The New Business Operating Context of the 2020s

Abstract

This chapter traces how technological, environmental, geopolitical and socio-economic shifts are changing the nature of value creation, risk and societal expectations of firms. These important changes in the operating context of business are aligning the interests of shareholders and other stakeholders more closely by increasing the financial materiality of environmental, social, governance and data  stewardship (ESG&D) risks and opportunities. The chapter traces the evolution of corporate governance and corporate responsibility since the 1970s and argues that the growing materiality of ESG&D considerations is driving their integration. Such integrated corporate governance, strategy and reporting departs from the mindset and associated practices of shareholder primacy and corporate social responsibility, which regard ESG&D factors as primarily non- or pre-financial matters. Instead, it takes a holistic view of shareholder and wider stakeholder interests by systematically internalizing ESG&D considerations in the firm’s strategy, resource allocation, risk management, performance evaluation and disclosure policies and processes. It does so not for ethical or political reasons, although these are factors that must also be fully considered by firms, but out of a recognition that in the twenty-first century, strong and sustained business value creation beyond the near term is increasingly dependent upon a rigorous understanding and active management of these considerations as part of the core governance and strategy of the firm.

In the twenty-first century, the business community is facing fundamentally new and more complex risks and opportunities. In this chapter, we first outline some of the most substantial shifts under way, most of which have been accelerated or exacerbated by the humanitarian and economic costs of the COVID-19 pandemic. We then outline the associated growing materiality of environmental, social, governance and data stewardship (ESG&D) issues and recent changes in corporate governance and corporate responsibility in response to these changes. We conclude by making the case for a more integrated approach to governing and managing businesses.¹

We argue that in today’s context, only by systematically integrating ESG&D considerations into core governance, management and disclosure practices can firms effectively implement the principles of stakeholder capitalism and consistently deliver sustainable enterprise value for shareholders and other stakeholders alike. Such integrated corporate governance, management and disclosure are the practical essence of stakeholder capitalism, the walk that accompanies the talk. In addition, corporate partnerships to drive system-level change are often necessary to overcome some of the systemic weaknesses or risks in their enabling environments that individual companies are unable to address effectively on their own.

1 Systemic Shifts and Shocks

Over the past two decades, the technological, environmental, geopolitical and socio-economic context in which major companies operate has changed fundamentally. This fourfold transformation is giving birth to a new phase of industrial development and global economic integration that have been described as the Fourth Industrial Revolution² and Globalization 4.0,³ respectively. It is also contributing to more severe and systemic shocks and crises. The trajectory of these major transformations will depend in large measure on how well governance at multiple levels—corporate, governmental and international—adapts. For companies, they are changing the nature of value creation, risk and societal expectations in ways that challenge the traditional conception of both corporate governance and corporate responsibility.

1.1 Technological

Economic activity has become much more knowledge intensive and geographically integrated as the digital economy and globalization have taken hold over the past two decades. It will become even more so as the next phase of automation, connectivity and market integration unfolds over the next 20 years. The massive scale and exponential speed of technological change and the growing convergence between digital, physical and biological technologies are creating fundamentally new risks and opportunities for companies in every industry sector. These secular forces are transforming corporate value creation and competitive advantage, making them increasingly dependent upon intangible capital formation, particularly innovation, talent development and branding. These usually require investment over a sustained period, a considerably longer time span than that required for two value creation strategies that have been in vogue for the past generation: aggressive cost-cutting including through outsourcing and offshoring; and overuse of leverage, share buybacks and financial engineering.

In today’s economy, for many industries the time to market and agility in response to changes in customer requirements are increasingly important sources of competitive advantage. Combined with threats to supply chain resilience caused by the pandemic, these have begun to induce a reshoring and reintegration of production as automation reduces the share of labour in the total cost of production. In particular, the ongoing digitalization of economic activity is reshaping industries and in some cases blurring the lines between them, creating new risks alongside enormous opportunities for value creation and intense competitive pressures on companies to make the investments in technology and people needed to stay ahead of such disruption. Mobile connectivity and cloud computing, machine learning and big data, ubiquitous sensors and the internet of things, robots and virtual reality, and additive manufacturing and nanotechnology are disrupting business models in virtually every industry and service sector.

