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Integrated Governance A NEW MODEL OF GOVERNANCEFOR SUSTAINABILITY

A report by the Asset Management Working Group of the United Nations Environment Programme Finance Initiative

June 2014 U N

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UNEP FI Asset Management Working Group report · INTEGRATED GOVERNANCE · A NEW MODEL OF GOVERNANCE FOR SUSTAINABIL ITY

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DISCLAIMER

he designations employed and the presentation o the material in this publication do not imply the

expression o any opinion whats oever on the part o the United Nations Environment Programme concerningthe legal status o any country, territory, city or area or o its authorities, or concerning delimitation o itsrontiers or boundaries.

Moreover, the views expressed do not necessarily represent the decision or the stated policy o the United NationsEnvironment Programme, nor does citing o trade names or commercial processes constitute endorsement.

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his publication may be reproduced in whole or in part and in any orm or educational or non-proitpurposes without special permission rom the copyright holder, provided acknowledgement o the sourceis made.

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INTEGRATED GOVERNANCE · A NEW MODEL O F GOVERNANCE FOR SUSTAINABIL ITY · UNEP FI Asset Management Working Group report

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TABLE OF CONTENTS

Mess age from the UNE P F I A sse t M ana geme nt Worki ng Group

1 Executive Summar y

2 The Large Corporat ion Today

2.1 Concentration of economic activity2.2 The socioeconomic ecosystem2.3 The role of governance2.4 The value creation process

3 Enabling a Sustainable Strategy

3.1 Integration of ESG issues in the business strategy. Does it pay off?3.2 Effectively implementing a sustainable strategy

3.3 Board committees and their link to sustainability3.4 Promoting effective corporate governance practices

4 Current State of Governance

4.1 Are current governance practices adequate?

5 Integrated Governance

5.1 The Integrated Governance Framework5.2 Board independence at the individual level

5.2.1 Expertise 5.2.2 ime spent goerning

5.2.3 Business ethics

5.2.4 No ailiation5.3 Board independence at the group level 5.3.1 Size o the Board

5.3.2 Diversity5.4 Aligning interests

5.4.1 Compensation Structure 5.4.2 Long-term compensation structure 5.4.3 Ratcheti ng and the use o compensation consultants

5.5 Investor Activism in Executive Compensation 5.6 Long term Active Ownership

5.7 Conclusions

6 Responses from Proxy Voting Agencies

6.1 Glass Lewis6.2 ISS6.3 Proxinvest

References

Endnotes

Ackn owledg ments

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EXECUTIVE SUMMARY1.

Te ocus o this report is to identiy corporate governance practices that could promote a durable culture o sustainability

within corporati ons. As companies increasingly recognize the need to develop a sustainable strategy, where sustainabi lit yissues are integrated into the core o the business model, a respective need is created or a governance model that is ableto supervise the ormulation and execution o such a strateg y.

In this report we propose a new governance model, which we call “Integrated Governance.” Integrated governance is“the system by which companies are directed and controlled, in which sustainability issues are integrated in a way thatensures value creation or the company and beneficial results or al l stakeholders in the long term.” Integrated governancecombines bringing sustainability oversight in the boardroom together with addressing some o the identified currentgovernance weaknesses that prevent boards rom operating in the most effective manner.

Integrated governance expresses an end state o governance practices. Tereore any firms aiming to operate under

those practices will have to go through a series o changes. We propose that the ultimate target or companies wouldbe to move rom “governance or sustainability” to an integrated governance perspective. Tere are three major stages,each with its unique characteristics that describe the journey each company has to go through to achieve a model ointegrated governance. In phase 1 are companies, which are not integrating sustainability issues into their strategicagenda, and merely have some (or even no) sustainability projects. In phase 1 there is no discussion o sustainability risksand opportunities at the board level and the responsibility o any sustainability projects lies with small isolated teams.For these companies to move to the next phase in their journey or integrated governance, an understanding o the valuecreation process through sustainability is required. Setting up a sustainability committee could also significantly assistin driving companies through their journey rom phase 1 to phase 2, rom having sustainability outside o the boardsagenda to having governance or sustainability become part o it.

Phase 2, governance or sustainability, describes firms that have established a sustainability committee. Tese firms usuallystart to measure the perormance o their efforts through KPIs, issue a sustainability report, and requently appoint a ChieSustainability Offi cer. Although companies in phase 2 bring the sustainability issues onto the agenda o board meetings,sustainability is stil l being treated as a separate unction and is compartmentalized. Tese companies have a sustainabilitystrategy rather than a sustainable strategy. A progression to phase 3, integrated governance, would require a holisticintegration o sustainability in the corporate strategy, without the need or a separate sustainability committee since eachboard member is now thinking in a way that would promote a sustainable strategy or the firm. Each board committee canintegrate sustainability issues in their char ter and replace the need or a d edicated sustainability committee. Adoption ointegrated reporting adds significant value in monitoring the progress against both financial and environmental, socialand governance (ESG) targets, and helps understand the benefits o the integrated governance approach. In order to

achieve integrated governance a company needs to make sure our elements are in place: Independence both at theindividual and at the group level, aligned incentives and investor long term active ownership

In section 2 o the report we discuss the increasing concentration o economic activity in a relatively small number ocorporations and their increasing impact on the environment and society. Entrepreneurs and the corporations createdas a result o the entrepreneurial spirit have provided enormous benefits to society uelling unprecedented economicgrowth and raising billions o people out o poverty by creating job opportunities. We describe the process o valuecreation inside organizations, emphasizing that the results o externalities rom corporate activities c an affect corporatefinancial perormance. Importantly, we show how company competitiveness depends on the viabilit y o human, natural,financial, intellectual, physical, and social capital.


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Having explained how environmental and social issues affect the viabilit y o the different orms o capital and as a result

company competitiveness, in section 3 we make t he case or the development o a sustainable strateg y, one that enablesa company to create value or its shareholders, while at the same time contributing to a sustainable society. Evidence osuperior financial perormance rom companies ad opting sustainable strategies is presented. We highlight the importanceo corporate governance and a well-unctioning board as the necessary condition or the successul supervision andexecution o a sustainable strategy. We list activities that the various board committees (corporate governance, audit,compensation, and nomination) could carry out as part o their sustainability oversight to show actual examples ointegrating sustainability into corporate governance practices.

In section 4, we d iscuss the current state o governance practices and seek to understand some o the s ystematic problemsthat lead to governance ailures. We review both board dynamics, such as the expertise o individual directors and thetime they spend governing, and compensation structures, such as t he level, orm and time horizon o incentives provided

to senior executives, to show that they are inadequate or the effective supervision o a sustainable strategy. Case studieso companies are presented throughout the section to provide examples o governance practices across firms.

Section 5 introduces the integrated governance model, as a response to the question: ‘I current governance practicesare ineffective in promoting a culture o sustainability, then what is the alternative? We describe the journey that acorporation would have to go through to reorm their corporate governance practices towards an integrated governancemodel. As companies move rom treating sustainability as a peripheral issue that is not integrated into their strategicdecisions to placing sustainabilit y at the core o their business model, governance should move in the same direction. Wediscuss each component o the integrated governance ramework and also present case studies. Integrated governancerequires a better definition o director independence, one that covers both the individual and the group level, coupled with a ligned interests and investor long-term active ownership. Troughout section 5 we out line our recommendations.

With this report w e hope to provide institutional investors with insights and suggestions that they could consid er whenengaging with corporations and exercising their ownership rights. Corporations may also use the integrated governancemodel as a guide to benchmark themselves against this new practice and their competitors and identiy areas orimprovement in their governance practices.

We have chosen not to include in this paper an in depth investigation o the role o governmental intervention andregulations. While governments do have an important role in driving corporate governance transormations, they arenot the only w ay to drive better integration o social and environmental actors, as well as financial ones, with governance. We believe that these transormations should happen even in the absence o regul ation, as market orces push companies

towards more robust configurations o their governance arrangements. In this report we shed light on what theseconfigurations might look like, although we recognize that such configurations might differ across companies.


