By Julie Linn Teigland, Andrew Hobbs, EY
3. Corporate Governance Is Critical To The Long-Term Value Agenda And Needs To Evolve
Overall, a range of challenges have emerged from this analysis, many of which fall squarely into the corporate governance domain. EY teams identified five governance-related areas that boards could focus on to positive effect, without the need for external assistance or regulation. To achieve this ambition, governance practices and structures need to be examined end to end to ensure they are aligned to the achievement of a sustainable strategy. Alignment is critical. If boards struggle to align with management on long-term value goals, progress will be stifled. There also needs to be alignment across the key areas of governance, from how boards manage risk to how they devise remuneration strategies, to drive sustainable and inclusive growth. The five areas are:
We asked executives to nominate which board attributes were most critical for making decisions that generate long-term value. Interestingly, the main attribute that emerged was behavioral — for a board to focus on the long term, the ability for directors to speak their mind is seen as critical. The top-ranked attributes are:
- First — A board that has enough trust to be honest, debate openly and have healthy disagreement
- Joint second — A board that engages and considers the interests of all stakeholders when making decisions. A board that implements management remuneration schemes linked to long-term value goals
- Third — A board that proactively identifies and engages potential investors focused on long-term value
In addition to the above other priority attributes are:
- Values: directors who are committed to long-term value creation, with values that recognise the importance of ESG and of understanding stakeholders, are important in a number of ways. First, boards setting the right tone at the top and acting as role models for management teams and wider employees is essential to embedding a culture that supports a company’s long-term stakeholder-focused strategy. Second, for external advocacy, demonstrating passion and commitment is needed to court the right shareholders to support the strategy.
- Diversity: healthy disagreement and honest debate also foster diverse opinions. Diverse and inclusive boards —including dimensions such as race, gender, career background and age — bring a full range of perspectives and solutions to big issues, such as climate change or inequality, and can challenge established thinking and biases in a way that homogenous boards will not. Diverse and inclusive boards are also better placed to ensure that different stakeholder impacts have been taken into account in decision-making.
- Skills: companies will need to make sure they have the skills, experience and knowledge to help them deliver on their long-term value strategy over time: for example, on matters such as climate change or ESG metrics. Companies are likely to need to actively refresh and change the skills profile of board members as they reach different stages of the long-term value strategy execution.
Internal and independent external board evaluations should naturally incorporate an assessment of these attributes moving forward.
When we asked executives what would likely deter their board from pursuing an initiative that was expected to improve long-term value but diminish near-term financial performance, the top two factors were:
- A high degree of uncertainty that the initiative will succeed
- A risk framework and appetite that is geared toward short-term shareholder return rather than long-term, inclusive growth
However, “lack of committed support and leadership from management” was much less of a concern for executives. This suggests companies have the willingness to pursue initiatives with longer time horizons, but need to improve their risk assessment and management capabilities to better understand long-term risk and the likelihood of success. In other words, it could allow boards to increase their risk appetite because they will have greater confidence about long-term risk-taking and the potential upside of doing so, including being able to explain it to stakeholders.
A critical function of boards has always been to understand and mitigate business risk — but the pandemic has brought that responsibility into sharp focus. Its unprecedented impact has highlighted the interconnectedness of risks and the velocity at which the landscape can change. In this environment, how can boards be sure that long-term risks — such as climate change — are appropriately forecasted and managed effectively across the organisation?
Before the COVID-19 crisis, EY Global board risk survey found that boards were concerned that their organisation was not paying enough attention to emerging and existential threats, but they were not equipped to adequately understand, detect and mitigate certain types of risk. Just 40% of boards said enterprise risk management was effective in managing atypical and emerging risks before the COVID-19 crisis. And only 21% of boards said their organisation was well prepared to respond to an adverse risk event from a planning, communications, recovery and resilience standpoint.
Now is the time to consider constructive reforms and embed cultural and operational changes to better equip businesses with the tools to respond to fluid and uncertain business environments and introduce safeguards to mitigate future crises.
Compensation schemes need a mixture of near- and long-term incentives to reward executives for generating sustainable growth. Coming up with the right mix can be challenging, but boards can consider the following guidance as a starting point to evaluate what is right for their company:
The short game: companies can focus first on short-term compensation plans, such as annual bonuses. This will allow them to get a feel for how the metrics are working and whether hurdle rates are reasonable. If adjustments need to be made, it is relatively easy to do so with short-term plans. Learning can then be applied to the design of long-term plans. If companies focus first on long-term plans, it may be hard to course-correct if things do not work as intended.
