February 27, 2019
February 27, 2019
It’s no secret to engaged corporate boards that the mainstream investor community is increasingly attuned to environmental, social, and governance (ESG) matters. What may be less obvious is what that means, exactly.
Many directors are likely to think, “We already have a corporate social responsibility program in place, so we’re covered.” If that sounds like your board’s approach, everything you think you know about ESG could be wrong.
Whereas corporate social responsibility (CSR) traditionally involves a company’s foundation, its charitable work, employee volunteer and recycling efforts and the like, ESG narrows the focus on business-critical sustainability issues.
It may sound like splitting hairs, but consider the difference between, say, a beverage company that donates time and money to alleviate poverty in its local community and one that invests in water efficiency initiatives at its facilities located in drought-prone regions. The first company’s intentions may certainly be noble, and its actions may enhance its reputation. But the second company’s investment in water efficiency is fundamentally linked to its value-creation strategy, and thus is likely to have direct and indirect impacts on the firm’s financial statements and market valuation.
The key to making this distinction is the lens of financial materiality, which helps identify the subset of sustainability factors most likely to have meaningful impacts on a company’s financial condition or operating performance.
Indeed, research shows this focus is associated with significant outperformance in terms of sales, sales growth, return on assets, and return on equity, as well as risk-adjusted shareholder returns. These findings, in turn, explain why a large and growing number of investors—including 73 percent of analysts and portfolio managers—integrate ESG considerations into their work.
What does this mean for boards of directors? Quite simply, because financially material ESG matters constitute legitimate strategic and risk considerations, they have significant fiduciary implications. In other words, the shift from CSR to ESG has raised the bar for board oversight of how these issues are managed and reported. For example, if your company is like 85 percent of the S&P 500, you’re already putting ESG information out into the marketplace. How can you ensure this data is both relevant and reliable—the twin hallmarks of decision-useful information?
For investors—and, by extension, for directors—not all sustainability issues are created equal. So, it’s important that companies assess ESG factors through the lens of financial materiality, which can help streamline their sustainability efforts to measure, manage, and report on the ESG issues that impact value and are critical to investors and shareholders.
With its lens focused on materiality, a company can more effectively integrate the resulting handful of key issues into its core business operations using standard approaches to strategic planning (such as balanced scorecards and strategy maps), enterprise risk management (or ERM, such as the COSO framework), and performance management (such as internal dashboards for monitoring progress). Such integration not only ensures crucial ESG factors are effectively managed, it enhances the ability of the board and its committees to administer appropriate oversight.
Of course, relevance is arguably in the eye of the beholder, and directors should also consider engaging with key investors to better understand which ESG risks and opportunities they care about most. These issues don’t always arise—or, more likely, get lost in translation—during earnings calls or discussions with buy-side analysts. To meaningfully explore and fully understand investor needs through engagement, a board may want to add or develop ESG-related expertise.
Boards of directors may find the following questions helpful in framing their company’s strategy and approach to sustainability:
Of course, even relevant information may be of limited use if it lacks reliability, including timeliness and accuracy. Although some ESG data—such as utility bills and invoices—may already reside in a company’s enterprise resource planning system, much of it has traditionally been collected and managed in spreadsheets—outside the rigor of the financial reporting process—which can result in information of less than desirable precision and limited verifiability. Companies can overcome this challenge and improve the data by designing, implementing, and maintaining a system of governance around financially material sustainability information that is substantially similar to what they use for financial reporting.
Such a system is likely to include an effective internal control environment and additional disclosure controls and procedures, as appropriate. In this context, internal audit can play a critical role in enhancing management’s and the board’s comfort over sustainability information. Some companies may also choose to engage an independent third party to provide assurance over key ESG data, which sends a signal of reliability to the investor community. Controls and assurance can thus strengthen the confidence of decision makers both inside and outside the firm while dramatically reducing the likelihood of restatements.
Directors can ask themselves the following questions to assess the reliability of their company’s sustainability reporting:
A company may not always be able to maximize both the relevance and reliability of its financially material sustainability information. In this sense, it is no different from traditional financial data, which involves its own inherent trade-offs (e.g., historical costs are more reliable but less relevant than fair values). However, as the evolution from CSR to ESG continues, effective board oversight can help ensure a company’s sustainability initiatives and related reporting are focused on issues that can create value for both the enterprise and its investors.
Along with the questions presented here, the 77 industry-specific standards recently codified by the Sustainability Accounting Standards Board (SASB) can provide a useful starting point for boards to kick-start their ESG oversight. In large part, this is because the SASB standards are designed to achieve both relevance and reliability.
First, by observing the threshold of financial materiality, the standards zero in on the subset of ESG factors that are critical to investors (an average of six per industry). Second, by providing detailed technical protocols, they ensure ESG data is prepared, compiled, and presented in accordance with rigorous definitions, scope, and accounting guidance—which can also serve as the basis for “suitable criteria” in an assurance engagement.
As the competitive landscape has evolved, so has our understanding of sustainability and its impacts on business outcomes. Having faced economic headwinds, technological disruption, and regulatory uncertainty in recent years, boards of directors are well-versed in change management and practiced at the art of adapting to new circumstances. These skills will remain invaluable as sustainability and finance continue to converge.
Robert B. Hirth Jr. is Senior Managing Director at Protiviti, Chairman Emeritus of the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and Co-Vice Chair of the SASB Standards Board.