This chapter contextualises the climate transition within the debate on corporate short-termism. It also presents how existing financial standards already require disclosure of climate change’s impact on a company’s business, and discusses the main drawbacks in existing transparency regimes. The chapter summarises the main concepts of materiality for corporate disclosure and discusses the main challenges related to the adoption of each concept. It then investigates the existing difficulties due the lack of comparability of companies’ sustainability disclosure and assesses new developments in sustainability standard-setting. It proposes four models to understand how director fiduciary duties are defined in different jurisdictions, and investigates their positive aspects and disadvantages. The chapter then focuses on how shareholders may exercise their rights on climate‑related matters. Finally it highlights how green bonds, voluntary carbon credit markets and well-developed capital markets may help in financing the climate transition.
Climate Change and Corporate Governance
2. Key issues
Abstract
2.1. Short-termism
A heated public debate has taken place during the last decade on whether public companies’ senior executives and shareholders are excessively focused on short-term results to the detriment of investment in long-term projects (so-called “short-termism”). Some have argued that short-termism is not a problem with economy-damaging consequences, as demonstrated by the recent success of innovative companies in public equity markets (Bebchuk, 2021[43]) and steadily rising investments in R&D (Roe, 2018[44]). Others, however, disagree with this assessment, and suggest, for instance, that there is a misalignment between executive pay and long-term results that has led to corporations investing less in projects with long-term payoffs such as building new factories (Strine Jr., 2017[45]).
Evidence shows that investment as a share of GDP by non‑financial companies has been sluggish, growing only slightly since 2005, while R&D has significantly increased during the same period (OECD, 2021, p. 32[46]). Other studies also find evidence of underinvestment both in the Euro Area when measuring net investment as a share of GDP (Kalemli-Ozcan, Laeven and Moreno, 2019[47]) and in the United States when comparing investment to corporate valuations and profitability (Gutiérrez and Philippon, 2016[48]). Finally, studies have found that in the US private companies invest less than public companies, particularly in R&D (Feldman et al., 2018[49]).
While contributing to the policy debate on short-termism is beyond the scope of this report, it is important to discuss how climate change and short-termism1 (if indeed an economy-wide concern) may be related.
To begin with a more pessimistic perspective, better disclosure on climate‑related risks and broad legal provisions for management to consider the environment may not achieve much if the incentives for directors, senior executives and investors are to act only on what is relevant for short-term financial results. In the same way financial reports’ information on R&D expenditure and capital investment may not be enough to incentivise a long-term view of senior executives and shareholders, it could be argued that data on GHG corporate emissions would not be sufficient to improve corporations’ climate‑related policies. According to this line of argument, corporations might eventually move towards a lower carbon footprint but most likely only if and when public policy or stakeholders’ preferences have a meaningful short-term impact on a company’s balance sheet.
In some circumstances, better disclosure of climate‑related risks and changes in company law (or at least how the legislation is interpreted) might indeed be effective regardless of executives’ and shareholders’ time horizons. For instance, transparency could lead environmentally conscious employees or consumers to steer away from an above‑average polluting company, potentially reducing, respectively, its productivity and revenues and, therefore, giving a competitive edge to greener companies. Likewise, better information on corporate climate‑related risks might make policy makers act sooner rather than later after realising the concrete physical risks companies face. Lastly, some individual court rulings involving major carbon-emitters may actually have a meaningful impact (e.g. the District Court of the Hague’s decision mentioned in Section 1.7).
In addition, such disclosure may impact the investment and voting decisions of asset owners and investors, who seem to be concerned with sustainability and climate‑related risks when managing their portfolios (see Table 1.1 and Figure 1.3). This might be the case either because many shareholders actually have a long-term view, or due to the fact that climate change has become a short-term concern for corporations’ financial results (or a combination of both factors). What remains to be seen – within the short-termism debate – is whether and how quickly investors’ concerns about climate change will translate into changes in directors’ and key executives’ decision-making processes. While it is still an open question, there is evidence that shareholders are making themselves heard rather quickly, including through changes in executive compensation plans (as seen in Table 1.7, over a quarter of the largest listed companies globally already use ESG measures in their plans) and shareholders’ proposals for companies to adopt GHG emissions targets (see Section 1.7).
2.2. Mainstream transparency regimes
Financial standards already require disclosure on how climate change may impact a company’s business in some circumstances. A US Financial Accounting Standards Board staff paper states that “an entity may consider the effects of certain material ESG matters, similar to how an entity considers other changes in its business and operating environment that have a material direct or indirect effect on the financial statements and notes thereto” (FASB, 2021, p. 3[50]). For instance, companies will have to consider whether reduced demand for products with high carbon footprints might impact the fair valuation of their assets, and banks may need to reassess expected credit losses for loans to companies in carbon-intensive sectors if a new environmental policy is expected to affect them. As an example, UK-based BP recognised an impairment loss of almost USD 13 billion in 2020 primarily relating to losses incurred with respect to changes in expected cash-flows of production and development assets due to lower oil and gas price and production assumptions in the context of a transition to a lower carbon economy (BP, 2020, pp. 166, 179[51]).
What may be less evident is that companies might need to disclose in the notes to their financial statements more than relevant changes in their balance sheets whenever the information is material for investors, including assumptions with respect to the future. As clarified by an IASB board member, for example, “a company may need to explain its judgement that it was not necessary to factor climate change into the impairment assumptions, or how estimates of expected future cash flows, risk adjustments to discount rates or useful lives have, or have not, been affected by climate change” (Anderson, 2019, p. 9[52]). Echoing this reasoning, an International Auditing and Assurance Standards Board (IAASB) staff alert highlights that “[i]f information, such as climate change, can affect user decision-making, then this information should be deemed as ‘material’ and warrant disclosure in the financial statements, regardless of their numerical impact” (IAASB, 2020, p. 3[53]).
