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Thought pieces

Board skills evolution crucial to drive ESG value creation

By April 7, 2022August 18th, 2022No Comments
By Julia Bailey

Why effective governance is important

Environmental, Social and Governance (ESG) issues cover a broad spectrum ranging across critical issues such as climate change, cybersecurity, biodiversity, supply chain considerations, equality and social licence. The pressure on companies to respond to this broad range of ESG issues from stakeholders including customers, employees, suppliers and investors, is increasing at a rapid pace with wide ranging operational and financial implications for companies and their boards.

Are boards adequately equipped for ESG risks and opportunities?

Skills, capabilities and perspectives need to continually evolve amongst boards in order to adapt and respond to the risks and opportunities that a rapidly evolving ESG landscape is presenting. Deloitte’s recently published “Bold moves in the boardroom: skills and capabilities fit for the future1” report writes that future fit boards need strong governance foundations, plus a broader set of skills and capabilities.  Boards require directors who can “add value through their heightened sensitivity to ESG issues, stakeholder capitalism, social licence to operate, elevated employee expectations, or through bringing digital fluency, an entrepreneurial mindset or systems thinking.”

The 2021 Sustainability Board Report2 found that 71 of the 100 largest global public companies now have a board committee overseeing sustainability. However, the same study identified that only 17% of the directors serving on these committees had relevant ESG or sustainability training or experience. In Australia, Melior’s proprietary ESG data shows that less than 30%3 of ASX300 companies have a designated board committee overseeing sustainability. Company board skills matrixes however do not always specify sustainability / ESG expertise suggesting a similar skills gap.

Post release of the 6th IPCC report4 and COP-26 in Glasgow, climate change is arguably the most prominent issue facing companies and boards. The Investor Group on Climate Change5 writes that “boards that fail to recognise the significant material risk climate change presents and the role they play in developing and driving the company transition to a low carbon business model are leaving the firm exposed to strategic and market risk.”

Melior’s recommendation to board and directors

In response to the evolving ESG landscape, the skills and competency of directors and boards will need to quickly evolve to include the expertise and experience of ESG-related risks and opportunities across the value chain and public policy.  We encourage boards to broaden the recruitment processes they use for new directors thereby gaining access to a wider pool of talent, and for directors to explore the increasing number of professional development options being offered in these areas.

Reporting requirements and litigation risks are ramping up

Multiple ESG reporting frameworks, principles and guidelines exist including the Sustainability Accounting Standards Board (SASB6), Global Reporting Initiative (GRI7) and The Task Force on Climate Relate Financial Disclosure (TCFD8). Reporting under these frameworks is largely voluntary although several jurisdictions are in the process of introducing mandatory disclosure under the TCFD framework including the UK and New Zealand, and other countries are expected to follow suit. In addition, the US Securities and Exchange Commission (SEC) has recently proposed rules to enhance and standardize climate-related disclosures by companies including certain climate-related financial statement metrics.

In reaction to the call from investors and other stakeholders for greater transparency, reliability and comparability of ESG reporting by companies, the International Financial Reporting Standards (IFRS) Foundation announced the development of an International Sustainability Standards Board (ISSB).  Two prototype frameworks for climate and general requirements9 were released in November 2021 and the impending release of the first ISSB sustainability standard has the potential to alter the way that directors and boards will need to consider and report on ESG issues.

Pressure is also mounting on boards and directors from the increasing litigation risk across a range of ESG issues such as announcing net zero targets without “reasonable grounds”, ‘greenwashing’ or embellishing environmental credentials10. According to the Global Trends in Climate Litigation: 2021 Snapshot, Australia is the second most active jurisdiction for climate change litigation behind the US11, and law firm King & Wood Mallesons, describe Australia as “a particularly fertile testing ground for public interest litigation on climate change12.”

“As interest groups, shareholders and communities around the world bring more (and novel) climate change actions before the courts, corporate decision makers are going to be challenged in ways that will impact everything from M&A strategies and diligence, to disclosures and decarbonisation plans. Boards will need to demonstrate they have reasonable grounds to support any representations contained in those disclosures, at the time which those disclosures were made. The questions likely to be put to directors and boards are -–what did you know? when did you know it? and what did you do about it?” Elaine Kwan, Partner, King & Wood Mallesons

Melior's advocacy approach to boards

Melior believes that boards play an integral part in value creation and driving positive social and environmental impact in the companies they govern. As part of our quarterly reporting, we track the relative performance of our fund vs the ASX300 benchmark against three Governance KPIs:

Melior Australian Impact Fund quarterly KPIs vs ASX300 benchmark (quarter ending 31/12/21)

Our advocacy strategy focusses on boards via two primary mechanisms:

  1. Active Corporate Stewardship, whereby we directly engage with boards (in addition to management teams) to raise ESG ambition and positive net impact,
  2. Conducting proxy voting on behalf our fund’s investors.

