Environmental, Social & Governance Briefs

On Governance: Setting the Stage for Sustainability

March 29, 2018

On Governance is a series of guest blog posts from corporate governance thought leaders. The series, which is curated by the Governance Center research team, is meant to serve as a way to spark discussion on some of the most important corporate governance issues.

By Sophia Mendelsohn

(Sophia is the head of sustainability at a major airline. The information and views set out in this article are those of the author and do not reflect the opinion or views of her employer.)

“Do corporate executives have responsibilities in their business activities other than to make as much money for their stockholders as possible? No, they do not,”

-       American economist Milton Friedman.

In the 1990s, the global manufacturing boom provided the perfect testing ground for Friedman’s philosophy. American companies shifted production abroad, aiming to maintain their reputations even as they outsourced the literal dirty work.  US consumers purchased cheap goods from hot brands, and the company and the consumer agreed to live in ignorant bliss together.

NGOs and the media soon began to ask who was paying the true cost of cheap goods, especially for branded products.  In 1996, celebrity and frequent brand spokeswoman Kathy Lee Gifford was publicly ridiculed for promoting clothes made by children in sweatshops.  Brands like Gap, J. Crew, Lands’ End, and Eddie Bauer^[1] were already battling the same reputational issues for the same reasons.

As outsourced manufacturing forced executives to consider the tradeoff between low production costs and high reputational risks, the first corporate philanthropy and social responsibility departments were born. 

From Defensive to Offensive 

Early corporate social responsibility (CSR) work focused on avoiding negative press coverage and tackling low hanging fruit, like improving labor conditions or creating foundations to give grants in corporation’s home towns. 

CSR or equivalent departments have since spread far and wide.  By 2016, 82 percent of S&P 500 companies had published a sustainability or corporate responsibility report, up from only 20 percent in 2011.^[2]  However, basic CSR initiatives soon failed to satisfy consumer demands and branded companies had to go beyond just avoiding negative perception.  Informed consumers now expect companies to fulfill an ever expanding set of responsibilities, ranging from equitable labor to minimal environmental impact to encouraging diversity. 

By the mid-2000s, large, branded companies were looking more holistically at their impact and their total responsibility as a corporate citizen. Innovative companies – already forced to invest in CSR – began to ask how their experience in their supply chain and other socially responsible initiatives could become a competitive advantage. These companies use a definition of sustainability/corporate citizenship that embraces Friedman’s desire to focus on profits, while simultaneously acknowledging that they are inextricably linked to their wider impact on society.

There are many terms – sustainability, corporate citizenship, corporate social responsibility – for a company’s ability to encompass societal issues with fiduciary responsibility. Many, including The Conference Board, have settled on the umbrella term “corporate sustainability.” The Conference Board’s excellent description of corporate sustainability is “the pursuit of business growth strategy that creates long term shareholder value by seizing opportunities and managing risks related to the company’s environmental and social impact.” At this point, I struggle to find a Fortune 500 company that does not claim to do this.

Evolution from ‘Sustainability’ to ‘ESG’

Despite the rise of corporate sustainability, few CEOs discuss these initiatives with shareholders. But that is changing. Companies and shareholders are beginning to use the term Environment, Social and Governance (ESG) to represent the more focused area of the overlap between financials and environmental/social issues, resulting in risk mitigation.^[3]

ESG is about how well companies and investors govern the increasing overlap between society/environment and business issues. Using ESG instead of sustainability narrows a manager’s focus to the material relevant to shareholders. The term implies weeding out the eco and social stories made to be told to the end consumer. As the Financial Times describes, ESG is used by capital market investors to evaluate corporate behavior and to determine the future financial performance of companies. ESG factors are a subset of non-financial indicators, which include sustainable, ethical, and corporate governance issues.^[4]

ESG allows for shareholders to focus on the quality of corporate governance over macro trends that represent the overlap between society/environment and business issues; and narrows the focus to what is relevant/material to the issuer and shareholder.

Previously relegated to the realm of impact investing, large banks and funds are now focusing on ESG. Examples have been pouring in since 2016. 

