It’s no secret to engaged corporate boards that the
mainstream investor community is increasingly attuned to environmental, social,
and governance (ESG) matters. What may be less obvious is what that means, exactly.

Many directors are likely to think, “We already have a
corporate social responsibility program in place, so we’re covered.” If that
sounds like your board’s approach, everything you think you know about ESG
could be wrong.

Whereas corporate social responsibility (CSR) traditionally
involves a company’s foundation, its charitable work, employee volunteer and
recycling efforts and the like, ESG narrows the focus on business-critical
sustainability issues.

It may sound like splitting hairs, but consider the
difference between, say, a beverage company that donates time and money to
alleviate poverty in its local community and one that invests in water
efficiency initiatives at its facilities located in drought-prone regions. The first
company’s intentions may certainly be noble, and its actions may enhance its reputation.
But the second company’s investment in water efficiency is fundamentally linked
to its value-creation strategy, and thus is likely to have direct and indirect impacts
on the firm’s financial statements and market valuation.

The key to making this distinction is the lens of financial
materiality, which helps identify the subset of sustainability factors most
likely to have meaningful impacts on a company’s financial condition or
operating performance.

Indeed, research shows this focus is associated with significant outperformance in terms of sales, sales growth, return on assets, and return on equity, as well as risk-adjusted shareholder returns. These findings, in turn, explain why a large and growing number of investors—including 73 percent of analysts and portfolio managers—integrate ESG considerations into their work.

What does this mean for boards of directors? Quite simply, because financially material ESG matters constitute legitimate strategic and risk considerations, they have significant fiduciary implications. In other words, the shift from CSR to ESG has raised the bar for board oversight of how these issues are managed and reported. For example, if your company is like 85 percent of the S&P 500, you’re already putting ESG information out into the marketplace. How can you ensure this data is both relevant and reliable—the twin hallmarks of decision-useful information

Relevance: Narrowing
the Focus

For investors—and, by extension, for directors—not all
sustainability issues are created equal. So, it’s important that companies assess
ESG factors through the lens of financial materiality, which can help
streamline their sustainability efforts to measure, manage, and report the
issues that matter most to shareholders.

With its lens focused on materiality, a firm can more effectively integrate the resulting handful of key issues into its core business operations using standard approaches to strategic planning (such as balanced scorecards and strategy maps), enterprise risk management (or ERM, such as the COSO framework), and performance management (such as internal dashboards for monitoring progress). Such integration not only ensures crucial ESG factors are effectively managed, it enhances the ability of the board and its committees to administer appropriate oversight.

Of course, relevance is arguably in the eye of the beholder, and directors should also consider engaging with key investors to better understand which ESG risks and opportunities they care about most. These issues don’t always arise—or, more likely, get lost in translation—during earnings calls or discussions with buy-side analysts. To meaningfully explore and fully understand investor needs through engagement, a board may want to add or develop ESG-related expertise.

Boards of directors may find the following questions helpful
in facilitating sustainability reporting that is relevant to investors:

  • Is the company’s approach to sustainability well aligned with its strategy?
  • Is the risk committee satisfied that management’s approach to ERM incorporates strategically aligned ESG matters in the context of the organization’s risk appetite?
  • Have members of the board engaged with investors to better understand their ESG-related areas of concern and information needs?
  • Does the company’s disclosure committee apply a financially focused materiality assessment to key ESG performance data?
  • Does the board’s composition include sufficient fluency in the financially material ESG issues that face the company?

Supporting Decision-Makers

Of course, even relevant information may be of limited use if it lacks reliability, including timeliness and accuracy. Although some ESG data—such as utility bills and invoices—may already reside in a company’s enterprise resource planning system, much of it has traditionally been collected and managed in ad hoc spreadsheets—outside the rigor of the financial reporting process—which can result in information of less than desirable precision and limited verifiability. Companies can overcome this deficiency by designing, implementing, and maintaining a system of governance around financially material sustainability information that is substantially similar to what they use for financial reporting.

Such a system is likely to include an effective internal control environment and additional disclosure controls and procedures, as appropriate. In this context, internal audit can play a critical role in enhancing management’s and the board’s comfort over sustainability information. Some companies may also choose to engage an independent third party to provide assurance over key ESG data, which sends a signal of reliability to the investor community. Controls and assurance can thus strengthen the confidence of decision makers both inside and outside the firm while dramatically reducing the likelihood of restatements.

Directors can ask themselves the following questions to
assess the reliability of their company’s sustainability reporting:

  • Does the board or its key committees have
    regular access to sustainability performance indicators?
  • How can technology facilitate more reliable (and
    verifiable) ESG data?
  • How might the audit committee gain visibility
    into the effectiveness of ESG-related internal controls—particularly where
    significant deficiencies or material weaknesses have been identified?
  • Has the company’s disclosure committee
    established appropriate disclosure controls and procedures to ensure
    financially material ESG information is effectively recorded, processed,
    summarized, and reported?

Leveraging Practical

A company may not always be able to maximize both the
relevance and reliability of its financially material sustainability
information. In this sense, it is no different from traditional financial data,
which involves its own inherent trade-offs (e.g., historical costs are more
reliable but less relevant than fair values). However, as the evolution from
CSR to ESG continues, effective board oversight can help ensure a company achieves
its sustainability reporting objectives in a way that creates value for both
the enterprise and its investors.

Along with the questions presented here, the 77 industry-specific standards recently codified by the Sustainability Accounting Standards Board (SASB) can provide a useful starting point for boards to kick-start their ESG oversight. In large part, this is because the SASB standards are designed to achieve both relevance and reliability.

First, by observing the threshold of financial materiality,
the standards zero in on the subset of ESG factors that matters most to
investors (an average of six per industry). Second, by providing detailed
technical protocols, they ensure ESG data is prepared, compiled, and presented
in accordance with rigorous definitions, scope, and accounting guidance—which
can also serve as the basis for “suitable criteria” in an assurance engagement.

As the competitive landscape has evolved, so has our
understanding of sustainability and its impacts on business outcomes. Having
faced economic headwinds, technological disruption, and regulatory uncertainty
in recent years, boards of directors are well-versed in change management and
practiced at the art of adapting to new circumstances. These skills will remain
invaluable as sustainability and finance continue to converge.

Robert B. Hirth Jr. is
Senior Managing Director at Protiviti,
Chairman Emeritus of the Committee of Sponsoring Organizations of the Treadway
Commission (COSO), and Co-Vice Chair of the SASB Standards Board.