Conducting proxy voting on behalf of a fund’s investors is an important responsibility and a key advocacy tool. As detailed in our recently published 2021 Proxy Voting Report, we have seen an increase in the number of environmental and socially focussed proposals brought by shareholders. We expect this trend to continue in coming years.

Whilst there are a range of issues that need to be considered when voting proxies, we believe that optimal board composition is particularly important for driving value creation and positive social and environmental impact.

Optimal board composition

We believe that periodic refreshment of board membership is crucial to ensure the inclusion of relevant skills, especially those related to ESG issues, and experience such as finance & audit, sector expertise, cybersecurity, customer & supply chain, environmental sustainability, international, social, and government relations. We also believe that diversity amongst board members should reflect the broader communities in which the company operates. This brings different perspectives and reduces “group think,” which in turn promotes better decision making and business outcomes.

Readily available and comparable data on board composition is generally limited to tenure, the number of boards a director sits on, and the gender of the director. We also take into account the broader composition of a board and look for boards to demonstrate diversity across dimensions beyond gender including cultural background, age and skill set. Current reporting by ASX companies is largely limited to gender and skill set so the ability for investors to easily assess companies on other diversity dimensions is limited. However, a couple of reports point to ASX board diversity across certain dimensions such as age13 and cultural background14 being deficient. We also believe that disclosure around skill set is often deficient especially with reference to skills relating to ESG expertise.

Board diversity has come into focus by financial market regulatory bodies in the US and UK. Major global asset managers are also raising expectations of board diversity to include underrepresented communities / ethnic minority groups via their proxy voting principles. So far, these expectations have mainly been applied to US and European companies but we believe that greater scrutiny from multiple stakeholders of the broader diversity of Australian boards will increase in coming years. We discuss this in more detail in our Diversity Beyond Gender thought piece published last year.

We continue to evolve our proxy voting principles and in 2022 we will increase our focus on board composition by greater scrutiny around the skills and perspectives of board members. We will also be advocating for clearer disclosures around the skills sets of individual directors in order to better inform our, and other investors’, voting decisions and have already engaged with several boards over the last few months which has provided valuable insights for our voting on director elections and re-elections. We believe this a powerful advocacy engagement tool to continue our conversations with management teams and boards around driving value creation and positive social and environmental impact.

Our 2022 board composition proxy voting principles:

We will generally vote against the chair of the nomination committee, chairman of the board or other relevant directors on a case-by-case basis if we believe:

1. The board is not comprised of directors who can collectively demonstrate an appropriate set of core skills. In Melior’s opinion, key skill requirements include:

  • Audit/corporate finance
  • Environmental sustainability (e.g. climate, waste, water, biodiversity)
  • Customer & supply chain
  • Cybersecurity
  • Digital/technology & data literacy
  •  International experience
  • M&A/capital markets
  • Public policy/government/regulatory relations
  • Sector/industry specific experience
  • Social (e.g. health & safety, workforce, culture)

and / or,
2. the Board is unlikely to represent a broad range of perspectives as a result of limited diversity across dimensions such as gender, age, cultural background, disability and sexual orientation.

As per our 2020 and 2021 voting principles, we will continue to generally vote against the election or re-election of directors if we believe they are over-boarded (defined as sitting on >3 publicly listed boards) or have excessive tenure (>9 years). Both these principles are considered on a case-by-case basis and take into account a number of factors which we discuss in our Proxy Voting Report.

Melior walking the talk

Melior’s Management Board and Advisory Council comprise members demonstrating gender, skills and age diversity with representatives from several generations. However, we recognise that we too have further to go in broadening our diversity in other dimensions.

This content is for general information only. In preparing and publishing this content, Melior Investment Management Pty Ltd (ACN 629 013 896, authorised representative no. 001274055) does not seek to recommend any particular investment decision or investment strategy and has not taken into account the individual objectives, financial situation or needs of any investor. Investors should consider these matters, and whether they need independent professional financial advice, before making any investment decision.
Investing involves risk. Returns are not guaranteed and investors could lose money. Listed equities markets can experience volatility, particularly in the short term. Investments in listed equities markets are therefore generally classified as higher risk than other asset classes such as fixed income and cash (which tend to have both lower risks and lower long term returns). As the Fund invests most of its assets in Australian listed equities, it should be considered a high risk investment. Please refer to the Product Disclosure Statement for details of the types of risks which are associated with investing in the Fund. The Fund is likely to be appropriate for an investor who has a 7 year investment timeframe, a high risk / return profile and wishes to have access to capital on short notice. Please refer to the Target Market Determination for further information and consider their own objectives, financial situation and needs before making any investment decision.”