How can boards strengthen governance to accelerate their ESG journeys?

Authors
Julie Linn Teigland

EY EMEIA Area Managing Partner and EY Global Leader – Women. Fast forward

Passionate about the transformational power of digitalization and innovation and its potential to deliver sustainable, inclusive growth for clients. Prominent voice of the Women20 global agenda.

Andrew Hobbs

EY EMEIA Public Policy Leader

Public policy leader focusing on talent, technology, corporate governance and corporate reporting. Father of four, cyclist and dabbling homebrewer.

20 minute read 17 Feb 2022

With a spotlight on sustainability, European boards must address ESG factors to out-pace competition and gain new sources of value creation.

In brief
  • European companies and boards are putting ESG at the heart of their strategy to build risk resilience, while also driving new growth opportunities.
  • Success means addressing major external and internal challenges, including economic uncertainty and the need to establish a clear ESG mandate for the board.
  • Three priorities will support strategic ESG decision-making: the right board operating model, innovative approaches to reward and effective ESG reporting.

We are at a turning point in the sustainability and environmental, social and governance (ESG) agenda. From within the organization, executives are passionate about making a difference to the planet as well as building their companies’ resilience and long-term value. From the outside-in, we have reached the point where investors, employees, consumers and the wider public simply expect a company to be actively addressing ESG priorities and opportunities. The sustainability agenda is redefining the relationship between European companies and their employees and stakeholders – businesses should act now to ensure they stay ahead of this transformation.

As well as providing a route to greater risk resilience in the face of increasing disruption, latest EY research shows that executives today believe that ESG is, above all, a major commercial and growth opportunity. For leading companies, it will be a route to innovation across products, services and even business models, allowing them to shape the future of their industry and stay a step ahead of disruption.

In fact, by deploying an ambitious long-term value approach that proactively addresses ESG factors, a company can out-pace its competitors, improve profitability and unlock new sources of value creation. To help guide European companies on this next evolution in governance, EY teams have conducted this second edition of its Long-Term Value and Corporate Governance Survey, building on inaugural EY research in November 20211. Respondents were split across 15 European countries and 25 industry segments.

Through this article we explore some of the key themes that will enable boards to position themselves effectively to tackle oncoming sustainability challenges whilst capitalizing on emerging opportunities. These themes include:

  1. Integrating ESG into a long-term growth strategy
  2. External and internal challenges facing companies today
  3. Three priorities that support strategic decision-making on ESG
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Chapter 1

Integrating ESG into a long-term growth strategy

Companies and boards putting ESG at the heart of their strategy can build risk resilience, while also driving new growth opportunities.

The ESG imperative: ESG factors are top of mind for consumers, employees and broader society

Today, leaders and board members recognize the importance of ESG factors in meeting the changing expectations of corporates:

  1. Eighty-four percent say “the COVID-19 pandemic increased expectations from stakeholders that their company will drive societal impact, environmental sustainability, and inclusive growth”.
  2. Eighty-six percent say “a focus on ESG and sustainable, inclusive growth have been critical to building trust with their stakeholders in today's uncertain times”2.

While it is clear from the research that board directors and executive leaders within Europe recognize the importance of the ESG agenda to driving long-term value, questions remain about how far these issues have been integrated into the company’s overall strategy and the oversight responsibilities of boards. If the organization’s approach is still at an early stage, there could be a significant gap between company “pledges” on sustainability and tangible results and action.

There is also the risk that companies will be focused purely on the “now” of ESG rather than also having one eye on the future. The sustainability agenda moves very fast. 

