ESG in 2021 So Far: An Update | Skadden, Arps, Slate, Meagher & Flom LLP – JDSupra JD SupraESG in 2021 So Far: An Update | Skadden, Arps, Slate, Meagher & Flom LLP – JDSupra JD SupraESG in 2021 So Far: An Update | Skadden, Arps, Slate, Meagher & Flom LLP – JDSupra JD Supra
Impact Investing Forum 2022
London. April 28-29, 2022.
Companies based in the U.K. or Europe continue to be influenced by the rapidly increasing focus on environmental, socio- and governance (ESG). ESG is being discussed at all levels: from the boardroom to investors and employees to regulators and companies. We identified the top ESG trends we believe will be important this year in our article “ESG: Key Trends 2020 and Expectations 2021”, published on February 1, 2021. This article reviews those predictions, discusses new issues, and identifies the trends that we believe will be most prominent in the remaining 2021. Looking Back: Correct Predictions Many of our key expectations from the beginning of the year were realized. ESG Funds1 The first quarter of 2021 saw inflows to European “sustainable” funds reach EUR120 billion. This is 18% more than the quarter of 2020 according to Morningstar. This represented slightly more than half the total fund inflows for this year. EUR36.5 billion was spent on passive index and exchange traded funds (ETFs). Despite this growth, there are concerns that passive funds will struggle match the service provided to active managers. This is due to (i), the subjectivity involved with determining appropriate ESG credentials and reporting, and (ii), the ease with which active mangers can react to controversy, compared to passive ETFs which must wait for an Index Committee review before changing investments. The Financial Conduct Authority (FCA), in the United Kingdom, issued a warning to all active and passive ESG funds that there was a need to improve. The FCA issued a Dear Chair letter stating the guiding principles for the products. Despite the FCA stating that it welcomes innovation in the market, there are some concerns about the rapid pace of change. The FCA is particularly concerned about the poor quality of fund applications it has received and the potential impact this may have on consumers. The FCA’s guidelines are based upon three principles. (i) The design and disclosure of the fund’s ESG strategy should be accurately reflected in the documentation. (ii). The fund’s implementation of its ESG strategy should be adequately resourced and consistent to its objectives. (iii). Investors should be able to easily access and understand the ESG-related information provided by the fund to help them make investment decisions. The impact of these new guidelines on the ESG fund application process will be particularly interesting over the next few weeks. The Sustainable Finance Market2 We predicted in February 2021 that the green bond market would explode. According to the Climate Bond Initiative, the global issuance of green bond is expected to reach between $400 billion billion and $500 billion by 2021. This is nearly twice the record of $270 billion set in 2020. In addition, $54 billion was invested in ESG bonds funds in the first five month of 2021. The sustainable finance market has expanded beyond green bonds. Although non-investment-grade sustainability-linked notes only appeared for the first time in March 2021, they have proved popular in Europe, with EUR3.44 billion worth issued by June. Nearly two-thirds of the widely syndicated leveraged loans in Europe contained an ESG pricing mechanism in Q2 2021. This allows the debt to be adjusted for ESG-related performance. This is a significant development considering that ESG pricing rates were not a common investment grade phenomenon in 2020. This market’s growth is due to both investors’ increased focus in ESG and the attractiveness of green debt for governments and companies. It is difficult to measure this so-called “greenium” due to the rare issuance of both green and conventional instruments concurrently. There is an easy comparison in Germany where the benchmark green bond yields around 0.05% less than its conventional twin. Investors have accepted the lower return on the green Bund, despite the fact that the pricing is the same as standard bonds. This has raised concerns that the market may be a bubble just waiting to burst. As the market shifts beyond investment grade products, there are also concerns about “greenwashing”. Many green instruments, for example, do not contain terms that limit the use of proceeds. Instead, they state that the issuer may be unable to use the proceeds for the purpose intended. This gives borrowers a way out and raises questions about the validity of the “green label”. The International Capital Market Association updated its social bond and green principles. They are the global standard for a $1.6 billion market. This has increased transparency. These principles recommend a framework, an external review of key performance indicators (KPIs) that are used to measure sustainability achievements, and more information at issuer level to increase investor confidence. To be labeled a “European Green Bond”, the EU will also require more stringent rules regarding impact reporting and external reviews. Although issuers will need extra effort to qualify for this designation, the goal is to lower borrowing costs as investors are willing to pay more for ethical quality. (We will discuss greenwashing in the last section. ESG Activism 3 Activists of all kinds pressed companies to address ESG issues aggressively this year, as predicted. Globally, there were 169 ESG shareholder propositions in the 2021 annual meeting season. These proposals have received support of nearly 34% of shares voted. This is mainly due to fund managers who are increasingly vocal about their support of ESG proposals. Comparatively, there were only 171 resolutions filed in 