Why ESG Is Material
Updated: May 14, 2020
By Joyce Cacho and Wanda Lopuch
Published in the "Directors and Boards". April 22nd, 2020
Purpose is at centerstage of complex factors redefining board director oversight. The dramatic shift in defining the purpose of the corporation by the Business Roundtable (BRT) from “shareholder primacy” principle in 1997, to a “commitment to all stakeholders” in 2019, is a pivot point for corporations.On the investor side there has also been significant shifts. In January 2020, the world’s largest fund manager — Blackrock, added $7 trillion to the $36 trillion Climate Action 100+’s assets under management by 450 investor members. Those members are focused on ensuring the world’s largest corporate greenhouse gas emitters to curb emissions, improve governance and strengthen climate-related financial disclosures.
At the same time, pension funds, such as CalPERS and CalSTRS — the largest public pension plans in the U.S. — are required to factor in climate-related financial risk in analyzing their public markets portfolio. In accordance with California state law, these pension funds are also required to report progress on climate risk, and progress towards aligning with the Paris Agreement and California climate policy goals.
Adding to the sharpened focus by investors and pension funds, to all shareholders and climate-related financial risk, is the increasing employee demand that employers be engaged in contributing to improving the environment, strengthening community, and stepping-up corporate governance (ESG).
Finally, customers are increasingly making purchasing decisions based on considerations, such as the carbon and water footprint of a product, and labor conditions throughout the supply chain.
Key factors shaping today’s complexity of demands on corporations include the accelerating rate of change and the related convergence of investor, customers/community, and employee goals. For example, how a company earns the ongoing acceptance of a company by the general public today, can echo to increase, or decrease, brand value with suppliers and consumers in distant markets. Today, in addition to fund managers and pension fund governance demand for climate-change accountability, retail investors through individual retirement accounts/401Ks, are seeking transparency and disclosure of the ESG strategies of equities in their portfolio.
Director responsibility: What does it mean today?
With increased focus on purpose, how a company translates ESG into value creation is a function of a company’s strategy, policies and operations. Board directors through their fiduciary responsibilities of duty of loyalty and duty of care are legally obligated to oversee the processes of value creation. Board review of company strategy, in particular, is an opportunity to assess links between operations, finance, R&D policies and ESG. Striking a balance between risks and opportunities, as well as achieving short-term goals and resilient enterprise value, are the dual challenges of modern boards of directors. Board directors play a crucial role in ensuring that strategy keeps the company competitive in current finance, investment capital, talent, and consumer markets, so that the foundation for future business growth, is strong.
Historically, the U.S. Securities and Exchange Commission (SEC) has prescriptively set disclosure requirements for publicly traded companies in U.S. equity markets. Currently, the SEC requirements for ESG reporting is still principles-based. With the 2019 shift to “commitment to all stakeholders" by corporations, ESG reporting is completely at the discretion of companies.
Financial disclosure by private/family-owned companies, and nonprofit organizations, is based in Internal Revenue Service (IRS) filing requirements. The IRS does not issue guidance, or require, ESG reporting in tax filings.
Therefore, the avenue for competition based on how, and what a company includes in reporting about ESG in strategy and financial performance, is wide open and goes beyond regulatory compliance. Publicly traded companies are scrutinized quarterly — a practice seemingly related to the filing requirement of SEC form 10-Q. Because private/family-owned companies IRS tax filings are not readily available to the public, their financial performance and any possible link to ESG being embedded in their strategy, policies or operations, may be hinted-at in their marketing, public relations, or charitable foundation communications.
Across all company types, stakeholders expect board directors or trustees to adhere to the highest standards of their fiduciary responsibilities. Board directors or trustees oversight responsibilities may be more important than ever before due to the complexities of rapid, technology-driven change, environmental risks which are borderless, ESG demands from several directions and the new “commitment to all stakeholders” by corporations.
The “how” of embedding ESG into business is reflected in the key performance indicators (KPIs) of a company’s strategy, its operating model, the factors included in internal capital allocation decisions, talent management investment decisions and the company’s innovation culture. How the three major financial statements evolve over time, to clearly account for underlying ESG factors of the KPIs, are as important to analyze to clearly understand the company’s level of commitment to all stakeholders, as are the trends in the company’s communication.
Over the past 15 years, board nominations and governance committees have increasingly included finance skills as a basic characteristic of prospective board members. Board director candidates, skilled in understanding the basics of the inter-relationships of the income statement, balance sheet and cash flow statement satisfy the minimum expectation of being capable of effective risk oversight. The SEC adopting rules to implement the Sarbanes-Oxley Act of 2002 (SOX), which requires a public company to disclose whether at least one audit committee financial expert (ACFE) serves on the audit committee, or disclose why such an expert is not on the audit committee, may have catalyzed the transition to searching for finance skilled board director candidates.
Today, board director expertise in finance, audit and corporate governance may not be sufficient to fulfill company oversight and fiduciary responsibilities. High-performing boards increasingly include thought leaders, with diverse industry experience, as well as experienced executives who are active, lifelong learners and “constantly curious.” To contribute to building a competitive, resilient company, directors are expected to oversee compliance, and interrogate the company’s strategy to explicitly catalyze long-term value creation.