This disruptive change has a long way to run. The World Economic Forum’s Digital Transformation of Industry initiative estimated that it has the potential to generate upwards of $100 trillion of value for industry and society over a decade’s time.⁴ The biotechnology revolution—particularly recent advances in the sequencing and manipulation of genes—is likely to create an additional large wave of disruptive value creation across multiple industries over the coming decade or two. A third disruption—an energy revolution—may not be far behind; the vertiginous decline in the cost of renewable energies and solar energy in recent years could be a harbinger.⁵

Advances in these three technology domains—digital, biotechnology and energy—are accelerating and intertwining. They are likely to reinforce each other over the next decade or two in ways that transform business models in nearly every industry. These shifts remain at an early stage, but clearly the COVID-19 pandemic has accelerated the first of these tectonic forces—digital—and may prove to have a similar impact on the second, biosciences. Its stimulative effect on the digital economy has taken the form of big increases in remote working, digital conferencing, e-commerce, e-learning, the digital consumption of entertainment, e-medicine, automated package delivery and logistics and more. Many of these changes in production and consumption appear likely to endure well beyond the public health crisis, with a profound and lasting impact on supply chains and distribution channels.

Thus, innovating to anticipate and adapt to technological change is likely to be the central value creation imperative of this new era for nearly every industry. After a generation of outsourcing and offshoring and a decade of extraordinarily low interest rates, most companies have passed the point of diminishing returns from creating value primarily through cost efficiencies and leverage. These strategies are not likely to be major sources of sustained enterprise value creation in the years to come. Instead, investment in the hardware and software of innovation, including particularly the skills, creativity and motivation of the people who drive and apply it, is poised to be the most important driver of competitive advantage. The sine qua non of business leadership in the 2020s will therefore be the ability to rally the firm around a strategy to increase investment, particularly in intangibles such as innovation, workforce development and empowerment, and customer personalization and brand loyalty.

1.2 Environmental

In the years since the UN Paris Agreement on climate change was agreed in 2015, there has been a major shift in social attitudes, energy markets, regulatory agendas and consumer and investor preferences with respect to the need to take urgent action on addressing climate change. These trends are accelerating, galvanized by a dramatic increase in climate-related, extreme weather events in many countries over the past five years and by evermore compelling scientific and economic evidence of the costs of inaction. The IPCC’s 2021 report provides the starkest warning to date that climate change is widespread, rapid and intensifying.⁶ These trends require companies to think more deliberately and strategically about the risks and opportunities that climate change and an energy transition towards net-zero carbon emissions by 2050 pose to their current operations and future strategies from the perspective of both mitigation and adaptation. Indeed, both regulators and investors are rapidly moving to require firms to integrate climate change considerations into corporate governance, strategy, risk management and disclosure, in recognition that related physical and transitional risks can have major implications for corporate performance, even the viability of some companies and industries.

The Network for Greening the Financial System (NGFS), for example, is a network of central banks and financial supervisors that aims to accelerate the scaling up of green finance and develop recommendations for central banks’ role in addressing climate change. Established in December 2017, NGFS had 95 members as of June 2021, including the world’s largest central banks. Among other actions, it has encouraged “all companies issuing public debt or equity as well as financial sector institutions to disclose in line with the Task Force on Climate-related Financial Disclosures (TCFD) recommendations.” As of late 2020, support for the TCFD had grown more than 85% over a period of 15 months, reaching more than 1500 organizations globally, including over 1340 companies with a market capitalization of $12.6 trillion and financial institutions responsible for assets of $150 trillion.⁷ In addition to voluntary initiatives and commitments, the European Union and the US Securities and Exchange Commission (SEC), among other regulators, are starting to establish requirements for mandatory disclosure by corporations and financial institutions on their climate strategies and metrics.

As a result of these regulatory, investor and business leadership initiatives, a new corporate best practice has emerged. It is a public commitment by companies and institutional investors to achieve a net-zero “science-based” emissions target by 2050 and to begin implementing within the next few years specific strategies and pathways consistent with this goal. As of mid-2021, over 1700 companies worldwide had committed to set emissions reduction targets grounded in climate science through the Science Based Targets initiative (SBTi).⁸ Some 715 of these firms have adopted the high ambition 1.5 °C target set by the Paris Agreement.

As for investors, the United Nations-sponsored Net-Zero Asset Owner Alliance and the Net-Zero Asset Managers Initiative have convened institutional investors representing US $6.6 trillion and US $43 trillion in assets under management respectively to commit collectively to transition their investment portfolios to net-zero GHG emissions by 2050 in line with the 1.5 °C target set by the Paris agreement.⁹ Political jurisdictions, both national and regional, are also setting net-zero targets, including such major actors as the European Union,¹⁰ China,¹¹ the US,¹² Japan and South Korea. These shifts in policy and regulation are bound to intensify the pressure on the corporate sector to move more rapidly in the direction set by these first-mover business and investor coalitions.

