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Responsible investment: What does it mean for boards of directors?
by Professor Fabrizio Ferraro
fferraro@iese.edu
@f_ferraro
The global rise of responsible investment, that is, the systematic integration of environmental, social, and governance (ESG) criteria in the investment process, is impressive. By 2018, more than 2,000 asset owners and asset managers had signed the United Nations sponsored Principles for Responsible Investment, and it is estimated that there are already more than $30 trillion in assets under management following ESG investment practices. Even mainstream asset managers like BlackRock and Fidelity are now active in this space. As a recent report by BlackRock concludes: “Sustainable investing was once viewed as a trade-off between value and “values.” Yet today, it’s something investors can no longer afford to ignore.”
Corporate boards, likewise, should start taking this trend seriously, and prepare for the changes in corporate governance that are about to come as a result of the mainstreaming of responsible investment. But what are these consequences?
As the core tenet of responsible investment is integrating ESG factors in the investment process, its first (perhaps obvious) consequence is that corporate environmental, social, and governance performance will be increasingly scrutinized not only by NGOs and the media, but also by the financial sector, with increasing sophistication and transparency. Good ESG performance, thus, will affect whether or not corporations can raise funds among investors.
The second consequence of responsible investment will be more active investment stewardship. Most institutional investors were traditionally passive owners and did not interfere with management decisions. As stewards of their investment, responsible investors are now raising ESG issues (climate change, child labor, executive compensation, …) through their voting power, but also more directly by opening direct communication channels with board members and top executives. And corporations increasingly comply, as seen in the case of Royal Dutch Shell which agreed to the investors’ request to set carbon-output targets and commit to halve its “net carbon footprint” by 2050.
And finally, we might observe increasing diversity among investors’ positions on ESG issues. As recent studies in finance show, investors’ voting behavior show that while investors might share a common interest in financial returns, they do hold different positions on ESG matters. Most likely, this has always been the case, but as investors did not have to take a position on these issues, it was possible to treat all shareholders alike. Not anymore.
Are corporate boards ready to deal with this new world of governance? Are current governance practices fit for coping with the controversies that arise as boards and investors move from discussing dividend policy to climate change? I believe they don't.
One limitation, for instance, is the lack of expertise on ESG issues on the board. Most board members have expertise in finance, law, or business. Inside the company, Chief Sustainability Officers are rarely members of the executive committee, so any corporate expertise on ESG will be far from the board. If ESG issues are becoming strategic for investors, there should be people on corporate boards who can understand the ESG ramification of their decisions.
Governance processes, including annual general meetings and informal shareholder and stakeholder engagement, are not really designed to engage in any serious discussion of the issues, but are primarily designed to fence corporate managers from shareholders and stakeholders. We need to rethink these processes to facilitate (rather than inhibit) deliberation, and boards should develop stronger engagement capabilities.
Finally, once staffed properly, and with better designed governance processes, boards will be able to revisit their corporate strategies to make sure they can deal with these emerging ESG concerns of shareholders (and of other stakeholders).
These changes will not only help corporations cope with novel demands from the financial sector, but will also help them play a larger role in addressing the prominent societal challenges we face, and eventually win back the legitimacy they have lost in society.
Professor Fabrizio Ferraro
Professor of Strategic Management
IESE Center for Corporate Governance
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