COVID-19 has revealed the gap between principles and practice
The pandemic has accelerated the need to prioritize stakeholders’ interests.
The Business Roundtable statement represented a significant achievement and a major step forward for stakeholder capitalism. Yet a year later, and nine months into the COVID-19 pandemic, a Fortune survey (pdf) found 64% of signatories didn’t think “good” businesses needed to change. Such a view is at odds with the vast economic, social and political damage the pandemic has wrecked. The K-shaped recovery (the type of economic recovery where professionals and certain industries recover at a faster rate than the rest of the population and smaller business) suggests that a complex mix of policy failure, political disfunction and a need to improve stakeholder governance has driven widening inequality.
While capital markets rebounded quickly, vulnerable communities are suffering disproportionately, exposing – and exacerbating – entrenched disparities in health, wealth and opportunity. Both stock market capitalizations and unemployment rates rose to record highs during the pandemic, suggesting that while some exceptional firms have “done well by doing good,” others have more work to do to truly bring their BRT commitment to practice.
The collective social response to the pandemic therefore, on aggregate, shifted risks away from shareholders and onto other stakeholders. This is in sharp contrast to the ideals of stakeholder capitalism. The chasm between stated principles and real-world outcomes risks a deteriorating business environment as trust is damaged, in turn threatening a firm’s license to operate. EYQ’s 2021 CEO Imperative study identified a significant “say-do” gap in the shift to stakeholder-based long-term value creation, suggesting a lack of common definitions and understanding of how to progress these objectives in the enterprise. There is now an opportunity for boards to help management demonstrate true consideration of stakeholder interests when making decisions that affect long-term value.
EYQ’s 2021 CEO Imperative study identified a significant “say-do” gap in the shift to stakeholder-based long-term value creation, suggesting a lack of common definitions and understanding of how to progress these objectives in the enterprise.
Fairness and trust lead the way
Fairness and trust are imperative for sustaining businesses in the long-term.
A recent survey of European CEOs and boards found the net effect of the pandemic has been to reinforce the importance of a long-term approach, rather than bowing to short-term market pressure. It also cemented the importance of stakeholder capitalism in rebuilding trust in business leadership. When respondents were asked to pinpoint the most significant benefits of pursuing long-term value creation: “improved brand, reputation and trust” emerged on top.
Here are three organizations leading by example:
- A multi-national retailer saw the pandemic as an imperative to bring its brand purpose to life and prioritize the needs of its stakeholders. Rather than emphasizing prices, the organization prioritized keeping its employees safe and supplying food for the communities in which it operates. Standard decision-making processes were abandoned in favor of a purpose-led approach to see the organization through the crisis. Profits increased nearly 30%, despite rising costs related to health and safety.
- A global food organization kept its stakeholders front of mind, maintaining a purpose-led model while its CEO and board directors took a pay cut. The company has four social and environmental objectives that align its purpose with the UN Sustainable Development Goals (SDGs). The board accepted the CEOs proposal to cut his fixed remuneration by 30% for the second half of the year, and its members voted to forego their own compensation entirely for the same period.
- A multi-national consumer goods organization identified the needs of its stakeholders, and donated money and goods while sharing expertise to help fight the virus. The organization gave away EUR 100 million worth of goods, including soap and sanitizer, and made EUR 500 million available to SMEs suppliers and customers. In the UK, it also helped make ventilators and recently announced all workers in its supply chain will receive a living wage.
Companies demonstrating transparency and accountability earn more trust, not only from customers but also employees. Companies that embraced these principles saw employee engagement increase during the crisis and might have become more attractive employers for members of Gen Z shaping the new normal.
Measuring what truly matters
Measuring what’s important can help focus on the long-term.
Over the past year, the EY organization – along with the other Big 4 firms as well as Bank of America has worked with the World Economic Forum International Business Council (WEF-IBC) to develop a standard set of metrics to help monitor stakeholder impacts. These are grouped under 4 pillars: Planet, People, Prosperity and Governance, the latter pillar includes metrics designed to incentivize executives to operate their businesses in ways that create value for all stakeholders over the long-term.
One of the most visible illustrations of the K-shaped recovery is a topic that’s been contentious for some time: executive compensation. Recognizing the need to show solidarity and share the pain, some CEOs have taken salary cuts of 10% to 100% as a largely symbolic gesture. However, the gulf between C-suite remuneration and the average wage for employees remains wide as the bulk of executive compensation is tied to rising stock prices.