In summary, the legal and political ground is rapidly shifting under companies with respect to environmental stewardship. While climate change has been the “game changer” in terms of putting environmental issues more firmly on the boardroom and executive agenda, other environmental issues are also rising in terms of their materiality and importance. They include the related and escalating challenges of water insecurity, biodiversity loss and a growing public backlash against pollution, ranging from a severe deterioration in air quality in certain cities to plastics in the ocean.

1.3 Geopolitical

The growing multipolarity of international relations and return of overt great power rivalry are contributing to the ongoing plurilateralization of the world economy—the fragmentation of international trade and investment driven until recently by regional trade agreements but increasingly shaped by geopolitical frictions. Uncertainty and complexity are on the rise, requiring multinational firms to take a more deliberate approach to assess such risks, including the threat of finding themselves caught in the middle of trade, investment and migration disputes or technological competition between major countries and trading blocs. Some countries are instituting new barriers to cross-border flows of investment, natural resources, people and data, reflecting a decline in trust among nations and the tendency of international rule-making to lag changes in the world economy.

Industrial policies of various sorts are on the rise around the world related to the increased economic and national security stakes countries perceive in the “winner-take-all” scaling effects of new digital technologies and business models. Investment screening, procurement requirements and export restrictions are on the rise, as is competition among regional preferential trading arrangements, all of which contributes to rising complexity and political sensitivity in running global supply chain and sales operations. The deterioration in Great Power relations and logjam within the WTO’s negotiating and adjudicatory functions are a clear sign that geopolitical factors are likely to remain a topic requiring strategic and operational agility by companies.

1.4 Socio-economic

As automation and globalization have increased economies of scale and industrial restructuring, income inequality and worker insecurity have risen in many countries. These trends have combined with longstanding racial and ethnic inequalities, the disproportionate impact on low-income households of the global financial crisis and COVID-19 pandemic, and rising tensions over migration to fuel a popular perception in many countries that their economies are not sufficiently benefiting the citizenry at large. These frustrations and the protests, civil unrest and political polarization to which they have contributed are a warning sign that the social consensus underpinning open, pro-growth economic policies and capitalism itself has eroded considerably, as has trust in corporations, which tend to be the agent and public face of economic disruption.

As governments struggle to respond to these socio-economic and political challenges, companies are faced with rising expectations regarding their role in contributing to the general welfare of their workers and communities. There are growing expectations that this role needs to include but go beyond respecting workers’ rights in the company’s own operations and supply chain and supporting host communities through contributions to charities and schools. Companies are increasingly being called upon to commit themselves and press governments to respect human rights, protect civil rights and address social injustice and structural inequity more generally.

In addition, while digital technologies offer many benefits to society, they also pose new challenges to human rights and to the social contract, from the use of mass surveillance technologies and large-scale collection and sale of other personal data to the growing need to tackle misinformation, disinformation and hate speech. As such, companies that produce or use these technologies are under growing pressure to demonstrate that they understand and are mitigating the corresponding risks to their workers, customers and the public at large, including those that might lead them to become complicit in human rights abuses or violations of local social norms.

In a climate of increased social fragility and diminished trust, a lapse by an individual company, such as an incident relating to customer data privacy, corruption, labour rights or environmental pollution, is more likely to escalate into a crisis, potentially to the point of threatening a firm’s very existence. This is particularly the case if a company already suffers from a deficit of trust because of a perceived track record of insensitivity to or degradation of the social context in which it operates.

1.5 Systemic Shocks and Crises

Systemic shocks and crises that cause substantial losses and disruption for millions of people are clearly not new. The enormous humanitarian and economic toll of two World Wars and the Great Depression are obvious examples. Yet, resulting from the transformational shifts outlined in this section, the frequency, speed and in some cases the scale of natural, humanitarian and economic or financial crises and system-level shocks have increased over recent decades. In most cases a natural or humanitarian crisis leads to substantial financial and job losses and these in turn further aggravate human suffering. Consider the following:

• Epidemics and pandemics: A prescient 2019 report by the World Economic Forum noted, “On the 100th anniversary of the 1918 influenza pandemic, it is tempting to believe the world has seen the worst epidemics. However, with increasing trade, travel, population density, human displacement, migrations and deforestation, as well as climate change, a new era of the risk of epidemics has begun. The number and diversity of epidemic events has been increasing over the past 30 years, a trend that is only expected to intensify. … Outbreaks and epidemics are also causing more economic damage when they occur.”¹³ Thus, we cannot assume the COVID-19 pandemic is a once-in-a-lifetime, black swan event.

