Placing ESG on the crowded Board Agenda

PLACING ESG ON THE CROWDED BOARD AGENDA?

This article is authored by?Ana Dutra ?and?Cigdem Oktem . All views and opinions expressed are solely those of the authors and do not represent any company or other individuals.

ESG remains in the spotlight???

As ESG continues to reverberate in headlines and investor communications, discussions in corporate boardrooms are evolving to reflect a multi-faceted view of corporate value – along with differing perspectives among directors themselves. Those who may have been confused about carbon-neutral vs. net-zero are no longer (or hopefully not after their companies have made public pronouncements). And supply chains and scope 3?(1) have become part of director parlance.?

The drivers that have defied those who considered ESG a passing fad remain strong. Self-proclaimed ESG funds and ETFs have continued to see inflows at greater rates than the market overall - even during the current period of market volatility – as US sustainable funds attracted $10.6billion in the first quarter of 2022(2). With greater numbers of millennials expected to shift into saving mode in the next few years, ESG investing can be expected to outpace other categories.?

Meanwhile, institutional investors and financial services providers are finding ways to connect capital to ESG priorities of investors from green bonds to working capital lines with climate impact covenants. The 2022 proxy season signaled continued overall support for ESG shareholder proposals, albeit less so for those considered to be overly prescriptive. The SEC and global regulators are also in the process of defining reporting requirements that will impact companies (far too greatly, according to a significant number of concerned directors with whom we have spoken).?

The trends of the last two years make clear ESG is not a fad, but what it actually means for boards and their oversight is less clear. With issues covering such a wide range, from green-house gas emissions, sustainability, cybersecurity, employee welfare, diversity & equity to board evaluations and appointments and social justice statements and positions, it is proving to be challenging for some boards to determine how to allocate their limited time and attention optimally to these continuously evolving issues.?

“Given the importance of ESG to investors and the recent attention to climate change by the SEC, Boards are prioritizing ESG oversight. Most boards have realized that a check-the-box approach will not suffice and are becoming fully engaged with respect to all ESG matters.” –?Director,??manufacturing company?

A general framework for consideration?

When we discussed ESG two years ago, we offered a 2x2 matrix with the axes of ‘differentiation’ and ‘impact’ to support board decision-making around ESG initiatives identification, prioritization and oversight. However, as we have seen boards and corporate leaders consider their options, we suggest an additional framework and categories to reflect the discussions taking place in boardrooms across sectors.?

Approaches to ESG:?

Rather than disparate options, the nested categories/positions reflect our personal observation that addressing ESG issues can create connections and leverage, and compliance has become ‘table stakes.’ Within each of these positions, boards have questions and issues to consider, which typically fall into what we are calling the Four C’s:?

(1) CONTENT - What does ESG mean for our industry and company when we play in this space? And, therefore, what skills does our board need to oversee and evaluate management efforts??

(2) COMMITTEES – Where does ESG oversight reside on the board? Which committees are involved? Should there be a separate ESG committee?

(3) COMMITMENTS - Should we make any specific public commitments to our stakeholders? If we already have, what do these commitments truly entail and how do we measure achievement of goals??

(4) COMMUNICATION - What ‘must’ or ‘should’ we measure, disclose or report and how? How and where will we communicate progress??

Ensuring the base level of?compliance

At this level, management and the board are protecting value by meeting mandatory disclosure or compliance requirements and ‘checking the box.’ Which means there is by definition little differentiation or impact on growth in the marketplace from ESG compliance efforts. This is the “ticket for admission” and essentially represents the fulfillment of a mandatory (or “strongly recommended”) disclosure.?

While more than 92% of S&P 500 companies are now producing sustainability reports (3), what is disclosed as well as the level of rigor and controls vary widely. The lack of standardized metrics and frameworks (SASB, TCFD) contribute to the challenge of stakeholders understanding what a company is doing in terms of environmental impact. When it comes to other aspects of ESG- social impact, diversity, governance – the activity is even less clear.?