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THE LARGE CORPORATION TODAY 2.

2.1

2.2

Companies have been the engine behind t he unprecedented economic growth o the past century. he big companiesthrough their operations have managed to raise billions o people rom poverty, provide employment and educationopportunities and unlock the human potential or innovation and creativity.

By comparing the evolution o the worlds largest 1,000 publicly listed companies (Global 1,000) rom 1980 to 2012,the progressive concentration o economic activity around the largest corporations can be observed. In 1980, the wor lds largest 1,000 compa nies made $2.64 tri ll ion in revenues or $7.0 tri ll ion in 2012 dol lars (adjusted using theconsumer price index), whereas by 2012 they made $34 t rillion in revenue. In 1980, the Global 1,000 directly employed

21 million people, whereas in 2012 they employed 73 million people. Finally, in terms o market capitalization, in1982 they had a total o close to $900 billion ($2,4 trill ion in 2012 dollars), or 33 percent o the world total, comparedto a staggering $28 tril lion market capitalization (50 percent o the world total) in 2012.

Given the size o these companies, the impact they have on societ y is becoming apparent. he Global 1,000 can nowinluence billions o people around the world, rom employees to suppliers, customers, and even regulators. Out o206 countries recognized by the United Nations, only 26 had nominal Gross Domestic Product (GDP) higher thanthe sales numbers reported by Royal Dutch Shell and Wal-Mart ($454 billion and $447 billion, respectively) in 2011.1 Another example is the concentration o ood supply in a handul o multinationals like Nestle, Kelloggs, GeneralMills, PepsiCo, Krat, Unilever, and Procter & Gamble.2 hese companies have a large eect on the dietar y liestyleo consumers and thereore inluence any impact this liest yle has on consumers health and well-being.

Corporations do not operate in isolation, but as part o a broader ecosystem consisting o the society as a whole and t heenvironment (Figure 1). Te large corporations today have enormous power to do good, beyond the benefits arisingrom their operations. As just one example, many corporations provided support to the victims o the Indonesiantsunami, a support that was much more than w hat could have been mobilized in such a short timerame by governments.

Concentration of economic activity

Te socioeconomic ecosystem

SOCIETY CORPORATIONS ENVIRONMENT

Figure 1

The Socioeconomic ecosystem


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At the same time, the goods, services, and wealth corporations create come at a cost. Teir operations require the

consumption o vast amounts o natural resources, they pollute the local and global environment at little or no cost,they can throw economies into recession due to poor risk management as in the case o large financial institutions,and can hurt individual employees well-being i wages and working conditions are inadequate. Dow estimates that itis consuming on a daily basis as much energy as Australia does. Some ood supply companies have been accused oconsciously contributing to the increasing problem o obesity.3 Foxconn, the Chinese electronic contract manuacturer,has been repeatedly criticized over its labor practices.

Society consists o numerous stakeholders that affect and can be affected by a companys operations.4 Employees,consumers, governments, local communities and institutional investors are examples o some o these stakeholders. Te various stakeholders within the society do not necessari ly have aligned interests. Consumers o goods and services requirehigh quality products at reasonably low prices. Tis is not necessarily aligned with what employees want (job security, air

compensation, and comortable benefits). Investors want a good return on the money they invested in the company. Localcommunities want an environment as undisturbed as possible and some compensation or giving companies a license tooperate in their area. Te larger a company is, the more diverse the range o stakeholders that are affected by its operationsand the more pressure they will apply to satisy their needs. Globalization has led to urther complexity, since companies thatnow supply their goods and services in other geographies will ace a divergence o interests and incentives.5

Almost as a response to the immense growth o the worlds largest corporations, national and trans-national non-governmental organizations (NGOs), which exist to represent the interests o the civil society, have also grown in powerand influence.6 More people now than ever show trust in NGOs as recent public opinion surveys show.7 Teir human capitaland financial resources have significantly grown in size. NGOs in 26 countries account or 31 million employees, or almost7 percent o the total workorce o those countries. Annually, NGOs in these 26 countries spend about $1.2 trillion, almostas much as the largest 1,000 companies o the world spend in capital expenditures. 8 Tese resources have been mobilized toproduce more effective and impactul campaigns. Aided by inormation technologies such as the internet and social media,their campaign reach has expanded, since now a large number o people can be inormed.

NGOs oten work in collaboration with corporations. he Investor Network on Climate Risk (Ceres/INCR),the Institutional Investors Group on Climate Change (IIGC C), the Carbon Disclosure Project (CDP) and severalother investment-oriented NGOs work with corporations to bring sustainability issues in the discussion and into

public policy. A good example is the Climate Declaration, a project o Ceres, which is a statement that companiessign as a declaration o their eorts to ight against climate change.9

With this rapid expansio n o access to inor mati on it is i ncreasingl y d i icult or corporat ions to indulge in activitiesthat could harm people, communities or the environment without attracting negative attention. his negativeattention could damage a companys reputation and brand name and reduce its social capital. Now that mostcompanies market capitalizations are more than double the value o their tangible assets, a loss o reputational orbrand value could prove detrimental. Regulatory actions have also come as a result o such campaigns, together withshits in customer attitudes, in some cases putting a companys license to operate or even entire industries at risk.


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2.3

2.4

Corporations should aim to create sustainable shareholder value over the long term while at the same time managing

their relationships with the various stakeholders rom societ y and minimizing any negative impact on the environment.Since corporate governance is the system by which corporations are d irected and controlled, it is through corporategovernance that the interests o al l these stakeholders and the interaction with the environment can be managed.

Directors as fiduciaries acting in the best interests o the corporation have several important responsibilities. Some o theseresponsibilities are approving the corporate strategy, reviewing risk management, setting perormance objectives and ensuringthat audit and accounting controls are in place. Several publications include comprehensive lists o these responsibilities.10, 11

By examining and understanding the responsibilities o the board o directors, the key role o corporate governance inthe relationship o corporations with society and the environment becomes apparent. Institutional investors will engagedirectly with the board about t heir request or governance reorms. Te NGO campaigns might trig ger business model

changes at the corporate level. Decisions about how to manage negative externalities such a s carbon emissions, or wastebecome items on the boards strategic agenda. Customers and shareholders wil l seek accountabilit y at the managementlevel in the case o a bribery scandal or ethics breach. Tese are just a ew examples o the multiple way that governanceis the mechanism driving the corporate interactions with society and the environment.

Firms use resources to produce and provide their products and services. Tese resources can be classified as natural capital,such as water, orest, and minerals; human capital, such as skills, capabilities, and experiences o people; and financial capital,such as unds rom investors and lenders or rom the reinvestment o unds obtained rom operations. Firms use theseresources during the production process to develop additional resources. Tese additional resources can be classified asphysical capital, such as actory equipment; intellectual capital, resulting rom employee efforts that generate intangibleassets; and social capital, deriving rom the relationship between a firm and society that secures its license to operate.Leveraging these additional resources, firms sell products and services in exchange or financial compensation.

Products and services are not the only output generated by a company. Externalities are another outcome o a companys activities.Positive externalities arise when a companys actions generate marginal private benefit that is smaller than the marginal social benefit.Consider, or example, the case o employee training. While the company benefits by improving the skills o its employees, it alsocreates benefits or other companies that these employees might join in the uture. Negative externalities arise when a companysactions generate marginal private costs that are smaller than the marginal social costs. Consider, or example, child labor. Employingchildren adversely affects other companies because the pool o skilled employees in the uture will be smaller, since children that are working are unable to attend school. Figure 2 illustrates the interrelationships in the value creation process.