The long game: long-term incentive plans should be designed so that they use multiyear measurement periods. In our experience, three-year measurement periods are a common tactic. In some countries, there is an increasing expectation that senior executives hold shares for a minimum period after they leave their firms, with two years being typical. Extending this principle to other countries can encourage executives to focus on the long-term consequences of the decisions they make.
Compensation schemes also need to alight on the right metrics, which can be challenging to both define and assess. Metrics related to ESG goals are an increasing focus. However, not all ESG metrics are relevant for all companies, so companies need to assess their strategy and determine which metrics are most relevant to them. This will vary by industry. Such metrics must be reliable if they are to influence executive remuneration; therefore, robust processes and controls will be required, including board committee oversight.
Finally, there is the question of how much pay to tie to long-term measures. In most companies today, the percentage of executive pay tied to metrics that reflect long-term value is fairly modest. But, if companies are to change executive behavior and drive long-term performance, they need to ensure that a meaningful portion of pay is at stake. Based on their experience, EY remuneration professionals believe that a range of 15%–25% of pay connected to long-term metrics, with clear performance targets, would make a significant difference.
While stakeholder engagement is not a new topic, many organisations still struggle to bring the stakeholder voice to the boardroom table and really consider their feedback in decision-making. Therefore, it is worth taking another look at the building blocks that are required for effective engagement:
- As a start point, organisations need to define their key stakeholders. While there will be any number of potential stakeholders for a company, they need to be prioritised, and boards need to be clear on who are the most important.
- Once stakeholders are identified, the next step is the engagement strategy. This has to take account of two factors. On the one hand, it is about getting the stakeholders onboard to develop loyalty and buy-in. On the other, it is important that boards use the engagement to understand what is important to the stakeholders. In other words, it is about understanding their needs and how they factor into the board’s decision-making about what is required for long-term value creation.
- The engagement strategy should also be pragmatic. It may not be possible for the board to engage evenly with all key stakeholders, from suppliers to communities. Therefore, boards must decide who they engage with directly and who they engage with indirectly through management.
- Finally, boards need to close the feedback loop. Getting feedback from a key stakeholder does not obligate boards to act in accordance with their viewpoint. However, there should be communication back to the stakeholder on how the feedback was considered, or the quality of the relationship will deteriorate.
There is increasing focus on engagement between independent board members and investors. As a starting point, it would be valuable for this director group to hear more about growing investor expectations regarding long-term value and ESG principles. However, if directors are to engage more directly with investors, it is important that they buy into a long-term value approach and have a deep understanding of the subject. This will be critical to ensuring not only that boards play an effective role but also that a focus on long-term value and ESG principles is achieved across the company.
Driving Progress In Stakeholder Engagement
One way to shift the dial on stakeholder engagement is for the board to define the engagement strategy, then measure and report on it — driving accountability and transparency. This would see companies describing publicly — and at least annually — information such as:
- Stakeholder outcomes that are necessary for successful strategy execution (key stakeholders): for example, target net promoter scores for customers, level of employee satisfaction, level of investment in employee development, and expected return on capital invested
- How the company has interacted with the key stakeholders • How the board has taken their interests into account
- How board-specific decisions have been influenced as a result
Such reporting would describe specifically what the board has done during the year and would avoid boilerplate. Through this mechanism, stakeholders should be able to assess how their interests are being considered. They should also be able to exercise their existing levers in holding companies to account: for example, purchasing power of customers or rights that already exist in law, such as health and safety. This approach will also help shareholders specifically to assess the company’s future prospects.
Long-term value orientation has significant implications for how corporates communicate performance. On the one hand, it is about being authentic and accountable. This means being open to communicating both good and bad news. As a recent EY survey on corporate reporting examines, this shift to a broader view of value and performance may require changes not only to frameworks and practices but also to mindset
and culture. Essentially, organisations need to adopt a new culture and mindset regarding the information they share about themselves — a culture based on authenticity and accountability.
Effective and credible reporting against long-term value metrics — establishing where there has been progress or lack of progress — is also key to accountability. Strong and effective audit committees have a key leadership role to play here. For example:
- Ensuring the company operates strong and effective controls that support the quality of both financial and nonfinancial information/reporting, including long-term value metrics
- Overseeing the robustness and reliability of risk information
Reliability and consistency is crucial to boards confidently making decisions and stakeholders using the information to assess the company’s future prospects and cash flow.