As a general rule, financial reporting standards do not require a structured disclosure on strategy, risk management and non-financial information (e.g. GHG emissions) that may be relevant for investors to assess a company’s business perspectives and risks. Moreover, management often has limited ability to communicate perspectives for the future in the management commentary to the financial reports and in other regulatory filings. Those features of the current transparency regimes have their justifications, but it is important to consider their drawbacks and observe how they relate to the climate change corporate disclosure debate.
In some circumstances, limiting the ability of managers to communicate their perspectives for the future is a sensible policy. After all, senior executives have strong incentives to convince investors that their recent results were positive and that the future is even brighter: their remuneration and security in their positions depend on that. In relation to past results, there might be some controversy (e.g. if an increase in profits can be attributed to management’s efforts) but, overall, books of accounts provide a relatively sound basis for assessing previous results. Nevertheless, the future is even more uncertain. It is often a mere educated guess whether a new product or factory will prove to be profitable.
A backward-looking transparency regime, however, has its weaknesses with respect to reducing the informational asymmetry between management and investors. While the future is evidently uncertain for managers, they have probably invested resources designing strategies and analysing risks, and their conclusions might be valuable for investors. This is especially relevant for risks that do not frequently occur (so-called “tail risks”) because they will seldom materialise in financial statements but, when they do, they might have a significant impact on a company’s businesses. Those “tail risks” might be financial ones (e.g. a sudden major move in interest rates), risks related to a company’s core businesses (e.g. flooding in a major factory), and environmental and social risks.
A number of capital markets regulators have considered the importance of management communicating on material risks faced by public companies, but existing disclosure has been sometimes insufficient for two main reasons: (i) rules demanding disclosure of material risks (e.g. in annual forms and initial public offerings (IPO) prospectuses) do not typically specify which types of risks and how they should be presented to investors; (ii) enforcement of those disclosure rules may have incentivised an opaque disclosure.
Not being prescriptive on which risks to disclose and how to present them to investors has a clear benefit. Different economic sectors face different types of risks and, in some circumstances, even companies in the same economic sector might encounter distinct perils, which may require flexibility to properly assess risks and disclose them. Nevertheless, managers may have the incentive to downplay existing risks because a riskier company has a higher cost of capital and, therefore, smaller market value.
The remedy to the problem above has been to rely on enforcement – by public regulators and through the courts – to discourage directors and key executives from misrepresenting the material risks of the companies they serve. For example, if a company did not include in the prospectus of its IPO the risk of flooding where it has its major factory, shareholders might file a lawsuit demanding compensation if there is indeed a disruption in production due to a major flooding. Shareholders will have to prove that mentioned risk was material for the company at the moment of the IPO, but what is material in a concrete case may be interpreted in different ways in the absence of a clear framework.
In order to avoid referred litigation risks, senior executives may conclude that it is in their interest to refer to many types of risks (regardless of whether material or not) but, at the same time, use boilerplate language that would not allow investors to effectively assess a company’s “tail risks” or competitors to identify a company’s strategic weakness. If demanded by regulators or the judiciary, managers would be able to point to a company’s public document where the materialised risk was referred to. However, because the material risks were not well detailed, investors would find it difficult to apply adequate discounts to a company’s value because of existing “tail risks”. Of course, a low quality disclosure of risks may actually mean that investors will apply a meaningful discount in their valuation of a company simply because they do not have access to sufficient information, which would be detrimental to the development of the capital market.
A number of regulators have rules to improve the clarity in listed companies’ filings, such as the US SEC in its note to rule §230.421 stating that “vague ‘boilerplate’ explanations that are imprecise and readily subject to different interpretations” should be avoided in prospectuses. Likewise, as one of its main messages, an OECD report on corporate governance and the global financial crisis concluded that “the overall results of risk assessments should be appropriately disclosed in a transparent and understandable fashion [and] disclosure of risk factors should identify those most relevant to the company’s strategy” (2010, p. 15[54]). While regulators’ efforts are welcomed, there is not any instant and permanent solution to the problem. For instance, an analysis of 2 751 IPOs of operating companies between 1996 and 2015 in the United States found that there was an average 32% – with 41% at the 75th percentile – of text similarity in the “risk factors” section of a prospectus compared to all prospectuses of companies in the same industry in the preceding year (McClane, 2019, pp. 229, 277[55]).
To some extent, the current regulatory movement and investors’ demand for better disclosure of climate‑related risks might be seen as a way to compensate for a transparency regime that has not been completely successful in informing the market on many future risks including climate‑related ones. In that sense, forward-looking information requirements may be important considerations when (and if) a jurisdiction decides to enact a disclosure rule for climate‑related information.
2.3. Materiality
An essential part of any reporting system is the criteria to choose which pieces of information must be communicated to end-users. In the case of companies, the term often used to refer to this assessment is “materiality”: whether a piece of information is material enough for its primary users to justify the costs of collecting the information and disclosing it. Clearly, a case‑by-case costs and benefits analysis of the materiality of every piece of information would not be feasible, so the implementation of the materiality concept depends to a large extent on reporting standards, securities regulators’ guidance and practices widely accepted in the capital markets.
Information has traditionally been considered material if it could reasonably be expected to influence an investor’s or a creditor’s analysis of a company’s future cash flows. For instance, IASB provides that “information is material if omitting, misstating or obscuring it could reasonably be expected to influence the decisions that the primary users of general purpose financial reports make on the basis of those reports, which provide financial information about a specific reporting entity” (2018, p. A22[14]). In an often‑cited precedent, the US Supreme Court clarified that “an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. […] Put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available” (TSC Industries, Inc. v. Northway, Inc.). This materiality concept can be labelled “financial materiality”, and, as detailed in Table 1.3, not only financial reporting standards but also a number of ESG reporting frameworks and standards adopt a “financial materiality” approach.
