Board Risk Oversight and Environmental and Social Performance

There is growing recognition that E&S issues are associated with major risks and opportunities and that these issues can materially affect firm performance and valuation (e.g., Ceres 2019; Liang & Renneboog 2017; NACD 2017). This has, in turn, led investors and other stakeholders to call on boards to consider E&S issues in their overall risk oversight and, in doing so, to identify, monitor, and respond to present and potential E&S risks (e.g., NACD 2022; WLRK 2022).

Motivated by these developments, in a recent study forthcoming in the Journal of Accounting and Economics, we examine the relation between board risk oversight and three elements of firms’ E&S performance. Specifically, we study the following three research questions:

• Is board risk oversight associated with the institution of E&S accountability mechanisms?
• Is board risk oversight is associated with the adoption of E&S-oriented strategic, operational, and disclosure policies?
• Is board risk oversight is associated with the realization of E&S outcomes?

Our assessment of these relations builds on a conceptual framework in which boards, acting on behalf of shareholders, establish accountability mechanisms for E&S issues. This, in turn, leads to the implementation of E&S-oriented strategic, operational, and disclosure policies, which can facilitate the realization of E&S outcomes. In addition, boards may directly influence the implementation of E&S policies and may influence E&S outcomes through other channels, such as setting the tone at the top for nurturing an E&S-conscious risk culture.

We focus on overall and not E&S-specific risk oversight for several reasons. While boards can conduct E&S risk oversight in isolation, the inclusion of these risks in their overall risk oversight can induce efficiency gains, provide a common language for articulating E&S risks, and lead to more effective risk oversight (e.g., KPMG 2023). It can ensure that E&S risks are integrated into strategy and thus elevate the importance of E&S risks and align E&S initiatives with a firm’s risk appetite and strategy. Leveraging overall risk oversight can also enhance boards’ ability to identify E&S risks and facilitate a more holistic monitoring of all risk exposures (e.g., COSO & WBCSD 2018). This will, in turn, reduce conflicts between risk management and strategic objectives, ensure that necessary trade-offs are well understood, and thus improve the board’s ability to anticipate and respond to the firm’s interconnected set of risk exposures.

The premise underlying the relation between board risk oversight and E&S accountability is that boards engaging in more extensive risk oversight are more likely to be cognizant of E&S risks and are thus more likely to establish accountability for E&S issues in order to influence E&S-related actions and decisions. Accountability mechanisms can include setting E&S targets or using E&S metrics in incentive contracts. Indeed, boards are encouraged to rely on E&S accountability to influence E&S outcomes. Findings in some studies support this view by showing, for example, that more difficult carbon emissions targets are related to greater target achievement (Ioannou et al. 2016) and that the inclusion of carbon metrics in compensation contracts is associated with lower emissions (e.g., Cohen et al. 2023).

Boards that conduct more extensive risk oversight are also more likely to adopt E&S-oriented strategic and operational policies. For example, with the rise of E&S regulation and E&S litigation and reputational issues (e.g., Ceres 2019; UNEP 2023), boards are expected to implement policies that ensure E&S regulatory compliance and mitigate E&S-related legal and reputational risks (e.g., OECD 2021). These include policies that incorporate the E&S risk appetite and priorities set by the board, integrate E&S risks into strategic plans, and allocate resources to achieve E&S objectives. In addition to directly promoting and monitoring E&S policies, boards can indirectly influence their adoption through E&S accountability mechanisms that incentivize managers to embed E&S issues into strategic and operational decisions (e.g., Flammer et al. 2019; Cohen et al. 2023).

Boards that engage in more risk oversight can further demonstrate their commitment to addressing E&S issues by adopting disclosure policies on the provision of information about E&S risks, objectives, outcomes, and their risk oversight practices. Such policies comport with sustainability reporting frameworks that call for disclosures on the governance of E&S risks and opportunities, metrics and targets used to assess and manage these risks, and how they are expected to impact operations, strategy, and financial planning (e.g., ISSB 2023; SEC 2022; TCFD 2017). Findings in prior research show that firms with sustainability-oriented governance provide better E&S disclosures (e.g., Mallin et al. 2013) and that investors value these disclosures (e.g., Krueger et al. 2024).

