We participated in the Council of Institutional Investors’ spring conference, Governance as the Linchpin: The “G” Is Key.
- Corporate governance sessions focused on the role, makeup and missions of a board of directors, with further discussion of human capital management practices as important to long-term value creation.
- Environmental, social and governance (ESG) considerations continue to be a hot-button issue for a wide range of participants, with growing politicization in the US further complicating the issue.
- The widescale deployment of artificial intelligence (AI) and its ability to transform business operations has inevitably raised questions around the social implications of its use, and how risks can be responsibly managed.
The Council of Institutional Investors’ (CII) spring conference is a large, predominantly US-centric event that features institutional investors, regulators, legislators and other corporate governance professionals. While the theme was corporate governance, the topics also included ESG (environmental, social and governance) issues, engagement, and other trends like macro and geopolitics. Attendees ranged from investment professionals to consultants and corporations. We discuss the key themes of the conference and how we at Newton consider them. While not all the discussions represented emerging or new topics, it is important for us to engage with the regional variances in viewpoints and the evolution of existing practices.
Board of Directors
Governance was at the center of this conference, and key to analyzing corporate governance is having a view on both the role and the composition of a board. One idea communicated at the conference is that a board’s role is not to set strategy for the company—that is done by management—but to question it. Strategic priorities are set for the long term and executives are recruited as aligned to the strategic direction for the company. During volatile times there may be a need for more tactical measures, and best practices suggest that the board should be actively involved in these discussions. The ability of directors to ask the right, but often difficult, question, is therefore an important skill which cannot be gleaned through disclosures alone.
Forming a view on whether the board can question management is where the composition of the board comes into play. We expect boards to have the requisite skills and experience to understand a company’s potential challenges and how to best navigate them. Directors at the conference stressed that boards do not need experts in every area relevant to the company. For example, not all boards need a climate expert! Board seats are valuable and there is always an opportunity cost when appointing relevant skills and experiences. If necessary, a board may want training sessions for directors or to use external experts on issues like climate or cybersecurity instead.
The War for Talent
Human capital management was a recurring theme from directors, corporations and investors. The idea of putting workers on the board of directors came up several times. There was no clear consensus, and there are regional variances, but the most consistent view in this audience seemed to be that worker voice at the board was essential. This does not mean adding workers or human resources professionals directly to the board. Instead, it could mean appointing a workforce non-executive director representative, or directors spending time on the ‘front line’ or with direct reports to the CEO without the presence of the CEO. Another way of involving employees in a company’s corporate governance, which is popular in certain European countries such as France, is employee shareholding and making all-employee stock grants, which allows the formation of employee stock ownership and involves human capital in the company’s profit allocation. We firmly believe boards should consider employee perspectives but should be able to determine the most appropriate way to achieve this within their individual circumstances and in line with local corporate law.
The theory is that employees tend to be viewed as an expense and not an asset. However, in a world where most company value comes through intangibles, human capital is an important component to understand. Moreover, labor can be an appreciative asset (more experienced employees can add more value) and best practices should be accretive to returns.
We believe human capital management can be important for investors to consider, and there is some empirical evidence to support this (e.g., Alex Edmans’ research on the best companies to work for). However, it is important to consider which practices are financially beneficial—not all spending on human capital is better and doing what is right for the employee may not always be in a company’s financial interest. However, this is an important and typically underappreciated lens through which to consider a company.
Furthermore, while it is easy to calculate the cost of increasing wages it is difficult to evaluate the cost of bad human-capital practices. These typically come through:
- Direct turnover – does a company calculate the cost of turnover?
- Revenues – poor customer satisfaction has an impact on sales, particularly in the hospitality or service sectors, but even in the likes of food retail.
- Efficiency metrics – e.g., fewer safety issues, lower cost of goods sold, less time spent on certain tasks.
The State of ESG in the States
Conference participants with diverse views on ESG topics also discussed the pros and cons for long-term shareholders of integrating environmental and social considerations into investment decisions.