While both positive and negative externalities can be imposed by a company on society, negative externalities in particularhave affected the value creation process described above. Negative externalities such as pollution, human rights violations,and excessive risk taking have significantly impaired many corporations social capital, putting their license to operate atrisk. Te public revolt against financial institutions that assumed excessive risks and caused one o the worst financial crises

in history has resulted in limitations on the bonuses that bankers can receive in Europe. As o 2012, many large financialinstitutions had been orced to divest many o their high-risk businesses and increase their capital requirements. Te resulthas been a drastic reduction in their profit margins and stock market valuations.12

Te role of governance

Te value creation process


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NATURAL CAPITAL

HUMAN CAPITAL

FINANCIAL CAPITAL

PRODUCTS/SERVICES

EXTERNALITIES

FINANCIAL RETURN

PHYSICAL CAPITAL

INTELLECTUAL CAPITAL

SOCIAL CAPITAL

Figure 2

The value creation process

In 2011, UBS announced a strategic plan to reshape its investment banking division and transorm the group in order tocreate the UBS o the uture, a firm ocused on its core business lines committed to deliver more sustainable and attractivereturns. UBS is not the only bank to be scaling back its investment banking activities and restructuring in accordance with the new operating realities; almost all big European banks are doing so in one way or another. UBS has acceleratedthe implementation o this restructuring in 2012 to protect the banks reputation. «Capital strength, cost discipline andstrong operational risk ramework are critical to our long term success», was announced in a June 2013 investor relationspresentation. As a result, UBS will exit non-core and legacy portolio positions to achieve its Basel III requirements.Business lines, predominantly in fixed income, that have been rendered uneconomical by changes in regulation and marketdevelopments will be closing down by 2015 and UBSs headcount will be reduced as a consequence. «As a result o these

actions […] UBS will be capable o maximizing value or its employees and shareholders.

Case study


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he nature o the products and services delivered has also been under intense scrutiny in recent years. obacco

companies were among the irst to be aected by a public outcr y against the negative externalities o their products.However, health concerns rom the consumption o products and services have not been restricted to tobaccocompanies. Many ood and beverage companies, including McDonalds and PepsiCo, are a lso under sc rutiny or thehealth eects o their products.

Moreover, environmental concerns about many natural resources have disrupted business models even i thesenatural resources have been regulated by the price s ystem and as a result would not be considered externalities. Forexample, Coca-Cola was accused o depleting water wells in India to make carbonated sugar sot drinks, leaving localcommunities without water supplies. Coca-Colas plant at Plachimada was shut dow n in 2005 ollowing a protractedlegal battle and a sustained campaign by civ il rights groups. Coca-Cola responded by increasing the water eiciencyo its plants and working to replenish 100 percent o the groundwater that the company uses throughout India. As o

2012, the company claimed to replenish approximately 93 percent o the groundwater it uses through the creationo rainwater harvesting structures, restoration o ponds, and traditional water bodies and interventions ocused onimproving water use eiciency in agriculture.13

Similarly, social concerns, such as employee saety, air wages, and child labor, have also disrupted business models.In 2012, platinum mine workers in South Arica went on a series o strikes over pay negotiations. Violent clashesbetween rival groups o miners and the police resulted in the death o 46 workers at the Marikana platinum mine.he mines owner, Lonmin PLC, resolved the strike by oering workers a pay increase o up to 22 percent but unrestsoon spread to other mines.14 Within a ew weeks, approximately 25 percent o all mineworkers in South Aricahad gone on strike according to the Chamber o Mines, capital was lying out o the country, and production hadstopped. Gold, platinum, coal, diamond, and iron ore mines had al l been aected. President Jacob Zuma claimed t hat wor k stoppa ges, incl uding stri kes , had co st t he gover nment $368 mil lio n in the irst s ix months o 2012. 15

Firms with products and services that are thought to generate negative externalities ace diiculties in attractingtalent and raising inance.16, 17On the other hand, research has shown that irms with better CSR perormance havebetter access to inance, due to superior stakeholder engagement and increased transparency originating rompublicly disclosing CSR metrics.18 Research has also shown that a company can use its corporate social perormanceactivities to attract job applicants and thereore develop a competitive advantage. Employees will be attracted tocompanies with a good reputation regarding qualit y products and ser vices, treatment o the environment and issueso diversity.19

hese environmental, social and governance (ESG) issues have made many observers question the appropriaterole o the corporation in society. Should companies try to eliminate negative externalities and provide positiveexternalities? How should companies respond to changing social expectations? Will integration o ES G issues in thestrategy and business model o a company increase or decrease its competitiveness?

Integrating environmental and social issues in the business strategy o a company can present tremendousopportunities or innovation and growth while ailing to do so might result in signiicant risks. I integration oESG issues is necessary to manage all these risks and to also create a competitive advantage or the company thencorporate governance mechanisms should be mobilized to ensure that this integration happens. Governance is themechanism that ultimately aects everything a corporation does; hence, making sustainability an integral componento corporate governance is both prudent and necessary.


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ENABLING A SUSTAINABLE

STRATEGY

3.

3.1

George Seraeim and Robert Eccles o Harvard Business School have proposed a ramework showing how acompanys competitiveness depends on preserving and enhancing the dierent types o capital in order to deliverexcellent products and services, while concurrently minimizing the amount o negative externalities. 20 his can beachieved through the systematic integration o ES G actors in the business strategy and as a result, irms succeeding

in this integration wil l outperorm their competitors in the long-term.

However, the mechanisms to improve long-term perormance will not be the same or every company since it isdependent on how critical each orm o capital is or a company. Although these mechanisms are unique to eachcompany, there is one common underlying actor and that is governance. All companies have some sort o governancestructure and most, i not all companies, rely on that governance structure to provide guidance and eedback to t heaccomplishment o speciied goals. hereore these ESG actors need to be brought into their governance structuresand processes i their ultimate goal is integration o ESG issues in their business strategy.

Companies are currently acing the challenge o deciding how they will adapt their strategy to satisy the needs andrespond to the pressure o multiple stakeholders. In doing so, they need to understand the relationship between

adopting sustainability initiatives and their eect on their inancial results.21 I there is a direct positive correlation oenvironmental and social perormance with inancial perormance, then any decision becomes more straightor ward.A signiicant study investigating this relationship has examined a matched sample o two virtually identical sets oirms in terms o size, inancial perormance, and growth prospects o 180 US companies over the period rom thebeginning o 1993 to the end o 2010.22

he authors classiied 90 o these companies as High Sustainability irms because long ago they adopted corporatepolicies regarding commitments to enhance environmental and social perormance; the other 90 were classiied asLow Sustainability irms because they had not. he Low Sustainability irms correspond to the traditional model oproit maximization in w hich social and environmental issues are predominantly regarded as “externalities” created bythe irms actions. he High Sustainability irms, in contrast, take into account these externalities in their decisionsand operations; this is maniested in their relationships with stakeholders such as employees, customers and NGOsrepresenting civil society. In other words, the notion o “sustainability” appears to be embedded in a holistic andmultidimensional manner within and t hroughout the organization.

Integration of ESG issues in the business strategy.Does it pay off?


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Te authors ound that firms in the High Sustainability group significantly outperormed firms in the Low Sustainability

group in terms o both stock market perormance (although both sets did better than the market as a whole) and accountingmeasures. Investing $1 in the beginning o 1993 in a value-weighted (equal-weighted) portolio o sustainable firms wouldhave grown to $22.6 ($14.3) by the end o 2010, based on market prices. In contrast, investing $1 in the beginning o 1993 ina value-weighted (equal-weighted) portolio o traditional firms would have only grown to $15.4 ($11.7) by the end o 2010.Similar results were ound or the measures o return-on-assets and return-on-equity.

Importantly, the High Sustainability group exhibited undamentally different governance procedures and practices romthe Low Sustainability group. Boards o directors were ormally delegated responsibility over sustainability, and executivecompensation was more likely to be linked to ESG metrics or this group. Moreover, High Sustainability firms were more likelyto measure and disclose their ESG perormance, and to allocate resources to a rigorous stakeholder engagement process.

