Board Action On ESG Needed To Ensure Long-Term Performance Gains

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By Russ Banham


n boardrooms throughout the corporate landscape, ESG is the acronym of the moment. Standing for Environmental, Social and Governance, ESG refers to a company’s adherence to principles that assure care for the planet’s resources, respectful treatment of all people, and actions promoting equality and fairness throughout the organization.

ESG is quickly rising to the top of boardroom agendas, given the impact of social issues — including diversity, human rights and gender discrimination, and environmental concerns like climate change and sustainability — on a company’s reputation, hiring opportunities, and long-term financial performance.

These interests are no longer a “nice to have.” Rather, they demand diligent board-of-director oversight; otherwise, an ESG-related failure may result in consumer boycotts, employee walkouts, and adverse proxy votes by institutional investors at annual meetings. By effectively overseeing ESG risks, boards also help ensure that governance practices within the companies they serve are aligned with the long-term sustainability of the business.

“There is now broad acceptance that many ESG issues factor into long-term financial performance and related increases in shareholder value,” said Annalisa Barrett, senior advisor at the KPMG Board Leadership Center and an adviser to board directors on emerging trends in corporate governance. “The challenge for boards is to know when to probe management on these issues and what questions to ask.”

Social Responsibility

This is not to say that most CEOs give scant attention to ESG risks; certainly not in this age of influential institutional investors. Larry Fink, CEO of BlackRock, the world’s largest asset management firm, has asserted that a CEO’s ability to manage ESG risks is directly related to their organization’s long-term financial prosperity.

“Society is increasingly looking to companies, both public and private, to address pressing social and economic issues,” Fink wrote in Purpose & Profit, his 2019 letter to CEOs. “These issues range from protecting the environment to retirement to gender and racial inequality, among others.”

CEOs are getting the message. According to survey findings published by KPMG International in its 2019 Global CEO Outlook, respondents identified environmental issues and climate change as the biggest threat to operational growth.

Barrett is not surprised by the finding.

“Think about the business impact of shorelines changing as glaciers melt and seas rise,” she said. “Board directors of potentially affected companies need to ask questions about the long-term effects of climate change and what the company is doing to limit the impact on its operations and employees.”

But most boards have yet to take up the mantle, according to the 2018-2019 Public Company Governance Surveyconducted by the National Association of Corporate Directors. It found that only 29% of directors believe it is important or very important to improve their oversight of ESG issues. The respondents ranked climate change second-to-last in a list of the top five risks facing the companies they serve over the next 12 months.

A similar finding was reached in ESG, Risk, And Return: A Board’s Eye View, which reported on a KPMG Audit Committee Institute survey of corporate directors and officers. While half the respondents believe a focus on ESG can improve a company’s financial performance and competitive position, the survey also found that boards are “moving at different speeds” in addressing the subject, and that ESG initiatives “appear to be at the periphery, rather than integrated into the core of the business.”

A Brewing Debacle

Complacence on ESG can backfire personally for board directors, in the form of an event-based derivative securities class action lawsuit filed against them for financial losses attributed to unexpected events like environmental disasters, cyberattacks or employment practices violations occurring under their watch. In such cases, directors are sued not for their actions but for their inaction.

Since its inception a decade ago, this growing form of securities litigation targets a specific adverse event that should have been anticipated and avoided, which occurs and causes a decline in a public company’s stock value. Plaintiff attorneys seek to relate the loss event to prior statements made by senior executives assuring shareholders and the public that the company is “in full compliance with the law” or “has the highest degree of safety possible.”

Many consumers, leery of corporate scandals, are also taking action by not buying from companies that don’t take a stand on ESG issues, leveraging their buying power to effect change, according to Battle of the Wallets: The Changing Landscape of Consumer Activism, a report coauthored by KRC Research and Weber Shandwick. Shareholders are getting into the act, too, by retracting their investments in the stocks of certain companies. While limited in taking such actions with assets that are passively managed, pension funds and other institutional investors have made it clear that they are looking to invest in companies with sustainable long-term growth that proactively manage their risks related to ESG issues.

A case in point is board gender diversity. After State Street displayed a bronze statue of a young girl staring down Wall Street’s giant symbolic bull in 2017, more than 300 of the then-787 public companies with all-male boards were induced to add women to their ranks, according to a State Street press release that announced the impact of Fearless Girl a year after her debut. Those that did not incurred the wrath of the asset management firm, which voted against the entire slate of directors picked by their boards’ nominating committees. Other shareholders followed the firm’s lead.

While the gender diversity of a board may seem to have little to do with corporate long-term performance, the truth is otherwise. “Studies indicate that more diverse boards fare better at mitigating ESG risks,” Barrett said. “Boards with directors of different genders, ethnicities, ages, geographic backgrounds, different industry experiences, and so on, tend to think more about things like social responsibility and long-term sustainability, as opposed to having a sole focus on short-term financial performance.”

She added, “Institutional investors are the owners of the company and boards should be sure they are aware of their concerns related to ESG matters.”

Barrett cited a recent petition to the U.S. Securities and Exchange Commission filed by the Human Capital Management Coalition requiring public companies to disclose information on their human capital management policies, practices and performance. The coalition is composed of 26 institutional investors representing a combined $3 trillion in assets.

“Investors want surety that directors are taking human capital management issues into consideration when they are making board-level decisions,” she said.

Picking Up The Mantle

The varied reactions of consumers, employees and investors to ESG failures are a means to challenge boards to ensure these issues are managed by company leaders. Regrettably, only a minority of boards have developed formal mandates demonstrating how directors need to engage on the subject, according to Systems Rule: How Board Governance Can Drive Sustainability Performance, a report coauthored by Ceres and KKS Advisors.

On the bright side, board audit committees increasingly perceive ESG oversight as part of their “normal risk and regulatory compliance activities,” according to a recent survey of audit committee members that the KPMG Audit Committee Institute highlighted in its report, Keeping Pace With Disruptive Risk, Digital Transformation.

More directors need to join the journey. Barrett suggested that directors insist that ESG is addressed at the board level, via a separate committee that reports to the full board about ESG issues relevant to the company. Directors also need to ensure they incorporate ESG considerations into every board-level decision. “Really, the board is in the optimal position here to ensure management has developed ESG policies that are integrated into the company’s culture—affirming values in the organization’s hiring practices and management decisions,” she said.

This task requires that directors, as part of their fiduciary oversight, jump into the trenches to learn the true state of ESG in the companies they serve. “To integrate ESG into the boardroom,” Barrett said, “directors have to learn about the most important environmental, social and governance issues facing the company and incorporate that understanding into all of the decisions the board makes.

Russ Banham is a Pulitzer-nominated financial journalist and best-selling author.

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