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VIEWPOINT - The role of the board in creating a sustainable strategy

Thomson Reuters Foundation - Tue, 29 Nov 2011 14:39 GMT
Author: Robert G. Eccles, Ioannis Ioannou, and George Serafeim
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While conceptually elegant, the belief that a corporation’s role is to maximize value for shareholders is under increasing challenge as society’s expectations for companies change.  Growing concerns about environmental degradation and the depletion of natural resources, human rights and social inequality, and disasters at companies in the capital markets due to weak governance and poor risk management are focusing the attention of governments and civil society on the actions and impacts of the world’s global corporations.  At the same time, due to their economic clout and resources, society is looking to them to address problems that have historically been seen as the province of the public sector.  Thus corporate executives and their boards are both exhorted to “do less harm” and “do more good.”

An equally elegant new concept that takes account of these dual pressures has yet to emerge, but terms such as “corporate social responsibility,” “shared value” and “stakeholder theory, ” and “sustainability” are being heard more and more.  The central thrust of these ideas is that the company “can do well by doing good.”  If only it were that easy.  The high-level rhetorical gloss that good performance on environmental, social and governance (ESG) dimensions results in good financial performance and value creation for shareholders is too simplistic. Sometimes this is indeed the case, as when greater energy efficiency reduces both costs and CO2 emissions.  But often these decisions require tradeoffs, at least in the short term.  Should a company pay a “living wage,” and one that is higher than its competitors, instead of paying the minimum wage required by law? Of course, the argument can be made that paying a living wage will attract and retain higher quality human capital, resulting in more satisfied customers who buy more of the company’s products, thereby leading to higher revenues. But there is no guarantee that this will happen and, in most cases, these decisions involve great uncertainty due to the lack of information and an understanding of costs and benefits.

Nevertheless, it is now essential for companies to have a deliberate process for making the tough decisions that involve short and long-term tradeoffs involving shareholders and other stakeholders.  Those that can do so will establish a sustainable strategy, which we define as one that will enable them to create value for shareholders over the long-term by contributing to a sustainable society. This requires putting as much emphasis on gathering and reporting on nonfinancial (ESG) performance as on financial performance. It also involves engaging as actively with stakeholders as with shareholders to understand their expectations regarding the use of the financial, natural, and human resources the company controls. Companies must be clear about their decisions, how they reached them and what they expect the consequences to be for both financial and nonfinancial performance, whether the relationship between the two is positive or negative.

The board of directors has a critical role to play in this. It is the responsibility of the board—we would argue it is at the very essence of its fiduciary duty—to ensure that the information gathering and reporting and engagement processes are in place in order to make these decisions. The board should insist on management clearly articulating to it the business models regarding the relationship between financial and nonfinancial performance and how it weighs the interests of shareholders and other stakeholders and over what time frame. Central to this is a clear view of “materiality” regarding nonfinancial factors since no company can optimize on every performance dimension and, depending on the company’s industry and strategy, some are more important than others.

In a study comparing the performance of two matched sets of 90 firms, one being High Sustainability firms and the other being Low Sustainability firms, we found that corporate governance was a central differentiating characteristic.  In High Sustainability firms the board took formal responsibility for environmental and social issues. The CEO’s compensation was also more tied to these outcomes.  High Sustainability companies also measured and disclosed more information on nonfinancial performance, were more engaged with a wide variety of stakeholders, had a longer-term view and had a great proportion of long-term investors.  Very importantly, they also showed superior financial performance measured over an 18-year period and with less volatility. 

These positive outcomes for creating value for shareholders by taking into account the needs of other stakeholders and having the systems, processes, and incentives to make the tough tradeoff decisions that are necessary all start with good corporate governance. A sustainable strategy starts with a company’s board of directors. We encourage every board member to ask and honestly answer the question of whether the company on whose board they serve has a sustainable strategy. If the answer is “No,” the responsibility for ensuring that it has one is clear. It is the board and this is a commitment that needs to be made one board member at a time.

Ioannis Ioannou is Assistant Professor of Strategy and Entrepreneurship at London Business School. Georgios Serafeim and Robert G. Eccles are professors at Harvard Business School – Assistant Professor of Business Administration and Professor of Management Practice respectively.

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