Other studies have added evidence or the positive correlation o ESG and financial perormance. A meta-analysis carriedout by Deutsche Bank in 2012 concluded that 89 percent o more than 56 academic studies, research papers, and meta-studies showed that companies with high ESG perormance ratings exhibit market-based outperormance compared toindustry peers, and 100 percent o the academic studies agree that companies with high ESG ratings have a lower cost ocapital in terms o both debt (loans and bonds) and equity capital.23

Further evidence is provided by the Caliornia Public Employees Retirement System (CalPERS) engagement process.CalPERS engages with selected firms rom their Governance Focus list due to concerns around their weak sustainabilityperormance. Tese firms produced cumulative returns averaging 39 percent below their benchmarks in the three yearsprior to CalPERS engaging with the companies and 17 percent above their benchmark returns or the five years afer theengagement was undertaken.24 Moreover, as we already mentioned in the previous section, there are a number o studiesdocumenting benefits or companies that have better ESG perormance in capital and labor markets.

Tereore the answer to the question ‘Does integration o ESG issues in the business strategy pay off? would be: it can, iimplemented successully. Key points or ensuring successul implementation are: appropriate governance processes and practices,stakeholder engagement, measurement and reporting o ESG perormance and the ability to think and act with a long-term view.

3.2 Effectively implementing a sustainable strategy

A sustainable strategy is one that enables a company to create value or its shareholders, while contributing to a sustainable society.A sustainable society is one that meets the needs o the current generation without sacrificing the needs o uture generations.Tus a sustainable strategy is one that minimizes its negative externalities and integrates the material sustainability issues or itssector and strategy into the core o its operations. Since there is clear evidence o benefits rom successully implementing asustainable strategy, the next logical question is how do you effectively implement a sustainable strategy?

Despite the act that research has shown that better ESG perormance o a corporation is positively associated with financialperormance and more specifically to access to finance, customer loyalt y and satisaction, and employee engagement, not allcompanies have embedded sustainability issues in their strategy. Te main reason behind this is the complexity o integratingthese ESG issues in a way that improves financial perormance. Te same applies to companies that have ormulated asustainable strategy but ailed to effectively execute it.


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A recent publication introduced the concept o t he ‘Perormance Frontier, an il lustrative way to show the relationship

between financial and ESG perormance. According to the authors, in the absence o substantial innovation, thefinancial perormance o a firm declines as its ESG perormance improves. o simultaneously improve both kinds operormance, companies need to innovate in terms o new products, processes, and business model s.25

Although many companies have managed to pluck the low-hanging ruit o introducing minor innovations, especiallyaround energy efficiency programs and reduction o carbon emissions, this has only pushed the perormance rontierup a bit. Major innovations are required to shif the overall slope and create a positive relationship between financial andESG perormance, innovations that would include large-scale investments and long payback periods.

Te correlation between financial perormance and ESG perormance has highlighted the criticality or companies toconsider the interests o a broad range o stakeholders in their decision making process. Te ocus is no l onger only on the

corporations shareholders as stakeholder theory, introduced by Edward Freeman, has shown.26 Later empirical researchhas demonstrated that superior sta keholder relations (e.g., with employees, customers, and local communities) can be asource o competitive advantage by not only enabling a firm with above average perormance to sustain its competitiveadvantage or a longer period o time, but also by helping poorly perorming firms to recover rom disadvantageouspositions more quickly.27

3.3 Board committees and their link to sustainability

Corporations that have grasped the importance o sustainability in the value creation process and the necessity orinnovation in products, processes, and business models have made the first important step towards a sustainable strategy.However, realization on its own is not enough i it is not ollowed by implementation. o enable innovation and makesustainability considerations core to a companys strategy and operations, a company needs to have a governance structureand process that is supportive o developing and executing a sustainable strategy. Te decisions around sustainability need tobe made at the top, as a result o discussions about the overall strategic agenda. Corporate governance has a key role in theimplementation o a sustainable strategy as the board o a firm is responsible or setting the overall direction and creating theappropriate systems that will acilitate it.

By examining archival data on how many firms embrace this approach today, we have ound that the governance osustainability is still at an embryonic stage. Using Bloomberg data or the 2011 fiscal year, we ound that out o 3,512companies (in a total universe o about 60,000 companies) that report at least one ESG data point, only 56 companieshad a non-executive director with responsibility over sustainability. Another 14 companies had an executive director withsimilar responsibility. Only 374 companies had a sustainability committee that reports directly to the board but none oits members were part o the board. Similarly, only 10 companies linked compensation to ESG metrics or the board andonly 32 or top management. Tese very low numbers suggest that most companies still have not taken responsibility orsustainability issues at the highest governing body o the corporation.28


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Studying committee charters can provide urther insight into how different companies are assigning the accountability or

sustainability issues. A recent study examining names and charters o board committees at North American companies toidentiy board-level oversight o environmental and social issues identified several important trends: 29

In the Russell 3000 only 8 percent o committees have a name that suggests oversight o environmental and social issues.

In the S&P 100 there is a much higher sustainability oversight through at least one committee (65 percent o the companies).However the ocus o these committees is concentrated on only a ew items. Te report lists seven key actors that boards shouldbe addressing: oversight or policies and compliance, trend assessment, strategy and perormance, risk management, stakeholderengagement, sustainability reporting, incident management and environmental and social impact assessment o businessdecisions. Most o the committee charters examined in the report ocus on reviewing and monitoring o policies and compliancearound corporate responsibility. Less than hal o these committees provide oversight on any o the rest o the categories or requiretheir directors to monitor and make orward-looking recommendations about sustainability trends, strategies or targets.

In order to examine how a board can integrate these sustainability issues, the typical charters o several board committees wereexamined and the possible link each committee could have with sustainability is described.

CORPORATE GOVERNANCE COMMITTEE

Tis committee is usually responsible or setting the overall approach to corporate governance o an organization and orreviewing and assessing with the board the appropriate skills, experience, and background that the company is looking or in itsboard members. Te corporate governance committee also decides on the size and composition o the board and is responsibleor evaluating the diversity o the board members in terms o gender, ethnicity and age. Other responsibilities might includesetting the boards meeting schedule or identiying directors who should leave the board and acilitating that transition. All o

this needs to be done in close coordination with the Board Chair and the CEO and so most governance committees are chairedby the Board Chair and have the CEO on them.

Corporate governance committee and sustainability:

Te corporate governance committee has the very crucial role o assessing the appropriateness o the boards diversity andmix o skills and experiences. Identiying the right size or the board is also very important, as will be discussed in urther detailin section 5, since it has been ound that it is directly related with the boards effectiveness in governing an organization. Tecorporate governance committee can build the right environment or decision-making and create and sustain a board that caneffectively support and oversee a companys activities.

In companies that have no stand-alone sustainability committee or are in the process o integrating sustainability issues into everycommittees agenda, the corporate governance committee would have in its charter several o the sustainability related activitieslike monitoring sustainability trends, reporting on sustainability risks and opportunities and overseeing sustainability projects.

Some o the responsibilities the corporate governance committee could undertake as part o its sustainability integrationare the ollowing:

Oversee matters o corporate governance, corporate responsibility, sustainability (including sustainability trends) and theimpact o environmental, social and governance issues to the business.

Review the director orientation and education program or ensuring the appropriate expertise and knowledge is present overall.Include training around sustainability.

Assist in monitoring and reviewing corporate governance and reputational risk exposures.

Review company wide policies regarding Corporate Governance Principles.


