ESG – Board of Directors and Auditor Matters
In a series of blogs, that is likely to be an ongoing topic for the foreseeable future, I have been discussing the barrage of environmental, social and governance (ESG) related activity and focus by capital markets regulators and participants. Climate change initiatives and disclosures have been singled out in the ESG discussions and as a particular SEC focus, and as such was the topic of the first blog in this series (see HERE). The second blog talked more generally about ESG investing and ratings systems and discussed the role of a Chief Sustainability Officer (see HERE). The last blog on the topic focused on current and prospective ESG disclosure requirements and initiatives, including the Nasdaq ESG Reporting Guide (see HERE).
ESG is not just a topic impacting social position disclosures but can go directly to the financial condition of a reporting company, and as such its financial statements. Accordingly, ESG reporting requires auditor and audit committee engagement.
Board of Directors, Audit Committees and ESG Disclosures
The “G” in ESG generally refers to the governing structure, policies, and practices employed by a company related to responsibilities and decision-making rights that provide the foundation for overall accountability and credibility. In other words, the “G” goes directly to corporate governance and internal controls, the oversight of which rests with the board of directors and its audit committee. Although not a completely new topic, ESG has gained momentum following the Covid-19 pandemic and social justice movement, prompting many companies to take a proactive instead of reactive approach to the matter.
A company that is either merely reacting to the ESG disclosure pressure or that simply has not developed an ESG thought process as of yet, generally does not have a system in place that integrates ESG considerations into its management decision ecosystem, nor does it have active board oversight on the topic. These companies are now developing controls and procedures that include reporting to and updating board members, creating accountability, often hiring a Chief Sustainability Officer and creating a reporting regime within the company that abides by specific standards. Although I am still skeptical on ESG-driven management decisions as a whole (my thoughts align more with Jay Clayton and Hester Peirce), the train has left the station and I wouldn’t be surprised if, in the near future, it goes so far as to include executive compensation tied to ESG performance.
Board oversight of an entity’s ESG reporting is critical for establishing and maintaining good governance, policies, and controls over the ESG reporting process. The board of directors’ responsibilities extend beyond simply reviewing past disclosures or current systems, but also include being proactive and ready for future implementation of new processes. Where ESG matters impact financial statements, oversight clearly lies with the audit committee of the board of directors, but the nominating and governance committee clearly has a role, and many boards are forming a separate ESG/Sustainability committee.
Where a board of directors is considering hiring a third party, such as its audit firm, to provide ESG attestation (and thus give assurances), it should be informed about (i) the purpose and objectives of the ESG information (SEC reports; separate sustainability reporting; future planning; investigation of potential deficiencies, etc..); (ii) the intended users of the ESG information (internal; public filings; investors; ratings organizations); (iii) why the intended users want or need the information; (iv) the potential risks associated with misstatements or omissions; (iv) the type of ESG information intended users are expecting; and (v) the level of ESG attestation service that will achieve the goals (full audit, review, etc.).
Regardless, all boards of directors should be considering (i) what are the company’s policies and processes with respect to the gathering and reporting of ESG information; (ii) how old or dated is the current available information; (iii) who in the company has responsibility for the oversight of ESG information; (iv) is ESG information material to or included in financial statement reporting; (v) what are the company’s internal controls vis-a-vis ESG information gathering and reporting; (vi) have ESG-related internal controls been tested; and (vii) what disclosure controls and procedures and related documentation are available for ESG information.
Auditor Role in ESG Disclosures
Generally, an auditor is only responsible for information contained in an SEC registration statement or report. However, under PCAOB auditing standards, an auditor must at least read the balance of a filing, including ESG information to ensure that such information is consistent with, and at least not materially inconsistent with, the financial statements and notes thereto. Where sustainability reports are presented by a company, either on its website or as an exhibit to a SEC filing, an auditor would have no responsibility for the information contained in those reports.
However, in today’s ESG-centric environment, some companies are seeking third-party assurance on its ESG information. Third-party assurance can (i) assist the board of directors in assessing the quality of ESG disclosures and in overall company oversight; (ii) enhance the reliability of ESG information for investor analysis; (iii) enhance management’s confidence in the integrity of the company’s disclosed ESG information; (iv) assist stakeholders such as customers, suppliers and prospective employees in making ESG based relationship decisions; and (v) impact a company’s ESG rankings and rating on sustainability indices (such as the Dow Jones Sustainability Index).
Public company auditors have stepped up to fill this role and are now regularly being engaged by their public company clients to provide ESG-related assurances. Other third parties, such as engineering or consulting firms, are also competing for this business. Where a public company audit firm is retained, they are guided by the American Institute of CPAs (AICPA) Statements on Standards for Attestation Engagements. That is, where an auditor is engaged to provide ESG attestations, they must comply with standards involving data and systems testing and evaluating evidence and procedures. Accordingly, there is a belief that auditor ESG assurances are reliable.
