The board of directors is responsible for the long-term success of a firm, including looking at how the company will operate in the future. Ouida Taaffe looks how companies can incorporate environmental, social and governance (ESG) into their operating models – and the regulatory risks they might face if they don’t.
Reaching net zero requires companies to change the way they operate. For some, such as oil majors, this will mean radical redirection. For others, like wind power generators, the shifts are likely to be less far-reaching. All, however, face transition risks that company boards will have to tackle.
One of the first hurdles will be mindset.
Chris McHugh runs our Centre for Sustainable Finance. “Initially,” he says, “Sustainability was seen as an extra task…and largely…as a bit of a burden or a cost. The journey that people have been on is to accept that it’s a business model for the future.”
Not all companies are at the same point in that journey, of course – though almost all have started.
Olivier Beroud is the Founder of LIBF’s Centre for Governance, Risk and Regulation. He points out that the main reason why firms are engaging with sustainability is that all their stakeholders think it’s important.
That means employees, suppliers and clients as well as shareholders. Regulators, too, are looking hard at sustainability, as are ratings agencies.
“There is a cost to not doing this,” says Beroud. “And just as exciting, there is also a great opportunity.”
What does being a sustainable company really mean?
Is being a sustainable company just about the firm hitting ESG metrics, or does it go deeper?
“The board is there to validate and set the strategy with senior management,” says Beroud. “So that's the first thing they should do. They should ask ‘how do we become a sustainable organisation?’”
To make the shift, of course, a board will need to be able to ask the right questions and to track and measure what’s going on.
Beroud says boards will have to look at a range of metrics, depending on their sector. So, a furniture manufacturer, for example, should be able to show that raw materials are sustainably sourced.
Just as they have auditors examining accounts or checks on health and safety standards – boards will require a clear view of whether sustainability ‘key performance indicators’ (KPIs) have been met. There won’t be any shortcuts.
McHugh points out that the United Nations’ (UNs’) Sustainable Development Goals (SDGsweren’t designed to be an investment framework and they don’t tell firms how to transition. What’s more, meeting the KPI numbers won’t be enough.
“If someone asks a board ‘how do you affect the environment?’ or ‘what social issues are you touching?’ boards should be able to answer,” McHugh says.
“They should know what good governance means to them and then have the data to explain and evidence that.”
ESG risk, regulation and financing
There are a number of reasons why clear assessments of ESG risk will be “at the core in the engine room of businesses” says Beroud.
Regulation is one. Beroud points out that the Bank of England is asking banks to include environmental risk in their risk frameworks.
“So, from a fairly general and slightly woolly objective that might have been connected in some cases to exclusion lists, suddenly it becomes core, central and therefore very important.”
Financing too will be a potent driver. McHugh expects investors and banks to “actively look for companies that live this process”. And companies that focus on ESG are likely to have a lower cost of capital and better access to funding. This will happen ahead of regulation, McHugh says.
Last, but not least, there will be corporate-to-corporate influence – often through the supply chain because big firms will want to reduce the risk of exposure to ESG problems, but also because big firms will want to be good corporate citizens.
See our Centre for Governance, Risk and Regulation
More about our Centre for Sustainable Finance