Understanding the Board’s Role in ESG
Environmental, social, and governance (ESG) performance as a criterion for investment has a growing impact on value preservation, value creation, and, ultimately, the future of the corporation itself. Although ESG is as broad as it is amorphous in scope, it is not an insurmountable topic for the board agenda.
The coronavirus pandemic has heightened the perception that ESG factors can affect a company’s risk management and improve its resiliency. UBS, in a statement about sustainable investing after COVID-19, said that, “We expect increased investor focus on ESG considerations after COVID-19, with particular demand for greater corporate transparency and stakeholder accountability.” The year 2019 set a record for net flows into sustainable trade funds in the United States at $20.6 billion for the year, which is four times the previous record set in 2018. In the first quarter of 2020, ESG funds saw half of last year’s total inflows at $10.5 billion.
The investor community has intensified its focus on the intersection of business and larger concerns for people and the planet, and as a result, companies and their boards have gradually started to prioritize doing business responsibly. In the 2019–2020 NACD Public Company Governance Survey, nearly 80 percent of directors report that their boards are focused on some aspect of ESG, with 52 percent seeking ways to improve their individual understanding of ESG performance. These data suggest that today’s directors are becoming increasingly aware of the importance of ESG to investors, consumers, and the company’s bottom line.
Directors are bound by fiduciary duties, which many argue now extend to considering ESG factors when providing oversight of strategy and risk. The broad scope and inherently dual nature of ESG—which facilitates the creation of business opportunities or reputational value, while companies also manage risks associated with ESG impacts—present a significant governance challenge for boards.
To ensure a practical focus on how corporate boards can provide effective oversight of ESG, NACD interviewed and surveyed more than 100 company directors and sustainability executives representing a wide spectrum of companies that vary in size, maturity, and industry. Their insights have been collected and distilled into NACD’s new Strategic Oversight of ESG: A Board Primer, which outlines four fundamental challenges in overseeing ESG issues and corresponding solutions for boards.
Challenge 1: Defining ESG for Your Organization
Many boards still view ESG as a narrow, noncore activity that primarily focuses on philanthropy through corporate giving and volunteering. However, ESG encompasses business practices far beyond the concept of corporate social responsibility, under whose umbrella those charitable activities traditionally fall. Management and directors must work together to create an organization-specific definition of ESG that is rooted in corporate strategy and company performance.
Solution: Use company products and services to anchor your company’s definition of ESG. Boards should ask the following questions:
- How does the organization define ESG?
- How has management communicated this definition to the broader workforce and to external stakeholders?
Challenge 2: Integrating ESG into Company Strategy
Incorporating ESG into the overall company strategy helps to focus company resources on the most important business areas. According to the 2019–2020 NACD Public Company Governance Survey, 49 percent of respondents discussed ESG’s link to long-term strategy at some point in 2019. Boards should be involved throughout the strategy-setting process, and they have a critical role to play during periods of adjustment, especially when a company is incorporating new external trends and performance expectations—such as ESG—into the strategy.
Solution 1: Identify the most material ESG risks and opportunities. Boards should ask the following questions:
- Which of the company’s strategic objectives are impacted by ESG?
- Which ESG risks and opportunities pose a significant threat to our current business model, strategy, and, ultimately, viability?
Solution 2: Link ESG to company financials. Boards should ask the following questions:
- Which ESG risks have the largest impact on our balance sheet and income statement?
- How are long-term growth forecasts reflective of ESG considerations?
Challenge 3: Moving the Board to Active Oversight
To move from passive governance to a more active posture, the board should strongly encourage continuous learning about ESG and related trends at both the full-board and individual levels. As ESG trends, standards, and the ESG lexicon continue to morph, director education becomes even more critical. Currently, according to NACD research, the majority of directors fall short, with just 24 percent of public company and 13 percent of private company directors participating in educational activities related to ESG in the last 12 months.
Solution 1: Clarify board ESG oversight responsibility and roles. Boards should ask the following questions:
- Would a specialized committee strengthen our governance of ESG risks?
- Is our board spending too much time in “the weeds” of ESG instead of discussing strategically focused aspects?
Solution 2: Ensure effective management reporting to the board. Boards should ask the following questions:
- Does the management team convey insights about our ESG risks and opportunities or just communicate information?
- How do our practices compare to those of our peers and the companies we admire?
Challenge 4: Addressing Increasing External Expectations
A focus on environmental and social issues is no longer seen as an altruistic endeavor for companies; it’s seen by many as a key responsibility for both management and the board. Investors and broader stakeholders expect to see public disclosure on how companies—and the board—are evaluating and mitigating ESG risks.
Solution 1: Engage with stakeholders to understand their unique perspectives. Boards should ask the following questions:
- How often does the company engage with top shareholders on ESG risks?
- How do the company’s practices align with stakeholder expectations?
Solution 2: Externally report the current state of ESG oversight. Boards should ask the following questions:
- Do we disclose the most financially relevant metrics and information on ESG risks and opportunities?
- How do our disclosure practices compare with our direct and industry peers?
ESG is an enterprise-level risk and should be viewed through the lenses of strategy and core operations. Boards need to continuously assess their effectiveness in addressing ESG risk, in terms of both their own fiduciary responsibilities and their oversight of management’s activities. While the approaches taken by individual boards will vary, 2020 has shown that boards must have a good understanding of their own companies’ ESG risks and opportunities.
For a deeper dive into the climate-related aspects of ESG oversight, register today for Virtual NACD Summit 2020’s Expert Insights: Environmental Risk Oversight session, which will air on October 15 at 3:00 PM EDT.
Leah Rozin is director, head of governance and sustainability research at Rivel.