Unpacking intangible assets and ESG
Building on basic financial skills of a modern board of directors is helpful in responding to the question: Why is ESG material? Today’s 20/80 split of physical-intangible assets in the composition of company valuation, reflects the economic shift away from the dominance of the industrial goods sector of 40 years ago, to the current diverse, services sector. Asset valuation plays a pivotal role in finance and often consists of objective and subjective measurements. A company’s fixed assets are objective and straightforward to value because data on comparable assets is easy to find. However, valuing intangible assets, such as goodwill, brands, customer data and trademarks relies heavily on the art of due diligence. With the value of intangible assets clearly being subjective their value is a risk for the company in a merger/acquisition (M&A) transaction. Accounting rules distinguish between two types of intangible assets: (1) those that companies acquire externally, through transactions and (2) those that companies generate internally, which are the most subjective of the intangible assets. For investors, reliable company financial information, including insights into the value of intangible assets, are essential to risk management in investment decision-making. This suggests that if income statement entries for revenue and expenses, and physical asset acquisition and liability decisions, can explicitly reflect an ESG lens, the key financial data will substantiate ESG and business performance linkages in a transaction, and support increased transparency of a company.
For publicly traded equities in Europe, for companies with more than 500 employees, an EU directive requiring filing of an integrated report about non-financial assets at the same time as the company’s annual report, means that aspects of ESG factors are disclosed. Although disclosure of non-financial assets for U.S. equities is discretionary, the complexities of demands on companies are heating up both competition for talent and customers, and disclosure of verifiable ESG related business performance data.
Financial materiality, redefining company strategy and board oversight
Boston Consulting Group reports that 46% of investors believe social issues will strongly impact share prices by 2022. Having invested in strengthening technology risk management systems in the recent past, companies are at the pivot point to investing in company value drivers. Another imperative for investors and companies to be more forward-looking and proactively manage ESG is increasing concern about portfolio resilience to systemic risks and responsiveness to emerging opportunities from climate change. Other concerns include heightened awareness of social-economic inequality and inequity, and the rising research pointing to biodiversity loss as a causal dimension in virus transfer.
For many, materiality is the most important concept in company financial reporting. Information is material if omitting or misstating it can influence decisions that stakeholders make. Outcomes of a company’s materiality assessment impacts decisions of how the company should recognize, measure and disclose specific transactions and information in their financial statements. Material issues have a major impact on the financial, economic, reputational and legal aspects of a company, as well as internal and external stakeholders of that company.
This means that the shift from prioritizing “risk management” to “value creation” with ESG drivers requires acknowledging there are additional issues which are material to a company’s operations, finance and R&D policies. Once determined to be material, the company is obliged by professional accounting standards, to disclose data and information in financial reporting.
Boards that live up to stakeholder expectations of the highest standards of director fiduciary responsibilities will question how the company’s business model can be “fit for the future” if they are based on materiality assessments which overlook ESG. Board oversight of strategy is instrumental to companies making the shift to prioritizing value creation, in a timely manner. Companies where there is poor board oversight of strategy, even if financially successful today, may receive discounted valuation if the materiality assessment does not reflect the complexity of current issues and the context for product competition assumes historical industry definitions.
Without reassessing materiality as part of company strategy oversight by board directors, the board may be fostering company financial valuation based on tangible/physical assets that have suffered from unanticipated or premature write-downs, devaluations or conversion to liabilities, resulting in “stranded assets.” The rapid pace of change, and complexity of issues companies are facing, creates a business operating environment which simultaneously demands (1) explicit review of financial materiality, (2) board agility and (3) data-driven financial statements which adds resilience to a company’s financial valuation.
Boardroom focus and change
With competition from existing and new industries in mind, the modern boardroom is challenged to be catalysts for strengthening of company strategy. Today, focusing on how a company navigates transformation towards explicitly including ESG factors without losing value created in the past is increasingly defining the highest standards of board directors' fiduciary responsibilities. ESG factors are of critical importance to company competitiveness, today and will be even more so in the future.
Effective levers of good corporate governance to explicitly account for ESG in strategy include challenging management to present analysis of the process with and without additional ESG hurdles for internal financial capital allocation. When it comes to talent management, ESG cuts across a range of employment policies. Similarly, asking the executive management team where consumer demographic shifts factor into the company’s innovation strategy is pivotal to cultivating additional market segments. This adds a portfolio approach to the company’s revenue by including a broader, more diverse market.
These complex questions from directors signal to management that ESG is a priority.
Although change is inevitable, directors can play a crucial role in shaping how companies respond to change, especially in terms of focusing on creating robust, enduring value. Linking ESG strategies to items included in the explanation of the intangible assets line of the company’s balance sheet is a minimum first step toward creating data which can hold up in M&A transactions. That level of duty of care, and duty of loyalty by board directors, shapes high performing companies, and is expected by investors, consumers, employees and the communities in which they operate.