Environmental, Social, and Governance (“ESG”) disclosure has become a big topic of focus over the last couple of years and has especially accelerated as investors have become more conscious of and involved in this topic. As this fast-moving area continues to become high profile for public companies, what do you see as changing and what are the forces that you see driving those changes?
The events of 2020 heightened interest in ESG matters, but even before those recent events companies faced mounting pressure to integrate ESG considerations into corporate strategy, operations and risk management, and to disclose information regarding ESG matters. One notable example is the Business Roundtable statement on corporate purpose issued in August 2019 that indicated businesses have a broader role to play in society with responsibilities to multiple stakeholders, including employees, communities, and the environment, as well as shareholders.
BlackRock’s high profile call for key performance indicators for human capital management and environmental sustainability is another example. Not only will BlackRock discuss these priorities with companies in outreach conversations, but they have indicated recently that if they see no progress, they will begin to vote against or withhold votes for board and board committee members. State Street Global Advisors has been vocal about ESG concerns for several years and has announced that they will independently assess companies on their ESG track records using their own proprietary scoring system.
We also have growing investor interest in corporate activities related to climate change, workforce diversity and corporate accountability. We see that in the proxy voting guidelines of institutional investors, such as Fidelity and Vanguard. We have seen a significant increase in petitions for rule-making by the SEC, for clear and comparable disclosure of ESG related goals and progress. We’ve also seen enhanced focus on corporate culture, the importance of human capital in an organization, and related changes in the nature of work and the workplace over the last year. Overall, there has been a dramatic rise in investor interest in and support for both ESG initiatives and enhanced disclosure of these initiatives. Increasingly, how a company addresses ESG matters is viewed as an important part of strategy, operations and the company’s potential for long-term success.
These areas of focus have continued to evolve and the conversations that are happening between issuers and investors have genuinely become much more meaningful, with an understanding that these topics have an impact on the business. Do you believe that the business case for ESG is limited to the pressures that are coming from investors, or is there very much a benefit that can help drive performance? Do we see it as a trade-off between ESG and business performance?
With the growing interest in ESG activities among investors, employees, customers, and other key constituents, enhanced attention to a company’s ESG position could provide it with some competitive advantages. It may also change the company’s risk profile. Given the significant opportunities and risks associated with ESG, companies that excel at identifying and incorporating these issues into their business strategy enjoy a competitive advantage in the marketplace and among institutional investors.
It’s become increasingly clear that ESG and return on investment (“ROI”) are connected. Strategy discussions that include ESG and the potential for innovation, disruption and value creation from effective ESG initiatives can add significant value. We often focus on investors and “others.” How about customers? Let’s consider how a company’s ESG profile could affect customer decision-making. What if customers were to choose a competitor because of the competitor’s ESG practices and how the customer perceives those? Benchmarking a company’s ESG performance against that of its top competitors could provide the company, its management and board with great insights into ESG initiatives that could be very beneficial to the company on a business basis. An integrated ESG strategy would also consider the financial impact on the company’s bottom line, capital allocation, supply chain management, marketing, partner choices, and the ESG profile impact of any potential acquisition.
We are so often focused on the ESG risks but there’s clearly also ESG opportunity, and as we go through these exercises with companies to understand what the ESG risks are, we have to remember that there is an opportunity to find those advantage points to distinguish the company within its peer group. Sometimes we see ESG initiatives disconnected from the core business strategy and not necessarily contributing to competitive advantage. Are companies effectively integrating ESG into their business decision making and effectively embedding it into their company strategy?
Effective integration of ESG into strategy and operations hinges on ensuring that the entire C-suite understands the importance of ESG to the company’s long term performance and how ESG issues impact their respective functions and areas of responsibility. ESG is an enterprise-wide issue; enterprise-wide buy-in is essential for its success. I’ve seen that some companies recently have added an SVP and Chief of ESG to their C-suites, an indicator that those companies view ESG as critical to their operations and strategy.
Questions for companies to consider would be: Are business unit leaders considering ESG issues when making marketing, procurement, hiring, financing, and investment decisions? Are business unit leaders aligned with the corporate vision on ESG? Once a company has identified its key ESG areas, it’s good to assess what the company is already doing in the ESG areas and has already incorporated into its strategy and operations. For example: recycling initiatives, supplier codes of conduct, sourcing standards, employee safety and wellness initiatives, and use these as a foundation to reinforce the links among ESG, strategy, operations and new initiatives that may be undertaken by the company.
