The EU needs to recognise what corporate governance can and can’t do

29 Apr

29 April 2021

Good corporate governance matters, but won’t solve the world’s problems. The idea that it will risks taking us in the wrong direction and could make matters worse.

There’s a flurry of activity in Brussels in the world of corporate governance. The European Commission is shortly expected to issue proposals on “sustainable corporate governance”, following a study and consultation in 2020. What’s going to be proposed isn’t entirely clear, but the impact assessment suggests that sustainability could be “further embedded into the corporate governance framework” by amending corporate and directors’ duties with a view to requiring companies “not to do harm” and empowering directors to integrate wider interested into decisions.

The mechanism by which this “further embedding” could be achieved include:

A due diligence duty to require companies to address adverse sustainability impacts in their own operations and value chain by identifying, preventing, and mitigating negative impacts.
Requiring company directors to take into account all stakeholders’ interests that are relevant for the long-term sustainability of the firm or those affected by it as part of their duty of care.
Requiring company directors to define and integrate stakeholder interests and corporate sustainability risks into corporate strategy with measurable and time-bound science-based targets.
An “appropriate” facilitating, enforcement and implementation mechanism including possible remediation.
Other possible corporate governance arrangements regarding directors’ remuneration.

Growing concern

Concern is growing. Chief Executives of the Nordic Confederations of Industries wrote to the FT criticizing the proposals:

“There is a substantial risk it will harm companies’ ability to do business effectively, weaken current corporate governance models and blur directors’ duties. This will probably result in risk-averse decision making, conflicts of interest, lawsuits and weakening of owners’ rights and incentives, which would harm the ability to attract risk capital, including capital needed to reach the sustainability objectives.”

A further concern is that the Commission’s thinking continues to be based on a study by EY which has been roundly criticized by academics from Europe and the US. A group of Harvard academics pointed out “deep flaws in the Report’s evidence and analysis” and said that “no EU policymaker should rely on this report”. In a detailed critique that challenges almost every substantive aspect of the report, Alex Edmans from London Business School said “it is surprising that such an influential document was produced by a consultancy with no academic coauthors”. A group of respected academics who are members of the prestigious invitation-only European Corporate Governance Institute recently issued a Call for Reflection asking the Commission to reflect on the serious issues raised by the feedback. In a delicious irony, EY’s own Swedish firm rejected the findings of the report, at least as they apply to Sweden.

What does seem clear is that the empirical basis on which the recommendations are being made is sorely lacking, and the EY report is considered by people who know what they’re talking about to be to be deeply flawed. The concern of these academics is that the problem itself has been misidentified, before you even get to the largely counterproductive proposals. This is disturbing, for what is such a potentially impactful issue. Decisions should be made on the best evidence available, not based on hand-picked and misrepresented studies presented in a way that appears to support an already-reached conclusion based on confirmation bias.

An unclear proposal, but with serious questions to answer

One of the problems with discussing the proposals is that it isn’t really clear what they are. For a start they mix up a due diligence duty, which could be a good idea, with corporate governance reform, which probably isn’t. Within the corporate governance proposals, the written words could be consistent with what already exists within, for example, the UK’s Section 172 Companies Act requirements relating to stakeholders. Or they could be consistent with a much more rigid multi-stakeholder model with enforcement powers.

And the proposals are not without support. A group of big hitters in the world of responsible business have issued a Call to Action in support of the proposals. It’s tough to question the combined might of Mervyn King, Paul Polman, Kerrie Waring, Bob Moritz, and Gilbert Van Hassel.

But I was always told that there’s no such thing as a stupid question, so here goes. When it comes to the corporate governance aspects of the proposals it’s incumbent on proponents to provide answers to the following.

