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Contributed by Andrew Droste, Russell Reynolds Associates
In the latter half of 2019, two influential organizations codified a significant shift in expectations for corporate priorities. The first came from the Business Roundtable in August, when the vast majority of its membership—including Apple, Amazon, and JPMorgan—endorsed an amended Statement on the Purpose of a Corporation. The second, in early December, came from the World Economic Forum in the form of a revised Davos Manifesto (the first since its original release in 1973).
Both declarations point to the same mandate—that companies should shift from satisfying just shareholders toward a more holistic approach that incorporates an array of voices and priorities (e.g., customers, employees, and society at large)—otherwise referred to as stakeholder capitalism. Each document is underpinned by an understanding that the decades-long focus on maximizing financial value for shareholders is no longer a viable or prudent approach to managing a company and overseeing risk.
This revived theory of stakeholder capitalism is the result of tremendous pressure from the world's largest institutional investors. They have increasingly come to realize that their passive investments are permanent capital, and that divesting from certain environmental, social and governance risks is no longer possible in standard index vehicles. For them, ESG has become a proxy for good risk management and long-termism, two primary concerns today, particularly evident during the coronavirus pandemic.
Moreover, companies are beginning to realize that considering such ESG risks (and, importantly, their opportunities) is good business. Unilever is the classic example of an issuer that's taken this approach for over a decade. In its 2019 20-F submission, Unilever stated that its purpose, supported by a Sustainable Living Plan, was crafted after gathering the views and priorities of “approximately 300 stakeholders, including more than 130 external experts” and “over 40,000 employees through a ‘Have Your Say’ survey.”
It has become abundantly clear that investors are asking management and directors to expand their scope of duties. This expectation goes beyond the Milton Friedman philosophy of simply maximizing shareholder profits (barring mergers and acquisitions or change-in-control situations). Companies now aim to improve the ways they capture (and measure) risks and opportunities related to a broader group of stakeholders. In fact, many institutional investors posit that ESG risks and opportunities are part of the board's fiduciary duty that directors are expected to oversee.
A New Era of ESG
For some, the mere mention of ‘ESG’ and concept of stakeholder capitalism can trigger anathema or aversion. Some on the financial side of the house believe ESG concerns can be “squishy”; likewise, legal may believe that they already solve for these concerns in existing enterprise risk management systems. Both can be true.
What is important for management is this: If the world's largest institutional investors believe that a stakeholder-driven approach and proper ESG management is linked to the long-term wellbeing of a corporation, then boards have an inherent fiduciary duty to provide oversight of those matters. Accordingly, it would behoove management to inform the board of this changing landscape as soon as possible, propose sensible adaptations, and filter material ESG risks and opportunities into management and board oversight processes.
The movement that has culminated in the surge of current ESG initiatives and disclosure of data will likely mean an increase in the reach of stakeholder capitalism in the 2020s. Investors will inevitably call on companies to include disclosure of unique material ESG risks and opportunities specific to not just their industry, but to their company. The stakeholder-driven approach undoubtedly enhances a company's ability to better identify what those may be.
Moreover, the societal consequences and expectations of a more human-centered form of capitalism—something stakeholder capitalism promises—is likely to emerge from the coronavirus pandemic of 2020. In other words, this era of leveraging a stakeholder approach to better identify, manage, and disclose ESG risk and opportunity is here to stay.
Building Infrastructure for Oversight
For the board to effectively oversee such risks and opportunities, management must first ensure they are defining ESG consistently across the enterprise. After standardizing definitions, they should undertake a materiality assessment that leverages both internal and external resources and data. Likewise, both internal and external forms of input should influence the triaging of ESG issues (and opportunities) that are identified during the assessment. Stakeholder input—be it from employees, customers, suppliers, and/or the communities in which the company operates—is key to tethering the process to the company's purpose and broader impact on society. Finally, management should separate material ESG issues from non-material ones and prioritize resources accordingly.