More recently, a “double materiality” concept has been adopted in some sustainability reporting frameworks, defining as material information that – in addition to being financially relevant to investors – would be pertinent to multiple stakeholders’ understanding of a company’s effect on the environment and on people (e.g. for consumers, employees and communities). For example, the 2014 EU Non-Financial Reporting Directive provides that a company subject to the directive is required to disclose information “to the extent necessary for an understanding of the undertaking’s development, performance, position and impact of its activity, relating to, as a minimum, environmental, social and employee matters, respect for human rights, anti-corruption and bribery matters” (Article 19a, item 1).
The G20/OECD Principles of Corporate Governance offer two alternative definitions of materiality in the annotations to Principle V. One closer to “financial materiality”, suggesting that “material information can […] be defined as information that a reasonable investor would consider important in making an investment or voting decision” (emphasis added). The alternative definition is more open and, while not necessarily adhering to a “double materiality” perspective, potentially includes stakeholders as main recipients of corporate information: “material information can be defined as information whose omission or misstatement could influence the economic decisions taken by users of information” (emphasis added). Likewise, with respect to the disclosure of sustainability information, annotations to Principle V.A.2 say that “companies are encouraged to disclose policies and performance relating to business ethics, the environment and, where material to the company, social issues, human rights and other public policy commitments” (emphasis added).
OECD Responsible Business Conduct (RBC) instruments also reflect public reporting expectations in the context of due diligence processes. The MNE Guidelines include expectations that enterprises publicly report information on all material matters regarding their activities, structure, financial situation, performance, ownership and governance, as well as additional information on their social and environmental policies and their performance in relation to these. OECD due diligence guidance clarifies the expectation to publicly disclose due diligence policies, processes, and activities conducted to identify and address actual or potential adverse impacts, including the findings and outcomes of those activities (OECD, 2018[56]).
While in theory clearly distinct, the frontiers between financial and double materiality may be rather fluid in practice. For instance, in what constitutes one aspect of “dynamic materiality” (WEF, 2020, p. 8[57]), a risk that does not seem to be financially material in a moment in time (e.g. GHG emissions in a country with a poor environmental track-record) may gradually or quickly become financially relevant if the social context changes (in the same example, if a climate‑conscious political leadership comes to power). In some contexts, economically irrelevant ESG risks that are material for a society may be expected at some point to become financially material for a company, either through society’s pressure for a switch in public policy (e.g. regulation that makes companies internalise externalities) or consumers’ and employees’ change of preferences (making companies voluntarily change their businesses). To some extent, therefore, the time horizon used in the materiality analysis seems to be also key: the longer the time horizon, the larger the potential for overlap between financial and double materiality (IOSCO, 2021, pp. 28-30[58]).
Regardless of the time horizon, it should also be noted that even in the shorter term there might also be a significant overlap between information items that are material both to a company’s cash flows and to society as a whole. To take the example of a company in the energy sector, Canada-based Suncor disclosed in 2021 its Scope 1 GHG emissions and energy consumption as required both by SASB and GRI standards (respectively, as seen in Table 1.3, they follow a financial and double materiality concepts). The same company also disclosed, among climate‑related items, Scopes 2 and 3 GHG emissions and the energy intensity of its operations, but, in those cases, only to align itself with the GRI Standards (Suncor Energy, 2021, pp. 76-87[59]).
By definition, “double materiality” requires wider disclosure than “financial materiality” because the former includes the latter (the example in the paragraph above concretely shows it). Since collecting information and disclosing it present a relatively fixed cost for a company (somewhat independent from its size), a mandatory requirement to disclose ESG information according to a double materiality standard would represent a greater relative cost for SMEs when compared to larger companies. Moreover, if disclosure is only mandatory for listed companies, it might represent a disincentive for companies to go public.
Another challenge for policy makers considering to mandate an ESG disclosure regime based on “double materiality” rather than “financial materiality” would be the transition and longer-term costs it would create for some key capital markets actors other than companies, namely for securities regulators and auditors. First, there would be a short-term cost for changing systems and rules that were typically based on the assumption that corporate information to be disclosed should be material for investors. For instance, securities regulators that have a legal mandate only to protect investors and to maintain fair, efficient and transparent markets might need to have their powers enlarged to also include addressing systemic risks (climate change can arguably be considered a systemic risk as discussed in Section 1.3) or non‑financially material ESG risks more broadly. Also as an example, audit firms and professional accountancy organisations would probably need to establish systems to assess the materiality of each different ESG risk, since there would not be anymore the financial impact as the “unit of account” for all risks and opportunities.
Second, if key capital market actors become responsible for analysing information beyond their core expertise in corporate finance, they might become less efficient as a result. For example, securities regulators would need to supervise risks that have been (and will probably continue to be) overseen by environmental agencies, potentially duplicating work and offering conflicting guidance on non-financial materiality in some circumstances. Likewise, the assessment of what is material for society as a whole requires the use of techniques, reference points and data from the public policy discipline, which are not often mastered by corporate finance experts and may be expensive (e.g. surveys to assess the preferences of a great number of individuals).
Much of the relevance of the discussion above would dissipate if investors were as concerned with their investees’ impact on society as they are with their long-term financial results. If this were the case, a company’s impact on society and the environment would necessarily become financially material because investors would be willing to accept smaller returns in exchange for positive contributions for society (i.e. a company’s cost of capital would be smaller). However, evidence so far is that investors continue to be by and large more concerned with the financial performance of their assets (as seen in Table 1.2, strategies that often accept a tangible trade‑off between wealth creation and better ESG results do not currently represent a significant share of assets under management) and investors are especially interested in sustainability information that is financially material (as shown in Figure 1.5, TCFD recommendations and SASB Standards – which follow a financial materiality criterion – are by far the preferred ESG framework by institutional investors). This is also corroborated by a recent survey of 325 institutional asset managers and asset owners globally where only 34% of them agreed to be “willing to accept a lower rate of return in exchange for societal or environmental benefit” (49% disagreed with the sentence, while 17% were neutral) (Chalmers, Cox and Picard, 2021, p. 4[60]).
