Henri Eliot: Embracing environmental, social and governance issues

Companies with higher ESG ratings are, on average, outperforming their peers. Photo / 123RF

In the May-June 2017 Harvard Business Review, Professor Emeritus Joseph Bower and Professor Lynn Paine argue for a company-centred model of governance that recognises the diversity of shareholder goals and the varied roles corporations play over long periods.

Bower and Paine have proposed a "governance model that better balances the needs of shareholders and stakeholders, and expands the board's focus on the organisation's long-term health rather than its short-term returns".

"The time has come to challenge the agency-based model of corporate governance," they write.

"Its mantra to maximising shareholder value is distracting companies and their leaders from the innovation, strategic renewal and investment in the future.

"History has shown that with enlightened management and sensible regulation, companies can play a useful role in helping society adapt to change. But that can only happen if directors and managers have sufficient discretion to take a longer, broader view of the company and its business. The prospect of a surprise attack by unaccountable 'owners', [means] today's business leaders have little choice but to focus on the here and now."

Bower and Paine's view is timely for New Zealand boards.

A recurring theme is boards wanting "greater focus on long-term value creation; more engagement in strategy creation, implementation and governance; and scope to better balance the needs of shareholders and stakeholders, by ensuring their organisation has robust environment, social and governance (ESG) performance".

But market demands for higher shareholder returns risk turning boards into overseers of short-term thinking rather than long-term custodians who act in the best interests of the corporations, all shareholders and the community.

The growth of shareholder activism offshore and the high turnover/low tenure of CEOs in developed markets is symptomatic of the pressure on corporations to achieve short-term returns.

Bower and Paine say the agency model of governance is the root cause of market short-termism. Under agency theory, shareholders are best protected when board and management roles are separate. Independent boards safeguard against opportunistic management behaviour and potential "agency loss". Agency theory implies that boards are there to keep watch on management and that directors have a supervisory role.

The authors argue that agency theory is flawed. They dispute that shareholders are "owners" of corporations given that they legally do not have the rights of owners (such as using company assets).

Moreover, they contest that managers and directors are agents of shareholders. Rather, they are fiduciaries who are obligated to exercise independent judgement to act in the best interests of the corporation, not simply to do shareholder bidding.

Aligning management and shareholder interests - a hallmark of agency theory that is grounded in contemporary governance practices such as executive pay - is misguided, say Bower and Paine. "When the interests of successive layers of management are 'aligned' in this manner, the corporation may become so biased toward the narrow interests of its current shareholders that it fails to meet the requirements of its customers or other constituencies. In extreme cases, it may tilt so far that it can no longer function effectively."

The authors believe the success of organisation leaders is more to do with intrinsic motivation, skills, character and capabilities, than whether their pay is tied to shareholder returns. They argue that corporates must continually adapt through innovation, perform many functions, have differing objectives and strategies, multiple constituencies, require high ethical standards, and are embedded in a political and socio-economic system.

Bowers and Paine write: "These propositions underscore the need for an approach to governance that takes the corporation seriously as an institution in society and centres on the sustained performance of the enterprise. [In this model] boards and business leaders would take a fundamentally different approach to such basic tasks as strategy development, resource allocation, performance evaluation and shareholder engagement."

In New Zealand, for example the New Zealand Super Annuation Fund actively manages the long-term risks and opportunities that environmental, social and governance issues present to the Fund.

"In line with their mandate of best practice portfolio management, they are also committed to global best practice and domestic leadership in responsible investment".

In recent years, investors around the world have begun to place a much higher emphasis on responsible investment and the effective management of environmental, social and governance risks. Maintaining a global best practice approach will therefore require constant improvement on our part.

The takeout is clear: companies with higher ESG ratings are, on average, outperforming their peers and attracting more capital. It is no longer a question of boards trying to balance the needs of shareholders and stakeholders. Governing in the best interests of the corporation, shareholders and the community is not just the right thing to do, it's smart business.

Henri Eliot is CEO of Board Dynamics.