What every manager should know about (3/5): New Governance

As your organization is getting ready for the implementation of EU guideline 2014/95/EU on the disclosure of non-financial information, I hand you a series of blog posts on non-financial topics that business managers might be less familiar with. My aim for this series of posts is twofold: First, to give you insight into concepts that are integral to non-financial frameworks on reporting, such as the Global Reporting Initiative (GRI) framework. Second, to show why and how you should integrate these specific non-financial disclosures into your overall business and risk management strategy.

The first blog in this series discussed climate change; the second post discussed human rights.

For the third installment in this series on non-financial information, I will focus on governance. Not the governance business managers might already be familiar with; but a new governance arising from a world where a diverse multitude of stakeholders influence the decision-making process within the firm.

I will discuss what new governance is, why new governance is a good way to manage your ESG-risks, and how you should go about implementing a way of working that takes into account new governance.

Corporate Governance

Governance is the process of governing. Governing, in turn, is defined by the Oxford English Dictionary as conducting (i.e. directing or managing) the policy and affairs of a state, organization, or people. Corporate governance, therefore, can be defined as managing the policies and affairs of a corporation.

Business managers will be familiar with corporate governance being described along the lines of the following (and many more) concepts: accountability procedures for board and management team; policies and accountability to shareholders and other stakeholders; transparency; ethical behavior; audit procedures. All these concepts and procedures of corporate governance have been well established: see for example the G20/OECD Principles of Corporate Governance. (Although I have to add that discussions on governance issues such as executive pay, and occurrences of accounting scandals will probably never end, as this article and this article (respectively) in The Economist show; I guess no amount of governance will ever change human nature…)

Since business managers (and their internal and external auditors) already have a very clear understanding of what corporate governance entails, it would not add anything to their knowledge by only restating the principles of corporate governance as defined by (e.g.) the OECD. Instead, I will focus on a broader definition of governance. As you will see, this broader definition will help you understand how governance is a more extensive issue than just corporate governance, and how it is linked to those other ESG-risks: environmental risk and social risk.

Beyond Corporate Governance: New Governance

Setting rules, regulations and policies to govern the organization internally is not sufficient to manage a business organization in the twenty-first century. A number of developments in the last decades have pushed governance from hierarchical structures (such as those followed by most corporates and all national governments) towards new forms of governance.

The first of these developments is the ‘explosion of advocacy groups during the last third of the twentieth century’ as Mark Bevir calls it in Governance, A very Short Introduction. Without a doubt, the increasing range and variety of stakeholders are getting an ever stronger say in policy development, whether it be government policy or corporate policy. A second development is that the rise of globalization has called for global governance to manage international flows of good, money and financial products or investment. Increasing globalization necessitates governance of non-economic issues such as security, food safety standards, climate change, and other issues affecting global commons that transcend national boundaries (e.g. clean air and water, protecting marine life).

The old form of hierarchical governance (via national or international institutions) is increasingly replaced by multi-stakeholder governance models. According to Bevir, the features that these new models have in common are:

  • they combine established administrative arrangements with features of markets and networks;
  • they are multi-jurisdictional and often transnational;
  • they involve an increasing range and plurality of stakeholders;
  • governing arrangements, different levels of governance, and multiple stakeholders are often linked together in networks.

Business firms should be aware of new governance because they increasingly run into non-economic issues that transcend national boundaries. In many cases, they will find that the issue at hand is governed by new governance, instead of by old-fashioned hierarchical governance (i.e. national rules and regulations).

Corporate Governance vs. New (or Network) Governance

Although governance in business organizations is already in place in the form of corporate hierarchical governance, business managers need to be aware of new governance in the form of network governance. There are roughly three types of governance according to Bevir:

Most of the typologies focus on three ideal types: hierarchy, market, and network. Each of the ideal types relies on a particular form of governance to coordinate actions. Hierarchies rely on authority and centralized control. Markets rely on process and dispersed competition. Networks rely on trust across webs of associations. (…) Box 1 provides an overview of the resulting types.

As for corporate governance, organizations are – by their very nature – steeped in hierarchical thinking. In addition, the market variety of governance should not hold too many secrets for business organizations either. Network governance, however, is a different matter. Because of developments described earlier – dramatic increase in advocacy groups, and increasing multi-stakeholder governance for transnational issues –, organizations are faced with mounting pressure to start using network governance as an additional governance model in organizational processes.