ESG agendas unlock long-term value when tied to governance and enveloped in a spirit of collaboration.
Julie Linn Teigland
EY EMEIA Area Managing Partner
Staying ahead of a fast-moving ESG agenda

Before we explore the progress that companies have made in their sustainable governance agenda and what they are planning to achieve with their efforts, it is worth clarifying some key concepts when it comes to ESG:

  • ESG is a broad concept and leaders will still need to decide what ESG themes should be prioritized, what results are being targeted, and the expected timeframe. This involves a detailed materiality assessment and making these fundamental strategic choices is one of the most challenging and time-consuming tasks facing companies today.
  • ESG objectives need to be integrated into the overall strategy of a company, not discussed and executed in isolation. This is to ensure conflicts with other strategic targets – such as financial goals – are identified and considered holistically so that they can be resolved or so that necessary trade-offs are properly understood.
  • Spotlight on the policy and regulatory agenda

    There is real impetus behind the reporting regulatory agenda. A number of regions and countries in Europe are making significant moves when it comes to mandating ESG disclosures and driving the quality of reporting, including the EU with its Corporate Sustainability Reporting Directive (CSRD). As EY teams outlined in How the EU’s new corporate sustainability reporting directive will be a game changer, the CSRD marks a step change in reporting and in the assurance of nonfinancial information3.

    The CSRD will apply to listed EU companies over a certain scale– and requires that they report against mandatory sustainability reporting standards related to environmental matters, social matters and treatment of employees, human rights, anticorruption and bribery, diversity on boards.

    Key proposals also include the following:

    • Double materiality (not only how sustainability issues affect the company but also how the company affects the environment and society)
    • Mandatory third-party assurance of the reporting
    • ESG information to be included in the management report and digitally tagged
    • Companies to report in 2024 for fiscal year 2023, though there is a possibility this will be delayed.

    Read more about the EU Corporate Sustainability Reporting Directive in our report (pdf). 

Robust governance: a key success factor in driving long-term, sustainable growth

Robust governance will be key to meeting changing stakeholders’ expectations, building risk resilience, and seizing the growth opportunities of the ESG agenda. One example would be the need for strategic decision-making that effectively balances near and long-term value creation.

In this year’s survey, over half of respondents – 55% – say that “there are significant differences of opinion within their leadership team on how to balance short-term considerations with long-term investments and sustainable growth.” While this is slightly down from the 60% who said the same in the 2021 survey, it is still a major issue for the board. If we look at just the board chairs and non-executive board directors in our survey, the number who say there are significant differences of opinion climbs to 68%.

While companies will be at different stages in their ESG journey, the survey shows that – overall – boards and CEOs are making encouraging progress in putting in place the governance frameworks needed to drive a long-term, multi-stakeholder orientation. For example, around a third (30%) feel they have made very significant progress in putting in place the controls and risk management system needed to address material ESG risks (see Figure 1). While this progress is encouraging, not least because it shows that this area is a priority, there will of course be more to do in terms of execution as well as striving for continuous improvement.

Opportunity and risk: creating and protecting sustainable long-term value

The risks related to ESG issues – from the resource dependency and scarcity issues linked to biodiversity loss or the potential disruption from physical environmental issues such as extreme weather events – are some of the most profound and challenging facing today’s businesses.

Having an internal control and risk management approach that mitigates these issues is key to maintaining performance and securing the long-term future of the organization. But at the same time, leading companies are also finding new revenue and growth opportunities as markets and the competitive landscape evolve in line with ESG factors. In fact, as Figure 2 shows, driving revenue growth from ESG-conscious consumers is seen as the main advantage of incorporating ESG factors into corporate strategy, even outweighing risk resilience in second place.

Finally, while “attracting ESG-focused investors” falls into sixth place, it is still the main focus of a quarter (25%) of respondents. However, given the inflow of capital into ESG-focused funds worldwide, and increasing investor scrutiny of companies’ sustainability performance in their investment decision-making, this remains a critical issue for companies and their access to capital markets.

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Chapter 2

External and internal challenges facing companies today

To deliver against their ESG agenda while managing significant volatility, companies need to clarify the board’s sustainability mandate.

