The question of how three words—environmental, social and governance—became fused as the acronym ESG is often raised. Within the last five years, ESG has emerged among the top 10 corporate-governance priorities within most corporate boardrooms globally. Some boards have gone as far as adding a new committee or changing the name of a standing committee to ESG. So, it is important to add context to this impactful change and relate it to the progressions that have brought ESG into the forefront of corporate-governance discussions as we enter 2022.
With the understanding that finance powers the global economy, the goal is to provide insight for bank leaders and board members about the history and potential impact of ESG in the boardroom.
Corporate governance’s history in brief
We are presently in the third phase of modern corporate-governance evolution. The first phase was the Industrial Revolution and the advent of stock ownership that led to the Banking Act of 1933. The second was the evolution of corporate governance from the 1930s through the financial crisis of 2008-09. The third phase, where we find ourselves currently, began as the world emerged from that financial crisis. During the past 12 years, the role of a publicly listed company board member has changed considerably.
The need and mandate for corporate governance are rooted in trust, which is one of the founding principles of financial services. Without trust, banking would deteriorate imminently. Today, board members are expected to uphold the core principles of trust through accountability—with an appropriate dose of skepticism. The global pandemic and social unrest have accentuated the need for higher accountability standards. Market resiliency and capitalism require a strong sense of trust today, and, to this end, stakeholders are holding boards to higher standards than ever before.
In order to understand this progression of stakeholder expectation, a measure of corporate-governance history may be helpful, with a focus on the United Kingdom and the United States. Many of us who follow and promote corporate-governance excellence review this short list of impactful events and see a mostly positive progression of corporate governance over the past 200 plus years.
- 1929 Wall Street stock market crash occurred (US),
- 1933 Banking Act [Glass-Steagall Act] came into effect (US),
- 1970 Milton Friedman’s New York Times Magazine essay “The Social Responsibility of Business Is to Increase Its Profits” was published,
- 1971 Nasdaq was founded,
- 1987 Treadway Commission called for improved audit-committee oversight (US),
- 1992 “The Financial Aspects of Corporate Governance” [the Cadbury Report] was issued by the Committee on the Financial Aspects of Corporate Governance (UK),
- 1994 The King I (now King IV) “King Report on Corporate Governance”, the first corporate-governance code for South Africa, was published,
- 1995 “The Greenbury Report” of the Confederation of British Industry (CBI)—focused on director remuneration—was released (UK),
- 1999 G20/OECD’s [Organisation for Economic Co-operation and Development] “Principles of Corporate Governance” were issued,
- 2002 The Sarbanes-Oxley Act (SOX) came into effect (US),
- 2006 The FRC [Financial Reporting Council] published the Combined Code on Corporate Governance (updated 2010-18) (UK),
- 2010 The Dodd-Frank Wall Street Reform and Consumer Protection Act was introduced (US),
- 2013 The Prudential Regulation Authority (PRA) came into effect (UK),
- 2014 The King IV “King Report on Corporate Governance” was published in South Africa,
- 2018 The UK Corporate Governance Code was released by the FRC (updated) (UK),
- 2020 The UK Stewardship Code was issued by the FRC (UK),
- 2020 The Board Diversity Ruling was signed into law by the state of California,
- 2021 The Financial Conduct Authority [FCA] proposed a Board Diversity Disclosure Transparency Rule (UK),
- 2021 SEC [U.S. Securities and Exchange Commission] approved Nasdaq’s Board Diversity Disclosure Rule (US).
One of the more impactful contributions of the last 50 years is what is generally described as the Friedman Doctrine, resulting from Milton Friedman’s 1970 essay “The Social Responsibility of Business Is to Increase Its Profits”. A frequent debate in recent years is whether ESG and the Friedman Doctrine conflict. If so, this is likely a healthy, ongoing conflict. And at the core of healthy corporate governance is appropriate skepticism in the boardroom and constructive conflict that augments accountability.
As we learn more about the science of ESG, we also learn that balancing profit and ESG-related interests are important business-sustainability considerations for bank leaders and board members. Over the last two years, work-environment changes and the so-called “war on talent” have increasingly brought corporate purpose and ESG-related issues into boardroom discussions. Companies must achieve profit in order to be sustainable, but today sustainability encompasses more than the financial profit goals that drive shareholder value. Sustainability has evolved to include initiatives and goals that address stakeholders’ interests. Stakeholder groups have the power now to ensure that a business that destroys the environment on its way to profitability will suffer an existential crisis.
