The ESG Opportunity for Corporate Directors5 Questions for ESG Board Oversight

Keynote Remarks for the New England National Association of Corporate Directors Event, January 12, 2021

It’s an honor to speak to you today about

board oversight of ESG issues.

I also think the timing for this topic could

not be better, following the extraordinary

year that was 2020 and the way events

have propelled ESG into the mainstream.

As Vladimir Lenin once said: “There are

decades when nothing happens, and

there are weeks when decades happen.”

2020 felt a bit like that.

The Challenge and Rewards

of Board Service

Before I turn to how the pandemic accelerated

the mainstreaming of ESG, I want to say

a word about the vital importance and

privilege of serving as a corporate director.

Gloria Larson and I serve together on the board

of Unum Group, and we have experienced

first-hand the growing complexities of board

oversight, as companies face a whole host of

new challenges, oftentimes external and very

hard to plan for.

These include everything from business

continuity and resiliency challenges in the face

of crises like a global pandemic to operating

model changes, cybersecurity risks and the

importance of diversity, inclusion, and

sustainability, as we address climate change

as well as racial, gender, and social inequities.

Throw in volatile interest rates and regulatory

uncertainty and one indeed has quite the cocktail

of challenges.

The issues are complex, especially as intangibles

become more important value drivers. In the U.S.

and U.K., more value is now driven by intangible

assets than tangible ones, as technology disrupts

traditional business models.

Ron O’Hanley

Chairman and Chief Executive OfficerState Street Corporation

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The rise of the FAANGs illustrates this point.

An Amazon represents little of the physical

asset intensity that drove the most valuable

companies 50 years ago.

Those intangibles are largely driven by

intellectual property assets but increasingly

include ESG “S” issues like human capital

management. By definition, intangible assets

are more difficult than tangible ones to

measure and manage with precision.

That is why effective board oversight today

requires a significant investment of time

and effort.

But Gloria and I have also experienced

the great satisfaction that comes from helping

management teams think critically about their

vision, purpose, and strategy in order to lead

a business successfully through even the

most challenging times.

Effective Independent

Board Leadership Drives

Company Success

I begin with the premise that the key driver

of a company’s long-term success is effective,

independent board oversight.

Even before the pandemic, the evidence

was clear that effective, independent board

leadership was critical to ensuring that

company management was executing

effectively against its business strategy.

In a world that is too often focused on the

short term, effective boards keep companies

focused also on their long-term goals and

hold management accountable for

progress toward achieving them.

At State Street, we have a particular interest

in effective, independent board leadership

because of the nature of our asset management

business, State Street Global Advisors.

In addition to being one of the world’s largest

servicers of investments, State Street is also

the third-largest asset manager in the world,

and a big share of the more than $3 trillion

in assets under management is invested in

index-based strategies.

That means that, unlike State Street’s active

managers who can remove companies from

their portfolios, for our index-based strategies,

we are invested in companies in, say, the

S&P 500, on behalf of our clients, for as

long as those companies are in the index.

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So we are very long-term investors on behalf

of pension funds, endowments and foundations,

or official institutions, who themselves all have

long-term investment liabilities and objectives.

That is why our stewardship team engages

with the boards of listed companies on material

environmental, social and governance issues

that impact long-term value.

Not surprisingly, our stewardship team sees

a range of board effectiveness and best practices

across public companies in every jurisdiction

around the world.

Even before the pandemic, our view was that

ESG provided a powerful lens for focusing

on the long term, both in terms of risks

and opportunities.

For many years our stewardship team focused

on board quality and effectiveness—the “G” of

ESG—and then expanded that engagement to

the “E” and “S” issues of ESG, beginning in 2015.

ESG as a Powerful Lens

on the Long Term

Since 2017, when State Street adopted the

principles of the Taskforce on Climate-Related

Financial Disclosures (TCFD), we have been

especially focused on the physical and transition

risks associated with climate change.

For us, climate change is a perfect example of

the textbook definition of risk: more things can

happen than will happen.

In addition to State Street reporting on its own

climate risks, SSGA’s stewardship team has

called on listed companies to report on climate

risks using the TCFD framework.

To be clear: we do not tell companies what to do.

Management and the board are best equipped

to evaluate risks and develop an action plan.

What we seek is evidence that companies are

doing so and that boards are effectively overseeing.

We approach ESG not only as a responsible

corporation focused on generating long-term

value for our shareholders, but also as a global

investment servicer and manager committed

to maximizing the probability of attractive

long-term returns for our clients.

“ESG provides a powerful lens for focusing on long-term risks and opportunities.”

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COVID Escalates the

Materiality of ESG

While the “E” and “G” issues have been

a clear focus for shareholders, the pandemic

reinforced the importance of “S” attributes

for corporate resiliency.