Implementing Network Governance

Implementation of network governance within a business organization – to manage issues that transcend the sole responsibility of the company – might feel unconventional for business managers for two reasons. First, companies are built on hierarchical foundations and compete in markets, but the principles of network governance – based on trust – will feel new and alien in a business environment. Second, corporate governance is still very much focused on shareholders (as opposed to stakeholders) as Bevir argues:

A key principle of corporate governance is thus the rights of shareholders. The main issue of corporate governance is how to ensure that the rights of the shareholders are properly safeguarded.

Network governance introduces the concept of interdependency between multiple stakeholders, which comes with a number of sets of conflicting modi operandi: trust vs. authority, interdependent vs. dependent, diplomacy vs. rules and commands, and reciprocity vs. subordination. (Again, see box 1.) It is, thus, not an exaggeration that the ways of network governance are a-typical for how most business managers are used to conduct their business.*

Taking into consideration that i) network governance is a-typical for any business organization, ii) the need for implementing network governance is increasing, and iii) not being able to handle new governance poses an (ESG-) risk in itself, I propose that organizations start implementing new governance on a case by case basis, in order for the organization to get used to the processes of network governance.

In my previous blog post in this series, I introduced an 8-step approach on how to implement a human rights policy in your organization. Here, I repeat that approach in a slightly different format to highlight the elements that I think will help you understand where network governance comes into play.

An approach to start working on an issue that needs involvement of many stakeholders should always start with a broader ESG-risk analysis to determine where your firm’s priorities should be. After that – and this is the first step of implementing network governance in your organization – engage stakeholders. Engage widely with stakeholders and formalize the dialogue. The engagement should lead to a decision on a compliance strategy: a code of conduct or certification scheme(s) that has the support of your stakeholders. (The next four steps in the 8-step approach are mainly geared towards supplier selection in such a way that you can deliver on your results, so I will not discuss these here.)

After you have results from your activities and operations, report and communicate your efforts and results according to your compliance strategy or integrate the results in your ESG-report. Reach out to all stakeholders involved and get their feedback. The last step is setting up a quarterly review board. Make sure it is composed of in-house and NGO experts, external academics, and local stakeholders such as unions and local communities.

In short, to put you on track for implementing network governance in your organization, you should: engage stakeholders, report to stakeholders and get their feedback, and finally discuss your results in a quarterly review board. Putting so much emphasize on stakeholder processes (and regular transparent public reporting) might feel unconventional in a business environment, but it is the only way to adapt the firm’s processes to face non-economic transnational issues.

As I already argued in my blog post The Business Case for Non-Financial Reporting, disclosing non-financial information can lead to insights on how to update your business strategy or improve stakeholder relations. In addition, by implementing the new governance model, your firm will report on ESG-topics in such a way that your stakeholders will endorse your efforts. Implementing network governance thus becomes a powerful mechanism to reduce your overall ESG-risk and manage your firm’s reputation.

(* On a more philosophical note: network governance might also feel a-typical or unconventional because of the reign of the two main theories in international relations. Realists seem to accept that international issues are power-issues not all too different from Thucydides’ history of the power struggle between ancient Athens and Sparta. (Reading the classics really never is a waste of time.) Liberals hope to solve international issues through international institutions and law. Network governance (in this case called global governance), in contrast, seeks a solution that is not found in realist or liberal views; it tries to solve international issues through informal norms and self-monitoring. This could also be called the multi-stakeholder view, I suppose. For a short introduction on these views, again refer to the excellent little book by Bevir on governance.)

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What every manager should know about (1/5): Climate Change

before-the-flood

As your organization is getting ready for the implementation of EU guideline 2014/95/EU on the disclosure of non-financial information, I hand you a series of blog posts on non-financial topics that business managers might be less familiar with. My aim for this series of posts is twofold. First, to give you insight into concepts that are integral to non-financial frameworks on reporting, such as the Global Reporting Initiative (GRI) framework. Second, to show why and how you should integrate these specific non-financial disclosures into your overall risk management strategy.

The first blog in this series will discuss what climate change is and what climate change has to do with managing business risk. If you are in need of a broader perspective on climate change I recommend Leonardo DiCaprio’s clear and informative film Before the Flood.

Defining Climate Change

Climate Change, according to the Concise Oxford English Dictionary is:

The change in global climate patterns apparent from the mid to late 20th century onwards, attributed largely to the increased levels of atmospheric carbon dioxide produced by the use of fossil fuels.