Fiduciary duty as it relates to ESG continues to evolve; a key discussion point focused on its interpretation and application. Without a consensus definition there will be different interpretations that can, among other problems, lead to myriad legal challenges. Fortunately, while the conference included a wide range of viewpoints from speakers and attendees, most of the discussions were more granular and nuanced. Listening to different points of view is important to all participants, and particularly to Newton. As ESG investing has become increasingly politicized in the US, this was a valuable forum to understand some of concerns and how we can engage with ESG-related challenges and critiques.
Where Does ESG Belong?
The theory for integrating ESG considerations into an investment process is that valuing a corporation can be impacted by considerations not contained within financial statements, including intangibles, whereas traditional accounting focuses on tangible assets. Investors increasingly want insights into intangible assets. This can be seen as simply considering a broader set of metrics to further assist in understanding risks and opportunities that may be material to a company but do not show up in the “bottom line.” These tend to be industry-specific and should focus on what is material. For example, it makes sense to consider the health and safety practices at a mining company, how management is incentivized, or if a product is at risk of regulation.
Language is a barrier to many constructive conversations on ESG matters. Commonly understood, ESG integration is about prudent risk management, but the conversation has in places become detached from risk/return expectations and seeking better information. Central to this has been the confusion around ESG as a process versus a product, with the rise of ESG-labelled funds further clouding the issue. This is similar to our experience of seeing the conflation and confusion between ESG integration and sustainable investments—with ESG integration a way of incorporating material issues into an investment thesis, and sustainable investments a differentiated product suite with dual objectives. We firmly believe that ESG integration is a process, and one that can provide us with a more complete view of a company and thus greater insight into its opportunities and risks.
These and other factors have contributed to the politicization of ESG issues in the US. One example is that the Securities and Exchange Commission’s climate disclosure proposal received 15,000 comments, more than any other proposal in its history. The debate is not likely to go away soon, but we feel it is important to be clear about what we mean by ESG, and how we incorporate these considerations as just one input into our investment process.
The Ethics of AI
Cybersecurity, digital rights and the ethics of AI were common themes throughout the conference, as they have been in internal discussions at Newton, following the release of OpenAI’s ChatGPT chatbot.
Experts offered a number of reasons why investors should care about ethical questions and AI. The first is that trust and purpose are increasingly important for attracting and retaining talent. Tangentially, this is increasingly a theme we see in ESG as a driver of sustainability initiatives, with employees citing the desire to work for an organization that aligns with their values or pushing companies to act on issues important to them. It is also important for widening consumer uptake—more inclusive technology may appeal to more people. Finally, regulation of technology and AI is likely to increase.
Key principles of responsibly developing AI can include:
- ‘Explainability’ – use lay terms to explain how it arrives at the predictions it makes.
- Fairness – equitable treatment of individuals or groups within context of use. Effectively this means mitigating biases across the life cycle.
- Robustness – AI should be resilient to attacks and developed in a secure environment.
- Transparency – How is it developed and trained? What are the intended uses?
- Privacy – should safeguard all data including training data and system use to protect personal data.
Our view is that AI needs to consider its social impacts if we are to avoid unintended consequences and potentially stringent regulation in years to come. However, AI is already present in many aspects of our lives and homes, so we need to engage with and learn from its current biases and impacts.
As much as we must focus on responsible and ethical AI, it is beyond dispute that it will also have positive impacts. We recently discussed the disruptive potential of AI in a blog post.
The CII conference provided a forum for healthy debate among different market participants with varied perspectives. We heard from lawyers, regulators, companies and non-governmental organizations, some of whom are very pro ESG integration, some with specific areas of interest, and others who were adamant in their disagreement. We were exposed to evolving views on governance: how companies are adapting their practices, controls, and procedures to make effective decisions, comply with the law, anticipate regulation, and meet the needs of external stakeholders. These, alongside ESG considerations more broadly, are of course not new considerations for investors, but provide Newton with opportunities to offer our perspectives as well as well as understand a spectrum of views across the US market. Intangible issues, not always apparent in financial statements, such as the ability to engage with the workforce constructively or ensure consumer and regulatory trust in new technological developments, are becoming increasingly frequent and complex for companies to manage. This is alongside a fast evolving macroeconomic and geopolitical environment. Therefore, the role of the board, in challenging management, and being appropriately constructed to do so effectively, continues to be crucial for investors to understand within investment processes.
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