Boards are pressed daily by new demands for compliance and information in the ever- exploding arena of environmental, social and governance issues, but their commitments and capabilities aren’t keeping pace with the rising clamor from progressive NGOs, activist investors, probing politicians and regulators, attuned employees, agenda-driven media and socially minded rank-and-file shareholders.
A case in point: The Securities and Exchange Commission recently proposed rule changes that would require companies to include climate-related disclosures in their stock-registration statements and periodic reports, including information about material risks from climate change on their businesses. The move represents a significant ratcheting up of the pressure on corporations to heed ESG sensibilities.
“You need to think about what’s material for your specific business,” said Jonathan Bailey, head of ESG investing for asset manager Neuberger Berman. “For instance, clearly, many companies have climate risks and opportunities. So what are you doing around climate-risk management and opportunities for your business and transitioning to a low-carbon future? That has got to be top of mind for board members.”
That’s why Corporate Board Member recently convened its ESG Board Forum, an online event that helped directors dive deeply and practically into the challenges of complying with the demands of this ever- expanding sector of responsibilities—and into opportunities for making leaders out of their companies in an important new area of differentiation for U.S. corporations.
Here’s some of what experts in the ESG domain shared at the forum:
Tips For Creating Good ESG Oversight
Melissa Waller, ESG and Sustainability Committee Chair, IperionX: “You need to not just talk the talk but walk the walk as an organization and what you’re reporting on and how that aligns with the SEC.” Also, “internal stakeholder feedback is important because employees are touching things daily and living and breathing the experience of the organization.”
Jamie Gorelick, Board Member, Amazon and VeriSign: “Try not to proliferate committees if you possibly can. My recommendation has been that the ‘E’ part and ‘G’ part be handled by the nominating and governance committee, while the ‘S’ part in the care and feeding of employees be in compensation and development committees, except to the extent that the ‘S’ part deals with vendors who are external, and then it goes to the nom/gov committee.”
Roel Campos, Board Member, Regional Management Corp., and former commissioner, SEC: “Large investors will be asking for more and more information about [ESG] because they have constituents and investors themselves who want to know about this. So have very objective measures: Is there a governance structure to deal with client risk? What committees or subcommittees are involved? Is there a process for risk management? These are object things without even getting to things like carbon measures [that will be] requested by investors.”
Ensuring The Right Information
John Roe, managing director and head of investment stewardship for the Americas for BlackRock, the $10 trillion (AUM) investment firm, outlined a “chain of answers and steps that have to happen” for boards to be assured they’re getting the right information about material ESG matters and are using it correctly:
Institutionalize interest: “The board has to be interested in receiving the information,” as demonstrated by committee structure and assignments. “There’s no silver bullet. Maybe rename an existing committee or the way you’ve divided overall responsibilities among the board itself. But doing it somehow is important.”
Identify specific risks: “The key ESG risks are different for everyone. You can turn to materiality determinations or the [Sustainability Accounting Standards Board index] as great starting points. Highlight what the external market is seeing as your key risks. But the board needs more information to say what they should be focusing on; for instance, with human capital, what is the specific set of risks? Is it how diverse employees are progressing through the seniority pipeline? Environmental risks such as water for data centers? There are real environmental risks that businesses are facing that they may not think they have.”
Link with management: “Determine the links between management and the board so that information can flow across. How is it being filtered? Do you trust the process? Make sure it’s working properly.”
Create “free-rangers”: “How can the board get information on its own if it feels the need to do so? Some people call themselves ‘free-range’ directors, able to roam the company and source information where they think it is important for them to do so—not in a rogue style, but in way that’s instructive, to bring additional information to the boardroom. What’s the equivalent of that ‘free-range’ director for your board? You may have a management team that’s fabulous and that you trust 100 percent, or not.”