Collectively, these arguments support the proposition that board risk oversight is positively associated with the institution of E&S accountability and the adoption of E&S-oriented strategic, operational, and disclosure policies. However, these relations are not obvious for four reasons. First, the effectiveness of risk oversight is constrained by limited board resources. Many boards lack the time, information, and skills required for risk oversight (e.g., NACD 2013), and as a result, their consideration of risks is analogous to a constrained optimization problem (e.g., Adams et al. 2010; Rock 2021), whereby risks are prioritized when conducting oversight, and in this process, E&S risks may receive limited attention. Second, surveys show that most directors do not view E&S issues as important risks or relevant to performance or shareholders, nor do their boards consider these issues when conducting risk oversight (e.g., KPMG 2018; PwC 2023). A similar sentiment is expressed in surveys that show that a majority of directors have limited confidence in their firms’ E&S initiatives; many lack an E&S framework and do not track E&S metrics (e.g., OCEG & Diligent 2021). Third, boards’ consideration of E&S risks is complicated by the difficulty of aggregating stakeholders’ conflicting preferences (e.g., Bebchuk & Tallarita 2020, 2022; Edmans 2023). This means that boards are required to prioritize different stakeholders’ interests and to assess the extent to which their divergent interests can be accommodated. As a result, not all E&S issues will receive the same degree of oversight by the board, potentially leading to a relation between board risk oversight and some elements of E&S performance but not others. Finally, boards may respond to E&S risks in ways other than relying on formal E&S accountability mechanisms or E&S policies. In particular, boards could set the tone at the top for an E&S-conscious risk culture (e.g., Braumann et al. 2020) or approve only those strategic initiatives or capital investments that are aligned with the firm’s E&S objectives, risk appetite, and desired E&S outcomes (e.g., NACD 2022). In doing so, boards may be able to forgo the use of E&S accountability and policies to influence E&S-related actions and decisions (e.g., Penno 2022).

Calls for the inclusion of E&S issues within overall board risk oversight assume that this inclusion ultimately improves E&S outcomes. If boards that engage in more extensive risk oversight are more likely to identify and assess E&S risks and ensure that E&S issues are incorporated into managerial practices and decision-making, then risk oversight should be associated with better E&S outcomes. While boards may be able to directly influence E&S outcomes in the short run (e.g., by pressuring management to sever ties with high-emission suppliers), inducing change in E&S outcomes through E&S accountability, E&S policies, and other mechanisms is inherently a long-term endeavor (e.g., Grewal & Serafeim 2020). Thus, while we may observe relations between board risk oversight and E&S accountability and E&S policies, this does not imply that we will find a similar relation between board risk oversight and E&S outcomes, at least not in the short run.

The relation between board risk oversight and E&S outcomes is also unclear for other reasons. First, recent studies question the credibility of firms’ E&S commitments and characterize them as attempts at green- and social-washing (e.g., Baker et al. 2024; Raghunandan & Rajgopal 2024). Thus, if risk oversight as it relates to E&S issues is symbolic, it may not be associated with E&S outcomes. Second, given that a feature of oversight of E&S risks is the pursuit of both environmental and social objectives, improving E&S outcomes will be subject to the same constraints that define the constrained optimization problem in relation to E&S inputs (i.e., E&S accountability and E&S policies). Considering the challenge of reconciling stakeholders’ E&S preferences, improving E&S outcomes will likely entail trade-offs (e.g., Scherer et al. 2018; Champagne et al. 2022). Lastly, recent studies highlight a general empirical challenge with examining E&S outcomes, namely that of data availability and measurement issues (e.g., Christensen et al. 2022). In light of these limitations, we recognize that our third research question on the relation between board risk oversight and E&S outcomes is inherently exploratory in nature.

Measuring Board Risk Oversight and E&S Performance

Our measure of board risk oversight is based on proprietary data from Aon’s Risk Maturity Index (RMI) survey, which was designed as a tool for firms to assess and benchmark their enterprise risk management (ERM) capabilities and covers major elements of the Committee of Sponsoring Organizations of the Treadway Commission’s ERM framework (COSO 2004). The survey is aimed at high-level risk management and C-suite executives and allows us to explore the unobservable black box of board risk oversight practices. Using the RMI data, we construct a measure of overall board risk oversight using five variables:

• Board risk understanding, which reflects the board’s understanding of key and emerging risks and existing risk management activities.
• Board risk reporting, which captures the scope and frequency of risk reporting to the board and board committees.
• Board and management risk alignment, which reflects consensus and communication between the board and top management on risk management strategies.
• Board and risk manager communication, which captures whether the risk management leader engages the board beyond internal risk reporting and exchanges at meetings.
• Board risk performance evaluation, which indicates whether risk management roles and responsibilities are incorporated in board members’ performance evaluations.

