How can boards strengthen governance to accelerate their ESG journeys?

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.

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.

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.

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.

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. 

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. 

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.