Climate, ESG, and the Board of Directors: “You Cannot Direct the Wind, But You Can Adjust Your Sails”

Keynote Address at the 2021 Society for Corporate Governance National Conference[1]

Good morning and thank you for the invitation to speak today at the Society for Corporate Governance 2021 National Conference. I’m impressed with your full and informative agenda over the next few days, and I appreciate the important work you do in supporting company boards and executives. 

I also appreciate your engagement in the SEC’s policymaking process, including your recent letter in response to the request for public input on climate change disclosures. In fact, we’ve received thousands of comments in response to that request, but we hardly need that statistic to understand that the subject of climate risk and our financial markets, and ESG more broadly, is top of mind in board rooms and c-suites around the globe.

Increasingly, boards of directors are called upon to navigate the challenges presented by climate change, racial injustice, economic inequality, and numerous other issues that are fundamental to the success and sustainability of companies, financial markets, and our economy. This call, welcomed by some and eschewed by others, is attributable in part to the large and growing influence that corporations hold over the social and economic well-being of people and communities everywhere. A study from 2018, for example, showed that 71 of the top 100 revenue generators globally were corporations while only 29 were countries.[2] In other words, corporations – in many cases U.S. corporations – often operate on a level or higher economic footing than some of the largest governments in the world. That is a dynamic worthy of reflection – and one that drives home the weighty consequences and obligations associated with some corporate decisions.

Small wonder, then, that not just investors, but employees, consumers, vendors, suppliers, and numerous other stakeholders, look to companies to design and implement long-term, sustainable policies that support growth and address the environmental and social impacts these companies have. And these expectations increasingly play out in ways that were far less a part of the corporate consciousness just a decade or two ago. Today, what your business does and says is as likely to be dissected on Twitter and TikTok as it is to be reported in the Wall Street Journal or over a newswire. Consequently, consumers, employees, both current and potential, and a host of others can affect how companies are perceived and how well they succeed.        

I know many in this virtual room, including those on boards of directors, understand this dynamic. And understand that these environmental and social issues, once perhaps treated as more peripheral, are now central business considerations. So boards are stepping up their engagement on climate and ESG related-risks and opportunities. For instance, in one recent survey, nearly 80 percent of directors reported that their boards are focused on some aspect of ESG.[3] An analysis of a selection of S&P 100 proxy statements found that 78 percent of companies had at least one board committee charged with overseeing environmental sustainability matters.[4] And 42 percent of companies reviewed in that analysis associated at least one director with expertise in environmental policy, sustainability, corporate responsibility, or ESG.[5] At the same time, while many companies report that they oversee ESG at the board level, some analysis suggests they may lack specific sustainability mandates and do not demonstrate board-management engagement on ESG.[6] In addition, there are some indicators that reported board expertise on ESG may be ill-defined[7] and still lacking.[8] There is more work to be done.

Because, in the words of prominent corporate attorney Marty Lipton, “a corporation ignores environmental and social challenges at its own peril.”[9]

Putting ESG in Context in the Recent Proxy Season

If we needed a more immediate reminder of the significance of ESG, the recent proxy season delivered one. 

First, there are the shareholder proposals. Climate proposals received record support.[10] This year, 98 percent of General Electric shareholders approved a resolution asking the company to explain how it intends to achieve net zero emissions in accordance with the Paris Agreement.[11] At ConocoPhillips, 58 percent of shareholders approved a measure requesting Scope 3 emissions reductions.[12] Sixty-five percent of shareholders at United Airlines voted in favor of a resolution seeking more information on how the company’s corporate lobbying aligns with the goals of the Paris Agreement.[13]

The ESG focus isn’t limited to climate. A resolution seeking a racial equity audit nearly won majority support from Amazon shareholders;[14] a similar proposal won almost 40 percent support at JP Morgan.[15] At Duke Energy, a proposal seeking more disclosure of political spending won majority support.[16]

And, not to bury the lede, but it wasn’t just shareholder proposals. Last month, we all watched with varying degrees of astonishment as climate activists won three seats on Exxon’s board during an annual meeting that produced what some have called the proxy “vote heard ‘round the world.”[17] Whatever one’s views regarding activist investors or a corporation’s role with respect to climate or ESG, this turn of events has focused the attention of directors everywhere.

This proxy season is just the latest affirmation of a sea change on climate and ESG. It occurs against the backdrop of the US reentry into the Paris Agreement and pledge to cut emissions in half by 2030,[18] and a broad global reckoning with the need for enhanced transparency on sustainability.[19] It also occurs in the midst of ever-more powerful signals from major institutional investors of their commitment to sustainability.[20] Finally, it occurs as the SEC considers potential rulemaking to improve climate and other ESG disclosures for investors.[21] These developments place ever greater responsibility on companies, and therefore boards, to integrate climate and ESG into their decision-making, risk management, compensation, and corporate transparency initiatives.

Understanding ESG and Board Obligations

So, what obligations do boards have?

