United States: Oversight Of ESG—ten Questions For Boards

According to Protiviti, in 2019, 90% of companies in the S&P 500 issued separate sustainability reports—not part of SEC filings—and, as of February 2020, over 1,000 companies with an aggregate market cap of $12 trillion have endorsed the Task Force on Climate-related Financial Disclosures (TCFD) recommendations for sustainability disclosure (see this PubCo post and this PubCo post). Similarly, use of the Sustainability Accounting Standards Board (SASB) framework has increased by 180% over the last two years (see  this PubCo post).  With this heightened focus on sustainability, how can boards best oversee ESG?  To that end, in this article, consultant Protiviti offers ten questions about ESG reporting that boards should consider with their management teams.

Under pressure from large asset managers and other institutional investors, such as BlackRock and State Street Global Advisors, environmental groups and climate activists, consumers and even employees, many companies have sought to demonstrate their bona fides when it comes to sustainability. According to the article, "ESG reporting presents an opportunity for companies to share what they are doing to sustain the long-term interests of shareholders while also addressing the interests of customers, employees, suppliers and the communities in which they operate." Just this year, in his  annual letter to CEOs, Laurence Fink, CEO of BlackRock, the world's largest asset manager, announced a number of initiatives designed to put "sustainability at the center of [BlackRock's] investment approach." According to Fink, "[c]limate change has become a defining factor in companies' long-term prospects." What's more, he made clear that companies needed to step up their games when it comes to sustainability disclosure. (See this PubCo post.) Similarly, SSGA has  announced that, in 2022, it plans to start voting against the boards of big companies that have underperformed relative to their peers on ESG standards, particularly financially material sustainability issues, and cannot explain how they plan to improve. (See  this PubCo post.) SSGA believes that directors have a significant  role to play in promoting action on ESG issues, but still exhibit some "ambivalence" about their roles in ESG oversight. During engagements, SSGA wants to "understand how boards are developing ESG-aware strategies, as well as how they are overseeing and incentivizing management to consider and measure performance of financially material ESG issues." (See this PubCo post.) But how should boards approach their oversight of this issue? Below are ten suggested questions from Protiviti about ESG reporting for consideration and discussion by boards with their management teams:

• "Have we set compelling sustainability targets and goals that appeal to the marketplace?" This question requires directors to understand where the company's sustainability goals stand relative to the competition. Are they serious goals that are integrated into the company's strategy?
• "What story are we telling the street?" How is the street reacting to the company's message on ESG, including in comparison with competitors and the rest of the industry? Protiviti advocates that companies "articulate how ESG initiatives make a difference in executing the strategy and identify areas where it sees the greatest opportunity to create value."
• "Can we integrate our ESG reporting with financial reporting?" Investing in ESG involves costs, but can also lead to new revenue opportunities and operating efficiencies, all of which can impact financial performance. As a result, Protiviti suggests, it would make sense to integrate ESG reporting into financial reports and earnings calls.

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Of course, where ESG involves risks or otherwise affects the financial statements, it will likely need to be discussed in SEC reports to the extent material. Likewise, the SEC recently added a requirement that companies include, as part of their business narratives, a discussion regarding human capital, frequently considered an element of ESG.  (See this PubCo post.) But beyond that, there is a distinct lack of enthusiasm at the SEC (the current majority at least) for imposing a prescriptive sustainability disclosure requirement that goes beyond principles-based materiality. (See, e.g.,  this PubCo post,  this PubCo post, this PubCo post, this PubCo post and this PubCo post.)

However, there has been some movement in favor of voluntary integration of ESG into financial reporting. Of course, integrating ESG into financial reports can lead to heightened scrutiny and potential liability. For example, in September, the World Economic Forum International Business Council together with the Big Four accounting firms, presented a whitepaper,  "Measuring Stakeholder Capitalism—Towards Common Metrics and Consistent Reporting of Sustainable Value Creation," which includes "a core set of common metrics to track environmental and social responsibility." In what might be a controversial aspect of the framework, the whitepaper advocates that, instead of discussing the various metrics in a separate sustainability report, as is the more common practice, the discussion should be mainstreamed. With the initiative,  the IBC hopes to trigger

• "What reporting framework are we using, and why?" In the absence of a consensus framework, Protiviti suggests that companies may need to use several frameworks to address  "investor needs for common industry metrics to compare and contrast performance."  A survey of the S&P 500 by the G&A Institute showed the usage of the most common frameworks as follows: the CDP (65%), Global Reporting Initiative (51%), the United Nations Sustainable Development Goals (36%), SASB (14%) and TCFD (5%). Until either the SEC mandates the use of a framework, which, as noted above, seems unlikely in the near term at least, or a consensus develops regarding adoption of a framework, Protiviti expects the use of multiple frameworks to continue. Protiviti believes that "the use of an established framework, such as the SASB's, is an effective way to avoid 'greenwashing,' or overstating ESG efforts."

