Alan is a director of a number of Canadian public companies. The opinions in this post are his alone.
There are a wide range of definitions of what ESG means in the investment and corporate performance process. I like the following from Gartner: “Environmental, social and governance (ESG) refers to a collection of corporate performance evaluation criteria that assess the robustness of a company’s governance mechanisms and its ability to effectively manage its environmental and social impacts. Examples of ESG data include the quantification of a company’s carbon emissions, water consumption or customer privacy breaches. Institutional investors, stock exchanges and boards increasingly use sustainability and social responsibility disclosure information to explore the relationship between a company’s management of ESG risk factors and its business performance.
What is most interesting about ESG and ESG performance measures is that almost be definition, ESG measures and strategies go beyond legal requirements. No one bothers to report or is much concerned with “met the legal requirements for effluent release or carbon emissions”. There would be significant consternation in the board room and amongst shareholders if companies did not comply with law and regulation and obviously adverse consequences would occur to executives if non-compliance were viewed as wilful or negligent.
However, if we examine almost all of the ESG criteria that are espoused by entities such as BlackRock, they relate to elements of business strategy that are not required by law.
For example, while there have been many public expressions by governments and corporations of a commitment to “net zero by 2050”, very few of these public expressions have been translated into law and regulation that have any significant chance of having the desired effect. The desired effect is itself most likely illusory as the depth and breadth of regulation, consumer behaviour and technological change has been shown to be well outside the bounds of realism. Governments have been very reluctant to prescribe the kind of drastic requirements that the IEA has noted, as there would be widespread revolt by the voters.
Therefore, the climate measurements and goals that are included in corporations’ strategic and business plans that might be incorporated into compensation measurements are subject to a very wide degree of interpretation beyond the law. Blackrock is clearly a very influential player in the determination of what ESG measures and goals should be considered by corporations to be “acceptable”. Given that BlackRock is a fiduciary for its unitholders, by definition they must believe that the various causes that they espouse will improve the sustainability and shareholder value of each of the companies that they own a part of. And because BlackRock is the largest ETF provider in the world, they own almost everything.
However, Boards of Directors cannot simply take BlackRock’s word for what is important to sustainability or long-term value for their specific corporations. Boards have an obligation to utilize their own judgement. Boards must weigh the costs and benefits of taking on extra-legal obligations and make the same kind of financial analysis that they might bring to any other kind of investment. In addition, they will have to determine which of many causes really will make a difference, in present value terms to the cash flows of the enterprise, given the required investment.
Much has been made in the past of the Board’s responsibility to various “stakeholders” rather than exclusively to the shareholders of the corporation. Recent changes to the Canada Business Corporations Act have attempted to codify this responsibility. However, these codified changes (and the case law that precedes it) does not give much, if any guidance to Boards where the potential interests of the various stakeholders collide. For example, a “living wage” policy could (in certain circumstances) be of benefit to some existing employees but could discriminate against future potential employees who would not be employed due to technological substitution. Boards will inevitably fall back on what is in the best interest of the corporation, which will lead to longer term value and sustainability of the business. It is not possible to consider the best interest of the corporation with out considering its reputation in the capital markets and its ability to raise capital for growth.
My point here, is that ESG goals are subject to a wide range of interpretation and must be considered by Boards of Directors in the circumstances of the individual company, and such matters cannot be sub-contracted to BlackRock or any of the other arms merchants in the ESG industry.
Translating ESG Goals to Compensation
There are a wide variety of ESG goals and measures. For example, the Bloomberg ESG Data set includes at least 120 measures.Companies cannot expect that any change in direction or performance can occur by having executive compensation focus on more than a very few measures that are most materially supportive of value and sustainability.
Many of the measures that various ESG rating services examine are, in my view, likely to be viewed as “table stakes” for corporations and to a significant degree under the control of the Board of Directors rather than executive management. Most of the (G)overnance elements of ESG will likely fall under this definition and may not have much space in compensation discussions.
Environmental and Social issues will be of significant interest and influence from management, however. The Board of Directors will have to determine, with management, which issues are most significant to the corporation and which will have near term effects on the value of the company. Many of the flavours of 2020/2021 such as Black Lives Matter and State voting regulation in the United States will be extraordinarily difficult to translate into value. While CEO’s, especially in the US have taken to commenting and committing their organizations to such causes, it would be difficult to see how these translate to value and even how they might translate in an unequivocal way to reputation enhancement. Particularly in the United States, the polarization of politics makes reputational assessment difficult outside of the main East and West Coast cities.
In the past, companies have focused on more measurable and directly relatable measures to include in compensation focus. For example, it has long been a part of the compensation structures of extractive industries and heavy industrial companies to measure and compensate based upon safety record, including employee and contractor safety and effluent release. I am assuming that with the renewed focus on ESG, these more traditional measures will not be downplayed.
Compensation systems address both short term and longer-term performance of the company. Other than for the range of measures that are already prevalent, many of the ESG measures will have a much longer effect upon the performance of the company. For example, it is extremely difficult to focus management’s attention on climate change as a short-term driver of value (or avoidance of value destruction). For most companies, the near-term effects of climate change are minimal. However, in the medium to longer term, the political risks of climate change regulation are likely to be much more significant (assuming that at some time regulation catches up to the rhetoric). So, including climate change measurements in compensation structures can be justified, not likely in net present value effects, but in reputational issues that may moderate the more aggressive and ill-informed regulatory pressures. In addition, such measures may have the effect of making interested shareholders more content with the alignment of their interests. And this is all in the context of these measures being outside of the regulatory and legislative framework, as I explained earlier, no one needs to get paid for simply following the law.
With all of this, Compensation Committees of the Board have a difficult job. Directors are viewed to be fiduciaries under the Canada Business Corporations Act, but jurisprudence (under the previous version of the Act) did not give significant guidance to how directors should act in the best interest of the corporation and balance the various views and interests of the stakeholders. Clearly shareholders (including the ubiquitous Blackrock) are important, but other constituencies can and must be considered. The compensation structure of the corporation is one of the more direct ties that directors can make to the long-term sustainability of the corporation.
It is extremely unlikely that earnings, free cash flow, leverage, growth, and risk profile will not collectively continue to play the biggest role in short term compensation. And in medium and longer-term compensation these elements, plus absolute or relative TSR will continue to dominate. Traditional ESG measures such as safety and environmental compliance, community support will also have their continued place. It is hard to imagine that responsible directors will weight these elements less than 90% to 95% of the variable matters in compensation, short, medium, and longer term.
In my view additional elements that go beyond legal compliance will have great difficulty in making up very much of the compensation envelope. Because of this, I believe that Boards of Directors will look more to their public and government relations staffs to decide which additional elements to highlight.
But shareholders should not confuse what is really happening here. This will mostly be a dance for Blackrock et. al.
 Total shareholder return