First, there was Larry Fink’s letter in 2018 asking CEOs to clarify their company’s purpose and long-term value to society. Then came last year’s Business Roundtable statement redefining the role of the corporation beyond the creation of value for investors to creating value for a multitude of stakeholders, including society at large.
This past January, Fink again pushed the envelope in his annual letter, saying that BlackRock would be encouraging votes against management when the company had not made enough progress on ESG disclosure in line with the Sustainability Accounting Standards Board and would be scouring its portfolios for exposure to “heightened ESG risk.” As the new year began, it fully looked as though the buzzword of 2019 would keep its spotlight in 2020 and for the foreseeable future.
Then came Covid-19, the black swan event that swept just about everything off the agenda other than strategies for keeping the lights on. Employees were furloughed, playbooks tossed, businesses shuttered—and boards understandably wholly focused on supporting management through the tsunami.
In a climate of crisis, the likes of which few businesses had ever lived through, many directors questioned whether ESG should still be a boardroom priority. With the pandemic threatening the very lives of both people and companies, shouldn’t ESG initiatives get shunted to the back burner until the fires are out and survival seems more certain? The first few months of the outbreak saw some sustainability projects put on hold—Unilever’s water conservation and sustainable farming initiatives, Starbucks’ reusable cups, Ford’s electric car initiative, for example.
But those inside the ESG debate say that the programs being put on pause are not what ESG is fundamentally about. Really, ESG encompasses any and all risks to long-term sustainable value—which is why it won’t be going away, says Sarah Fortt, a securities lawyer for Vinson & Elkins, who works with boards to assess their readiness to address corporate crises, including cybersecurity incidents, investor activism and, yes, pandemics. “When we think of sustainability, we often see it as a two-dimensional thing,” she says. “This crisis has shown us that it has many more dimensions to it. If anything, the pandemic has underscored the need for companies and boards to look at non-financial risks much more closely.”
Time to Decouple an Acronym?
It’s understandable if directors are still confused about how relevant ESG is to their companies, given an overhyped, often politicized and roundly misunderstood acronym. “You could argue that the whole space is somewhat fatigued by the definitional confusion,” says Deloitte partner Kristen Sullivan, who leads the firm’s sustainability and KPI services. “You’ve got corporate responsibility, you’ve got sustainability, you’ve got citizenship—a lot of different framing in terms of how different market participants are talking about this whole evolution.”
That fatigue is likely responsible for at least one result in PwC’s 2019 Annual Corporate Directors Survey: 56 percent of directors felt ESG was getting too much attention—a jump from just 26 percent the previous year. “The term has become so broad that it is impossible to reach your arms all the way around it,” says Margaret Peloso, a partner in Vinson & Elkins’ environmental and natural resources practice. “It is definitely useful to think about non-financial risks, but I would agree that the concept of the ESG brand has perhaps outlived some of its usefulness.”
Fortt agrees, noting that when the pandemic has passed and the economy resumes, we will see “whether we’re successful in breaking the concept of ESG apart into the individual aspects of it that can really add value—because adopting an ESG policy is very close to useless if you’re not thinking about the individual components that matter to your company.”
Employee safety, for example, might be considered an “S” risk under ESG, but on the board of Coeur Mining, it’s not talked about that way—it’s simply a key risk for the business, says independent chairman Rob Mellor. “It’s always been a big issue, it’s always covered in board meetings—and environmental, along with safety, are at the top of the page,” he says, because they’re critical to the company’s viability. “It’s a human issue, but it’s an economic issue as well.” If the company gets sloppy and starts failing tests and audits routinely conducted by the EPA and by local government agencies, “you’re gonna get not only fined but shut down—and then you’re in the penalty box.” Coeur’s board has an Environmental Health and Safety committee that meets prior to every board meeting and reports back on all relevant issues. Workforce, diversity and income equality issues are covered by the nom/gov and comp committees, largely, but none of it, says Mellor, appears on the agenda under the heading “ESG.”
“A lot of boards and companies are doing a lot more than they’re giving themselves credit for, but they’re doing it in a much more integrated way than just having it as a topic they can check off the list once a year,” says Maroon Peak Advisors Principal Lauri Shanahan, who sits on the boards of Deckers Outdoor, Cedar Fair Entertainment and Treasury Wine Estates. In fact, addressing ESG as a separate agenda item “is one of the biggest mistakes boards can make,” she says. “As a director, every single time I hear from the supply chain, every single time I hear from retail or from any constituent or any part of the business, [ESG] should be baked into that presentation. It should be part of the long-term strategy discussion and not just standalone.”
ESG has certainly come up in the Deckers boardroom, she adds, “because it’s the buzzword of the day, but it’s less about ‘here’s what we have to do’ and more ‘here are all the things we do that fall under this umbrella.’ The challenge for the Deckers of the world is then how do we articulate that in a way people can judge us and hold us accountable?”
That is much harder done than said, largely because standards for reporting on ESG and for compliance are still a disorganized alphabet soup. “There is a lot of inconsistency in the space,” says Global Sourcing Council chair Wanda Lopuch, who also sits on the boards of Entelligent and HEVO Power. Europe has been further along on standards, she adds, particularly with regard to climate risk disclosure, “but jumping across the Atlantic, there are no mandates, and the guidelines from regulatory bodies are not very precise and are based on voluntary disclosures.” Even when there are guidelines—SASB, for example—they’re geared to investors “and directors are not always in sync with that.”
