ESG: A Primer for Boards

Investors, business leaders, employees, and the general public increasingly care about environmental, social, and corporate governance issues. Some companies are already taking strides towards meeting significant ESG goals; others are earlier in their process. This article is meant to set the ESG table for corporate boards that are still in the early stages of addressing the issues.

What Is ESG and Why Should Boards Care?

ESG stands for "environmental, social, governance" and is a set of non-financial corporate performance indicators being used to measure the impact that companies have on the environment, their people, and society.

One challenge of ESG is the absence of a universally adopted framework for measurement and reporting, though many third parties are working to address this. While it is true that there is no GAAP-equivalent for ESG, the runway for companies that would prefer to avoid making ESG disclosures is getting short. Investors, businesses, and employees want the information.

Large institutional investors like BlackRock, for example, have become increasingly focused on corporations doing their part to support broader societal goals rather than being narrowly focused on shareholder returns. You may remember BlackRock CEO Larry Fink's surprising statement in 2018 that corporations should have a goal to maximize positive societal impact in addition to shareholder value.

Then in 2019, nearly 200 CEOs of America's largest corporations formally rejected the Business Roundtable's decades old policy that defined a corporation's main purpose as maximizing shareholder return. The new purpose would be to "serve not only their shareholders, but also deliver value to their customers, invest in employees, deal fairly with suppliers and support the communities in which they operate."

To be sure, it is not clear that a focus on ESG has to be to the detriment of maximizing shareholder returns. Indeed, taking a forward-looking perspective, 83% of executives and investment professionals say they expect that ESG programs will contribute more shareholder value in five years than today, according to a 2020 McKinsey study.

Another driver of ESG is employee expectations. In 2020, employees are increasingly expecting more from their employers. They are also increasingly willing to wield their power when necessary. Just look to Google's global walkout as an example, where 20,000 employees across the globe walked out of work to shed light on harassment and discrimination at the company.

While the Securities and Exchange Commission has yet to weigh in on ESG in a significant way, it has adopted some important disclosure requirements, for example its disclosure requirements concerning board diversity. Currently, the SEC is being urged to regulate ESG disclosures, including by its own Investor Advisory Committee.

Finally, we are seeing some litigation around corporate ESG disclosures, though it is not widespread yet and those in the pipeline are unlikely to yield large settlements. However, the lessons learned are still useful and further highlight the fact that corporations will be held accountable for their ESG agendas.

Because of all these factors, companies that aren't focusing on ESG may soon find themselves at a disadvantage. 

The Three Pillars of ESG

Let's briefly look at highlights of the three pillars within ESG: environmental, social, and governance.

Environmental

The environmental aspect of ESG looks at a business's environmental impact. It can involve everything from the company's operations to the natural resources it uses and every step in the supply chain.

This is an area that has fallen under quite a bit of scrutiny in the past decade. As a result, more and more public companies provide the public with sustainability-focused disclosures.

In 2020, BlackRock's letter to its clients stated that climate risk is an investment risk and that BlackRock would put sustainability at the center of its investment approach. This is certainly a significant statement from the world's largest asset manager.

Nevertheless, climate-related disclosures can be a tough ask for many corporations. It is helpful that the guidance for industry-specific standards is evolving and indeed converging. Several organizations are leading the charge to standardize reporting in this area, including SASB and TCFD (of which BlackRock is a founding member).

In his 2020 letter to CEOs, BlackRock CEO Larry Fink is asking companies to voluntarily provide environmental disclosures in a manner that will allow for comparability over time:

This year, we are asking the companies that we invest in on behalf of our clients to: (1) publish a disclosure in line with industry-specific SASB guidelines by year-end, if you have not already done so, or disclose a similar set of data in a way that is relevant to your particular business; and (2) disclose climate-related risks in line with the TCFD's recommendations, if you have not already done so. This should include your plan for operating under a scenario where the Paris Agreement's goal of limiting global warming to less than two degrees is fully realized, as expressed by the TCFD guidelines.

Of course, all companies are required by the SEC to disclose material risks to the business, be they climate change or otherwise. But it has been 10 years since the SEC issued its seminal interpretive guidance on what scenarios might trigger a climate disclosure. Earlier in 2020, however, Chairman Clayton specifically addressed the work the SEC is doing with climate disclosures.

Social

Arguably the most challenging of the three pillars, the social aspect of ESG concerns how a corporation navigates workforce matters as well as a corporation's place and activities within the context of the society at large, including politics.

This area can be especially tricky because it is broad and fast moving. Forty-nine percent of companies cite the "S" as the hardest to analyze and integrate, according to The ESG Global Survey 2019 by BNP Paribas. And, of course, how a company responds to current political and social issues can quickly impact financials.

Currently, major movements like #MeToo and Black Lives Matter are driving much of the narrative in the "S" category. Through these movements, historically challenging issues are ending up as front-and-center issues in corporate boardrooms.

Given that social matters can be so broad and the lack of consensus concerning the contours of the "S" in ESG, measurement and reporting is a huge challenge. 

Governance

Governance is perhaps the most mature of the three pillars because it has been a focus of institutional investors and proxy advisory services for so long. Governance relates to how a corporation makes key decisions and can include a broad range of issues including board independence, CEO succession, executive compensation, dual class shares, and more.

Because of its maturity, there's a lot of consensus on the types of issues that are meaningful from a governance perspective. Static issues like separating the CEO and chair, majority voting for directors, and poison pills are well known.

Areas that are still arguably in flux include director tenure and board diversity. With respect to diversity in this pillar, it may be less a question of social justice and more about enhancing shareholder value. For example, a board that limits its directors to only one type of person runs the risk of missing out on the information and expertise other types of board members might bring to the mix for the benefit of shareholders.

Institutional investors like BlackRock and others will continue to be very influential when it comes to what elements of governance should be measured and reported. Historically, proxy advisory services also played a big role here, but it is less clear what their role will be in the future in light of the SEC's new rules regulating these services.

Next Steps for the Board

ESG is an enormous task, and it cannot be allowed to swallow the world. The board still must run the business. Having said that, most boards are moving forward to address ESG issues, often tasking the nominating and governance committee to lead the charge.

First, it's important to have an understanding of what statements have already been made internally and externally about ESG and what is being done to follow through on them. Disclosures should be accurate, not merely aspirational.

Reviewing the ESG frameworks, policies, and risk factors disclosed by peer companies can be a useful exercise as well. As boards dig into this, it will be meaningful to discuss the board's and management's view of how deeply they want their company to engage with each pillar, as well as what will be measured and disclosed. It's probably most useful to take a conservative disclosure posture and involve outside counsel and other experts as well.

Finally, a reminder: A lot of institutional shareholders don't just want reports about numbers. They actually want to know about the board's involvement in the ESG process. A board disclosing its involvement in the process from an oversight perspective is highly consistent with what we've seen when it comes to the court's view of the board's duty of oversight more generally.

ESG is an issue that will continue to be dynamic, so a one-and-done approach will not work. Nominating and governance committees and, ultimately, boards must continue to be thoughtful about engaging with their stakeholders when it comes to what ESG metrics make sense for a particular company to measure and disclose.