The Board and ESG

Fuente: Harvard Law School Forum on Corporate Governance and Financial Regulation

Discussions of environmental, social, and governance (ESG) matters have taken hold in mainstream media, government bodies, coffee shops, the food industry, clothing manufacturers, and boardrooms. With such high stakes, this is an area that organizations, and their boards, cannot afford to get wrong.

As overseers of risk and stewards of long-term enterprise value, board members have a vital oversight role in assessing the organization’s environmental and social impacts. They are also responsible for understanding the potential impact and related risks of ESG issues on the organization’s operating model. In light of these factors and stakeholder concerns, organizations are reimagining and enhancing their ESG positions. This is happening more in some regions (e.g., Europe) than in others, and it is more prevalent in certain sectors (e.g., consumer products, heavy industry). Shifting political winds also can affect these efforts. Since ESG issues began to move into the mainstream, the trend has generally been for organizations to pursue sustainable practices for the long term.

It can be challenging for boards to connect global issues, such as climate change, water scarcity, or human rights, to the organization’s operations, strategy, and risk profile. But given that ESG concerns both influence and are influenced by operations, finance, risk, compliance, legal, human resources, and other considerations, leadership teams have ample opportunity to leverage ESG for the long-term good of the organization, its stakeholders, and society. It’s an endeavor both management and the board need to undertake for the general betterment of those inside and outside the enterprise.

The Evolving ESG Landscape: Trends and Practices

ESG matters are finding their way onto boardroom agendas more frequently. As the scope of these and the debate surrounding them continue to expand, so do the board’s oversight responsibilities. The following are among the key ESG-related trends:

• Impacts are increasing and increasingly important. Business activities have both positive and negative impacts on society. Negative impacts include their contribution to climate change and weather-related events, air and water pollution, ecosystem degradation, mistreatment of animals, human rights abuses in supply chains, and potentially unsafe practices and products. Many believe that most negative impacts related to human activities, such as climate change and biodiversity losses, are worsening. Among the most favorable trends is a decline in world poverty; global GDP has risen steadily in the past two decades. Business has also been credited with innovations, job creation, philanthropy, and other contributions. Some organizations have actively embraced and promoted “green” goals and aim to boost the “triple bottom line,” which considers people, planet, and profits.
• Transparency is the new normal. Trends in ESG reporting indicate a steady move toward greater transparency. Standard-setting organizations, including a number of stock exchanges, have called for enhanced ESG disclosures. Civil organizations and the media regularly track and report on ongoing performance and specific events in terms of industrial accidents, environmental degradation, and impact on human populations. Social media has also become a force for ongoing transparency, and consumers increasingly want to understand what is behind the product they see on a shelf.
• Reputation is an indispensable asset. As trust in institutions and the power of traditional advertising have diminished, organizations have come to realize that reputation constitutes a strategic asset and can be directly and indirectly influenced by ESG practices. Although reputation is often viewed mainly as an issue for business-to-consumer companies in developed countries, many business-to-business companies in all markets are affected by greater risks and heightened transparency requirements across the supply chain. In response, many companies are now prioritizing ESG factors internally and among their vendors. These organizations realize that a significant ESG event anywhere in the extended enterprise can damage their reputation.
• The workforce cares. Employees want to be proud of where they work and want its purpose, mission, and culture to reflect, or at least not oppose, their values. This is especially true of younger professionals. Corporate value statements and management’s cultural messaging may mean little to these workers in the face of negative ESG impacts, which can compromise an organization’s ability to attract talent. A favorable ESG profile and an absence of negatives can be an asset, particularly in areas where talent is scarce and competition is strong.
• Business value is at risk. ESG issues can take a long time to erupt into risk events. While many environmental risks, such as climate change and water scarcity, have been anticipated for a long time, others emerge rapidly. A recent example includes the plastic backlash that began a year ago, soon after the discovery of the Pacific garbage patch and the subsequent media reporting. Not all ESG risks are long term. Depending on the business model, material and labor sources, evolving regulations, and stakeholder behavior, ESG matters can also present near-term threats to an organization’s supply chain, reputation, and shareholder value. Consider the potential impact of child or forced labor in the supply chain, carcinogenic ingredients or conflict minerals in products, or major class-action suits launched over executive decisions or behavior. Given the potential impact on near- and long-term shareholder value, leaders must gauge the full range of factors that generate ESG risks and develop ways to address them.

