ESG Olympics: is bronze the new gold?

In this three-part series we explore the incentives and disincentives for achieving green goals in light of directors’ duties, brown penalties and ‘greeniums’. We also question whether aiming for a “gold only” ESG medal table is truly achievable for any country in isolation.

Governance: are we doing enough to put the “G” back into ESG?

You would be forgiven for thinking ‘yet another paper on ESG’ as you open this article. ESG fatigue faces many of us, yet global carbon emissions have risen from 25 billion tonnes in 2000 to 37 billion tonnes in 2022. 

The recent ruling by the European Court of Human Rights (ECHR) that a right to private and family life means that contracting states are obliged to protect their citizens from the “serious adverse effects” of climate change has also firmly brought the “governance” aspect of ESG back into the spotlight. A similar advisory opinion was issued by the international tribunal for the law of the sea and the International Court of Justice has also been tasked with giving its views on the legal duties of a state with respect to climate.

How often though do we stop to think about what those letters actually stand for? Let’s start with the alphabet. “ESG” is not a word; it’s shorthand for three distinct concepts.

If a company is polluting the environment, that is an “E”, environmental. If there is modern slavery in a supply chain, that is an “S”, social. It is the “G”, the governance, which pulls it all together. Governance is how an entity conducts itself, what its policies are, what its culture is. It is, all at once, the pillars of integrity, transparency, responsibility and effective risk management, which support the good governance of an entity.

The ECHR ruling suggests that governments need to do more than virtue-signal environmental policies. Contracting states must, it stated, implement measures for the “substantial and progressive” reduction of emissions with a view to reaching net neutrality within the next three decades, or risk failing to protect their citizens. To achieve this, they must act “in good time, in an appropriate and consistent manner”.

Whether or not the ECHR has jurisdiction to make this ruling is up for debate. Some see it as a welcome, and even inevitable, extension of social views on climate change, whilst others note the intrusion into state sovereignty and democratic decision making with concern.

If we put that to one side for the moment, what is clear is that we need to reduce emissions and surely at some point, if a country fails to do so, to the detriment of the health of its citizens, should it not be held accountable? How though do we measure which actions lead to a “substantial and progressive” reduction of emissions?

“Substantial and progressive” action

Take the UK government as an example: plans are already in place to reduce all direct emissions from public sector buildings by 75% by 2037 (against a 2017 baseline). Direct emissions from public sector buildings however account for a mere 2% of UK emissions. Whilst every percentage counts, this is not where the biggest impact is to be had.

If the remaining 98% of UK emissions are outside of the public sector, then we need to look at individual companies to ensure that they are run “efficiently” - and we are not talking about reducing headcount, we are talking about environmental efficiency and ultimately the reduction of emissions.
In a recently-published opinion¹, the authors (a leading group of barristers) argue that directors owe a duty to consider nature-related risks (and inherent within that also environmental harm) in their actions. This is based on Sections 172 and 174 of the Companies Act 2006 (CA).

Section 172 requires a director to “act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole”.

Section 174 continues with a requirement that a director must “exercise reasonable care, skill and diligence”.

Adopting this reasoning, they argue that a company must have regard to its impact on the environment and that a failure to properly take account of this in decision making risks breaching this duty.

Yet what isn’t clear is what standard directors should be held to in “promoting the success of the company”. How do we look back and judge one company’s efforts to reach net zero against those of another company and determine what the appropriate benchmark is? Hindsight is, as they say, often 20/20.

Since the early 1990s a director’s duties, or rather the standards they are held to, are assessed both by reference to their own knowledge, skill and experience and by that which could reasonably be expected of a person carrying out that same function. We also know that “the law may be evolving in response to changes in public attitudes to corporate governance”.
In Antuzis v DJ Houghton Catching Services Ltd² a director’s failure to comply with statutory obligations in the pursuit of profit for the company exposed the company as a “pariah” and the director to personal liability. Chasing profits at the expense of the environment may well at some point become as morally unconscionable as neglecting workers’ rights in the pursuit of profits.

But we are not yet there. The statutory obligations with respect to environmental considerations are aspirational, often vague and mostly lacking in clear obligations. Unless they are more clearly stated in law it is hard to envisage directors incurring personal liability.

The missing claimants

Even if we can come to a consensus on what a director’s duty in the context of environmental risks entails we still need to consider those to whom those duties may be owed.

The obligations under section 172 and 174 of the CA 2006 are owed to the company itself. When breached a claim can only be brought by the company following a decision of its board of directors, or, upon insolvency, by the company’s liquidator or administrator. Under section 212 of the Insolvency Act 1986, a creditor may also be entitled to apply for an order that a director breached their duties.

Directors are perhaps unlikely to take action against one of their own and there would be limited circumstances where an insolvency officer would make such a claim for breach of environmental duties unless these obligations were clearly expressed in law. There’s also the inevitable problem that by then the damage is already done.

There is the possibility of derivative actions, but recent case law shows how difficult it can be to establish a derivative claim as a shareholder.

The financial services industry

When most people think about a company, it is probably either a small, family-run business or a large multinational, often even a household name. What they likely don’t envisage are the banks, asset managers, lenders, private equity houses and investors that make up the financial services industry.

Financial services companies don’t operate like a traditional company. Banks in particular have systemic importance and the inter-related nature of their relationships mean a relatively small shift in one area can ripple across many others. This adds complexity to a desire to take environmental factors and nature-related risks into account in decision making.

If there is to be a “substantial and progressive” measure to reduce emissions, it cannot be based on an uncertain duty of care owed by directors where the standard they are held to is unclear and constantly evolving.

The way forward

The Better Business Act seeks to amend Section 172 of the CA 2006 to ensure businesses are legally responsible for benefiting workers, customers, communities and the environment. If that were to become law, and a consequential change were to be made to Part 11 of the CA 2006 allowing such individuals to bring a derivative claim, then the “G” would become more prominent for all companies, not just those positively aligning themselves with “green” credentials.

Whilst commendable from a social perspective, the lawyers in the room will be deeply concerned. What does “benefiting” mean in the context of say, a bank. Should they simply divest themselves of all fossil-fuels and brown assets, even at the expense of risking the stability of their balance sheet? The answer must be no; rash decisions to focus on one goal have inevitable consequences on other areas (like the mountaineer who prioritises reaching the summit over allowing enough time for a safe descent). If there is to be a duty owed to the wider public regarding the environment then governments, as the custodians of the public interest, are surely the institutions that should implement such requirements. Any such legislation needs to set clear requirements, rather than just objectives and aspirations.

A study from WWF and Greenpeace in 2021 assessed the emissions associated with the global investments held by 15 British banks and 10 asset managers. Their investments, at that time, were responsible for emitting 805 million tonnes of carbon per year. If the financial services sector was a country, it would rank 9th in the world for carbon emissions and ahead of, for example, Germany. The assessment included traditional loans, investments in sectors including IT, energy, industry, and mortgages, but excluded insurances and property investment.

Even if we consider these data limitations, it is clear that driving change in the financial services industry is of critical importance if we are to achieve any environmental targets. We cannot ignore the financial services industry if we are to achieve net zero targets - we must, as they say, follow the money.

How regulators are approaching this is the subject of part two in this three-part series, “The blind spot”.