Historically, many ESG issues were seen as not within the purview of the board of directors. These matters, referred to as “corporate social responsibility” or CSR issues, were largely treated as if they were separate and apart from the business of generating revenue and earning profits.[22] Debates about director duties around climate and ESG often centered on whether directors were even permitted to consider issues that previously fell under the rubric of corporate social responsibility.[23] In that Milton Friedman era, risks like climate change and many other issues we would now call ESG were characterized as topics that could bear on the public good, but were not relevant to maximizing value for shareholders.[24]

Those days are over. I will set aside for now the debate over whether the shareholder maximization model for corporate governance has continuing relevance or vitality because the connection between ESG and the interests of shareholders has become evident. Our understanding of the significance of ESG and its short-, medium- and long-term relationship to financial performance has evolved to the point that the principal debates are about when, not if, these issues are material.[25] Thus, regardless of whether one agrees with the Business Roundtable’s position on corporate purpose and service to stakeholders and the broader economy,[26] it is clear that the board has a role with respect to ESG.   

There is, for example, broad consensus regarding the physical and transition risks associated with climate.[27] SASB (now the Value Reporting Foundation), the Global Reporting Initiative, and many others have clearly set forth financially material ESG risks for companies. There is tremendous and growing investor demand for climate and ESG disclosure.[28] The world’s largest asset managers and other institutional investors have been direct and vocal in conveying that they consider ESG material to their decision-making.[29] No matter the view of regulatory involvement in climate and ESG disclosures, directors must reckon with this growing consensus and growing demand from the shareholders who elect them. 

Accordingly, boards increasingly have oversight obligations related to climate and ESG risks – identification, assessment, decision-making, and disclosure of such risks.[30] These obligations flow from both the federal securities laws and fiduciary duties rooted in state law.

Under the federal securities laws, the board plays a critical and mandatory role in the existing corporate disclosure process. This increasingly requires directors to think about and consider the impact of climate change and other ESG matters on the financial statements and other corporate disclosures.

Since the passage of Sarbanes-Oxley in 2002, boards at listed companies directly oversee the audit of financial statements, including responsibility for the appointment, compensation, and oversight of the independent auditor.[31] Exchange rules impose direct requirements with respect to board oversight of audits, including that boards discuss any difficult issues with the independent auditor.[32] Likewise PCAOB rules require auditors to communicate with boards about significant issues arising in the audit.[33] Because matters such as climate change may bear on the valuation of assets, inventory, supply chain, and future cash flows,[34] board oversight of audits increasingly necessitates engagement on those issues.

Boards also play an important role in the oversight of other types of disclosures made outside of financial statements.[35] These disclosures may also implicate ESG considerations. For example, the SEC’s 2010 climate guidance identifies multiple existing disclosure requirements, most prominently Management’s Discussion & Analysis, that may give rise to climate disclosure obligations.[36] The SEC’s recent update to Regulation S-K’s Item 101 specifically identifies human capital as a potentially material disclosure topic.[37] And there is a requirement under item 407(h) of Regulation S-K for disclosure of the board’s role in the risk oversight of a company, which in many instances could include climate change risks.[38] These are just a few of the currently existing federal requirements that implicate board involvement and engagement on climate and ESG.

Under state law, as everyone here knows, directors have fiduciary duties of loyalty and care.[39] A director’s duty of care fundamentally requires that a board must be well informed when making corporate decisions.[40] When those decisions, for example, relate to long-term business strategies, a board may well need to ensure it has relevant information related to the climate and ESG-related risks and opportunities its company faces.[41]       

What’s more, under the duty of good faith (considered a subset of the duty of loyalty under Delaware law) directors may need to investigate “red flags” that suggest legal violations or other harm to the corporation.[42] This may require directors to do a deeper dive on climate change and other ESG issues as the regulatory landscape evolves. Unaddressed red flags relating to a violation of emissions regulations, for instance, could implicate the duty of good faith.[43]

All of this suggests that climate change and other ESG matters should be regular and robust topics for the board, whether at meetings of the full board or in key committees, such as the audit committee, the compensation committee, or the risk committee. Or, perhaps, as some companies have already done, handled in a more centralized manner through a sustainability or ESG committee of the board.[44]

Mitigating ESG Risks and Maximizing ESG Opportunities

Growing recognition of the importance of climate and ESG presents both risks and opportunities for companies and their boards. On the risk side of the equation, there is, among other things, physical risk, transition risk, and regulatory risk. There is also reputational risk, as investors and consumers increasingly make decisions based on companies’ sustainability profiles. And human capital risks as well, as younger workers increasingly place a premium on whether a company’s values align with their own.[45]

There is a rising expectation that boards will play a key role in managing these risks. A core component of the framework created by the Task Force on Climate-Related Financial Disclosures is disclosure of the board’s oversight of climate-related risks and opportunities.[46] The World Economic Forum published a white paper last year explaining that boards need to integrate ESG into corporate governance out of a recognition that “business value creation” is increasingly dependent on understanding and managing these risks and opportunities.[47]

This year, BlackRock emphasized that it expects “boards to shape and monitor management’s approach to material sustainability factors in a company’s business model” and will hold directors accountable where they fall short.[48] Similarly, State Street announced that it will start voting against the boards of companies that underperform their peers when it comes to ESG standards.[49] Proxy advisory firms ISS and Glass Lewis have announced new voting policies that include director accountability for ESG governance failures.[50]

As shareholders and others increasingly emphasize the need for climate and ESG to be incorporated into risk management and governance practices, they have mechanisms to hold companies accountable where they fall short of expectations. They can put pressure on boards to act through shareholder proposals. They can replace directors, as we saw with Exxon. And ultimately both investors and consumers can take their capital elsewhere.