It can be useful to think of ESG risks in terms of the organization’s social license to operate. Unlike a legal license to operate, the social license to operate is granted, in part, by customers through their purchasing decisions. If your ESG reputation is tarnished or people associate your enterprise with global warming, water pollution, resource abuse, child labor, or poor working conditions, your business may suffer either a gradual or rapid decline in demand. Many consumers seek out companies known for sustainable practices and are willing to pay a premium for sustainably produced food and clothing or space in a LEED-certified building. Such consumers often represent a substantial, loyal, and affluent minority. Equally important, sustainable products are being brought to market at costs increasingly comparable to those of more traditional versions, a trend that we expect to continue.

Regulators tend to follow the public’s concerns on ESG matters, although they also develop their own views. In general, the European Union has been the global leader in ESG policies, followed by North America and Asia. Under Directive 2014/95/EU, as of 2018, about 6,000 EU companies must disclose their policies on environmental protection, treatment of employees, respect for human rights, anti-corruption and bribery, and board diversity. Lower and more variable regulatory demands in North America tend to generate practices driven by stakeholder expectations and individual companies’ initiatives, with some organizations and jurisdictions pursuing aggressive programs. California will, as of 2020, ask the two largest US pension funds to consider disclosing material climate-related risks if it is in the shareholders’ best interests. [1] ESG practices are also reaching new regions; for example, many Southeast Asian companies have boosted ESG efforts to bolster their reputations and their ability to do business in countries with stronger policies.

Investors look to ESG

The ESG concerns of specific investors vary, as does their view of organizational responses, but all need information to help them make investment decisions. They want insight into management’s posture on ESG topics and the associated issues and risks, as well as plans and responses. For example, institutional investors have become highly concerned with climate change, and many are voting their proxies, engaging management, and seeking clarity on management’s and the board’s positions in this and other areas. Engagement can help companies better understand which ESG topics their shareholders see as priorities.

Investors realize that ESG activities can have negative or positive financial consequences and they want to anticipate and account for the operational, regulatory, and reputational impacts of ESG issues. They see the link between ESG and the value of the business, but they cannot forecast value and factor in related risks without better ESG information.

It is in the organization’s interest to provide robust ESG disclosures. First, these disclosures give investors information they want and need; when it is lacking, they may think the worst or simply invest elsewhere. Second, public disclosure allows businesses to demonstrate progress and benchmark their own practices and reporting. Finally, public disclosures put management in control of the ESG narrative. When investors do not receive ESG data directly from the company, they will turn to other sources for that information or an approximation of it. It’s highly preferable for the organization to provide accurate data and develop the narrative context for its ESG practices to communicate the right message.

Unfortunately, even those companies that are working to enhance their disclosures often produce results that lack the relevance, transparency, and comparability that would really benefit stakeholders. Some have still not identified the most material ESG issues for their businesses. Most communicate aggregate information rather than reporting on specific geographies and lines of business; this high-level aggregation is of little help in comparing companies with different geographical footprints and different degrees of value chain integration. Investors would need further investigation and analysis to make those comparisons when they are even possible. While the trend has clearly been in the direction of increasing ESG disclosure, there’s room for improvement on detail, transparency, and comparability.

Some financial institutions now consider ESG factors in their lending and investing decisions, with others moving quickly in this direction. Although these institutions might not have considered corporate customers’ ESG profiles in the past, they now realize that ESG risks could affect those customers’ future financial performance. They are scrutinizing these issues more closely when considering which companies and projects they will finance, particularly in light of climate-related issues, although concerns extend to other areas. This trend is strongest in Europe, where sustainability performance can influence what corporate customers will pay for a loan, which would not have happened years ago.

Sources of guidelines

Boards, CFOs, and audit committees should be aware of organizations and initiatives that promulgate ESG reporting guidelines. Some of these include:

• The Global Reporting Initiative is a network-based organization committed to improving sustainability reporting; its participants include business, social, labor, and professional organizations. GRI’s Sustainability Reporting Guidelines are widely used by large companies and set forth reporting principles, standard disclosures, indicator protocols, and economic, environmental, and social performance measures. The latest release stresses “material aspects” to help organizations identify issues significant to stakeholders. [2]
• The International Integrated Reporting Council promotes periodic, holistic reporting about value creation. The IIRC helps organizations consider how environmental strategy, governance, and performance can create value in the short, medium, and long term. The IIRC also strives for a reporting environment that promotes understanding of strategy, drives performance internally, and attracts investment. [3]
• The Sustainability Accounting Standards Board sets sustainability accounting standards for publicly listed companies in the United States for use in disclosing material sustainability issues to investors and the public. It is developing standards for more than 80 industries in 10 sectors by researching material issues, convening industry working groups to establish accounting metrics, and providing education on how to recognize and account for material nonfinancial issues. [4]
• The World Federation of Exchanges, a global industry association for exchanges and clearinghouses, published principles in 2018 to integrate a long-term perspective into financial markets to reduce socioeconomic and physical risks. While member exchanges are not required to adopt additional rules or recommendations on ESG disclosures, 39 of the WFE’s 79 members have issued such guidance, and the new principles were greeted as a milestone by the United Nations Sustainable Stock Exchanges initiative. [5]

