Environmental, social and governance (ESG) concerns have climbed up the corporate agenda in recent years. We take a look at four key considerations for NEDs on how to deliver effective challenge over ESG themes.
Fundamentally, ESG is about how organisations live their values. While this strengthens the core of every business, it is also a deciding factor for customers, as reflected in action against businesses perceived to be socially irresponsible. As such, NEDs have a critical role in challenging how these values are realised and operationally embedded across the organisation.
The most important first step is to make sure everyone is on the same page when discussing ESG. The term itself is nothing new, but many businesses do not have a set standard for what each element means in practice and there’s limited consistency across organisations. Getting the basics in place now can help NEDS improve accountability, create tangible business goals and provide the toolset for benchmarking against the wider sector.
1. How to develop an ESG strategy?
As with any change initiative, establishing a clear strategy for the short, medium, and long term is essential to achieving organisational goals. NEDs are vital in shaping that strategy, and it is essential to consider how well it reflects the business’ core values and how they align with customer expectations.
It’s also important for NEDs to consider the current business model and the impact of the ESG strategy. This will vary considerably, depending on the sector and the scale of ESG ambitions. For those in the energy sector this may bring significant changes to how the business operates, with key services being overhauled or gradually phased out. For those in the financial sector, it could affect investment portfolios or hedging strategies, amongst others. It is essential for NEDs to recognise how the business model will change and to ensure that executive directors are looking at the long-term operational impact and associated risks.
Once a strategy is decided, NEDs need to consider how well it has been communicated to the rest of the business. Many change programmes fail due to poor stakeholder buy-in, which can be down to miscommunication around end goals, strategic planning, and expectations across each business unit.
2. How to identify ESG exposures?
As ESG becomes increasingly important, NEDs need to consider the business’ risk profile and risk appetite. These will vary depending on the organisations business activities, but looking across each strand of ESG, key risks for NEDs to consider include:
Environmental impacts such as climate change, energy efficiency, resource depletion or pollution all bring a range of business risks. This is generally seen in the context of both physical and transitional risks and NEDs should consider the impact of both. Physical risks refer to factors such as rising temperature, increased sea level or reduced access to water. Transitional risks refer to legislative or regulatory intervention to reduce the impact of physical risks. Rapid change initiatives may lead to a sudden drop in asset values or some business services ceasing virtually overnight, and NEDs may need to consider how this could impact business stability.
Liability risk is also a key consideration for NEDS, and businesses that do not take appropriate action to improve sustainability may face legal action in the future. Offering effective challenge now, can help identify areas of the business where legal risks could crystallise in the long term.
Social impacts such as human rights, diversity and inclusion, and employee wellbeing, introduce additional risk across the business. Since COVID-19 lockdowns began, many NEDs have focused on the social aspects of ESG, with employee support taking centre stage in the media. Failings in this area can lead to significant reputational damage, which undermines the organisation’s value and can create a disconnect for customers.
There are also legal risks for NEDs to consider and it is important to challenge executive directors about how well policies and procedures are embedded across the business.
Governance impacts include concerns such as executive pay, bribery and corruption, and shareholder rights. Poor governance carries a multitude of risks including regulatory and legal breaches, poor business performance and reputational damage. As new requirements come into play for climate risk and ESG disclosures, greater transparency will put governance processes into the spotlight.
This is a key area where NEDs can make a significant impact on ESG, by challenging codes of conduct, and making sure they are culturally and operationally embedded across the business, through effective policies and procedures. It is also important for NEDs to consider how employees are incentivised to meet ESG expectations, including a high-level plan for embedding the strategy into individual and team goals.
3. What does good look like and what are the benefits?
Looking beyond risk management and changes to the business model, NEDs need to consider what good looks like and how an effective ESG framework can add value.
Reducing the impact of climate change and moving to sustainable business practices will benefit society as a whole, and all organisations and individuals have a key role to play. Consumers are increasingly looking at sustainability as a differentiating factor, and the ability to keep pace with expectation and actively demonstrate it cannot be overestimated. NEDs have a key role in challenging the business against the expectations they have set and requiring accountability for performance to date.
Similarly, an effective and demonstrable ESG framework gives firms greater credibility in this space. In the past, ESG has been a fairly nebulous term, allowing firms to state environmental, social or governance credentials that are not fully supported. Increased public scrutiny and greater globalisation have uncovered many of these failings, putting organisations in the spotlight to remedy a situation quickly. NEDs are well placed to challenge ESG credentials, upholding organisational values and preventing reputational damage.
Businesses that live by their values create the right working culture, which supports good services delivery and a consistently strong reputation. NEDs are crucial in holding the board accountable for embedding the right culture, and ensuring corporate values are reflected at every level of the business and supply chain.
4. Are disclosures robust?
While ESG disclosures have been included in annual reports for a number of years, they are currently under increased scrutiny. Most organisations also have to make disclosure for a range of material risks under the UK Companies Act, UK Accounts Regulations, the UK Corporate Governance Code, the Prospectus regulation, the Shareholder Rights Regulation, and recent HMT climate risk disclosure expectations, amongst others.
Making disclosures over ESG is inherently tricky and relies on developing effective metrics to create targets and track progress. NEDs need assurance that processes are in place to support these disclosures, with adequate oversight from senior management. Key questions include what metrics are used, how they are defined and measured, and making sure they genuinely reflect the organisation’s strategy. It is essential for NEDs to gain assurance that disclosure data is robust and fit for purpose, with clear assumptions and methodology that can stand up to scrutiny.
It seems that companies are now paying more attention to reporting environmental, social and governance issues relevant to the business however, limited detail is provided on their impact and/or strategic importance to the business model. Early research indicates that much in this area is rhetoric as there is limited evidence to demonstrate how aspects of ESG are embedded into the wider business’ thinking.
As an example, findings from our annual Corporate Governance Review found 31% of companies have an environmental KPI, and 27% consider environmental risks a principal threat to achieving their strategy; 18% say this about climate change risk specifically. Yet just 27 companies (10%) use environmental indicators, and ten (4%) use specific climate change metrics in executive long-term incentive plans and bonuses
At the same time, 44% of companies have an employee KPI, and 14% of companies have a societal KPI, while only 39 companies (14%) use employee metrics and 14 (5%) use any social metrics in executive long-term incentives and bonuses. Again, the overarching question around accountability arises, of the FTSE 350:
- 77% give a good or detailed level of explanation on environmental matters
- 27% identify environmental risks as a principal threat. 31% have an environmental KPI
- Only 10% use climate change or other environmental metrics in executive long-term incentive plans
- 14% have a social KPI only 5% companies remunerate executives against social metrics
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