Nota Bene: Calpers Isn’t Happy
The California Public Employees’ Retirement System (CalPERS) has hundreds of billions of dollars in assets and is perhaps the most influential of the public-employee pension funds that comprise a huge portion of America’s investment capital. CalPERS has been at the vanguard of agitating boards concerning ESG and takes a broad definition of the field to cover other areas, including human-capital management as well as more typical ESG concerns. So when James Andrus, CalPERS’ managing investment director of board governance and sustainability, speaks about ESG, board members should listen. And Andrus shared a largely dour view of how well most U.S. corporations are addressing CalPERS’ growing list of concerns and demands in this area:
On companies’ current reporting: “The baseline for information is quite low in terms of what is actually provided by companies, especially within financial statements,” Andrus said. “They provide very little information, [although] some of this is material. Climate-related information isn’t in there, and yet [the Financial Accounting Standards Board] isn’t even taking up this [deficit] as a research project. “Some would say this information isn’t material, but no—that information isn’t there because the standard setter hasn’t done the work to place it there.”
On the lack of a long view: “Financial statements don’t look long-term. If they’re looking forward at all, it may be just one or two years, and anything longer than that is just speculative. But we’re in a technology age where we can do substantially better. Investors need better information, and [companies] have all the systems available to do that. And companies get better” when they provide such information. “Some of these pieces of information in regard to ESG can be incredibly critical to certain companies, such as in identifying long-term risks such as climate change and in how companies treat their employees.”
On internalizing “externalities”: “We’re focused on having companies internalize the externalities that companies create,” Andrus said. “Externalities are, for example, when a company can operate in a market and cause a burden on people who aren’t part of the basic contract—like a chemical plant that is in a community and isn’t benefiting the community in any way; there are no jobs, and there’s no relief from odors or additional traffic. “Those things won’t stand anymore. We live in a technology environment where people won’t sit and take it. This causes a future burden on the company. It’s better to be a great corporate citizen now and into the future so that you don’t have that pushback. You need to take a responsible-contractor approach that will benefit the company and the community.”
On human-capital issues: “We have [an] issue with labor costs: People are companies’ most important asset, but you can’t find that information within financial statements. We need to correct that.” Andrus continued, “There are foundational issues with regard to how you treat other human beings. Some activities are going on in the U.S. that could not go on in other countries, such as how people treat farm workers. In some places, it’s not a requirement [to provide] farm workers with water and shade. “The questions become: Can huge companies, paying executives huge salaries and having sophisticated directors, operate in 2022 in a [way] that is on some level and in some manner treating people in a disgusting manner? We would prefer companies up their game and treat people better, especially their workers.”
Five Factors Driving Esg In 2023
ESG is “one of the top board-level topics today in the North American marketplace, up there with digitalization and technology, regulatory affairs, the future of work, inflation and sustainability,” said Anthony Decandido, ESG advisory partner for RSM U.S. LLP, a provider of tax, audit and consulting services for mid-market companies.
However, thus far the ESG movement “has been mostly stakeholder-driven,” he explained. “This is a difficult point for many boards to get around because we have a tendency in the North American economy to respond to instances of [regulation]. I promise you [ESG activism] is being done mainly because of the preference differences among folks moving into executive and management ranks now.”
Yet, Decandido stressed, “the level of interest and requirement around ESG will change dramatically” in large part due to five factors:
1. Companies are struggling to understand their poor ESG-compliance scores by big investors, NGOs and others grading their performance. “It’s hard to get credit,” he said. “You might be doing some great things organizationally, but if you’re not disclosing them, you’re not going to get credit in the market valuation of your business just yet.”
2. Outside agencies are available to help with this task. “Companies are struggling how to understand and support [information] and how that Anthony Decandido, ESG Advisory Partner and Financial Services Senior Analyst, RSM US LLP might be decision-useful to stakeholder groups, the board and the C-Suite,” Decandido said. But, “There’s a lot of interest in market consistency and comparability over these reporting frameworks.”
3. Help for boards in framing responses is on the way. For example, he said, the Financial Accounting Standards Board has put out a whitepaper “about the convergence of sustainability topics with traditional financial-reporting topics. So if you’ve got an operating footprint in an area that’s prone to natural disasters,” for instance, “and you represent a certain existential risk for operating there because of climate-related issues, FASB is now saying you have to consider that in your financial disclosures.”