While encouraging progress has been made in how leaders and boards govern their organization’s approach to long-term value and ESG factors, significant internal and external challenges stand in the way of delivering on an ambitious ESG agenda. In particular, survey respondents point to two issues:

  • Externally, they are concerned about near-term economic uncertainty, no doubt reflecting in part the continued market disruption caused by COVID-19 variants.
  • Internally, they are concerned about whether boards have yet established a clear mandate for integrating ESG factors into major strategic decision-making. This, of course, is also a critical requirement for addressing the external challenge of increasing volatility. The ability to respond quickly and effectively to volatility and disruption – and set a new direction for sustainable growth – requires decisive, integrated leadership that focuses on long-term business resilience and not just immediate short-term crisis response.
Robust and innovative corporate governance approaches are critical for getting on the front foot with ESG.
Andrew Hobbs
EY EMEIA Public Policy leader

Challenge one: How to drive long-term value in a volatile and challenging macro-economic environment

As European leaders and boards look to make the long-term decisions needed to manage major risks and seize ESG growth opportunities, they are faced with significant uncertainty in their domestic and global markets. And this is not just an issue for companies that see a challenged future for their company. Figure 3 shows, “near-term economic uncertainty” is the primary challenge for both companies that are optimistic about their growth prospects and those that are more concerned.

The uncertainty caused by a range of issues – from disruption caused by COVID-19 pandemic variants, to supply chain interference due to extreme weather events – is a top-of-mind issue for all executives and boards seeking to make long-term investments and decisions.

Economic uncertainty is driven by a range of concerns, such as geopolitical instability, inflation and talent shortages. It is also likely that the COVID-19 pandemic will continue to make its presence felt in the long-term, as we learn to live with its “long-tail” effects. Overall, the impact of the pandemic – and the clearer understanding it has given us of the devastating impact of black-swan events – have raised concerns about the challenges of delivering long-term value when there is so much uncertainty about the future economy and potential disruption.

Challenge two: How to generate long-term value when the board’s role in ESG is still evolving

To unlock the value of a company’s ESG agenda, a clear-sighted focus on the long-term is critical. Boards play an essential role in aligning ESG initiatives with the strategic direction of the company, ensuring it is focused on material topics (both risks and opportunities), establishing targets and accountability, and assessing the company’s performance at a company-wide level. While ESG implementation will be devolved to individual business units, boards play a central role in establishing a clear strategic direction, focusing on the long-term, and developing a plan to avoid fragmentation and duplication.

However, the research shows that the board’s role in ESG is still evolving and that there is a need to strengthen the role of the board in ESG strategy. As Figure 4 shows, the major internal challenge facing companies today when it comes to generating long-term value through a strong ESG proposition is “lack of commitment from the board to make decisions that fully integrate ESG factors and create long-term value”. Today, 43% of respondents identify this as a significant challenge, up from 28% in 2021.

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Chapter 3

Three priorities that support strategic decision-making on ESG

An effective board operating model, new approaches to reward and remuneration and ESG reporting will support long-term sustainable growth.

Board oversight: ensuring your board is equipped to deliver against its ESG goals

Creating an agile board operating model

The move to a sustainable economy raises questions about whether some boards need to rethink their core operating model and whether they have the agility to respond to a fast-changing environment. Do they have the credible, forward-looking data they need and the digital tools to analyse its implications?  Are they devoting enough time to the ESG agenda, given the many demands on their time?

On this latter question, as Figure 5 shows, the amount of time that boards devote to ESG topics has increased significantly. Two years ago, for example, only 15% used to discuss the ESG agenda and reporting at every meeting. Today, 49% do so, with another 33% discussing these issues frequently.

 
Diversifying your board composition

Diversity of skills, experience, outlook and culture – encouraged by a focus on areas such as diversity of gender, race or age – leads to different ideas and thinking. This, in turn, is critical to the “combinative” thinking needed to find innovative solutions to complex ESG issues. Diversity has been shown to result in better problem-solving and decisions, helping ensure that assumptions and entrenched beliefs are challenged, and different perspectives are aired.

Building your board’s skills and ESG expertise

Building the board’s ESG awareness, skills and knowledge is critical if they are to ask the right questions and challenge management on sustainability topics in the short- and long-term. As well as including sustainability skills as criteria when assessing new candidates for supervisory boards, other interventions can help existing board members build their ESG expertise. One example would be putting in place advisory groups for the board, perhaps including academics or scientists that have a particular understanding of environmental or social issues. 

