Commentary

The Governance of Sustainability

Filip Gregor, Head of Responsible Companies at Frank Bold, explains the impact of two key European regulatory initiatives on material sustainability data for companies and their investors.

In 2021, the European Commission will present two intertwined legislative proposals aiming to foster integration of sustainability in corporate strategies. The first one, the reform of the EU Non-Financial Reporting Directive (NFRD), aims to ensure transparency on companies’ sustainability performance to improve corporate accountability and enable sustainable finance (see related article here). The second one, the sustainable corporate governance initiative, will clarify corporate obligations to identify, prevent and mitigate severe human rights and environmental impacts, and Board oversight over sustainability risks, strategy and targets.

Such a combination of transparency and governance incentives, together with the push of responsible investors, will reinforce the market pressure for companies to elevate the consideration of sustainability among managerial and Board priorities, whilst granting companies considerable flexibility in how they do this.

In this article, we explain how the governance of sustainability matters helps companies to identify material sustainability information, and how such data enables companies, their managers and their investors to properly consider risks and opportunities and make strategic decisions.

The importance of governance in sustainability

Directors’ associations, business organisations and investors, increasingly recognise the urgency of the climate crisis and the need to fully integrate sustainability and respect for human rights in companies’ business models and risk management. The sustainability crisis and the challenge of ensuring recovery from the CoViD-19 crisis are of an unprecedented scale and urgency, as highlighted by EU Commissioner for Justice Didier Reynders who also stressed that “companies that are ahead in the game will benefit most”. According to an estimate from the European Commission, at least half a trillion euros of additional investments per year will need to be redirected from business-as-usual to sustainable activities. The risks and opportunities linked to the realignment of finance and markets are therefore equally unprecedented.

The need for effective governance and oversight from the company’s most senior governing body and integration of sustainability is proportionate to the challenges facing companies. This is particularly relevant where risks and impacts are connected to the company’s business model, as this will in turn require major changes to the strategy and financial planning.

The International Corporate Governance Network (ICGN) is currently updating its Global Governance Principles, and as George Dallas (its Policy Director) highlighted at an event this February, there will be a “big emphasis” on the themes of boards as they develop their understanding of not only how ESG factors impact them, but on how their company impacts society in a broader context (…) this, in turn, leads to the need for good information and metrics to guide both executives, board directors, as well as give investors clues in terms of where opportunities and risks might lie.”

As the Alliance for Corporate Transparency research on corporate sustainability reporting shows, the problem is that sustainability information is often invisible to corporate decision makers, which makes it impossible for companies to make fully strategic decisions. Furthermore, from the point of view of investors and lenders, sustainability information is of little value if it is not clear how it is used by the company and reflected in strategy.

Larry Fink, founder and CEO of BlackRock (the world’s largest asset manager), in his notorious annual letter to CEOs, is directly asking companies in their portfolio to “disclose a plan for how their business model will be compatible with a net zero economy. We are asking you to disclose how this plan is incorporated into your long-term strategy and reviewed by your board of directors”.

Along similar lines, Rients Abma, executive director of Eumedion, an organisation that represents the interests of institutional investors with investments in Dutch listed companies, also stresses: “Sustainability risks and opportunities will impact the company’s ability to create long-term value and to promote the company’s long-term sustainable success. Consequently, proper and knowledgeable Board oversight on these subjects and meaningful reporting on the execution of that duty are extremely important for institutional investors”.

The need for a strategic approach

With respect to climate change risks, it is paramount that energy producers, manufacturers with high greenhouse gas emission intensity, and banks and investors urgently chart their long-term transition plans to survive – and ideally thrive on – the major market changes just beyond the horizon. A recent study by CDP showed for example that European companies had identified €1.22 trillion in new low carbon business opportunities, such as through higher demand for electric vehicles and green infrastructure. The value of these opportunities is more than six times the investment cost of €192 billion. Yet, Alliance for Corporate Transparency found out in its 2020 research of 300 European companies that less than 17% explain business opportunities related to sustainability challenges.

A critical step for companies to prevent or mitigate sustainability risks and impacts, is the adoption of targets and proper ways to monitor progress and results.