Some policy makers have suggested that there may be some space for a compromise between either adopting the financial materiality approach or the double materiality concept. A definition of materiality could rely not solely on the expected impact of a piece of information on how investors assess the cash-flows of a company and their volatility, but also encompass the most relevant considerations an investor makes when trading securities and voting in a shareholder meeting. The financial results of a for-profit company are generally a major consideration for investors, but a limited number of other considerations could also be commonly relevant to many investors (and therefore considered material for a company). Adopting such a flexible definition of materiality may be practical and would allow companies to adapt the content of their sustainability disclosure over time in line with changes in shareholder preferences.
Considering the concerns about how interested and effective investors may be addressing businesses’ impacts on climate that are not financially material, many stakeholders and some policy makers continue to seek additional sustainability disclosure beyond that which is material. However, it should be noted that the continued adoption of a financial materiality criterion for the disclosure regime of listed companies does not preclude environmental agencies and other self-regulatory or public bodies from enacting transparency standards guided by the interests of society as a whole. There would be three reasons in favour of governments keeping the traditional division of labour between capital market regulators focused on investor interests and environmental agencies protecting society concerns. First, this division would avoid the transition and long-term costs inherent in the adoption of an ESG disclosure regime based on “double materiality” as mentioned above. Second, since companies’ externalities are relevant for society regardless of whether corporations are listed, a disclosure requirement applicable both for listed and privately held companies may be more effective and level the playing field. Third, government agencies with the experience in protecting consumers and employees may be more effective in communicating with them. For instance, easy-to-read information about a refrigerator’s energy consumption in a store is arguably more useful for an environmentally conscious consumer than the disclosure of Scope 3 GHG emissions in a sustainability report from the company that manufactured it.
2.4. ESG accounting and reporting frameworks
As covered in detail in Chapter 3, many jurisdictions do not currently mandate the use of a specific ESG or climate‑related risks reporting framework or standard. This freedom has led corporations to adopt a number of different standards or, in some cases, disclose only some information items foreseen in a specific standard (see often used standards by large US companies in Figure 1.4). Moreover, 9% of 1 400 large listed companies globally did not report any level of sustainability information in 2019 (see Section 1.4 for more information).
The lack of comparability between companies’ sustainability information harms investors’ capacity to adequately value each company and, therefore, to decide how to allocate their capital and engage with companies. In other words, capital markets are less efficient if companies do not disclose sustainability information that is financially material or if their disclosures are difficult to compare. Likewise, disclosure of material risks is essential for investors to effectively manage the aggregate risks of their portfolios, and for financial stability supervisors to anticipate systemic risks (see Section 1.3 on NGFS’ recommendation for regulators to achieve “robust and internationally consistent climate and environment-related disclosure”).
The importance of comparability was underlined in a survey recently conducted by the International Organization of Securities Commissions (IOSCO) of 60 asset managers across 19 jurisdictions on sustainability information for investment decisions. The survey identified the creation and adoption of a mandatory common international standard reporting as the most important area for improvement with respect to sustainability (IOSCO, 2021, p. 18[58]). Similarly, a 2019 survey with investors representing 27 asset managers and 30 asset owners from Asia, Europe and the United States found that 75% of them agreed with the statement that “there should be one sustainability-reporting standard” and 82% concurred that “companies should be required by law to issue sustainability reports” (McKinsey & Co., 2019, p. 3[61]).
In a very concrete way, the adoption of multiple ESG or climate‑related risks reporting standards also creates costs for corporations, which may have to either comply with different reporting standards or respond to ad hoc information requests by institutional investors interested in comparing results and business prospects of their investees. Moreover, directors and key executives may be interested in benchmarking their non-financial performance against their peers in order to better identify where improvement is needed or claim their success if their results are above‑average. This may explain why, in the same aforementioned 2019 survey, 58% of executives representing 50 companies from Asia, Europe and the United States agreed with the statement that “there should be one sustainability-reporting standard” and 66% concurred that “companies should be required by law to issue sustainability reports” (McKinsey & Co., 2019, p. 3[61]).
As detailed in the Chapter 3, some jurisdictions have already established regulations or initiated public consultations or legislative proposals to mandate companies to disclose sustainability information according to a specific reporting standard. There are two main challenges in such processes: (i) the definition of the group of companies that will be subject to the new disclosure obligation; (ii) the co‑ordination across jurisdictions to adopt – if not the same reporting standard – at least to develop some core guidance and metrics that could be identical in all markets.
As discussed above, disclosure requirements often represent a greater relative cost for SMEs when compared to larger companies and, if disclosure is only mandatory for listed companies, sustainability disclosure requirements might represent a disincentive for some companies to go public. With respect to disclosure costs, it should be noted that there are not only direct costs such as developing internal control systems and hiring an external auditor, but there are also indirect costs such as revealing information that may be useful for competitors. Having those challenges in mind, policy makers have devised financial information rules that are flexible according to the size of the company or its stage of development, for instance providing a waiver from some non-essential disclosure requirements for emerging growth companies (OECD, 2018, pp. 17-18[62]).