These include issues like employee

engagement and loyalty, the resilience of

supply chains, and the agility of companies

to adapt products and offerings as the crisis

took hold.

In fact, the pandemic has reinforced the

connections across resiliency, sustainability

and inclusiveness.

In our view, COVID has been a dramatic

trigger that should drive a deeper integration

of ESG into a company’s core business strategy.

And there is growing empirical evidence that

focusing on ESG has real business benefits.

For example, a study that State Street undertook

with our research partner, Harvard Business

School Professor and ESG expert George

Serafeim, further underscored the relationship

between ESG and better performance.

Using market and State Street flow data,

George and team looked at the performance

of more than 3,000 global companies during

the worst of the equity market sell-off in March

and found that those companies with stronger

ESG characteristics, especially “S” strengths,

experienced smaller stock declines than

competitors with weaker ESG characteristics.

The clear message from this research is that

investors seek companies that understand

the importance of ESG management when it

comes to business resiliency and operations.

That in turn speaks to the core reason why

ESG issues are becoming financially material.

So, while the pandemic has showcased the “why”

of board oversight for ESG, the “how” of ESG

oversight is still an issue for shareholders and

corporate directors alike.

In fact, while the most recent NACD survey

of public company governance found that

80 percent of directors reported that their

board is focused on some aspect of ESG,

52 percent were looking for ways to improve

their own understanding of ESG.

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I will posit five key questions that corporate directors must consider when it comes to ESG oversight.

Is our Board focused on

the right issues?

Has the board determined what are the

key ESG issues for our company? There is

no one-size-fits-all approach to ESG.

For example, environmental risks will be

very different for an oil and gas company

as compared with a software company.

Boards should undertake an inventory of

the ESG issues that are most relevant to

the company’s long-term performance.

This is an area where SASB’s sector-

specific materiality framework can help

as a guide, as well as peer reviews to

establish a baseline of relevant issues.

Shareholder engagement is also helpful in

identifying perceived risks and oversight

challenges. Effective stewardship is a

dialogue, not a monologue. Boards should

engage investors like State Street, BlackRock,

and Vanguard on what they are seeking.

Each year, State Street Global Advisors

announces the engagement themes for

the coming proxy season.

This year, not surprisingly, climate risk as well

as racial and ethnic diversity are the two main

focus areas.

As shareholders on behalf of our clients, we

have a vested interest in helping boards think

through how they are identifying and managing

ESG risks and opportunities.

Does our Board have the appropriate

skills and governance process

for effective ESG oversight?

As ESG evolves and potentially becomes a bigger

driver of shareholder value, boards need to

critically evaluate their collective skill set and

oversight processes.

Some boards are accomplishing this rethink

with a dedicated sustainability committee that

includes ESG-informed descriptions of duties

and responsibilities for directors.

Some use the sustainability committee more

broadly. For example, in regard to climate risk

disclosures aligned with the TCFD framework,

15 of the 40 largest oil and gas and mining

and utilities companies around the world

assigned environmental and climate-related

responsibilities to a dedicated sustainability

committee at the board level.

To date in the U.S., a much smaller proportion

of companies have a dedicated sustainability

committee charged with overseeing a company’s

response to climate or environmental risk,

and are instead relying on existing

committee structures.

Five Questions for ESG Oversight

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Deloitte recently found significant variability

in board oversight of ESG among S&P 500

companies, including 28 percent that still do

not disclose how the board has defined

the governance structure for ESG.

A large share of the companies, 41 percent,

assigned ESG to the Nominating and Governance

Committee; 10 percent have a dedicated ESG or

Sustainability Committee; 7 percent assigned it

to the full board committee; 5 percent to Health

and Safety Committees and only 1 percent to

the Audit Committee.

Recently, the SEC released a final rule that

will amend Regulation S-K to require enhanced

human capital management disclosure in

financial filings.

This suggests a greater role for Compensation,

Human Resources, and management

development committees as they are called upon

to disclose more information around diversity

and inclusion and equal pay for equal work.

We expect that this variability in committee

oversight will likely evolve to fit the specific

ESG objectives of each company.

Again, the point is not for all boards to do

the same thing, but that every board recognizes

that ESG may be an inflection point for the

company and, thus, the board needs to

examine its own capabilities and approaches.

In terms of skill sets, while boards do not

need to hire climate scientists to understand

environmental issues, some companies will

need internal resources who understand

the technical details of climate risk reporting

according to the TCFD framework and can report

those to the board in a comprehensive way.

The TCFD organization publishes helpful updates

on its website detailing reporting best practices.