Where is the supposed pressure for short term profit maximisation really coming from? Shareholder value is an inherently long-term concept, representing the present value of all future cashflows in perpetuity not just a few years (look at Amazon’s valuation) – for every seller there needs to be a buyer, and buyers can’t be duped forever into buying over-valued shares. Evidence from the academic contributors to the consultation suggest the premise of endemic short-termism is just wrong.
Why will lessening board accountability to shareholders improve matters? For every CEO that’s released to become a purposeful corporate exemplar, there’s a risk that many more will take their company in the wrong direction or extract private benefits. This is what the evidence on board insulation and entrenchment shows. And in many cases it’s shareholders pushing companies to go faster on climate, not the other way round. It seems odd to suggest that these same companies will immediately become climate activists once released from shareholder scrutiny.
How will giving boards more, and shareholders less, say over complex stakeholder decisions improve legitimacy? At least shareholders speak for millions of citizen shareholders through their pensions and savings. Do we really want to attribute to unelected boards and CEOs the wisdom of Solomon when it comes to the public interest? The public doesn’t trust boards on matters as simple as CEO pay. Why will it trust them to save the planet?
How will we ensure that no stakeholders are significantly harmed? We’re entering one of the most profound periods of capital reallocation in history from dirty to clean industries. Some current vested interests will most definitely be harmed in the process, including innocent employees and members of their communities. There will be trade-offs between the pollution produced by a coal plant and the livelihoods of its employees – surely promising no harm will simply embed the status quo.
How is an attempt to optimise stakeholder impacts at the company level consistent with optimal outcomes at a societal level? We need resources to flow from bad to good: people, technology, capital. How will multi-stakeholder rights at the company level facilitate this? The likelihood is that it leads instead to greater entrenchment of the status quo rather than facilitating the profound change we need.
Why do we need to pay executives to do this by including ESG targets in pay? If we need to release executives from investor pressure so they can follow their intrinsic motivation to pursue sustainable initiatives, it’s not clear why we also need to pay them to ensure this is what they do. And as the recent report from London Business School and PwC showed, there are significant risks and potential unintended consequences from this approach.

A different approach is needed

So how might we want to think about these issues instead?

Companies should pursue long-term purposeful strategies that serve stakeholders. It’s good for shareholders and good for society. It captures as much as possible of the alignment between shareholder and stakeholder interests. There are many examples of such companies supported by their investors within the current corporate governance system. Including those currently or previously led by the distinguished leaders who issued the Call to Action referenced above. I’ve not seen any compelling evidence that changing that system is going to shift the dial on any important question.

We mustn’t overclaim for what responsible business can achieve. There are real externalities that need strong government regulation, particularly in relation to carbon pricing and environmental degradation. Individual companies, even investors acting in concert, cannot optimise the transformation we need to achieve: optimisation for society cannot be achieved at the individual company level. Placing too much weight on this possibility distracts attention from the urgent necessity of decisive and far-reaching government action. We have a limited environmental budget that can be spent on a sustainable basis and a finite carbon budget. We need system change, not corporate governance change, to create the incentives to spend this in the right way to get us out of this mess.

If anything, we need more long term shareholder value not less. Capital needs to move rapidly from industries of the past to industries of the future, and only shareholders can make this happen at the required speed, provided they have the right incentives. Shareholders can also play an important role in reflecting beneficiary concerns through their engagement and stewardship policies, as we’re seeing, for example, with Climate Action 100+.

There will be significant stakeholder impacts through this transformation, the idea that no-one will be harmed is fanciful. Companies can play their part, but only governments can ensure a just transition. We need a new set of economic incentives, but this needs government action not just company action. In this regard, one useful thing companies can do would be to abandon company-specific lobbying efforts that seek to undermine development of needed regulation and instead commit to a constructive policy development charter – shareholders should push them to do this (provided their rights aren’t weakened to prevent shareholder resolutions).

Responsible business can mean great business for shareholders and stakeholders. Responsible business can create coalitions of investors, customers, employees, suppliers that show what’s possible and so help shift the Overton window. Responsible business can contribute to designing effective regulation. Responsible business can develop the technology solutions we need. Responsible business can cause capital and resources to flow to point of greatest impact with the right economic incentives. Responsible business can work with governments to accelerate change and to bring private capital to bear in the creation of public goods. Responsible business can improve stakeholder outcomes while creating value for shareholders.

I’m a responsible business fan, and it’s got an important, indeed vital, role to play.

But only governments can bring about the scale and pace of change we need. Responsible business by itself can’t. And changing corporate governance in the way the EU Commission proposes certainly can’t. In fact, it would likely make things even worse.

The EU proposals are based on a report that has been widely discredited and has little basis in rigorous evidence. There’s good reason to think that the proposals would make matters worse rather than better.

I have huge respect for a number of the signatories of the Call to Action. But on this one I side with another prestigious group and support the Call for Reflection.