In considering a path towards greater comparability, the experience of adopting IFRS Standards across most jurisdictions on a global basis can serve as a reference. In total, 144 jurisdictions required the use of IFRS Standards for all or most domestic listed companies as of 2018 (IFRS Foundation, 2018[63]). This successful experience is probably the reason why the IFRS Foundation November 2021 announcement that it would amend its constitution to accommodate an International Sustainability Standards Board (ISSB) within its structure has been met with enthusiasm by a number of jurisdictions and the IOSCO (see more below).
The ISSB will build on the work of existing investor-focused sustainability reporting initiatives to set IFRS Sustainability Disclosure Standards. The IFRS Foundation’s recently amended constitution provides that IFRS Sustainability Disclosure Standards “are intended to result in the provision of high-quality, transparent and comparable information […] in sustainability disclosures that is useful to investors and other participants in the world’s capital markets in making economic decisions” (item 2.a). Likewise, by June 2022 this new board will merge with the CDSB, SASB Standards Board and Framework Board to consolidate their technical expertise, content, staff and other resources (for more information on those boards, see Table 1.3). In this context, the Technical Readiness Working Group (TRWG) – a group formed by the IFRS Foundation Trustees to undertake preparatory work for the ISSB2 – has already published a prototype climate standard building on the TCFD recommendations and another prototype document on general disclosure requirements for consideration by the ISSB in its initial work plan (IFRS Foundation, 2021[64]).
Of special interest is the IFRS Foundation’s views of a “building blocks” approach and an initial priority for climate‑related matters in the work of the planned ISSB (IFRS Foundation, 2021, p. 5[65]). This would mean that ISSB would co‑operate with standard-setters from key jurisdictions in order to have a globally consistent set of core standards that would allow the comparability of sustainability reports in those jurisdictions, and expect that standard-setters from smaller markets would eventually adhere to this global reporting baseline. The “building blocks” strategy may also allow, for instance, globally accepted standards based on a financial materiality criterion but with the flexibility for complementary regional or national standards requiring disclosure on matters deemed material only from a “double materiality” perspective.
The IFRS Foundation’s decision to initially focus on climate‑related matters before working towards other ESG issues is also interesting from a practical point of view. Local standard-setters may be willing to wait for the establishment of global sustainability standards by the ISSB – instead of creating their own – if they foresee in the short term a standard on one of the most pressing ESG issues. Indeed, as shown in Section 1.5 and Figure 1.6, despite some regional variations, some climate‑related risks are financially material for an important share of listed companies by market value globally (more than other environmental risks), representing 65% of the total market capitalisation.
Finally, if disclosed ESG information is not assured by a third-party based on robust methodologies, it could undermine confidence in the disclosed information and the possibility to compare sustainability reports between companies. As noted in Section 1.4, only around half of large listed companies that disclosed sustainability information in 2019 provided some level of assurance by a third party. Moreover, only a small minority of these assurance engagements offered “reasonable” assurances (“reasonable” is the level expected from audits of financial reports3). While reasonable assurance for all disclosed sustainability information may not be achievable with the stroke of a pen, there may be space for short-term advancements with mandatory assurance for some key climate‑related metrics such as GHG emissions. With clearer sustainability standards and more experience by all capital markets service providers, however, greater convergence of the level of assurance between financial and sustainability reports may be expected in the longer term.
2.5. Directors’ fiduciary duties
While business reality is complex, corporate law and capital markets regulation generally present a simplified definition of directors’ and key executives’ duties in order to make them functional. Corporate laws often provide – in a language similar to the one adopted by G20/OECD Principle VI.A – that “board members should act on a fully informed basis, in good faith, with due diligence and care” (“duty of care”) and “in the best interest of the company and the shareholders” (“duty of loyalty”). As a whole, these duties of care and loyalty are often referred to as directors’ and executives’ “fiduciary duties”.
As detailed between Sections 1.6 and 1.7, company laws in different jurisdictions vary in relation to who is effectively the recipient of directors’ and executives’ fiduciary duty of loyalty. For ease of discussion, one could outline four models:4
a. At one end of the spectrum, company law and judiciary precedents may fully adhere to the “shareholder primacy” view, obliging directors to consider only shareholders’ financial interests (e.g. some Delaware precedents in takeover cases) while complying with the applicable law and ethical standards. This still requires attention to non-shareholders’ interests, but only to the extent that those interests may be relevant for the creation of long-term shareholder value.
b. Close to the approach above, loyalty could be largely to shareholders’ financial interests but directors would have to consider stakeholders’ interests, and the social and environmental stakes of a company’s activity (e.g. the language in the French Civil Code). Consideration here might be interpreted as careful thought given to stakeholders’ interests to a degree that is equal or higher than well-established standards (such as those in the MNE Guidelines) but still falling short of what a social planner would prefer for society as a whole.
c. A third approach would be to amplify the group of recipients of the duty of loyalty. Directors would therefore be equally devoted to shareholders and to a number of defined stakeholders, such as employees and customers. This may imply, in a concrete case, directors making a decision that would meaningfully reduce long-term shareholder value in order to benefit a group of stakeholders.
d. At the other end of the spectrum, directors would need to balance shareholders’ financial interests with the best interests of stakeholders (just like in the third approach above), and, in addition, to fulfil a number of specified public interests (e.g. PBCs in Delaware and société à mission in France). In relation to these public interests, directors would be responsible for maximising social welfare in a manner virtually similar to what public servants do.
Zooming out from any individual legal system, there are positive aspects and drawbacks to all of these models. Model “a” above has a significant advantage: directors and key executives are clearly accountable to the sole goal of maximising shareholders’ wealth within what is legally and ethically permissible. This model still leaves significant discretion to managers – because what is ethically required and expected to increase long-term value may not be evident – but there are some relatively good proxies to assess management’s performance, such as equity prices and profits during a reasonable time period.
