The rise of sustainability as a governance imperative is inextricably tied to the growing influence of large institutional investors, particularly index funds, and the governance teams within them. Generally speaking, governance-focused asset managers now control more than one-third of the average public company’s shareholder register. Recently, the world’s three largest investors bulked up the staff of their governance teams dedicated to analyzing and meeting with portfolio companies, which included hiring individuals with expertise on environmental and social topics.
The heightened focus on environmental, social, and governance (ESG) analysis and corresponding engagement is heavily influenced by the Principles for Responsible Investment (PRI). The PRI promotes “active ownership” (such as engagement and proxy voting) and “ESG integration” (which is intended to improve investment decision-making by linking the analysis of ESG factors with financial performance). What began in 2006 with 200 asset owners has grown to more than 1,600 global signatories, including investment managers, with more than $60 trillion in assets.
Recently, the PRI announced that it will de-list signatories if they do not show progress in implementing the Principles. Because being a PRI signatory is commonly a requirement for asset managers to win mandates from asset owners, this move may incentivize PRI members to increase the frequency and sophistication of their engagements and add momentum to the quest for ESG data that is comparable across companies and industries.
Market participants are also seeking to understand and quantify the link between ESG and financial value. An increasing number of data providers, consultants, credit rating agencies, and nonprofits are assessing and rating companies on their performance on ESG criteria. Concurrent with that analysis is the emergence of academic and proprietary research which correlates effective ESG oversight with financial value creation, further encouraging investors to understand how companies link sustainability and business strategy.
Investors Take Action
These dynamics are already changing the market. Investor coalitions, including the Commonsense Corporate Governance Principles and Investor Stewardship Group, have been formed to issue guidance and perspectives on governance and sustainability issues. In addition, certain shareholder proposals on environmental and social issues are receiving high levels of support from a growing range of institutional asset managers. Importantly, within the past few months, both BlackRock and State Street Global Advisors have stated that if they do not perceive progress from issuers on sustainability initiatives in their engagement, they will consider voting against the nominating/governance committees of those companies.
Preparing to Engage
Given these trends, it is incumbent on issuers to take steps now to ensure that they are engaging effectively with their investors. Here are four ways to prepare:
Establish clear governance of sustainability. Investors want to know that their portfolio companies have effective governance structures in place to manage the development and execution of sustainable strategies. A coordinated program should be built with the following points in mind:
Employees across the organization need to be educated, aligned and incentivized toward common sustainability goals;
The financial risks and opportunities of sustainability activities need to be assessed for potential return on investment;
Metrics and systems need to be established to track progress against sustainability goals; and
The board and management should clearly identify who is responsible for sustainability in order to ensure the integration of sustainability considerations into strategic planning and incentives, as appropriate.
Identify the material ESG factors for your company. It is critical to identify which ESG issues have the greatest potential to create risks or provide opportunities that may impact the long-term value of your company. Investors are increasingly looking to the Sustainability Accounting Standards Board (SASB), which provides industry-specific guidance on the most potentially material ESG factors in a given industry, and other disclosure standard setters for this information.
Tell your story. Companies should be proactive in communicating with investors about sustainability. That means strengthening disclosure of sustainability governance, strategy, goals, and performance in public filings and producing enhanced sustainability reports to demonstrate the financial materiality of ESG topics. Companies will also want to ensure internal subject matter experts are equipped to engage with investors and external rating agencies.
Keep your eye on the future. Today, investors frequently compare financial disclosures to material non-financial information contained in documents such as sustainability reports. One trend that is emerging to help ensure these disclosures are complementary is integrated reporting, which combines financial and sustainability disclosure in a single, cohesive document. While still nascent, this practice is intended to provide investors with a better understanding of the link among corporate business strategy, sustainability initiatives, and short- and long-term value creation.
From traditional governance factors like compensation, board composition, and independence, to environmental and social factors like energy efficiency and diversity, sustainability is now integral to every company’s business model. As the market continues to incorporate, value, and reflect the materiality of sustainability into investment strategy and engagement, companies that can effectively tell their sustainability story will be best positioned to succeed with the world’s largest investors.
Chad Spitler is head of the Sustainability Advisory Practice at CamberView Partners.
Last month, Exxon Mobil Corp. appointed a leading climate scientist to its board. Exxon’s move underscores the growing pressure shareholders are exerting on the issue of climate-competent boards.
Climate competency of boards—and broader corporate attention to escalating climate change risks—isn’t just a hot topic for one set of shareholders and one oil company. It is a key investor imperative for all sectors of the economy.
Look no further than the new guidelines from the G20’s Task Force on Climate-related Financial Disclosure to understand how profoundly expectations are shifting. The task force, chaired by Michael R. Bloomberg, was created by the Financial Stability Board at the request of the G20 ministers to help companies identify and disclose which climate risks have a financially relevant impact on their business. The task force’s very first recommendation focuses on the governance practices of companies for climate change, including deeper board engagement on the topic.
So what does it mean for boards to be climate competent? Climate competency means much more than just getting one person with expertise on a corporate board. So while we applaud the important step that Exxon has taken, it’s only a first step.
At the end of the day, a climate-competent board is one that can make thoughtful decisions on climate risks and opportunities that a company is facing. When trying to set up a climate-competent board, companies should think holistically about what needs to be done for boards to achieve competent, informed decision-making on this issue.
1.) Put board systems in place for climate change oversight. Boards need to have a committee that is assigned formal responsibility to oversee climate change. By doing so, companies can ensure that boards oversee how climate risks are integrated into operations and decision-making on an ongoing basis. Numerous companies have dedicated board sustainability or environment committees that can be leveraged for this purpose. Companies like Citigroup, Ford, and PG&E have specifically identified climate change as a key focus area in the charters of their board public affairs or sustainability committees. Having the issue identified in such an explicit manner ensures it will be discussed systematically in committee meetings.