  • Key recommendations: equip your board to achieve its ESG goals

    Boards and leaders can take a number of steps to build effective board oversight through the right operating model and composition and skills.

    Operating model and committee structure
    • The right structure in terms of board oversight is a complex issue. Many companies will assign responsibility to a committee – either a dedicated sustainability committee or an existing one, such as the audit committee. The other approach is to give ESG responsibility to the board as a whole. There are important success factors when it comes to these respective choices.
    Composition and skills
    • Based on the organization’s strategy – and its ESG priorities – assess the skills needed to deliver and whether today’s board – as well as critical senior executives – possess those skills currently. Then, put in place a specific plan to address critical gaps and regularly assess the picture.
    • Revisit the board’s approach to learning and development, putting in place programs to build understanding of the key trends and considerations for a sustainable business. This should include understanding of major ESG risks as well as opportunities.
    • Provide exposure to expertise – as well as new perspectives – by considering introducing external advisory boards, including scientific and academic expertise

    Read more key recommendations in the report (pdf).

Leveraging reward programs: including remuneration and incentive plans

There has been heightened investor focus on how companies operationalize their ESG goals across their organizations over the last 24 months. Key investor focus areas include the identification, measurement, and assessment of ESG performance metrics to foster accountability and create long-term value.

A strategic lever that can be used to enhance leadership accountability on sustainability is executive remuneration and incentive plans. Survey respondents recognize this focus on accountability: 75% say there is more focus today on the personal responsibility and accountability of board directors and management teams for whether a company is making progress against ESG goals.

The research asked respondents to think about the governance changes needed to support their approach to ESG and long-term value and then identify the major changes they have made over the last two years to reinforce accountability and what the priorities will be for the future. As Figure 6 shows, remuneration will be the main focus over the next two years. 

While the goal is clear, the design and implementation of ESG-focused remuneration schemes is more complex and challenging. While alignment of ESG and executive remuneration is a key tactic, it is not a remedy that will solve every sustainability issue. This topic has many nuances that demand specific consideration and evaluation if approaches are to be effective.

Issues surrounding ESG-focused remuneration schemes
  • Before compensation schemes are defined, organizations need to align on the right metrics and KPIs, time horizons and monitoring and governance structures, which can be challenging to define and assess. Companies need to evaluate their strategy and determine which metrics are most relevant to them, while ensuring that focus is given to all three pillars of E, S and G. This will vary by sector, based on different industries’ unique sustainability profiles.
  • There is the question of how much is results- and output-based and what scale is appropriate. For example, just rewarding a CEO on output results could ignore the stellar work she or he has done in changing processes or culture to achieve a goal, such as driving diversity. Also, when it comes to results, there needs to be clarity on how the scale runs from “acceptable achievement against results” to “high-performance”, so that meaningful progress is also assessed and rewarded.
  • There is the question of materiality, or how much compensation to tie to ESG measures. If companies are going to change executive behaviour and drive long-term performance, they need to ensure that a meaningful portion of pay is at stake. Based on their experience, EY remuneration professionals believe that companies must identify a material level of pay be connected with ESG goals and objectives, with clear performance targets to make a meaningful impact. 
  • Key recommendations: incentivize the generation of sustainable growth

    Boards can consider the following guidance as a starting point to evaluate what is right for their company:

    • Align metrics with the company's ESG strategy.
    • Determine what metrics and in what percentages make sense in the short- and long-term: benchmarking by sector, by position and the characteristics of the metrics (i.e. measurable, understandable etc). Benchmarking will also be important so that boards can show that what they propose is in line with the company’s peer group.
    • Build transparency and effective communication to markets, shareholders and employees. If the ESG goals that leaders are tasked with achieving are too vague it will be impossible for stakeholders – such as investors – to hold remuneration committees to account.
    • Examine the wider roll-out of ESG-focused reward programs within their company. While executive remuneration is a focus of governance and board oversight, building a sustainability culture across the enterprise – and mobilizing staff behind the ESG approach – can also involve introducing ESG priorities into broader total reward programs (e.g., “green reward” programs that incentive wider groups of employees to embrace sustainable behaviors).