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AUDI T CO MMI TTEE

Every board has an audit committee. his committee is mandated with the task to provide oversight o the CFOunction, the auditors, and related matters like ta x compliance, SEC compliance etc. Some o the responsibilities othe audit committee are the ollowing:

Monitor the integrity o inancial statements and the companys accounting and inancial reporting processes

Oversee the companys compliance with legal and regulatory requirements

Ensure the risk management process is comprehensive

Evaluate the perormance o the companys independent auditor and internal audit unction

Discuss with management and the independent auditor the annual and quarterly inancial statements, earningsresults, earnings guidance

Audi t c ommi ttee and sustainabi lit y:

One o the most important links o the audit committee with sustainability is that o ESG reporting and disclosure.A recent study has shown that 60 percent o CFOs at companies with average annual revenue o $17 billionindicated that sustainability challenges will change inancial reporting and the associated auditing activities. 30 Sincesustainability reporting is becoming mainstream, pressure or greater transparency and ocus on t he ESG reporting isbuilding up, and the concept o integrated reporting is gaining momentum, the audit committee needs to understand

the chal lenges presented.31

he International Integrated Reporting Council (IIRC) deines integrated reporting as: a process ounded onintegrated thinking that results in a periodi c integrated report, by an organization about value creation over time andrelated communications regarding aspects o value creation. An integrated report is a concise communication abouthow an organizations strategy, governance, perormance and prospects, in the context o its external environment,lead to the creation o value over the short, medium and long term.” 32 he Association o Chartered CertiiedAccountants (ACCA) has recently become the irst global accountancy body to introduce integrated reportinginto its qualiication.33

Another link o the audit committee with sustainabilit y is that o corporate communications. here has been a strongbelie that the provision o regular earnings guidance is an eective and eicient way or managers to communicatetheir belies to the market, dierentiate their companies rom peers and allow investors to make better-inormeddecisions. Earnings guidance is the regular disclosure o point or tight range earnings orecasts or uture quartersor the next iscal year. However, some o the perceived beneits o earnings guidance have recently been scrutinized.


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A recent report has studied in depth the costs and beneits o this managerial practice.34 he report ound that some

o the perceived beneits like lower inormation asymmetry, higher analyst coverage and reduced stock volatilityhave not been thoroughly investigated up until now. here are also several potential costs associated with regularearnings guidance that could undermine a companys long-term vision and inancial health. he most importantcosts identiied are: earnings management, attracting short-term investors, analyst herding and insider trading. Somebig corporations have already introduced changes in their corporate communications towards an elimination oearnings guidance (e.g. Coca Cola, Unilever and Google).35

he audit committee could greatly support the development o sustainable strategies by understanding the newreporting challenges and proactively introduce integrated reporting and also manage the risks arising rom earningsguidance by appropriately adapting corporate communications.

Some o the responsibilities the audit committee could undertake as part o its sustainability integration are the ollow ing:

Signiicant eort has been put into promoting listing standards or stock exchanges that include requirements orsustainability disclosure.36 he audit committee could have the responsibility o carrying out an ESG materialityassessment, and o discussing the companys process or determining the ESG actors material to the business as wellas the outcome o the assessment within the annual inancial ilings.37

Understand any risks and opportunities related with reporting on the sustainability perormance o the irm.

Ensure the quality o communications and data around sustainability. Assist in deining what the company shouldbe reporting on and understand how the investment community, regulators, consumers and the public, will perceivethe inormation.

Modiy corporate communications towards the elimination o Earnings Guidance. o achieve this, the auditcommittee should identiy appropriate long-term strategic inancial benchmarks that could be communicated andestablish ways to measure the progress towards these goals.

Introduce integrated reporting and ensure the quality o inormation reported.

Actively monitor latest research and development in the world o sustainability.

Ensure compliance with new regulations around sustainability.

Ensure the appropriate ethical standards are set that reward good behaviour and at the same time discourage excessiverisk taking


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COMPENSATION COMMIT TEE

he compensation committee provides oversight o the Companys compensation plans, including equitycompensation, and also is directly involved in setting the compensation o the CEO and oten the senior managementteam. Some o the responsibilities o the compensation committee are the ollowing:

Review and recommend remuneration arrangements or the senior mana gement including the CEO.

Ensure that the organizations compensation plans are appropriate to allow attraction and retention o the best talentin the market.

Ensure that there is no l oss o value or the shareholders due to over ‘generous compensation.

Decide on the structure o the compensation plans (restricted stocks, options, bonuses etc.).

Decide on the incentive strategy (short-term vs. long term perormance targets).

Compensation Committee and Sustainability:

he compensation committee has a very tig ht link with sustainability in that it is the committee that should structurecompensation packages with appropriate short and long-term incentives that are chal lenging and lead to the creationo sustainable social as well as inancial returns on investment that are durable over long term spans.

he compensation committee needs to strike the diicult bal ance o attracting and retaining the right ta lent but at

the same time avoiding excessive compensation packages and loss o value or the shareholders. he compensationcommittee needs to be aware o the market trends and current compensation levels among competitors, whichmeans access to inormation. Caution should be exercised when compensation consultants are used, in order to avoidany possible ratcheting o remuneration as will be discussed in urther detai l in section 5.

Some o the responsibilities the compensation committee could undertake as part o its sustainability integrationare the ollowing:

Link sustainability issues material to the business to ES G targets.

Determine the percentage compensation rom meeting ESG and inancial targets or the CEO and the executives

and compare with market d ata o comparable companies or competitors.

Identiy any risks related to the compensation structures and the time horizon o the associated targets.

Review the annual perormance evaluations o the objectives relevant to their compensation o the CEO andother executives.

Engage with investors and stockholders around their proposals related to compensation matters.


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NOMINATING COMMIT TEE

he nominating committee is responsible or overseeing the recruitment and on-going development o boardmembers. Some o the responsibilities o the nominating committee are the ollowing:

Identiy appropriate candidates in the event o a board vacancy.

Review and recommend to the board, the criteria or a board membership and the desired competencies o board members.

Oversee the evaluation o the perormance o the board and the management, including the CEO.

Nominating committee and sustainability:

Succession planning is one o t he most important responsibilities o the nominating committee and a key requirementor the creation o sustainable strategies.

he nominating committee has to ensure that there is an existing process behind appropriate succession planning.Succession planning is recognized as one o the weaknesses in current corporate governance practices and an areathat boards need to ocus urther eort and attention. Succession planning should be considered part o the boardsagenda and not an event t hat is triggered only when things are not going well. I it is integrated as part o the sustainablestrategy o a irm then it will not be perceived as a sensitive and sometimes awkward issue or current CEOs who areperorming well. Keeping this in mind, the CEO succession planning should almost start the irst day a new CEOstarts their job. he same principle would apply or t he succession o any board members.

he nominating committee is also responsible or identiying prospective new board members to replace departingones or to expand the board. hereore i the board does not have the necessary expertise in sustainability, it is thenominating committees responsibility to identi y the appropriate candidates who do have the expertise needed.

Some o the responsibilities the nominating committee could undertake as part o its sustainability integration arethe ollowing:

Maintain an up-to-date skills record or board directors. Introduce sustainability skills in the directors selection process.

Establish an assessment o perormance o the board as a whole and its indiv idual members. Ensure that sustainability

metrics are part o the overall assessment

Proactively communicate the succession plan.


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Some examples o how companies have so ar addressed integrating sustainability issues in t heir committee chartersare presented in the list below:

CORPORATE GOVERNANCE COMMITTEE

Review on a regular basis the Companys practice or d irector orientation and education (Biogen Idec).

Review and report to the Board on a periodic basis with regards to matters o corporate responsibility and sustainabilit yperormance, including potential long and short term trends and impacts to their business o environmental, social,

and governance issues, including the companys public reporting on these topics (INEL).

Review with the Board rom time to time the appropriate skills and characteristics required o Board members inthe context o the current make-up o the Board, including issues o diversity, age, skills such as understanding omanuacturing, technology, inance and marketing, and international background (INEL).

AUDI T CO MMI TTEE

Review any signiicant changes in accounting principles or developments in accounting practices and the eects othese changes upon the Companys inancial reporting (IB M).