Following a materiality assessment, management should ensure that each of the material ESG issues are integrated into the company's ERM (enterprise risk management) and board reporting structures. Likewise, the opportunities and efficiencies discovered throughout the process should be shared to ensure collaboration as well as adequate capitalization. It is crucial that each of the ESG priorities be given key performance indicators so that the board may properly benchmark and oversee progress. Moreover, educating the board on every material ESG risk and providing them insight and access to the people responsible for the KPIs will facilitate proper oversight.
Sophisticated boards set the tone at the top by ratifying a statement of purpose, engaging with the investor community alongside management, and thoughtfully prodding management on attendant ESG risks and opportunities associated with short-, medium-, and long-term business strategies. They are also led by a strong chair, lead independent director, or committee chair that maintains ESG oversight responsibilities. Sophisticated boards should be supported by an equally sophisticated management team—one that sets ambitious targets and provides up-to-date sustainability data to the board on a regular basis. Ultimately, directors should understand how management has selected ESG priorities and be able to articulate this to the investor community if called upon to do so.
Striking the Right Chord on Disclosure
From the standpoint of disclosure, the world's largest institutional investors are pushing for more data. Both active and passive investment professionals are incorporating ESG data into their processes with the goal of enhancing risk-adjusted returns. As of the writing of this article, the U.N. Principles for Responsible Investment had signatories that comprise roughly $90 trillion- worth of global assets under management. BlackRock, the world's largest asset manager, is integrating ESG data, tools, and advisory research across each of its asset classes. Such commitments and usage of this type of data makes it all the more critical for companies to not only manage well, but also disclose well.
Increasing disclosure remains the only way to assure the company is being reasonably assessed on its ESG risk management. In order for advisory firms and ESG data providers (e.g., MSCI, Sustainalytics, and Bloomberg) to effectively capture risk profiles, the company's disclosure of material ESG issues must be clear and, where possible, quantitative.
One disclosure vehicle for ESG issues is the Corporate Social Responsibility report. This report should tell the story of the corporation's purpose and include managerial processes and board oversight responsibilities. Ideally, it should disclose the best practices outlined above—i.e., that an ESG materiality assessment was conducted and that its results influenced the disclosure that follows in the report. If the company hasn't yet conducted a materiality assessment, it should consider leveraging an external set of standards such as those from the Sustainability Accounting Standards Board to determine what ESG-specific issues are material to the company's industry and sector. This can be a useful first step in identifying and defining the concerns that investors are most likely to consider financially material to the business.
The CSR report should contain year-over-year data on material ESG risks and align with a generally accepted ESG disclosure framework, such as the Global Reporting Initiative, the Sustainability Accounting Standards Board, the Task Force on Climate-Related Financial Disclosures, the International Integrated Reporting Council, and the U.N. Sustainable Development Goals. Be advised that there are industry-specific reporting frameworks, as well—e.g., the Global Real Estate Sustainability Benchmark for REITs, or the Edison Electric Institute framework for utilities.
In some instances, a company will leverage more than one framework. Surveying top investors and researching the company's existing and aspiring peer groups can be helpful in choosing the framework that's best for the company.
Because investors want to see a fully integrated process, consider calling material ESG issues what they are—financially material risks. Therefore, the 10-K, 14A, board committee charters, website, and CSR report should all correspond with one another.
Connecting the Future With the Past
All of this can sound overwhelming; however, it's unlikely that management teams will have to begin the process from zero. In most cases, some of the material ESG risks have already been identified and are being managed, so the task becomes a reframing and reprioritization exercise. Moreover, many companies already have various forms of stakeholder outreach and human capital management strategies that have always made bottom-line business sense. In each of these cases, the main requirement is to quantify the impact on various stakeholders—shareholders included—and disclose these metrics.
Of course, there is a healthy degree of skepticism as to this new order of ESG integration and stakeholder capitalism. What's important for executives and directors is that such opinions are balanced against investor agendas. Companies that don't adopt these foundational theories may find themselves lagging behind peers in disclosure and have management playing catch-up. Even worse, the company could be mismanaging risks, feeding inadequate information to the board, or leaving capital on the table due to the company's exclusion from ever-growing ESG investment strategies.