On Monday, in a keynote address before the Society for Corporate Governance 2021 National Conference, SEC Commissioner Allison Herren Lee discussed the challenges boards face in oversight of ESG matters, including “climate change, racial injustice, economic inequality, and numerous other issues that are fundamental to the success and sustainability of companies, financial markets, and our economy.” Shareholders, employees, customers and other stakeholders are now all looking to corporations to adopt policies that “support growth and address the environmental and social impacts these companies have.” Why is that? Because actions or inactions by our largest corporations can have a tremendous impact. According to Lee, a 2018 study showed that, of the top 100 revenue generators across the globe, only 29 were countries—the rest were corporations, that is, corporations “often operate on a level or higher economic footing than some of the largest governments in the world.”
No longer on the periphery. Environmental and social issues are no longer considered peripheral but are now viewed as more central to businesses. As a result, boards are more engaged on ESG risks and opportunities, Lee explains, citing a survey showing that almost 80% of “directors reported that their boards are focused on some aspect of ESG. An analysis of a selection of S&P 100 proxy statements found that 78 percent of companies had at least one board committee charged with overseeing environmental sustainability matters. And 42 percent of companies reviewed in that analysis associated at least one director with expertise in environmental policy, sustainability, corporate responsibility, or ESG.“ Nevertheless, other analysis suggests boards may lack specific sustainability mandates” and may be lacking board expertise on ESG.
Lee points to the results of the recent proxy season to underline the increasing significance of ESG. Shareholder proposals on climate received “record support,” including 98% support in one instance at a large company and several proposals achieving significant majority votes. Not to mention that climate activists conducted a surprisingly successful proxy contest. Proposals on racial equity audits almost achieved majority votes and several proposals for political spending disclosure did achieve majorities. (See this PubCo post.) Notably, Lee observes, this proxy season occurred against the backdrop of “ever-more powerful signals from major institutional investors of their commitment to sustainability. Finally, it occurs as the SEC considers potential rulemaking to improve climate and other ESG disclosures for investors. These developments place ever greater responsibility on companies, and therefore boards, to integrate climate and ESG into their decision-making, risk management, compensation, and corporate transparency initiatives.”
Board obligations. Lee begins this part of her presentation by observing that, historically, many ESG issues were dismissed as only a component of “corporate social responsibility” and not really considered part of the board’s principle responsibility—to “maximize shareholder value.” Perhaps ESG issues might “bear on the public good, but were not relevant to maximizing value for shareholders.” However, Lee concludes, “[t]hose days are over.” We don’t need to reach the debate over shareholder primacy versus stakeholder capitalism in this context because “the connection between ESG and the interests of shareholders has become evident. 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.” (Of course, Commissioner Elad Roisman might take issue with that conclusion. See this PubCo post.)
For example, she suggests, there is “broad consensus regarding the physical and transition risks associated with climate.” Many standard setters, such as SASB (now called the Value Reporting Foundation following a merger with the International Integrated Reporting Council), have identified ESG risks and standards that are financially material. Because the largest asset managers and other institutional investors view ESG to be “material to their decision-making,” they have demanded ESG disclosure. Regardless of whether the SEC steps in to mandate specific ESG disclosure regulations, she contends, “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.”
Board’s oversight obligations “flow from both the federal securities laws and fiduciary duties rooted in state law.” The board plays a “critical and mandatory role” under the federal securities laws in connection with oversight of the financial statements, which is evident from SOX requirements, as well as Exchange rules and PCAOB requirements. Climate change, Lee asserts, “may bear on the valuation of assets, inventory, supply chain, and future cash flows,” making engagement on those issues increasingly a part of board oversight of audits. Similarly, in light of the SEC’s 2010 climate guidance, boards are increasingly required to consider ESG matters in the context of other corporate disclosures, such as MD&A. She also highlighted the SEC’s recent update to Reg S-K, Item 101, regarding human capital, as well as the Item 407(h) requirement for disclosure of the board’s role in the risk oversight, all of which could involve climate and other ESG issues.
Lee also observes that ESG-related risks and opportunities may be implicated under state law, as directors seek to fulfill fiduciary duties of loyalty and care. And, under the duty of good faith, she contends, “directors may need to investigate ‘red flags’ that suggest legal violations or other harm to the corporation. This may require directors to do a deeper dive on climate change and other ESG issues as the regulatory landscape evolves. Unaddressed red flags relating to a violation of emissions regulations, for instance, could implicate the duty of good faith.” Accordingly, Lee advises, “climate change and other ESG matters should be regular and robust topics for the board.”
Risks and Opportunities. Climate and other ESG, Lee explains, involve both opportunities and risks—physical risk, transition risk, regulatory risk and reputational risk. There is even risk in connection with human capital, she maintains, “as younger workers increasingly place a premium on whether a company’s values align with their own.” Boards are expected to oversee and manage these risk and opportunities, she argues, citing the TCFD framework, as well as a World Economic Forum white paper advocating that boards “integrate ESG into corporate governance out of a recognition that ‘business value creation’ is increasingly dependent on understanding and managing these risks and opportunities.” Large asset managers also have expectations for board oversight of ESG. For example, BlackRock has urged “boards to shape and monitor management’s approach to material sustainability factors in a company’s business model,” indicating that it “will hold directors accountable where they fall short. Proxy advisory firms ISS and Glass Lewis have announced new voting policies that include director accountability for ESG governance failures.” Shareholders can also hold boards accountable for failures to include climate and ESG as part risk management and governance —through shareholder proposals, proxy contests and even selling their shares. And boards that are proactive, she maintains, can not only mitigate risk, but also “better position their companies and business models to compete for capital based on good ESG governance.”
Key steps for boards. Lee then suggests several steps that boards can take to “maximize ESG opportunities, message their commitment on these issues, and position themselves as ESG leaders.”
- Enhance Board Diversity. Lee suggests that there are still some laggards on boards that have failed to fully appreciate the need to integrate climate and ESG into governance practices, citing a 2019 report in which 56% of directors “thought investor attention on sustainability issues was overblown.” One way to address this problem, she suggests, is to refresh and diversify boards to introduce new perspectives.
- Increase Board Expertise. Addressing climate and other ESG issues requires that boards have “adequate expertise on these subjects.” But some research suggests that boards may not have the appropriate level of competence in these areas. To enhance the ESG competence of boards, boards should consider “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.”
- Inspire Management Success. Finally, Lee suggests that boards use financial incentives to “spur progress” to achieve strategic company goals associated with ESG: 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.” To illustrate, she observes that some companies that made commitments to racial diversity also tied executive comp to diversity metrics, employing “one of the most powerful tools they have to make real progress on ESG goals, and at the same time signaling the strength of their commitment to these issues.”
Key to Lee’s message is that “substantive consideration of ESG should be meaningfully integrated into board oversight.” Lee acknowledges, however, that there is “no one right answer for each individual company on how to mitigate risks and maximize opportunities with respect to climate and ESG issues. They are complex, evolving and, in some cases, highly charged issues.” The public needs to to able to test whether “public pledges on ESG issues are actually backed up by corporate action”—that’s one reason why Lee believes that the disclosure regime must provide investors with adequate information. “The more we can have open, thoughtful, and well-researched dialogue on the specifics of these issues,” she concludes, “the more companies, investors, and all stakeholders will benefit.”