Corporate governance continues to be a priority for investors, but new challenges are emerging.
For many, 2021 was characterised by a focus on climate, with environmental issues dominating asset owner and manager engagement efforts. But high-quality corporate governance has a pivotal part to play in the realisation of investors’ environmental objectives, as well as securing sustainable returns.
After all, when it comes to assessing how an investee company is tackling environmental and social issues, corporate governance performance can serve as an “enhanced early warning system” for its approach to sustainability, says Vanda Rothacker, ESG Analyst at Union Investment.
From a long-term returns standpoint, corporates with effective governance structures are also “less susceptible to event, lawsuit and reputation risks and are thus more robust and successful in the long run”, Rothacker tells ESG Investor.
Behind the climate-dominated headlines, asset owners are keeping a close eye in governance. UK pension scheme Railpen, which has £37 billion in assets, published its 2022 voting policy last month, citing three corporate governance themes: board composition and effectiveness, remuneration and alignment of incentives, and shareholder rights, risk and disclosure. “Where we identify poor practice on the issues highlighted, a negative vote will be considered, [and] we may vote against the individual director we deem responsible,” Railpen warned.
Investors aren’t the only ones alive to poor corporate governance. A recent Organisation for Economic Cooperation and Development (OECD) report on the economic impacts of Covid-19 called on policymakers to adapt corporate governance frameworks to address weaknesses revealed by Covid-19 (such as audit quality), facilitate access to equity markets for “sound businesses”, improve the management of ESG risks, and ensure insolvency frameworks are fit for purpose and support recovery and resilience.
Investors’ 2022 governance priorities are consistent, with much of the focus remaining on executive remuneration and audit. However, new priorities are moving up the agenda, with experts citing responsible tax and cybersecurity as emerging themes this year.
Reining in executive pay
Executive remuneration is expected to remain a hot topic this year, partly due to the light the pandemic continues to shine on pay differences between executives and lower-level employees.
“The current issue with executive pay is the balance between a company’s desire to pay what it believes necessary to recruit, retain and motivate the best possible executive team and its need to ensure that pay reflects the wider stakeholder experience – in terms of investors, the workforce and society,” says Peter Swabey, Policy and Research Director for the Chartered Governance Institute (CGI), a qualifying and membership body for governance in the UK and Ireland.
Although AstraZeneca has been one of the pioneers creating vaccines for Covid-19, CEO Pascal Soriot has been subject to public disapproval following his lucrative pay incentives last year. With a base salary of £1.3 million, 2021 saw him eligible for share awards worth up to 900% of base pay. AstraZeneca narrowly won the pay vote during the 2021 AGM season, with just over 60% of investors supporting it.
Further, Morningstar research highlighted the average S&P 500 CEO is paid 291 times more than a median worker – earning an average of US$15.3 million a year. Average support for Say on Pay votes at S&P 500 companies was 88.4% in 2021, 1.2 percentage points lower than the year before. Large asset managers supported more than 90% of these votes, with two of the world’s largest asset managers, BlackRock and Vanguard, supporting more than 95% since 2013.
However, voting is inconsistent. A study by investment consultancy Willis Towers Watson recorded 56 failed Say on Pay votes during the 2020 US AGM season, with the highest number of failures occurring at smaller companies.
The US Securities and Exchange Commission has proposed new rules that will require asset managers to disclose how they voted on Say on Pay by no later than 31 August each year. Currently open for consultation, further developments are expected in 2022.
If the SEC proposal goes through, it will “create greater visibility into investment fiduciaries’ exercise of votes on this ballot measure and would likely spur broader investor interest in CEO and senior executive pay practices,” says Hortense Bioy, Director of Sustainable Research at Morningstar.
Asset owners and managers are also increasingly interested in companies that are linking executive pay to sustainability KPIs and the company’s overall environmental strategy.
“In 2022, as more investors make pledges to bring financed emissions down to net zero by 2050, we can expect more pressure put on corporate boards to link executive compensation to climate targets,” Bioy tells ESG Investor.
In November 2021, the Investment Association (IA), a UK trade body, urged FTSE 350-listed companies to ascertain executive remuneration is at least partially dependent on achieving ESG KPIs.
The IA’s annual pay guidelines for 2022 includes four minimum disclosure objectives: a stated policy linking aggregate remuneration to overall corporate performance, the company’s remuneration policy, a “relevant and fairly constructed” peer universe which doesn’t use median pay as a benchmark, and pay ratios spanning all levels of the company’s workforce.
Validating corporate information
Investors have always needed to trust corporate financial reports and today also demand credible environmental strategies. This is why third-party verification will be an important 2022 theme.
Poor quality audits have underpinned corporate scandal headlines in recent years, such as those featuring Carillion and Patisserie Valerie. Unsurprisingly, investor opinion on the effectiveness of audit has suffered.
Going into 2022, investors are increasingly concerned about the reputational and financial impact future auditing scandals may have. Audit should be just as important as other issues, such as executive pay, says Swabey.
“It seems to me that a clear and competent audit is perhaps a higher priority when considering the safety and potential return on an investment,” he says. “The central issue with corporate audits at present is a lack of trust in their effectiveness – a concern that their quality is lacking. Quality in the audit market is a demonstrable issue.”
The UK’s Financial Reporting Council (FRC) reviewed 103 audits from audit firms between 2020-2021, noting that 29% required improvement or significant improvement. Big Four accountancy firm KPMG came under fire for the third year running, as the FRC “found improvements were required to KPMG’s audits of banks and similar entities”.
The UK government is proposing a number of changes to strengthen the market and to restore trust in audit and corporate governance.
