Companies Need to Start Adopting Sustainability as a Legal Duty

Companies have been responding to numerous disclosure standards with greater frequency, most recently those launched by the Task Force for Nature-Related Financial Disclosures, a market-led and science-based initiative supported by governments, businesses, and financial institutions.

Yet the push for transparency could obscure a deeper transformation that’s underway in company-investor relations.

Systemic threats to the economy such as climate change have important implications for how we understand the legal duties of those running companies, and the institutions invested in them—for example, under company or pension plan legislation.

Integrating Risk

The integration of material environmental, social, and governance factors into business strategies has become commonplace in companies during the past decade. Similarly, investors routinely consider ESG factors in their investment processes.

Yet neither is turning the needle on global challenges. One reason is that ESG investments principally concern how an investor selects assets, filtering down the investment universe into what it hopes will be a low-risk, high-return portfolio.

This falls short of addressing the root causes of systemic risks facing those investments. Tackling these challenges requires a toolbox that recognizes the complexities of long-term financial value, economic resilience, societal well-being, and environmental health.

This more holistic mindset demands a reappraisal of the way legal duties apply. For example, investors have come to rely on modern portfolio theory to manage idiosyncratic risks by diversifying their portfolios.

MPT is a valuable tool, but portfolio growth is highly dependent on the underlying health of whole economies. And that’s precisely what global sustainability challenges threaten.

MPT treats systemic risks of this sort as immutable, overlooking the fact that investors and portfolio companies are themselves actors in the system. The result? Market failures where capital is allocated to activities that undermine future economic success, and hence the ability of companies and investors to reach their legally determined goals.

Tackling Risk

Companies can help address this by moving to sustainable business models that contribute to their long-term success and investors’ returns. Investors, in turn, can encourage companies to adopt sustainable practices.

Addressing root causes of systemic risks requires longer-term strategies, however, that redefine the way companies create value. This could mean accepting lower returns from some companies in the short term to achieve longer-term gains in portfolio value.

For example, promoting regenerative agricultural practices among commodity producers might help address soil degradation and biodiversity loss, benefiting other sectors of the economy and hence the value of a diversified portfolio as a whole.

These types of interdependencies between companies in the same portfolio bear on the legal question for directors of how, broadly, they pursue corporate success in the interests of shareholders.

The most successful companies create value over both short and long-term horizons without contributing to societal and environmental failures that damage other industries. They strike a balance between short-term returns and a longer-term, environmentally conscious outlook, factoring in the interests of present and future shareholders.

A reorientation of this sort requires coordination among companies, investors, governments, civil society organizations, and citizens, as competition regulators increasingly recognize. Critically, systemic risks are a collective challenge that demand a system-wide response: No single entity can resolve risks of this magnitude alone and legal duties must be seen in that context.

Collective action mitigates the risk of first-mover disadvantage. It pools wisdom and experience, increases impact, and spreads the costs of action. It can take various forms, including alliances between companies, investors, and industry sectors, as well as engagement with stakeholders and policymakers. It can support progress towards shared goals relevant to outcomes targeted by directors’ and investors’ legal duties.

Companies and investors can encourage policymakers to introduce sustainability-oriented policies, rather than lobby against them, and deliver positive outcomes through their allocation of capital. Investors can initiate corporate engagement that supports and leads sustainability issues.

Effective engagement challenges existing practices and encourages companies to adopt strategies that support long-term value creation, and it respects the political and social headwinds faced by companies that can impact their scope for action.

Headlines sometimes suggest conflicts between companies and investors over sustainability. Yet to a large extent these actors share a common interest in addressing core sustainability risks and building a prosperous economy. Legal duties emphasize the importance of doing so.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

David Rouch is an international financial services regulatory lawyer and partner at Freshfields Bruckhaus Deringer.

Jake Reynolds is head of client sustainability and environment at Freshfields Bruckhaus Deringer.

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