• Natural disasters: Countries around the globe are experiencing unprecedented droughts, heatwaves, wildfires, floods, hurricanes and other climate-related extreme weather events. The associated humanitarian crises, economic costs and enterprise risks are continuing to grow, in size and severity. Research by both scientists and practitioners highlights increasing concerns. According to Aon’s 2019 annual Weather, Climate and Catastrophe Insight Report, “The decadal period from 2010–2019 marked the costliest in the modern record for global natural disasters on a nominal and inflation-adjusted basis. Total direct economic damage and losses tallied USD 2.98 trillion. This was USD 1.1 trillion higher than the previous decade. … It is impossible to know precisely what the next decade will bring. If loss trends are a guide, however, then it is expected that there will continue to be larger and costlier events on a global scale.”¹⁴

While the world’s attention is rightly focused on addressing the COVID-19 pandemic, the potential widespread humanitarian, economic and environmental costs of climate change and climate-related shocks cannot be underestimated and need to be mitigated and adapted for immediately, not left to some future date. As Aon conclude in their 2020 Weather, Climate and Catastrophe Insight Report:

Perhaps the biggest takeaway from 2020 was the recognition of how concurrent events can have major global implications. These ‘compounded’ or ‘connected extremes’ will provide critical learning opportunities for better planning as the world becomes increasingly complex and faces growing or emerging risks. 2020 also highlighted topics such as the protection gap to address the underserved, increasingly vulnerable populations, the need for additional investment around risk mitigation strategies to navigate new forms of volatility, and the growing influence from climate change on daily life.¹⁵

2 The Growing Materiality of ESG&D Risks and Opportunities

The trends outlined above are increasing the materiality of ESG&D issues for corporations in almost every industry sector. While the specifics differ depending on industry and circumstances, ESG&D risks and opportunities are having a growing impact on the financial condition or operating performance of companies through their effect on the ability of firms to create and sustain new economic value, manage risks and preserve existing value, and meet societal expectations and evolving social norms and values that relate to the firm’s social licence to operate. This shift in the relative weight of so-called non-financial factors in the creation and maintenance of enterprise value is increasingly requiring boards to think beyond the traditional segmented logic of shareholder primacy and corporate responsibility.

2.1 Creating and Sustaining Value

Healthy profits remain the sine qua non of corporate performance. But in this new context issues that were previously considered secondary or even ancillary matters for CEOs and boards—the province of the firm’s stakeholder relations, philanthropy and information technology departments—have become more important determinants of a firm’s capacity to create and sustain economic value. They therefore merit full integration into the core oversight, strategy formulation, risk management, performance evaluation and public reporting duties of boards and executive teams.

Climate change, water, biodiversity and other aspects of environmental stewardship, for example, are increasingly material economic factors in a world in which related technology, regulation and physical impacts are changing within the space of years and sometimes months. The same is true for the management of the key source of competitive advantage in the Fourth Industrial Revolution: intangible assets and particularly people. The continuous cultivation of the talent, motivation and diversity of a firm’s workforce and of its intellectual property, including new technologies, process innovations and data, are central to value creation in this new era.

Considerations related to people, planet and innovation, including the protection and value-added application of company data, must therefore figure more prominently in capital allocation and other core management decisions going forward. The increased significance of these value creation factors implies a growing need to better understand the trade-offs between investment in new capacity and capabilities and rationalization of existing operations and assets. Doing a better job of investing for future growth while delivering current operational efficiency and excellence implies a lengthening of investment time horizons beyond the depreciation schedules of capital equipment and typical return-on-investment timelines of cost-cutting, restructuring and outsourcing strategies. These will clearly remain important elements in the ability of companies to create value, but for company success to be sustained over time and shared with key stakeholders, boards and executive teams will need to pay careful attention to the full range of shifts outlined in the previous section to ensure that capital is properly allocated to longer-term investments in new products, skills, markets and productive capacity.

2.2 Managing Risks and Preserving Value

Effective stewardship of the firm’s environmental, social, governance and digital footprint is also increasingly important for value preservation. It therefore must figure more prominently in enterprise and operational risk management as well.

An important part of the risk these factors pose is reputational. As such, they are just as crucial to the maintenance of trust as traditional governance issues such as ethics, transparency and board independence. The reputational damage resulting from a customer data breach, environmental disaster, corruption scandal or human rights abuse can be substantial and enduring. In many cases, however, reputational damage is only part of the cost a company will incur. Failure to manage ESG&D risks effectively can result in a combination of safety risks, other physical and supply chain risks, litigation and regulatory risks, and risks to employee morale and the ability to attract and retain the best talent. In addition, failure to anticipate changes in technology or environmental regulation can result in serious transition risk for companies in certain industries, potentially to the point of threatening their long-term viability if they are not able to adapt with new products, services and business models.