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At the request of Senator Mark Warner, the GAO prepared a report on public company disclosure regarding ESG.  It should come as no surprise that investors cited as problematic

Consistent with those concerns, the GAO found substantial inconsistencies—in definitions, in metrics and methodologies—that would limit comparability. The GAO found "instances where companies defined terms differently or calculated similar information in different ways," most often in connection with climate change, personnel management, resource management and workforce diversity.  For example, companies used different groupings for employee demographics or reported greenhouse gas emissions data differently, combining carbon dioxide and other greenhouse gases in some cases, while reporting carbon dioxide emissions alone in other cases.  (See this PubCo post.)

In addition, the proliferation of frameworks has led some institutional investors to question the quality of the data provided. For example, at a meeting of the SEC's Investor Advisory Committee in December 2018, one meeting participant contended that the voluntary nature of current standards is a problem because it allows companies to engage in cherry-picking and "greenwashing," that is, filtering to portray an environmentally responsible public image. (See  this PubCo post.) And at a 2019 Committee meeting, a representative of a large asset manager contended that evaluating ESG information is an imprecise task because of the "patchy" and inconsistent nature of the disclosure among companies. There is insufficient quality, decision-useful data, exacerbated by corporate greenwashing, he said.  In his view,  companies are typically unwilling to share more information because their competitors are not disclosing it and it's not legally required.  Another participant observed that, even though there are a number of frameworks, they are not regularly used or, if used, companies may respond selectively or fail to include quantitative data. One panelist observed that there is insufficient transparency into how companies determine which ESG issues are material for their financial performance. (See  this PubCo post.)

• What accountabilities have we set for ESG-related performance?" Protiviti advocates that, to ensure appropriate management attention, executives should sponsor ESG initiatives, and ESG performance should be monitored together with financial and operational performance and linked to incentive compensation plans.

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In May 2019, comp consultant Mercer conducted a  spot survey of 135 companies, looking at the prevalence and types of ESG metrics used in incentive compensation plans, including metrics related to the environment, employee engagement and culture, and diversity and inclusion. The survey found that 30% of respondents used ESG metrics in their incentive plans and 21% were considering using them.  Mercer observed that with the "growing expectations for organizations to operate in an environmentally and socially conscious way, [ESG] incentive plan metrics are increasingly being considered as effective tools to reinforce positive actions." ESG metrics were used by 28% of respondents in their short-term incentive plans, most commonly environmental metrics (66%), followed by social metrics (employee engagement and culture) (37%), governance (diversity/inclusion) (18%) and other (most commonly employee health and safety) (13%).  ESG metrics were used in only 9% of long-term incentive plans, again most commonly environmental metrics (67%) followed by social (58%) and 17% for governance. In the energy and metals and mining sectors, 96% used an environmental metric, compared to 22% for other sectors, while 76% of other sectors used a social metric, compared to only 22% for energy and mining. Efforts to link ESG factors to executive comp have also been a common thread in a number of shareholder proposals.  (See this PubCo post.)

• "Is our ESG reporting satisfying the needs of the investment community and other stakeholders?"  How does management engage with institutional investors and ESG stakeholders to understand their expectations? Protiviti also suggests monitoring ESG ratings and the reasons for changes in those ratings.

• "What are our ESG risks, and how well are we managing them?" Protiviti advises that companies view ESG risks and opportunities through the company's "enterprise risk management lens," and refers companies to a COSO document, "Applying Enterprise Risk Management to Environmental, Social and Governance-Related Risks," for guidance. As part of its oversight responsibilities, the board will need to consider the adequacy of the disclosures of material risks related to ESG issues, such as climate, and the material impact of the company's ESG-related activities in its periodic reports and other SEC filings.

