In recent years, ESG investing has gone mainstream with investors making the argument that it offers superior risk-adjusted returns. Investors have found that ESG offers two distinct advantages: providing unique opportunities to increase the value of their portfolios while also protecting those portfolios against downside risks. Today, roughly 25% of all assets under management are invested in ESG funds, and the U.N. Principles of Responsible Investment, or PRI, which was launched in 2005, has since grown to more than 2000 signatories from over 60 countries representing over $80 trillion of assets.

Why do investors want boards to oversee ESG?

Sustainability and ESG are no longer the sole responsibility of a company’s sustainability officer or other corporate executives. Today, investors expect that the board will be fully engaged on ESG, as it has been shown that companies with robust board oversight tend to do a better job managing ESG risks. Accountability for board members has also been brought to the forefront, as noted in BlackRock's 2020 CEO letter:

3 Key Components of an ESG Competent Board

An ESG Competent Board is one that can responsibly oversee ESG risks and is so enabled by the following three characteristics:

1. ESG Expertise: One or more Directors have ESG expertise, meaning they have significant qualifications related to material environmental and social issues;

2. ESG Fluency: The board should have an overall fluency in ESG, meaning they can connect ESG issues to the strategic decision making for the business; and,

3. Continual Learning: All directors should continually learn about ESG issues and their relationship to the business.

ESG Expertise vs. ESG Fluency

What is the difference between ESG expertise and ESG fluency on the board? 

Having an individual board member with ESG expertise does not guarantee that there is overall board ESG fluency. In order to have overall ESG fluency, the board collectively needs to be able to have nuanced conversations about ESG issues and connect those issues with the business. The board must act as a cohesive and deliberate body and must be fluent in ESG issues - meaning it can apply them to decision making, in terms of strategy, risk management, executive compensation, etc.

The board must have a basic understanding of ESG in order to ask the right questions of management and each other, and ultimately tie ESG back to the business case and strategic decision making. Deep expertise, experience, and fluency of individuals are important, but the board must also be able to process and leverage that expertise to the benefit of the business. A company must continually educate board directors in ESG to maintain that fluency. A board Skills Matrix is one way to demonstrate both the ESG expertise of individuals and the broader ESG fluency of the board as a whole.

Structuring Board Oversight of ESG Risks

What are the benefits and drawbacks of having a designated Sustainability or ESG committee?

Assigning ESG to a board committee signals publicly that ESG is important to the company. Another benefit of assigning ESG to a single board committee is that it ostensibly ensures dedicated time on their committee agenda when it might not get that level of attention if it is solely assigned to the full board. However, some board committees, like the Audit Committee, may already have a crowded agenda and spend little time discussing ESG meaningfully. What discussions they do have may, unfortunately, be siloed from the relevant deliberations of other board committees (like the Nomination Committee or the Compensation Committee). Assigning ESG to a single board committee, though, assumes the board committee has ESG fluency and particular members have ESG competency. If that board committee does not have ESG fluency and members with ESG competency, it will underperform in its role.

An ideal solution could be to assign ESG to several ESG fluent board committees, which then share their reports with each other, and together share a synthesis of the issues and strategy recommendations with the full board. This all assumes that ESG issues have been surfaced and prioritized with input from management. The board may need to first empower management to complete a fact and circumstance analysis of material topics and then compel management to present their baseline performance on those topics to the board.

Navigating ESG Risk

Why are ESG risks so difficult to identify, assess, and mitigate?

A risk identification system won’t find what it is not designed to look for and a company culture that willingly ignores ESG risks will likely not have the self-awareness needed to upgrade its risk identification systems. A risk identification system constrained to only look for traditional financial risks that have impacts on shareholders’ return on investment will lack the sophistication needed to detect a wider range of environmental and social risks.

ESG risks are inherently dynamic and interrelated, emerge often from a confluence of factors (a perfect storm), and result in compounding and varied impacts. ESG risks are characteristically not near-term, top-down, and compliance-driven. Instead, they emerge at their own pace from the interests of a wide array of stakeholders, some of whom a company may not readily engage with – at best – or others with whom a company has an adversarial relationship. A high-performing risk identification system that senses emerging ESG risks from a cross-section of internal and external stakeholder groups is an essential element of this trio of tasks.

If the system used to identify risks does result in an inventory of ESG risks relevant to operations, products, services, and markets, the next essential task is to assess those risks for their materiality – in other words, the likelihood and the severity of their impacts. Reaching consensus on prioritization criteria can be challenging, will again test company culture, and requires buy-in. Monetizing the impacts of reputational risk, for example, is far more abstract than monetizing the cost of non-compliance with regulatory requirements.

