The post-COVID-19 pandemic world is almost certain to see an increased focus on climate change and social issues, further underscoring why strong ESG performance is now an imperative. It conveys the potential for more sustainable financial performance, lower employee turnover and reduced regulatory risk. Protiviti’s Jim DeLoach discusses the importance of strong ESG reporting.
In recent years, it has often been asserted that corporate leadership is needed to enhance civilization’s ability to address critical environmental, economic and social challenges and to enable the general welfare of present and future generations. This assertion has evolved to an explicit statement of expectation as institutional investors state their intention to proactively apply environmental, social and governance (ESG) criteria to screen investments in actively managed accounts. The use of ESG criteria to screen investments grounds the discussion and cannot be ignored in the boardroom and C-suite.
That’s why the topic is gaining traction. In a recent survey of more than 500 public-company directors, 79 percent of participating directors indicated that their board is focused on some aspect of ESG. In addition, 52 percent of directors noted they are seeking ways to improve their own understanding of ESG performance, and half of them reported that they assess ESG in relation to risk and opportunities for the company and discuss the linkage between ESG and corporate strategy. This is marked progress compared to where we were, say, three years ago. It is likely due to increasing shareholder interest evidenced by high-profile proxy battles over ESG-related topics and, as noted earlier, institutional investors actively assessing ESG performance of the companies in their respective portfolios.
No doubt, the CEO’s level of interest is crucial for companies to progress to an action-oriented perspective with regard to sustainability issues.
2 Important Developments to Watch
- Further evidence sustainable investing is on the rise. Sustainable, responsible and impact investing assets have expanded to as much as $12 trillion in the United States, up 38 percent from $8.7 trillion in 2016. Much of this growth is driven by asset managers considering ESG criteria across $11.6 trillion in assets, up 44 percent from $8.1 trillion in 2016. The top issue for asset managers and their institutional investor clients is climate change and carbon emissions. From 2016 through the first half of 2018, 165 institutional investors and 54 investment managers controlling $1.8 trillion in assets under management filed or co-filed shareholder resolutions on ESG issues.
- Evidence of responsible investing emerging as a source of outperformance. A study released last year by an asset management company noted that during the period from 2014 to 2017, responsible investing was generally a source of outperformance in both the Eurozone and North America. In the Eurozone, all ESG pillars (environmental, social and governance) and ESG score integration displayed positive returns, with the governance pillar dominating. In North America, ESG investing during this same period (2014 to 2017) also displayed positive returns, although the environmental component was the largest winner. Once again, the study noted that the massive mobilization of institutional investors regarding ESG investing in Europe has impacted demand mechanisms, with a consequent effect on prices, thereby triggering a performance premium.
In addition to the above, there are several factors for interested companies to keep an eye on for purposes of gauging the extent to which they give attention to the quality of their ESG reporting.
8 Key Factors to Monitor Going Forward
- Competitors issuing voluntary reports. As more companies report voluntarily, peers must consider whether to follow suit. The Sustainability Accounting Standards Board (SASB) provides many examples of companies reporting with its standards to illustrate the transparency and impact of such reports on risk management, long-term performance and brand image.
- U.S. Securities and Exchange Commission (SEC) mandates. The SEC continues to be petitioned to standardize and mandate ESG disclosures through rulemaking, and attempts at legislation to enhance ESG disclosures ratchet up attention. Whether by legislation, SEC ruling or investor demand, public companies are likely to gain even more clarity around expectations of quality ESG reporting going forward.
- Attestation of selected sustainability information is increasing. In 2017, the American Institute of Certified Public Accountants (AICPA) issued attestation standards in response to increasing stakeholder expectations and more companies issuing information on sustainability performance in addition to financial reporting. Attestation still has a long way to go in North America as it continues to lag behind the European Union in the number of externally assured reports. While attest fees may be a potential barrier (at least initially), management should consider the viability of a cost-benefit assessment that weighs the cost of attestation against the favorable impact on the company’s ESG rating and the related effect on market capitalization. Therefore, voluntary use of attestation services is a key factor to watch.
- Pressure from activist shareholders. Pressure comes in many forms. For example, activists apply pressure on board composition and management incentives in the proxy process. They also use ESG screening criteria to drive investment decisions within their portfolios. Institutional investors (e.g., BlackRock and State Street) are communicating pointed messages to boards and CEOs regarding the importance of ESG-related issues and, in particular, climate change and use of fossil fuels.
- Convergence of frameworks. Because the SASB’s standards are specifically tailored to U.S. companies and SEC filings, it is likely that they will continue to gain traction in the United States. However, other frameworks, such as the Global Reporting Initiative, are in use in different regions worldwide. Efforts to harmonize alternative frameworks and metrics have not borne fruit. As a result, others have stepped up to propose an approach to common metrics and consistent reporting to allow for the comparability that investors need.
- Disruptive industry developments. Dutch Royal Shell’s decision to link incentive compensation to climate change is an example of an industry-first commitment to improving the environment. The automobile industry investing heavily in hybrid and electric cars is another. According to the aforementioned survey, energy, consumer discretionary and materials are the sectors most likely to have focused on ESG during the last year, whereas telecom, health care and financial services are among the least likely.
- Egregiously misleading ESG reporting. If such instances occur, the pressure on the SEC to mandate standards is likely to increase. This development could also drive momentum to some form of attestation.
- Traction on use of COSO ERM ESG supplemental guidance. This guidance incorporates ESG-specific issues into companies’ enterprise risk management (ERM) processes. As companies increase their focus on ESG reporting, this integration effort makes sense. It is possible that internal audit functions may lead the way on this front.
Sustainability reporting is finding its way into the mainstream of corporate affairs. Voluntary reporting along with voluntary submission to attestation, coupled with pressure from activists and convergence of global reporting standards, will provide a powerful mix of drivers that move the needle in many boardrooms and C-suites. The key factors listed above bear monitoring going forward, as they could drive further emphasis by CEOs and their boards to improve their companies’ sustainability reports.
Questions for Executive Management and Directors
Following are some suggested questions that executive management and boards of directors may consider, based on the risks inherent in the entity’s operations:
- Does the company’s sustainability reporting provide sufficient insight into its nonfinancial activities related to ESG matters? Is it sufficiently focused on the ESG criteria being used by investors and asset managers following the industry? Does management focus on ESG reporting as a compliance activity, or is it truly integrated with the corporate strategy?
- Does the organization have a clear long-term vision regarding sustainability? Is that vision responsive to investor and stakeholder expectations regarding environmentally and socially responsible behavior for the industry?
- Is the board sufficiently engaged in developing the organization’s long-term strategy and plan to create long-term value for shareholders? Is the board satisfied that its composition, diversity and structure reduce the risk of groupthink or missed opportunities in addressing sustainability matters?
 “Sustainable Investing Assets Reach $12 Trillion as Reported by the US SIF Foundation’s Biennial Report on US Sustainable, Responsible and Impact Investing Trends,” US|SIF: The Forum for Sustainable and Responsible Investment, October 31, 2018.
 Letter to Brent J. Fields, Secretary, Securities and Exchange Commission, October 1, 2018.
 “Analysis Tracking SEC’s Evolving Approach to ESG Disclosures,” by Preston Brewer, Bloomberg Law 2020.
 “World Economic Forum and Big Four Propose New Sustainability Reporting Framework,” by Cydney Posner, Cooley PubCo, January 29, 2020.
 2019–2020 NACD Public Company Governance Survey.