Claude Brown, Partner at Reed Smith, outlines why good governance serves as the glue that binds a cohesive ESG strategy together.
It is a truth, universally acknowledged, that the last item on a list receives the least attention. It may be because it is in the “too difficult” category but rarely is it because it is the least important. As so it is with ESG. Given the importance of climate change and the need to nurture the natural environment, it easy to see why it leads the three virtues. Social is a natural follow on but to leave governance until last risks belittling its importance. Governance is the key to an effective ESG strategy within any organisation and a key consideration in any investment assessment.
What does ‘good’ look like now?
It is important to understand what governance means in the context of ESG. Generally, it is commonly understood to mean how a company regulates itself internally and implicitly means good governance. Yet it goes beyond virtuous corporate hierarchies and protocols. Today, it is also taken to encompass an enterprise’s policies towards critical issues, such as the way employees are treated both by management and each other; employment policies addressing gender, sexual and racial equity, physical and mental health and well-being; as well as the established principles such as health and safety, meritocratic advancement, and equitable and non-discriminatory complaints procedures. Employees like working in organisations that respect them and treat them well. Good internal governance practices reflect that desire and the leadership’s responsibility to develop and promote the right environment internally.
Governing from the top down
Yet with the growth of ESG on the corporate agenda, there is another, newer aspect to governance; that of an organisation’s governance of its approach to ESG. Increasingly, good governance is measured by what an enterprise does internally in respect of its ESG strategy. Just as employees want to work in a welcoming, nurturing environment, so too they increasingly want to feel pride and satisfaction in their workplace. Responding to these aspirations requires a governance policy that seeks to integrate good internal governance in relation to the workforce with a responsible approach to the environment and engaging with social issues; in short, an integrated and comprehensive governance policy for ESG. This makes sense in that those who are responsible for devising the policy (usually the board or its equivalent) are best placed to implement and supervise it. It also makes sense from a management and coordinative perspective, especially in the context of balancing the various aspects of the E, the S and the G.
Critics of this top-down approach counter that the most effective ESG strategies come from the bottom up, harnessing the enthusiasm of employees and middle managers to do good works. Whilst engaging and empowering personnel at all levels, there is a latent risk that, without an overarching strategy, individual internal initiatives within the organisation can be duplicative, conflicting or produce unintended consequences, for example promoting laudable environmental goals but causing unforeseen and unintended social consequences. A governance policy, devised and implemented at the top of the organisation should seek to avoid this. It also has the merit of leadership by pace and standard setting showing the internal stakeholders that the organisation is committed to its ESG strategy at the highest level.
The bigger picture
However, just as ESG is not purely an internal issue, nor is governance. One feature of the growth of the ESG agenda is the growth of involved stakeholders in the enterprise’s approach to ESG. Like relatives, one does not get to choose one’s ESG stakeholders. Some are clearly identifiable as defined and discernible groups, such as shareholders, customers, suppliers and service providers, although increasingly there are more amorphous and shifting stakeholder groups, such as single-issue activists, pressure groups, lobbyists and even the public at large. The ESG stakeholder community is not one that the enterprise gets to define – more often than not these newer stakeholder groups get to define themselves. Whilst they can change because their focus changes, they can also change as the ESG agenda extends up and down the supply chain, adding new stakeholders of the enterprise’s customers and suppliers to its existing ones. This external scrutiny requires an external-facing ESG policy. That is not to say that it is discrete from the internal one; seeking to do that will prompt accusations of double standards or hypocrisy. The policy needs to be integrated and consistent. Again, governance is the key to ensuring this.
Governance is also critical to ensuring that the ESG strategy is sufficiently far-sighted to identify unintended consequences of one strand of the strategy impacting adversely on another and bringing the requisite degree of leadership and authority in order to head the situation off before it crystallises. There is also a delicate balance between having a governance strategy which has sufficient constancy so that all stakeholders, both internal and external, can measure and assess the organisation against it over time, and one that is agile enough to adjust for changes in the ESG agenda. One only has to look at the rise of nature and biodiversity to see how quickly and markedly issues can rise up the agenda.
Where does the buck stop?
A frequently asked question is who should be responsible for the ESG strategy? Whilst the counsel of perfection is that it should be the board that is responsible, too often it is allocated to the sustainability officer, the general counsel or some other division outside the inner sanctum of the board room. This risks the ESG strategy losing currency in the organisation as internal stakeholders see that the board are not accepting primary responsibility for implementing it or setting it. Whilst is axiomatic that boards have more things to deal with than they have time, allocating responsibility for ESG strategy outside the board members risks it becoming one item to be reported on during a board meeting. Being one of the newer items to be added to a board meeting agenda also exposes it to the curse of being last on the list. Even if the board assumes responsibility for the ESG strategy, ideally it should not feature as an agenda item. It should be an integral part of the discussion and decision-making process for each action that the board sanctions.
So, what should an investor look for as hallmarks of good governance with an enterprise’s ESG strategy? Implementation and engagement at board level is paramount. The strategy should balance the E, S and G of the organisations initiatives and be watchful of unintended consequences spilling over from one initiative to another. The approach to governance should demonstrate due regard for both internal and external governance and be consistent between the two. Governance should fashion the ESG strategy to be responsive without being capricious and adapt to a rapidly changing community of stakeholders and their fast-evolving concerns and priorities. Finally, as with so many things, do those who talk the talk, also walk the walk?