This comes in addition to investors urging company boards with an increasing level of intensity to review the components of their corporate strategy through an environmental, social and governance (ESG) lens.

Below we’ll explore the most cited top-of-mind issues company boards must address. While this article focuses on the state of corporate governance pre- the pandemic, our next article (link to article 3) will look more specifically at corporate governance challenges that have arisen during the pandemic and how the experiences during COVID-19 will affect corporate governance going forward.

UK Corporate Governance Code (The Code): Established in 1992, and developed since then, the Code sets out principles of good practice for corporate governance of listed companies on the London Stock Exchange.

UNPRI: The UN Principles for Responsible Investing is an organisation propagating principles of responsible investing and working with investors to implement ESG factors. It has over 2,000 participating signatories from over 60 countries representing more than US$80 trillion of assets.

ICGN: Founded in 1995 as an investor-led organisation, the International Corporate Governance Network’s mission is to promote effective standards of corporate governance and investor stewardship.

A recent survey amongst global institutional investors, pension fund managers and corporate governance professionals to identify corporate governance trends found that, for the first time, environmental and social issues are taking the greatest precedence for investors, who expect company boards to strengthen their oversight and knowledge of material E&S matters.

While there are regional differences, the following trends, all representing subsets of ESG considerations, have and will be shaping the work of company boards:

Strategic

• Reviewing the corporate purpose
• Setting ESG targets

Risk management and disclosure

• ESG risk management and oversight
• Transparent ESG reporting and climate-related financial disclosures

Board governance

• Board diversity
• Shareholder and stakeholder (particularly staff) engagement
• Executive compensation
• Special aspects: Tax disclosure and Lobbying

What are the key considerations for each?

Defining corporate purpose and demonstrating a company’s social return as well as shareholder return has been a key trend in Europe over the last several years and will receive even greater attention in the UK with the recent release of the Financial Reporting Council’s (FRC) updated UK Stewardship Code, which contains substantial revisions from the last edition, such as the requirement to report on company purpose, values and culture.

The Purposeful Company (TPC) Task Force, established in 2015 with the support of the Bank of England, has also helped to revive the discussion about the purpose of corporations. The task force states: “Leaders in a company should put its purpose first and seek investors who are equally committed to pursue it and thereby achieve long-term, sustainable value,” and it emphasises that “investors and boards should recognise that making competitive returns for shareholders is essential to a company’s success – but is not its purpose”.

With clear evidence that purpose-oriented companies benefit from higher productivity and growth rates, higher levels of innovation along with a more satisfied workforce, formulating and publishing a Statement of Corporate Purpose ought to be a top priority of every company board that hasn’t yet addressed it. While templates from governance experts and consulting firms can guide the process, company boards will need to take the time to define the purpose of their business, which is uniquely suited to its business strategy, stakeholders and sustainability goals. Internal and external discussions with staff, customers and other stakeholders can deliver helpful insights.

Company boards will find that defining a meaningful corporate purpose can also help to:

• Reshape corporate reporting to provide a holistic picture of the business and its value drivers;
• Direct shareholders’ attention to the company’s unique characteristics and values;
• Designate company-specific performance metrics linked to business strategy and value creation;
• Reduce investors’ reliance on external one-size-fits-all standards and inappropriate metrics and reduce vulnerability to shareholder activism

Before meaningful discussions about ESG goals can take place in the boardroom, company boards should request a thorough ESG risk assessment of the company (see next point). Equally, board directors should urge their management to engage with stakeholders in order to base ESG targets not only on the perceived risks but also on the ESG priorities of key stakeholders – some companies already gather such information through periodic surveys, while others have established stakeholder panels to discuss ESG.

The number of risks that company boards oversee continues to grow. And with a fast-increasing number of large institutional investors looking to get answers how ESG risks could impact on the long-term value of a company, board directors need to take a fresh look at how current risk management considerations and processes take into account ESG risks.

