Corporate ESG practices can help catalyze revenue growth, reduce the cost of capital, impact operations positively and lower idiosyncratic risks.
Challenges in the way
Despite the multiple benefits associated with sustainable corporate governance, various internal and external challenges may stand in the way of implementation.
One of the key issues is investor pressure to prioritize short-term earnings. This may compel companies to redirect resources and capital from long-term strategic initiatives to meet immediate financial goals. To address this, the board should challenge the management to implement a decision-making framework that balances short-term and long-term value generation. It should also seek to engage with investors proactively to build trust, communicate the corporate purpose and secure support for strategic, long-term value-creation approaches.
Internal challenges may include reframing how the organization ties CEO and executive compensation to short-term versus long-term performance. The lack of internal processes or metrics to assess nonfinancial drivers of long-term value, such as human capital, poses another challenge.
Putting governance for good into action
Boards can take five approaches to implement an ESG strategy based on good governance.
Emphasize critical board attributes
It is crucial to have directors dedicated to long-term value creation and who recognize the importance of ESG. This helps set the right tone at the top and provides role models for the management and employees. Furthermore, certain attributes place the board in a stronger position to make decisions that deliver long-term value. These include the ability for directors to speak their minds and debate openly as well as a willingness to consider the interests of all stakeholders.
Diversity is another essential board attribute as it brings a wide range of perspectives and solutions to tackle complex issues. Diverse boards can challenge established thinking and biases in a way that homogenous boards cannot. Moreover, they are better equipped to ensure that decision-making considers the impacts on different stakeholders.
Crucially, the board must possess sound sustainability knowledge to be able to challenge the management on sustainability plans, oversee execution and progress toward fulfilling pledges. Engagement with investors on sustainability initiatives is also important. As companies forge ahead in their long-term value strategy execution, they may need to actively refresh and diversify the skill sets of their board members. Internal and external board evaluations should encompass an assessment of these desired attributes.
Deepen stakeholder engagement
Effective engagement entails bringing stakeholder voices to the boardroom table and genuinely considering their feedback in decision-making. Many companies, however, struggle to do this well.
As a starting point, boards must clearly define their key stakeholders and be clear on who are the most important. The engagement strategy should concentrate on understanding stakeholder needs and how they factor into boardroom decision-making vis-à-vis long-term value creation as well as getting stakeholders on board to drive buy-in.
The engagement strategy should also be pragmatic. It is not feasible for the board to engage directly with every key stakeholder from suppliers to communities, so it must decide who to engage with directly and who to engage with indirectly through the management. Boards should also strive to close the feedback loop by communicating with stakeholders on how their inputs were considered. Failing to do so risks eroding the relationships over time.
Provide material and credible disclosures
Long-term value orientation has profound implications on how corporates communicate their performance. Organizations would need to shift from backward-looking financial reporting to forward-looking insights based on financial and nonfinancial (including ESG) disclosures.
Embracing this broader view of value and performance may require changes not only to frameworks and practices but also mindsets and cultures. Authenticity and accountability are paramount. This means being willing to share both positive and negative news openly.
Audit committees have an instrumental role in this transformation. They can help ensure that the company establishes and maintains effective controls supporting the quality of financial and nonfinancial information and reporting, including long-term value metrics. They can also oversee the robustness of risk information. Delivering reliable and consistent enhanced corporate reporting is crucial to help boards make confident decisions and for stakeholders to assess the company’s future prospects and cash flow.
Cultivate an appetite for long-term risk-taking
Companies may have a desire to pursue initiatives to enhance long-term value but may be held back by the uncertainty of success. Also, their traditional risk framework and focus on short-term shareholder returns might hinder them from acting boldly.
Boards should, therefore, seek to strengthen their risk assessment and management capabilities, including for atypical risks. Doing so will make them more confident in long-term risk-taking and understand the potential upsides of initiatives with a longer time horizon. The current uncertain environment presents an opportune time to embed cultural and operational changes to help businesses navigate emerging risks better as well as put in safeguards to mitigate future crises.
Link executive compensation to sustainability
Establishing “remuneration-grade” KPIs for sustainability objectives is challenging. But there is a compelling case to do so. Effective variable remuneration schemes can hold the management accountable to sustainability goals and support the achievement of desired outcomes.
To this end, compensation schemes should include a combination of near- and long-term incentives to reward executives for generating sustainable growth. These may include short-term compensation plans like annual bonuses alongside long-term incentive plans that encompass multiyear measurement periods.
To be effective, compensation schemes need to be aligned with the right ESG metrics. These can be challenging to define and assess. Not all ESG metrics are relevant for all companies, so organizations need to identify reliable metrics that are most material to them. Robust processes, data and controls as well as keen board committee oversight will be required.
Unsurprisingly, grappling with these intricate issues can lead to inertia. The EY Europe Long-Term Value and Corporate Governance Survey 2023 found that less than half of organizations currently incorporate sustainability into their remuneration practices. The study surveyed 200 directors and senior leaders and split respondents into two groups: “experts” and “beginners”, depending on their score on sustainability governance. Interestingly, 61% of the experts include ESG metrics as a significant element when setting the compensation of senior executives, compared with 29% among the beginners. This highlights the value of investing efforts in this area.
The rubber hits the road
Ultimately, board leadership is integral to driving sustainability from ambition to action and from targets to concrete outcomes. Society is looking to businesses to take the lead in addressing the most pressing sustainability issues, and leaders need to pivot their governance approach to deliver real-world outcomes. Now is the time to establish strong multistakeholder engagement and implement the corporate governance elements that can help deliver sustainable value for all and the long term.
Boards should consider the following questions:
- Are we considering the interests of all stakeholders in decision-making and not just shareholders?
- Do we have an approach to strategy formulation and decision-making that effectively balances near-term and long-term value creation?
- Do we have an established approach to measure and communicate the long-term value generated by the company?
- Do we communicate to all stakeholders with authenticity, including being transparent about the positive and negative impacts of business decisions?
- Are we implementing remuneration schemes for executives and the management tied to long-term value creation?
This article first appeared in the Q4 2023 issue of the SID Directors Bulletin published by the Singapore Institute of Directors.
Our related articles
Summary
Companies can realize many benefits through robust corporate ESG practices. To implement an ESG strategy effectively, it is essential to have board directors who recognize the importance of ESG and consider the interests of all stakeholders as they commit to long-term value creation. Other key actions include deepening stakeholder engagement, providing material and credible disclosures, strengthening risk assessment and management capabilities to encourage long-term risk-taking, and linking executive compensation to sustainability.