During the 2019 proxy season Glass Lewis found that approximately 43% of Russell 1000 companies had established some sort of board oversight of ESG issues. However, based on the disclosure we’ve reviewed, it appears that some boards are performing this oversight better than others. With issues such as climate change and human capital management presenting ever-increasing risk to companies, it’s important for boards to really consider how this oversight function is structured and executed.

Ceres’ new report, Running the Risk: How Corporate Boards Can Oversee ESG Issues, examines how a variety of different companies are managing ESG risk. Courteney Keatinge, Senior Director of ESG Research at Glass Lewis, was a contributor on the report, and spoke to Hannah Saltman, Manager, Governance at Ceres.

You can listen to their conversation here, or read a transcript below. For more information on the subject, the Running the Risk report is available at Ceres’ website.

Courteney Keatinge: I was hoping that to start off you could tell us a little bit about the governance program at Ceres and what you are focused on.

Hannah Saltman: Absolutely. Ceres is a sustainability nonprofit organization based in Boston, working with some of the largest companies and investors to examine and act on the financial risks and opportunities behind some of the most pressing sustainability issues we’re currently seeing, including climate change, water scarcity and human rights abuses. We really do this through four main networks of investors, companies and non-profits, all who have committed to working with Ceres in driving solutions to develop a sustainable economy.

Our governance program really focuses on positioning U.S. corporate boards to achieve a competitive advantage by understanding how these sustainability issues can be material to their enterprise, and how to make better decisions for strong sustainability performance. We focus on the board due to their immense leadership potential within companies. They sit at the top of a company’s organizational structure, so their networks are significant, meaning that the average corporate director sits on multiple boards. Engaging one corporate director on sustainability could affect multiple boardroom discussions.

We’re seeing investors increasingly interested, not just on a company’s commitment to relevant sustainability issues, but specifically on the role of the board in overseeing management on these topics. As fiduciaries to shareholders, directors are facing increasing asks and continue to face increasing asks to demonstrate that they’re serving their duty as stewards of short- and long-term value creation, for shareholders and stakeholders.

The foundation of our program really rests on the collateral that we’ve developed in identifying best practice for how boards can oversee sustainability largely developed through interviews with directors, investors, and other corporate governance professionals.

This focuses on providing strategies and tools for boards to effectively oversee these issues including within discussion on corporate strategy risk management and executive compensation. We then take these leading practices to boards themselves to key executives including in-house legal counsel that serve as key advisors to boards, as well as investors that are engaging with their own portfolio companies to operationalize these recommendations to drive decision-making on sustainability.

Courteney: Thanks Hannah for giving us that overview. I think that sets us up really nicely to talk about the report you guys just put out. I’m hoping you could give us an overview of what Running the Risk is about and what some of your high-level findings and recommendations are?

Hannah: Absolutely. Our latest report Running the Risk really identifies how directors can move from a reactive to a proactive type of oversight on risks posed by ESG issues So we’ve seen even an enormous amount of impact from such ESG issues and continue to do so really month after month on business performance.

What we wanted to do with this report is move the conversation beyond whether a board should oversee these issues to how a board can oversee these risks, and to do that we interviewed over two dozen corporate directors that sit on a board risk and audit committee along with a few other key governance professionals. In doing the research for this report, and in speaking with corporate directors, we really identified three main barriers on why boards are not as far along as we’d like to see on overseeing ESG risk. The first is that too many directors don’t actually view ESG issues as material to the company in question. The second piece is that even when a few directors do identify ESG issues as having material impact, they don’t think that they will affect the company right now — they see this as a much longer term risk that doesn’t require deliberation and decision making in the immediate term.

And lastly, for those that do identify that ESG issues could pose material risk and could impact the company, perhaps even in the short term, they don’t always understand how to classify or identify these impacts as business risks and opportunities to really speak that language in the board room and making the case amongst the other directors on their board.

The thing is, when we look at the financials around this, we know that there are immediate financial impacts that have already happened. Last year, 500 of the largest global companies estimated that financial implications from climate change-related impacts alone totaled at just under a trillion dollars at risk. So this is not something that is far off in the distant future, it’s happening in the here and now, and we need boards to be able to understand the impact on their company and what decisions they need to make in order to act.

There are really four main recommendations from the report on how boards can oversee these types of risks. The first is through the risk identification process. We’ve identified a set of questions that board management to ensure that environmental and social issues are factored into the enterprise risk management or “ERM” process across their operations, supply chain capital risks and others, including considering diverse information sources, really relying on looking to stake holder engagement to provide this key information and being sure to examine a variety of time frames and identifying risk.