ESG history in brief
ESG was first promulgated in the business lexicon around 2004 and is attributed to the United Nations (UN) Secretary-General Kofi Annan’s Global Compact. What began as a voluntary initiative to encourage companies to adopt a sense of responsibility and operate in ways that recognized and protected human rights and the environment (among other principles) evolved to include capital markets, corporate governance and, yes, ESG. Since then, ESG has experienced “meteor in the sky”-like attention within the global corporate community. It is fair to write that ESG is here to stay.
“The six overarching Principles, which are voluntary, are underpinned by a set of 35 possible actions that institutional investors can take to integrate environmental, social and corporate governance (ESG) considerations into their investment activities. These actions relate to a variety of issues, including investment decision-making, active ownership, transparency, collaboration and gaining wider support for these practices from the whole financial services industry.”1
In 2006, the UN and Principles for Responsible Investment (PRI), an investor initiative in partnership with UNEP (United Nations Environment Programme) Finance Initiative and UN Global Compact, put forward six principles:
- Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.
- Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.
- Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.
- Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.
- Principle 5: We will work together to enhance our effectiveness in implementing the Principles.
- Principle 6: We will each report on our activities and progress towards implementing the Principles.
“These Principles grew out of the understanding that while finance fuels the global economy, investment decision-making does not sufficiently reflect environmental, social and corporate governance considerations—or put another way, the tenets of sustainable development,” said the Secretary-General.
Example areas of criticality for bank leaders and board members include:
- Lending practices,
- Regulators and their ESG-related expectations,
- ESG impact on shareholder returns,
- Balancing stakeholder expectations,
- Institutional shareholder ESG expectations.
Impactful ESG considerations for bank leaders and board members looking forward include:
- Inclusion and diversity,
- Income inequality,
- Social unrest,
- Community impact.
The COVID-19 pandemic and the social turmoil of March and April 2020 shined a spotlight on opportunities for improvement that exist within our capitalist economic structure. To paraphrase Sir Winston Churchill, like democracy, capitalism may be the worst of all economic systems, but it’s better than all the others.
Many board members identify ESG as both a risk and an opportunity. The following chart identifies a sample group of ESG priorities2:
Examples of ESG opportunities may include pay incentives that reward employees who identify profitable means of, say, energy savings, data-privacy protection or ways to reduce employee turnover. Bringing employees and other stakeholders into the discussion may also help avoid unintended consequences. Ultimately, it is the board’s job to set an appropriate tone from the top that engages and authentically messages the company’s core values.
The law of unintended consequences
Reduced lending to fossil-fuel production (an E factor in ESG) may improve the banking sector’s carbon-footprint disclosure, but if this reduction negatively impacts community employment, this scenario highlights how E and Scould be at odds. And globally, human rights, health and labor issues are linked to economic conditions. To avoid running afoul of the law of unintended consequences, we must carefully examine the potential impacts prior to enacting a change, or we risk the possibility of creating a dramatically negative outcome.
Over the past year, the Nasdaq Board Engagement team3 has conducted one-on-one interviews with hundreds of directors in the course of our work with boards. A key question we ask board members is, “What are your board’s top priorities for 2022?” The answers have indicated what many boards are likely to prioritize in the coming year. Key themes that have emerged from their responses include:
- Long-term strategy with a proactive view towards sector competition and disruption,
- Succession for both chief executive officers (CEOs) and boards with an ERM (enterprise risk management) perspective,
- Cost of capital looking forward at lending-rate trends,
- Executive and global pay trends impacted by social and political movements,
- Addressing ESG from a practical approach within a “lofty goals” political environment,
- Tabletop exercises that engage board agility.
In closing, ESG is sometimes a confusing acronym since a strong argument exists that the E and the S are subsets of the G. After 18 years of acronym use and broad proliferation today, it is a movement here to stay, a tour de force. Fighting ESG is like fighting the tide. Forward-looking bank leaders and board members are seeking to find the opportunity.
1 United Nations: “Secretary-General Launches ‘Principles for Responsible Investment’ Backed by World’s Largest Investors,” April 27, 2006.
2 Nasdaq: “Environmental, Social and Governance.”
3 Nasdaq: “Board Engagement helps drive governance excellence.”
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
If you are interested in more leadership insights and resources, join the Nasdaq Center for Board Excellence, a community and collaboration environment in which board engagement is deepened and experiences are shared. Sign up today at: www.nasdaq.com/solutions/governance/center-for-board-excellence