Review the consolidated social and environmental statement in the Annual Report. Monitor and review theadequacy and eectiveness o the systems o internal controls over inancial, social and environmental reporting andapprove signiicant changes therein. Monitor the eectiveness o the risk management systems in relation to inancialreporting and review and discuss policies with respect to risk assessment and risk management. Review long-termincentive programs and the cal culations and achievement o inancial targets in t he long-term incentive programs orSenior Management (Novo Nordisk).

Discuss with management and the independent registered public accounting irm, as appropriate, earnings results,earnings guidance, and signiicant inancial disclosure issues (Biogen Idec)

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COMPENSATION COM MITTEE

Assess the results o the companys most recent advisor y vote on executive compensation (INEL)

Review and make recommendations with respect to stockholder proposals and stockholder engagement related tocompensation matters (INEL)

Annually review an assessment o any potential conflicts o interest raised by the work o compensation consultants, whetherretained by the Compensation Committee or management, who are involved in determining or recommending executiveor director compensation (INEL)

Review the succession plans and leadership development or the executive officer positions, including a review o theCompanys development, succession management and diversity efforts (NIKE)

Review the Companys overall philosophy and practices regarding executive compensation (NIKE)

Oversee the leadership development (Unilever)

NOMINATING COMMIT TEE

Regularly discuss long term succession planning or the Board and present a proposal to the Board (Novo Nordisk)

Annually review developments in respect o required and desired diversity aspects or boards o directors and review thecomposition o the Board in relation to diversity (Novo Nordisk)

Develop and oversee orientation materials or programs or new Board members (NIKE)

Oversee an annual sel-evaluation o the Board and each committee o the Board (NIKE)

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3.4 Promoting effective corporate governance practicesSeveral governments and organizations have been contributing to the creation o an imperative or companies andinvestors alike to take sustainability issues seriously and to implement more eective corporate governance processesin this regard. heir eorts have come mostly in the orm o regulations and reporting standards.

Some o the organizations that have been established to promote governance reorms and help mitigate agencyproblems, train individuals and disseminate knowledge are the ollowing:

ICGN: he International Corporate Governance Network (ICGN) is an investor-led organization o governance

proessionals with the mission to inspire and promote eective standards o corporate governance to advanceeicient markets and economies worldwide.

PRI: he United Nations-supported Principles or Responsible Investment (PRI) is an international network oinvestors working together to put the six Principles or Responsible Investment into practice.

GCGF: he Global Corporate Governance Forum (GCGF) is part o the International Finance Corporation(IFC) Corporate Governance group. he GCGF supports corporate governance reorms in emerging marketsand developing countries l ike the United Kingdom, have made signiicant progress towards regulations promotingeective corporate governance.38 he UK Corporate Governance Code sets out standards o good practice in relationto board leadership and eectiveness, remuneration, accountability and relations with shareholders.39 A requirementhas been added to the Listing Rules o the London Stock exchange, that companies iling or a premium listingshould report on a “comply or explain” basis, either conirming that they have complied with the recommendations,or (where they have not), providing an explanation why they have not done so.

A Premium Listing means the company is expected to meet the UKs highest standards o regulation and corporategovernance and as a consequence may enjoy a lower cost o capital through greater transparency and through buildinginvestor confidence. In 2010 the UK Stewardship Code was published, which aims to enhance the qual ity o engagementbetween asset mana gers and companies to help improve long-term risk-adjusted returns to shareholders.40

Disclosure and reporting standards can also be a driver or change. As an example, sustainability reporting can have

a signiicant eect on key country characteristics. Countries that mandate sustainability reporting through variouslaws and regulations enjoy an enhanced social responsibility o business leaders within society, with companiesattributing higher priority to both sustainable development and employee training.41 In countries that adoptmandatory sustainability reporting, the adoption o ethical practices by irms and eicient corporate governancebecomes signiicantly more widespread.42


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Some o the key organizations behind efforts to create rameworks and standards around reporting o ESG inormation are:

GRI: Te Global Reporting Initiative (GRI) is an organization promoting the use o sustainability reporting as a way ororganizations to become more sustainable and contribute to sustainable development.43 Teir vision is a sustainable globaleconomy where organizations manage their economic, environmental, social and governance perormance and impactsresponsibly and report transparently.

SASB: Te Sustainability Accounting Standards Board (SASB) is a non-profit organization that provides standards oruse by companies listed in the U.S.44 SASB seeks to develop sector-specific sustainability accounting standards suitable ordisclosure within the Securities Exchange Commissions Forms 10-K and 20-F (or other standard filings). Although SASBs work is mostl y US-centric, given that most large US companies operate and compete globally, and that ESG issues thatare material or a sector will largely be the same all over the world, SASBs standards are highly likely to be transerable and

applicable to most corporations around the world.

IIRC: Te International Integrated Reporting Council (IIRC) is non-profit organization that has created the “International Framework”, which it is testing with a Business Network Pilot Program. 45 Te IIRC is seeking to build a consensusaround the case or an integrated reporting ramework and also develop a consistent methodology. In this multi-stakeholderengagement process, corporations, investors, accountants, securities regulators, standard-setting organizations and the civilsociety have been involved.


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CURRENT STATE OF

GOVERNANCE

4.

4.1

Although the role o governance is undamental or implementing a sustainable strateg y, there are currently severalundamental weaknesses hindering the seamless integration o sustainability and business strategy. Some o thesecorporate governance weaknesses and their eect in corporations today will be discussed in this section. We illustratethe importance o those weaknesses by providing speciic examples.

BOARD OVERSIGHT OF SUSTAINABILITY

As previously d iscussed in section 3, there are several responsibilities that the various board committees can integrateinto their charters to ensure sustainability oversight.

So ar boards o companies in the sectors that have been traditional ly scrutinized or their negative externalities (e.g.,environmental impact and poor l abor practices) like the Energy, Basic Materials and Utilities Sectors are more li kelyto have committees that have been assigned corporate responsibility and sustainability oversight. 46 Other sectorsthat were so ar considered to ace e wer concerns o this kind like the echnology, Communications and Financialsectors are less likely to address environmental and social matters with a board committee ocused on the issue. Arecent report examined Cisco Systems as a case study. In its 2009 annual report Cisco mentioned that the board o

directors is involved in oversight o sustainability issues, but a ollowing review o their committee charters revealedthat the company had ailed to assign these responsibilities to any one o their committees.47

he integration o sustainability issues in the board committees charters is o paramount importance because itdemonstrates commitment to these issues and also deines accountability. Deining targets and perormancemeasures will ollow assigning accountability. Without these crucial steps taking place, there can be no signiicantprogress towards a sustainable strategy.

BOARD DI RECTORS: DO THEY HAVE THE EXPERTISE TO GOVERN A N ORGANIZATION?

he composition o skills and experiences o a companys board o d irectors must match the strategy o the company.As businesses expand globally, a diversiied board o directors with experience in international markets is o increasingimportance. Directors with a deep knowledge o oreign markets can provide the company with guidance on oreignexpansion and operations, increasing their chances o success. 48 In addition, a directors industry experience andskillset must be relevant to the company and complement those o the other board members.

Are current governance practices adequate?


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Te audit committee is a good example o how important particular skills are in carrying out the work involved. For

audit committees there are several requirements around t he directors expertise to ensure the appropriate qualificationsare in place. For example, the New York Stock Exchange has established this l isting requirement: Each member o theaudit committee must be financially literate, as such qualification is interpreted by the companys board in its business judgment, or must become financia lly literate within a reasonable period o time afer his or her appointment to theaudit committee. In addition, at least one member o the audit committee must have accounting or related financialmanagement expertise, as the companys board interprets such qualifi cation in its business jud gment.49

he same rationale should apply or the rest o the committees. hereore either in the case o a sustainabilitycommittee or in the case o integrating sustainability issues into an existing committees charter, the directors shouldhave the required skills and experience or be given the tools to develop it.

Directors that lack the necessar y experience or background can have negative eects on the eective unctioning othe board and the uture perormance o the company.