Some directors are not aware, for example, that Moody’s increasingly uses ESG disclosure in its credit ratings. “That is a link that is not well appreciated or well recognized. And it means that ESG is not about being nice—it’s about the cost of capital,” says Lopuch. “For investors, ESG is the surrogate for risks. If boards do not report on the risks, that’s a red flag.”
With metrics still scarce and standards inconsistent, boards and management are left to figure out which ESG risks are actually material to the business and what their investors want to see. Lopuch points to fintech companies operating from remote locations, sans supply chains, as an example of those who “used to brush off the question of mitigating climate risk,” she says. “But when you start to peel back the onion of what that means—climate risk, from physical risk to transitional risk—there is a different picture, and, sometimes, elements of that are being captured by ratings agencies, which catches directors by surprise.”
One thing that seems to be growing abundantly clear is that ESG is not, as it was once thought, “the softer side” of governance. Though not as easily measured as financial risk, “it really is, in fact, the iron fist in the velvet glove if companies are caught unaware,” says Fortt. “Unfortunately, I think we’re seeing that play out on a very global scale.”
Making It About Materiality
The area of focus for particular boards depends heavily on the type of company and industry—and to say focus varies widely is a grand understatement. “That’s where materiality becomes so important,” says Ryan Resch, managing director at Willis Towers Watson. “What’s important for one industry is not necessarily important to another, so that’s where you need to tell your story and decide what’s material to your business, your investors and your long-term value creation.”
Long-time board member Cynthia Hostetler agrees that monitoring and measuring ESG progress is highly company specific, which makes it critical to have good relationships with stakeholders and an open, honest line of communication about what they’re looking for. “I see it from both sides because I wear two hats,” says Hostetler, a director with Invesco Funds, Vulcan Materials Company, TriLinc Global Impact Fund and, since March, Resideo Technologies. “From the industrial company perspective, it requires having good relationships with your institutional investor base and understanding what kind of data they find helpful. And then, from an institutional investor perspective, a lot of this is driven by portfolio managers and what they think is important to understand about a particular company.” She adds that all of the boards she sits on take ESG seriously. “It’s not soft—it’s a priority.”
That priority will look different company to company and, therefore, board to board, given that the severity of risks apply so differently. For Russell Reynolds, a global executive search and advisory firm, human capital is a top priority for the health of the company. “If our people are sick and they can’t perform, what good are we?” asks the board’s lead director Gaurdie Banister, who says that, in the wake of Covid-19, the first thing he would talk to the CEO about in preparation for board meeting would be the well-being of the staff. “The health and well-being of those people is absolutely critical to the future success of the business. As such, the board has to be paying attention to that.”
Human capital is one of the ESG areas highlighted most prominently by the pandemic and its fallout, as companies have had to take quick, and sometimes painful, action vis-à-vis staffing. “In every annual report, in every CEO/president’s letter, somewhere it says something to the effect that ‘our people are our greatest asset.’ Covid-19 hit, and one of the first questions from customers, communities and investors was, ‘how are their people being treated?’” says Joyce Cacho, an independent director with Sunrise Banks. Some companies, like Amazon and Instacart, quickly found that spotlight when employees protested unsafe warehouse conditions. “Covid-19 came along and separated the wheat from the chaff, when it comes to answering the ‘people’ question—and it continues to.”
Companies that are perceived to have failed to live up to their own cultural statements about the importance of employee welfare and of being good citizens generally have not had much time to reverse course, thanks to the speed of social media. A single misstep can blow up quickly into a blow to a venerated brand, as happened with companies that were vilified for applying for and accepting coronavirus relief funds.
On the other hand, companies already operating with a laser-focused ESG lens had a leg up in the crisis, says Cacho, who points to Sunrise Banks, which earned a B Corp certification back in 2009. “That means they have not invested any time [recently] in debating whether or not how they do their business makes a difference to their value,” says Cacho. “They’re 10 years, give or take, into focusing on value creation through a huge ‘S’ lens.”
When the pandemic hit, they had already made tech investments to allow for flexible, secure, work-from-home options and had already written the definition of essential staff into policy. “It’s been seamless, so we’ve actually been able to be part of the solution to Covid-19 by being the backdrop to contactless transactions through our fintech partners.”
Preventive vs. Prescriptive
It is not yet clear whether a focus on ESG risk helped companies better weather the storm, but if ESG-focused funds are any indicator, the answer is yes; even as the markets rocked, roiled and tanked, funds with a strong sustainability profile and limited exposure to energy outperformed peers. And anecdotal evidence suggests that boards that have adopted ESG religion tend to think more broadly about risk, look more deeply into supply chains, spend more time on third-party risk and do more robust scenario-planning than their counterparts.
“It’s still too early to tell exactly what will happen coming out of this, but past experience suggests that companies that have focused on sustainability have a better chance when it comes to survivability,” says Paul Washington, executive director of The Conference Board’s ESG Center. There will also always be skeptics and those who see ESG as the flavor of the month, he adds, “but that skepticism was already breaking down as ESG went mainstream, and now this pandemic has caused people to take a look at some of the issues—sustainability of your supply chain, how you treat your workforce, your impact on the environment—they’re looking at that now with a fresh lens.”
Those who ignore ESG may find themselves in the crosshairs of activist shareholders who, post-pandemic, are more focused on the financial risks associated with sustainability, rather than less. But more than that, “you may be forfeiting opportunities,” Washington says. “If you think about your business in a sustainable way, which requires you to think a little more longer term, more broadly, it can lead to greater innovation and, frankly, greater collaboration because the process of thinking about sustainability issues is inherently a collaborative process.”