With the SEC’s proposed rules for GHG emissions disclosures and general federal and state legislative efforts on curbing GHG emissions, boards (audit committees in particular) are focusing on what companies will be required to report. In addition, human capital disclosures are likely to receive an update from the 2020 amended rule, according to the Notice of Proposed Rulemaking.?

Should we have a paragraph briefly explaining the three proposed scopes for GHG emissions? I don’t feel strongly one way or another but it can make the point more clear…

There is a significant difference between voluntary disclosures and telling a company’s story in their own ESG metrics vs. reporting requirements that will require some level of assurance. Data definitions and warehousing across different systems will be considerably challenging even with principles-based rules. Boards will need to help management consider capital allocation and expectations (such as early adoption) while keeping an eye on how investor expectations for information may (or may not) align to regulators as institutional investors develop their own frameworks and metrics.?

In the Compliance category, the Four C’s are likely to include:?

(1) CONTENT – The ESG content in this category will be determined by regulators, legislators and, in some cases, proxy advisory firms and even institutional investors (which will likely fall in the “strongly recommended” sub-category). Most compliance items will be non-negotiable, e.g., number of women/ POC directors (although we have already seen steps forward and backwards in this category).?

(2) COMMITTEES – in this particular case, the responsibility for reporting will likely fall under the audit commit since we are referring to compliance items.

(3) COMMITMENTS – there might be some mandatory commitments and goals imposed by legislators and regulatory agencies. When that’s the case, the goals and timeframes should be disclosed in the proxy report. It is still unclear whether regulators will impose minimum levels of commitments and disclosures but there is a dialogue already taking shape between companies and main investors.

(4) COMMUNICATION – companies will have to measure and report on compliance items, whether it is in a separate report, throughout their proxies, or both.

Enhancing?risk management?via ESG?

This category naturally addresses value preservation and moves further by taking into account the changing profile of a company with a more dynamic and integrated approach to risk management around ESG. Here compliance is one outcome of the broader risk mitigation approach.?

For example, supply chain resiliency is now a concern for boards who may have only received an annual briefing previously. For boards focused on a risk management approach to ESG, sustainability and GHG emissions had already put the supply chain on the agenda and opened the door to risk mitigation options. Similarly, with human capital, identifying the risk elements in the ‘S’ – lack of employee wellbeing, lack of diversity and equity – is more likely to preserve value by increasing retention and perhaps even attracting new talent.?

Cybersecurity risks mitigation disclosure is another important topic worth noting as part of enhanced risk management. Companies that have risk mitigation and disaster anticipation and recovery methods and communicate them to their key stakeholder groups will be better prepared to address a cybersecurity breach and stakeholders will know it.

In the Risk Management category, the Four C’s are likely to include:?

(1) CONTENT – The ESG content in this category will highly depend on the company’s disclosed risk appetite and in the ERM areas it identifies as high risk. Most risk items will be choice-based but the goal will likely be to follow trends, anticipate future compliance areas and protect the company from potential liabilities. Content candidates are likely supply chain, talent, cyber and financial risks as a starting point.

(2) COMMITTEES – if the board has separate risk and audit committees, the responsibility for tracking will likely fall to the risk committee while oversight of reporting will likely fall under the audit committee. For boards that do not have a risk committee or boards that combine risk and audit, these ERM items will likely be under the overall board scope. In addition to that, Boards may decide to have a risk section under the audit, comp and governance committees and address ERM that way.

(3) COMMITMENTS – our recommendation in this case is to take a case-by-case approach. Once a commitment is made public, the board will have the obligation to track it and communicate to its key stakeholder groups.

(4) COMMUNICATION – companies can choose if and how to measure and report on risk management items, whether it is in a separate report or throughout their proxies.

Creating?strategic and marketing opportunities?via ESG

This is where the potential for value creation, differentiation and growth is significantly higher as taking a strategic perspective opens the door to major changes and opportunities. Where ESG issues are becoming part of business conversations, such as:?

·???????Financial decisions – the flow of money and investments incorporating ESG, whether it be funding or capital allocation. Funding includes ‘green bonds’ as well as carbon target-tied working capital lines of credit. ESG considerations in M&A are now also coming into play. Pre-IPO companies are adding diversity to their Boards in anticipation of going public, a common practice among PE-owned portfolio companies.

