The ESG challenge for Australian boards is about to get a lot more complicated, writers former diplomat Patrick Gibbons MAICD.

    For the past five years, ESG-related (environmental, social and governance) issues have increasingly featured in Australian board discussions, with a number of high-profile AGM campaigns involving remuneration resolutions linked to climate objectives. It’s more than just activist campaigns driving the focus on ESG — it’s investors, employees, customers and, increasingly, regulators. But while the trend had been in one direction, countertrends are now emerging internationally that will make their way to Australia in some form — presenting an increasingly difficult problem for Australian directors to deal with.

    Russia’s invasion of Ukraine has brought many of these challenges into focus. More than companies being condemned for doing business with Russia long after the invasion — such as Tencent, Yamaha and Atlassian (which stopped operating in Russia on 31 October) — it has highlighted the central role that affordable and reliable energy plays for all developed economies. 

    Energy is now a national security issue, which is accelerating demand to reduce dependence on Russian fossil fuels yet increasing demand for coal and gas from others, including Australia, the Middle East, Latin and North America, along with new nuclear power build programs.

    This goes against the climate ambitions of Europe and other developed countries, and fundamentally challenges previous ESG criteria that excluded investments in fossil fuels and nuclear power. The EU’s Sustainable Finance Taxonomy — which defines what is “sustainable” — now includes gas and nuclear power. The European armaments industry has also been pushing for inclusion.

    This also highlights the trade-offs inherent in ESG. The simplistic approach of addressing ESG by prioritising the “E” component through signing power purchase agreements for 100 per cent renewable energy meant, in effect, locking into supply chains mostly dominated by China. This poses multidimensional challenges to the “S” and “G” components — revolving around human rights, national security and threats to Western democratic values. For example, 90 per cent of the solar panels used in Australia come from China, with key ingredients such as polysilicon produced with cheap coal-fired electricity. The complement of renewable energy — battery storage — depends on critical minerals overwhelmingly processed in China. Several major Chinese solar companies have been named by the US Department of Commerce for using Uyghur forced labour, with the Uyghur Forced Labor Prevention Act of December 2021 being strongly pushed by the Biden administration.

    Economic backlash

    But more than the energy crisis engulfing Europe and the trade-offs that come with focusing on one energy technology, it is the broader economic headwinds that will start to challenge ESG and present Australian boards with tough choices that will be increasingly difficult to navigate. This is starting to play out internationally, where four main threats are starting to confront ESG — the shifting focus of financial institutions, the rising threat of litigation, greater regulatory focus and the increasing cost of compliance.

    In the US, the combination of substantially higher fossil fuel returns, the need to remain invested in these asset classes, and increased political focus by Republican states might force recalibration among some financial institutions that have heavily promoted ESG.

    In August this year, 19 Republican state Attorneys General wrote to BlackRock, alleging the company’s positions on climate change and ESG-limiting fossil fuel investments were not consistent with its fiduciary and legal duties. While BlackRock denied this was the case, the Financial Times reported it has lost more than US$1b of investments from Republican states including Arkansas, South Carolina and Utah. But more importantly, with the US mid-term elections likely delivering (at the time of printing) Republican control of the House of Representatives, the scene has been set for a showdown that will challenge ESG proponents.

    Elsewhere, a number of financial institutions, including Australian super fund CBUS, have walked away from the Glasgow Financial Alliance for Net Zero (GFANZ) that was launched with great fanfare at COP26 last November. Large US banks are also considering the same, in part because of their potential legal exposure about meeting the GFANZ emission reduction targets. Combined with the emergence of high-profile, anti-ESG investment funds such as Strive Asset Management, the US financial community is increasingly divided on how to respond to ESG.

    Litigation risk and regulatory pressure

    Secondly, the threat of legal class actions from across the spectrum is now a major challenge. Whether it is investors annoyed by companies divested from fossil fuels at the expense of shareholder returns, or companies not acting fast enough on stated sustainability goals, the US is likely to see litigation on this. The same is also probable in Australia.

    At its heart is a legal question of fiduciary duty, and what that actually entails. In this case, whether a firm that has eschewed fossil fuel investments is acting in the best interests of investors, especially when fossil fuels continue to dominate global energy supplies, with demand increasing for the foreseeable future. 

    Thirdly, the pressure from regulators to expose and address greenwashing is substantial. The Australian Securities and Investments Commission (ASIC) and the Australian Competition and Consumer Commission (ACCC) have said they will be scrutinising company claims — as will activists. Fundamentally, this is a deceptive conduct issue, which should be front and centre for all boards. Any claims about ESG need to be substantiated, but more importantly, survive scrutiny from well- informed stakeholders.

    Shifting standards

    Finally, rising compliance costs of meeting changing and increasing levels of ESG requirements need to be considered in the world of a slowing economy. While there has been a push for harmonised reporting standards such as those proposed by the US Securities and Exchange Commission (SEC), it remains unclear what the actual compliance cost will be.

    As a general rule, once government agencies and regulatory authorities are involved in setting standards, the inherent uncertainty of the political process comes into play — where winners and losers reflect relative political power. In this world, complying with ESG requirements could become a lucrative revenue stream for some, a major cost for others. In the US, this is likely to be a focus of a Republican-controlled House of Representatives.

    In the past nine months, the world has seen a fundamental reordering of global energy markets where Russia’s weaponisation of energy is reminiscent of the oil embargoes imposed by the Organization of Petroleum Exporting Countries in 1973–74. In the face of restricted oil supplies, the priorities of governments — like those in Europe today — shifted to accommodate real-world needs to keep the lights on and vehicles on the roads.

    This is the world ESG now confronts. The risk for ESG is the emergence of parallel universes where proponents talk about a world that is at odds with what is really going on. Understanding what the gap is and how to respond to it is an immediate challenge for boards. Australian directors need to pay attention to the debates occurring in the US and Europe, and recognise that these will have implications here in Australia.  

    Former diplomat and policy adviser Patrick Gibbons MAICD is a partner with business consultancy Orizontas.

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