The second bucket is to the risk assessment to really clarifying ways that the board can engage management appropriately across the impact and materiality of identified ESG risks including using a scenario analysis when appropriate to consider whether the issue surfaced could significantly impact the company’s performance.

The third piece is the ACT function. So how can boards really acted to mitigate or adapt to these risks that have been determined to be material to the company and a post a high level of risk.

The board plays an important role in working with management here to keep the company strategy and performance resilient in the face of these risks and we can get into a little bit more of the specifics around what we’ve seen in terms of decision-making, on capital expenditures, M&A, things like that, and some of the key companies that we’ve seen do this well.

The last piece is across board systems. This is about ensuring the right systems are in place to oversee ESG risks across the board, both at the full board level and within committees, and then disclose how the board is posed to effectively oversee such risks. One thing we found again and again through our director interviews is that while each committee at the board has a really important role to play in overseeing ESG, these risks and opportunities really do surface across almost every committee at the board and many do need to also be discussed at the full board level.

Courteney: Thanks Hannah. That’s a great overview of this report. I’m hoping we can start to break down some of the things that you talked about. First off, I’m hoping to go into a little more detail on how companies should be identifying ESG risk.

Is this something that the board should be a part of, or is this something that should flow from management to the board or what’s the best way for a company to start looking at these things?

Hannah: Absolutely. While management is responsible for identifying risks through their enterprise risk management, their ERM process, and bringing “material risks” to be reviewed by the board, the board has a really important role to play in their oversight of the risk identification assessment, and mitigation parts of the process.

What we’ve done to aid boards in when they’re reviewing the results of the ERM whether it’s through a heat map materiality analysis, the scenario analysis results is to build in the right kinds of questions for the board to ask management across each element of these stages to ensure that these risks that are posed by ESG issues are being integrated within the ER and process by management.

Really leaning on the board’s role as overseers, of how this whole process is happening. One of the key things that we really want to bring into the ERM process and have directors be asking management about is using the materiality lens for surfacing ESG issues to really make sure, that these risks are surfaced appropriately and actually getting to the board for them to discuss, in decision making around corporate strategy and risk, and perhaps even executive compensation.

Courteney: That makes a lot of sense.

One of the things that I couldn’t help but think about when going through this report was the language used around some of these issues. Do you think that by calling material risks “ESG risks”, it leaves directors to maybe not prioritize a risk as much as they should? Do you think that we need to change our language around these issues in order to make them more of a priority for these companies?

Hannah: That’s a really terrific question and something that we discussed at length throughout the course of our interviews when we were speaking to directors and really what we heard from them is that there needs to be this translation of how ESG risks are mainstream business risks and we’ve really tried to do that in a good level of detail in the report, particularly because when we look at the most recent surveys of corporate directors in the U.S. over half — 56% — say that shareholders devote too much attention to ESG issues and this is up from 29% just a year ago. So this is really something that we think is critical and a big reason why we wanted to write this report.

We actually begin the report with a table that explains exactly what we mean by ESG risks across the more traditional risk categories, so bringing in that translation function to start with physical risks, supply chain risks, reputational risks, regulatory risk, even capital risk, and then having an example of how an ESG issue or ESG risk would fit in across that.

And then, what we do in the identification section of the report is really take it one step further to illustrate exactly how ESG factors fit within mainstream risk that a board is responsible for overseeing such as the types of governance risks around board composition, and executive compensation; enterprise risks, emerging risks for new technologies or regulatory policy change and then of course in the classic board approval risks across major capital expenditures, and things like that.

One of the examples that we use in the report, which hopefully will be helpful to really understand how this is put in place in a leading practice is Pepsi. So Pepsi actually incorporates environmental sustainability criteria within its capex filter, which is applied to all capex request over $5 million, and what that means is that each request is reviewed not only against business financial metrics and value to advancing business strategy but also for the positive or negative impact that it will have on the company’s contribution to their efforts to achieve their climate goals, which for them include energy and greenhouse gas emissions.

This is a really great example of how this company has done the translation piece, of how these risks are business risks and move them into the governing structures for both management and board to achieve that goal.

Courteney: Great. I definitely think laying out what ESG means is really important, so I’m really glad you guys have kind of taken the initiative to do that, especially when we’re looking at this and what it means to different people. So getting back to how boards can practically start implementing some of these suggestions I’m curious if you have a view as to how boards should be overseeing these risks, is this something that can or frankly should be handled at the committee level or do you think that it’s something that needs to be handled by the full board?