SASB

In 2011, SASB became the newest addition to the alphabet soup of ESG. The Sustainable Accounting Standards Board (SASB) is a reporting structure designed to encourage/pressure companies to report metric-oriented ESG information separately from their general sustainability reports which tend to tell stories about the brand, showcasing NGO partnerships, new ideas, volunteering and philanthropic efforts.^[5] According to SASB, SASB guidelines are “a set of “sustainability accounting standards—for 79 industries in 11 sectors—that help public corporations disclose financially material information to investors in a cost-effective and decision-useful format. The SASB’s transparent, inclusive, and rigorous standards-setting process is materiality focused, evidence-based and market informed.”

As Ernst & Young said, “The launch of SASB signals an important milestone in the development of integrated reporting practice and, indeed, the integration of financial and non-financial performance and management into companies going forward.”^[6]

Task Force on Climate-related Financial Disclosures (TCFD)

In 2017, Within a year of the SASB bursting onto the scene, the investor community, led by former New York City Mayor Michael Bloomberg, former SEC head Mary Schapiro, and Bank of England Governor Mark Carney, founded the Task Force on Climate-related Financial Disclosures (TCFD). TCFD asks issuers to identify and access climate-related risks and opportunities.^[7]

The task force developed the first and only consistent climate-related financial risk disclosures for use by companies, investors, lenders, insurers, and other stakeholders.^[8] TCFD’s goal is that this disclosure leads to “better access to data will enhance how climate-related risks are assessed, priced, and managed. Companies can more effectively measure and evaluate their own risks and those of their suppliers and competitors. Investors will make better informed decisions on where and how they want to allocate their capital. Lenders, insurers and underwriters will be better able to evaluate their risks and exposures over the short, medium, and long-term.”

BlackRock letter

In 2018, BlackRock Chair and CEO Larry Fink wrote an annual letter to the leaders of all companies the institutional investor holds. The letter called for those CEOs to align their business purpose with societal needs, including addressing climate change. Business media called it awatershed moment and said it wasthe talk of the town at Davos, the prestigious meeting of world leaders. (If you have not read the letter, I recommend it in fullhere.) 

The letter had three major points, together which are cornerstones of executing ESG.

• Emphasizing long-term strategy over quarter-to-quarter profits. Fink writes, “Companies have been too focused on quarterly results; similarly, shareholder engagement has been too focused on annual meetings and proxy votes. If engagement is to be meaningful and productive…then engagement needs to be a year-round conversation about improving long-term value.” Fink defines a measure of a company’s success as being “able to describe their strategy for long-term growth.”
• Governance, or the role of the board in long-term (ESG) related strategy. Fink states that the long-term strategy should be “reviewed by [your] board of directors. This demonstrates to investors that your board is engaged with the strategic direction of the company. When we meet with directors, we also expect them to describe the Board process for overseeing your strategy.”
• Understand the company’s role in environmental and social issues.  Fink articulates why a board should demand an ESG strategy from their CEO: “a company’s ability to manage environmental, social, and governance matters demonstrates the leadership and good governance that is so essential to sustainable growth, which is why we are increasingly integrating these issues into our investment process.”

This is the closest Fink comes to mentioning ESG as a proxy for board competence, company sophistication, or future earnings. ESG experts, including this one, are watching Wall Street to see if a financial institution will be able to research and prove that ESG predicts future earnings. 

All of these examples have brought the theoretical demand for ESG information into the tangible realm for both investors and issuers. While observers look to see board fluency on ESG topics, companies like the one I work for, and observers, like The Conference Board, are looking for the same thing from investors.  Despite the robust ESG demands from investors through 2017, there are many investors who still think ESG can be relegated to the realm of philanthropy. The trend, however, is “long” in favor of the investor and company who uses ESG factors as a piece of understanding a company’s strengths.

The views presented on the Governance Center Blog are not the official views of The Conference Board or the Governance Center and are not necessarily endorsed by all members, sponsors, advisors, contributors, staff members, or others associated with The Conference Board or the Governance Center.