To incentivize CEOs to work toward long-term value creation, boards might consider linking executive compensation packages to a broader set of purpose-led metrics. Rather than tying bonuses purely to stock price performance, executives could be compensated based on how they are delivering long-term value to all stakeholders in line with their purpose-led strategy. It is encouraging that 73% of leading organizations across Europe have implemented remuneration schemes tied to long-term value creation. EY teams estimate linking 15% to 25% of executive pay packages to the newly proposed metrics alongside clear performance targets could make a significant difference in stakeholder outcomes.
EY Long-Term Value and Corporate Governance Survey73%
Leading organizations across Europe implemented remuneration schemes tied to long-term value creation.
Taking stakeholder capitalism to the next level
An explicit and transparent stakeholder stack can help managing trade-offs when considering a broad range of stakeholders.
These examples show it’s possible to be profitable and drive positive social impact during a crisis. What can boards do to make sure management remains focused on all stakeholders after the immediacy of the crisis has passed, moving beyond new metrics to track progress toward purpose-led objectives?
One possible governance solution lies in formalizing the principles laid out in EY Embankment Project for Inclusive Capitalism (EPIC) (pdf) report by analyzing the company’s context, examining its purpose, reviewing its strategy and governance and conducting a detailed stakeholder assessment to reprioritize business expenditures to reflect the new broader purpose.
Another possible approach is for businesses to explicitly reveal their “stakeholder stack” to increase transparency. Borrowing a framework from corporate finance, the “creditor stack” organizes equity and debt holder claims to assets held on a firm balance sheet. This schedule sets out how an organization honors its liabilities, aligning expectations and providing certainty in distressed scenarios including bankruptcy. Certain liabilities, such as debt, sit at the top of the stack and are given seniority in a wind-down. Others, such as equity, are subordinated and get paid last.
Analogously, the stakeholder stack organizes claims to firm incomes beyond shareholders to include employees, communities and the environment. Every organization’s stakeholder stack would be uniquely tailored to its values, purpose, strategy and context to help guide management when making decisions about difficult trade-offs. To illustrate, an organization that puts humans at the center of its purpose might structure its stack so employees are the senior stakeholder, and therefore executive pay is automatically reduced before lay-offs commence. A firm with climate change at the heart of its purpose might nominate Mother Nature as the senior stakeholder and thus make decisions to preserve the environment over other claims.
Every organization’s stakeholder stack should be uniquely tailored to its values, purpose, strategy and context to help guide management when making decisions about difficult trade-offs.
These two examples are simplistic illustrations, as the stakeholder stack of any reasonably sized firm is much more complex, involving countless trade-offs amid scarce firm resources. Just like the creditor stack evolves as companies issue new liabilities to optimize the cost of capital; the stakeholder stack also evolves along with the challenges and context the firm faces. But by providing a clear hierarchy, boards can ring-fence purpose-led objectives while simultaneously allowing capital markets to better price social and environmental risks resulting from corporate actions. Creating such a governance structure might also provide management with a values-based “North Star” to aid decision making in the face of uncertainty as well as the fluctuations of the market.
5 questions to help boards drive stakeholder capitalism
The stakeholder stack is just one possible mechanism for managing the trade-offs when considering a broad range of stakeholders. If organizations are serious about creating long-term value for all stakeholders, rethinking how firm resources are prioritized must be embedded into their purpose, strategy and transformation initiatives. Long-term focused metrics are needed to measure, track, and report progress toward new objectives, and executive compensation must be tied to the full range of outcomes across stakeholders rather than just shareholders.
To further consider how these concepts could help their organizations, boards should ask themselves and their management teams:
- Have we worked together to define what stakeholder capitalism means to our organization? If so, have we formalized that through our purpose, strategy and transformation initiatives? Do we have long-term focused metrics to track our progress?
- Have we developed a framework that reflects the principles of stakeholder capitalism – and restructured our processes so every material stakeholder issue is considered within the remit of the main board or relevant committee?
- Do we need to create any new committees to strengthen oversight of these issues, such as for environmental, social and governance (ESG) issues?
- Do the incentive plans for the CEO and management team meet the needs of all stakeholders? Do they reflect our values, strategy and purpose?
- How much of our executive pay is linked to long-term metrics with clear performance targets?
Business leaders have voiced support for the shift toward stakeholder capitalism, and the COVID-19 crisis has accelerated the need to convert this ambition into action. Customers, investors and employees have high expectations for management to create and protect long-term value for all stakeholders. Boards should consider how to evolve governance structures, which may include an explicit and transparent stakeholder stack, to reinforce firm commitments to all stakeholders so that risks and rewards are distributed more equitably.