The governance focus
The global perspective
As noted in our environmental protection introduction, environmental issues have been prevalent, in terms of both likelihood and impact, like the annual World Economic Forum (WEF) Global Risk Perception Survey assessed.3 Our social inclusion brief also highlighted risks encompassed in the WEF Report, including shockwaves from the COVID pandemic, which are contributing to growing social fragmentation and heightened instability. In addition to other overarching economic and technological risks, the knock-on effects of these environmental and social issues will continue to affect our organisations’ business models and levels of resilience. Organisations will need to understand the broad network of drivers that are collectively affecting governance risks and how they conduct business.
Governance and the U.N. Sustainable Development Goals
In 2015, as outlined in the CGMA® guide, The role of the accountant in implementing the Sustainable Development Goals, the United Nations established its 17 Sustainable Development Goals.4 The goals recognise that ending poverty must go hand-in-hand with strategies that build economic growth and address a range of social needs, including education, health, equality and job opportunities, while tackling climate change and working to preserve our oceans and forests.5
Organisations and finance professionals have an important role to play in understanding their business impact and the opportunities for change across the three ESG core elements the United Nations’ 17 Sustainability Development Goals (SDGs) encompass.
While good governance is important for achieving all of the goals, there are six Sustainable Development Goals that directly link to the governance pillar.
8 — Decent work and economic growth Promote sustained, inclusive and sustainable economic growth, full and productive employment and decent work for all.
9 — Industry, innovation and infrastructure Build resilient infrastructure, promote inclusive and sustainable industrialisation and foster innovation.
11 — Sustainable cities and communities Make cities and human settlements inclusive, safe, resilient and sustainable.
12 — Responsible consumption and production Ensure sustainable consumption and production patterns.
16 — Peace, justice and strong institutions Provide access to justice for all, and build effective, accountable, and inclusive institutions at all levels.
17 — Partnerships for goals Strengthen the means of implementation and revitalise the global partnership for sustainable development.
The goals should not be viewed in isolation from each other. By contributing towards one goal, there could be positive impacts on other goals not directly linked to the governance pillar. Alternatively, a narrow focus on one goal may lead to a negative impact or consequences on others.
In a conversation with the director of operations for a public body specialising in culture and education, they talked about the decision process for the location of new global service centres. This was essentially a governance, building, equipment and infrastructure focused project, directly linking to ‘industry, innovation and infrastructure’ (SDG 9). The organisation works in over 100 countries and as part of the business case for the siting of a new service centre, potential city location pollution data and metrics are used as a criteria measure in the approval process. It forms part of their environmental framework tool to manage and monitor their activities. This example also directly links to ‘life on land’ (SDG 15) and climate action (SDG 13) in the environmental space, but the public body’s driving motivation was the ‘good health and well-being’ (SDG 3) of staff working in a service centre. It shows the interconnectedness when contemplating sustainability factors. Actions under the governance pillar can have both positive and negative implications for the environmental protection and social inclusion pillars.
As stakeholders and investors increasingly rate the health of an organisation on its SDGs information, the finance function and finance professionals can help by providing an integrated scenario approach that links the 17 goals to their strategy and business model.
For more information on the Sustainable Development Goals and the role of the accountant download our report.
The organisational perspective
For an organisation, the focus of the governance pillar is the effective management and leadership of the business. It is about using accurate and transparent accounting methods to communicate important issues to stakeholders and providing assurance that an organisation avoids any conflicts of interest.
Using three sustainability frameworks and standards to compare terms the following is a list of governance areas the finance professional could encounter, be asked to analyse data sets or be asked report on.6
For most organisations and finance functions, these will be familiar topic areas. There are likely to be mature processes already in place around the metrics and targets, and the reporting of issues externally. These are also the areas that have the most mature regulatory requirements when looking across the three ESG pillars. However, this should not make you complacent. Traditionally the audience was shareholders, now organisations have to be more transparent within a ‘real’ multi-stakeholder environment.