While many environmental and social risks will be on the radar already, company boards will most likely have to include additional areas of risk, such as for example a firm’s dependency on fresh water or usable land for its production; its exposure to severe weather events; or the likelihood of public repercussions if employees in the supply chain aren’t receiving a minimum wage or are suffering under unsafe working conditions.

For many board directors these will be topics where they don’t necessarily have expertise. However, investors keep on pointing out: a key part of directors’ fiduciary responsibility is the duty of care, which in this case translates into the duty to adequately inform themselves on ESG issues. Furthermore, investors, and the wider public, are expecting that those supervising company executives ought to view the risk universe not only from the company’s perspective but, following ESG thinking, also consider risk from the perspective of shareholders and other stakeholders, such as employees, customers, suppliers, communities and regulators.

Against this backdrop, boards will need to find out which business risks are already actively tracked and monitored by management and their board, and which will have to be added. While this is a relatively straightforward exercise, it becomes more challenging to then decide how the increasing number of risks can be effectively overseen. This has lead boards to start thinking about forming a separate risk committee – a characteristic of the financial services industry, but still very rare in other industries. A Spencer Stuart survey found that in 2019 only 12% of companies in the S&P 500 have risk committees.

Overall, detailed risk disclosures are coming from a growing number of firms, indicating that board directors and management are determined to “ESG risk-proof” their businesses – to a big part guided by the UK Corporate Governance Code (The Code). Grant Thornton’s annual Corporate Governance Review found for 2019 that 78% of companies now produce high-quality risk disclosures, with businesses increasingly linking risks to company strategy and providing a barometer of trends and management concerns. And 76% of firms have strengthened their efforts to give a good level of detail on environmental matters.

Articulating clear and measurable goals on ESG issues should go hand-in-hand with defining how the reporting format can meet the information needs of investors, stakeholders, ESG rating agencies and the wider public. While there are a number of ESG reporting frameworks available, such as from the Global Reporting Initiative, the Sustainability Accounting Standards Board (SASB), CDP and the UNPRI, company boards and management need to invest some time to find the most suitable format for their business. How to report and which framework to apply significantly depends on the information preferences of the report’s target groups: are they, for example, specifically concerned about climate related risks? Does the reporting need to satisfy the information needs of potential investors in a green bond or lenders for a green loan?     

With investors and regulators demanding climate related financial risk disclosures – the EU’s Technical expert group on sustainable finance (TEG) published its final report on climate-related disclosures in January 2019 based on recommendations from the Task Force on Climate-Related Financial Disclosures (TCFD) – company boards must also engage with their management on how to retrieve the data required to deliver these disclosures. Boards can turn to the TCFD for guidance on how to implement the TCFD recommendations.

Furthermore, best practice in ESG reporting also includes detailed disclosure about the company board’s role in supporting an ESG approach. Information could for example cover how board directors:

• oversee ESG key risks, including board structure and board expertise
• receive training on key ESG risks,
• approach allocating ESG risk oversight responsibilities,
• receive reporting on ESG risks and ESG measures;
• and integrate ESG issues within other management discussions on business strategy and performance.

Increasing gender and ethnic diversity of boards is one of the longest standing corporate governance issues, not only in Europe.

The 2018 update of The Code, emphasising diversity, will provide a further push for diversity laggards, but overall board and staff diversity is on the rise and measures are underway to promote diversity: In its 2018 report on board diversity, the Financial Reporting Council found that 98% of FTSE 100 companies now have a diversity policy (up from 56% in 2012) and estimated that 20-30% of the FTSE 100 are ‘best in class’ by setting measurable objectives for diversity.

Especially gender diversity of UK boards has significantly improved: in 2010, women comprised 12.5% of the members of the corporate boards of FTSE 100 companies. In 2019, this had risen to 32.4% of directors in the FTSE 100 and 29.6% of directors in the FTSE 250, as evidenced by the November 2019 Hampton-Alexander Review. The FTSE 350 as a whole stands at 30.6% female board members, close to the voluntary target of 33% in 2020, with companies now showing efforts to also increase the proportion of female executive directors and board chairs.