The main drawback of model “a” is that, if there are relevant market failures, the maximisation of profits by a company may reduce welfare for society as a whole or even the long-term value of its shareholders’ portfolios. With respect to society’s welfare, for example, if there are no adequate public policies to reduce GHG emissions, companies may emit more than what would be socially desirable – taking into account the trade‑off between economic development and climate‑related risks – with the goal of maximising profits. In regard to an investor’s portfolio, for instance, the wealth created by a profit‑maximising major carbon emitter company may be more than off-set by losses in the long-term value of other investee companies affected by climate change (e.g. a hotel chain that would need to write off assets affected by rising sea levels).
Models “b”, “c” and “d” – with their own peculiarities – attempt to solve the challenge mentioned in the paragraph above. Recognising that contracts between the company and stakeholders are often incomplete, and that the state – especially in developing countries and with respect to highly complex industries – may not always be able to implement optimal or fully enforceable regulation, those three models impose a duty for corporate managers to consider or fulfil stakeholders’ and society’s interests. If managers have adequate incentives to consider or fulfil these interests, the solution of expanding the duty of loyalty might be advisable because directors and key executives are arguably the most well-informed individuals with respect to their company’s risks, opportunities and societal impact.
When compared to model “a”, however, the decision-making process of managers and the evaluation of their results may grow exponentially more complex in the other three models because non‑financial results are extremely difficult to compare and value, both with other non-financial results as well as with financial results. For example, if a company faces the alternative between upgrading a factory to emit 1 Mt CO2 less a year or preserve 40 000 hectares of tropical forest, it may not be evident what the best option for society would be. The CO2 storage capacity of the forest could be estimated, but there would also be benefits – such as protecting biodiversity and water security with the forest preservation option – that are not straightforward to compare to CO2 storage. Moreover, there would also be the option of not adopting any of the two alternatives, which may increase profits and dividends to shareholders. This could allow the shareholders themselves to donate more money to an environmental philanthropic organisation or increase tax revenues that governments may use to support environmental objectives.
The greatest risk of models “b”, “c” and “d” is, therefore, threefold. First, managers would need to make decisions on projects that are not necessarily within their expertise. For instance, running a steelmaking business efficiently may have little to do with cost-effectively reforesting. While expertise can be developed internally or outsourced in some cases, at C-level positions and on the board new issues to consider will inevitably mean more time demanded from individuals who may already struggle with a great number of responsibilities. Second, while the economics discipline has found creative ways to value public goods and human life, the technical and ethical challenges of doing so are seldom trivial. For example, it may not be difficult for a manager of a European company to assess the trade‑off between profits and CO2 emissions, because the market for carbon permits is active in Europe, but it may be more challenging in other parts of the world. Third, if shareholders and stakeholders cannot properly compare financial and non-financial results, directors and key executives may become less accountable. In the same example, a CEO in a steel-making business may argue that below-average return on equity was due to a stellar environmental performance and not to their incompetency in leading the company.
While the risks summarised in the paragraph above may be to some extent manageable, this could still be costly and present at least one unintended consequence. With respect to costs, for instance, in order to increase managers’ accountability, companies may be required by legislators to hire an independent third-party to regularly verify whether management fulfilled their non-financial goals. The unintended consequences are difficult to assess because the number and size of companies with legally actionable non-financial goals – as seen in Section 1.7 – is still small, but one could conceive the role courts may have in enforcing a broadened duty of loyalty such as in models “c” and “d”.
How common court cases involving managers’ duty to fulfil non-financial goals may be depends on many factors (e.g. if only shareholders or others have a standing to sue, the standard of review adopted by the courts,5 and the extent to which a jurisdiction’s legal framework is conducive to the use of private enforcement), but the fact is that judges may eventually need to decide whether managers have abided by their broadened duty of loyalty. This control by the courts, however, might face limitations for the same reasons that may have justified – as argued above – broadening the fiduciary duties in the first place. If the executive and the legislative branches of government – with all their multidisciplinary experts and public consultations – were unable to enact optimal regulation to reduce market failures, it is an open question whether professionals with legal training could do better when assessing corporate executives’ decisions. Moreover, as previously mentioned, evaluating trade‑offs between non-financial goals may be technically or ethically challenging (e.g. closing a coal-fired power station that is the only source of employment in a poor community in order to fight climate change), and it is not clear-cut whether the courts (or, in the first place, directors and key executives) would have the social legitimacy to be the arbiter in those cases.
Finally, it should be noted that – as well explored in the G20/OECD Principles – directors are responsible for overseeing the company’s risk management, which involves “oversight of the accountabilities and responsibilities for managing risks, specifying the types and degree of risk that a company is willing to accept in pursuit of its goals, and how it will manage the risks it creates through its operations and relationships” (annotation to Principle VI.D.1). Evidently, therefore, if climate‑change risks are financially material for a company, they would have to be properly managed by senior executives and overseen by the board as an expression of the duty of care (OECD, 2020, pp. 74-75[66]), regardless of any more complex discussion about the scope of the duty of loyalty.
2.6. Shareholders’ rights
Corporate and securities laws usually provide – in a language similar to the one adopted by G20/OECD Principle II – that shareholders have the right to “obtain relevant and material information on the corporation on a timely and regular basis”, “elect and remove members of the board”, and “approve or participate in decisions concerning fundamental corporate changes”. As seen in Section 1.7, shareholders have been exercising some of those rights on matters related to climate change, such as requesting a company to substantially reduce Scope 3 GHG emissions. Likewise, investors managing more than USD 10 trillion have reported to be willing to engage with companies on sustainability issues (see Table 1.2).
