A range of ESG policy, social, and technological developments are poised to impact companies and investors in the coming year.

By Paul A. Davies, Nicola Higgs, Sophie Lamb QC, Ryan J. Maierson, Colleen C. Smith, Michael D. Green, and Edward R. Kempson

Despite concerns early in 2020 that the pandemic would impact the growth of environmental, social, and governance (ESG) initiatives, the opposite proved to be the case with political and investor momentum aligning and ESG initiatives surging in the climate of “building back better”. This growth will likely accelerate in 2021, particularly as leading economies and financial centres in the US, China, the EU, and the UK make political and legislative commitments focused on ESG and investors double down on their ESG demands.

This second instalment of Latham’s annual 10 Things to Look Out For blog post highlights ESG-related developments and trends to anticipate in 2021.

  1. Climate Change Policy Developments in Advance of COP 26, Glasgow

Like last year, a focus on climate change starts the list. A number of States are strengthening their climate commitments in advance of the 26th Conference of the Parties (COP 26) to the UN Framework Convention on Climate Change, which will be taking place in Glasgow in November 2021.

Notably:

The United States is also likely to announce further ambitions at the start of the new Biden administration. (More details are provided later in this post.). These commitments — particularly the 2030 targets, given the relatively short timeline — mean that policy developments can be expected imminently. Significant government investment will likely target infrastructure investments aligned with these policies.

However, climate change advocacy is not the exclusive domain of governments. The 2021 proxy season will likely see an increasing number of climate-related resolutions. In particular, there is growing momentum (led by hedge funds) to encourage annual votes on companies’ climate change policies. Additionally, it is expected that continued investor demands will lead to further corporate commitments concerning climate change performance, while also driving enhanced ESG corporate reporting — particularly in accordance with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), which is emerging as the global standard for climate change corporate reporting.

  1. Growth of Biodiversity and Pandemic Resilience Initiatives

The pandemic has drawn to light the increasing connection between biodiversity degradation and global health pandemics. Against this backdrop, the 15th Conference of the Parties in Kunmig will take place in May and focus on biodiversity. Considerable political momentum is likely to surround the event, building on the establishment of the Task Force for Nature-related Disclosure (TNFD).

TNFD seeks to advance biodiversity initiatives in the way that TCFD has advanced climate change initiatives. Given that biodiversity benefits have been significantly underestimated in economic terms, biodiversity will likely emerge as a major long-term trend in ESG.

It can also be expected that greater efforts will be put into future pandemic preparedness, including research and reports focusing on the effectiveness of State responses to COVID-19. The lessons learned will continue to influence enterprise risk management evaluations, and supply chains will likely be the subject of further scrutiny. (More details are provided later in this post.)

  1. ESG Policy Developments in the US Under the Biden Administration

Much anticipation surrounds the ESG policy developments that are expected to emerge in the US under the new Biden administration. Biden’s nominations of Brian Deese as chief economic advisor to the White House and of John Kerry as a Special Global Envoy on Climate Change indicate the likelihood of a significant focus on climate issues beyond the US re-joining the Paris Agreement.

ESG policy developments at the US Securities Exchange Commission (SEC) and the US Department of Labor (DOL) are equally important to follow. Recent DOL policies regarding ESG financial products may be a focal point for new rulemaking and the comments of SEC Commissioners Lee and Crenshaw in November 2020 may provide an indication of the changes that could potentially emerge with regard to ESG-related disclosures.

  1. Rise of ESG Litigation

It can be expected that ESG-related litigation will increase amid greater scrutiny regarding companies’ ESG performance and higher expectations from stakeholders regarding ESG. Such litigation is likely to cover a broad range of ESG factors, including climate change litigation — which has thus far taken centre stage and will likely remain a key theme, particularly in relation to the large carbon majors.

Supply chain issues, greenwashing, and diversity appear common topics for litigation, as stakeholders look to challenge companies whether there are material differences between public commitments and the actual position on the ground. Infrastructure projects that may conflict with good ESG practices will come under increasing focus (this focus will also be on those providing finance and other support to such projects).

Boards and senior management may consider their ESG strategies and begin developing mitigation measures and resilience to head off and address ESG litigation.

  1. Continued Focus on Social Matters

The pandemic has been credited with shifting the ESG focus away from environmental factors and towards social and governance factors. While climate change had dominated the ESG discussion up to 2020, the pandemic forced companies to rapidly reconsider their approach to human capital management. This is particularly acute in the EU where legislative measures have been taken to promote investment into companies with demonstrable social and governance priorities. Further, events in the US and elsewhere put a spotlight on diversity and social justice. These effects are still being played out, particularly in corporates — many of which are increasingly implementing human rights policies and raising expectations for senior management to improve diversity efforts. Investors will be increasingly focused on boardroom diversity in line with companies’ corporate policies, and may even pursue litigation.