There are a lot of topics that a company can focus on. For companies that are still in the early stages, how should boards and senior management determine which ESG topics to prioritize initially and, as you move forward, how do you ensure that you maintain focus on those priority issues?
The structure and processes that a board uses to oversee ESG issues are going to vary based on the size and complexity of the company’s operations, including its supply chain.
Boards and senior management could consider developing an ESG statement or policy that explains the company’s values and culture, along with requirements for the company’s business. For example, it’s hard to imagine an airline operating without needing to burn jet fuel. A company ESG statement or policy could provide a framework for how the company addresses ESG issues in its operations, as well as its ESG disclosures.
Boards can help lead the company forward by focusing on big picture questions, such as: Which ESG issues are of strategic significance to the company? How is the company managing ESG-related risks and opportunities? How is the company embedding ESG into strategy, operations and culture to drive long-term performance? And how is the company telling its ESG story to investors and other stakeholders?
As the company and its business grow and evolve, the answers to those questions likely will change. The questions are apropos for companies of all sizes and at all stages of development and can help in maintaining focus on high impact areas as business changes.
Once a company has that guiding document to help direct the company in terms of selecting priority topics, how then does the board effectively manage the ESG strategy? What role does the board play in making sure that the company continues along that journey and stays true to the focus values?
How the ESG issues are framed for discussion in the boardroom and across the company is going to influence whether they are viewed as business issues that are essential to long-term value creation. Framing the discussion in business terms -- particularly opportunity, efficiency and financial performance, as well as risk -- is important. For example, climate change could be framed as a discussion of the risks water shortages pose to a company’s manufacturing operations, the potential financial impact these risks pose, and how the company is planning to mitigate these risks in a way that would allow the company to expand its operations as well as improve bottom line performance.
The truth is there’s no cookie cutter approach to ESG. The strategic importance of specific ESG issues can vary widely by company and industry and a company’s ESG profile is likely to change as the company’s business evolves. Addressing ESG as a long-term strategic issue and embedding it into the company’s strategy, operations, risk management and corporate culture really requires an understanding of why ESG matters to the company’s long-term performance, as well as a clean, clear commitment and strong leadership from top management.
For many companies, incorporating ESG into strategy is a change management effort. Adding an ESG lens to strategy, incorporating ESG risks into the overall enterprise risk management process, and establishing and tracking metrics that include strategically significant ESG initiatives as part of assessing progress against overall company strategy, along with implications for compensation, talent, and culture, may indeed require a significant organizational change in some companies.
How does the board ensure that there’s oversight? Do you find that the board has to be involved in the ESG strategy or can the board depend upon management itself? What are the factors to take into consideration and to what degree should the company’s board be involved in the approach?
The board’s role remains one of oversight. The board of directors or an appropriate board committee should be briefed on a regular basis regarding developments and trends in the area of ESG and ESG disclosure, including initiatives and statements of significant and influential investors, trends in shareholder proposals, activities of non-governmental standards setters like ISS and Glass Lewis, and ESG disclosures of peer companies, as well as federal regulatory activities. The board and management together should determine what information the board will receive. An ESG dashboard could help facilitate understanding and discussion of important ESG matters at board meetings.
The board also should ask management for an assessment of the company’s ESG reporting practices, including the quality of data systems and internal controls. Rising investor demand and the growth of non-financial data sources available to the public are prompting boards to consider whether proper oversight and governance procedures are in place to ensure the quality and credibility of ESG information that the company is sharing.
It’s also important for boards to understand how evolving ESG investing and stewardship trends are impacting access to capital and relationships with investors. Boards should be sufficiently informed to confirm whether the company is effectively capitalizing on these trends to attract long-term investors and secure shareholder support. This in particular is an area where I think our colleagues at Morrow Sodali are in a great position to assist companies with ESG oversight and assessment.
From our standpoint, we consistently see investors assessing the board’s fluency on ESG topics. A clear demonstration of that fluency and an understanding of what the topics are, how the company is addressing those topics and what the steps are in moving forward as those topics continue to be further addressed -- this is really what’s important. As a company manages this oversight in terms of board responsibilities, we have seen ESG trickle down from the full board into ESG specific committees. Do you think this is a trend that will continue into the future? How are you seeing the board ensuring that this oversight remains top of mind for the company?
