A new prism for understanding Board accountability is emerging. Through Fidelio’s Search, Evaluation and Development assignments we see Environmental, Social and Governance (ESG) factors gaining traction with implications for Board effectiveness and Board composition.
Importantly we see institutional investors – driven by their clients – embracing ESG both as a framework for investing and a means of holding Boards and management to account. While we are not yet seeing negative AGM votes on ESG as we are on executive pay, a shift is happening.
Investors in the extractive industries have for some time been concerned about legacy implications and the risk of stranded assets. More recently, investors have also insisted that management KPIs in the oil / energy sector are also linked to cutting carbon emissions.
With the dramatic switch in consumer behavior on plastics and recycling, driven by the illustrious Sir David Attenborough, and leading to dramatic business model implications for the FMCG, retail and plastics sector, we see clearly how quickly the license to operate can be withdrawn. Boards need to be alert and recent NGO coverage of the environmental implications of the fast fashion industry should be setting off alarm bells to Board in the sector.
In 2018 Fidelio conducted research with leading Chairs into the main sources of disruption. ESG featured obliquely. This may be about to change.
In this Overture, Fidelio reviews the dramatic shift in focus with regard to ESG and how investors and regulators are increasingly holding Boards to account. Most recently, in the Proposed Revision to the UK Stewardship Code, a key change is the inclusion of ESG factors for investors.
“Signatories are expected to take into account material ESG factors, including climate change, when fulfilling their stewardship responsibilities.”
Environmental, Social, Governance: The New Disruptors
Environmental, Social, and Governance (ESG) factors are gaining traction but Fidelio still sees a lag in the response of many public company Boards – beyond healthy statements in the annual report. In Fidelio’s ongoing research project on “Disruption and the Chair”, surprisingly ESG factors gained barely a mention across a range of Chairs from a number of industries. The principal sources of disruption identified by our Chairs have been Technology (43%) and Regulation (24%): yet in Fidelio’s view, recent events indicate that the salience of ESG factors is increasing, and that Boards need urgently to ensure they have strategies in place for their effective management.
There is clearly reputational risk here, but also a business and shareholder imperative: the costs of missing environmental, social and governance risks can be substantial. The appetite of both broadcast and print media for stories, combined with the astonishing speed with which issues propagate on social media, make this an area where companies cannot afford to be on the back foot. Moreover, Boards are increasingly being held to account.
Environmental: Oceans of Plastic
An explosion on an oil rig resulting in loss of life combined with widespread environmental damage; a celebrity wildlife documentary showing vast quantities of plastic detritus injuring fish and other ocean creatures. These are just two of recent events which have caused significant disruption to the companies and industries concerned. In one case, the root causes are health and safety management in a challenging engineering environment; the other is causing many FMCG companies to urgently review their packaging strategies with recyclability now at the top of the agenda. Both issues arose extremely quickly, and Boards have scrambled to keep up: a flat-footed response in the current climate of public mistrust of business can result in the effective withdrawal of a business’s license to operate. And that’s before taking account of the global economic effects of climate change which are beginning to enter corporate and political consciousness.
Social: The Abuse of Power
Abuse, both historic and current, has started to come into the public view after many years of silence. Once-celebrated businessmen, actors, producers, and politicians have been accused of abusing the power differential between themselves and the people around them to psychologically abuse and to demand sexual favours. Investigative reporting by the leading business paper, the Financial Times, led to the shutdown of a prominent City charity which raised significant sums for worthy causes through events that have become socially unacceptable.
It’s now clear that societal norms have changed, and Boards face a challenging task in ensuring that abusive behaviour is not tolerated anywhere in their company. In many cases this amounts to major culture change: easy to say and very hard to do, especially since abusive behaviour has been found in otherwise very successful and high-performing individuals.
And that’s before we talk about the extent to which the broader social impact of a business should be measured and how shareholders and stakeholders should best set about this.
Governance: The Essential Intangible
Reading a corporate annual report, one could be forgiven for thinking that governance is about boards, committees, meetings, audits, and the people who take part in them. And of course it is; but, crucially, it’s also about something much less tangible: the effective functioning of the entire organisation, led by those at the top. A retailer is found to have systematically over-stated profits by accounting for supplier rebates. An automaker is found to have manipulated the results of engine emissions tests. An infrastructure company collapses amid claims of suspect contract accounting, excessive debt-funded dividends and poor-quality financial audits.
In all these cases the boards and committees were present, had meetings and audits were carried out, but these did not prevent the breaches of trust and resulting reputational and valuation impact. Executives were not adequately challenged; regulators received a partial picture; pension trustees were overlooked; suppliers were pushed to unacceptable limits, while dividends and bonuses were paid whether they were affordable or not. The structures were present, but the intangible essence of governance – an ethical sense of sustainable purpose – was absent.
Board Composition, Board Evaluation and the next wave of activism
Fidelio has a strong commitment to Board effectiveness – cross-border, cross-sector, cross-function. Boards are under increasing scrutiny and the sharp rise in the importance of ESG creates an additional complexity and ambiguity for Boards to absorb.
Board Evaluation is a means for identifying where the Board needs to be in its understanding and proactivity regarding ESG, versus where the Board is today.
This shift in focus also has implications for Board composition. Boards which on paper espouse an ESG agenda, friendly to both stakeholders and society, but which manifestly lack directors with the skill sets and experience to oversee the delivery of this agenda, lay themselves open to the next wave of activism.
As Nominations Committees think through Board succession planning and the Chair plans the next three-year cycle of internal and external Evaluations, ESG should be featuring very prominently.
For further details of Fidelio’s Search, Evaluation and Development capability, please contact Gillian Karran-Cumberlege at gkarrancumberlege@fideliopartners.com or call on +44 (0)207 759 2200.