Hannah: Really, we think both, I think there’s an immense opportunity for multiple committees across the board to have ESG issues and risk surface that in fact, what we really have heard from all the directors we work with, is that there isn’t one Board Committee where we could really say ESG issues have to come up here. If you look at the numbers, you can see that across US corporate boards, most boards if they have included reference to ESG or sustainability in their committee charters, most of the time they have it in the nominating and governance committee charter, but if you take a look at a broad spectrum of companies, they’ll really have ESG references across a variety of different committees.

What we did actually in this report is do a little bit of that analysis to really illustrate how all different kinds of board committees already typically can oversee ESG risk. It’s just about making that connection between what their typical oversight responsibility is, examples of ESG risk that could be surfaced up through that committee, and then specific examples of companies that are already incorporating ESG language into that board committee charter and the specific ESG issue mentioned.

This is across all committees — audit committees, risk committees, compensation committees, traditional environmental health and safety, or sustainability committees, technology and innovation, etc….  Of course, at the very end, we have the full board on there because the full board is responsible for deliberations, and oversight on strategic planning and business strategy. When issues are discussed in committee that are material that the committee feels have a significant impact on the company strategy, those need to be surfaced, and in discussion handled by the full board.

Courteney: That makes a lot of sense. Given the breadth of issues that could be considered ESG issues, it definitely makes sense for the different subject matter committees to be looking at the various aspects of this.

I’m curious if we can stay on the oversight topic, do you have a view on whether or not companies should be appointing subject matter experts on relevant ESG issues like climate, or environmental issues, or do you think that these issues are something that can be accomplished by people familiar with the industry, maybe with a little training or additional explanation as to why these are ESG risks? Do you have a view on that?

Hannah: We do, and it’s interesting, earlier you mentioned our report lead from the top that my colleague Veena Ramani spoke on a prior podcast a few years ago and that report really dived deep into our thinking on this issue. And what we really found is that there are three main actions that boards can take to what we define as to build fluency, for ESG issues on the board.

The first is to recruit the right people on the board. That speaks to your question around individuals with perhaps subject matter expertise. The second piece is to educate the entire board on the material ESG issues in question that face the company, and the third piece is to engage both shareholders and stakeholders on relevant ESG topics to really make sure that the board is briefed on the most salient and relevant information.

Here we found, again, this issue of having directors on board that do have relevant expertise and can also serve as this translator role is really critical. What we’ve heard is that it isn’t enough to perhaps on-board a subject matter expert that can’t speak the financial language, at the board room. What we really need is individuals who do possess that knowledge and they can also read a profit and loss statement, really translate how these issues are business risks and opportunities, and provide that kind of oversight in their position in the board room.

The other piece of this which gets to our education recommendation here is that there’s an important difference between a sustainability- or ESG-fluent board and having one ESG-fluent director.

Having one director, with the right type of background and expertise can be important — but it’s not the end of trying to get ESG expertise on the board. It really can’t be a check the box exercise. What was typically found is that while the expertise is important to have, it’s also really important to have ongoing education for the full board, whether that’s presentations from management bringing in external stakeholders or other types of consultants that can provide additional context for the relevant material ESG issues that are facing the company so that the entire board is able to get the same amount of information at the same time and have discussions together around how this impacts the company.

Courteney: That makes a lot of sense. To move on to disclosure of this information, which is a really, really important aspect of this oversight function, so the shareholders have a sense of what’s going on. You recommend that companies disclose information about the role of the board in ESG oversight and that’s something that Glass Lewis is increasingly looking at. I was wondering if you could give any specific examples of companies that do this particularly well?

Hannah: Yes. It’s worth noting that every single company example we have embedded throughout our this report and all of our reports is taken from publicly available information, so that’s really what we look to. Is this information readily available, is it just as for us to find as it would be for investors or other stakeholders.

One company where we talk about in the report that is really providing a very transparent lens around the role of executive and board in overseeing ESG risks is Jones Lang Lasalle. And the company integrates their identified material ESG risks within its existing risk management program and that program is overseen by their global executive board that includes both the company’s CEO and CFO and is actually coordinated through the enterprise risk management team that’s led by the company’s legal department.

The top risks that are surfaced from those deliberations are communicated to the Global Executive Board, to the company board’s audit committee, and then the whole board of directors on a semi-annual basis.

We really see this as great disclosure because you’re able to get a lens into not just what management is doing around embedding ESG within enterprise risk management process, but you’re also able to see that there’s significant buy-in from executive management. The legal team is already on the ground and heading up this effort, the CEO and CFO are there to sign off, the board’s audit committee is being briefed these risks, which is appropriate as they’ve been deemed to be material and then it’s also going to the full board of directors for their deliberation on strategies more than once a year. So this is really one company that we picked out here to highlight to give a sense of what sort of transparency is really helpful for external individuals to understand about this process when it’s happening and oversight by the board.