As you mentioned, I am aware of a few companies that have established ESG board committees or corporate social responsibility committees. Other companies have delegated oversight of ESG matters to the nominating and governance committee (emphasis there on governance), some to the risk oversight committee or another standing committee of the board, while other companies have retained oversight of ESG matters at the board level as part of the board’s overall review of strategy. Whether it rests with the chairman, lead director, the governance committee, an ESG committee, or somewhere else in the board structure, there needs to be a home for oversight of ESG integration at the company.
What’s really important is ensuring that the engagement between the board and management is truly two-way in the sense that it is very much an engagement to ensure that the board’s perspective on these topics is heard and incorporated back into the strategy and that management can also inform the board on the direction they’re heading. These are topics that can’t be passively managed by the board; you do have to have some level of involvement, especially to ensure that the direction the company is heading is reflective of the priorities of the stakeholders of the company and are also in the company’s best interests.
Let’s head into ESG measurement. How does a company ensure that they are reporting on the topics that are most material to themselves while also taking into consideration the third parties that are advising on and recommending specific topics?
Well, the coexistence of competing voluntary disclosure standards and frameworks has pros and cons. The existence of multiple voluntary disclosure regimes such as the Global Reporting Initiative (“GRI”), the Sustainability Accounting Standards Board (“SASB”), CDP (previously the Carbon Disclosure Project), the Task Force on Climate-Related Financial Disclosures (“TCFD”), to name just a few, may be viewed as a plus for stakeholders who support the continuing expansion of companies’ ESG disclosure. However, as noted, this leaves companies unsure as to which methods to use and also makes it difficult for investors to compare ESG performance across companies.
Each company needs to make its own strategic decision regarding which ESG disclosures it will make, if any, and how. In addition to being a business call, it is a legal decision reflecting the company’s judgment regarding materiality of the information that a company chooses to disclose or not disclose.
While we do have a lot of third parties that are providing guidance on what topics companies should take into consideration when reporting, we’re also starting to see that larger institutional investors appear to be establishing their own ESG criteria for the companies in which they invest. How should companies react to this, how much weight should they give these third parties when considering the topics that are most relevant to the company?
We have the larger institutional investors and we also have rating agencies that may request data from companies via questionnaires. MSCI, S&P, Moody’s and Sustainalytics all create assessments of companies. Global asset managers, debt financing sources, securities exchanges, ESG rating agencies, and regulators are all seeking more quantifiable ESG information on a basis that permits comparisons within and across industries. We’re likely to see additional reporting requirements from the SEC and or the exchanges and a convergence in reporting standards in the not-too-distant future, but until then companies need to make their own qualitative and quantitative assessments when choosing what ESG related disclosures they will make or not make. In making their assessments, companies should also consider the potential disclosure risk of material misstatements or omissions regarding ESG matters, including any forward-looking statements the company makes about achieving ESG goals within specified time period.
In making these assessments companies might want to consider questions such as: Which ESG risks have the largest impact on the company’s balance sheet and income statement? Which new opportunities created by ESG show attractive financial returns? What is the time horizon to realize positive gains from investing in ESG initiatives? Are long-term forecasts reflective of ESG considerations? Do any of the company’s customers have ESG requirements for their suppliers? There are many potential audiences that a company needs to consider when contemplating ESG disclosures and it is important to evaluate the benefits and the risks of those disclosures to the company and its business.
There are many different forms of ESG disclosure. Over the last year, we’ve seen more disclosure on human capital management in the 10-Ks. Recent developments at the SEC suggest that we may be seeing more requirements in SEC filings from an ESG disclosure standpoint, but we currently continue to see ESG disclosures in supplemental reports on company websites. What have you found to be the most effective approach to providing disclosure? And especially as we likely may see some changes moving forward, what advice could you offer for companies to take into consideration at this time?
Many companies publish their sustainability and other single issue ESG information reports on their company websites and choose not to file them with the SEC. But more and more, investors are looking for a “one-stop shop” for ESG disclosure and leading proponents of ESG disclosure are working toward requiring these disclosures in SEC reporting.
Companies need to be aware of requests and the expectations of their institutional investors, trends in shareholder proposals and initiatives, activities of ISS and Glass Lewis as well as other non-governmental standard setters, and disclosures by their peer companies, as they are assessing where, how and what they choose to disclose.