Reinventing corporate reporting
Of course, being authentic and accountable will not happen if organisations are still heavily dependent on conventional reporting frameworks. Focusing on the long term requires organisations to shift from a narrow focus on backward-looking financial reporting to forward-looking insight based on financial and nonfinancial disclosures, including ESG disclosures. Significant progress has been made in using nonfinancial metrics to measure and communicate performance:
- 69% make consistent use of nonfinancial metrics to set organisational targets for performance and growth (39% ‘often’ and 30% ‘always’)
- 65% say the same of communicating sustainable performance to investors (40% ‘often’ and 25% ‘always’).
While progress has been made, organisations are seeking greater clarity and rigor in producing nonfinancial disclosures that are credible and comparable. For example, 80% of executives say it would be helpful to have globally consistent frameworks and standards for long-term value-focused corporate reporting. Without it, there is a risk that stakeholders do not get an authentic, credible picture of whether KPIs such as emissions reduction targets have been met.
However, firm guidance on metrics and reporting standards is difficult because businesses are structured and create value differently. That said, leaving it up to individual companies is inefficient in terms of identifying common areas of value, as well as frustrating for stakeholders who struggle to make relevant comparisons. This is an area where policy-makers and advisors can make a meaningful difference. Initiatives such as the Sustainable Value Creation program, led by the IBC of the WEF in conjunction with EY, has developed a set of core metrics for businesses to which 61 top business leaders across industries have committed already. As these gold standards emerge, it will be easier for companies to measure and communicate the total value they create for stakeholders.
This desire for consistent, credible and comparable approaches is reflected in the appetite for policy and regulatory changes that clarify or amplify the pursuit of long-term value:
- Developing globally consistent frameworks — 80% think that it would be helpful to develop frameworks, standards and guidance for measuring and communicating how long-term value is being created.
- Putting a stronger focus on multi-horizon risk — 76% think it would be helpful to require companies to disclose any major risks to, and uncertainties regarding, continued viability in the long term, in addition to the short and medium term.
Defining Long-Term Value
Long-term value is how EY teams define the human, financial and societal value that companies generate over time for their stakeholders, including investors, customers, employees and wider society. There are many competing and overlapping terms that try to capture this concept, but we use long-term value to acknowledge and emphasize that companies need
to focus on sustainable growth over a long-term horizon. We believe that long-term value includes the following concepts and considerations:
- Stakeholder capitalism: focusing on delivering long-term value to shareholders by understanding and addressing the needs of customers, employees, investors, regulators and other key stakeholders. This is opposed to shareholder primacy, which is commonly understood as a focus on maximising shareholder returns in the near term. A multi-stakeholder approach can perhaps be seen as a form of “enlightened shareholder value.” By that, we mean that the main reason for being interested in stakeholder outcomes is that it leads to better shareholder returns over time.
- Resisting short-term earnings pressure: this is part and parcel of stakeholder capitalism, as the outcomes desired by key stakeholders will tend to be realised over a longer time horizon than the earnings pressure from some investors.
- A purpose-driven approach to strategy: using a “reason for being” to define an organisation long-term strategy and align business with social and environmental goals.
- Sustainable growth: considering the long-term impact
of corporate decisions to build a more sustainable future for all. Note that “sustainable” growth means more than environmental considerations. It includes the pursuit of a wider environmental, social and governance (ESG) agenda: environmental issues (such as climate change), social (such as inequality and diversity) and governance (such as ethics and transparency).
- Management of multi-horizon risks: including managing the impact of risks such as climate change on a company’s long-term prospects.
- Business and investment decision-making: making critical decisions about strategic positioning and investments, not just for today’s business but for future growth in a changing environment, creating the flexibility to respond to disruption.