Thus, the growing materiality of ESG&D factors for both value creation and preservation creates an imperative for them to be integrated fully into the theory and practice of corporate governance, strategy, capital allocation, risk management, reporting and performance evaluation and remuneration. In the new environmental, social, geopolitical and technological context of the 2020s, these factors are not only ethical or constituent relations matters. They are fundamental to the exercise of fiduciary duty in the disposition of corporate resources.

2.3 Addressing Changing Societal Expectations, Norms and Values

Finally, the growing materiality of ESG&D issues is also a manifestation of important changes in the social license to operate of firms in the 21st century. Societal expectations of corporations are shifting, as popular concern about automation, trade, climate change, inequality, immigration, corporate ownership of personal data, corruption and other issues rises. These broader trends, compounded by the legacy of the global financial crisis, have produced a deficit of trust in corporations in many countries,¹⁶ as well as growing debate about whether they contribute sufficiently to the ultimate purpose of economies, which is to produce the broad-based gains in living standards that come from inclusive economic growth.¹⁷

These social pressures are likely to mount further as technology continues to increase economies of scale, disrupt industries and, other things being equal, shift the distribution of national income in the direction of owners of capital and away from labour. The OECD reports that there has been a significant such shift in the past two decades within advanced economies, although with considerable variation between countries, industries and skill cohorts of workers.¹⁸ This distributional shift and hollowing out of the middle class in many countries has been driven by not only technological change but also public policy and corporate strategy choices, and it is contributing to the drop in public support for open markets and to the polarization of politics more generally in some countries.

Thus, there is a larger social and political economy rationale for boards of directors and executive management teams to ensure that their firms are creating sustainable value and not just maximizing short-term profit through cost efficiencies and rent extraction and that they are properly addressing new risks that have grown out of the changed technological, environmental, geopolitical and social context of their operations. Business leaders must recognize that the long-term viability of their companies as engines of value creation is in no small part a function of the viability of the societies and economies in which they operate. In other words, companies are stakeholders themselves in the health of their social, policy and economic enabling environment. They have an intrinsic, material stake in both the social cohesion of the jurisdictions in which they have significant operations and the capacity of public institutions therein to deliver basic public services and ensure the fair and efficient functioning of markets.

In summary, ESG&D risks and opportunities are becoming more material to the ability of companies across industry sectors to create and sustain value, manage risks and preserve value, and address changing societal expectations, norms and values. Failure to understand and manage these factors effectively is likely to result at best in lost business opportunities and at worst serious deterioration in financial and operational performance as well as reputational standing and relationships with key stakeholders from investors and regulators to employees and customers. In extreme cases, it could threaten the firm’s viability as a going concern.

2.4 The Material Consequences of Getting It Wrong or Failing to Act

Some companies and industry sectors are already learning the hard way that failure to treat their material ESG&D issues as important corporate governance and strategy considerations can result in the rapid deterioration of investor, employee and societal trust, heightened financial and operational risks, and impairment of value.

Consider the escalating business risks and costs associated with climate change, for example. Companies are facing substantial physical, operational, financial and transitional risks resulting from the impact of extreme weather events or failures to adequately address the impact of climate change on their business. These include significant short-term costs as well as risks to long-term profitability and even viability for some companies, especially but not only those in the utilities, insurance and financial services, energy, food, beverages and agriculture, and tourism sectors. In 2020, S&P Global estimated that “more than 40% of the world’s largest companies have sites at high risk from the physical impacts of climate change—that’s wildfires, water stress, heatwaves and hurricanes among others. For US companies this rises to almost 60%.”¹⁹ A 2019 study by Ceres cited the following climate-related business risks and costs, all of which are likely to have increased substantially since the research was undertaken:

• Physical risks: In 2017, 73 companies on the S&P 500 publicly disclosed a material effect on earnings from weather events and over 90% of these companies disclosed the effect on earnings was negative.

• Supply chain risks: Supply chain disruptions due to climate risk increased 29% from 2012 to 2019.

• Litigation risks: More than 100 cases had been filed in the US on climate change impacts as of May 2019.