Alberto Carillo Pineda, co-founder of the Science-based Targets Initiative, confirmed that a growing number of companies are asking their suppliers to set science-based targets and noted how this would be a key component to accelerate their adoption and institutionalise the practice. In addition, he stressed that other actors and initiatives are pushing towards the same goal “All of these are necessary ingredients to really create an enabling environment and to make SBTs and the adoption of sustainability targets and strategies that are in line with planetary boundaries, our goals, a common practice.” The Alliance research positively noted that, in the last two years, there has been a 20% increase  in companies reporting science-based targets (improvements are concentrated in Spain with 41% of companies disclosing this type information, reflecting the clarification in the Spanish transposition of the NFR Directive that companies should disclose their climate targets).

A strategic approach to the governance of sustainability is also required where companies are connected to severe human rights and environmental impacts through their value chains. Companies will be increasingly expected by market mechanisms and by the law to assume responsibility in this area. In order to achieve the objectives set in the European Green Deal, severe impact by companies to society and the planet need to be mitigated, rather than perpetuating the current model of externalising and dissolving responsibilities across global supply chains. Such systemic problems include large scale deforestation and land grabbing linked to agricultural commodities such as soy, beef and palm oil; exploitation of workforce in garment and footwear supply chains or abuse of technologies by the clients of ICT companies.

Théo Jaekel, Corporate Responsibility Expert at Ericsson, is crystal clear in his support for the EU plans to introduce mandatory due diligence requirements: “We need to go beyond disclosure and move to the management of risks. It is important to see this kind of legislation as an opportunity, and not as a burden because it can clarify how the responsibility of companies looks like in the entire value chain in comparison to current uncertainties around how far-reaching responsibility is, and what can we actually expect from companies. If done correctly, it will alleviate these concerns”.

With regards to board oversight and management of sustainability issues, Mr Jaekel sees this as a crucial part of embedding due diligence requirements, rather than an issue to be solved by changing directors’ duties. “The targets we set at a group level, including environmental and human rights targets, are approved by the management and the board, their results are reported back to the board on a regular basis”.

John Ruggie, author of the United Nations Guiding Principles on Business and Human Rights, has recently explained the connection with human rights due diligence as follows: “By making human rights due diligence mandatory, with penalties for non-compliance as the EC intends, it becomes a legal responsibility not only for management but also for Board oversight.” In this context, investors as well as leading reporting frameworks, increasingly expect transparency on Board oversight over due diligence and materiality determination processes and how the results of these processes are reflected in the company’s strategy as a whole.

How can companies better report the ‘G’ in ESG

Reporting on the governance related matters concerning sustainability is addressed by leading reporting standards, including GRI, SASB and CDSB, as well as in the benchmarks developed by the World Benchmarking Alliance. The Recommendations of the Task Force on Climate Related Financial Disclosures, the standard for climate reporting endorsed by the international investors community as well as by the European Commission, includes board-level governance of an organisation’s climate risks and opportunities as one of the four main areas for disclosure. Similarly, the UN Guiding Principles on Business and Human Rights require the involvement of the most senior level of a company’s governance in discussing its salient human rights challenges, policies and targets, and in tracking progress.

The EU Non-Financial Reporting Directive requires companies to disclose strategic information, but it fails to provide clear guidance on how to determine which information is material and how to select relevant data and metrics from existing sustainability reporting initiatives and standards, which together include over 5,000 highly divergent KPIs. This, combined with proprietary questionnaires of rating agencies, investors and buyers in the supply chain, makes it very difficult for companies to approach reporting and sustainability from a strategic perspective.

In reaction to these problems, the reform of the EU Non-Financial Reporting Directive (see previous article here) will aim to help companies by clarifying which information should be reported on governance and integration of sustainability in corporate strategy. The European Project Task Force on Non-Financial Reporting Standards under the EFRAG has recommended in its final advice to the European Commission that future EU reporting standards should include a standard on “Strategy”, to be structured under three components: a) Overall business strategy b) Material sustainability risks, threats & opportunities and c) Sustainability governance & organisation. This overarching standard should be then supported by topical standards, for example on climate-related information, addressing Implementation (policies and actions) and Performance measurement (achievements and progress measured by KPIs).

Please click this link for the full version of the article, which includes an an overview of the three areas of information on governance and integration of sustainability that the reform of the EU Non-Financial Directive will seek to clarify.  

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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