4. The SEC’s climate proposal “is a watershed moment, a signal that the market wants this, that things have to be sorted out.” But the public-comment period on the proposed standard is likely to be extended, Decandido said, “because the reality is a lot of companies lack the competency to report climate-related carbon emissions at this time.”
5. The Biden administration’s infrastructure-improvement package “signals that things are heating up for ESG” because of its many aspects that boost spending on environmental quality and sustainability.
Four Ways To Get Good Esg Reporting
Boards and management may demonstrate the will to improve and execute ESG metrics, but how can they make that happen in a field where competence is still only developing yet demands for reliable information are outstripping its availability? RSM’s Anthoney Decandido suggested four approaches:
Recruit on campus: “Folks coming out of universities now have the opportunity to study sustainability, while most [directors] didn’t. The limitation there is that these [graduates] don’t have a rich degree of business acumen.”
Seek certification: Programs are emerging that offer professional licenses “that [require] a relatively limited cost” to get people up to speed who “want to re-tool themselves” and provide ESG-reporting expertise in the new era.
Start by crawling: “Reduce the number of things you’re presenting” at first, Decandido said, instead of falling for the temptation to over-report. “Ultimately, there are going to be business units in the company that have a high degree of competency with data aggregation, while others may not. That’s OK. It’s a journey, not a sprint. “Think through things that you can report quickly and accurately, so that when it’s published to the outside world, you can put your hand on your heart and say, ‘You can rely on this data.’”
Sponsor it: At the board and top-management levels, he said, “sponsorship is important” to make a priority of thorough, accurate and comprehensible reporting on ESG metrics. “You’re going to need at least a handful of people who are going to hold the company flag up on this and say, ‘This is important,’ or nothing will pick up traction.”
Tying ESG Performance To Executive Compensation
Investor and societal pressure is one thing, but board-designed incentives are the key to getting management to move deliberately and swiftly on ESG metrics and initiatives. So directors must be figuring out how to tie ESG performance effectively to executive evaluation and compensation.
“Start with the idea that compensation is an extraordinarily powerful tool, and pair that with swift performance appraisals,” said Joseph Bower, board member of Loews and of New America High Income Fund.
A long way evolved from old-fashioned notions of “corporate social responsibility” that often were “divorced from strategy,” companies today “see ESG as integral to their strategy in terms of risks as well as opportunities, and remuneration is really important to that,” said Hazel McNeilage, chair of the human capital and compensation committee for Reinsurance Group of America.
Tara Tays, partner with Pay Governance, a compensation advisory firm, suggested boards should “inventory the company’s most crucial ESG topics or issues and determine what has the most impact on enterprise value creation. An ESG materiality assessment and discussion can enable companies to have a multi-stakeholder view for what to consider including in incentive plans.
“Then you have to figure out how best to measure ESG performance” by executives. “Are there internal reporting mechanisms? What is the appropriate time horizon for measuring ESG performance? How should incentives be tied to ESG measures?” Tays said.
Be careful about “slipping into metrics and goals that are completely unachievable or that are homeruns for management,” McNeilage said. “Do materiality assessments comprehensively, and make sure you really understand where you’re starting from and that you’re paving the way for something that can work well.”
Promoting The ‘G’ In ESG
Neuberger Berman manages hundreds of billions of dollars in assets, and the investment firm has created an initiative called NB Votes in which it discloses its voting intentions for proposals at dozens of shareholder meetings. ESG issues have moved to the heart of its concerns.
“There are companies that we own [shares in] where it’s important to focus on getting the ‘G’ in ESG,” Jonathan Bailey, head of ESG investing for the New York-based outfit, told the Forum. “People sometimes assume that governance is great in the U.S. But there are board members who are more the petting-zoo version of governance than the oversight version.” He added, “So over these last three years, we have become very public about some of these votes.”