In his insightful book Climate Change, A Very Short Introduction, Mark Maslin writes:

Over the last 150 years, significant changes in climate have been recorded, which are markedly different from the last at least 2,000 years. These changes include a 0.85°C increase in average global temperatures, sea-level rise of over 20 cm, significant shifts in the seasonality and intensities of precipitation, changing weather patterns, and the significant retreat of Arctic sea ice and nearly all continental glaciers. (…) The IPCC [Intergovernmental Panel on Climate Change] 2013 report states that the evidence for climate change is unequivocal and there is very high confidence that this warming is due to human emissions of GHGs [i.e. greenhouse gases, such as CO2].

To be able to visualize why it’s so hard to combat climate change caused by CO2, consider this illuminating analogy from Climate Shock, by Gernot Wagner and Martin Weitzman:

Think of the atmosphere as a giant bathtub. There’s a faucet – emissions from human activity – and a drain – the planet’s ability to absorb that pollution. For most of human’s civilization and hundreds of thousands of years before, the inflow and the outflow were in relative balance. Then humans started burning coal and turned on the faucet far beyond what the drain could handle. (…) Inflow and outflow need to be in balance, and that won’t happen (…) unless the inflow goes down by a lot.

Recently, we have learned (see a recent Guardian article) that the amount of CO2 in the atmosphere reached 400 parts per million (ppm); that’s 40% higher than pre-industrial levels (280 ppm). In Climate Shock we read why this is a serious problem:

Last time concentrations of carbon dioxide were as high as they are today, at 400 parts per million (ppm), the geological clock read “Pliocene”. That was over three million years ago, when natural variations, not cars and factories, were responsible for the extra carbon in the air. Global average temperatures were around 1-2.5°C (…) warmer than today, sea levels were up to 20 meters (…) higher, and camels lived in Canada.

The conclusion that we must draw from this is not that climate change is new. Rather, for the first time in the earth’s history, climate change is manmade and happens at a rate which would make it impossible for us to re-actively adapt our infrastructure accordingly. Think for example of shifting entire agricultural regions, or moving complete cities from their present-day ocean front locations.

For an illustrated (and witty) example of how extraordinary the current spike in average temperature really is, see A Timeline of Earth’s Average Temperature. Below, only the very last brief time period – with a sharp increase in average temperature – is shown; the full infographic shows much slower changing average temperatures in the last 20,000 years.

temperature

Skepticism towards climate change is like denying smoking causes cancer

Perhaps most of the general public would not see climate change as an urgent problem, as Wagner and Weitzman point out in Climate Shock.  Although the science behind climate change is solid and has been accepted by the scientific community on the weight of evidence of the research, there seems to be an amazing amount of skepticism around the subject in non-science circles. In trying to explain this phenomenon, Maslin writes:

…the media’s ethical commitment to balanced reporting may unwittingly provide unwarranted attention to critical views, even if they are marginal and outside the realm of what is normally considered ‘good’ science. (…) Add to this the greater ease of communication, from conventional media, such as newspapers, radio, and television, to more informal blogs, tweets, etc. Normal private debate among scientists and experts can easily be shifted into the public arena and anyone, what ever their level of expertise, can voice an opinion and feel it is as valid as that of experts who have dedicated their whole lives to studying areas of science. Overall, this contributes to a public impression that the science of climate change is ‘contested’, despite what many would argue is an overwhelmingly scientific case that climate change is occurring and human activity is a main driver of this change.’

Or, maybe skepticism has to do with cognitive dissonance (i.e. a state of inconsistent thought, beliefs, or attitudes), write Wagner and Weitzman:

Whenever science points to the very real potential of these types of catastrophic outcomes, cognitive dissonance kicks in. Facts might be facts, the reasoning goes, but throwing too many of them at you at once will all but guarantee that you will dismiss them out of hand. It just feels like it can’t be true.

Leonardo DiCaprio in Before the Flood echoes this:

We keep being inundated with catastrophic news about the environment every single day, and the problem seems to get worse and worse. Try to have a conversation with anyone about climate change, and people just tune out.

The key point here is that the efforts to understand climate change are a scientific effort. Maslin rightfully states that ‘science is no belief system’. As Armand Marie Leroi points out in his book, this has been true ever since Aristotle invented science:

‘A scientist is someone who seeks, by systematic investigation, to understand experienced reality.’