·???????People decisions - human capital management is firmly on the board agenda, for example compensation committees now expanding remit to be about compensation, talent and human capital. This opens the door to new types of information for the board as the typical annual employee engagement surveys can be stale and mis-represent what is happening. Depending on how the company approaches and communicates its people decisions, it can certainly impact its employee, customer and investor value propositions.?

·???????Technology decisions - investments in emerging capabilities and companies for sustainability, investing in changing processes and supply chains to reduce carbon footprint.?

“If leadership decides sustainability and ESG are among the big issues, they need to ensure the company aligns strategic focus accordingly” –?Director, manufacturing and materials company??

In the Strategic Opportunity category, the Four C’s are likely to include:?

(1) CONTENT – The ESG content in the strategic marketing category is 100% optional and primarily based on the company’s values, marketing strategy and strategic gaps. For example, a company that has been criticized for its non-environmentally friendly practices may want to highlight initiatives in this area, even without any disclosure mandates. Similarly, an organization that has experienced lawsuits or shareholder activism in the DE&I category may choose to underscore its human capital practices, ERGs or DE&I efforts.

(2) COMMITTEES – again, because of the non-mandatory nature of this category, activity, initiatives and programs may be discussed under the most relevant committee or in board updates. In many companies, marketing or investor relations groups are the Board liaisons in this category.

(3) COMMITMENTS – in line with the risk management category, our recommendation is to take a case-by-case approach. From the management perspective, initiatives discussed with the board may be led by a number of corporate officers, including – but not limited to – CEO, COO, CIO, CHRO, CDO and CMO.

(4) COMMUNICATION – companies can choose if and how to measure and report on marketing items. Options may include advertising, public and investor relations campaigns, targeted sponsorships, spokespeople or publicly speaking about specific issues or proxy filings.

Conclusion?

Other than mandatory and compliance items which are non-discretionary and non-negotiable, it is now an opportunistic time for companies to think strategically about ESG and all its components. The boards willing to go beyond a compliance approach and instead ask provocative and strategic questions to management will have the ability to enhance value for shareholders and stakeholders. The basics have not changed. Boards should start by asking management to: present an inventory of all the ESG items; understand impact and resource requirements to make changes; determine reasonable levels of commitment and communication; and evaluate management’s marketing strategies. Of course, these all need to be done in concert with all the other competing priorities on the board agenda. In some cases, rethinking board composition and represented skills and experience will be essential. In other cases, the experience is already there and all that needs to be done is to rethink committees and their agendas.

“ESG is a hot topic for boards both in the US and Europe and is now part of the standard topics for Board oversight. The next step will be for boards to determine the weighting of these ESG metrics vs. the traditional financial metrics” -?Director, technology and services company

Next level questions for boards to consider

·???????Where does the company want to ‘play’ in the ESG space? How are competitors positioning themselves??

·???????Has the company done a materiality assessment to understand stakeholder priorities??

·???????Should management integrate ESG functions and efforts into operations and finance or keep them??siloed? What organizational structure at the executive level would allow for optimal processes and synergy??

·???????As the management team and board learn more about ESG, how are the considerations changing (i.e. reporting, public commitments, capital allocation)??

·???????Would a Chief Sustainability Officer role be helpful? What reporting structure would make sense for the company?

·???????How is the company going to leverage investments in sustainability? How is innovation being driven by sustainability efforts??

·???????How is the board getting insight into employee attitudes and changes beyond the annual employee engagement report??

Endnotes

(1)?Scope 3 definition:?EPA definition?

(2)?https://www.morningstar.com/articles/1091550/us-sustainable-fund-flows-slid-in-first-quarter-2022

(3)?https://www.globenewswire.com/news-release/2021/11/16/2335435/0/en/92-of-S-P-500-Companies-and-70-of-Russell-1000-Companies-Published-Sustainability-Reports-in-2020-G-A-Institute-Research-Shows.html