The new transparency technology and social media created means that anything and everything an organisation does can be seen in the public domain. Mark Carney in his book, Value(s): Building a Better World For All, views the COVID crisis as a test of stakeholder capitalism, When it’s over, companies will be judged by ‘what they did during the war’. How they treated their employees, suppliers and customers. Who shared, and who hoarded? Who stepped up, and who stood down?7
The reality is, if you are not measuring and reporting on your organisation’s ESG impact, somebody else is. Bodies and stakeholders use your exhaust data to benchmark your organisation’s sustainability performance and test the robustness of your strategy. Exhaust data is simply the digital trail of ‘breadcrumbs’ organisations leave that stakeholders can then hoover up to increase their understanding of an entity’s ESG performance landscape and long-term viability. One example is the World Benchmarking Alliance. It has assessed 2,000 of the world’s companies, measuring contributions to the U.N. Sustainable Development Goals (SDGs) and ranked the most influential.8
Time to reassess the governance pillar and make sure your organisation’s maturity is moving towards a ‘systems value perspective’, where ‘G’ is aligned with ‘S’ and both are dependent on ‘E’.
Stated purpose
An organisation’s stated purpose provides the foundation for why it exists and what it does. As models of capitalism are reimagined for the 21st Century, and the millennial generation’s expectations of business change, organisations need increasingly to think about their wider societal impact and their ability to help build a more sustainable world. Once an organisation has synthesis on this, it needs to become the DNA of their purpose and built into their values, strategic direction, policies and goals.
As Rebecca Henderson highlights, in her book Reimagining Capitalism, finding that authentic organisational purpose is not an easy process, 'Becoming authentically purpose-driven is all about exploring the boundary between purpose and profit — about choosing to do the right thing and then fighting hard to find the business case to make it possible'.9
An authentic stated purpose is a balancing act between serving shareholder primacy and providing value to societal stakeholders. In August 2019, the Business Roundtable, an association of the chief executive officers (CEOs) of leading U.S. companies, redefined the purpose of a corporation. The statement, which 181 CEOs signed, committed the executives to lead their companies for the benefit of all stakeholders. This includes customers, employees, suppliers and communities (environment), as well as shareholders.10 Carney reminds us that the purpose of business, ‘must be grounded in the objectives of clients, society and humanity'.11
Currently, the reality isn’t so black and white. As the battle for a more stakeholder-based capitalism approach continues, an organisation’s stated purpose has become an issue of contention amongst different stakeholder groups.
In 2020, Danone became the first big listed French company to adopt an ‘Entreprise à Mission’ model or purpose-driven company. This status requires Danone not only to generate profit for its shareholders, but to do so in a way that will benefit its customers’ health and the planet.12 To pursue a more responsible form of capitalism their purpose includes:
Improving health through a healthier portfolio of products and brands that encourage better habits.
Preserving the planet and renewing its resources, supporting regenerative agriculture, protecting water cycles and accelerating the circular economy of packaging to help fight climate change.
Creating new futures with our teams, in line with our innovative governance model 'One Person, One Voice, One Share’, which gives each of our employees the power to have an impact on the company's decisions.
Promoting inclusive growth, by ensuring equal opportunities within the company by supporting the most fragile players in our ecosystem and by developing everyday products that are accessible to the greatest number.13
However, by March 2021, activist investor pressure forced Danone’s board of directors to replace its chief executive and chairman, Emmanuel Faber. The move is seen as an action to tip the balance back in favour of the primacy of shareholders’ interests.14
Another debate continues as to whether large tobacco and cigarette-maker with a stated purpose of, ‘commercializing smoke-free products that are less harmful than smoking, with the aim of completely replacing cigarettes as soon as possible’, can legitimately acquire a health care company that manufactures inhalers for the treatment of asthma and lung disease.15 Some stakeholders accuse the company of hijacking the health care industry to help its cause. Whereas, the organisation sees the move as part of, ‘natural evolution into a broader health care and wellness company.’16 This example illustrates the complex landscape when thinking about an organisation’s stated purpose; there are many shades of grey.
Once an organisation’s stated purpose is communicated more widely, it is important to understand that it will not be then taken at face value in the wider ecosystem. Stakeholders have access to other sources of data and information to compare against. An organisation’s purpose must be built into its strategy and at its business model core, if it is to be viewed as authentic.