2020, with support averaged less than 29% of votes. The most attention was paid to ESG challenges to “Big Oil”. Engine No. 1 was the most prominent activist hedge fund. Exxon Mobil’s board elected three directors and sponsored two shareholder proposals. All of these were rejected by the board. One proposal required an annual report on lobbying. The second requested a report detailing how lobbying efforts are aligned with the goal to limit global warming.4 A Hague district court ruled in favor of climate campaigners challenging Royal Dutch Shell’s emissions policy. The company must take more action to meet the Paris Climate Goals. BP successfully defended a call to increase action on climate change in the U.K. However, the resolution received 21% votes. This means that the company will need to return to investors to address their concerns, as per the U.K. Corporate Governance code. Some commentators argue that Engine No. Engine No. 1 was only possible because of Exxon’s ESG performance and financial performance. This makes Exxon a traditional activist target. Others have argued that shareholder pressure may not result in a reduction in oil and gas use or emissions from production, but that it may just result energy assets being sold. Even if listed companies make divestments to meet their carbon emission targets, there are still plenty of private and public buyers who will purchase these assets. The impact of such activism may be overstated. Public companies hold only 12% of the world’s oil and gas reserves. The past six months have seen a shift towards ESG activism. Big Oil is not likely to be the only focus, as other investors and campaigners push for ESG issues. Numerous companies have been asked to disclose their race and gender diversity figures. Activists also requested information on Hugo Boss’s supply chain. Executive Remuneration5 Executive pay has been a contentious topic for 2021. PwC found that executive pay at the U.K.’s largest companies fell by almost a fifth due to companies responding to warnings from institutional investor that they expected remuneration would reflect the pandemic’s impact on stakeholders. This was the case for Foxtons and Morrisons. A significant number of shareholders voted against the companies remuneration plans, especially if they received government support during the pandemic or raised emergency cash, and/or experienced a significant fall in share prices. The U.K.’s approval for remuneration resolutions fell to an eight year low, but support remained at 91.4%. Shareholders who voted against such policies were reluctant to vote against those responsible for making these decisions. Proxy Insight found that less than a fifth of the companies that had to face a revolt over their pay reports (defined as at least 20% opposition) faced resistance to the appointment or removal of one or more directors. This is because the opposition to pay packages made little difference. EU Sustainable Finance Disclosure Regulation (SFDR)6 Six months on from the initial implementation of EU Regulation 2019/2088 on sustainability-related disclosures in the financial services sector, many firms are still adapting to the obligations and requirements. There are still questions about how certain obligations will be applied to entities that are not part of the European Economic Area (EEA). There is still no guidance on the scope of the obligations, including whether a financial product that incorporates ESG factors in its decision making process falls within the scope SFDR Article 8. This article sets criteria for ESG funds. Additional regulatory uncertainty exists because many of the obligations under SFDR are intended to be detailed in regulatory technical standards (RTS). Although a draft RTS was published by the Joint Committee of European Supervisory Authorities on February 2021, it was not finalised and the date of implementation was delayed from 1 January 2022 until 1 July 2022. Firms must comply with certain SFDR disclosure obligations, but they don’t know if they will be compliant next year. UK ESG Disclosure The FCA published an initial consultation on ESG disclosures by asset mangers in the U.K. that was consistent with the requirements of the international Task Force on Climate Related Financial Disclosures (TCFD). Asset managers’ obligations are due to enter into force in January 2022. They will not apply to firms with assets greater than GBP5billion. These obligations are more narrowly defined than those under the SFDR and will only apply to firms with assets greater than GBP5 billion. They also place a greater emphasis on climate-related disclosures rather than on governance and social factors. The FCA recently stated that it will be focusing on ESG funds. This will include how information about ESG investment strategies is disclosed and other related information. The FCA indicated that it does not believe there is a need for new rules in this field, as regulated U.K. companies are already subject to strict standards of disclosure. Biden Administration ESG Policies7 From the beginning, it was clear that the Biden Administration would have a different approach to climate change/ESG matters than the Trump administration. This has been reflected in a variety of actions taken by different parts of government. In March 2021, for example, the U.S. Department of Labor declared that it would review and not enforce rules from late 2020 that had raised questions about whether pension funds could consider ESG issues in their investment decisions and voting decisions as shareholders. This uncertainty may have contributed in part to the record-breaking support for shareholder proposals related to environmental and social (E&S), which received 34 E&S proposals from majority shareholders. This is up from the previous record of 21 supported propositions in 2020. These votes will likely result in enhanced corporate