Boards Are Obstructing ESG — at Their Own Peril

By Matt Dallisson, 05/02/2021

The list of environmental, social, and governance (ESG) issues that can pose financial risks to corporations exploded in 2020: climate change, water scarcity, pollution, #metoo, #blacklivesmatter, worker welfare, employee diversity, corruption, human rights abuses, supply chain scandals…not to mention Covid-19. Yet while many investors and chief executives now take ESG seriously in their decision making, one powerful constituency is lagging: corporate boards.

Recent research — including studies conducted by us and former MBA students Jamie Friedland and Ellen Knuti at the NYU Stern School of Business — show that many boards have little ESG-related expertise and many do not even recognize the need to pay attention to material sustainability issues.

For instance, PWC’s 2020 Annual Corporate Directors Survey found that only 38% of board members think ESG issues have a financial impact on a company. This despite the fact that institutional investors such as BlackRock and State Street Global Advisors — as well as major asset owners such as the California Public Employees’ Retirement System (CalPERS) and the California State Teachers’ Retirement System (CalSTRS) — are increasingly focused on ESG performance. Corporate chief executives have joined the chorus, too: The Business Roundtable’s August 2019 pronouncement of corporate purpose was a broad and powerful embrace of positive ESG behavior that requires board action to execute.

But boards remain a stubborn outlier when it comes to embracing sustainability. Much of the problem lies in a lack of expertise. We followed up PWC’s study by analyzing the individual credentials of 1,188 Fortune 100 board directors in 2018 based on Bloomberg and company bios (we assumed credentials deemed important by the company would be listed) and found that less than one-third (29%) had relevant ESG expertise. For example, in the “E” category, climate and water are two areas of material importance to most companies and investors.  However, across all 1,188 Fortune 100 board members studied, a total of just five had relevant experience.  Industries with material environmental issues, determined using the Sustainable Accounting Standard Board (SASB) categories, do not reflect that materiality on their boards: the Consumer Durables & Apparel sector had no board member with environmental credentials despite the sector’s large energy, waste, and water footprint.  The health care, financials, and insurance sectors have material “E” risk (most notably, climate change) yet only 11 members of 149 in the sector study group had “E” credentials.

The “S” category has the highest concentration of ESG board expertise at 5% of the 1,188 board members studied. Most of that 5% is dedicated to supporting an increase in the number and influence of women in the executive and board suites. In contrast to that hint of hope on an otherwise gloomy landscape, material “S” issues such as human rights, human resource development, benefits and safety, had negligible board member representation.

In the “G” category, just eight board members of the 1,188 studied had expertise in cyber/telecom security, an area where the material financial risk is increasingly apparent, and very few directors had authoritative experience with ethics, transparency, corruption, and other material “G” issues.

This desolate picture of board director ESG expertise stands in stark contrast to the growing importance of material ESG issues in creating financial risk and opportunity: Studies have shown an outperformance of companies exhibiting good performance on material ESG issues driven by operational efficiencies (i.e. reduction in waste, less volatile supply chains), innovation (i.e. new technologies that change the category such as Nike’s Flyknit sneakers), improved employee relations (i.e. lower turnover and higher productivity) and risk mitigation (i.e. regulatory, operational, market, and reputational).  A significant portion of a company’s value is tied to its reputation, and management of ESG issues can negatively or positively affect public perception of a company.  These are clear indications of the emerging relevance of material ESG factors for which most boards are unprepared.

So what is a board to do?

Recruit ESG-savvy board members. Boards need members who understand the risks and opportunities of material ESG issues, specifically, those with lived experience. No, an “E” savvy board member doesn’t have to be a climate change scientist; the board can hire that kind of specialized expertise. But, more board members must have a strategic understanding of material ESG issues.

Today, most corporations have a preponderance of former CEOs on their boards. Those CEOs were in charge 10-20 years ago when ESG issues were not specifically identified as financially material and may burden boardrooms with an out-of-touch mentality. In contrast, PWC found that female board members are more likely to say that material ESG issues like climate change and human rights should be part of business strategy.

Dow Chemical has distinguished itself as a company that has aligned its board member expertise with its ESG exposure. To address its material environmental risks (e.g., materials, energy, water, climate), Dow has three board members with relevant “E” credentials: A member of the U.S. Climate Action partnership, a former EPA Administrator, and the Chair of the World Business Council for Sustainable Development.

On the other hand, Liberty Mutual (property and casualty insurance), despite significant climate risk exposure, has no board members with climate credentials, though two are affiliated with energy companies.

Understand the material ESG issues for your company, today and tomorrow. Make sure you understand the perspective of critical stakeholders such as workers, civil society and long-term investors on those ESG issues. Ensure ESG is built into the culture and business strategy of the company, both in terms of risks to be managed as well as opportunities to be developed.

McKesson has material “E” (energy, materials, water), “S” (access to medicines, ethical clinical trials), and “G” (misleading advertising, doctor “incentives” related to habit-forming drugs) exposure. Yet, McKesson has no board members with relevant ESG credentials. That deficit exposes the company and its investors to material financial risk; McKesson is currently a defendant in a multi-state lawsuit seeking $26 billion in fines related to unscrupulous opioid distribution practices by four companies.

Think sustainably. Board members should ensure that the company has a sustainability strategy that is embedded in the company’s business strategy, as well as KPIs aligned with key reporting standards that are built into work plans and compensation and are third-party assured. SASB provides uniform reporting standards, custom designed to indicate material ESG issues based on sector, that allow directors and investors to monitor and track a company’s focus on material ESG issues. Board members should also ask the executive team to report on the financial impact of their ESG investments, including intangible and tangible benefits such as risk avoidance, employee retention, and operational efficiency as per models such as the NYU Stern Center for Sustainable Business Return on Sustainability Investment (ROSI) methodology.

Ensuring good performance on material ESG issues is not only a board’s fiduciary duty, important to investors and the public, and supportive of long-term strong financial performance; it is critical to a company’s relevance in a world increasingly suffering from ESG-related crises. A sustainable corporate sector starts at the very top.

This content was originally published here.

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