Board quality
This relates to the persons or organisations given the responsibility for overseeing strategic direction, organisational accountability, and stewardship. When it comes to ESG issues governance boards or committees must spend more of their time engaged in robust discussions, and making more informed decisions for their organisations. The senior executives and board directors of an organisation are the individuals best enabled to reduce ESG risks and encourage opportunities. However, to have an informed debate, they require relevant, insightful content and the ability to take a long horizonal view. This is where finance function and finance professionals have a key role in board quality by providing insightful assessments to inform decision-making.
O’Leary and Valdmanis in their book, Accountable, highlight that governance boards must be held accountable to an organisation’s stated purpose. The best corporate boards are highly informed, highly engaged in strategy, and clear about the purpose of their company. Sadly, many boards are stacked with retired grandees and faces friendly to the same senior executives they are meant to oversee.17
Board composition, as the authors allude to, must be based upon the diversity of the qualifications, skills, and backgrounds of individual members. Evaluating the performance of governance boards and committees through a competency or composition matrix can help to identify gaps in training and the need for new candidates to fulfil any gaps.18
Traditional areas of focus for governance boards or committees outside of the strategic direction and stewardship include regulatory compliance, audit, internal/external controls and shareholder engagement. Environmental and social issues, along with technology and cybersecurity, are among the emerging competencies boards need for effective governance in today’s business environment.
Product and service innovation and intellectual property (IP)
Key to these is an organisation’s business model innovation and resilience. An organisation’s strategy sets out corporate objectives, which are implemented through their business model. The business model explains what value is generated, delivered and preserved, and links directly to product and service innovation. Finance professionals must be able to use the business model to understand the end-to-end view of an organisation and use it to explore future innovation. They must also think about how products, services or IP innovation targets and achievements will be measured.
Stakeholders looking for a proxy indicator of an organisation’s health in these areas have used an organisation’s disclosure on the total costs relating to research and development. This is seen as an indicator of future product and service innovation and a key to prosperity for the organisation.19 The same can be said for the number of intellectual property patents filed. These are intangibles that highlight the value of knowledge and creativity within an organisation.
There has been a trend by some organisations to build obsolescence into their products. This is where, over time, a piece of technology or product ceases to be compatible, work or be useful, forcing consumers with no alternative but to buy new replacements. Actions have included refusing to give repair information, using copyright laws to keep repair manuals secret or restricting the supply of spare parts to extend the life of products.20
A move towards circular economies is challenging organisations to reassess their product lifecycles. The Ellen MacArthur Foundation defines a circular economy as a framework that is restorative and regenerative by design, and based on three principles,
Designing out waste and pollution
Keeping products and materials in use
Regenerating natural systems21
To combat product obsolescence, regulators in the European Union, 20 states in the United States and the United Kingdom’s government have introduced right-to-repair legislation.22 Primarily focused on household domestic appliances, manufacturers now must make their appliances longer-lasting and supply spare parts to new products for up to 10 years. The battle to reduce electronic waste continues and needs to be built into future product innovation.
The Swedish furniture retail company Ikea has thought about the lifecycle of their flat-pack furniture. In 2021, it launched sets of disassembly instructions to encourage reuse of furniture when moving, making their products more sustainable. They have also started selling furniture spare parts to make repairs easier, and introduced an Ikea furniture buy-back scheme to encourage the recycling of unwanted products.23
Moves to a circular economy approach are just one factor driving organisations to understand the full costs of a product or service. This means factoring in the negative impacts the product or service has on the environment or society, and reflecting these consequences at a true price.
As part of our sustainability and business programme, in 2022, we will explore circular economies and the role of organisations and the finance professional in more detail.
Buildings, equipment and Infrastructure
Mariana Mazzucato, in her book Mission Economy, highlights the practice of where, ‘An ever-greater share of corporate profits has been used to boost short-term gains in stock price rather than provide long-term investment in areas like new capital equipment, R & D and worker training…’24 This has caused enlightened investors and stakeholders to question building, equipment and infrastructure investment when assessing the long-term resilience of organisations. They see that investments in sustainable and resilient infrastructure projects also create value for the wider economy.
Although buildings, equipment and infrastructure are listed as governance issues, they are also directly affected by environmental protection and social inclusion factors. Organisations and their finance functions must become more familiar with and understand climate-change opportunities and risks on their buildings, equipment and infrastructure.