To study our research questions and measure the institution of E&S accountability, adoption of E&S-oriented strategic, operational, and disclosure policies, as well as E&S outcomes, we combine the RMI data with E&S data from Refinitiv (now LSEG) ESG, BoardEx, Bloomberg, the Impact-Weighted Accounts Project, and RepRisk. Our sample includes 377 unique firms from 33 countries that completed the RMI survey between 2011 and 2019 and have the requisite environmental or social data, board data from BoardEx, and accounting (stock market) data from Worldscope (Datastream).

Board Risk Oversight and Environmental and Social (E&S) Performance: The Evidence

With respect to our first research question, we find a positive association between board risk oversight and the institution of E&S accountability. Specifically, we show that firms with more extensive board risk oversight are more likely to adopt E&S compensation schemes and to set environmental (but not diversity and opportunity) targets. Investigating our second research question, we find that these firms are also more likely to implement strategic and operational policies that address E&S risks and opportunities, ranging from environmental, employment, and product risks to green innovation initiatives. In addition, firms with more extensive board risk oversight are more likely to issue an E&S report. We also find marginally significant evidence that the quantity of E&S disclosures is higher for these firms.

To address our third research question, we use E&S externalities and E&S risk incidents to capture E&S outcomes. We find that firms with more extensive board risk oversight have lower monetized environmental costs. But such firms also have lower monetized employee benefits (such as lower wage quality and a lack of diversity), suggesting that they experience worse employee-related social outcomes. The disparity in the results for E&S externalities is consistent with our findings for environmental and social targets and the notion of constrained optimization in that E&S risks may receive uneven oversight by the board. It also indicates that reconciling stakeholders’ preferences can entail conflicts between environmental and social goals. We further find that firms with more extensive board risk oversight are no more or less likely to experience an environmental risk incident. This result is consistent with the view that effective oversight does not require firms to avoid all (environmental) risks but rather to manage (environmental) risks based on their chosen risk appetite and risk management capabilities. Consistent with our results for monetized employee benefits, we also find that firms with more extensive board risk oversight are more likely to experience a social risk incident involving human rights or labor issues. Collectively, these findings suggest that boards tend to prioritize environmental risks over social risks when conducting risk oversight. We note, however, that data availability constraints, measurement issues, and likely discrepancies between the timing of E&S inputs and the realization of E&S outcomes impose limitations on our analyses (e.g., Christensen et al. 2002).

E&S Risks and Financial Risks: A Test of the Constrained Optimization Problem

In additional analyses, we explore the idea that boards may trade off E&S risks and financial risks in allocating their oversight resources. We use probability of default (PD) to proxy for firms’ exposure to financial risks and split the sample into low-PD (high-PD) firms, based on the in-sample PD at or below (above) the median level. For high-PD firms, it is plausible to assume that their boards will focus more on financial risks, and as a consequence, they may pay less attention to other risks, including E&S risks. Our findings, however, suggest otherwise. Specifically, for high-PD firms, we find a positive association between board risk oversight and the institution of E&S accountability and the adoption of E&S-oriented strategic, operational, and disclosure policies. We find no association between board risk oversight and the likelihood of environmental or social risk incidents in these firms. Conversely, for low-PD firms, we find a positive association only between board risk oversight and the adoption of E&S-oriented strategic and operational policies—board risk oversight has no relation with E&S accountability or E&S disclosure policies. We further find a positive association between board risk oversight and the likelihood of both environmental and social risk incidents in these firms. A potential explanation for these results is that, in conducting their risk oversight, boards of low-PD firms placed more emphasis on managing and mitigating financial risks at the expense of E&S risks in the past, thereby lowering the probability of default but increasing the likelihood of subsequent E&S risk incidents. This interpretation is consistent with the notion of “overload by distraction” reported in Ashraf et al. (2024) who show that a focus on financial risks by audit committees (a noncore duty of these committees) is negatively associated with financial reporting quality.