Later in this paper, and as part of the research survey, we examine the progress that companies have made in specific long-term value approaches. These include:
- Embedding a corporate purpose with a focus on generating sustainable, long-term value for a broad set of stakeholders
- An approach to strategy formulation and decision-making that effectively balances near-term and long-term value creation
- Continuously reassessing the company’s strategy and organisational structure to improve the ability to generate long-term value
- An established approach to measure and communicate the long-term value the company generates
- Considering the interests of all stakeholders in decision-making, not just shareholders
- Communicating to all stakeholders with authenticity, including being transparent about the positive and negative impacts of business decisions
- Implementing remuneration schemes for executives and management tied to long-term value creation
Professor Rajna Gibson Brandon, University of Geneva
Rajna Gibson Brandon is Professor of Finance at the University of Geneva and Deputy Director Education & External Affairs of its Geneva Finance Research Institute as well as Managing Director of the Geneva Institute for Wealth Management, Switzerland. EY EMEIA Public Policy Leader Andrew Hobbs spoke to Professor Gibson Brandon to understand her views on corporate governance and long-term value.
The pandemic has brought increasing focus on strategic risk — how can boards be sure that the effects on the company of long-term risks, such as climate change, are appropriately modelled and managed?
Long-term risk factors can be hard to measure when there is no reliable data. Therefore, scenario analysis and complex statistical models will be necessary to allow some level of assessment. However, even these methods may not prove completely accurate.
Climate change is not an issue that will manifest itself on next year’s balance sheet or P&L; rather it will show over the next five, ten or even twenty years from now. You can’t reduce this down to one single number. Instead we need to think in terms of ranges. This can be quite challenging and complex. It’s going to require quantitative forecasting methods, scientific insights into the determinants of climate change and qualitative judgment. The appropriate analysis and “blending” of these factors is what will make the difference.
What are some of the challenges for board members in achieving a long-term value orientation?
One of the questions to consider is the optimal tenure of a board member. We re-elect board members over relatively short periods these days, which is viewed as a good thing. Very long tenures have downside for sure so at one level this is a positive change. But there is a danger that short terms could encourage short termism. If a board member is only elected for two years, it doesn’t necessarily give them the incentives to think about what’s going to happen in the company after they leave. Another important consideration is the director’s company’s knowledge and learning about long-term value as a desired objective to pursue in all its complexities, especially in large, global companies. In order to be effective, challenge decisions and give valuable advice, directors must have the time and opportunity to understand the complexities of a company sustainability objectives, its sector, market positioning and the environment in which it sits. That takes time.
What do you think are some of the key attributes of a board that drives a long-term, stakeholder-focused strategy?
When a board wants to adopt a broader stakeholder perspective and seek to promote resilience, it inevitably goes to your ethics and your values. Part of my research looks at how you reconcile moral values with financial decision-making. This is a very important part of the challenge, because how a board deals with issues like climate change or social inequality will depend on the values of the board and its individual members. This means recognising the importance of financial value to the viability of the company, but not exclusively prioritising that factor.
That means choosing the right people, with the right mindset, and right intrinsic motivation. As well as extrinsic motivators — like remuneration — you need corporate leaders also to be intrinsically and morally motivated to address issues such as social inequalities or climate change.
Business leaders are increasingly realising that, to be successful, they need to have a multi-stakeholder, long-term value orientation. Sustainable corporate governance is a key enabler for companies to embed a long-term focus — and one that is within their control to change.
Now is the time to reframe the relationships and establish effective multi-stakeholder engagement to implement the key corporate governance elements that are instrumental to delivering real value for all — and for the long term.
About The Survey
Between December 2020 and January 2021, 102 business leaders were interviewed to understand their progress and challenges in driving long-term value, and the implications for corporate governance. Over a quarter of respondents (29%) were CEOs, 7% were board members and the remainder (64%) were drawn from across the C-suite. Half of respondents’ organisations have revenues in excess of €1 billion a year, with the other half between €100 million and €999 million. Respondents were split across 15 European countries and 13 sectors.
The survey was supplemented by in-depth interviews with the following business leaders, academics and other professionals:
- Chris Hodge: Advisor, International Corporate Governance Network (ICGN) Helena Stjernholm: CEO, Industrivärden
- Ilham Kadri: CEO, Solvay Group
- Professor Rajna Gibson Brandon: Professor of Finance at the University of Geneva and Deputy Director (Education & External Affairs) of its Geneva Finance Research Institute
Our thanks also go to the EY subject matter professionals who contributed their insights: Alexis Gazzo, Caroline Johnson, Danielle Grennan, Eric Duvaud, Gill Lofts, Iain Harrison, Ilaria Lavalle Miller, Jan-Menko Grummer, Jens Massmann, Maria Kepa, Martin Reynolds and Dr. Max Weber