As when engaged to perform an audit, the auditor engaged for ESG matters must: (i) be independent of the company; (ii) be skilled in understanding the company including its business and processes; (iii) have the resources, such as specific expertise, to provide the requested services (think expert on greenhouse gas emissions); (iv) are required to plan and perform attestations with professional skepticism; (v) are experienced in reporting on compliance matters (not just standard audits); (vi) are required to maintain a system of quality controls; and (vii) are required to maintain continuing professional education and other licensing requirements. A company will often retain the same firm that is performing its regular audit work as that auditor will have a depth of knowledge about the company making the ESG attestation more economical and efficient.
Generally, an auditor’s ESG attestation is made more reliable because of their requirement to test against specific standards. Those standards must be recognized as reliable, such as those published by the Sustainability Accounting Standards Board or the Global Reporting Initiative. Where a company makes a broad statement related to ESG matters not supported by evidence or capable of being measured against a specific metric, the auditor would not be able to provide assurance.
Moreover, just like the difference between an annual audit and quarterly review of financial statements, an auditor can be retained to provide a full independent report and opinion on ESG information or a more limited review such as for material deficiencies with no separate report. An auditor may also provide consulting services helping a company determine its ESG reporting systems, internal controls and best metrics and standards.
« Section 12(g) Registration The MEMX »
ESG Investing and Ratings
As I mentioned in the last blog in this series on ESG, back in September 2019, when I first wrote about environmental, social and governance (ESG) matters (see HERE), and through summer 2020 when the SEC led by Chair Jay Clayton was issuing warnings about making ESG metric induced investment decisions, I was certain ESG would remain outside the SEC’s regulatory focus.
Enter Chair Allison Herron Lee and in a slew of activity over the past few months, the SEC appointed a senior policy advisor for climate and ESG; the SEC Division of Corporation Finance (“Corp Fin”) announced it will scrutinize climate change disclosures; the SEC has formed an enforcement task force focused on climate and ESG issues; the Division of Examinations’ 2021 examination priorities included an introduction about how this year’s priorities have an “enhanced focus” on climate and ESG-related risks; almost every fund and major institutional investor has published statements on ESG initiatives; a Chief Sustainability Officer is a common c-suite position; independent auditors are being retained to attest on ESG disclosures; and enhanced ESG disclosure regulations are most assuredly in the works.
Investors are focused now more than ever on ESG matters. The world is experiencing an enormous intergenerational wealth transfer concurrently with the rise of Robinhood type trading platforms and digital asset acceptability that value ESG in making investment decisions. Heavyweight investors are also on board. In his annual letter to CEOs, Larry Fink, head of giant BlackRock, was very clear that he wants to see climate disclosure including a net zero plan and board responsibility for overseeing such a plan.
One thing has not changed and that is that the system of “rating” or “scoring” a company based on all things ESG is extremely over-inclusive and imprecise. The Aggregate Confusion Project from Massachusetts Institute of Technology (MIT) found that “It is very likely…. that the firm that is in the top 5% for one rating agency belongs in the bottom 20% for the other. This extraordinary discrepancy is making the evaluation of social and environmental impact impossible.”
In a series of blogs I am tackling the wide and popular current ESG conversation. In the first blog, I focused on climate change initiatives (see HERE). In this second blog I am discussing ESG investing, ratings and the role of a Chief Sustainability Officer, and the third blog will be on ESG disclosures in general.
Backing up – What is “Environmental, Social and Governance” or “ESG”
It is clear that ESG matters are an important factor for analysts and investors and thus for reporting companies to consider. It is also clear that companies have increasing pressure to report ESG matters and will be judged on those reports by different groups with different criteria in a current no-win environment (pun intended).
In the broadest sense, “Environmental, Social and Governance” or “ESG” refers to categories of factors and topics that may impact a company and that investors consider when making an investment and analysts and proxy advisors consider when making recommendations about investments or voting matters for corporate America. However, from a micro perspective, ESG means different things to different constituencies and has become a sort of catch-all phrase for a spectrum of topics ranging from very real and serious societal issues to the topic de jour touted by paid special interest groups and influence peddlers.
The G (governance) in ESG is a little more concrete, including, for example, whether there are different share classes with different voting rights, the ease of proxy access, or whether the CEO and Chairman of the Board roles are held by two people. The environmental category can include, for instance, water usage, carbon footprint, emissions, what industry the company is in, and the quantity of packing materials the company uses. The social category can include how well a company treats its workers, what a company’s diversity policy looks like, its customer privacy practices, whether there is community opposition to any of its operations, and whether the company sells guns or tobacco.