The FRC has published a blueprint detailing best practice for audit firms, which can be used by investors to assess corporate audit quality. It highlights six key attributes for audit firms to consider when auditing, including assessing firm quality risks, performance monitoring and remediation, and information and communications.
An even more notable change for the UK audit market is the launch of a new regulatory body – the Audit, Reporting and Governance Authority – to replace the FRC.
“Investors should ensure they are aware of these changes as and when they are enacted,” says Swabey.
Elsewhere, the Monitoring Group has begun its three-year implementation process of its strategy to improve international audit standards. It aims to achieve an independent and inclusive multi-stakeholder standard-setting system for audit, with support from the European Commission, Financial Stability Board and the Basel Committee on Banking Supervision. Further, Hong Kong’s Financial Reporting Council has issued new guidelines for effective audit committees, including examples of best practice in the selection, appointment and reappointment of auditors.
Investor demands for the standardisation of corporate governance-related information in 2022 will help improve overall audit quality, says Ashley Hamilton Claxton, Head of Responsible Investment at Royal London Asset Management (RLAM).
“By first ensuring more consistency in the data and disclosures provided by companies, there will be an inevitable increase in investor requests for corporates to have that information audited, therefore putting pressure [on audit firms] to improve the quality of those audits,” she explains.
Investors are also pushing for more credible and verified information on corporate climate strategies, Hamilton Claxton adds. Last year asset owners and managers representing US$2.5 trillion in AUM – such as the UK-based Brunel Pension Partnership and Environment Agency Pension Fund, as well as Danish pension fund provider PKA – wrote to COP26 President-Designate Alok Sharma to urge governments to introduce net zero accounting and auditing.
Time to tackle tax
While executive remuneration and audit are important themes, investors are beginning to consider a wider range of elements to form a clear picture of a company’s overall governance-related performance.
Tax is one of the most labyrinthine areas of corporate governance for investors to tackle, encompassing a number of complex and morally grey issues. With the OECD reporting that aggressive practices – such as domestic tax base erosion and profit shifting – currently cost governments between US$100-US$240 billion annually, responsible investors will be closely scrutinising corporate tax policies in 2022.
“Many companies would see it as part of their fiduciary duty to their investors to manage their affairs to pay the minimum amount of tax possible,” Swabey notes. However, this means companies can be “too aggressive” in their tax management, “particularly when it sees major organisations pay little or no tax in a jurisdiction where they are perceived to make a lot of income”, he says.
Asset owners such as PKA are engaging with investee companies on tax-related issues, calling for more transparency to ensure they have visibility of their own exposure to tax-related reputational or financial risks.
Big tech firms, in particular, are a source of concern for asset owners. In December, the Greater Manchester Pension Fund and the Oblate International Pastoral Investment Trust filed a shareholder proposal at Amazon. They called for the multinational tech company to disclose its global tax practices and risks to investors through the Global Reporting Initiative’s 2021 Tax Standard, which supports global public disclosures of company tax payments on a country-by-country basis.
A shifting regulatory landscape means that, more than ever, investors need to consider what a credible corporate tax policy should look like.
In Europe, multinational companies will be required to publish reports on their income tax by the mid-2020s, such as disclosing tax payments made by parents and/or subsidiaries in each EU country and in jurisdictions considered tax havens.
The OECD has developed a two-pillar global tax reform strategy to ensure a fairer distribution of profits and taxing rights, including the introduction of a global minimum tax rate of 15% by 2023. Almost 140 countries have announced their support of the strategy so far.
“Ultimately, tax laws are up to governments to decide,” RLAM’s Hamilton Claxton says. “But, going into 2022, it’s vital investors make sure they have maximum transparency so they can make informed decisions.”
Shoring online defences
The drastic increase in remote working over the past two years during the pandemic has thrown companies’ exposure to cyber risk into sharp relief for investors.
“Investors are beginning to ask whether companies have the necessary processes and systems in place to protect themselves from cyberattacks,” says Hamilton Claxton.
Research company Cybersecurity Ventures estimated that global cybercrime will cost US$10.5 trillion a year by 2025, up from around US$6 trillion in 2021. The World Economic Forum’s 2021 ‘Global Risks Report’ noted that cyberattacks are one of the biggest risks facing the world over the next decade, alongside climate change and more pandemics.
Colonial Pipeline, the largest fuel pipeline in the US, suffered a ransomware cyberattack in May last year. Due to a compromised password, hackers were able to gain access, causing fuel shortages across the East Coast. The same month, the Health Service Executive of the Republic of Ireland was targeted by a national ransomware cyberattack that shut down its IT systems, resulting in compromised patient records.
In RBC Global Asset Management’s fifth Responsible Investment Survey, cybersecurity was one of the top three themes for asset owners and managers into 2022, cited by 56% of respondents.
Guidance is increasingly available to asset owners. In 2020, the UN-convened Principles for Responsible Investment (PRI) published a series of questions for investors engaging with companies on privacy rights and cyber governance. The questions span legal responsibilities concerning end-user’s privacy rights, whether all data gathered is relevant for company purposes – i.e., not more than necessary – and company due diligence when identifying cyber risks along its supply chain.
An earlier PRI-led investor engagement initiative found that “a majority of targeted companies did not provide information on audits, evidence of cyber security training for all staff or details of relevant board expertise”. As a result, the PRI recommended that investors validate board oversight of cyber risks, ensure cyber resilience is incorporated in corporate strategy, and that they set disclosure expectations.
Issues with cybersecurity also bleed into firms’ data and information ethics. Even if a company is not subject to a cyberattack, investors should be aware of how it is ensuring employee and consumer data privacy, Hamilton Claxton notes. “The ethical challenges surrounding online data will become a more important theme in 2022 for RLAM and other investors,” she says.