Michael Schmidt: What can be done to bolster corporate governance to achieve European sustainability goals?

Members of HLEG share their thoughts on key topics under discussion

This article is one in a series of thought leadership pieces written for Responsible Investor by members of the European Commission’s High Level Expert Group on Sustainable Finance. To see other HLEG coverage, see here, or to comment, visit our discussion page.

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Good corporate governance is worldwide regarded as one of the factors essential for sustainable economic activity. Increasingly – and rightly so – the understanding of good corporate governance goes beyond the formal set of rules that determine best management practice in order to achieve financial targets. Supra-national institutions and environmental and human rights organisations have long emphasised the responsibility that companies have to society and the environment. Responsible corporate governance takes account of long-term economic goals just as much as the effects of a company’s activity on its employees and business partners, as well as the environment and society at large. This wider stakeholder approach of responsible management and leadership can be shown to improve value creation for companies and their shareholders. It comes as no surprise, therefore, that many investors have started to pay attention to responsible governance principles and actively engage with companies to drive respective improvements.
For the promotion of good responsible corporate governance, appropriate frameworks and incentives are important. Commitments by investors such as the PRI or industry-wide rules of conduct help, as do corporate guidelines on a national basis. Politicians increasingly expect trustees of assets such as asset managers to have an active influence. On a European scale, the Commission also aims at encouraging both the shareholder’s long-term involvement and its transparency (via the EU Shareholders‘ Rights Directive). HLEG has in its recent interim report clearly highlighted the interplay between investor engagement, good corporate governance of firms, and sustainability.

The EU should actively encourage professional accreditation bodies to incorporate sustainability

The starting point, logically, is the governance of financial institutions and investors themselves. It is the HLEG’s firm belief that it is key that those who lead institutions become fluent in sustainability risks and opportunities. Therefore, improving investor and lender governance is central to aligning financial markets with sustainability outcomes. Investors and lenders need to understand both the risks associated with unsustainable business practices, and the interests of their clients in taking account of sustainability considerations and adopting a long-term approach to investment. The HLEG takes the view that it is important to build the governance skills necessary to anticipate and address long-term sustainability value drivers. To do so, the EU should actively encourage professional accreditation bodies to incorporate sustainability, and embed it as part of the requirements for continuous learning for directors and other investment professionals.
Research suggests that beneficiaries are better off when they are involved in the decision-making process of institutional investors. According to an OECD working paper on insurance and private pensions from 2008 there is a positive link between pension schemes performance and their size, business model and governance arrangements, as well as their adoption of leading practices for responsible investment. A more recent study provided by ShareAction, the UK-based movement for responsible investment, shows that well-governed schemes exhibit the following characteristics: All beneficiaries are consulted on their ESG preferences and have a voice in the investment process; board or trustee members have suitable skills, knowledge and resources; and board decision-making is transparent and accountable. The findings also suggest that the funds that have moved furthest in their integration of sustainability considerations into their strategy have explicit sustainability expertise in their governing bodies.In consultant and intermediary-led markets, the governance arrangements of pension funds can be a barrier. Since the members of governing bodies are often not financial specialists, reliance is placed on specialist financial advisers and outsourced investment managers who may not take responsible investment considerations into account. These governance arrangements often limit the ability of pension funds to deal with long-term sustainability risks. On this note, the HLEG supports the recommendation that advisers to institutional investors should have a duty conferred on them to raise ESG issues pro-actively within the advice that they provide. This requirement would have to be established by the supervisory authorities, based on an extended definition of advisers’ duties. More broadly, responsible investment, active ownership and the promotion of sustainable business practices should be a routine part of all investment arrangements, rather than an optional add-on.

Advisers to institutional investors should have a duty conferred on them to raise ESG issues pro-actively within the advice that they provide

Such improved investor governance, based on a wider understanding of fiduciary responsibility should help accelerate the engagement of investors with their investee firms as a lever to achieve sustainable goals in the corporate sector and the economy as a whole.
Active responsible ownership is already being exercised by growing numbers of investors, but much more could be done. A more explicit reference to sustainability issues in corporate governance and stewardship codes, for example, would help to increase the positive influence of the investment community. This has been addressed in some corporate governance codes, including in France, Germany and the Netherlands, and should be encouraged further. In addition, the EU could support the adoption of stewardship codes that are designed to make shareholders more effective in holding firms to account.
The dynamic relationship between firms and their investors could also be enhanced through the development of European principles for both corporate governance and stewardship. As providers of capital to public and private firms, investors have both the right and responsibility to hold firms to account and to call for change where needed. In line with actions that some investors have already adopted to promote a long-term perspective in the boardroom, European corporate governance principles could enshrine recommendations such as:

• Explicit board responsibility for sustainability, including capacity to determine long-term materiality from a wider perspective in terms of both stakeholders and non-financial aspects.
• A board sustainability committee in certain industries or for firms above a certain size.
• Clear links between executive remuneration and key indicators of performance on sustainability measures.

In summary, the HLEG is utterly convinced that there is a strong link between good governance of both firms and financial institutions, and their performance, including on sustainability matters. Thus, the Group will further work on ideas of how to improve investor and corporate governance with a focus on questions around how long-term value creation and sustainability can be embedded in corporate governance and stewardship principles in Europe, and how sustainability can be incorporated in the objectives and incentive frameworks of board directors, investment institutions and their advisers.

Michael Schmidt is a member of Deka Investment’s Board and is responsible for alternative investments at the German-based firm. He previously headed up equities for Union Investment and Deutsche Asset Management.

To give feedback on the group’s interim report, published in July, see here.