NVIDIA, an American global technology company, had revenues o $4 billion in 2012. 50 According to NVIDIAs 10-Kreport, «a majority o our revenue is generated rom customers located outside the United States, and a significant portiono our assets, including employees, are located outside the United States.»51 NVIDIA generated 78 percent, 83 percent, and84 percent o total revenue or years 2012, 2011, and 2010, respectively, rom sales to customers outside o the United Statesand other Americas.52 NVIDIA has a nine-person board, yet only one board member has international work experience,and none have an academic degree rom an institution that resides outside o North America.53

Amazon.com, Inc. is an American e-commerce company, with $61 billion in revenue in 2012.54 Amazon has a diversifiedboard o directors, with members coming rom the investment community, technology sector, law, and philanthropy. In2010, when Amazon was expanding its offering in the Ebook and tablet field, the company elected Jonathan Rubinstein,head o Hewlett-Packards Palm smartphone unit, to its board o directors. 55 And in 2012, Amazon elected Jamie S.

Gorelick, Deputy Attorney General during the Clinton Administration, to its board. Ms. Gorelicks experience includesrepresenting corporations in the regulatory and enorcement arenas.56 Each election represents a strategic move by Amazonto cultivate a board with the expertise necessary or Amazons strategy.

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Sirius XM Radio, an American broadcasting company, had revenues o $3.4 billion in 2012.65 Siriuss board is composed o13 members, and has seven meetings a year. Members sit on an average o 2.9 boards, with three directors sitting on morethan our boards.66 In 2011, one member ailed board attendance minimums (75percent).67

Hertz Global Holdings, Inc., is an American car rental company with locations in 145 countries. In 2012 the company had

revenues o $8.8 billion.68

Hertz has 12 board members, and 14 board meetings a year. Members sit on an average o 1.5boards, and no member sits on more than five boards.69 In 2011, no members ailed the attendance minimum (75percent).70

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BOARD OF DIRECTORS AND TIME SPENT GOVERNING

he amount o time spent by the board o directors with a company has been recently scrutinized because o thetrend observed o directors acquiring several directorships. he time spent by these so-called ‘busy directors hasbeen proven to be associated with weaker corporate governance and inerior inancial perormance. Directors areconsidered busy i they serve on three or more boards.57

Serving on a companys board o directors requires a serious time commitment, requiring both preparation andattendance at the board meetings. In addition, most directors join at least two board committees, which demandadditional preparation and meetings.58 racking the number o board meetings a year can provide an accurate gaugeo the amount o time directors spend on corporate matters.59 In 2010, 41percent o boards met between our andsix times, while 35percent met between seven and nine times. 60 he average number o meetings was 7.8.61 Another

measure to gauge director commitment and time spent is the total number o boards that directors sit on. hosedirectors sitting on a higher number o boards will necessarily have limited time or each company.

he number o directorships an individual hold s is also related to board meeting attendance. Directors with multipleboard seats exhibit a higher tendency to be absent rom board meetings. 62 he number o board meetings and therequency with which directors attend these, has been ound to be positively related with irm stock perormanceduring the latest inancial crisis.63 Board meetings and the attendance at these meetings are important channelsthrough which directors obtain irm-speciic inormation and ulill t heir monitoring role.64


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COMPENSATION - CEO REMUNERATION

CEO pay has increased dramatically in recent years, and a signiicant divergence rom the average employee hasbeen created. Median CEO-to-employee pay in the US has risen rom 42 in 1980 to 343 in 2010. 71 Ron Johnson,ormer CEO o J.C. Penney, got a compensation package worth 1,795 times the average w age and beneits o a USdepartment store employee when he was hired in 2011.72

According to an Economic Policy Institute study, CEO compensation grew more than 725 percent between 1978and 2011.73 he CEO-to-employee compensation ratio, which measures the ratio between CEO pay and that othe average employee, has also changed dramatically, going rom 18.3-to-1 in 1965, peaking at 411.3-to-1 in 2000,and decreasing to 209.4-to-1 in 2011. Large CEO salaries are deended on the grounds that they are necessary toattract and retain top talent in a globalized marketplace and that the amount is just compensation or an extremely

challenging job that includes motivating employees, crating a vision or t he company, and successully executing astrategy. Furthermore, CEOs are capable o earning huge amounts or their companys shareholders, such that theirsalaries pale in comparison.74

Arguments against high pay include the act that high pay packages distort a CEOs outlook and create perverseincentives. A high compensation package can reward decisions and behaviors t hat are not in the long-term interest othe company, to the detriment o employees, shareholders, and stakeholders.75 High executive compensation can alsonegatively aect employee motivation, productivity, and turnover. 76 A recent working paper has ound that “irmsthat pay their C EOs in the top 10 percent o excess pay earn negative abnormal returns over the next three years oapproximately 8percent.”77 he use o executive compensation consultants has been suggested to be contributing tospiraling CEO pays.78

Apart rom the absolute CEO pay, the pay disparity, the dierence between the CEO pay and that o other seniorexecutives has recently been at the centre o attention. Investors, rating agencies and regulators have begun to examinethe eect pay disparit y has in eicient corporate governance.79 Moodys would consider as a red lag or credit riska large pay disparity between the CEO and other senior executives, more speciically when CEO pay is more thantriple that o any other executive named in the proxy statement.80 hrough the Dodd-Frank law, listed companies arerequired to disclose the ratio o a CEOs pay to the median pay o all other employees o the company. Shareholderscan view a large pay disparity as a symptom o CEO entrenchment, implying more opportunistic behaviors duringhis tenure and higher succession risk when he leaves. Bebchuk et al. have ound that executive pay disparity isassociated with lower irm value and lower uture cash lows.81 Further research by Chen et al. has shown that there is

a signiicant and positive correlation between executive pay disparity and the cost o equity capital implied in stockprices and analysts earnings orecasts. he positive association is more pronounced the more likely the CEO is toleave in the near uture and the more diicult it is to ind a suitable successor.82 hese results highlight the importanceo succession planning.


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European executive pay levels tend to be lower than in the US. A recent paper examining CEO pay ound that US CEOs

made 26 percent more than their oreign counterparts or the year 2006, afer controlling or the size o the firm, its sales,and the type o board and ownership.83 However, CEO pay is rising similarly in Europe as the US, with Germany providinga representative example: “Average employee wages have increased by 6.1 percent since 2000, while the salaries o seniorexecutives at companies traded on Germanys DAX stock exchange index have risen by almost 55 percent during thattime period.”84 Tere has been regulatory pressure in both the US and Europe to cap CEO pay, with the US proposing thedisclosure o the CEO-to-worker pay ratio at public companies, and different European countries wanting to cap bonuses,allow shareholders to set executive compensation, limit golden parachutes, and more heavily tax severance packages.85

Examining the data in able 1 can provide an insight into the costs o excessive CEO pay. Te list o CEOs in table 1 istaken by a report o executives who were awarded the largest pay packages during the period 1992-2005. 86 Tese firms wereidentified in a Wall Street Journal article in 2006. For those firms we collected data o company stock price perormance

over six years (2008-2013) and compared it to the perormance o their main competitors or the same period. Te purposeo this exercise was to identiy any systematic competitive advantage given by employing members rom this list o highlypaid CEOs. In other words, what is the competitive advantage and financial health o firms that awarded the largest paypackages to their CEOs? I CEO compensation reflects also the extent to which board directors take into account how well the firm is positioned or long-term success then one would expect these firms to outperorm competitors in theuture. In contrast, i CEO compensation reflects potentially above normal current perormance at the expense o buildinga long-term sustainable competitive advantage then one would expect these firms to underperorm their competitors in theuture. Rather consistent with this second explanation, 12 out o 20 companies have underperormed their competitors.Interestingly out o the 8 companies in the list that did outperorm their competitors, three had CEOs who were eitherounders or co-ounders o the companies (Lawrence Ellison – Oracle, Irwin Jacobs – ualcomm, Dwight Schar – NVR).

