‘What on earth are Scope 3 emissions?’ This question, asked by the senior independent director of a FTSE small-cap company during the October 2022 board meeting, caught my attention. (I was observing the meeting as part of a board performance review.)
Both the question, and the subsequent lack of engagement by other directors, suggested that the board was not well-informed about environmental, social and governance (ESG) concepts or frameworks. This was surprising but consistent with other findings of my review of the board’s performance, such as the absence of effective oversight mechanisms for ESG (there was no ESG sub-committee) and no evidence of the board considering ESG risks (none were listed on the strategic risk register). The conclusion was clear: the board was not leading on ESG matters.
Board leadership in ESG is a challenge because of its uncertainty
Board struggles
ESG is a developing framework used to assess organisations on various sustainability and ethical issues. It provides a way to measure business risks and opportunities, and is a major factor in competitiveness. Many investors today use ESG criteria to evaluate company performance.
Board leadership in ESG is therefore a critical aspect of modern corporate governance and responsible business practices. But it is often a challenge for directors because of its uncertainty and the opaque, technical language used around subjects such as carbon footprint and social responsibility. The director’s question above is an illustration of this challenge.
What are the ‘scopes’?
Scopes are the basis for mandatory greenhouse gas (GHG) reporting in the UK. Scope 1 and Scope 2 cover GHG emissions that a company makes directly and indirectly; Scope 3 encompasses emissions that are not produced by the company itself but by those that it is indirectly responsible for across its value chain. Directors need to be well informed on all environmental, social and governance matters relevant to their company’s success.
Evolving best practice
In May 2023 the Financial Reporting Council (FRC) launched a consultation on its proposals to revise the UK Corporate Governance Code. The new code will address for the first time the role of directors in the ESG framework, and their responsibilities for sustainability and ESG reporting.
The FRC recognises that ESG factors are now essential for companies throughout the world, noting that ‘The code should reflect the importance of these matters and recognise that good governance will play an essential role in assessing sustainability-related risks, opportunities and impacts, setting targets, using appropriate internal controls and commissioning assurance where necessary.’
ESG proposals
The FRC is proposing the following changes to the code:
- expanding the current Provision 1 (the board’s assessment of how the company generates and preserves long-term value). The annual report will include a description of ‘how environmental and social matters are taken into account in the delivery of its strategy, including its climate ambitions and transition planning’
- adding a new responsibility for the audit committee to monitor the integrity of narrative reporting, ‘including sustainability matters’
- expanding the audit committee’s reporting requirements: the significant issues it considers regarding narrative reporting, including sustainability matters, how these issues are addressed and the assurance it receives on ESG metrics
- requiring a consideration of ESG objectives when deciding whether remuneration outcomes are clearly aligned to the successful delivery of the company’s long-term strategy.
The revised code will apply to accounting periods starting on or after 1 January 2025.
Too prescriptive?
The FRC invited comments on the proposals from its stakeholders and generally these are very positive. ACCA is supportive, welcoming proposals that aim to get boards ‘more active in building resilience and reporting on how they do this’.
The Institute of Directors is concerned that the code is becoming too prescriptive
Some responses are more cautious. The Institute of Directors (IoD) sets out various concerns including a danger that the code is becoming too prescriptive, thereby eroding the ability of boards to make judgments. To illustrate this, it uses the FRC’s recommendation that it should be the audit committee that oversees ESG disclosures, controls, processes and assurance.
The IoD sets out alternatives, suggesting that ‘an individual board might reasonably determine that a sustainability committee, an ESG committee or the board as a whole is the more appropriate mechanism through which to oversee these areas’.
The consultation closed in September. The final version of the new code may well be amended to take account of views expressed by stakeholders.
Recommendations
Going back to the company I mentioned at the start of this article, the absence of visible board leadership on ESG was noted by the chair, who took urgent steps to address it. By the time I next visited, he had already instigated three significant improvements in ESG governance. An ESG sub-committee was now in place, chaired by one of the independent non-executive directors; the board reviewed the strategic risk register and amended it to include the principal ESG risks to the business; and the board instructed the remuneration committee to consider the most appropriate way to build ESG performance metrics into the executive bonus scheme.
Companies should foster ongoing dialogue with all key stakeholders
In addition to these three areas, there are other key considerations and practices on board leadership in ESG that all companies should be considering:
- ESG considerations should be fully integrated into the business strategy and decision-making. Clear, measurable ESG goals and targets should be established that align with mission and values.
- Companies should foster ongoing dialogue with all key stakeholders, especially engaging with ESG-focused investors and listening to their concerns.
- Companies should provide ESG training opportunities for directors to enhance their knowledge and consider bringing in external ESG experts or advisers to support the board’s efforts.
The introduction of the revised code signals an important shift in the FRC’s approach to incorporating ESG into the UK’s corporate governance framework.