• Regulatory risks: The number of climate change regulations had grown to 1500 globally, up from 72 in 1997.²⁰

Another increasing risk and cost for business is the challenge of avoiding and responding to breaches in data privacy. The 2021 ForgeRock Consumer Identity Breach Report, for example, offers sobering evidence of the increased business risks and costs of cyberattacks on consumer data following the large-scale digital migration of consumers, workers and students that occurred during the COVID-19 pandemic, when the amount of time that people spent online was estimated to have doubled.²¹ Among their findings was evidence of a 450% increase in breaches containing usernames and passwords in 2020, totalling 1.48 billion breached or compromised records in the US alone.²² They found that while healthcare was the most targeted sector, accounting for 34% of all breaches, the technology sector paid the highest aggregate cost of recovery at US $288 billion, with more than 1.6 billion records stolen.²³ In 2020, the so-called Solar Winds hack alone breached hundreds of government agencies and large corporations at an estimated cost of as much as $100 billion.²⁴ While it is the mega-breaches and cyberattacks on well-known consumer brands that make the headlines, small and medium-sized companies can be devastated by the financial and reputational costs of a data breach.

Increased public awareness of the human costs and abuse of people’s rights associated with sexual harassment and misconduct in the workplace offers another example of the growing financial, reputational and operational costs faced by companies that fail to strategically address this issue. Over the past decade, the #MeToo movement has played a crucial role in raising awareness, mobilizing activism, influencing corporate cultures and policies, starting to shift legal and regulatory reforms, and increasingly holding both companies and culpable senior executives to account. As Fortune magazine noted in an article on the Conference Board’s 2019 edition of the CEO Succession Practices report, “Among the 18 non-voluntary CEO departures, 5 were related to personal conduct and #MeToo allegations. That’s especially noteworthy given that only one CEO between 2013 and 2017 was fired as a result of personal conduct unrelated to performance, according to the Conference Board. Overall, the trend is proof that the #MeToo movement has reached the boardroom.”²⁵ This is just the tip of the iceberg in terms of the costs to employee morale and trust, lost productivity, litigation, shareholder derivative lawsuits and reputational harm that companies are starting to face as a result of failure to address long-standing human rights, inclusion and diversity issues that had not been given the prominence and importance they deserve at the board level.

These brief examples of the growing materiality to companies and their boards of climate risk management, consumer and employee data stewardship, and respecting human rights are just three key examples of the need for greater board oversight of ESG&D issues. More broadly, research by Bank of America Merrill Lynch released in September 2019 found that “15 out of 17 (90%) bankruptcies in the S&P 500 between 2005 and 2015 were of companies with poor Environmental and Social scores five years prior to the bankruptcies” and “major ESG-related controversies during the past six years were accompanied by peak-to-trough market capitalization losses of $534 billion for large US companies. Loss avoidance is key for portfolio returns over time.”²⁶

An analysis of US proxy voting trends on environmental and social issues from 2000 to 2018 further illustrates the point of growing materiality. As a commentary by the Managing Editor of ISS Analytics states:

the reality is that investor voting behaviour among owners of U.S. companies has changed significantly—perhaps almost revolutionarily—over the past two decades. … Proxy voting policies are becoming more complex, as investors continue to add to the list of factors they consider in their review and analysis of governance practices, including board independence, board accountability, diversity, myriads of executive compensation factors, shareholder rights, and environmental and social factors. Based on our analysis, the most significant change in investors’ voting behaviour pertains to environmental and social issues, as these issues are earning record levels of support in recent years.²⁷

The Bank of America and ISS Analytics research are just two of a growing number of studies from the financial, consulting and academic communities to make the case for the growing materiality of ESG&D issues and for integrating them into corporate governance. The specific issues and the materiality of the risks and opportunities that they present to a company will vary based on industry sector, jurisdiction and circumstances, but no large company or its board is immune to this trend. The Sustainability Accounting Standards Board (SASB), now part of the Value Reporting Foundation, has undertaken an extensive consultation process with major corporations and investors over the past decade to identify the subset of ESG issues most relevant for financial performance in each of 77 industry sectors, with the goal of helping companies in these sectors to disclose the most financially material sustainability information to their investors.²⁸ The Global Reporting Initiative is also developing sustainability reporting standards for 40 sectors, starting with those that have the highest impact on people and the planet.²⁹ As outlined in detail in Chap. 6, concerted efforts are underway to achieve a comprehensive global baseline of sustainability-related disclosure standards that provide investors and other capital market participants with information about companies’ material sustainability-related risks and opportunities.

Thus, the business case for full integration of ESG&D factors into the core governance, strategy and reporting functions of firms has been growing stronger and is increasingly accepted in principle. However, stakeholder capitalism and sustainable enterprise value creation remain a long way from supplanting the doctrine of shareholder primacy and narrow, near-term optimization of financial performance in practice, particularly in the US and UK but also in other important segments of global business and financial markets. The next section describes the journey traveled thus far, placing stakeholder capitalism’s promising resurgence in historical, legal and cross-cultural context.