policies and disclosures over the course of the year and into 2022. They also may alter the calculation for companies that receive shareholder proposal later this year for their annual meetings in 2022. The U.S. Securities and Exchange Commission (SEC), announced recently that it will be drafting new ESG rules over the next few months. SEC Chair Gary Gensler stated in a June 2021 speech to London City Week that he had asked staff to make recommendations for mandatory disclosures “around governance strategy, and risk management related climate risk” and about human capital disclosure. These metrics could include metrics on workforce turnover and training, compensation, benefits, workforce demographics, health and safety, and compensation and benefits. In a speech in July 2021, Chair Gensler stated that he had asked SEC staff for a proposal on climate risk rules to be considered by the SEC by 2021. Acting Chair Allison Herren Lee sought public comment before he assumed office on climate change disclosures. More than 550 comment letters were submitted. The SEC’s June 2021 regulatory agenda reflects the SEC Chair’s focus on ESG issues, including disclosures about corporate board diversity, climate change and cybersecurity risk governance. Although the SEC rulemaking process will likely continue into 2022, it is likely that enhanced corporate disclosures will be made in response to investors and other stakeholders in the near term. New Areas of Interest Tech, Data and ESG8 Investors have shifted their investment to technology and have gotten rid of fossil fuel-based holdings. ESG-focused ETFs that are large have a lot in common with tech-sector ETFs. Alphabet, Alphabet, Apple, Microsoft and Alphabet are just a few of the top holdings. As the technology sector develops and data becomes more valuable, it will be important to ensure that the industry is still considered ESG-friendly. Cybersecurity has been identified as a critical governance concern when evaluating investments. This concern has only been increased by the shift to remote work during the pandemic. Apple and Microsoft, two of the largest tech companies, have resisted calls to disclose ESG issues in SEC filings. These companies argued that such information could expose them to legal risks due to the current difficulties in quantifying ESG data. Despite the fact that both companies are sustainability leaders and have greatly benefited from the ESG boom, this reluctance has been evident. Microsoft is, for example, the most popular company in the U.S. ESG funds. The environmental impact of cryptocurrencies has been under increased scrutiny. Greenidge Generation was sued for its planned expansion and purchase of a New York State power plant to mine Bitcoin. Elon Musk, Tesla’s chair, commented recently on the industry, saying that “cryptocurrency” is a good idea from many angles and has a promising future. However, this cannot be done at great expense to the environment. It remains to be seen if environmental concerns will impact the growth of cryptocurrency. Looking Forward: Our Expectations for the 26th United Nations Climate Change Conference of the Parties (COP26), will still be held in Glasgow in November 2021. Many participants are preparing to discuss the progress since the 2015 Paris Agreement as well as the next steps. The Climate Change Committee (CCC), which is the government’s environmental advisor, has criticised the U.K. government for not combining rhetoric with concrete action as the COP26 host. The committee complained that key sectors plans had been repeatedly delayed and that there was a lack in strategy over the past twelve months, according to a CCC report on decarbonisation. This was just one week after a CCC assessment of climate risks in the U.K. found that the government had done little preparation for the inevitable dangers of climate change. These have increased pressure on the government to act in the months preceding November. Greenwashing concerns10 Greenwashing remains a major concern for ESG investors as well as regulators, as we discussed above. The U.K. Treasury formed a new panel called the Green Technical Advisory Group (GTAG) to establish the criteria for financial investments that are environmentally sustainable. This was created out of concern that investors don’t have enough information to understand their investments’ environmental impacts. The U.K government opted not to adopt the EU’s taxonomy regulation – its framework for classifying environmentally-sustainable economic activities, which comes into effect in 2022 – and it is not yet clear what approach the GTAG will take. The FCA’s Dear Chair letter to fund managers sets out its investment principles, with a special focus on greenwashing and how to avoid it. Consistency seems to be the overriding principle, which includes fund names, objectives and policies, as well as strategies and strategies. The FCA letter contained specific examples of greenwashing. These include passive funds with ESG-related name making investment decisions based only on high-level criteria, and funds that claim to have a positive environmental impact but invest in low-carbon companies instead of those contributing to a net zero transition. These measures will have a greater impact on the U.K.’s market in the coming months. ESG and Board Composition11 Equity, diversity, and inclusion have been at the forefront of many developments, but there have been constant reminders of how much work remains to do. In the U.K., more than half of the directors appointed to public company boards were women in 2020, but more than 80 percent of those appointees were of white descent. A large number of these positions were non-executive directorships and very few women were able to gain the top executive positions. The FCA announced a new proposal at the end of July that would force U.K. companies into ensuring