2.) Include directors with expertise in climate change on boards. When climate change is a material risk to a company, boards should recruit directors with expertise on that material issue. Such companies should also explicitly identify climate change expertise as a board qualification. This means making it a part of board skill matrices. It’s worth noting that two of the country’s largest pension funds, CalPERS and CalSTRS, recently amended their global governance guidelines to ask portfolio companies to recruit directors with climate change expertise.
3.) Train the full board on climate change. Boards and management should provide climate-related training opportunities to all board members, or, at a minimum, to relevant committee members. Organizations like The Co-operators have detailed systems in place to train its board on sustainability issues that are crucial to their businesses, including leveraging external experts for this purpose. Certain groups offer education curriculums where issues like climate and sustainability are addressed.
4.) Consult stakeholders and shareholders to inform directors’ understanding of climate change. Internal training sessions are key, but it’s just as important that directors reach out to external stakeholders, including investors, to share firsthand the company’s different approaches to climate change learn from voices outside of management. Investors in particular are critical groups to engage. Having this broader multi-stakeholder perspective can help directors make better-informed decisions. In 2016, shareholders filed a record 172 shareholder resolutions on climate change and sustainability. Given that directors are fiduciaries to investors, director-investor dialogues on climate trends will provide an important context to board discussions on this issue.
5.) Be more transparent. Finally, and perhaps most importantly, we need more transparency on climate-related board decisions. We need to know whether boards are prioritizing climate change as a material issue. Companies have to do a better job of disclosing how climate trends are affecting corporate strategies and risks that are relevant to investors.
Market and shareholder scrutiny of board engagement on climate issues is only going to grow sharper with time. While companies will be impacted differently by these risks, few industries are immune. Climate change affects 72 out of 79 industries and 93 percent of the capital markets, according to SASB’s Technical Bulletin on Climate Risk.
The key for board members now is to ensure that they’re well positioned to exercise informed oversight so that they can make thoughtful decisions on this escalating issue.
Veena Ramani is program director, Capital Market Systems, at Ceres.
It is clearer than ever before that sustainability practices can affect corporate value. That was the main thread of a panel that I led at the National Association of Corporate Directors’ 2016 Global Board Leaders’ Summit in Washington, D.C. My co-panelists Christianna Wood, director at H&R Block, and Seth Goldman, founder of Honest Tea, and I discussed the potential risks and opportunities that environmental and social issues pose to companies.
Sustainability is a broad term, and not every environmental or social issue belongs on the board agenda. But when an environmental or social issue has the potential to affect corporate revenue and earnings in the short and long term, sustainability absolutely should be on the table.
At the end of the day, it all comes down to materiality, and this is where corporate directors have a critical role to play.
Materiality is about determining a company’s priorities. As fiduciaries responsible for overseeing a company so that it not only survives but also thrives in the long term, directors have a responsibility to assess whether a company is making the right choices.
But the much harder question is: When does an environmental or social issue rise to the level of being material?
Here are some steps directors can take to drive discussions about whether sustainability issues are material to the companies that they oversee.
1.) Understand how sustainability is being integrated into your company’s efforts as a way to identify material issues.
There are a few ways to do this. Directors could point management towards the Sustainability Accounting Standards Board’s Company Implementation Guide, which provides a great starting point for companies to assess whether certain sustainability factors could be considered material for the purposes of the company’s financial filings. Directors could also integrate themselves more meaningfully into corporate efforts aimed at identifying material sustainability issues. They could provide perspectives on the connections between sustainability factors, corporate strategy, risk, and revenue.
2.) Include key issues being raised by critical stakeholders in the materiality exercise.
While a broader range of stakeholders is raising a variety of issues these days, the financial community is a particularly critical constituency to direct attention towards. As we discussed in our panel, the U.S. investor community is starting to make the connections between sustainability and the financial value of companies in their portfolios. During the 2016 proxy season, close to 400 shareholder resolutions on climate change and other sustainability issues were filed. Large investors including CalPERS, CalSTRS and State Street Global Advisors are asking their portfolio companies to put directors with climate expertise on their boards.
In addition to tracking broad sustainability trends that investors are paying attention to, prudent directors could consider opportunities to engage directly with key shareholders to get a sense of issues specific to the company and the industry. Directors could also track and engage with the broader activist and advocacy community as a risk management exercise.
3.) Weigh in on the time frame over which issues are considered to be material.
Since the board in particular is responsible for long-term corporate performance, directors play an important role in examining whether their company’s materiality process focuses on considering issues over the long or short term.
Overall, momentum is building to adopt a more long-term view to encourage companies and boards to think more broadly about sustainability and materiality. The recently released Commonsense Corporate Governance Principles, which are backed by major U.S. companies including JPMorgan Chase & Co., Berkshire Hathaway, and Blackrock, support the move to long-term thinking. And more companies including Unilever, Coca Cola, and National Grid are moving away from the practice of issuing quarterly guidance specifically to encourage investors and other stakeholders to adopt long-term thinking.
4.) Disclose details on what you consider to be your company’s material priorities.
Noting that determinations of materiality depend on whom the company considers to be its most significant stakeholders, governance experts are starting to call on corporate boards to release a statement noting critical audiences that the company is oriented towards and issues that the corporation is prioritizing. Companies like the Dutch insurance company Aegon have started to issue such statements.
The process of helping to identify the right issues is just a first step in a director’s responsibility on materiality. Directors have an important role to play in ensuring that material issues, when identified are integrated into board deliberations on strategy, risk, revenue and accountability systems. However, getting to the right issues lays an important foundation for the company and its key stakeholders to build on.