What Could Your ESG Risk Really Cost?

Each new year, corporate governance reviews and predictions abound. For the past several years, annual culminations and new-year predictions have included environmental and social aspects in addition to governance. Whether your company calls it ESG, sustainability or corporate responsibility, the multistakeholder focus on climate and human capital now parallels that of traditional governance. (For purposes of this article, ESG will be used.)

Because of this, boards would do well to consider the ESG business case. One straightforward approach is anchoring this analysis in the context of risk. The types of traditional risk — operational, financial, market, supply chain, fiduciary, strategic, reputational — also may be bifurcated into “perceived” and “real.” In this manner, directors may better pinpoint blind spots; appropriately contextualize ESG in relation to vision, mission and business strategy; and, further, quantify associated risks.

For example, with respect to climate impact, directors should:

• Understand the location of key assets.
• Determine if location-specific business continuity plans exist.
• Ensure redundant business systems in diverse geographic locations are in place, to mitigate climate effect.
• Determine the estimated daily cost, including lost business, of climate impact.

Clear financial analysis will help boards better evaluate risk mitigation plans while placing a spotlight on corporate functions key to sustainability – environmental, health and safety; supply chain and human capital.

A Word About Stakeholders

In 2024, Glass Lewis strengthened its policy guidelines to ensure that board oversight responsibility of ESG is “designed and codified” in committee charters. Glass Lewis also expanded the application of its climate policy to all S&P 500 companies with material exposure to climate risks coming from their own operations and according to SASB standards. If you think this doesn't apply to your organization, think again. The number of industries considered by Glass Lewis is vast in scope. Specifically, the proxy advisor seeks to determine if reporting is in line with the Task Force on Climate-Related Financial Disclosures (TCFD) and if companies have clearly defined oversight of climate-related risks.

Enhanced “Leg and Reg”

Increasing legislative and regulatory demands are anticipated in 2024; some already are enacted, others are pending. One notable set of new state legislations, California's S.B. 253 (the Climate-Related Financial Risk Act) and S.B. 261 (Climate-Related Financial Risk Act), relates to both public and private companies. Those laws focus on Scope 1 and 2 reporting, Scope 3 in certain instances, as well as climate-related financial risks, all starting in 2026. Is your organization prepared?

For U.S.-based entities, legal teams should keep current regarding non-U.S. requirements. For example, the new Corporate Sustainability Due Diligence Directive (CSD³) affects both private and public companies with a relatively low threshold for inclusion. SEC Chair Gary Gensler has voiced concerns about EU oversight imposing regulation on U.S. companies.

Is the Right Talent in Place?

ESG's increasing complexity requires reevaluation of organizational talent. Consider if your company has the appropriate executives to identify and advance ESG efforts and assess risk. For example, does your chief risk officer, in developing business continuity plans, consider all stakeholders and local tax credit implications when evaluating a greenfield site or relocation? Does that individual have a pure finance or audit background, where environmental, human capital and reputational risks may not come naturally to mind? Does your organization need a team member experienced in ESG matters to work collaboratively on the ERM plan?

Underscoring this complexity, 2022 saw a new specialty role emerge: ESG controller. This role assists a corporate controller in verifying sustainability-related disclosures, once again demonstrating that risk mitigation is central to ESG initiatives, oversight and reporting.

Board Governance and Oversight Is Not Just “On Paper”

A 2023 Sustainability Board Annual ESG Preparedness Report revealed that, of the 100 largest public companies, disclosure regarding board oversight of sustainability governance increased from 50% in 2019 to 88% in 2023.

Beyond stakeholder pressure, what is driving this? The answer is risk management and oversight. In a March 2023 Harvard Law School publication, 86% of the top 50 companies in the 2021 Fortune 100 had a board committee responsible for ESG oversight. More recent data from The Conference Board indicates that “virtually all” S&P 500 firms disclose assignment of ESG oversight to the full board and/or one or more committees. Some boards have created stand-alone ESG or risk committees.