• "What have we done to ensure that our ESG-related disclosures are reliable?"   Here, Protiviti recommends that directors understand the level of management's confidence in the company's disclosure controls and procedures related to ESG metrics and reporting. Internal audit may also be able to provide assurance as to the fair presentation of the underlying data.

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With the increasing focus on sustainability reporting, as discussed in this article in the WSJ, also comes increased scrutiny. Is the company engaged in greenwashing? While positive reports and ratings "can attract investments and sales,... along with heightened interest comes heightened scrutiny. Indeed, misleading claims can backfire if they are called out as inaccurate or misleading. Investors are quick to punish companies for transgressions across the landscape of ESG issues."  "'The stakes are just much higher,'" according to one commentator, citing a 2019 report from a large bank "that showed 24 major controversies related to ESG topics erased more than $500 billion in market value of S&P 500 companies from 2014 to September 2019." Another survey of 250 institutional investors showed that over half "believe companies are presenting misleading environmental credentials, and 84% think the practice is becoming more common." While regulation of claims about products varies, the article contends that there is less regulatory scrutiny of voluntary sustainability reports, and companies have more flexibility in the selection of information they present in these voluntary reports, especially to the extent that the statements are considered vague "marketing speech" (provided it's not false). But where ESG intersects with financial information, such as details about their investments in sustainability projects, the disclosures tend to be more rigorous.

• "Does — and if not should — our independent auditor have a role in ESG reporting?"   Protiviti  observes that 29% of S&P 500 companies use external assurance for ESG data. But as interest increases, independent assurance may become more important. Will underwriters begin to request comfort letters in connection with some ESG disclosures in the context of securities offerings?

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There appears to be growing interest in assurance about ESG data, especially as investors increasingly consider it as part of their investment strategies.  At a 2019 meeting of the SEC's Investor Advisory Committee, one panelist observed that, although many companies provide sustainability reports, less than a third include third-party assurance. How do investors know that the information provided is accurate and comparable across companies? (See this PubCo post.) Taking up that issue, in its whitepaper, the World Economic Forum advocates that "the metrics should be capable of verification and assurance, to enhance transparency and alignment among corporations, investors and all stakeholders."

• "How has the COVID-19 pandemic affected our ESG reporting?" It's well known that COVID-19 has affected workforce health and safety, the nature of workplaces, customer behavior,  global supply chains and communities. Protiviti asks "how are these and other pandemic-induced impacts altering company discussions of ESG strategies and initiatives, including the balancing of short-term needs and decisions with long-term resilience?"

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What has been the impact of the COVID-19 pandemic on companies' sustainability efforts? On the one hand, as discussed in  this article from the WSJ, C-suite occupants have been "trying to figure out what they're willing to throw overboard as the economic storm spawned by the pandemic is swamping their ships. Businesses that were planning to help save the world are now simply saving themselves....History suggests this new [sustainability] paradigm is probably on the back burner." On the other hand, however, as  this article from Financial Executives International observed, the COVID-19 pandemic has highlighted "the very issues that have been driving ESG concerns—managing resources, sustainability, community impact and employee well-being."  While it might have been "easy to assume the current crisis may permanently shift attention away from environmental, social and governance (ESG) concerns as management teams grapple with existential issues," it has turned out that "the very actions companies are taking will likely bring them closer to the multi-stakeholder, long-term value principles that lie at the heart of ESG." 

In particular, as discussed in this  Reuters article, the welfare of workers "is having a moment on Wall Street."   Issues surrounding paid sick leave and safe working conditions have become a top priority for managements and boards; for some investors, they have become "a golden opportunity to apply the principles of ethical investing." While, previously, investors tended to focus on the environment ("e") and governance issues such as proxy access ("g"), now social issues ("s"), especially human capital management, have become predominant. The  WSJ has also reported that investors are pressuring companies to "strengthen employee benefits after the coronavirus pandemic exposed shortcomings in U.S. labor policy. Investors have scrutinized how U.S. companies have managed their workforces during the crisis to determine how ready they are for future global emergencies. Issues include offering paid sick leave, counseling, protective equipment, flexible work and the option to work from home."  The article reports that both BlackRock and State Street are focusing on "more immediate ESG issues," such as employee health and safety.  According to one commentator cited in the article, the "crisis presents the best opportunity yet for companies to prove whether they are pledged to stakeholders as many have claimed for years, like workers and local communities, and not just stockholders. 'This is a litmus test for corporate commitment.'"

The Conference Board reports that investors are continuing their ESG push:

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