Key Takeaways and Directions for Future Research

We study the relation between board risk oversight and E&S performance. Growing awareness of E&S risks has prompted investors and other stakeholders to call for the inclusion of these risks in the purview of board risk oversight. Specifically, as part of their overall risk oversight, boards are encouraged to establish accountability for E&S issues, adopt E&S policies, and influence E&S outcomes. Using novel survey data on board risk oversight, we assess the extent to which boards have responded to these calls by examining the relation between board risk oversight and E&S accountability as well as E&S-oriented strategic, operational, and disclosure policies. We also conduct exploratory tests to examine the relation between board risk oversight and E&S outcomes. Our assessment recognizes that boards have limited resources and that their risk oversight is analogous to a constrained optimization problem. We are also cognizant that many directors do not deem E&S issues as value relevant or important from an oversight standpoint and that, even if they do consider these issues, trade-offs between the interests of different stakeholders will be inevitable.

Our findings indicate that firms with more extensive overall board risk oversight are more likely to institute accountability through E&S compensation schemes, set environmental (but not social) targets, adopt policies that address E&S risks and opportunities, and issue an E&S report. Our exploratory evidence also shows that more extensive board risk oversight is associated with better environmental outcomes, specifically lower monetized environmental costs, but worse social outcomes, namely lower monetized employee benefits and a higher likelihood of social risk incidents. We also explore the idea that boards may engage in trade-offs between E&S risks and financial risks when deploying their oversight resources. Our findings suggest that, when boards had focused less (more) on mitigating financial risk in the past, their firms achieve better (worse) E&S performance in some of the dimensions that we examine.

Our findings offer new insights that speak directly to growing investor and stakeholder demand for the inclusion of E&S risks in the purview of board risk oversight. Our evidence adds to the broader governance literature on the relation between observable board attributes and E&S performance (e.g., Dyck et al. 2023; Iliev & Roth 2023). We do so not only by leveraging novel data and illuminating firms’ board risk oversight practices but more so by demonstrating how these practices play a higher order role in explaining firms’ E&S performance beyond the role of observable governance features, including that of E&S committees. Our findings also highlight the need to consider both environmental and social risks, as trade-offs between them may be unavoidable, akin to how boards prioritize their oversight of different risks more generally. Lastly, our study constitutes a response to calls for research on the black box of internal board practices and its consequences (e.g., Cornelli et al. 2013; Schwartz-Ziv & Weisbach 2013; Cheng et al. 2021).

While our study is subject to certain caveats (e.g., selection biases inherent in survey data and samples, data availability constraints, inability to draw causal inferences, etc.), we contend that our evidence advances the understanding of an under-researched topic. We encourage future studies to build on the foundation laid by our findings and to identify settings that can facilitate the development of new, large-sample datasets needed for structural estimation and causal inference on the relation between board practices and different aspects of firms’ E&S performance. In particular, the rise of risk oversight disclosure requirements in different jurisdictions (e.g., the SEC’s 2010 enhancement of proxy statement disclosures on the risk oversight role of the board) enables researchers to leverage text-based datasets on board risk oversight practices for a potentially larger set of firms and in time-series, which could enable the study of how the evolution of risk oversight practices relates to different elements of E&S performance. While such datasets may also be subject to limitations, for example those stemming from the use of boilerplate legal language in regulatory filings—a concern that our use of the RMI survey mitigates—they may provide the required sample size and time-series data needed to better understand the relation between board risk oversight and E&S inputs as well as its direct and indirect (through E&S inputs) influence in driving E&S outcomes. Moreover, while our findings highlight the relation between board risk oversight and the institution of certain E&S accountability mechanisms and the adoption of a variety of E&S policies, future work can also explore alternative channels through which boards contribute to E&S performance. These could include the role of the board in: (a) fostering an E&S-conscious risk culture, (b) identifying E&S outcomes that should be prioritized (e.g., emissions, water consumption and pollution, employee health and safety, etc.) given the firm’s industry, business model, and value chain, (c) identifying or approving investments that are in alignment with E&S priorities, (d) managing or overseeing trade-offs between financial and E&S objectives or trade-offs among stakeholders that may arise (e.g., climate stakeholders versus employees), and (e) designing a disclosure strategy that emphasizes progress on E&S issues while minimizing the risk of green- and social-washing. We believe that exploring these and other related questions offer fruitful avenues for future research.