Earlier this year, a small hedge fund shocked the energy industry and dealt a major blow to Exxon Mobil at its 2021 annual meeting by unseating 3 Directors (out of a board of 12) and replacing them with its nominees. This coup was significant, not only because it was one of the most high-profile and expensive proxy fights in recent years. It was also the first time that the outcome of a board election turned on Environmental, Social and Governance (ESG) issues. This was the first big boardroom contest at an oil major that made climate change the central issue at stake.

Investors led by Engine No. 1, which owned only a 0.02% stake in Exxon, had indicated that Exxon was not doing enough on its path towards carbon reductions to ensure Exxon’s future value to investors. They wanted to bring in “fresh perspectives” and “transformative energy experience” to the board to help Exxon evaluate the risks and opportunities presented by the energy transition from fossil fuels.

After a climatic fight, the appointment of the 3 directors nominated by Engine No. 1 was hailed as a signal to the world that directors and boards that do not have the competence and resolve to address climate change will be held accountable by investors. The global investment community has increasingly made ESG a board issue over the years and is now putting pressure on boards to demonstrate their ESG competence.

The problem, however, is that even though ESG issues like climate change have disruptive capabilities that undermine the sustainability and success of companies, most boards do not have the know-how and the capability to address the business challenges that are caused by these ESG issues.  Today, directors need to add a new set of skills to their toolkit. They must understand ESG factors, they must be able to determine which ESG risks are most material to their companies and they must address them. They also need to oversee their company’s strategy in exploiting opportunities created by addressing these ESG factors. What this means is that when ESG factors are material to a company, it is essential that the company recruits ESG-competent directors with the knowledge and capability to build an ESG competent board that can safeguard the resilience of a company’s long-term strategy. It is important to note that the materiality of ESG factors may differ from company to company and from industry to industry.

What is ESG?

Environmental, Social and Governance factors are non-financial performance indicators used in measuring the sustainability and ethical impact of a company. Environmental factors speak to the company’s impact on, and management of, environmental resources, including climate change and water scarcity. Social factors reflect its management of human rights and capital, as well as relations with customers, suppliers, and the community; Governance factors include the company’s structure and leadership, internal controls, and relations with shareholders. It is important to know that these factors are often interwoven even though they may appear distinct.

ESG factors can have a material impact on the business strategy, risk, and performance, and are therefore incorporated into risk mitigation, compliance, and investment strategies. On the downside, the impact of ESG factors may include reduced revenues or reputational damage, while the upside may include cost savings or the exploitation of new business opportunities. Companies that use ESG standards are deemed to be more diligent, more risk averse, and are more likely to have sustained success. To assist in their decision making, investors can assess companies using ESG standards as an appraisal structure to evaluate corporate conduct and culture, to evaluate investments, to assess risks and to determine the future performance of companies.

ESG and Sustainability are sometimes used interchangeably. Sustainability can be described as the economic, social, and environmental issues that affect corporate strategy and long-term performance – the so-called triple bottom line of people, planet, and prosperity.

Why should boards be responsible for ESG oversight?

There has been increasing agitation amongst stakeholders, including regulators, investors, shareholders, and customers, for companies to optimally manage ESG issues as a factor of their corporate responsibility to society, while creating long-term value.

Companies are directed and controlled by their directors. Directors have legal and fiduciary duties to exercise reasonable care, skill, and diligence in promoting the success of the company they lead, in an ever-evolving landscape. Where ESG factors are material to a company, it is the director’s job to provide oversight over the risks associated with those ESG factors. For directors to carry out this role and make strategic decisions that will create long-term value, they must be adequately informed; they must understand ESG risks; and they must have the skills to assess the ESG risks and how they interrelate to each other.

In addition, boards of public companies and regulated private companies have clear reporting obligations under listing and sector regulations, including various Corporate Governance Codes and Sustainability Guidelines, requiring them to report on their company’s ESG activities and to ensure that management systems are in place to identify and manage environmental and social risks, as well as their impact on the company’s operations and prosperity.

What are the steps to build a ESG competent board?

An ESG competent board sets the tone at the top, ensures that ESG is on the board and corporate agenda, and ensures that ESG is incorporated into whole-board strategic conversations and organisational functions.  To embed sustainability into board oversight and ensure that it is incorporated into its decision-making on strategy, risk and compensation, a company needs to take certain actions, including the following;

1. Recruit diverse and ESG-competent directors by expanding the board selection matrix to include candidates with experience and exposure to material ESG issues
2. Make ESG a key issue for all board members when assessing the company’s business strategy
3. Ensure that suitable information is provided to help directors understand the materiality of ESG issues specific to the company
4. Integrate ESG into coordinated boardroom deliberations
5. Formalise the oversight of ESG risks at board level
6. Establish a governance system that captures ESG factors
7. Institute a robust director onboarding and education program in sustainability and ESG issues
8. Set ESG targets
9. Link ESG targets to Executive Compensation
10. Carry out regular stakeholder engagement on relevant ESG issues, including ESG specialists

There seems to be no question that ESG belongs firmly at the board level, and that directors will be held responsible by their stakeholders for how ESG issues are addressed by a company. In his 2021 Letter to CEOs, Larry Fink, Chairman and CEO of BlackRock with assets under management of US$7 trillion, revealed that companies will be requested to disclose how a board reviewed plan for how the company’s business model will be compatible with a net-zero economy by 2050. So, let’s be clear. In addition to the advantages of enhanced long-term risk-adjusted returns, the investment community now require boards to have oversight of ESG risks as core issues of governance, with the expectation that boards will fully embrace this enhanced responsibility or face the consequences.

In a climate of uncertainty, building ESG competence into boards, such that directors are skilled at overseeing the creation of economic value while assessing business risks and growth opportunities within the context of emerging ESG factors, is surely the way to go.