent active fund managers have recently reaffirmed their focus on ESG as part of the active management process.
For example, in a note titled “The World is Watching”, Wellington described how it is assessing companies’ responses to the COVID-19 crisis, highlighting employee safety and benefits, supply chain impacts and other stakeholder issues. And Neuberger Berman recently stated its intention to become the first major asset management firm to disclose its votes in certain instances prior to the annual meeting, with a focus on ESG. In support of this initiative, the fund stated that “sustainability practices will increasingly matter and can directly impact both long-term performance and resilience in future crises.”
ESG in Activism and M&A
M&A and activism may be less robust in the near term. However, ESG is likely to be highlighted in M&A transactions and in activist campaigns when the markets return. Prominent activists have already begun to highlight ESG in recent years, including hiring ESG experts, perhaps in an attempt to gain support from index fund and ESG-focused shareholders and proxy advisors. Support for ESG shareholder proposals averaged 46% in 2019, up from 27% in 2015, demonstrating the shift in pro-ESG shareholder sentiment. Moreover, ESG is increasingly highlighted in M&A due diligence and valuation discussions. We expect the pre-crisis trend line of heightened focus on ESG in activism and M&A will continue to increase.
Implications for Boards
• First, boards are well advised to weave oversight of sustainability strategy and ESG issues into the annual board agenda. Boards should be prepared to comprehensively disclose their approach to oversight and ensure at least one director is well-positioned to articulate the board’s role in ESG oversight in shareholder conversations. This is especially relevant in the context of COVID-19, in light of the extremely difficult judgments that boards are making today.
• Second, investors are coalescing around SASB as the favored ESG reporting framework. Shareholders also are seeking enhanced reporting of financially material, comparable, industry specific ESG data. These developments will become part of the disclosure landscape – and investors will expect progress on these fronts, notwithstanding the global pandemic.
• Third, index funds are under considerable pressure to be more transparent in their voting and engagement efforts. This dynamic translates into index funds’ efforts to demonstrate oversight and accountability– including through public rebukes and votes against management and directors on an expanding set of issues.
• Finally, given these ESG and shareholder dynamics, companies must maintain and evolve their engagement strategies, including at the board-level, as part of a comprehensive, strategic approach to investor relations. This effort should include preemptively and strategically positioning the company’s approach to ESG in advance of potential activist activity or M&A in a post-COVID-19 world.