Courteney: Great, thank you so much for that example. I know it’s always really helpful to understand what “the best” looks like. And I know that companies and investors always like to have those highlights, and the report is full of those types of examples. 

So to stick on the disclosure topic you recommend in the report that companies disclose material ESG risks in their financial filings. 

And this has been kind of a debate; for example, SASB initially asked for information to be disclosed in financial filings, and then getting into a debate between do we disclose this in the financial filings, or in a sustainability report? So how do you think companies should go about determining what to include in their financial filings and what to include in their sustainability reports because they’re two different reports made for two different audiences (most of the time)?

Hannah: In our report, we really recommend that if an ESG risk has been found to be material to the company, then it belongs right in their financial filings. We talk about how the most effective type of ESG disclosure goes beyond boilerplate language and really offers a true discussion on the ESG risks facing the company as well as on the actions the company has taken or plans to take to mitigate these risks and the company should really provide disclosures that meet investor expectations on material ESG issues — by focusing on what really is material, by not ignoring emerging trends, by disclosing decisions in the full context of quantitative and qualitative information, and by integrating sustainability information where investors are already looking.

There are a couple company examples that we highlight here that are doing this in the report, one of which is Jet Blue.

It’s currently using the Taskforce for Climate-related Financial Disclosure framework [“TCFD”] to disclose its board committee involvement in oversight of the company’s financial exposure to ESG risk, so the top environmental issues surfaced are reviewed by JetBlue’s board and the integration of these risk factors are included in the discussion of the company’s ERM process that’s all overseen by their audit committee and publicly disclosed. If it is material it belongs in the financial filing.

Other elements that have not been found to be material are appropriate for sustainability report, and I think it’s worth noting that there is, you can see a degree of difference, even in reading company sustainability reports when there’s a statement from the board that lends credibility to the finding of how the company has gone about assessing what ESG issues are really critical for their company and company operations and strategy.

In the same section, we talk about how Coca-Cola in their sustainability report includes a letter authored by the company’s board and signed by its board chair explaining how the board provides oversight of the company’s sustainability progress as a part of their fiduciary duty. So there are, I think, ways in both financial filings, sustainability reports, and other types of public reports put out by the company, to really underscore how the company is thinking about materiality and ESG and how the board is involved, in these deliberations.

Courteney: Those are great examples, thank you so much.

Something I hear from investors a lot is, how do you assess whether or not a company has sufficient oversight of ESG issues? It’s one thing to kind of look at the disclosure and assume that there’s robust oversight process there, but we’re not in the board room, so we don’t actually know what kind of discussions people are having or anything along those lines. So how would you recommend that an investor assess the company’s level of oversight or the robustness of their oversight on these important ESG issues.

Hannah: So we have a couple of different criteria that we encourage investors to review as we know that boardroom deliberations are privileged and confidential. In what is disclosed about board oversight of ESG — the first place we encourage investors to look is at the language of each board committee charter. This really speaks to the structural component — is there a formal mandate what we call formal mandate for ESG or sustainability at the board level? By having this language specifically noted in a board committee charter identifying that this committee or multiple committees, is charged with oversight of these issues.

The second piece is the expertise issue that we spoke about earlier. This is really about both the existing members of the board and if they disclose expertise in relevant sustainability or ESG issues within their biographies as well as to what criteria are included in the board matrix for when the company is assessing what directors will be onboarded to the board in future.

There’s an offset here that I also like to mention, which speaks to the education piece that I noted earlier. There are some companies that do disclose that their board receives ongoing education on ESG topics that have been bound to be salient or material to their business and this I think also provides another line of sight for investors into how committed a company board is to ongoing development and education on those topics for which, as we all know, the landscape is shifting rapidly.

The third piece here is how we can measure board action on material ESG issues. The example of Pepsi really integrating the ESG filter in their capex is one piece where we can look to and say “This is a concrete change that a company has made in response to these risks and these issues.”

The other piece of this is around executive compensation so in financial filings, investors can go and examine whether the company has disclosed if a ESG issue has been included within the company’s compensation package, which we really see as evidence that the board has made a decision that this is important enough, to incentivize top level executives to take action on.

The final piece is disclosure around the board’s general role in overseeing material ESG issues which we have gone over in some level of depth, so I don’t want to repeat, but this is, I think, critical in terms of how investors understand that decision-making process, how these issues are surfaced up to management, and then how board contracts with management to ensure all relevant ESG issues are included in that process.

Courteney: Great, thank you so much for those tips. I’m sure that everyone will find that really useful in trying to suss out how exactly companies are going about the oversight function and how robust it is. And thank you so much for your time today, we really appreciate your insight on all of these issues. 

 

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