that at least 40% are women on board directors. Companies would be required to “comply” or explain why they have not met the new diversity targets for gender representation and ethnic minorities. These targets are not mandatory but will allow companies to measure their success in bringing more diversity to their senior management. The FCA will consult on these proposals, with the market’s response likely influencing the FCA’s plans for the next six months. Flexible Working12 Employers have struggled with issues related to work force during the pandemic. As the world is facing new COVID-19 variants and increased surges, it has been difficult for governments and businesses to create guidelines for returning employees to work. The “new normal” may be here, with a complete return to work varying depending on the role and employer and rules constantly changing in response to the nature of the pandemic. It seems that hybrid work is becoming the norm in many industries. This creates new problems. According to English law, employees can request flexible work if they have been employed for 26 weeks or more. Employers must also respond in a “reasonable” manner to requests. Because many employees have worked flexiblely for the past 18 months, it may not be reasonable to refuse new flexible work requests. Reputational factors also play a role. Employers’ willingness to accept flexible work patterns is seen as a sign of commitment to diversity and inclusion initiatives. Flexibility-oriented employers are seen as more committed to gender diversity at senior level. It is important to remember that it has been the most practical and widespread option to work from home in professional and other office-based industries. The proportion of U.K. employees who worked from home rose to 35.9% in 2020. However, this was only 9.5% more than 2019. The pandemic has not affected working practices for many people and industries. The return to work at the office is now delayed and it remains to be seen what long-term effects all these changes will have. Six months more of working remotely has led to increased conversations about the effects of isolation and remote work on mental health. According to some studies, almost one fifth of all adults in the U.K. are likely to experience depression during the pandemic. Employers should be mindful of their duty to care for employees. This includes their mental and physical health, as some employees claimed they worked longer hours due to blurring of their private and professional lives. In some cases, the impact of the new job arrangement on mental health could be considered a breach of duty of care. Employers may face claims for personal injury and constructive dismissal. Mental illnesses may in some cases be considered a disability under U.K. law. Equality Act 2010. Equality Act 2010. _______________ 1 Morningstar. “European Sustainable Fund Flows Q1 2021 in Review” (25 Jun 2021). FT Adviser. “Rise in ESG renews the debate over whether passive funds deliver” (25 Jun 2021). ICMA. “Green & Social Bond Principles 2021 Edition Issued” (14 Jul 2021). Corporate Counsel. “Sustainable finance: Green Bonds Shine – But It’s not Easy Being Green” (10 Juil 2021). Bloomberg, “BP dodges new climate targets as activist pressure grows” (12 June 2021); Bloomberg; “European Sustainable Fund Flows: Q1 2021 in Review” (25 June 2021); Financial Times,”How green are green bonds?” (2 June 2021); Forbes, “How green are green bonds” (2 June 2021); Covenant Review, “ESG Trendlines in European Leveraged Loans – Q2 2021” (14 July 2021); Bloomberg; Corporate Counsel, “Sustainable Finance: Green Bonds Shine -But It’s to zero” (15 June 2021). 4 See Skadden’s publication The Informed Board (16 juin 2021) for “What the Exxon Mobil Shareholder votes Mean”. 5 Financial Times. “UK chief executives suffer large pay cuts” (10/05/2021); The Observer. “Executive pay – big names that fell foul to shareholders” (26/06/2021); Financial Times. “Investors protest against large payouts for UK bosses (18/05/2021); Financial Times. “Why investor pay rebellions need to get personal” (2/06/2021). 6 FCA Consultation Paper CP21/17, Enhancing climate-related disclosures from asset-managers. Life insurers. FCA-regulated pension providers. June 2021. 7 U.S. Department of Labor. “US Department of Labor issues statement on enforcement of its final ESG investment rules, proxy voting by employee benefits plans” (10/03/2021); SEC Chair Gary Gensler. Prepared remarks at London City Week (23 juin 2021); SEC. “Public input welcome on climate change disclosures” (15/03/2021); SEC. Gensler. Prepared Remarks before the Principles of Responsible Investment ‘Climate & Global Financial Markets Webinar (28/7/0221); SEC Announces Annual Regulatory Agenda (11 June 2021). 8 Forbes, Data Governance: The Next Big ESG Controversy (4 February 2021); Bloomberg: “BlackRock’s record breaking ESG fund looks just as big tech ETF” (15 March 2021); SEC, “Public input welcomed on climate change disclosures” (15 March 2021); Gensler, Prepared Remarks Before the Principles for Responsible Investment ‘Climate and Global Financial Markets’ Webinar (28 July 2021); SEC, “SEC Announces Annual Regulatory Agenda” (11 June 2021). 9 Financial Times, “UK fails to match climate rhetoric with actions, advisor warns” (24 juin 2021). 10 Bloomberg, “UK tackles greenwashing with push to define sustainability” (8 juin 2021). 11 Financial Times, Women take half of UK board seat (9 June 2021); Financial Times: “UK boards face pressures to increase female directors under FCA Plans” (28 July2021). 12 The Verge, Apple employees resist returning to the office in an internal letter (4 June 2021); BBC. “The bosses who want to us back in office” (25/03/2021); U.K. Office of National Statistics. “Homeworking hours and rewards in the UK: 2011-2020” (19 April 2021). 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