In the fall of 2021, NACD, with KPMG, brought together lead directors from eminent corporations to share what they think board leaders get right and get wrong about environmental, social, and governance (ESG) issues and strategy.
During the meeting, they also had a conversation with Chris James, founder and executive chair of Engine No. 1, and reflected on the implications of that discussion for their boards and their roles as lead directors. They discussed the need to take a longer-term view in their corporate strategy to address existential ESG-related risks, the role of the lead director in doing this, and why the entire board needs to understand the strategy.
Business Strategy Needs to Incorporate Social Change
James shared his views with the group about why having a greater focus on ESG and tying it to strategy are now of the utmost importance. According to James, when it comes to ESG and strategy, boards and the companies that they serve need to view corporate strategy in broader terms now than they have in the past. Now, strategy also needs to take into account the existential climate threat, a longer-term view, and broader societal issues. “Climate risk is business risk,” he said. “This is a big deal because there is a real linkage between ESG criteria and a company’s financial performance.” Lead directors play a key role in helping their boards to understand this.
Delegates agreed that if they want to set their companies apart and attract future generations of investors, they need to pay more attention to this. “Talk of ESG being a ‘thing’ will only accelerate,” said one delegate. Another added, “As directors, we need to open our minds to seek change because younger investors are investing with purpose.” Boards also need to view ESG and the business strategy as one entity, instead of two. “At the moment, ESG is almost treated as a separate appendage,” said one delegate. “You need ESG to become part of strategy and enterprise risk, not something separate.”
Adopt commonsense capitalism. James noted that Engine No. 1 takes a different approach to strategy than a lot of its competition. “We are a purpose-driven firm. Our belief is that we are at a convergence where what is good for society is what is good for companies. In order to quantify the impacts that companies have, we built a framework to measure those impacts; it’s called the ‘total value framework.’ This is a data-driven approach, where we link ESG criteria to economic outcomes that drive value for the companies.”
Pay attention to the existential risk. Creating a strategy that is dependent on society’s failures, such as a strategy dependent on the continued societal reliance on fossil fuels, is probably not the best approach, James told the group. Instead, a better way to encourage companies to pay more attention to the long-term view is to look at the existential risk, such as for climate, and how climate risk can affect the organization. “Existential threats to our company’s long-term survival are self-evident,” agreed one delegate. “So we need to make sure there is ESG [among the risks we oversee]. For example, if there are no raw materials, there’s no end product. It’s commonsense capitalism, so make the right choices. It’s not just about data and checking boxes.”
Take a long-term view. When companies transition to a strategy that takes a longer-term view, the board needs to accept that sometimes there may not be a short-term economic benefit, according to James. However, there is still enormous opportunity to create value in transitioning to a longer-term view, despite the potential for short-term economic setbacks. “If you can play a leading role in the transition and have a chance to redefine yourselves as a company, then you want to support that idea,” James said. “Decarbonization is a transition you want to accelerate. You want long-term targets. You don’t want short-term earnings to overly constrain you when you have a onetime chance to make a change per generation to have an impact.”
For example, the auto industry has a clear path for starting such a transition: moving away from manufacturing vehicles that use an internal combustion engine and toward producing electric vehicles that run on batteries to decarbonize. Other industries have less of a clear path, but it is the board’s responsibility, James said, to help their organizations to get on board with this mindset, regardless of industry. Taking only a short-term view during a transition has its own set of risks, such as opening up a company to activists, he added.
Include social issues and DE&I in the strategy. Companies will also want to build social issues and diversity, equity, and inclusion (DE&I) into their strategies along with taking a longer-term view, according to James. “We can link these to economic outcomes,” he said. “We can A-B test two companies in the same industry around DE&I and wages. Take into account the long-term view that employees are there for you. [Paying higher wages and incorporating equity] looks like short-term expenses, but it pays off in the long run.”
The group agreed that building ESG into a company’s overall business strategy and taking a stand on an issue, and then making these part of its brand, are important. Consumer brands that have already done this have experienced better business outcomes, according to group members. “Show your values. Be transparent,” James said. “Know you’ll make mistakes, and don’t blame anybody. Blame is not constructive. But take into account where society is moving to create your strategy.” One delegate added that doing this has been a huge recruiting tool. “People get excited to work for companies that do good for the planet and that align with employee values,” added another delegate.
The Role of the Lead Director
Lead directors need to be able to start tough conversations and to get all board members on the same page when there is disagreement over what may be the best direction for the company. James explained one aspect of a lead director’s role: “When there is no separation between the chair and CEO, you need lead directors to start conversations about the challenges,” he said.
Another important aspect of the lead director’s role is convincing the board to adopt a long-term view and convert the resisters. For example, the lead director needs to make sure that the board is open to giving up short-term progress in some areas and that they are comfortable with a few down quarters when a company is making a bigger transition for the greater good. “The [European Union] has shown a willingness to take on addressing ESG-related externalities much earlier than US companies,” said James. Directors may want to speak to their European counterparts to understand what roles boards played in the planning process.
He told a story about how at one US-based company, the CEO and the lead director were interested in making a transition to a long-term approach, but they did not have buy-in from the rest of the board at first. “[To convince a skeptical or resistant board], you can’t just say we’re focused on the long term. You need to say we’re focused on the long term with this strategy and these measures,” said one delegate. Over time, the lead director was able to gain the support of the other directors by talking with European companies in the same industry that had made a similar change and sharing the strategy in greater detail.
The Board Needs to Understand the Strategy to Hold Management Accountable
Understand the role of the board around long-term value. The board needs to be able to understand the strategy well enough to hold management accountable to it, especially during a transition. Many companies, especially long-established ones, traditionally haven’t had a lot of conversations with their stakeholders around strategy, but they need to start, since a growing number of consumers want to do business with purpose-driven companies whose values align with their own and with companies that are transparent about their ideology and values. “There is a real competitive advantage for companies that make their values on [ESG strategy and climate risk] transparent and public,” said James.
Boards also need to understand that such a transition will likely create more value for the organization, so they first need to know where the organization is going in terms of strategy. This way, they can work with the management team to execute that strategy.
Consider your board’s composition. Boards need to look at their composition and make sure that they have the right level of expertise and skills to focus on ESG criteria and to take a long-term view. Going through a transition can be turbulent. Directors will need to actively participate, and boards will need to have multiple points of view among their members to address the many challenges the company will face. According to James, “You need to have this kind of multidisciplinary understanding on boards. It creates more value. This kind of mindset can help US companies gain market share.”
Directors will need to read and understand the research on ESG issues, examine and interpret the data, and then bring that data to their discussions, said multiple delegates. “Just because there’s data doesn’t mean it’s the right data. We need to determine what’s important versus what’s easily available,” stressed one delegate. Board members will want to engage with management and also obtain feedback from first-line managers on climate risk.
Delegates agreed that companies also need to build in measuring progress toward achieving ESG goals in relation to the strategy. Then boards need to think about how to tie this to compensation as an incentive for senior leadership.
However, some debate still exists as to where oversight for ESG lies within boards. Should it sit within the audit committee? Or would it be better served in the risk and compliance committee or somewhere else altogether? This remains to be seen, and the work continues. The corporate truism holds here: one size does not fit all. The bottom line is that regardless of how a board and corporation address ESG, it has to begin somewhere. Inaction, it seems, is not an option.
Editor’s note: The meeting was held using a modified version of the Chatham House Rule, under which participants’ quotes are not attributed to those individuals or their organizations, with the exception of cohosts.