Driving sustainable performance: ESG’s significance for the board

August 2023 | EXPERT BRIEFING | BOARDROOM INTELLIGENCE

financierworldwide.com

The heightened focus on environmental, social & governance (ESG) issues is presenting corporate boards in Europe with a single fundamental question: what is the nexus between the board and ESG? The question is no longer whether the board of directors has a role to play. The focus has now turned to how a board can best utilise its decision making, oversight and advisory roles to build a more sustainable organisation.

Responsible businesses benefit from incorporating ESG and stakeholder perspectives into existing board processes – by mapping the board’s current roles, responsibilities and approach toward these issues. Board composition, allocating ESG responsibilities precisely within the board, correct use of committees, committee rotation and succession, all contribute to a strong governance team at board level. Directors who have a deep understanding of their firm’s industry are better suited to ensure oversight of the company’s key ESG risks and opportunities. Companies should be cautious though about having specialist directors, which can be counterproductive if the rest of the board defers to them too much.

The next step is building ESG fluency. Management should set reasonable expectations on achieving board fluency in ESG. With over 200 issues across the ‘E’, ‘S’ and ‘G’ categories, boards cannot possibly address them all (nor should they). Management should focus on areas strategically important to the company, establish the firm’s degree and assess the level of knowledge needed, depending on how far the company wants to go in its commitment to ESG. Boards must necessarily understand and prioritise compliance, risk reduction, reputation protection and level of industry leadership. Management, on the other hand, must appreciate that education takes time, and companies can expect ESG fluency to increase along with the maturity of the firm’s ESG programme.

Keeping the board informed on ESG requires a combination of direct board engagement and data. Companies can enhance communication with the board and the board’s engagement on ESG topics in various ways, including through the board’s discussion of the company’s purpose, the integration of ESG in strategic planning, and operating and capital budget processes, and the incorporation of ESG in compliance and risk management discussions at board level. The company should also ensure that the board understands the breadth and depth of internal and external ESG-related communications, as well as the processes by which management seeks to ensure the accuracy and consistency of such communications.

The discussion now turns to what should be top of the board agenda to drive the sustainability journey. Driving the ESG agenda is not a series of distinct singular actions, but a fluid and continuous strategic conversation. Three key strategies that boards need to internalise to be impactful in the ESG arena are: ask the right questions, raise red flags, and align and oversee policies.

It is important that boards proactively ask their management the right questions to seek more information on ESG and stakeholder expectations. Recent research demonstrates a disconnect between directors and their organisations in terms of environmental concerns. For example, a study published by Harvard Business Review in January 2022 found that while 72 percent of boards expected that their companies would reach their climate goals, 43 percent of these companies were yet to establish a carbon-reduction target. This points to the information asymmetry between the board and management.

Additionally, existing laws and upcoming legislation that apply to the company give rise to several open questions which directors must not hesitate to ask. Directors in the European Union (EU) need to be mindful of, for example, the Corporate Sustainability Reporting Directive that entered into force in January 2023, the proposed Corporate Sustainability Due Diligence Directive and the Shareholder Rights Directive II, and the obligations that they entail. Legislative changes are bolstering expectations for companies to demonstrate that their executive pay practices are aligned with their company’s ESG performance and long-term value creation. Boards should proactively seek to fully understand the extent of sustainability reporting and third-party assurances, core concepts such as double materiality, supply chain due diligence and the enforcement of these new laws.

Additionally, directors also need to stay updated on legal and policy developments in other countries as well, as many regulations have extraterritorial effects. For example, in May 2021, a court in the Netherlands ruled that Shell must reduce its carbon emissions by 45 percent by 2030. This was in effect a mandate to comply with the Paris Climate Agreement. The rationale of the judgment broadens the applicability and enforcement of international law in the context of ESG. Boards must aim for ESG fluency and be informed about current events that may or may not be sector specific. Based on available information, asking questions to better understand how the company will deal with a specific issue forms the backbone of a sturdy risk management exercise.

The second key duty of a board member in the ESG space is to be quick in overseeing risk identification and raising red flags at the earliest opportunity in any given matter. A survey published by Zurich American Insurance Group in 2022 found that only 25 percent of corporate directors said their board members can comprehend ESG risks well. Risk identification is the first step toward building a strong corporate risk management policy. Boards can play an effective role in ensuring that the company is identifying potential risks and opportunities and bringing them to the attention of management.

Recent and ongoing lawsuits and class actions, regulatory policy documents and geopolitical events are key sources of information for flagging various kinds of potential risks in a timely manner. ESG analysis and compliance are effective tools for a corporate board to assess what is material as it builds a sustainability culture and strategy, and hoe to safeguard it from various risks.

Notwithstanding board structure, whether it be unitary or dual, overseeing the company’s internal policies is a facet of a director’s fiduciary duty. Boards can be more ESG-effective by identifying aspects of company policies that need to be improved. European boards can take the cue from their peers in the EU as well as global counterparts, and work toward embedding ESG awareness and targets in their company strategy by ensuring that the company is approaching ESG strategically, in keeping with building a sustainability culture and reviewing policies periodically to ensure that they are in line with ESG best practices and regulatory requirements, using peer networks and benchmarking tools if necessary.

Today, increased focus on ESG issues is having a significant impact on European boards. There is now greater external pressure on companies to address ESG issues. Institutional investors are playing a key role as well. For example, in 2022, 36 management proposals on climate, at companies in the energy, finance, industry and services sectors, were submitted to shareholder vote in European markets under review, as opposed to 19 in 2021. Similarly, annual general meetings for companies across eight European markets indicate growth in ESG resolutions, which emphasises the need for boards to keep up with ESG-related developments.

A board equipped with the above tools and strategies can play a crucial role in its company’s ESG journey. While corporate purpose gives meaning to a company’s existence, ESG practices – together with financial stability – ensure its sustainability. By making ESG a priority in the era of stakeholder capitalism – the idea that businesses serve the long-term welfare of all their constituents, not just shareholders – boards can send a strong signal to employees and other stakeholders that the company is committed to sustainability.

Manali Paranjpe is an associate director and Anuj Saush is centre leader of the ESG Center, Europe at The Conference Board. Ms Paranjpe can be contacted on +32 (2) 675 5405 or by email: mparanjpe@tcb.org. Mr Saush can be contacted on +32 (2) 675 5405 or by email: asaush@tcb.org.

Manali Paranjpe and Anuj Saush

The Conference Board