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Article | Executive Pay Memo North America

The intersection of human capital, risk and ESG

Governance Advisory Services |Executive Compensation|

By Don Delves and John M. Bremen | March 25, 2021

The dynamic tension between performance and risk creates a new lens through which boards and management can view and act on their responsibilities.

Environmental, social and governance (ESG) concerns were not invented during the pandemic but, as companies grappled with massive health, social, climate and financial risks last year, they accelerated and expanded their focus on ESG-related issues.

Today, corporate boards and management teams around the world are considering ESG in the context of mitigating risk and creating value for all stakeholders.

ESG is mostly about risk

At its core, ESG is about today’s most pressing risks: climate risk, human capital risk and governance risk.

Climate risk is increasing for many companies — dramatically so for some. At the same time, the human crisis created by the pandemic accelerated human capital risks. And many investors believe that increasing governance risk can be mitigated or reduced by having more diverse boards with members who have varied viewpoints and world views.

So, if ESG is largely about risk, what are those risks and why have they become so important?

Managing new risks presents new challenges to boards and management

As these risks emerge and accelerate in importance and urgency, boards and management teams are contending with how to provide effective governance and prioritization of risks and opportunities including:

  • Which risks are highest priority to address?
  • Which initiatives to pursue?
  • Where to focus investments?
  • What to measure?
  • What to include in incentive compensation plans?
  • What to publicly disclose?

Let’s take climate risk as an example: Investors are increasingly concerned about it and want evidence that companies are taking it seriously. As a result, companies are working to measure, monitor, mitigate and transfer climate-change risk from their assets and supply chains.

Managing individual company risk is logical to stakeholders from a financial perspective, and it’s intuitive as part of the overall corporate value equation. But how do stakeholders view broader risks to the environment and society?

Increasing pressure from investors, regulators, consumers and employees is pushing companies to act on broader environmental risk and focus on outcomes (e.g., carbon footprint, overall environmental impact). Additionally, large institutional investors have made strong cases for companies to tackle these broader environmental issues.

Investors care about overall market risk levels

Even with increased pressure from multiple sources, acting on broader environmental issues doesn’t always appear logical to stakeholders. After all, these actions involve short-term costs that don’t directly mitigate company-specific risks or lead to more favorable financial outcomes. So, why are institutional investors interested in companies taking these actions?

In answering that question, it’s important to acknowledge a simple formula:

Driving performance + Managing risk = Value

The performance part of the corporate value equation is relatively easy to understand and quantify — growing profits in excess of the cost of capital creates value.

But risk is less easy to understand and quantify, and it’s not directly captured in accounting statements. Yet, stakeholders know that companies with higher risks typically have higher costs of capital: Lenders require higher interest rates on debt and shareholders expect a higher return on investment.

As such, most investors prefer to invest in companies a) where boards and senior management teams spend meaningful time and effort monitoring and managing business risk, financial risk, market risk and cyber risk; and b) that have a solid, independent board and well-established good governance practices.

More broadly, institutional investors are concerned about the impact of risk on markets and prioritize investment in companies that are taking action to address broader environmental issues. They tend to own significant shares in most publicly traded and many privately-owned companies. If all the companies in their portfolios collectively acted on the environment, overall market risk levels would fall (theoretically) — or at least be managed more effectively. This would benefit all parties by creating more economic value in a lower risk environment.

Managing and mitigating both company-specific and broader environmental risk requires significant involvement from management and employees, plus board oversight. Real, tangible environmental goals that are embraced by employees, included in incentive plans, reviewed by the board, and publicly disclosed are enablers for companies to pursue positive, consistent change.

Human capital risk drives the very dynamic ‘S’ in ESG

Companies also are under investor, regulatory and consumer pressure to manage human capital effectively and disclose material elements of their human capital value. Because a substantial portion of many companies’ intangible economic value is embodied in their people, this is logical to investors and provides relevant information for those trying to determine a company’s value. Boards also are spending more time on human capital governance and oversight, a significant component of which involves managing risk.

Investors know there are substantial potential risks associated with a company’s human capital. For example:

  • The ability to attract and retain the right talent.
  • High — or extremely low — turnover.
  • Low engagement and productivity.
  • Low levels of innovation.
  • Risk to customer relationships.
  • Compliance risks.
  • A non-diverse workforce or management team.
  • Not meeting stated diversity, equity and inclusion goals (i.e., gender and racial pay gaps).
  • A culture that is toxic, fosters or tolerates abusive behavior and/or overly focuses on making high-risk decisions.

Unlike many other risks, human capital also presents the opportunity for tremendous upside. People, teams and organizations theoretically have unlimited potential for growth, creativity and productivity. As such, human capital involves both sides of the value equation: risks to be managed and mitigated and performance and creativity to be developed and cultivated. People drive both risk and performance/value creation.

Navigating the road ahead

As we emerge into a changed world, the way that stakeholders — employees, shareholders, consumers — create and derive value is changing. The dynamic tension between performance and risk is more evident than ever and creates a new lens through which boards and management teams can view and act on their responsibilities. And that is necessary for the resilient, high-performing company of the future.

A version of this article appeared in Workspan Daily on March 18, 2021. All rights reserved, reprinted with permission.


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