Is Sustainability the Key to Good Corporate Governance?

Good corporate governance has always been built on a set of guiding principles. Although the exact wording may vary around the world, the themes remain basically the same. The Financial Reporting Council in the UK, for example, lists those principles as:  

• Leadership – an effective board should take collective responsibility for the success of the company in the long term.  
• Effectiveness – the board should feature a range of skills, make informed decisions and evaluate its performance. 
• Accountability – this requires the board to provide an honest assessment of the company’s position as well as dealing with all aspects of risk management and internal control procedures. 
• Remuneration – there should be a transparent procedure for agreeing on executive compensation and for measuring the success or otherwise of the director in meeting their targets. Such packages should also be designed to help the long-term success of the business.  
• Shareholder relations – the board is responsible for encouraging shareholders to interact and ensuring that this dialogue takes place.  
  
  

However, given the rise of responsible investment, there is a need to evolve corporate governance to encapsulate sustainability, too.  

Although there is evidence that investors are increasingly interested in the non-financial performance of issuers, some organisations are yet to catch up. Ethics & Boards, a partner of Euronext Corporate Services, European leader in corporate governance data and benchmarking, found that 96% of the S&P 100 CEOs have no climate-related objectives in their compensation packages. In addition, 29% of the pay policies that were revealed were only based on financial metrics. 

The increasing interest in sustainability 

KPMG dates the current boom in sustainable investing back to the ambitious Paris Agreement of 2016. The climate change treaty expects countries to collaborate and limit global warming. The goal is to reduce greenhouse gas emissions and keep the global average temperature well below 2°C above pre-industrial levels. This bold target cannot be achieved through governments alone. It requires organisations in all sectors to step up and take action.  

Following the publication of the UN’s 17 Sustainable Development Goals (SDGs) in 2015, the Paris Agreement seems to have increased investor demands. Issuers are now expected to show that they mean business when it comes to not only climate change concerns but also all sustainability factors relating to the environment, social and corporate governance (ESG).  

Pressure on issuers 

This wave of sustainable finance resulted in shareholders scrutinising an organisation’s ESG policies before deciding whether to invest. This means that firms must have these processes in place and they need to make sure they are working hard to show strong progress in their non-financial reporting.  

On top of the pressure from activist shareholders, there are legal concerns and compliance requirements, too. The European Union has already instigated legislation in the form of the Sustainable Finance Disclosure Regulation (SFDR) and the Non-Financial Reporting Directive (NFRD) to mandate the recording of ESG reporting for businesses. The US is looking to follow suit, currently consulting on guidelines to determine which climate change metrics businesses might be obliged to report in the future.  

There is no doubt that environmental risks are high on the agenda for investors but there’s more to it. Other ESG topics such as business ethics, board composition and executive remuneration are important, too.  

The COVID-19 pandemic has resulted in some major institutional shareholders using their votes to block compensation packages that feel out of step with the events of the previous year. Where employees have taken pay cuts, there have been job losses or companies have relied on taxpayer support, institutional investors like Blackrock have voted against management on executive pay more often in 2020 than previously. 

The Black Lives Matter protests following the murder of George Floyd by a police officer in Minneapolis in 2020 have also had a significant effect. Asset managers have been insisting that issuers do more to tackle racial injustice as part of their ESG policies, making that a priority for any sustainable business with ambition.  

How to integrate sustainability into corporate governance  

1. Work on transparency and engagement

In relation to the calls for diversity and equality within organisations, asset managers have already begun to make their demands on corporate governance policies. Katie Koch, a managing director at Goldman Sachs Asset Management, said in September 2020:  

“Something we are going to spend a lot of the next proxy season engaging on is getting better workplace demographic disclosure so we can actually hold companies accountable.” 

Transparency is very much the key when it comes to good governance and reassuring investors about your ESG rating. Engage shareholders and disclose the information they need to make their sustainable investment decision.  

You should plot your ESG goals using a sustainable development roadmap and issue progress reports to shareholders, showing both the positive and negative outcomes.  

2. Integrate sustainability in your operations  

The board is in charge of driving forward the company’s strategy, so an organisation cannot be truly sustainable unless its board is behind the sustainability agenda. Top-level leaders need to embrace the benefits of a sustainable future, integrate ESG goals in the company’s operations and implement mechanisms to monitor success.  

The World Economic Forum has called for directors to step up in terms of driving sustainability. It says: “Having the strong commitment, collaboration and strategic direction from the board is an essential first step for an organisation as it starts its ESG journey. By focusing on both what not to do, as well as what needs to be done, the board should be able to connect with stakeholders within the business and the wider ecosystem, to pursue sustainable practices that fit into the business strategy and achieve positive outcomes for the long term.” 

