Note: this blog was written for the National Association of Corporate Directors and will be forthcoming from NACD. Reprinted with permission.

by Gib Hedstrom

The recent news of California utility PG&E should cause pause in every corporate boardroom. On Monday January 14, 2019 The Wall Street Journal reported that analysts had pegged PG&E’s wildfire liability exposure to be as high as $30 billion – roughly triple the company’s market value of $9.12 billion. By Friday that week, The Wall Street Journal called this “the first major corporate casualty of climate change.” One week later, California investigators said PG&E did not cause the major 2018 fire (Tubbs Fire), but although that announcement caused a bump in stock price, it did not change the $30 billion tab, which the company itself has estimated. The company filed for bankruptcy on January 29, 2019.

But judging its external environmental, social, and governance (ESG) ratings, PG&E was doing fine. Clearly, this situation shines a spotlight on the serious limitations of external ESG ratings. It also highlights the need for companies across virtually all industry sectors to build robust ESG governance systems.

PG&E seemingly had its “ESG house” in order. External ESG rating organizations praised PG&E. Sustainalytics (the company providing data to Yahoo! Finance) rated the company as an “outperformer” (in 88^th percentile on Environment and 82^nd percentile on Governance). PG&E rated #1 among utilities and #22 overall in Corporate Responsibility Magazine’s 100 Best Corporate Citizens. Newsweek Green Rankings listed the company #1 among electric and gas utilities and #4 overall. And, PG&E was named to the Dow Jones Sustainability North America Index for the eighth time. Certainly there were apparently good reasons for high ratings.

• The company’s recently-published 187-page 2018 Corporate Responsibility and Sustainability Report seems to “check all the boxes.” Sustainability is explicitly called out in the company’s mission, vision, and values. Board committees are in place; ESG materiality assessment has been done, ESG is incorporated in the company’s financial incentive plan, and the organization has a dedicated Chief Sustainability Officer, along with an outside advisory group. PG&E has a long history of ESG disclosure, bold goals to cut greenhouse gas emissions, and a record of early delivery on rigid California compliance standards (three years ahead of schedule). The list goes on.
• PG&E has $34.5B worth of renewable energy contracts.
• The company has discussed the California wildfires, noting actions PG&E is taking to address the “new normal.”

So we have a situation of high external ratings and a company apparently in compliance. Yet a $30 billion environmental liability exposure happened anyway. Clearly, there is a disconnect somewhere.

I noted in my earlier NACD blog (“Scorecard Data Suggests Many Companies Are Not Future-Ready”) that “without getting governance right, it’s hard to get anything else right.” That is precisely the lesson companies can learn from the PG&E situation.[1]

Were the ESG raters Wrong?

Clearly, PG&E has a long track record of important accomplishments in the areas of environmental stewardship and social responsibility. But what can outsiders know about the company’s internal governance processes? Did something go amiss here?

How can other companies learn from this situation? It starts by avoiding two fatal flaws:

• It’s often not about compliance.S. companies have a 50-year history of looking at environmental, safety, and societal issues as compliance. They often view ESG oversight and management through a compliance lens. That’s yesterday’s view. Managing the mega risks today (climate change, water shortages, etc.) is often not about compliance. You might comply with your water intake permit requirements – but what happens when the well runs dry, or when (like Flint Michigan) the water is contaminated?

• Beware the 80/20 Governance Trap. Only a very small portion (let’s call it 20 percent) of what constitutes robust management and oversight of environmental and social risks can be measured from outside the company. The other 80 percent – what I call “the soft stuff” – is comprised of the internal company practices and business processes to manage risk. That 80 percent does not easily lend itself to being measured.

External ESG raters look at “the hard stuff” – aspects of corporate governance and strategy that can be measured. Examples include gender diversity of the board or executive ranks, CEO compensation as a multiple of average worker pay, or the existence of a board committee with ESG oversight. But while external ESG raters may measure the existence of a board committee, it is almost impossible for them to measure the effectiveness of C-suite and board deliberations about ESG risk.

Bottom line: a company may be in compliance today and may receive high marks from external ESG raters; but directors should take all of that with a grain of salt. They should insist on measuring the other 80 percent of what constitutes robust governance.

The “soft stuff” actually can be measured

Companies can measure the “soft” components of sustainability governance. They can measure the effectiveness of C-suite and board deliberations about ESG risk. More than 60 major U.S. corporations have used the Corporate Sustainability Scorecard^TM – a management tool for companies, built over 20 years based on industry best practices. (The Scorecard is available to companies requesting access. And, the rating criteria are now public – published by De|G PRESS (November 2018) in “Sustainability: What It Is and How to Measure It.”

I do not know what went amiss at PG&E. But we do know that, using the Scorecard, eight peer utilities rated themselves fairly low on over a dozen “key sustainability indicators” (KSIs) that aim squarely at the ESG risk oversight issues highlighted in the PG&E situation. On those dozen KSIs, the peer utilities rated themselves on average at about Stage 1.7 on a Stage 1-4 maturity scale. In other words, they acknowledged they have a long way to go – if they deem those items material to their business.

I encourage company executives across all industry sectors to check it out.

[1] Note: the author does not have any relationship with PG&E and is only using public information about this situation as an example to illustrate the limitations of external environmental, social and governance (ESG) ratings.