What may not be clear in some jurisdictions and in the G20/OECD Principles are the limits for a majority of shareholders to impose non-financial goals and reporting obligations to companies (especially public ones). Arguably the two rights are closely linked: if the central objective of the corporation is to maximise long-term shareholder value, the relevant information to be disclosed would be focused on what is financially material. However, when the corporation has societal or environmental goals together with the purpose of maximising shareholders’ wealth, both what is financially material and relevant to those chosen non‑financial goals may need to be reported to shareholders.
This section will refer to the discussion on materiality above, and focus on the questions related to the imposition by shareholders of non-financial objectives that would divert a company from the sole purpose of making profits. Under any circumstance, the following should be clear: if the fulfilment of a stakeholder’s interest is expected to increase a company’s long-term value, it is beyond doubt that management should be allowed to fulfil such an interest. The hard question – which is the focus of the following paragraphs – is whether a trade‑off between long-term value and stakeholders’ interests may be possible.
Something to consider is that some individuals who are – directly or through investment vehicles6 – shareholders of listed companies are also philanthropists and may have concerns other than their wealth. Even mainstream economic models that assume rational behaviour often recognise that individuals maximise their utility, which may include avoiding an environmental catastrophe, and not strictly their wealth. This begs the question of whether corporations should fulfil their shareholders’ willingness to advance the common good instead of distributing dividends that may be eventually donated by the shareholders to philanthropic institutions.
It is difficult to assess the extent to which individuals would accept a trade‑off between their wealth and public goods. A proxy may be the value of assets under management by philanthropic foundations, which are sometimes linked to controlling shareholders or founders of public companies, in 24 major jurisdictions in all continents: USD 1.5 trillion in assets as of mid‑2010s with an annual average expenditure rate of 10% (Johnson, 2018, pp. 17-20[67]). These assets under management represent only around 1% of global equity markets, which may signal that individuals’ willingness to accept an exchange of their wealth for public goods is low.
Despite its conceivable small practical relevance as suggested in the paragraph above, it may be argued that corporations could provide some public goods (or reduce a public bad) more cost-effectively than philanthropic institutions. For instance, permits for European companies to emit one ton of CO2 (a proxy of the cost for a company to emit one less ton) reached a record price of USD 71 in August 2021 (Financial Times, 2021[68]) while the cost of capturing CO2 directly in the air (what an independent institution may do) – without even considering the costs of transporting and storing it – was over USD 134 a tonne in 2019 (Baylin-Stern and Berghout, 2021[69]). In many other contexts, however, corporations may not have any clear advantage in advancing the common good when compared to philanthropic institutions, such as if a fossil fuel company were to develop a reforestation project.
In considering the challenges above, a majority of shareholders have the right in some jurisdictions to eventually decide to change a company’s articles of association in order to establish goals other than maximising long-term value. That is exactly what – as detailed in Section 1.7 – shareholders may do in Delaware with the PBCs and in France with the sociétés à mission. In those cases, however, some consideration may also be due to the rights of shareholders that opposed the transformation in the purpose of the corporation. After all, in many jurisdictions, shareholders have traditionally had at least a de facto expectation that the main goal of a company is to maximise long-term value. For instance, jurisdictions could consider the advantages and drawbacks of requiring a supermajority to add non-financial goals, or the right for dissenting shareholders to sell their shares back to the corporation at a fair price.
Finally, companies that voluntarily adopt environmental and social goals will face the challenge of making directors and key executives accountable both for their financial and non-financial performance. As previously mentioned in the “directors’ fiduciary duties” subsection, since the comparison between goals of different natures can be difficult, companies may consider adopting new controls, such as hiring an independent third-party to regularly verify whether management fulfilled its non-financial goals. Governments may even decide to regulate which controls must be adopted in case a company voluntarily assumes non-financial goals in order to protect the interests of retail investors and unsophisticated stakeholders who value the company higher due to its commitment to the environment and society.
2.7. Financing climate transition
On top of governance related challenges discussed in this report, it is crucial that policy makers also address the issues related to the financing of the climate transition. The Paris Agreement stresses the necessity of financing the climate change transition as one of its three long-term goals. In Article 2.1.c, the Parties committed to “make finance flows consistent with a pathway towards low greenhouse gas emissions and climate‑resilient development” (UN, 2015[3]).
As set out in Section 1.5, almost 65% of listed companies globally face financially material risks in terms of Scope 1 and Scope 2 GHG emissions, as well as the physical impact of climate change. While it is clear that mobilising a major amount of funds is necessary to finance the activities for the adaptation to and mitigation of climate risks faced by those companies, the exact amount of funds required is uncertain. According to one estimate, a USD 6.9 trillion investment for 15 years between 2015 and 2030 would be needed to meet climate objectives in the infrastructure industry in line with the Paris Agreement (OECD, 2017[70]). Another estimate for the energy industry claims that annual clean energy investment worldwide will need to more than triple by 2030 to around USD 4 trillion to reach net zero emissions by 2050 (IEA, 2021[71]). At the regional level, financing the net zero GHG emissions target of the EU by 2050 is estimated to cost an annual investment of 2% of GDP of which public investment would amount to between 0.5 and 1% of GDP (Darvas and Wolff, 2021[72]).