Novartis AG is a multinational corporation based in Switzerland, specializing in the research, development, manuacture,and marketing o a range o healthcare products driven by pharmaceuticals.87 Te company had revenues o $56.7 billionin 2012. Novartiss CEO, Joe Jimenez, is the highest paid CEO in Switzerland, with total compensation o 13.2 million

Swiss rancs in 2012.88

In comparison, the average pay or CEOs o companies in Europes Stoxx 600 index which disclosedexecutive salaries was 2.7 million euros (3.3 million Swiss rancs). 89 Novartis recently sparked public outrage withinSwitzerland when it proposed a $78 million compensation package or outgoing Chairman Daniel Vasella.90 In March 2013,Swiss voters approved a reerendum that will require publicly listed companies to give their shareholders a binding annual vote on top executives pay, while also eliminating the practice o “golden handshakes” and “golden parachutes.”91

Swedbank is a Sweden-based bank offering retail banking, asset management, and financial services. In 2012, the bank hadrevenues o SEK 14.4 billion.92 Swedbanks CEO, Michael Wol, earned SEK 11.3 mil lion ($1.69 million) in 2012.93 Along with other top executives at the bank, he is not eligible or a bonus.94 Commenting on his compensation, Wol stated, “AndIm not underpaid - relative to many workers in Sweden, I am ver y well paid.”95

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COMPENSATION - STOCK OPTIONS

he short-term nature o some o the current incentive based compensation schemes has oten been associated wit h excessive risk t aking and shor t-ter m oppor tunism. Variable pay pack ages consisting o bonu ses bas ed on year lyinancial perormance create the wrong incentives, the results o w hich one can clearl y see within t he inancial sector. Whi le the idea o stoc k option- based compensation appears to be a good solution or al igning mana gerial andshareholder incentives, recent research has shown that some o its unintended consequences can be damaging toorganizations and markets.96

Stock options are increasingly part o a CEOs remuneration package and are quickly becoming universal. However,there are several caveats that make this alignment considerably less than perect. First, stock options allow a CEOsubstantial upside without much downside. When the stock price increases, the CEO gains, and when the stock

slides, the CEO doesnt lose money but rather makes less. his promotes a degree o risk taking, a s the payo can bequite large i the risk pays o.97 Second, stock options arent usuall y granted with any regard to the perormance oother companies.98 Most options will pay out even i companies perorm worse than their competitor irms. In a bullmarket, with the market liting all stock prices, everyone will beneit, even the industry la ggards.99

Dennis Michaud and Yunwei Gai investigated the relationship between CEO compensation and the effect on a firmsperormance.100 276 firms were selected (out o the S&P) or a 10-year period (1995-2004) or which firm perormance was measured by return on equit y, return on equit y average and economic value added. CEO compensat ion wasmeasured by six categories: CEO salary, restricted stock grants, options awarded, bonus, long term incentive pay-outs and total CEO compensation. Interestingly the authors ound that a firms perormance is not affected by CEOcompensation, nor by the incentive components o the compensation like bonuses and stock options.

Oracle, an American multinational computer technology company, had $37 billion in revenues in 2012. 101 LawrenceEllison, the CEO o Oracle, w as the highest paid CEO o any US publ ic company in 2012, with a total compensation o$96.2 million. Although his salar y was only $1, he received $90.7 million in stock options, representing about 94 percento his salary.102 He did not receive any restricted stock awards or incentive awards.103 In fiscal 2012, Oracles stock pri ceell by 22 percent.104

esoro, a Fortune 100 company, is a exas-based refiner o oil and petroleum products. Its revenues in 2012 were $33billion.105 Te company has begun to move away rom stock options as a orm o executive remuneration. Rob Patterson,managing director o compensation and benefits at esoro, commented, «It is not the ideal vehicle to use any longer.»106 Tey have attempted to incentivize employees with other means, including time-vested restricted stock and rewardingemployees with cash or hitting certain perormance targets.

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COMPENSATION - TIME HORIZON

Executives oten have minimal time horizons or compensation. A 2012 study o the 1,500 largest companies in theUS ound that l ess than 8 percent tied executive compensation to metrics with perormance periods longer than our year s.107 Recent studies rom inancial industry groups have recommended that variable compensation and bonusesbe deerred more than three years.108 Longer tenure and time horizons or compensation are necessar y so that CEOsdont sacriice short-term inancial gains or the l ong-term strategy and inancials o a company.109

A board that is engaged in a sustainable strategy ormulation is more likely to ocus more heavily on a CEOs strategyimplementation and long-term success, rather than short-term inancial results.

Voest alp ine AG is an Aus tria-ba sed compa ny t hat prod uces, processes, and dist ribu tes steel products . he companysupplies the automotive, household appliance, railway, and oil and gas industries. 110 In 2011/2012, their revenues were €12 bil lio n.111 Voestalpine AGs CEO, Wolgang Eder, received compensation o €2.3 million in 2012. Hiscompensation did not include any l ong-term incentive plans.112 he CEOs time horizon to meet ull compensation was onl y one year, and no mana gement or board members had remunerat ion lin ked to targets or objectives more

than two years orward looking.113

Eaton Corporation, a US-based power management company, had revenues o $16.3 billion in 2012.114 In addition tousing a our year perormance period when setting pay or executives, part o the incentive compensation is based on t hecash flow return generated by capital.115

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SUCCESSION PLANNING

One o the most important responsibilities o the board is a sustainable CEO succession plan. he process osuccession planning includes the selection, development, evaluation and compensation o the CEO. he highturnover rate o CEOs being recently observed and the increased shareholder pressure or new CEOs at somecompanies, make succession planning a key strategic subject in a boards agenda. A recent report carried out by PwCshowed that CEO succession was the second matter ater strategic planning that d irectors would like to d evote moretime, with 66 percent expressing a desire to spend more time discussing it.116

Succession planning and internal talent development have become a undamental component o risk managementor companies. Investors, rating agencies and government entities are starting to request more inormation aboutsuccession planning.

A lack o proper CEO succession planning shows underpreparedness and a weakness in corporate governance, andhas been scrutinized by investors. Recent examples are the retirement o Steve Ballmer as a CEO or Microsot andthe lack o replacement and the c ase o Bank o America , which had its board directors caught by surprise rom theannouncement o Ken Lewis leaving the irm.117, 118 It took the board al most three months to ind a successor, during whi ch t ime the companys sto ck el l 10 percent .

Occidental Petroleum is a Cal iornia-based oil and gas exploration and production company. Te company had revenueso $24.1 billion in 2012 operating primarily in USA, Middle East and Latin America. Concerns over Occidentalsgovernance practices triggered a joint letter rom Anne Sheehan, the director o corporate governance at the CaliorniaState eachers Retirement System (CaLSRS) and Ralph Whitworth, ounding member and principle at RelationalInvestors LLC, an activist investment und. In their letter, they criticized the companys compensation, successionplanning and board composition. Some observations along different board dimensions are given in table 2. Te non-executive directors o the board are listed together with some key characteristics around their background. Te summar yresults o the overall row are subjective based on our analysis. Te analysis reveals that directors have very long tenureand high median age. Teir industry expertise seems to be relevant or the business. Tere is a good match between thegeographic locations o the operations o the firm and the directors geographic expertise. Te board has low genderdiversity and seems to be relatively busy. Te size o the board has been ound to be relatively large with respect to themain competitors (15 directors or Occidental vs 11 or ExxonMobil, 13 or Chevron and 10 or Anadarko)

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TENURE AGEINDUSTRY

EXPERTISE

INDUSTRY

RELEVANCE

GEOGRAPHIC

EXPERTISE

GEOGRAPHIC

RELEVANCEBUSY GENDER

Abraham 7 57 Pol

UNEPFI_IntegratedGovernance

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