Being skeptical towards climate change is therefore the same is being skeptical towards the process of scientific discovery itself. It is, Maslin states, to ‘deny that smoking causes cancer, or that HIV causes AIDS’.

Climate Change and business risk management

Integral risk management for your organization should include climate change risks. As the authors of Climate Shock put it: ‘First and foremost, climate change is a risk management problem’.  A risk analysis of climate change would lead to defining business risks that stem from both the direct consequences of climate change (like more severe weather events), and risks that stem from external stakeholders’ actions to curb climate change that, in turn, have an effect on the company’s operations or profitability (e.g. tighter regulations for GHG emissions). Without making any claims of exhaustiveness, as a minimum, your organization’s risk assessment should include the following risks in a risk assessment:

risk-matrix

Asset and infrastructure risk. We already see an increase in extreme weather events that could hurt a firm’s assets and supply chains. In Climate Change, A Very Short Introduction, numerous relevant examples are given:

[I]n recent years massive storms and subsequent floods have hit China, Italy, England, Korea, Bangladesh, Venezuela, and Mozambique. In England in 2000, 2007, and 2013/13, floods and storms classified as ‘once-in-200-years events’ have occurred within 13 years and frequently within a single year. Moreover, in Britain the winter of 2013/14 was the wettest six months since records began in the 18th century, while August 2008 was the wettest on record.

Organizations could use climate forecasting models to show which assets and infrastructure are more at risk because of climate change. A next step would be to develop scenarios that would lessen the impacts on your assets and supply chains (e.g. moving operations to areas less affected by extreme weather events).

Yield and price risk. When climate change starts to affect crop yields, it will also affect purchasing prices. The IPCC (Intergovernmental Panel on Climate Change) brings together key climate research conducted all over the world and provides a consensus of this research. The IPCC, 2014 report found:

Based on many studies covering a wide range of regions and crops, negative impacts of climate change on crop yields have been more common than positive impacts. [S]everal periods of rapid food and cereal price increases following climate extremes in key producing regions indicate a sensitivity of current markets to climate extremes (…).

Your organization should know which commodities are most at risk from the impacts of climate change. This should be a starting point for developing scenarios to mitigate yield and price risks.

Government regulations. Now that the Paris Agreement has come into force, we can see governments stepping up their work to implement policies that will make sure global average temperatures well below 2°C. Barack Obama in The Economist:

[S]ustainable economic growth requires addressing climate change. Over the past five years, the notion of a trade-off between increasing growth and reducing emissions has been put to rest. America has cut energy-sector emissions by 6%, even as our economy has grown by 11%. Progress in America also helped catalyse the historic Paris climate agreement, which presents the best opportunity to save the planet for future generations.

Any policy changes that try to curb climate change will impact business-as-usual. As a mitigation strategy, organizations should try to understand possible policy options and work out the effects on operations and profitability.

Reputation risk. Awareness of climate change in general is on the rise. Whenever the public is of the opinion that the firm’s activities are harmful (this obviously extends beyond climate change), there’s a probability that profitability is at risk. For example, the big palm oil trader IOI was accused of illegal logging recently  ̶  contributing directly to climate change because of loss of rain forest that stores CO2  ̶  , experienced extreme negative publicity (see this article in the Financial Times), and saw share prices and revenues tumbling. As a first step in creating mitigation scenarios, firms should make an effort in understanding external stakeholder’s views and wishes towards the firm’s climate change actions. As the IOI example shows, reputation risk does not only revolve around emissions but also around having supply chains that contribute towards climate change by deforestation (e.g. beef, soy, palm oil, and wood fiber). Your organization should therefore not only know which operations are most at risk from the impacts of climate change (direct risks), but should also know which commodities contribute the most towards climate change (reputation and regulatory risk).

As I already argued in my blog post The Business Case for Non-Financial Reporting, disclosing non-financial information can lead to insights on how to update your business strategy or improve stakeholder relations. Reporting on climate change gives you the opportunity to update your risk management framework. By breaking climate risks down into direct and external stakeholder risks, and putting in place mitigation scenarios, your organization will be well prepared for an age where climate change is at the top of the agenda.

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Beyond Shareholder vs. Stakeholder Value

In a recent article in the Economist (Analyse This), shareholder value is still seen as ‘the governing principle of firms’. Despite increasing calls to start running firms for the sake of stakeholders, the influential newspaper sticks to running the firm for shareholders and thus to an idea that was described by Milton Friedman in his seminal Capitalism and Freedom in 1962:

 There is one and only one social responsibility of business — to use its resources and engage in activities designed to increase its profits so long as it … engages in open and free competition, without deception or fraud.

