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Conversations on the environmental, social and governance (ESG) topics that impact a company’s business operations have become increasingly complicated.
Since our last refresh in March 2022, much has changed. This updated guide captures the practices that have emerged, and questions that boards should consider when determining the governance structure that is most appropriate for overseeing sustainability given the company’s industry, size, growth trajectory and strategy.
"Market integrity and disclosure help protect investors and build trust in capital markets. Such trust helps lower the cost of capital for issuers and enhance returns for investors. It also helps increase participation in the capital markets. This is good for those investing for their future and for issuers. Integrity and disclosure facilitate what can be the best of capital markets and guard against the worst."
Understanding the sustainability landscape
Directors have a responsibility to oversee company risk, ensuring material risks are identified, assessed and mitigated. This includes sustainability risks. The board also plays a role in challenging management to think creatively about strategic alternatives and opportunities — including sustainability topics.
Investors tend to view sustainability through the lens of long-term risk and returns, but that is evolving. Here are some of the ways investors are incorporating sustainability into their processes:
Some institutional investors are urging companies to build ESG considerations into their strategies, bringing it up during engagements and sometimes, using shareholder proposals to encourage companies to act. Some of the world’s largest asset managers have used their votes against directors at companies that, in their view, lag on one or more ESG topics. These investors are leading the call for more disclosures from companies, both qualitative and quantitative, so that they can better assess how each company is addressing risks and opportunities.
These investors are important sources of capital for many companies. In addition to using ESG factors to assess default risk, a market has developed for products that offer a lower interest rate so long as certain ESG key performance indicators are met (or a higher rate if they are missed).
Increasingly, hedge funds and other activists are incorporating ESG factors into their investment strategies. Their focus can range from areas where they believe a company has failed to set or meet goals, lags its peers’ practices or has failed to adequately account for sustainability in its strategy. While we do not expect many public campaigns and proxy fights entirely based on ESG factors, ESG is likely to feature in attempts to influence management and other investors.
Understanding the board’s role in overseeing sustainability
Companies that embed sustainability into their strategies are better positioned for success. They can spot growth potential in identifying and managing ESG issues. They can also shape the narrative of their brands and practices while expanding their investor bases. So, as companies are telling their sustainability stories and integrating ESG into their strategies, it’s important to think through the “how” of implementation.
Here are some considerations for the board on how to understand their role in overseeing sustainability:
A key part of board oversight is taking a broad view of risk, and that may be harder in areas where management has less muscle memory because they may have less experience thinking of topics in the context of sustainability. Environmental and social factors heavily influence some of the thorniest business challenges companies must overcome.
These include workforce dynamics, innovating and incorporating new technologies, and supply chain disruptions due to natural disasters. Sustainability disclosure standards are still evolving, and companies are likely to be in scope of more than one. There is not one single standard that boards can consider when building their risk register. Furthermore, growing mandatory reporting requirements globally, with complex applicability, increases compliance risks.
In addition to mandatory reporting regimes, stakeholders want a comprehensive, cohesive story when it comes to sustainability. Qualitative sustainability messaging should reinforce the company’s purpose statement, while quantitative metrics bring that purpose to life and help companies measure their progress toward goals. These sustainability metrics also help investors compare companies across industries and companies set transparent milestones along the way to long-term goals.
A company’s purpose is often expressed as the reason it’s in business. But it’s more than that. A company’s purpose needs to be aligned to the overall business strategy — how the company will achieve returns year after year. As companies attempt to serve a diverse group of stakeholders – including investors, employees, customers, suppliers and communities, it shouldn’t come as a surprise that many struggle to balance all those interests. To help, the board and management need to work together to define what’s important and measure progress.
The company’s purpose should be reflected through its messaging and activities. And as part of its oversight role, it’s up to the board to make sure these things all tie together.
Mapping sustainability to oversight
Companies have made rapid strides in unlocking the business value of sustainability in recent years. The sustainability issues a company faces vary widely by industry and company maturity, and there is no one-size-fits-all solution. The rapidly evolving regulatory environment, including the final SEC rules on climate-related disclosures and the laws instituting California disclosure requirements for companies doing business in California, means companies should act now to reduce the burden of future disclosure requirements. Directors have a big role to play in guiding management to allocate the appropriate resources and attention. Forward-looking companies value being a frontrunner on sustainability issues because they see the connection to the company’s long-term success.
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