It seems everywhere you look these days the talk is of ESG, or environmental, social and governance. A commonly used argument is that improving ESG performance has beneficial effects on the product markets (consumers care about ESG), on the labor market (ESG helps retain and attract talent), and on the financial market (investors increasingly demand ESG performance).
While there is no doubt there are many advocates (The Business Roundtable, McKinsey, Blackrock), there is a growing chorus of those who criticize ESG and especially the requirement by governments. Tesla CEO Elon Musk tweeted that ESG is “a scam.” Former Vice President Mike Pence penned a Wall Street Journal op-ed calling ESG “a craze.” Nevertheless, it seems clear that multiple stakeholders are holding board members responsible for the oversight and governance of climate-related risks and related financial impact.
As a result, better education for boards about what ESG is and what changes need to be made is now at their doorstep, especially with the proposed Securities and Exchange Commission ruling. Regulations have significantly changed the role of the board concerning ESG and even if it doesn’t pass as written, it will change board composition forever.
Specifically, the proposed SEC rules stiffen board member oversight responsibilities, adding a new element to Regulation S-K that includes Item 1501, which addresses board governance. Item 1501 would require board oversight of climate-related risks. Importantly, the names of board members and specific board committees responsible for this oversight must be disclosed, and boards must identify members with expertise in climate-related risks and describe the nature of their expertise. According to Spencer Stuart’s latest Board Index, just 11% of S&P 500 companies have a standing committee dedicated to the environment.
Other board-related items on the table include disclosure of the processes and frequency by which members or committees discuss climate-related risks and how they consider these exposures in relation to the registrant’s business strategy, risk management and financial oversight. Also potentially required is disclosure about whether and how the board sets climate-related targets or goals and how members oversee progress toward achieving these aims. Therefore it will also be necessary for boards to understand various ratings by firms such as MSCI, Sustainalytics, ISS and PRI.
ESG is a multidimensional concept with many aspects that are hard to quantify, making disclosure challenging. In fact, there is an ongoing debate about how to design sustainability reporting rules, and commercial ESG ratings are subject to substantial criticism.
There is a lot of focus on disclosing ESG factors and reporting on “scope”. In fact, the SEC’s recent proposal includes guidelines about scope 1, 2 ,3.
Scope 1 and 2 emissions are a mandatory part of reporting for many organizations across the world and relate to systems that are within reasonable control of an entity, such as onsite and purchased energy.
Scope 3 emissions are centered on sources of emissions that are more external to a specific organization, such as those across the supply chain. Scope 3 emissions remain mostly voluntary to report, however, in most cases the reduction of Scope 3 has the potential to have the largest impact.
Given all that’s going on in the ESG space, it’s time for boards to step up their efforts on hiring a sustainability expert who can help them navigate this changing terrain.