  1. Emphasis on Supply Chain Resilience

In 2020, supply chains came under increased strain, particularly as Chinese environmental policy led to factory shutdowns and relocations. However, the pandemic has significantly relieved supply chains by prompting companies to work to maintain a continuous supply of essential goods. Companies now also broadly recognize the existence of supply chain risks in addition to operational risks when considering ESG performance.

Governments and the courts are increasingly holding corporates accountable for the actions of their suppliers. Consequently, they are developing and implementing codes of conduct establishing expectations in relation to their suppliers. Concerns are also being raised around the ESG implications for supply chain finance, and governments are developing stricter regulations connected to supply chains.

This level of scrutiny and focus can only be expected to intensify. The EU and other major economies are likely to implement supply chain-related regulation in the next year. Supply chain resilience is also likely to become an increased area of litigation and NGO activity. Accordingly, investors will want to further expand their ESG focus to a company’s supply chain, including Scope 3 greenhouse gas emissions.

  1. Growing Impact of ESG on Global Trade Developments

Supply chains and ESG policy are also playing out in global trade policy. For example, environmental and social standards were a focal point of the recent negotiations between the UK and the EU. As some countries develop increasingly advanced ESG policies and positions, entry to those economic markets will require enhanced ESG standards. Supply chain ESG policies (such as those referenced previously) will have their part to play in raising such ESG standards.

ESG matters are becoming potential flashpoints in trade policy. For example, the EU is seeking to implement a carbon border adjustment mechanism. Those countries importing into the EU that have equivalent carbon pricing mechanisms will be exempt from such adjustment (or tax), whereas those countries without such carbon pricing mechanisms will be subject to a carbon levy on imports. This policy will likely result in the imposition of retaliatory levies. Other countries may very well follow suit by considering the use of ESG factors to support import taxes or other limitations.

  1. Proliferation of Innovation, Technology, and the ESG Data Lake

As ESG is — in relative terms — still at a nascent stage, the ESG data lake is quickly filling up. Thus, the proliferation in ESG data services is poised to continue. Further innovation and the development of technological solutions will likely allow companies, investors, and other stakeholders to analyse more readily available ESG data, and assess ESG risks and opportunities. This development will also be critical for the success of ESG taxonomies and benchmarks that are rolled out.

  1. Heightened Attention to Sustainable Finance and ESG in Financial Services

ESG-related finance gained popularity in 2020 as a number of companies looked to take on financing and shore up their balance sheets, including in order to support and evidence their ESG strategies and to combat the impact of the COVID-19 pandemic. The sustainable finance market witnessed the development of a wide range of newer instruments, including ESG, social, sustainability and sustainability-linked bonds and loans and transition bonds, in addition to the continued growth of the more established green bonds and loans.

Further innovation in this area is expected to continue as governmental organisations look to align their financing in accordance with their climate and ESG commitments. Financial institutions are under pressure to direct their capital to ESG-friendly projects and corporates through the imposition of standards which require them to disclose the impact of their financed corporate clients’ activities as part of the financial institution’s own sustainability impact assessments. In addition, public and private companies will likely look to enter finance arrangements that reward conformance to their ESG targets with lower interest rates. This will be an area where greenwashing will be closely monitored.

  1. Convergence of Governance and Standards

The final trend to highlight connects all of these developments: the convergence of the alphabet soup of ESG terminology, standards, and initiatives that began in 2020 will likely be an area of continued focus.

As mentioned previously, the recommendations of the TCFD have become widely accepted as the reporting standard for climate change matters. In respect of broader ESG matters, activity is underway at the International Financial Reporting Standards Foundation (which is looking to develop a global ESG standard),  the World Economic Forum (which is working toward common ESG reporting metrics and disclosure standards, with the support of the Big 4 accounting firms) and the International Organization of Securities Commissions (which is working to support convergence amongst securities regulators). Further focus on ESG at the board and senior management levels can also be expected. The EU is currently consulting on sustainable corporate governance, and its conclusions will likely ripple out to other leading economies. This development will be compounded by the focus on fiduciary duties for directors and trustees in commonwealth jurisdictions.

Converging standards will also be essential as many countries implement compulsory ESG reporting; for example, the UK is rolling out requirements for companies to report in accordance with the TCFD, and the EU is expected to expand the Non-Financial Reporting Directive. And as discussed previously, developments at the US SEC on ESG matters will be followed.