The third task, mitigation of ESG risks, is equally complex but one that can be shared by a cross-functional team of subject matter experts, management, and board committees.

ESG Performance and Executive Compensation

Does tying executive compensation to ESG targets change how ESG risks are managed?

Anyone versed in sustainability knows the concept of “Triple Bottom Line” where not only financial success is sought (traditionally represented by “The Bottom Line” which is the last line on a Profit and Loss Statement that shows if a company has made money or lost money that period) but also when Environmental and Social goals are achieved. However, anyone who is engaged with the actual practice of seeking sustainability on behalf of a business knows that human behavior is often the key to success, and unfortunately, human behavior is largely influenced by financial rewards. “At the end of the day, everyone is motivated by their compensation,” says Veena Ramani, Ceres Senior Program Director, Capital Market Systems.

Tying executive compensation to ESG targets can be highly influential in how ESG risks are managed if it is done in a way that truly incentivizes executive behavior. Vague, poorly defined metrics, discretionary targets (or too many targets or targets that are not material to the company), lack of third-party verification of performance, opaque compensation formulas, and minimal weight given to ESG targets result in lukewarm behavior change at best or gamesmanship at worse – meaning that the increased stock value due to the PR value of announcing linkage of executive compensation to ESG actually outweighs the amount that the executives would get by actually achieving the ESG targets.

Further, if the Compensation Committee is not ESG fluent and has no member who is ESG competent, the commitment will lack teeth. Explicit, material, well-defined goals, transparent and frequent disclosure on progress, adequate weighting of E and S targets on compensation, and an ESG fluent Compensation Committee – with a charter that makes this function persist over time – have the potential for real change. Based on the avalanche of press releases in 2021 about companies linking compensation to ESG performance (Jet Blue, MasterCard, etc.) we should have lots of models in the coming years to examine for a formula that works.

The Board’s Role in ESG Disclosure

How can board members effectively leverage the GRI and SASB standards to ensure that management is overseeing Environmental and Social risks?

As a consultant and practitioner of ESG reporting, I have years of experience applying GRI and SASB standards on behalf of KERAMIDA’s clients. I think of the GRI standards as both reporting standards (how to report) and disclosure standards (what to report). I consider the SASB Standards, on the other hand, to be mainly disclosure standards, having contemplated their inclusion in the SEC's reporting standards (such as those for creating a 10-K).

GRI Standards

GRI's reporting standards (101, 102, & 103) tell an organization how to report and call for transparency around processes for stakeholder engagement and for determining materiality. If an organization is using the GRI Standards, the board needs to ask if those processes will result in a disclosure that is comparable to its peers. It also needs to ask what processes ensure reliability of the data that is being used to describe performance and set targets. Third-party assurance of non-financial disclosures is a maturing service and variation in quality and scope might go unappreciated by stakeholders. The board also needs to ask if the contents of the disclosure – its GRI report – is balanced. I have seen too many Legal departments pull unflattering content from a draft report before it ever gets to Executive Management or the board. When that happens, I often wonder if the board had the chance to ask any questions about how management was responding to those negative aspects of their ESG performance.

SASB Standards

If an organization is using the SASB Standards, either as an index that accompanies a GRI report or as a standalone table, the board needs to ask if SASB’s description of the chosen industry’s context (found in the “Industry Description” paragraph) is accurate and adequately covers all of the organization’s significant operations, and if each “Topic Summary” resonates with why the topic is likely material to the reporting organization. If there are gaps, the board needs to ask what other SASB standards and topic disclosures can be used to fill them to provide a complete picture of material topics. Also, if topics within the chosen SASB standard are not applicable, the board should ask if the report explains why.

If both GRI and SASB standards are being used, the board should ask how the report addresses the difference in how GRI and SASB define materiality and any other inconsistencies between the two. 

KERAMIDA’s team of Sustainability and ESG consultants have a wealth of expertise and experience in all aspects of ESG issues. We can work with boards who seek to improve their members’ ESG competency, their overall ESG fluency, and their ability to adequately oversee the company’s ESG aspects including identification, assessment, and mitigation of risks. Contact us or call (800) 508-8034 to speak with one of our professionals today.

Contact:

Becky Twohey, Ph.D.
Vice President, ESG Strategy, Planning and Reporting
KERAMIDA Inc.

Contact Becky at btwohey@keramida.com