Bailey cited some examples:
Boeing: Neuberger Berman intended to vote this year for a shareholder proposal encouraging further progress against key climate indicators after the plane maker had made what NB Votes believes are several improvements pertaining to climate-risk practices and disclosures in the past few years.
The firm also voted several years ago against a board member who was chair of Boeing’s audit committee, which had responsibility for product safety amid the company’s disastrous experience with safety risks in the 737 Max model. “We felt that was a failure [in governance], so we voted against that individual,” Bailey said.
“Not everything is perfect at Boeing [now], but we’re also engaging them on environmental issues and their role in the climate transition,” including private meetings with company executives and directors about “putting in much more explicit oversight of climate risk,” he said, including “steps the company is taking in measuring [so-called] Scope 3 emissions and other oversight.”
“This is incredibly difficult for an aircraft manufacturer to do, but they have to be at the center of that solution, because at the end of the day, a more efficient flying engine is better for the end customer and the planet.”
General Motors: “GM is facing a generational shift in the type of cars it’s going to make, and we are fully supportive of its capital allocation to make that happen,” Bailey said. “It will cost in the short- and medium-term, but it’s important that the executive team and board are behind that. It’s important to have that in their long-term plan.”
Questions To Answer On The ESG Journey
Witold Henisz is a professor and founder of the ESG Analytics Lab at the famed Wharton School at the University of Pennsylvania and author of Corporate Diplomacy: Building Reputations and Relationships with External Stakeholders. He laid out some pragmatic thoughts for board members looking to link purpose to profits. Here are a few of his top-line thoughts from the Forum:
Nothing but noise: Most data about ESG performance is still “bad,” he said. “This data doesn’t allow people to assess materiality. You look at the correlation of ESG data across providers, and it’s almost noise. For the most part it’s a cloud, with almost no pattern. Most asset managers still aren’t incorporating ESG because they can’t prove an investment thesis or a business case.”
Weighting is important: How an individual company scores can depend greatly on how E, S or G factors are weighted against one another and on how various impacts of corporate practices are compared. “If Apple is in the bottom quartile or the top one” of an ESG evaluation “depends on how much you weigh human-rights atrocities in factories against greenhouse-gas emissions from Apple facilities in the U.S.,” Henisz said. “Is it good or bad to be in or out of natural gas? And even if you dollarize it and say, ‘What is the negative impact of emitting carbon?’ we disagree on the social cost of carbon.”
Pick and choose: For such reasons, he said, companies so far have been free to report different responses to ESG concerns. “Most report on carbon and on worker training,” Henisz said. “Beyond that, they choose what makes them look good and omit what makes them look poorly.”
Threatening the core: ESG issues don’t only stay on the fringes but can “affect value of top-line growth, the costs of waste, the costs of manufacturing, the costs of logistics and distribution and a range of additional costs if you have to pay security guards, lawyers and media-repair experts,” he said. “Will you be sued and brought into government hearings, and how well will you manage that? There are a number of high-profile cases, from Volkswagen to Boeing, where companies have been on the verge of bankruptcy because of ESG issues. And before that, these same firms were among the worst-performing in their sector on specific ESG issues they were subsequently sued for.”
Apply a proven tool: “You need to use your enterprise-risk management system here,” he said. “In terms of ESG, it’s about looking out across the business and all of its functions and identifying the biggest risks and opportunities, and building a governance system and strategy for identification of them, for measuring your performance in seizing those opportunities and for repeating the next cycle.” Boards could have been used to assess “safety or operational risks, but now you add climate risk or a risk of the lack of diversity and start modeling the impact on the organization, and start recognizing where you are on the journey.”
Not a question of morality: “ESG isn’t about goods and bads, rights and wrongs. Boards and executives may want to take stands,” Henisz said. “But I’m talking about material impacts on business, ESG factors that will change the P&L. You need to understand those linkages and manage them. If you manage them, you’ll have a win-win. Boards must manage material risks and make sure executives are doing that, focusing attention not on moral challenges per se but on those material to your business— and making sure management addresses or mitigates them appropriately.”