Public resources alone will not be enough to cover the trillions of dollars needed to fulfil the goals of the Paris Agreement, and to adapt infrastructure and industrial systems to climate change. Private financing sources such as institutional investors will also have a key role to play in financing the climate transition. Recently, sovereign and corporate green bonds have been issued in response to demands for climate finance, even though the spreads on ESG corporate bonds versus their conventional counterparts has been often negligible (Stubbington, 2021[73]). Since the first green bond issued in 2007, there has been a gradual increase in the amount of funds raised via green bonds, reaching almost USD 300 billion in2020 (CBI, 2021[74]), which is still a modest amount compared to the USD 18 trillion of government borrowing by OECD countries (OECD, 2021[75]) as well as the USD 5.9 trillion in corporate bond borrowing the same year.7 The criteria for determining whether an activity to be financed by the issuance of a corporate bond is environmentally sustainable, however, can vary. In order to protect the buyers of corporate bonds and other financial instruments, some jurisdictions have been developing a taxonomy to classify which economic activities could be considered environmentally sustainable (allowing, for instance, a company to name a bond it issues as “green”).8
The establishment of an emissions trading system is one among different policies jurisdictions may use to create market-based incentives to reduce carbon emissions where these are more cost-effective. In most compliance trading systems, the government sets an emissions ceiling for companies in high‑polluting sectors, and corporates covered by the system may trade emissions permits – buying if they want to emit more than what they are allowed, or selling permits if they emit less (IEA, 2020[76]). Voluntary carbon credit markets may also allow entities not covered by emission ceilings to manage their carbon footprint or to raise private financing for projects with positive contributions for the climate transition (TSVCM, 2021[77]). For instance, a company with a self-imposed target of net zero emissions may decide to acquire carbon credits if they are (at the margin) cheaper than reducing its own carbon emissions. Likewise, municipalities or private entities may be able to sell carbon credits representing effective reductions in their emissions (e.g. avoided deforestation) or carbon captured in their projects (e.g. technology-based removal). For a system of carbon credits or permits to work efficiently, however, the certification of emissions reduction and carbon captured must be credible (just like external auditors and custodians are needed for a stock market to flourish) and flows of negotiation should be as free as feasible (so that carbon emission reductions are achieved for the smallest possible costs). Standardisation of carbon credits is especially important to facilitate trading flows, making cross-border negotiations and price‑discovery easier.
Policy makers can contribute to the climate transition by creating policies and a regulatory environment that leverage the necessary private finance. In this respect, it is important to identify the degree of the contribution to climate action by each financing type so that policy makers can direct their efforts to increase the efficiency of financing towards climate goals. Empirical evidence shows that economies with relatively more funding from stock markets than from credit markets generate fewer carbon emissions. Even within carbon-intensive sectors, more developed stock markets are associated with more green patents. Importantly, the size of financial markets alone – independent of the size of stock markets -- is not related to the environmental performance of the economy (Haas and Popov, 2019[78]).
The positive contribution of stock markets to a greener economy comes from their critical role in supporting innovation through equity investors’ willingness to share the risk in projects to a higher proportion of intangibles assets. Deeper stock markets are found to enable the growth of innovative sectors with less tangible assets such as energy efficient sectors, while sectors with more tangible assets that are higher carbon emitters, grow faster in economies that depend more on bank financing (Brown, Martinsson and Petersen, 2017[79]). Moreover, equity investors’ demand and power in pushing companies towards greener technologies may contribute to stock markets’ better performance in terms of financing climate reduction, as shareholders mostly want to decrease any future cost for the company of the management of environmental risks such as compliance and litigation costs, fines, penalties, and reputational damage. On top of that, private equity and venture capital have the potential to strengthen the positive impact of stock markets on climate action through their support for innovative high-tech risky start-ups that lack the scale to access public markets. To a certain extent, the discussion between financing of innovation and risk appetite of investors also holds for the corporate bond market, as longer term corporate bonds can be used to finance longer term innovative projects that could support the climate transition. Additionally, investors in corporate bonds, not necessarily green ones, can, through provisions on covenants, also use their stakeholder powers to drive companies’ green transformation.9
Notes
← 1. “Short-termism” could be defined as an investment-making process that favours projects with higher short-term cash inflows to the detriment of projects with longer-term payoffs, without properly considering the net present value of all possible investment projects.
← 2. The TRWG is composed of representatives from the CDSB, the IASB, the Financial Stability Board’s TCFD, the VRF and the World Economic Forum, and it is supported by IOSCO.
← 3. The IAASB defines a “reasonable assurance engagement” as one in which “the practitioner reduces engagement risk to an acceptable low level in the circumstances of the engagement”, while a “limited assurance engagement” is defined as one “limited compared with that necessary in a reasonable assurance engagement but […] likely to enhance the intended users’ confidence about the subject matter information to a degree that is clearly more than inconsequential” (IAASB, 2013, p. 7[101]).
← 4. Some company laws merely mention that directors should act in the best interest of the company, but, evidently, companies are only fictional persons, and, therefore, regulators, courts and other practitioners will have to – in concrete cases –definewho the company effectively serves.
← 5. As previously mentioned, if courts adopt the business judgement rule (or similar doctrines in non-US jurisdictions), they would review directors’ decisions only in the relatively rare circumstances where plaintiffs can prove negligence or bad faith.
← 6. Another layer in this discussion would be whether institutional investors (e.g. pension and mutual funds) would be able to consider non-financial goals of their final beneficiaries. In many developed jurisdictions, institutional investors are permitted (or may even be required in some cases) to integrate ESG issues into their investment decisions and ownership practices with the goal of maximising financial return (Freshfields, 2021[108]). However, pursuing an investment for non-value‑related sustainability reasons would not likely be possible in the absence of a clear mandate from final beneficiaries. For instance, the US Department of Labor holds the view that employee benefit plans’ fiduciaries are not permitted to sacrifice investment return or take on additional investment risk as a means of using plan investments to promote collateral social policy goals (Interpretive Bulletin 2015-01).
← 7. OECD Capital Market Series Dataset.
← 8. See, for instance, Regulation EU 2020/852 on the establishment of a framework to facilitate sustainable investment.
← 9. In 2019, Enel, an Italian utility company, issued a corporate bond of which the covenants linked the coupon rate to the goal of making 55%of the energy company’s overall installed capacity renewable by the end of 2021. If that target is not met (as reported by an independent auditor), the interest on the bond will increase by 25 basis points (Taylor, 2020[102]).