This will require an integrated approach to minimise the impact of possible changes and create transparent, adaptation plans. Climate change and biodiversity considerations must become factors in all policy decisions when embarking on these types of projects.
Bill Gates suggests a three-stage approach to climate change adaptation in How to avoid a climate disaster.
Stage 1: Reducing the risks posed by climate change, through steps like climate-proofing buildings and other infrastructure
Stage 2: Developing early warning systems and being prepared to be able to respond to future emergencies
Stage 3: Have plans for a recovery period after a disaster (including insurance for rebuilding and plans for displacement).25
More details on the environmental protection issues affecting this topic, download our guide, Putting the E in ESG.
Enterprise risk management (ERM)
ERM is a structured enterprise-wide view of risks and opportunities affecting an organisation and a critical aspect of good governance. It is also important that the outputs of the ERM process are embedded into an organisation’s strategy and business model.
A typical ERM process includes
Risk or opportunity identification
Risk or opportunity assessment against its potential impact and likelihood
Planned response strategy to the risk or opportunity
Implementation of the mitigation strategy
Performance monitoring of the mitigation
This provides a systematic approach to understanding the key risks and opportunities that could prevent organisation’s from executing their current strategies.
The oversight of risks and opportunities must be integrated across the three pillars of environmental protection, social inclusion and governance, leading to the disclosure of any material concerns to key stakeholders.
For more information on the case for risk assessment and the visualisation of risks using a heat map, download our risk assessment tools, Risk heat map and Communicating risks using a heat map.
Anti-corruption activity
Transparency International simply defines corruption, ‘as the abuse of entrusted power for private gain.’26 When thinking of anti-corruption activity, ‘a corrupt practice is the offering, giving, receiving or soliciting, directly or indirectly, of anything of value to influence improperly the actions of another party.’27 Anti-corruption must be at the heart of an organisation’s ethical behaviour. Organisations must have anti-corruption policies and practices in place that employees are cognizant of, and trained in.
They also need to be transparent in the monitoring and reporting of any confirmed incidents of corruption. This includes practices of ‘bribery, facilitation payments, fraud, extortion, collusion and money laundering’.28
Acts of corruption are likely to happen where multiple jurisdictions are involved, so it is important to understand the risks within your supply chains and carry out due diligence. These supply chains might sit outside your organisation’s domiciled national anti-corruption legislation, but there are still potential legal risks, reputational risks and financial costs to the business if corrupt practices are uncovered.
At a personal level, every AICPA® and CIMA® member and student is bound by the AICPA Code of Conduct or CIMA’s Code of Ethics.29 These aligned codes are based upon the five fundamental principles of
Integrity
Objectivity
Professional competence and due care
Confidentiality
Professional behaviour
For professional accountants, who must uphold integrity and objectivity, there is a clear requirement to not knowingly misrepresent facts or subordinate their judgment to others, and to be straightforward and honest in all professional and business relationships.30
To understand more around trends on fraud and corruption globally and the role of the management accountant in helping establish best practices in their organisation, download our guide; Keeping business clean: a CGMA guide to countering fraud and corruption.
Remuneration
This focuses on the basic salary plus any additional amounts paid to employees and those working for an organisation. Additional amounts could include bonuses, either in cash or in stocks and shares, benefit payments, overtime and additional allowances for items such as transportation or child care.31
Remuneration is the key to attracting and retaining talented employees who develop and execute an organisation’s strategy. In most organisations, employees are their number one asset and resource. Employees affect productivity, brand and profitability, but also their high turnover is costly.
In setting performance criteria, organisations need to ensure that employee compensation and incentives are consistent with and linked to long-term economic, environmental and social value creation. The remuneration focus needs to be on the long-term success and sustainability of an organisation, rather than purely on short-term objectives. It also must be transparent and aligned to an organisation’s stated purpose.
At the executive compensation level, Carney suggests the reconfiguration of incentives to foster behaviour that aligns with long-term value creation. Annual performance-based income bonuses should be replaced by — or play a secondary role to — equity and debt packages that, through vesting structure and sales restrictions, extend the executive’s interest in the company over a period of at least five to seven years — with the specific timeframe tailored to the industry.32
Remuneration is intrinsically linked to the social pillar — the issues of decent work and jobs, and, equity and inclusion. More details on these social inclusion issues are in the sustainability and business report, Social Inclusion Introduction: Putting the S in ESG.
