What is ESG and why is it important?

Environmental, social and governance (ESG) refers to a set of criteria used to evaluate the sustainability and ethical impact of an organisation on the environment and society, as well as compliance with laws and regulations. In light of current global challenges, ranging from climate change to the violation of human rights, organisations are feeling pressure from a spectrum of stakeholders to not only implement adequate strategies and ensure the successful strategy and implementation thereof, but also to ensure the transparent reporting of these ESG issues.

South Africa’s historically coal-reliant energy infrastructure has led to an abundant release of greenhouse gases which has had a paramount effect on climate change. The South African employment sector also leaves much to be desired due to high unemployment rates, poor working conditions, social inequality, and numerous accounts of alleged unfair dismissals. These issues, amongst others, emphasize the need for organisations to address ESG issues and work towards a sustainable future.

 
How does ESG affect directors and officers?

As per the Companies Act, 71 of 2008, all directors and officers are expected to act in good faith, in the best interests of the company, and with a degree of care, skill and diligence that would be reasonably expected by an individual in such a position. The Act requires entities to consider the broader impact of their activities, including environmental and social factors, and to make certain disclosures in this regard in their annual financial statements. This legislation promotes transparency and accountability but does not explicitly define or mandate ESG practices. It is for this reason that directors must use their discretion when it comes to addressing ESG.

In a recent survey conducted by PwC, investors ranked ESG-related outcomes among their top five priorities for businesses. However, 81% of participants further commented that they would only accept a reduction of 1% or less in investor returns to fulfil ESG objectives. Approximately half of the participants proclaimed that they would not accept any decline in returns. Thus, directors are presented with a unique dilemma: “Can their company perform well for investors and pursue a clear ESG strategy at the same time?” (Gassmann & Jackson-Moore, 2022).  

Directors are not only feeling the heat from investors and shareholders but also from the abundance of legislative and regulatory developments, the purpose of which is not only to promote awareness but also to encourage businesses to operate sustainably by adopting sustainable business practices. Within the South African regulatory landscape, this includes the Climate Change Bill, the Carbon Tax Act (recently amended by the Taxation Laws Amendment Act, 2022), the Green Hydrogen Commercialisation Strategy (currently in draft form), amendments to the Electricity Regulation Act 2006, and the adoption of the Just Transition Framework by the Presidential Climate Commission, amongst many others. Further to this, the King IV Report on Corporate Governance is a set of voluntary principles and leading practices which is widely recognised and accepted in South Africa. It emphasises and encourages transparency and responsible business practices, including environmental and social considerations.

The question is, how are directors exposed in light of the greater focus on ESG considerations? Alleged failures in environmental stewardship, social responsibility and/or governance practices by directors could lead to claims by various stakeholders including shareholders, investors, non-governmental organisations and advocacy groups who could allege that directors have breached their duty of care to the company. For example, stakeholders could sue directors for alleged environmental violations, failing to disclose material ESG-related risks, human rights misconduct and other labour violations as well as a lack of diversity in the boardroom. The breach of fiduciary duty relied upon in this respect exposes directors to allegations of wrongdoing, the ensuing litigation (by virtue of class actions and/or derivative actions) as well as to reputational damage. In the case of ClientEarth, an environmental law charity instituted legal proceedings against the directors and officers of Shell for breaching their duties (alleging a failure to adequately prepare for a net-zero transition).

 
What is the potential impact on directors and officers and their insurance?

In light of the possible consequences that may arise from neglecting ESG considerations, one possible risk mitigation tool that directors may elect to use is to purchase a Directors’ and Officers’ liability policy, the purpose of which is to provide financial protection to directors, officers and employees who fulfill managerial or supervisory positions. In the event of a claim, alleging a breach of fiduciary duty or other wrongful act (perpetrated in their capacity as director), a Directors’ and Officers’ liability policy may advance legal defence costs reasonably incurred in defending same, as per the policy’s defined scope of coverage (and the merits of the claim at hand). There is limited case law available where directors have been held personally liable for breaching their fiduciary duties in respect of ESG considerations, and thus Directors and Officers insurance to settle legal defence costs may be of more relevance at present.

Claims relating to ESG issues have seen an upward trend on both the international and African front. A class action ESG litigation, one of the first of its kind in Africa, was instituted against Anglo American, one of the world’s largest mining companies, in 2019. A group of Zambian women and children instituted a class action in the High Court to seek compensation for alleged lead poisoning. This case, and others, will set an important precedent for future litigation in the African and potentially South African environments.

 
And what does this mean for directors and officers overall?

Given the many environmental and social difficulties in South Africa, and the evolving regulations in this regard, directors are exposed now more than ever to lawsuits based on ESG concerns. Directors are caught between a rock and a hard place when it comes to achieving financial success (and investor returns) whilst also addressing environmental, social and governance factors. Directors must therefore generate sustainable and ethical profits whilst mitigating their negative impact on the earth and its people. In light of the ever-increasing stakeholder activism and heightened scrutiny of an organisation’s ESG policies, it is likely that we will see steady increases in the demand for Directors’ and Officers’ insurance, as directors seek to mitigate the risks associated with ESG considerations and the potential for legal proceedings. With the changing ESG landscape and the risks underpinning such, it is imperative that directors hold some protection. Camargue offers Directors’ and Officers’ liability policies for both commercial and financial institution risks.

https://www.camargueum.co.za/products/directors-officers-liability/

 

Reference list:

Gassmann, P & Jackson-Moore, W. (2022). The CEO’s ESG dilemma. [Online]. Available at: https://www.pwc.com/gx/en/issues/esg/ceo-esg-dilemma.html