Increasingly, boards of directors are called upon to navigate the challenges presented by climate change, racial injustice, economic inequality, and numerous other human right issues that are fundamental to the success and sustainability of companies, financial markets, and economies. This call, welcomed by some and eschewed by others, is attributable in part to the large and growing influence that corporations hold over the social and economic well-being of people and communities everywhere. So boards are stepping up their engagement on climate and ESG related-risks and opportunities.
Understanding ESG and Board Obligations
So, what obligations do boards have? Historically, many ESG issues were seen as not within the purview of the board of directors. These matters, referred to as “corporate social responsibility” or CSR issues, were largely treated as if they were separate and apart from the business of generating revenue and earning profits. Debates about director duties around climate and ESG often centered on whether directors were even permitted to consider issues that previously fell under the rubric of corporate social responsibility. In that Milton Friedman era, risks like climate change and many other issues we would now call ESG were characterized as topics that could bear on the public good, but were not relevant to maximizing value for shareholders.
Those days are over. Our understanding of the significance of ESG and its short-, medium- and long-term relationship to financial performance has evolved to the point that the principal debates are about when, not if, these issues are material. Thus, regardless of whether one agrees with the Business Roundtable’s position on corporate purpose and service to stakeholders and the broader economy, it is clear that the board has a role with respect to ESG.
There is, for example, broad consensus regarding the physical and transition risks associated with climate. SASB (now the Value Reporting Foundation), the Global Reporting Initiative, and many others have clearly set forth financially material ESG risks for companies. There is tremendous and growing investor demand for climate and ESG disclosure. The world’s largest asset managers and other institutional investors have been direct and vocal in conveying that they consider ESG material to their decision-making. No matter the view of regulatory involvement in climate and ESG disclosures, directors must reckon with this growing consensus and growing demand from the shareholders who elect them.
Accordingly, boards increasingly have oversight obligations related to climate and ESG risks – identification, assessment, decision-making, and disclosure of such risks.
- In the European Union, these obligations are for instance directly embedded in the compliance of SFDR where Fund managers and Funds should document their policy on integrating sustainability. The policy should be documented for each Fund, be reviewed and approved by the board of directors of the Fund manager on an annual basis. In France for instance, and since late 2022, The AFEP-MEDEF recommendations strengthen the board’s missions so that it can oversee the company’s ESG strategy. It is therefore recommended that the Board determine multi-year strategic orientations in these areas, particularly with regard to climate change, for which this strategy must be accompanied by precise objectives defined for different timeframes. It is also recommended that ESG issues be the subject of preparatory work by a specialized committee of the Board. To this end, directors may receive training on environmental and climate issues. Finally, it is recommended that executive compensation include ESG criteria, at least one criterion related to climate objectives.
- In the US, these obligations flow from both the federal securities laws and fiduciary duties rooted in state law. Under the federal securities laws, the board plays a critical and mandatory role in the existing corporate disclosure process. This increasingly requires directors to think about and consider the impact of climate change and other ESG matters on the financial statements and other corporate disclosures. Since the passage of Sarbanes-Oxley in 2002, boards at listed companies directly oversee the audit of financial statements, including responsibility for the appointment, compensation, and oversight of the independent auditor. Exchange rules impose direct requirements with respect to board oversight of audits, including that boards discuss any difficult issues with the independent auditor. Likewise PCAOB rules require auditors to communicate with boards about significant issues arising in the audit. Because matters such as climate change may bear on the valuation of assets, inventory, supply chain, and future cash flows, board oversight of audits increasingly necessitates engagement on those issues.
Boards basically play an important role in the oversight of other types of disclosures made outside of financial statements. These disclosures may also implicate ESG considerations. A director’s duty of care fundamentally requires that a board must be well informed when making corporate decisions. When those decisions, for example, relate to long-term business strategies, a board may well need to ensure it has relevant information related to the climate and ESG-related risks and opportunities its company faces.
All of this suggests that climate change and other ESG matters should be regular and robust topics for the board, whether at meetings of the full board or in key committees, such as the audit committee, the compensation committee, or the risk committee. Or, perhaps, as some companies have already done, handled in a more centralized manner through a sustainability or ESG committee of the board.
Mitigating ESG Risks and Maximizing ESG Opportunities
Growing recognition of the importance of climate and ESG presents both risks and opportunities for companies and their boards. On the risk side of the equation, there is, among other things, physical risk, transition risk, and regulatory risk. There is also reputational risk, as investors and consumers increasingly make decisions based on companies’ sustainability profiles. And human capital risks as well, as younger workers increasingly place a premium on whether a company’s values align with their own.
There is a rising expectation that boards will play a key role in managing these risks. A core component of the framework created by the Task Force on Climate-Related Financial Disclosures is disclosure of the board’s oversight of climate-related risks and opportunities. The World Economic Forum published a white paper explaining that boards need to integrate ESG into corporate governance out of a recognition that “business value creation” is increasingly dependent on understanding and managing these risks and opportunities.
Importantly, all of these risks also present great opportunities. Boards that proactively seek to integrate climate and ESG into their decision-making not only mitigate risks, but better position their companies and business models to compete for capital based on good ESG governance.
So what are some key steps for boards that seek to maximize ESG opportunities, message their commitment on these issues, and position themselves as ESG leaders?
1. Enhance Board Diversity
There are many reasons for companies to seek to enhance the diversity of their boards, not least because investors increasingly expect them to do so. Board refreshment introduces opportunities to put new directors on boards, and emphasizing diversity increases the likelihood new directors will actually bring new thinking. This, in turn, could facilitate more current and proactive approaches to climate and ESG governance.
2. Increase Board Expertise
To effectively address climate and ESG risks, boards need adequate expertise on these subjects. Investors are increasingly emphasizing their expectation on this point. Yet research and empirical experience show that directors may still fall short in terms of ESG credentials. Companies should consider ways to enhance the ESG competence of their boards. These efforts could include integrating ESG considerations into their nominating processes in order to recruit directors that will bring ESG expertise to the board; training and education efforts to enhance board members’ expertise on ESG matters; and considering engagement with outside experts to provide advice and guidance to boards.
3. Embed ESG in Executive Compensation
Executive compensation is a powerful tool for achieving strategic company goals. This dynamic is not limited to simply linking executive compensation to certain corporate financial goals. In addition to helping achieve strategic goals related to issues such as reduced carbon emissions or increased diversity of the workforce, tying executive compensation to ESG metrics can offer an important way to deliver on a company’s commitment to issues that matter to investors and consumers.
Conclusion: Work at the Interface of Climate and Social Issues to Identify Way Forward
While legal frameworks vary between jurisdictions, it is generally the case that directors act as fiduciaries
of the company in discharging their functions, and owe duties of loyalty and care and diligence to the
company. Case is clear to increasingly consider ESG becoming mandatory duties and boards have therefore to work on diversity, competencies and incentives to accelerate the transitions needed by the assets under their responsibilities.