ESG Predictions for 2024: What Boards Must Know

Several law and advisory firms have recently published predictions about ESG in 2024. I offer some of my own:

• Investor support of ESG proposals will become more selective, based on how prescriptive the proposal, the company's response, and the proponent's identity and connections.
• Companies will continue to use ESG, despite the backlash of 2023 and despite political use of the term. Whether you love it or hate it, the term “ESG” is firmly embedded in our lexicon and has meaning to many stakeholders.
• SEC focus on company climate, cyber and human capital disclosures will increase. With a final SEC cyber disclosure rule and draft human capital and climate rules, the SEC enforcement division is posturing to continue stepping-up efforts. Companies and audit committees will do well to review all disclosures, including risk factors, to ensure they are sufficiently, strategically, holistically and accurately painting a picture of the corporate environment across all types of communications.
• The breadth and number of greenwashing claims will continue in 2024. As a result, “greenhushing” — purposely avoiding certain environmental disclosures — will increase as enhanced disclosure risks and related penalties come into play.
• ESG third-party assurance will significantly increase in 2024. Currently, there are more companies than third-party assurers; the SEC will need to further define the term “environmental expert” within its climate disclosure proposal.
• ESG raters/rankers (ERF) will increasingly seek decarbonization plan disclosure. In fact, MSCI and Sustainalytics no longer give full credit for climate reporting. The ERFs are aligned with IFRS 1 and 2 and CSRD reporting in seeking climate mitigation plans regardless of size or industry — everyone is accountable.
• Directors may wish to consider biodiversity and natural capital impact and suggest incorporation into corporate ESG programs and disclosures.
• AI increasingly will be used in ESG statements — by companies to generate disclosure, by ERFs to rate disclosure and by stakeholders for assessment.
• During this election year, cybersecurity breaches, misinformation and disinformation will proliferate. Boards and their companies need to remain hypervigilant.
• Competing for talent will continue to be a focus. Attracting and retaining talent, relative to a company's ability to address employee needs and wants in today's sustainability-focused environment, will be increasingly challenging.

Most of these 2024 ESG predictions are grounded to disclosure risks. Therefore, directors need to remain especially vigilant when evaluating ESG initiatives and public commentary.

Director Guidance

I suggest the following guidance for directors as they seek to navigate ESG initiatives.

• Link ESG strategy to business strategy. Too often, there are disconnects. ESG strategy and initiatives must align with, and support, the vision, mission and business strategy. Ensure boardroom discussions include risk and consider the macroeconomic environment, near- and longer-term.
• Ensure the company has an appropriate governance structure and oversight, including delineating a specific board committee (or committees). Investors demand it and ESG is now considered a director's fiduciary responsibility.
• Don't boil the ocean. Stay focused on priorities that tie back to business strategy, weighing real vs. perceived risks and identifying material disclosures.
• Be hyperaware that ESG ratings are relative, weighted against peers. Ensure your company is appropriately forward-leaning without “getting over its skis.” Leave room for nonmaterial disclosures to demonstrate real progress on a year-over-year basis.
• Directors need to keep a watchful eye over corporate culture, talent, leadership development, advancement opportunities and succession planning. Sustainability and responsible corporate action are a concern for all generations. A Deloitte March 2023 survey indicated that 69% of employed adults wanted companies to invest in sustainability efforts. Unsurprisingly, much of this focus came from the group ages 18 to 34; 27% indicated they would evaluate a company's sustainability role when considering employment.
• Foster a board culture of trust and openness. Listen carefully to dissenting director voices while assessing motivation. Is the director opinion or recommendation based in personal political belief or born from valid business experience?
• When evaluating ESG initiatives and disclosures, take into consideration all stakeholders, but avoid trying to appease all stakeholders. Recognizing the pros and cons of each action, including financial impact, is key to a thorough evaluation process.

“Above all, assess and build your board culture, which will enable your boards to candidly discuss and evaluate ESG risks and opportunities,” remarked Jane McCahon, JD, vice president and corporate secretary, Telephone and Data Systems Inc. Whatever the nomenclature, a director's role in ESG oversight is clear. With that role comes increased responsibility and exposure for directors. Therefore, directors should ask themselves, “At what cost is my risk?”