Material issues to stakeholders
The Integrated Reporting (IR) framework defines materiality as, ‘A matter is material if it could substantively affect the organization’s ability to create value in the short, medium or long term.’33 However, materiality is a dynamic concept as issues are not always easily identified, their relevant stakeholders defined or their long-term significance fully understood. Henderson highlights this in the difficulties of understanding how minor issues might play out and engage with stakeholders.
In many situations, the issues are so highly technical, so narrow or so dull that neither the media nor the general public cares much about them. For example, changes in accounting standards are hard to understand and rarely arouse much public interest. But seemingly minor changes in accounting rules were one of the causes of the Great Crash of 2008.34
The Statement of Intent to Work Together Towards Comprehensive Corporate Reporting identifies two materiality concepts used by organisations in sustainability disclosure:
topics that are material for disclosure based on the organisation’s significant impacts on the economy, environment and people and their importance to its stakeholders
topics that are material for enterprise value creation (The ability to influence economic decisions)35
The notion of dynamic materiality (figure: 1.4.) addresses the possibility that sustainability topics can move between the set of topics that are material for the broader stakeholder audience interested in sustainable development, and the sub-set of topics that are material for enterprise value creation, which is the concept of materiality used.
In our current business environment, the longer-term and more comprehensive view of sustainable development is leading to a convergence between social value and enterprise value. Accordingly, assessing the materiality of impact on society for a particular metric can help establish its materiality for enterprise value creation, thereby anticipating potential future developments.
The EU Non-Financial Reporting Directive (NFRD) uses the term, ‘double materiality’. This is where organisations not only disclose how sustainability issues affect them, but also how organisations affect the environment and society — an organisation’s view of ‘outside-in risks’ and ‘inside-out risks’.37
For an organisation’s transparency, it is important that the materiality determination assessment process, and key judgements are open to scrutiny and articulated widely. At the very least, the process must be focused on understanding stakeholders’ key concerns and the impact an organisation has on them. This engagement with stakeholders must then be used to inform organisational decision-making when prioritising long-term value.
Net investment and net economic contribution
As Carney argues, the economic contract for organisations is in flux, and it is shifting towards a social one for inclusive growth.38 The Dasgupta Review: The Economics of Biodiversity, which the U.K. Government commissioned and published February 2021, points out that we need to change how we think, act and measure success. One of Dasgupta’s option recommendations is around changing our measures of economic progress.39
As a measure of economic activity, Gross Domestic Product (GDP) is needed for short-run macroeconomic analysis and management. However, GDP does not account for the depreciation of assets, including the natural environment. As our primary measure of economic success, it therefore encourages us to pursue unsustainable economic growth and development.40
The report recommends a more inclusive measure of wealth. This has implications for organisations and finance functions. It will require a different path when thinking about organisations’ net investments and net economic contributions to society.
As countries around the world declare net-zero carbon targets and build them into legislation, it will fall to organisations to demonstrate their contributions to reducing greenhouse gas emissions.41 Increasingly, an organisation’s net investment strategy will be required to also describe its carbon adaptation journey. In May 2021, a group of investors and shareholders challenged an oil company’s low-carbon investment strategy for lacking ambition and credibility.42 The same oil company was later challenged in a Dutch court over its insufficient carbon emission targets to 2030.43 Here, reduction obligations have been linked to the net economic contribution of an individual organisation.
The implications for organisations are around how to tell the stories of their economic impact on society. These stories need to be told more holistically and transparently. They must cut across environmental protection, social inclusion and governance factors. Tim Jackson, in Post Growth, reminds us:
For green growth to play the role of saviour in this reversal [of capitalism], we must solve all the problems associated with the expanding scale of the economy — climate change, species loss, the pollution of rivers and oceans, the degradation of soils, the depletion of resources — whilst never for a moment letting up on the accelerator pedal of growth.44
It is a complex situation, with competing priorities for organisations to wrestle. The demand for growth and financial returns to investors remains paramount, while at the same time, being judged by stakeholders on their enterprise’s net contribution to the planet.