However, once a topic is fitted into a category, the measurement of that category and the meaning behind the information are much more nebulous. Furthermore, ESG topics are being heralded by non-shareholder stakeholders influencing investors. A number of self-identified ESG experts have developed and many groups produce ESG ratings. The ratings are not standardized, and as such the analysis can be arbitrary as it may treat similarly situated companies differently and may even treat the same company differently over time for no clear reason.
ESG Investing and Ratings
It is clear that ESG matters carry great weight with the investment community, especially powerful investors such as hedge funds, ESOPs, pension funds, family offices, unions, and private equity groups, and as such companies cannot ignore potential ratings and analyst coverage on these matters. Investors are pouring billions into asset managers who proclaim ESG who are in turn pumping out new ESG products (I can’t help but think about the mortgage bundling and complicated hedging products created around it right before the housing bubble in 2007-2008).
However, just like with ratings organizations, ESG fund managers and ESG products are not standardized in their meaning. As Commissioner Roisman said in a recent speech:
“When an asset manager markets a fund as having an ESG strategy, it has an obligation to disclose material information about that fund to investors and potential investors. Additionally, it would make sense to me that asset managers who want to use these terms to name their funds or advertise their products should be required to explain to investors what they mean. How do the terms “ESG,” “green,” and “sustainable” relate to a fund’s objectives, constraints, strategies, and the characteristics of its holdings? Are “E,” “S,” and “G” weighted the same when selecting portfolio companies? Does the fund intend to subordinate the goal of achieving economic returns to non-pecuniary goals, and if so, to what extent?”
Also, it would not make sense for ESG to mean the same thing for different funds. That is, one investor may be much more interested in investing in a fund that is concerned with renewable resources while another wants one focused on social issues such as diversity. I note that the same issue presents itself when talking about a standardized ESG disclosure regime, which I will talk further about in another blog in this series.
Irrespective of the difficulty in defining ESG, it is clear that index funds and long-term investors are interested in long-term value for their portfolios. In order to preserve long-term value, a fund or investor must have a diverse portfolio that mitigates systematic risk including climate change risk, financial stability risk and social stability risk. This long-term portfolio management means that not every investment will be a winner and not every investment will consider ESG, but a diverse portfolio definitely involves ESG considerations.
We also now have an ESG friendly administration, meaning that ESG issues could find more support by the SEC for inclusion in a company’s annual proxy statement. Shareholder proposals such as demands for reporting of greenhouse gas emissions, gender and race issues in the workforce and of course more on climate change, have historically been blocked as involving ordinary management decisions or micromanagement of the corporate structure. Under the new administration, these proposals may survive attack and appear on proxy statements for shareholder approval.
Likewise, the new administration is likely to support regulatory changes that will either directly or indirectly impact public companies. For example, near the end of the Trump administration the Department of Labor (DOL) passed rules that would prohibit ERISA fund managers from considering factors, that were not directly cost benefit based, such as ESG, in making voting and investment decisions for retirement funds. On March 10, 2021, the DOL announced that it will not enforce these new rules. Rather the DOL recognizes the use of ESG considerations in improving investment value and long-term investment returns for retirement investors and as such fiduciaries will not be prohibited from using these factors in any voting or investment decision analysis.
Who is a Chief Sustainability Officer
The time and expense of covering ESG ratings and attracting ESG investors is substantial. Enter a Chief Sustainability Officer (CSO). A CSO is now a common position in Fortune 500 companies and growing in all sectors. In addition to fielding the numerous ratings organizations and assisting management with messaging on ESG matters, a CSO is generally responsible for reviewing and helping to formulate ESG policies. These policies include both engaging in more socially responsible activities (investments in climate change initiatives) and reducing irresponsible activities (reducing pollution from corporate plants or changing materials to make products more sustainable). A CSO will also be integral in assisting with compliance with the existing and new climate and ESG disclosures in general.
Importantly, a CSO has the potential to reduce the impact of third-party ratings organizations. Until there are standardized rating systems in place, third-party ratings remain arbitrary and capricious. A CSO can work on data and analytics that are presented to rating organizations and analysts that reduce the information gaps and analyst irregularities. A CSO can also put programs and messaging in place for direct corporate engagement with the investment community related to ESG matters.
It is now commonplace for a company to issue sustainability reports and those reports, although not generally currently filed with the SEC, are made publicly available on a company’s website. A CSO should likewise be integral in the reports contents and importantly communicating its meaning to the board of directors.
Regardless of the noise surrounding ESG, there is no doubt that ESG is an important factor in Enterprise Risk Management (ERM) and must be understood and considered by a board of directors in its duties for ERM oversight. An effective CSO must be able to help the board unpack these issues as well.
« ESG Matters – What a Difference A Year Makes ESG Disclosures – A Continued Discussion »