They also should be aware of any disclosure requirements or information that is required to be provided by their customers. Customers often get overlooked in the litany of people to whom disclosures are being made, but as larger companies are requiring more from their suppliers, companies need to be aware that they will likely have to provide information on a readily accessible basis for their customers.
What do you find is effective ESG disclosure and what are some of those hurdles that companies have to overcome to effectively roll out this disclosure?
What is effective ESG disclosure? Again, it’s going to be something that is going to be particular to the company, to the particular situation and relevant to what the company set forth when it made its previous ESG disclosures. Benchmarking peer disclosures can provide great insights into competitor strategies, different disclosure methodologies regarding ESG, and the expectations of investors and even debt sources for companies in particular industries, because they’re likely looking at those competitor disclosures as well. Benchmarking peer disclosures can also indicate where improvements in the company’s own disclosures could lead to improvements in its ESG profile with customers, employees, rating agencies, and investors, all of whom are very important stakeholders.
We have seen that some companies have come out with very robust sustainability disclosures, but others try to “fly under the radar” to some extent and take a “wait and see” approach. Do you feel that the latter is a realistic strategy? While historically it may have worked, are we starting to see that companies need to be more proactive?
A company might have felt that it could fly under the radar for a while in 2017; it’s a different world in 2021. Investors now clearly see a link between positive ESG activity and financial value. It has been demonstrated that corporate attention to ESG issues can have a positive effect on a company’s long-term financial performance. Public pension funds and private asset managers are actively seeking ESG information to enhance their understanding of risks that could affect a company’s value over time and to assist them in making their investment decisions. Investors are considering ESG performance in making voting decisions at annual meetings. Two large public pension funds have been reported to have suggested withholding votes for directors if the company has not effectively disclosed information regarding certain issues such as climate risk.
Investors are creating new ESG funds and portfolios. These funds have goals such as promoting social responsibility and environmental sustainability, and they have garnered billions of dollars of investor support. Key customers are requiring increased ESG disclosures from their suppliers to support the customers’ own ESG commitments and initiatives. So given all of these changes, I do not think that trying to fly under the radar until the SEC comes forth with official regulations is a viable strategy.
Even if a company has been able to fly under the radar, what we’ve seen over the last year, especially as companies think about investors’ focus, is that it’s less a matter of if but when are we going to be asked about these issues? And once it does happen, we believe that the investors will be very quick to expect companies to make changes if they have not already. If it is something that a company has not started thinking about, they certainly need to start to see where they can make some progress because we will see more and more pressure.
If I may add just one more thing -- as part of a company’s financing activities, lenders and debt holders are looking for ESG information and ratings and debt pricing is now being based to some extent on a company’s ESG profile. MSCI is out there; Bank of America has indicated that it is pricing based on a company’s ESG profile. So as a company is looking to refinance current significant debt, having good ESG responses and being ESG attentive can be helpful to it on a real financial basis.
With so much happening today, is there anything that a company should do if they feel that they do not necessarily agree with the direction that things are heading? How can a company voice its opinion to ensure that the demands from investors and other third parties do not go to a point where a company cannot necessarily keep up? During engagements with investors, it is clearly important to note the hurdles or pain points that the company may face in attempting to address some of the issues that investors may be looking for. But is there anything else that a company should be doing to ensure that they do not get caught in a position a down the road where the demand for some of this information is not only too great to be addressed effectively, but perhaps beyond the scope that the company feels is impactful for the company?
The company could consider expressing itself through engagement with its investors and stakeholders when the company is having communications with them, along with trade associations and organizations such as the Business Roundtable. There are other places where industry groups can voice their concerns regarding the burdensome nature of requests, what it will take to comply, what information is readily available or obtainable versus what would be exceptionally burdensome for companies to have to produce. Those thoughts need to be expressed now, as disclosure standards are being developed and are expanding. The company’s investor relations team, communications team, legal team and industry representatives need to ensure that their voices are heard. I think that those are all very important avenues and channels of communication.
I think that that’s a good place to end this conversation: on a high note where, while we certainly are seeing challenging trends, companies also have a way of influencing the direction this is all heading as well and should take advantage of those opportunities. Maryann, we really appreciate your time; it was a very informative conversation.
Thank you so much.