Meanwhile, the progress on ethnic diversity has been much slower: in 2020, 37% of FTSE 100 companies surveyed still do not have any ethnic minority representation on their boards, and the FTSE 250 boards were even less diverse, with 69% of the FTSE 250 companies analysed reporting they have no ethnic diversity on their boards. Those numbers show that it’ll be challenging to meet the “One by 2021” target (appointment of one company director of ethnic minority background by 2021) set in the Parker Review published in 2017.

To help accelerate the rate of progress, the 2020 Parker Review report set out additional recommendations:

• Engage: FTSE 350 companies must engage constructively on this issue and report on the ethnic diversity of their boards
• Report: The Review urged companies to report fully on their ethnic diversity policies and activities as part of their reporting requirements and in compliance with the Corporate Governance Code
• Recruit: Executive recruiters should be much more proactive in ‘marketing’ highly talented ethnic minority candidate
• Develop: A pool of high potential, ethnic minority leaders and senior managers should be developed as part of a cross-sector sponsorship/mentoring programme lead by the companies’ CEOs

Many point to the fact that low boardroom turnover means that change takes time. In this context, the 2019 numbers of the Spencer Stuart Board Index, which analyses the board governance practices of the S&P 500 in the US, provide some positives: the 2019 incoming class of 432 independent directors, the most since 2004, shows that 23% of new S&P 500 directors are minorities (defined as African American/Black, Asian and Hispanic/Latino). With the Black Lives Matter movement having a deep and seemingly transformative impact on society, governance experts expect ethnic board diversity to show an even clearer upwards trend for 2021 and beyond.

The Code’s principle around shareholder engagement, calling for company boards to ensure effective engagement with their shareholders and stakeholders (e.g. employees, customers and communities) and encourage participation from these parties has been bearing fruit: Grant Thornton’s 2019 Corporate Governance Review of the FTSE 350 found that shareholder engagement increased for the first time in four years: the number of companies that give good or detailed disclosures on shareholder engagement is now at 44% (2018: 31%), with 62% of the FTSE 100 providing extra detail on how they engage with shareholders (2018: 44%).

The report also noted a rise in face-to-face meetings between companies and major investors: 64% of companies now mention face-to-face engagement (2018: 46%), representing a 16% increase in the FTSE 100 and a 18% increase in the FTSE 250. In line with the Code, which also recommends that committee chairs should engage with shareholders on matters related to their areas of responsibility, a growing number, 33% up from 22% of FTSE companies are reporting that their committee chairs have attended meetings with shareholders and large investors in the past year.

Likewise, company boards are embracing employee engagement: 87% (compared to only 66% in 2018) stated that they proactively seek to get the views of their staff and establish a two-way communication. Engagement tools range from surveys (most often cited) to “Meet the Board” events and/or selecting a staff representative for the board or nominating a Non-Executive Director as well as employees for a workforce advisory panel. Community engagement via staff volunteering and events is equally on the rise.

While there’s visible progress, there’s still some work to do: The FRC has pointed out that company boards should also explain how effective the various engagement methods have been in influencing board decisions and articulating outcomes.

Seemingly lavish executive compensation packages have been met with public outcries for many years. As part of a wider global debate around inequality and the need for a more socially responsible capitalism (the S in ESG), the ethics around fair pay remain a hot topic for board oversight – going further than solely limiting executive pay by also including discussions around fair wages for all company employees.

“Say on pay”, the right for shareholders to annually vote on the executive pay report prepared by the board of directors and introduced in the UK already in 2002, didn’t bring much change. Enhanced executive remuneration disclosure rules, which came into force in 2013, equally didn’t show the desired effect, with many shareholders claiming a lack of initiative from company boards to provide transparent reports and/or to properly link pay with performance.

