Smart Governance in a Risky World

Earlier this year, the CEO of the world’s largest asset manager, BlackRock, sent a letter to CEOs and boards of its portfolio companies that underscored the link between financial performance and atypical risks like climate change.

“Your company’s strategy must articulate a path to achieve financial performance,” wrote Larry Fink. “To sustain that performance, however, you must also understand the societal impact of your business as well as the ways that broad, structural trends—from slow wage growth to rising automation to climate change—affect your potential for growth.”

Larry Fink’s letter, which is cited often, reflects a burgeoning investor movement calling on companies to better understand environmental and social risks that are disrupting their business. The financial consequences of risks like climate change, water scarcity, and human rights abuses are clearer than ever. Investors are looking for companies in their portfolio to put smart governance systems in place that will proactively identify, assess, and manage these risks.

Additionally, in many cases, investors are looking at the quality of those governance systems to predict the resilience of a company’s future performance. For instance, a 2017 survey by CFA Institute revealed that financial analysts believe board accountability is the most important sustainability issue in their investment analysis and decision-making.

Data around environmental and social issues provides a good sense of a company’s current and past performance. But details on governance systems give investors and other stakeholders key insights into whether the company is likely to sustain this performance in the future.

In other words, companies that are governed well for sustainability, especially at the board level, also demonstrate resilient performance in the face of risks. In particular, the board is responsible for making sure that these atypical sustainability risks are integrated and managed as enterprise risks when they are material to the organization.

One of Ceres’ recent reports backs this up. Systems Rule analyzes how the boards of the world’s largest companies oversee sustainability issues, assessing whether businesses with the right board governance systems also performed well on environmental and social issues.

The answer was a definite yes.

We found that companies with strong board governance systems were more likely to also set environmental and social targets. The best performing companies also tended to have holistic systems for board sustainability oversight, including mandates, incentives, and expertise among their ranks on sustainability issues.

Why is there such a strong link? The best performing companies, much like sophisticated investors, recognize that environmental and social issues such as climate change, water scarcity, and human rights pose material risks to corporate performance. Putting robust governance systems in place and setting performance goals are ways to mitigate this risk.

Smart companies are ensuring that these governance systems are integrated into the management level as well.

For instance, at Lockheed Martin Corp., enterprise risk and sustainability are structured under a single management team. Rather than having siloed discussions about existing and emerging risks, the team considers these risks and brings them to the board’s attention in a coordinated way.

There are now moves to make this integrated approach the industry standard. The Committee of Sponsoring Organizations of the Treadway Commission (COSO), which creates globally recognized frameworks for enterprise risk management (ERM), recently released draft guidance for how its ERM framework could be applied to environmental, social, and governance risks. Because the board is responsible for oversight, the COSO draft also calls on boards to be aware of these risks.

So how can boards effectively oversee environmental and social risks? Based on the findings of Systems Rule, companies can take a few key steps:

1. Make board governance systems holistic. Companies that perform best on sustainability risks are those that have incorporated mandates, expertise, and incentives for sustainability that reinforce one another. Such holistic board governance systems allow directors to better understand and make smart decisions on these risks.
2. Exercise sustainability oversight with an eye towards performance improvements. The board can play an important role in asking management the right questions and encouraging executives to identify the right material issues for corporate performance, as well as setting goals and strategies to manage these risks. Financial incentives can also be used to spur performance.
3. Orient board governance systems towards performance on material risks. The strongest performing companies don’t just have the right board governance systems in place. They also link them to specific sustainability risks that materially affect corporate performance.
4. Provide more detailed disclosure about board governance systems. More detailed disclosure, including on the material risks prioritized by the board and how it addresses these priorities, can spur further sustainability commitments and improvements.

The message is clear: Smart governance systems help corporate resilience in a risky world.

Veena Ramani is the program director of Capital Market Systems at Ceres, a sustainability nonprofit organization working with the most influential investors and companies to build leadership and drive solutions throughout the economy.