3 The Evolution of Corporate Governance and Corporate Responsibility Since the 1970s

3.1 Corporate Governance

The paradigm of shareholder value maximization as the paramount fiduciary responsibility of boards of directors gained prominence in the US during the 1970s. It was influenced by two seminal articles and the academic research underpinning them. First was Milton Friedman’s New York Times Magazine article of 1970, “The Social Responsibility of Business Is to Increase Its Profits,” challenging both the theory and practice of corporate social responsibility.³⁰ Second was the 1976 Journal of Financial Economics article “Theory of the firm” by Michael Jensen and William Meckling.³¹ This view was also supported by business leaders and organizations such as the Business Roundtable (BRT), which issued its first Principles of Corporate Governance in 1978. From its origins in the US, the shareholder primacy concept has driven the practice of corporate governance and the legal interpretation of fiduciary responsibility in a growing number of other economies, gaining additional traction in the late 1980s and 1990s during the era of large-scale economic liberalization, globalization and privatization.

As discussed in Chap. 1, different ownership structures and corporate governance models in European and Asian countries have tempered the spread of shareholder primacy, such as two-tier boards with an explicit governance role for labour and foundation ownership structures. Likewise, in a variety of jurisdictions, such as the UK, Australia, India and South Africa, the legal concept that directors owe their duty to the company rather than to the shareholders has become more clearly articulated as a result of seminal reviews and revisions to corporate governance codes. The OECD’s Principles of Corporate Governance, first published in 1999 and most recently revised in 2015, now provide guidance on responsibilities to both shareholders and other stakeholders and are increasingly used as an international benchmark including by the G20, Financial Stability Board and World Bank.

This trend reflects decades of scholarship focused on developing a theory or set of theories around the role of stakeholders in corporate governance.³² Most researchers trace the origins of this line of intellectual inquiry and the use of the term “stakeholder” in the context of corporate governance to the Stanford Research Institute in the early 1960s, where a working group was examining the question of who should have a say in formulating a company mission. Their discussions resulted in a basic diagram and methodology for stakeholder needs assessment.³³ In 1971, Hein Kroos and Klaus Schwab published the German book Moderne Unternehmensführung im Maschinenbau (Modern Enterprise Management in Mechanical Engineering) arguing that the management of a modern enterprise must serve not only shareholders but all stakeholders (die Interessenten) to achieve long-term growth and prosperity.³⁴ And R.E. Freeman developed the concept further in his 1984 Strategic Management: A Stakeholder Approach. Referring to the social, economic and environmental shifts in the business context of the day he argued: “Our current theories are inconsistent with both the quantity and kinds of change that are occurring in the business environment of the 1980s. […] A new conceptual framework is needed.”³⁵

Today, even in the countries where it is most deeply rooted, the paradigm of shareholder value maximization is under rising pressure from dramatic changes in the underlying operating context of businesses. This corporate governance reset is being driven not only by the recent pandemic and economic crises but also by the secular increase in ESG&D materiality described in this chapter and the lessons learned from decades of corporate scandals resulting from serious lapses in attention to such factors. The ability to be profitable and deliver measurable value for shareholders in the near term remains essential and is a particularly strong focus of influential activist investors. But an expanding combination of leading CEOs, investors, regulators, activists and academics are calling for companies also to make an explicit and measurable commitment to harmonize the needs of all key stakeholders and demonstrate that their strategies are fit for the purpose of delivering long-term as well as short-term value.

In 2017, an article by Professors Joseph Bower and Lynn Paine in Harvard Business Review made the compelling assertion, “Most CEOs and boards believe their main duty is to maximize shareholder value. It’s Not.”³⁶ The authors make a strong case for moving to a “company centred” versus “shareholder centred” approach to corporate governance, with guidance on the changing role of boards, including setting the business purpose of their company. Research by a growing number of other management and legal academics reinforces these ideas of companies having a broader corporate purpose than maximizing shareholder value and a changed role for boards of directors as a result.

As outlined in other chapters, many of the world’s largest asset owners and managers are also increasing their focus on long-term value creation and ESG stewardship as part of their analysis of, engagement with and investment in major corporations. The evolution over the past few years of the annual corporate governance letter sent to CEOs by BlackRock’s Larry Fink is one example, which explicitly calls on CEOs and boards to take responsibility for focusing on strategy aligned to long-term value creation, for understanding and ensuring oversight of the company’s purpose and role in society, and for assessing and reporting on climate-related financial risks.

