Boards are navigating waves of change on many fronts, and ESG is a powerful current bringing new risks and opportunities into view. As policymakers, regulators, investors and civil society press their causes, competing narratives claim attention across the United States and international markets. The questions facing corporate boards come swiftly in the wake of this attention: What is the board’s role? Is ESG a diversion of time, attention and precious company resources? Or is ESG a fresh insight into the drivers of a company’s success?
Boards have a fiduciary duty to their investors and shareholders to address financially material risks that could impact the profitability of their company. Old school economics tells us that oversight relies upon the effective management of the financial, human and natural capital that generates value for shareholders. With this in mind, ESG becomes part of business as usual (BAU), with the board in a vital role overseeing management’s execution of strategy, capital allocation and reporting, and company resilience and prosperity.
Part of the challenge with a short acronym is the wide range of possibilities for its meaning. ESG swims in an alphabet soup of terminology. Corporate lawyer Marty Lipton unpacks this, explaining the term ESG refers to “a collection of…disparate risks that corporations face from climate change to human capital, to diversity, to relations among the board, management, shareholders, and other stakeholders.”
Boards must assess whether and how these risks — and the opportunities they bring — are being effectively managed and monitored by management. The mix will be specific to each company’s sector, the strategy being overseen by the board and the markets in which the company operates. Risk and opportunity are two sides of the performance coin. Oversight of strategy, capital allocation and reporting require a mindset in which relevance holds the key to the board’s role.
Relevance is an essential judgment by the board. Not all issues matter to all companies, in all places, at all times, or in the same way. Working out what matters — as well as when, where and how — is the task of management, and ensuring accountability is the job of the board. Where to begin in that acronym soup?
Help is at hand. The U.S.-based Sustainability Accounting Standards Board (now part of the International Financial Reporting Standards, or IFRS, Foundation) provides companies with a materiality map, helping guide the identification of ESG issues for particular industries. Over 1,000 U.S. companies are using this framework to guide their sustainability reporting and provide decision-useful information for investors.
In the story, “Companies Quiet Diversity and Sustainability Talk Amid Culture War Boycotts,” The Wall Street Journal observes, “Companies still regularly voluntarily issue detailed sustainability reports, disclose greenhouse-gas emissions and tie a portion of their executive compensation to ESG metrics … What’s more, 70% of U.S. chief executives said that their company’s ESG programs improve their financial performance, up from 37% a year earlier, according to a KPMG survey released last October.”
The economic logic at work and understood by CEOs has the attention of investors. Morningstar notes that in the past year, on average, a majority of independent shareholders supported “key resolutions.” These are the annual general meeting proposals filed by investors that won at least 40% of votes from independent shareholders (which excludes insider holdings), seeking expanded reporting on issues like human rights, DEI, pay equity, employee safety, labor rights, greenhouse-gas emissions, methane production and water risk. Based on shareholder disclosures in mid-2022, Georgeson LLC reports that investors cited climate change as a reason for opposing the election of a management-backed director at 225 U.S. companies, up from 157 in 2021 and 83 in 2020.
Initiatives in private markets are reflecting the widening recognition of sustainability as part of BAU. For infrastructure and real estate, there has long been another acronym, GRESB: the Global Real Estate Sustainability Benchmark. This initiative was formed in 2009 to provide validated ESG performance data and peer benchmarks for investors and managers to “improve business intelligence, industry engagement and decision-making.”
Likewise, private equity investors have moved toward gathering standardized sustainability data from portfolio companies through initiatives like the Institutional Limited Partner Association, which developed its ESG Data Convergence Project with a pithy call to action: “ESG data is a mess. The market is splintered. Convergence is needed. Private equity is collaborating on a way forward.” The point is made at greater length by Novata in its “Four Tactics for Building the Business Case for ESG.”
Amidst the growing range of industry initiatives to improve reporting, clarity and coordination is on the horizon. In March 2022, the International Sustainability Standards Board released its first exposure draft for the 144 markets that follow its guidance. IFRS S1 (General Requirements for Disclosure of Sustainability-Related Financial Information) and S2 (Climate-Related Disclosures) build on the recommendations of the prior voluntary reporting framework launched by the Financial Stability Board via the Task Force on Climate-Related Financial Disclosure. This was in parallel to its incorporation of other best practice initiatives, such as Sustainability Accounting Standards Board, the CDP and, via memorandum, the Global Reporting Initiative.
In parallel, California adopted the Climate Corporate Data Accountability Act and Climate-Related Financial Risk Act, extending the reporting scope beyond listed companies to all those doing business in the state, within certain revenue thresholds. U.S. companies doing business overseas are also preparing for European requirements on sustainability reporting and other regulatory requirements from the United Kingdom, Hong Kong and Australia.
Markets are taking note of which companies are tackling ESG. Over a four-year study, MSCI found that, on average, companies with high ESG scores experienced lower costs of capital than companies with poor ESG scores in both developed and emerging markets. The cost of equity and debt followed the same relationship.
But does the cost of capital reflect improved operational performance? FCLTGlobal and Wharton Business School tested whether companies’ words and actions are matched and, in turn, how this showed up in performance metrics. After controlling for sector-specific events, the study “found firms that paired strong stakeholder language with strong performance on material ESG measures generated higher returns on invested capital over a three-year period, delivered higher sales growth and delivered more stable returns.” The study concludes that, if the example of the highest performers was followed by other companies in the top tercile, this would “combine to generate $3.2 trillion in additional firm value over our 11-year study period.”
The final word goes to Jim DeLoach, managing director of Protiviti.
“…The point is that leaders have a fiduciary responsibility to address the opportunities and risks posed by ESG matters as they ensure the long-term viability and well-being of their companies. Accordingly, they should focus on appropriate sustainability objectives while keeping an eye toward delivering expected financial results … Ultimately, directors must view ESG considerations the same way they view everything else that involves the allocation of capital and the future (e.g., understand the strategic opportunity and purpose, inquire as to the risks, and measure and monitor return on capital).”
That, to me, sounds like the closing argument for ESG as BAU. If it matters to the business, it matters to the board.
Anne Simpson is global head of sustainability at Franklin Templeton. She is a visiting fellow at Oxford University, a lecturer in sustainable and impact finance at UC Berkeley Haas School of Business and a member of the Directors & Boards Editorial Advisory Board.
This article reflects the views of the author and does not necessarily represent the views of Franklin Templeton or its autonomous investment managers.
