Building an ESG Structure and Program (Part II of III)
Investor demand for companies to provide robust and transparent ESG information is growing quickly. Investors understand that companies have to develop effective strategies to address ESG risks. The impact on shareholder price is evident – stakeholders are demanding that companies devote time and attention to ESG issues. Companies have to respond to this demand.
Government regulators are quickly pushing the ESG movement. The European Commission has established ESG disclosure and reporting rules but is now considering expanding then requirements to unlisted companies. The SEC is expected to announce disclosure rules on climate risk this year. In addition, the ESG created a Climate and ESG Task Force in its Enforcement Division.
ESG Board Responsibilities
In the face of these significant trends, companies are responding quickly to establish ESG programs. As an initial step, corporate boards are tackling the ESG issue. Most companies have assigned responsibility for the oversight of ESG program at the full board level. Some companies have assigned ESG responsibilities to the Audit Committee – that raises more questions than answers. Audit committees already are overloaded with financial report and ethics and compliance program oversight. It is problematic to add ESG to the Audit Committee’s charter.
As an alternative, companies should split off ethics and compliance to a separate committee, and could easily add ESG to the same committee. Audit committees are not the proper place for ESG management, and a strong case can be made that the full board is not nimble enough to manage ESG given all of the risks and issues that may arise in this fast-moving area. Another alternative would be to assign ESG responsibilities to a Nominating and Governance Committee, given the overlap with Governance as part of the ESG complement of risks.
ESG Internal Controls
An ESG program has to be tailored to the company’s risk profile. A company has to identify, measure and assess its climate and environmental risks. This, in turn, means understanding the company’s environmental footprint and attendant risks. While everyone may be tempted to assign this to the Audit Committee, Ethics and Compliance responsibilities entail a very similar process, requiring risk assessments, design of policies and procedures to mitigate those risks, and implementation, measurement and monitoring of compliance controls. This function translates well into the ESG sphere. Again, merging these operations into a separate E&C/ESG Committee or having the Governance Committee assume responsibilities for these functions makes sense from an operational standpoint.
Measuring ESG Performance
ESG operations entail a cross-section of corporate operations – environmental concerns, social issues and ultimately governance. Companies have to identify those issues falling under its ESG umbrella, tailor an ESG program and select key measures of performance. For example, in the social justice area, companies can craft a robust diversity, equity and inclusion initiative across the entire organization, meaning at the board, senior management, middle management, and employee level. To execute this, a company would have to devote significant resources to addressing DEI issues at every level of the company.
Measurement of DEI performance would require definition of objectives, collection of data, and disclosure of results. Regulatory disclosure requirements are likely to extend well beyond the concept of financial materiality. ESG disclosures will open up a whole new set of standards, controls and requirements surrounding proper disclosure of ESG-relevant information and performance. DEI is just one example. Climate change and environmental issues will raise another interesting constellation of requirements. Companies will have to determine what kids of information shareholders, investors and other stakeholders are focused on for ESG evaluation purposes. The SEC is likely to establish some minimum requirements in this area. Most companies will exceed these basic requirements given the importance of stakeholder disclosures.
The initial steps in this area have occurred already as many companies are providing robust annual sustainability reports. Companies can build on these existing reports and processes to layer in other ESG issues. Investors and shareholders are demanding even more information. Investor organizations are pushing for a standardized reporting framework. It is unlikely that such a global standard will ever be set. Corporate boards have a variety of disclosure options to pursue and innovation inn this are will definitely occur with time and experience.