Consequently, the updated UK Corporate Governance Code 2018 spelled out the importance of designing remuneration policies and practices to support strategy and promote long-term sustainable success, emphasising that:

• executive remuneration should be aligned to a company’s purpose and values, and be clearly linked to the successful delivery of the company’s long-term strategy
• the remuneration committee should review workforce remuneration and related policies, the alignment of incentives and rewards with culture, and take these into account when setting executive pay policy
• the board should exercise independent judgement and discretion and that incentive arrangements should also allow the company to recover and/or withhold sums or share awards in specified circumstances

Similarly, the EU updated its Shareholder Rights Directive in 2019, which amongst other requirements directs European companies to submit their remuneration policies and their remuneration report to periodic shareholder votes and disclose how the voting results were taken into account by the board.

At the same time, apart from cutting executive salaries in order to make them “fair”, company boards are facing increasingly impatient calls to link ESG performance to executive pay in order to protect and create value, which is in the interest of both companies and their investors. The World Economic Forum responded to the demands in January this year with a new Davos Manifesto, which states that a new measure of “shared value creation” should include “environmental, social, and governance” (ESG) goals as a complement to standard financial metrics.

While sceptics expect that the hot topic executive pay will remain just that, first corporate examples might indicate change: Royal Dutch Shell, bowing to pressure from investors announced that it will tie executive pay to three-to-five-year targets for net carbon footprints from 2020.

Tax disclosure

Corporate tax arrangements continue to inspire similar fierce public debates as around executive compensation. The Independent Commission for the Reform of International Corporate Taxation (ICRICT) highlighted a report by the UN Conference on Trade and Development estimating corporate income tax losses for developing countries, due to profit-shifting by multinational corporations, at one-third of total corporate income taxes due — US$100 billion per year.

While strengthened tax enforcement is exposing corporates to unexpected tax assessments and increases in tax liability, company directors are also appreciating that publicly perceived tax avoidance by creatively exploiting loopholes in different tax frameworks can also undermine the efforts invested by the company into their corporate responsibility and overall sustainability positioning.

As part of good governance company boards need to understand their business’s tax decisions and how those decisions impact the company’s financial results and stakeholders, and they need to be able to explain to investors how their company’s global tax strategies align with their sustainability commitments. In this context, the UNPRI published “Investors’ recommendations on corporate income tax disclosure”, which highlight that:

• tax governance is part of the risk oversight mandate of the board, including the setting of clear responsibilities and mechanisms to maintain compliance with the firm’s tax policy
• the board must discuss the ramifications of the company’s tax strategy on its brand and reputation, including assessing potential stakeholder perceptions regarding the “spirit” of tax laws.

Lobbying and donations

The guidance from the International Corporate Governance Network on "Political Lobbying and Donations" (PDF), published in 2017, addressed the dilemma of lobbying as on one hand representing a legitimate tool for companies to take an active and constructive role in helping to inform public policy debate, but on the other hand being associated as a tool to seek political influence through corrupt practices.

As such, the ICGN guidance gives recommendations on how company boards can ensure that any political activities undertaken by their company have appropriate ethical and legal foundations. Key points include:

• The company policy towards political lobbying and donations should be communicated clearly by company management throughout the organisation and should apply to company agents and external representatives when representing company interests.
• The company should establish robust internal controls and reporting processes as part of a risk management system to monitor compliance with its policies on corporate political activity. Clear sanctions should be in place for individuals who are found to be in breach of these policies.
• It is the responsibility of the board to understand and explicitly approve the company’s policies with regard to political lobbying and donations. This includes charitable donations and donations to trade associations or related third-party organisations.
• The board should appreciate the legal and reputational risks associated
  with improper political activity and be responsible for oversight of political activity. This could come under the purview of board corporate governance or risk management committee, and includes monitoring and approving political and related charitable donations.
• In its monitoring the board should ensure that lobbying and political spending do not reflect narrow political preferences of the company’s executives that have little or no bearing on the company’s own commercial performance.

Our selection of the most debated corporate governance challenges not only shows that company boards are stretched in many directions, but also underlines that corporate governance has become a topic of broad public interest around the globe; and even more so during the pandemic. Our next article will look into how COVID-19 has affected governance.

Corporate clients who would like to discuss this topic further should contact:

Varun Sarda, Head of ESG Advisory