Notes for the Responsible Investment Community
Evolving landscape of corporate governance
Coming into force in 2019, the Financial Reporting Council's (FRC) new Code of Corporate Governance, has, alongside 2020’s reviewed UK Stewardship Code, endeavoured to set out a fresh framework for promoting ‘transparency and integrity in business’. Together, the two codes promise much for the responsible investment community, encouraging more in-depth reporting on ESG standards within companies, and, particularly in respect to the Code of Corporate Governance, greater interaction between companies and their internal and external stakeholders.
With the Code of Corporate Governance now having been implemented for nearly 12 months, its recommendations are beginning to enter into mainstream reporting. Ethical Screening has taken the opportunity to update our processes for assessing governance performance, aligning ourselves with the most up-to-date metrics and standards. To deepen our understanding of the changing landscape of corporate governance and what to look out for, we travelled to the University of Warwick to meet Dr Andreas Kokkinis (Associate Professor of Corporate Law and Financial Regulations and Director, LLM in Corporate Governance and Financial Regulation) to discuss how corporate governance and ethical investing are evolving, focusing on company disclosure, remuneration and labour relations.
New and old approaches to regulatory change
For Dr Kokkinis, the new standards of corporate governance and reporting from the FRC continue with the common emphasis among UK regulators of employing 'soft law' approaches to encourage cultural changes in corporate behaviour. 'Soft law' employs non-binding recommendations for business leaders to follow, rather than setting out tougher regulatory and legislative frameworks ('hard law') which require comprehensive provisions for policing and enforcement with mechanisms for investigation and sanctions. Although soft law does not demand compliance, this collaborative rather than punitive approach is necessary to encourage better relationships between companies and regulators, and perhaps more meaningful outcomes in the longer-term. Importantly, this can also reduce the propensity for companies to offer "piecemeal" reporting of standards, as complying with regulation becomes a process of risk management and avoiding liability rather than self-expression and genuine stakeholder engagement. However, this semi-informal enforcement environment, allows for 'market-based' governance systems, where the rigour and value of that output will be decided by stakeholders, both internal and external, be they civil society groups, research agencies, NGOs, or active shareholders. In this way, changes in the Corporate Governance Code are expected to be more impacting on company behaviour than the UK Stewardship Code, with Kokkinis highlighting the importance of "audience" in corporate governance regulation. Whereas the Stewardship Code requires institutional investors to provide evidence of transparency to their clients, who are perhaps unwilling or unable to engage on issues of compliance, the Corporate Governance Code requires a mutually influential communication between company management and the investment community, with active investors able to steer corporate behaviours.
Soft law regulation can also help with cross-border markets and international harmonisation of standards, as more intense localised legal mechanisms can lead to a "silo-ing" of compliance understanding, discouraging companies from entering markets with unfamiliar regulatory risks, and discriminating against smaller and emerging companies which cannot access the auditing and legal expertise to navigate more complex regimes. Although common in UK regulatory practice, pan-European initiatives, such as the 'principled-based approach adopted by ESMA in the suggested amendments to the MiFID II requirements, suggest that this approach is being more widely adopted by trans-national regulatory bodies.
Interpretation, adaptation and normalisation of standards
Within the last five years, improvements in the diversity of UK Boards following the recommendations of the Davies and Parker reviews have been seen as signalling the meaningful impact of this approach on company non-financial standards. However, 'soft law' regulation will always require the acquiescence of company management to embrace cultural change. As such, the new standards will be reliant on the normalisation of trends through widespread adoption. This will require collaboration from auditing and industry bodies, but effective implementation will remain the responsibility of companies and dependent upon the resources that are put towards non-financial standards. With this in mind, what changes can we expect from business reporting, and how should this impact on responsible investment?
Broader stakeholder engagement
Of particular interest to the ethical investment community, is how new recommendations on corporate governance are redefining the methods through which companies interact with stakeholders, and how the melding of ES and G reporting can "breakdown the shareholder versus stakeholder argument". Importantly, both the UK Corporate Governance Code and the UK Stewardship Code, highlight the need for well-defined corporate values, and the aligning of business activities and policies with these values through evidentiary metrics and standards. Here, companies will be guided as much by additional recommendations on reporting processes, but active stakeholders can also influence the depth of this reporting. This communication between business processes and external expectations has also influenced regulatory changes, as has been seen in evolving legislation requiring disclosures on issues such as supply chain transparency and engagement in the UK, and worldwide. With involvement in global development initiatives and investor interest in impact and ESG performance growing, companies are increasingly aware of the need to outline how they provide social benefit, yet advances in reporting standards and requirements for quantifiable evidence will expose areas of weakness.
