The changes reflect the growing importance of environmental, social and governance (ESG) issues to financial markets. They add to the increasing pressure on directors to take meaningful action to address critical ESG issues, such as the climate emergency, so they can effectively manage the risks and opportunities they present.

Gabriella Covino, Chair of the IBA Corporate Governance Subcommittee and a partner at Gianni & Origoni, explains the changes ‘may have a significant impact in the next shareholder meetings season for large corporations, and may influence the results of the same meetings in compliance with the recommendations contained in the new ISS policy’.

ISS’ move should be viewed in the broader context of an overall rise in engagement by investors on ESG issues. Tom Matthews, Head of the Global Shareholder Activism practice at White & Case in London, says that ‘what ISS is doing is the continuation of a trend that has been building for some time’. For him, its policy changes add to the ‘weight of capital’ behind ESG issues, meaning they cannot be ignored.

Laura Richman, counsel at Mayer Brown in Chicago, agrees. ‘I see this step by ISS as part of the continuum of raising the voices that [say that] environmental and social, and specifically climate change, is something that companies need to take seriously,’ she says.

‘It is fair to say directors are being put on notice that [these issues] could have these ramifications,’ she adds.

The influence of ISS and other proxy advisory companies, such as Glass Lewis, has grown as the bigger institutional investors have come to own large amounts of stock and the voting rights that come with it. While some investors have internal teams deciding how to vote on ESG issues, many outsource the decision-making process to proxy advisers instead. Some will vote exactly as ISS recommends.

Simon Toms, a M&A and corporate governance partner at Skadden in London, says that ‘what is influential in ISS and Glass Lewis formalising into their guidance the specific topics around ESG is it really will make boards sit up and think carefully about how they capture the data that’s required to report on these topics’.

By citing demonstrably poor oversight of environmental and social risks as an example of a material failure of the same magnitude as committing bribery or being issued with large fines or sanctions, ISS has reflected the growing recognition that ESG risks are material – and thus business critical.

‘The position of ISS on ESG risks and their correlation with financial risks is of fundamental importance,’ says Covino. For her, this position can be viewed in the broader context of efforts by European lawmakers to link long-term growth to a company’s environmental and social sustainability, particularly through the European Commission’s Action Plan for Sustainable Finance, adopted in 2018.

‘There is a change in tone and a change in emphasis on these issues,’ agrees Toms. ‘It’s not simply a matter of appearing to do good; it’s about linking it also to driving the long-term value of businesses.’

The emphasis on racial and ethnic diversity in ISS’ policy changes is part of a growing focus on the ‘S’ in ESG. The Black Lives Matter protests of 2020 drew attention to systemic racial inequalities in the US, which in turn prompted many other nations to examine their own attitudes to race and ethnicity. In this context, investors have become more focused on a lack of racial and ethnic minority representation at board level.

Richman says that ‘to the extent ISS incorporates [diversity issues] it becomes part of the framework reflective of the growing sensibility in that area.’

Activity relating to the social bucket of ESG also includes continued efforts to achieve gender balance at board level – a priority for both investors and proxy advisers.

There’s also a growing focus on employee health and wellbeing in light of the Covid-19 pandemic. ‘It would be desirable for boards of directors to develop workplace health and safety procedures to protect employees,’ says Covino.

In addition, the idea of linking executive pay to ESG criteria is gaining traction, although precise metrics will be needed to ensure doing so acts as a real incentive to change director behaviours.

There’s a sense that more ESG regulation is on the horizon. Richman says specific developments at the US Securities and Exchange Commission (SEC) are likely. ‘It’s rulemaking that has been talked about and it’s an area to watch,’ she says.

Toms highlights moves in the UK to introduce mandatory climate change reporting. He sees the current lack of standardised rules or benchmarks as a challenge that boards need to address. They can do so by deciding which existing standards they will report against, ‘to demonstrate they are taking these topics seriously’.

‘It is driving towards some level of common standard in years to come,’ says Toms. The international Financial Stability Board in particular is pushing for standardisation across markets. ‘It’s a real challenge for businesses,’ he says, ‘but I think the regulators recognise that.’

Boards would be wise to prepare now for future regulation. Richman suggests US companies could look at the feedback the SEC is giving on ESG disclosures to gain an insight into the form any future regulation is likely to take.

Matthews also highlights the likelihood of more shareholder resolutions being proposed that are focussed on ‘E’ and ‘S’ issues and the emergence of specialist funds with an ESG mandate. Both developments will ramp up the pressure in these areas.

‘This is only going in one direction,’ he says. ‘Boards would be well advised to get ahead of the narrative.’