Trust and transparency: effective reporting to steer the business and support investor engagement

Corporate reporting is increasingly expected to include enhanced and material ESG disclosures alongside other information to show how a company is driving value for all stakeholders. There is increased pressure on corporates and their leaders to improve their ESG reporting – from equity investors, insurers, lenders, bondholders, and asset managers as well as customers. All these stakeholders want more detail on ESG factors to assess the full impact of their decisions. 

CEOs and boards need to move quickly to meet stakeholders’ expectations and articulate a unique narrative on how they create long-term value. In the latest EY Global Corporate Reporting survey, 74% of more than 1,000 CFOs and finance leaders surveyed said that they had seen an acceleration in the past 12 months in “the transition from traditional financial reporting to an enhanced reporting model that encompasses financial and ESG reporting”4

In this Long-Term Value and Corporate Governance Survey, as Figure 7 shows, around a third of companies are “very satisfied” that the ESG disclosures they share with stakeholders are completely trustworthy (35%), material (31%) and clearly communicated (33%).

  • Key recommendations: use enhanced reporting to engage investors

    Boards and leaders can take a number of steps to move to an “enhanced reporting” model, where stakeholders are provided with consistent and credible ESG disclosures on material issues alongside the financial reporting that companies traditionally disclose:

    • Better understand the climate risk disclosure element of ESG reporting. Companies around the world are undoubtedly making progress on climate risk disclosure, spurred by growing demand from investors, regulators and the public. But there is growing pressure for them to do more.
    • Deepen engagement with investors and understand how new ESG disclosure requirements could differentiate the organization from competitors. EY research has shown that investors view a company’s ESG performance as pivotal in their investment decisions. As well as the existing ESG information that companies provide, issuers should understand what kind of new information investors are demanding, and how well prepared they are to access and disclose the relevant data.
    • Make strategic use of both the sustainability and the finance functions to help inject rigor and materiality into ESG reporting. Investors care about the veracity and credibility of companies’ ESG performance data, including whether it is material. Boards and management teams should clarify the role of the finance function in ESG reporting.

    Read more about these recommendations in our report (pdf). 

Looking ahead to establishing a proactive sustainability agenda

An ESG agenda that is capable of unlocking long-term value needs to be tied to business strategy but also to governance. Unless it is at the heart of governance, the chances of long-term success will be undermined.  There needs to be a spirit of collaboration as this significant sustainability transformation takes place and best practices emerge. This is about market participants giving feedback that is constructive. Their response needs to be proportionate should new reporting standards create a different picture of a company’s ESG opportunities and risks than previously thought.

This report shows how European boards can put in place the right information, skills, operating model and reporting to carve out a proactive sustainability agenda and really deliver on the company’s ESG commitments.

The views of third parties set out in this publication are not necessarily the views of the global EY organization or its member firms. Moreover, they should be seen in the context of the time they were made.

Summary

Sustainability is in the spotlight and ESG priorities will pose both challenges and opportunities for European companies now and in the future. Robust corporate governance and a central role for boards are critical for getting on the front foot with ESG and achieving the cultural and mindset change needed to drive sustainability transformation. To build a winning strategy, boards must have the operating model, data, and capabilities to provide strong direction and support, whilst also adopting innovative approaches to reward and renumeration and investigating new ways to optimize ESG reporting.

About this article

Authors
Julie Linn Teigland

EY EMEIA Area Managing Partner and EY Global Leader – Women. Fast forward

Passionate about the transformational power of digitalization and innovation and its potential to deliver sustainable, inclusive growth for clients. Prominent voice of the Women20 global agenda.

Andrew Hobbs

EY EMEIA Public Policy Leader

Public policy leader focusing on talent, technology, corporate governance and corporate reporting. Father of four, cyclist and dabbling homebrewer.