Companies should update board charters and

governance documents as necessary to reflect

oversight practices, and identify which board

committees and functions engage in executing

ESG initiatives and monitoring ESG risks

and opportunities.

If directors have particular skills or expertise

relevant to those ESG issues, those should be

disclosed in the proxy statement in the board

skills matrix.

Is the company taking a strategic

or tactical approach to ESG?

The realities are that many companies are taking

a reactive, tactical response to ESG rather than

formulating an approach that integrates ESG

risks into their long-term strategy.

In SSGA’s engagement with portfolio companies,

it finds that less than 25 percent of the

companies evaluated by the stewardship team

have meaningfully identified and incorporated

material ESG issues into their strategy.

A majority struggle to articulate how they are

incorporating ESG issues into the company’s

long-term business strategy and how, if at all,

ESG issues are affecting the company’s capital

allocation decisions.

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Here again, SASB’s materiality framework can

help to understand the long-term risks and

opportunities that specific ESG issues present.

Engagement with long-term shareholders

should also help clarify the implications for

strategy and capital allocation choices.

Is the company setting appropriate

ESG KPIs and aligning incentives

to them?

Talking about ESG oversight is not enough,

and likely will be increasingly called out by

shareholders, regulators, employees, and

other stakeholders.

Directors should confirm that, when possible

and practicable, measurable ESG goals are

established and disclosed, and progress in

meeting those goals is tracked.

Here, too, the pandemic has accelerated

progress on this front.

A Willis Towers Watson ESG Survey of Board

Members and Senior Executives from 168

organizations in North America, EMEA, and

Asia published last month found that nearly

80 percent of companies plan to change how

they use ESG with their executive incentive

plans over the next three years. 41 percent

said they plan to introduce ESG measures

into their long-term incentive plans.

Nearly three-quarters of the North American

respondents have implemented at least one

initiative to promote inclusion and diversity

at their organizations, with another quarter

planning or considering to do so.

As shareholders focus on climate and equality

issues around diversity and inclusion, boards

will need to work more closely with management

to institute milestones and incentives.

At State Street we have extended compensation-

driven accountability of our executive management

committee around gender diversity goals to

include racial diversity goals as part of our own

action plan around racial equity.

How is your company reporting

ESG Issues?

Much work is required to ensure that companies

are disclosing ESG information in a way that is

consistent, comparable, and decision-useful to

their shareholders.

While 90 percent of S&P 500 companies provide

some form of sustainability or ESG disclosure,

a wide degree of variability exists in the quality,

consistency and reliability of the information.

Moreover, companies are struggling with the

explosion in ESG surveys, especially when

each asks slightly different versions of the

same questions.

The good news here is that all stakeholders:

companies, shareholders, regulators, and

standard-setters, recognize the need for

convergence around standard frameworks

and metrics.

State Street, like other large investors, has

endorsed SASB and TCFD as two market-driven

frameworks that ask companies to provide

decision-useful information in a consistent way.

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Corporate directors have the opportunity to steer companies toward a more resilient, sustainable, and inclusive future.

Recent news that the International Integrated

Reporting Council, or IIRC, will be merging

with SASB is another encouraging sign

of convergence.

The next step is to obtain assurance on

ESG disclosures.

Here, too, the major accounting firms have

been working with the IFRS and IASB to agree

on auditable standards for ESG reporting.

Where Do We Go From Here?

When we look back at the last year and the

issues that shareholders focused on in the past

proxy season and have signaled will be key for

the coming proxy season, it is clear that ESG

is now front and center.

COVID quickly drove resiliency issues around

labor practices and employee health and safety

to the top of shareholder engagement with

companies, and that focus will persist as we

continue to manage our way through

the pandemic.

Human capital management issues, including

workforce diversity, were already topics

of engagement before the pandemic.

But the speed with which the racial turmoil

of the last year has propelled issues of racial

equity to the forefront of the corporate agenda

is both impressive as well as long overdue.

Shareholder demands for better disclosure

of racial, ethnic, and gender diversity detail,

including the Consolidated EEO-1 Reports,

will likely be the number one engagement

topic in 2021 in the U.S., in addition to

heightened urgency around climate issues

with the advent of a new administration.

As I said at the outset, corporate directors

now face a broader and more complex set of

issues they need to oversee, support, and, when

appropriate, challenge management to do more.

But the opportunity corporate directors have

to steer companies toward a more resilient,

sustainable, and inclusive future is more

rewarding than ever and is a mission I would

challenge all of you to embrace in 2021.

Thank you.

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For more information, go to:

www.statestreet.com/solutions/by-capability/esg

State Street CorporationOne Lincoln Street, Boston, MA 02111

www.statestreet.com

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