Striking the right balance

The investment community’s interest in Environmental, Social and Governance (ESG) data has attracted much coverage. Less considered are potential, unintended consequences from too much governance focus on ESG issues, to appease institutional investors.

They include rising board workloads from ESG-related issues, a blurring of executive and director roles on ESG, disclosure risks and extra reporting costs. Perhaps the biggest risk is listed-company boards taking their eye off the main game: financial performance.

That is not to downplay the importance of ESG or suggest all boards face these risks. Evidence so far suggests Australian boards collectively have reasonable balance in ESG monitoring and disclosure – and are responding to market concerns on ESG issues.

Good progress on ESG issues, from boards and the investment community, is being made. It has taken time, but both sides understand the importance of non-financial data in investment decisions and that future earnings are not the only determinant of company value.

ESG oversight, reporting and disclosure are, of course, vital board tasks. A hallmark of good governance is the ability of boards to consider and manage all material risks facing their organisation, including ESG risks. High-performing boards look beyond financial risks.

The question is how far this trend runs and whether some boards over-reach on ESG issues at the expense of strategy oversight, succession planning and other critical board tasks. Or if some boards bog themselves down in more ESG compliance box-ticking that adds little value.

ESG workloads increasing

I recently interviewed several current or former chairs of ASX 200 companies on ESG and investor relations for AICD Company Director Journal (the story will be published next year). I was struck by the amount of extra work boards are doing on ESG issues.

Some chairs said their meeting schedule with investors had substantially increased and that half of many meetings were now spent on ESG-related issues. The upshot is chairs spending more weeks each year with investors in Australia and overseas, to discuss a wider range of ESG issues.

Five years ago, an ASX 200 company chair might have met with a few key Australian institutions on the share register to discuss executive pay, board and management succession planning and other core governance tasks. Today, the same chair could meet with beneficial asset owners, fund managers and other investment intermediaries, proxy advisers, ESG analysts and investor associations here or overseas.

Topics discussed could range from the organisation’s human-rights approach, climate-change-exposures, diversity at management and board level, occupational health and safety, employee turnover and myriad other ESG-related issues.

Each topic is worthy, but requires preparation and communication by chairs, whom investors expect to be across a huge range of issues.

More ESG topics are being added: latest governance guidelines from the Australian Council of Superannuation Investors include “tax transparency” in a new chapter on ESG risks and opportunities. Investors want more information from boards on the appropriateness of the organisation’s tax-planning approach and their oversight of it – another topic that adds extra complexity and work for boards on ESG monitoring and reporting.

Boards must be on top of these topics. But there is a limit to what the market can reasonably expect from a board of mostly independent, non-executive directors. Part-time directors do not have the same depth of knowledge on these issues as executives who work each day in the business. Nor are directors paid like full-time executives.

Expecting detailed information from boards on human-resource issues, for example, may be getting too granular from a governance perspective. These are management issues.

Excessive focus on ESG data, should it occur, could push more non-executive directors towards management-type work – a trend that benefits nobody in the long run.

The workload of chairs is another issue. Do we want chairs of ASX 200 companies spending so much of their time on ESG-related issues and investor meetings?

Disclosure risks are another issue. Boards need to understand which ESG risks, such as climate-change exposures, may be material financial risks and so must be reported, to comply with continuous disclosure rules. But there is a danger that reporting unnecessary ESG information or forward-looking statements opens organisations to attack from local or international shareholder activists, non-government organisations and the media.

Another risk is boards over-responding to the market’s ESG demands with cumbersome governance structures. There has been talk overseas of boards needing to form shareholder-engagement committees, the firm’s investor relations officer reporting to the board, and the ESG/investor relations workload being shared across more directors to help the chair.

That is folly. Another new sub-committee is not the answer. Investor relations officers should report to management, and having directors beyond the chair of the main board or chair of the remuneration committee meet independently with investors is dangerous. It can lead to mixed messages in the market from directors, or views different to those of management.

Good reasons for a measured ESG approach

Nevertheless, as agents of shareholders, boards must respond to investors’ demands for extra ESG oversight and reporting – and respect their views on this topic. They should understand why more investors than ever are focused on ESG opportunities and risks.

Numerous academic and financial studies show ESG leaders outperform ESG laggards over time. Macquarie Group research in December found companies with top ESG scores in its dataset had outperformed low-ESG companies by 2.7 per cent annually since 2011.

Risk management is another reason for greater ESG focus. Organisation-culture problems have wiped billions of dollars off the market value of Australia’s banking sector, for example. Too many corporate scandals stem from inadequate ESG monitoring by boards.

Moreover, ESG is fundamental to an organisation’s “social licence” to operate and part of a changing conversation between companies and owners around long-term issues, rather than mostly short-term results. Done well, ESG can help companies communicate with communities, not only shareholders, and boards to think more broadly as stakeholders’ custodians.

The key is moderation. As with most governance trends, boards need a careful, incremental response to ESG that evolves over years, not a kneejerk reaction. The focus should be on ESG issues that add or detract most value, not peripheral topics that attract quick headlines or help activists raise their profile.

Ultimately, the board’s main task is to choose the right CEO, incentivise him or her and monitor performance. Then to help guide strategy and its implementation, and to ensure the organisation has appropriate risk-management frameworks and compliance.

ESG has a role in all that, but should not divert too much board focus.