Guiding the enterprise toward greater sustainability for the long term

Most leadership teams already see the need to identify and manage ESG impacts and risks. Boards have the responsibility to influence management to enhance the organization’s approach to ESG. This is not just about public relations and branding, although those are valid considerations, nor is it merely a matter of ethical practices and having a positive organizational impact. It is also a question of business performance and long-term value. Almost by definition, sustainable practices aim to ensure that the organization creates and maintains value over the long term.

The business case for ESG generally begins with operational efficiency and risk reduction as primary goals and then extends to longer-term operational and organizational resiliency and sustainability.

To head the organization toward an increasingly robust approach to ESG, the board might also consider the following practices:

• Request a formal ESG assessment. Senior executives and the board should be aware of all potential impacts, risks, and opportunities posed to the business by ESG concerns and be clearly informed of those that are most material for the future of the organization. An ESG inventory and formal risk assessment should extend beyond the organization and its internal operations, and it may be appropriate to engage external stakeholders. The assessment should cover the complete supply chain, the extended enterprise, and strategic considerations such as resource accessibility, usage, and sustainability; talent recruitment, engagement, and retention; financial performance and risk; and reputational impacts. The assessment should not only identify and rate all risks, but also consider how those risks interrelate at the enterprise level.
• Urge management to engage with stakeholders. Management must understand the ESG priorities of key stakeholders—particularly investors, customers, employees, regulators, and business partners—and how they view the organization’s performance. This information can be gathered and monitored through periodic surveys of specific stakeholder groups or across all stakeholder segments. It’s best to have a formal process of ongoing stakeholder engagement at the management level, and in some cases to involve the board. For example, some companies develop a committee of representatives of key stakeholder communities to discuss ESG matters. Others will consult “critical friends” on sensitive ESG topics. Many also monitor their reputation in traditional and social media and work to address ESG concerns raised there.
• Insist on high-quality internal ESG reporting. The board needs to understand management’s approach to ESG and its performance against relevant metrics. Energy use is an excellent starting point for many large organizations; other metrics may involve water use, especially in areas where it is scarce; critical metals; chemicals, plastics, and other materials; labor practices; climate and other environmental impacts; and extended enterprise practices. Coverage should extend to foreign, as well as domestic, operations. ESG events should be reported to the board in keeping with the organization’s established risk-reporting procedures regarding type and magnitude. Developing a reporting protocol can be challenging, because this goes beyond financial and standard operating reporting. Either the board or specific directors should engage with management and external experts regularly to understand the interplay between ESG and the organization’s operational and financial performance, goals, risks, and reputation. The board should also work with the CFO and other senior leaders to obtain data that is relevant and comparable from period to period.
• Encourage more proactive disclosures and goal setting. Management should be aligned on which facets of ESG are most important to the organization and adopt a method of reporting on related activities, risks, and opportunities. The organization should articulate clear and measurable goals on ESG issues so it can gauge progress over time. Gathering ESG data and developing an ESG reporting infrastructure now helps position the organization for a future in which the demand for this information will likely increase. Management should make ESG disclosure a priority, update disclosure practices based on changing standards and organizational practices, and maintain control of the organization’s ESG narrative.
• Establish specific ESG roles and responsibilities. Once an organization has identified and assessed specific ESG impacts, risks, and opportunities and the data gathering, measurement, and reporting mechanisms are in place, management and the board are better positioned to set and pursue near- and long-term goals. Many large organizations have appointed a chief sustainability officer, while others have given the CEO or other C-suite executives explicit ESG responsibilities. From a board perspective, ESG is most often overseen at the full board level or by the board’s strategy or risk committee. The audit committee should also initiate or strongly support efforts to provide high-quality ESG assurance to the board, or to the primarily responsible board committee.

Arguments boards make to encourage management’s ESG efforts typically involve business disruption, regulatory compliance, and reputational risks. These arguments are compelling in the absence of strong regulatory imperatives or in the presence of weak ones.

In keeping with recent trends, ESG regulation is expected to continue to strengthen, as is the interest that investors, customers, supply chain partners, civil organizations, and the media have in ESG policies that have a positive impact on the communities they touch.