Importantly, all of these risks also present great opportunities. Boards that proactively seek to integrate climate and ESG into their decision-making not only mitigate risks, but better position their companies and business models to compete for capital based on good ESG governance.

So what are some key steps for boards that seek to maximize ESG opportunities, message their commitment on these issues, and position themselves as ESG leaders?

Enhance Board Diversity. Despite the progress I mentioned earlier, some evidence suggests that directors have been slow to understand the need to integrate climate and ESG into governance practices. In one 2019 report, only 6 percent of U.S. corporate directors surveyed selected climate change as a focus area for the coming year.[51] The same report found that 56 percent of directors thought investor attention on sustainability issues was overblown.[52] This suggests that some boards may need to refresh and diversify perspectives. There are many reasons for companies to seek to enhance the diversity of their boards, not least because investors increasingly expect them to do so. Indeed recent proxy seasons have reflected investor focus on both board refreshment and greater diversity.[53] Board refreshment introduces opportunities to put new directors on boards, and emphasizing diversity increases the likelihood new directors will actually bring new thinking. This, in turn, could facilitate more current and proactive approaches to climate and ESG governance.

Increase Board Expertise. To effectively address climate and ESG risks, boards need adequate expertise on these subjects. Investors are increasingly emphasizing their expectation on this point. For instance, Vanguard in its recent comment letter to the SEC on climate change disclosures expressed its view that corporate disclosure should allow investors “to assess the climate competency of a company’s board.”[54] Yet research shows that, while boards have made strides in recent years, directors may still fall short in terms of ESG credentials.[55] Companies should consider ways to enhance the ESG competence of their boards. These efforts could include integrating ESG considerations into their nominating processes in order to recruit directors that will bring ESG expertise to the board; training and education efforts to enhance board members’ expertise on ESG matters; and considering engagement with outside experts to provide advice and guidance to boards.[56]

Inspire Management Success. Directors’ decisions on compensation can spur progress on corporate strategies and approaches to address the risks associated with ESG matters. In fact, our economy is built on, and responds directly to, financial incentives. Executive compensation is thus a powerful tool for achieving strategic company goals. This dynamic is not limited to simply linking executive compensation to certain corporate financial goals. In fact, compensation works for any number of more specific goals or targets a company may set. Consider for instance academic research from 2019 demonstrating that airlines offering their executives bonuses for on-time flight arrivals did in fact achieve more on-time flight arrivals.[57]

In addition to helping achieve strategic goals related to issues such as reduced carbon emissions or increased diversity of the workforce, tying executive compensation to ESG metrics can offer an important way to deliver on a company’s commitment to issues that matter to investors and consumers.

For example, in the wake of racial injustice protests, companies have made numerous pledges regarding their commitment to racial diversity. Going further, some companies have tied executive compensation to relevant ESG metrics. Companies like Starbucks, McDonalds and Nike, for example, have all recently said they will tie executive compensation to diversity metrics.[58]

Boards that tie executive compensation to ESG metrics are using one of the most powerful tools they have to make real progress on ESG goals, and at the same time signaling the strength of their commitment to these issues.

*          *          *          *

Let me close with a thought about the range of views and opinions regarding the right course for companies to take. There is no one right answer for each individual company on how to mitigate risks and maximize opportunities with respect to climate and ESG issues. They are complex, evolving and, in some cases, highly charged issues. This can make collaborative discussion more difficult.

In that regard, I note that a focus on these issues is sometimes labeled “woke washing” or even woke policymaking. We should consider whether public pledges on ESG issues are actually backed up by corporate action. That’s part of my message today – that substantive consideration of ESG should be meaningfully integrated into board oversight. And why I’ve previously suggested that our disclosure regime should provide investors with adequate information to test public pledges like these. But the use of labels that might be considered dismissive rarely adds value or contributes meaningfully to solutions in policy debates. In addition, as a valued colleague recently pointed out to me, these terms carry significant histories in Black vernacular and are thus all the more ill-suited for purposes of dismissing attention to issues that have serious economic and social consequences, often disproportionately so for communities of color.

The more we can have open, thoughtful, and well-researched dialogue on the specifics of these issues, the more companies, investors, and all stakeholders will benefit. It’s more critical than ever for boards to explore how to integrate sustainability into their governance practices, and consider specifically what is best for the companies they oversee. That’s because (if you’ll forgive me one last quote), as Yogi Berra put it, “if you don’t know where you are going, you might wind up someplace else.”

Thank you and I look forward to taking questions.