Rise in importance of non-financial remuneration
Remuneration is another vehicle through which business operations can be guided through external expectations, and one area in which shareholder activism has been notably influential. Shareholder revolts on company remuneration plans have become common, and have encouraged executive compensation plans to be increasingly transparent, and more aligned to company performance. The new code also encourages remuneration to be linked to company values, incorporating non-financial elements and as such, executive remuneration may become another area through which active shareholders can encourage business leaders to adhere to ESG standards. Within remuneration plans, non-financial targets are set to become an important measure of how embedded ESG standards are in company performance. Non-financial targets remain closely tied to financial performance, such as improving measures of customer satisfaction, and the distance non-financial targets drift from profit motives is likely to not be substantial in the short-term. Established standards, such as the EU Commission's Non-financial Reporting Directive, have encouraged managers to integrate environmental and social activity into remuneration offers, but, as Kokkinis describes, executives are ultimately required by investors to be held to account for a company's long-term financial performance. Despite the increasing significance of ESG, executives and investment managers are ultimately responsible for delivering financial return, and will want to see incentives that promote positive growth and returns. Ultimately, effective alignment of values and performance will come from profiting from sustainable growth, with incentives geared to target improvements in efficiency and sustainable business practices that promote longer-term returns. Here, companies can draw from the experiences of the banking and financial sectors, where remuneration policies follow FCA guidelines and CRD IV rules which require variable pay to be risk-adjusted, and ensure performance is assessed by a combination of financial and non-financial metrics.
Deepening of internal stakeholder engagement
The impact of variable pay and incentive plans for executives has certainly motivated corporate planning for financial gain and strong shareholder returns, but, it can be argued, to the detriment of labour relations and external societal engagement. Through a historical lens, as Kokkinis describes, during the managerialist governance models of the post-war period through the 1970s, managers and workers had more direct relations, with a degree of reciprocity being seen as an important part of strong financial performance. Changes in practice on executive pay that have emphasised shareholder returns and company profits have created a more antagonistic relationship between employers and employees, and with the decline of formal unionism during from the 1980s onwards, labour relations in the United Kingdom and abroad have evolved to a situation in which organised labour is no longer a significant constraint on managerial discretion. Within this changing landscape, the labour movement has become more inclined to campaign on social issues, such as gender equality and tax transparency, that transcend traditional union areas of focus such as pay and conditions and allow for greater collaboration between labour groups, civil society and activists. In this way, new approaches to corporate governance are also encouraging companies to interact with the labour - activist dynamic more directly. Boards are now expected to employ methods of top-down employee engagement, be that through advisory panels, designated non-executive directors or worker representation on boards. In discussing research in the area of corporate governance and labour relations, Kokkinis describes how evidence on the financial benefits of improved labour relations through board-level engagement is mixed. Germany, as one prominent example, has had many years of experience with worker representatives being a formal part of company supervisory boards. However, although the consensus is that this policy has been beneficial to overall company health, its contribution to financial success is less clear. As the UK adopts this approach, he believes that dedicated Non-Executive Directors are likely to be the most common method of implementing this policy, and as time goes on more research will be required to get an insight on which forms of engagement best serve company aims and those of the workforce.
Momentum of change both internal and external
Changes are coming in how UK companies disclose their corporate behaviours and define their relationships with non-financial, ESG and other non-financial impacts. With the 'soft law' approach, how and to what extent companies engage with these goals will be defined internally by each entity, based on interpretation, resources and business strategy. However, this flexibility and mobile framework brings opportunity to the responsible investor, as in the longer-term standards will be defined more by market demands, shareholder expectations and the force of civil society. In the next 12 months, responsible investors should be looking to identify what has changed in company disclosure, while taking time to reflect on what needs to change, as the pace of change in governance transparency will be dictated as much by consumers of information as by producers.
For more information on our corporate governance analysis please contact us: firstname.lastname@example.org
For more information on Dr Kokkinis' work please visit his page at the University of Warwick