It adds: “It’s time for boards around the world to walk the talk and take ESG standards and practice to new levels. Companies need to be a true positive influence.” 

Investment firm Vanguard makes clear that boards have a strong role to play in creating the sustainable environment in which its clients want to invest, emphasising the importance of “supporting sound business practices when investing. For example, by trying to make sure that executive pay is tied to performance, company boards reflect society and minority shareholders are protected.” 

3. Appoint a chief sustainability officer

Currently, the Ethics & Boards data shows that 37.5% of the Stoxx Europe 600 boards and 62% of the S&P 100 boards have no committee in charge of Corporate Social Responsibility (CSR) or sustainability. Sustainable growth and development cannot flourish unless the board buys in to the cause. 

Appointing a Chief Sustainability Officer (CSO) to sit in the executive committee and report directly to the CEO shows a commitment to sustainability and board ethics. This means that there is someone to lead on sustainable activities and to be able to provide feedback to the board, giving the benefit of their expertise to help their colleagues follow best practices and make informed decisions.  

Dr Mary Martin, director of the UN Business and Human Security Initiative at LSE IDEAS says:  

“Large companies are now accustomed to having investor relations and government relations teams as part of the corporate management function. In today’s climate of increased focus on companies’ social responsibility, any business of significant size needs staff who understand the sustainability challenge. Importantly, they also need to be able to intervene at local and regional operating levels, not just work in headquarters.” 

4. Train your directors

With sustainability being such a major focus area, it is important that board members are not simply interested in it but also understand the issues around climate change, sustainable development and diversity, and so on. They also have to be aware that all stakeholders in the company’s supply chain play a role in remaining sustainable — from creditors to suppliers. 

Ethics & Boards found that 85% of the Stoxx Europe 600 boards and 90% of the S&P 100 boards had not declared any skills relating to climate or the environment at all.  

5. Assess and map sustainability risks

Sustainability risks vary between sectors and also act as the catalyst to the development of sustainable strategies. So, it is important to spend time assessing those risks in your industry and mapping the challenges that could lie ahead. These might include climate impact, declining resources, social issues, labour rights issues or any other development that could affect your business.  

For example, PepsiCo assessed its sustainability risks and came to the conclusion that water stewardship was a major risk that affected its environmental policies, raw materials, competitiveness, community relations and brand perception. As a result, the firm put in place a series of goals to reduce its water usage intensity before the risk developed into a reality.  

6. Consider ESG materiality

Although the basics of ESG are related to ‘doing the right thing’, that doesn’t mean that you should ignore the materiality of sustainability. As Richard F. Lacaille, Executive Vice President and Global Chief Investment Officer of State Street Global Advisors says:  

“Consideration of sustainability factors in corporate strategies is a matter of value, not values, and we seek to capture these drivers of long-term shareholder value for our clients.” 

To drive the uptake of ESG within your organisation, you may consider linking CEO pay to sustainable factors. Ethics & Boards found that only 16% of Stoxx Europe 600 companies and 4% of S&P 100 companies included climate and environmental criteria in CEO annual variable compensation policy in 2019 

Sustainability as a competitive advantage  

Your corporate sustainability strategy must be coherent in order to provide a competitive advantage for your business. It has to travel from the top down, with buy-in at all levels and from all stakeholders. Otherwise, it is disjointed and seems performative.  

When you see it as a chance to reduce risks and cut costs, it stops being perceived as a hindrance and provides a real opportunity. It drives staff retention, better brand perception and more.  

Corporate boards should discuss the value of sustainability and use it to inform decision-making for the good of the business.  

FAQs

How Does Impact Investing Influence Shareholder Engagement?

Impact investing is gathering substantial pace, with environmental, social and governance (ESG) ratings factoring high in the minds of an increasing number of investors. To be precise, 85% of investors, including 95% of millennials, are looking into sustainable investments going forward. The sheer weight of momentum towards this shift is likely to lead to more requests for shareholder engagement from investors who want to influence the issuer towards a greater ESG score and better sustainability. 

How Does SRD II Impact Shareholder Engagement?

The revised European Union Shareholder Rights Directive (SRD II) came into force on 3 September 2020. It requires more transparency over engagement policies by investors and asset managers, necessitating that they are available online. In addition, they should be more open about voting behaviour and investment strategies. The idea is to increase long-term engagement and transparency over the whole process. On the sell-side, this can create more challenges and require more resources such as skilled experts to monitor assets, prioritise engagement issues and communicate with investors.

References and Further Reading 

• Impacts of good corporate governance 
• Purpose and examples of corporate governance 
• About Ethics and Boards 
• ESG Advisory 
• The increasing interest in ESG 
• What is an ESG rating and why it is important?