In contrast to Friedman’s (and The Economist’s) view, there’s an ever increasing movement that calls for running firms for the sake of its stakeholders (e.g. employees, local communities, public interest groups and financiers) instead of its shareholders. Frameworks are being developed that try to capture more than the financial value of a firm (e.g. the Integrated Reporting framework). Even arguably the most famous of the management scholars, Michael Porter, turns his back on shareholder value. In a 2011 Harvard Business Review article he argues:

A big part of the problem lies with companies themselves, which remain trapped in an outdated approach to value creation that has emerged over the past decades. They continue to view value creation narrowly, optimizing short-term financial performance in a bubble while missing the most important customer needs and ignoring the broader influences that determine their longer-term success. How else could companies overlook the well-being of their customers, the depletion of natural resources vital to their businesses, the viability of key suppliers, or the economic distress of the communities in which they produce and sell?

I propose to move away from the confusing discussion about shareholders and stakeholders for two reasons.

First, shareholder value never seems to be properly defined in the general debate. And certainly not when it’s in the hands of stakeholder-theory proponents. It often gets twisted into something that makes the business world look immoral: businesses will do just anything to make a profit at the expense of everything else. This is, however, not the shareholder theory Friedman had in mind. I included his quote at the start of this text to show that the shareholder view actually calls for ‘free competition, without deception or fraud’ (italics mine). The important phrase ‘without deception or fraud’ seems to be left out of the discussion by stakeholder-theory supporters all together. Furthermore, the attack on shareholder value usually includes the argument that shareholders aim for short-term profits. Business valuation theory, however, actually teaches us that the valuation of a firm is an outcome of its long-term operating income (or cash-flow) and not short-term profit (or short-term rise in stock prices). I do not think it is possible to change the general public’s feelings about the shareholder value concept. It has a tarnished reputation that cannot be mended.

Second, the concept of running a firm in the interest of all its stakeholders is flawed. Stakeholders often have conflicting interests. You cannot shut down environmentally damaging operations without cutting jobs (in the short-run at least). Cheap raw materials or supplied goods can keep prices for consumers down, but might fuel bad ethical practices by suppliers. A firm might be able to balance those interests but can never acquiesce to all without hurting the bottom-line.

Some concepts to change the debate

If a stand-off between a stakeholder and a shareholder view is not the answer, what is? First, try to think of businesses as entities that maximize value to the economic system, i.e. long-term positive cashflow that secures jobs and tax income. Second, acknowledge that firms cannot possibly adhere to all stakeholders’ demands instantaneous and simultaneous. That would certainly hurt the long-term positive cashflow, and thus jobs and tax income. Instead, allow firms to balance the interests of stakeholders and their own long-term positive cashflow goal. In fact, firms are increasingly adopting materiality analysis in which the social and environmental impacts are weighed against the impact on the firm’s profitability.

In combining these two aspects – a firm balances the interests of all stakeholders whilst safeguarding long-term positive cashflow – a model arises where a firm can perform its task of providing maximal value to the economic system by adjusting to changing stakeholder pressures. The task of stakeholders (maybe society in general is an even better concept) is to guide behavior of all entities in society to behavior it deems beneficial. Firms can choose to be front-runners by using Environmental, Social and Governance topics (ESG-topics) to craft strategies to gain competitive advantage (maybe even working together with certain groups of stakeholders). Or firms can take a more defensive stance and wait until regulators or market conditions push them to include ESG-topics into their business practices. For most firms, especially SMEs, the latter strategy may seem the only viable option considering available resources anyway.

In other words, if society wants to push sustainable strategies in companies it should not put pressure on companies alone. Society should put pressure on governments and regulators to adopt rules and regulations to develop the world it wants. A model would arise in which society as a whole moves the world in a direction it wants to go, a world that ought to be. (The ultimate guiding principles in this respect could be the 17 Sustainable Development Goals, which were put forward by the United Nations recently.) The world that ought to be should be translated in rules and regulations. For citizens. But also for companies.

There will, of course, always be companies that shape the world that ought to be in accordance with stakeholder views. But this is not the corporate world’s main task. A firm’s main task is to create maximum value to the economic system by supplying jobs and generating tax income. It should do so in a context where the rules are set by others.

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