Legal scholars and practitioners have also contributed to the shifting paradigm. In 2019, for example, Martin Lipton of the law firm Wachtell, Lipton, Rosen & Katz issued a commentary entitled “It’s Time to Adopt the New Paradigm.” Based on a 2016 paper prepared for the World Economic Forum, he outlines “a reconception of corporate governance as a collaboration among shareholders, managers, employees, customers, suppliers, and the communities in which corporations operate.”³⁷ This law firm is not alone, and many others are issuing guidance to their clients on the evolving practice of a stakeholder-oriented approach to corporate law and governance. In recent years, the American, European and International Bar Associations, among others, have also provided guidance to companies and their boards on the legal implications of respecting human rights and addressing other ESG&D issues.

Business leadership groups are also becoming more active in the debate. In August 2019, 181 CEO members of the BRT signed a new Statement on the Purpose of a Corporation, committing to leading their companies for the benefit of all stakeholders—customers, employees, suppliers, communities and shareholders. As the BRT comments, “Each version of the document issued since 1997 has endorsed principles of shareholder primacy—that corporations exist primarily to serve shareholders. With today’s announcement, the new Statement supersedes previous statements and outlines a modern standard for corporate responsibility.”³⁸ In making this statement, the BRT, among other business organizations, is committing to a clearer alignment between the concepts and the practices of corporate governance and corporate responsibility. Also in 2019, in preparation for its 50th anniversary Annual Meeting in Davos, the World Economic Forum issued its Davos Manifesto 2020: The Universal Purpose of a Company in the Fourth Industrial Revolution, updating its earlier 1973 Davos Manifesto.

These developments indicate that the paradigm of shareholder value maximization is shifting and leading to the convergence and effective integration of corporate governance with corporate responsibility.

3.2 Corporate Responsibility and Citizenship

The related fields of corporate responsibility and corporate citizenship have also evolved substantially over the past two decades—and in a similar direction. During this period, they have transformed from being focused almost solely on corporate philanthropy and basic compliance with the law to concentrating primarily on:

• How companies identify and manage the ESG risks and opportunities that are most relevant to their core business strategies, operations and performance and that are most salient to people and the planet.

• How companies measure, report and account for their performance in relation to these ESG risks and opportunities to key stakeholders, including but not only shareholders.

In 1999, at the World Economic Forum Annual Meeting in Davos, the late UN Secretary-General Kofi Annan called on business leaders, “individually through your firms, and collectively through your business associations—to embrace, support and enact a set of core values in the areas of human rights, labour standards, and environmental practices.”³⁹ This led to the creation of the UN Global Compact, today the world’s largest voluntary initiative based on CEO commitments to uphold a set of 10 universal principles in the above areas and anti-corruption.

In 2002, we co-authored a World Economic Forum report entitled Global Corporate Citizenship: The Leadership Challenge for CEOs and Boards. The report was written for a task force of 46 chief executive officers from a diverse range of countries and industry sectors, and it was developed in partnership with the Prince of Wales International Business Leaders Forum. Working closely with the CEOs, we identified three key leadership challenges and a framework for action. We summarize these here, in part to recognize some of the early business pioneers, most of whose companies continue to play a leadership role today in driving more just, inclusive and sustainable growth.⁴⁰ In addition to recognizing some of the pioneers of stakeholder capitalism, we re-state this three-pronged leadership statement because it remains not only relevant but more important than ever in today’s world. The 46 CEOs signed the following statement:

• First and foremost, our companies’ commitment to being global corporate citizens is about the way we run our own businesses. The greatest contribution we can make to development is to do business in a manner that obeys the law, produces safe and cost-effective products and services, creates jobs and wealth, supports training and technology cooperation and reflects international standards and values in areas such as the environment, ethics, labour and human rights. To make every effort to enhance the positive multipliers of our activities and to minimize any negative impacts on people and the environment, everywhere we invest and operate. A key element of this is recognizing that the frameworks we adopt for being a responsible business must move beyond philanthropy and be integrated into core business strategy and practice.

• Second, our relationships with key stakeholders are fundamental to our success inside and outside our companies. Being global corporate citizens requires us to identify and work with key stakeholders in our main spheres of influence: in the workplace, in the marketplace, along our supply chains, at the community level and in public policy dialogue. Our key stakeholders will vary based on our particular circumstances, but for most of us our employees, customers and shareholders are of fundamental importance, together with host communities and governments and a growing variety of civil society organizations.

• Third, ultimate leadership for corporate citizenship rests with us as chief executives, chairmen and board directors. Although it is essential that we assign clear responsibilities, resources and leadership roles to our managers for addressing these issues on a day-to-day basis, ultimate responsibility rests with us. While specific definitions, approaches and issues may differ according to industry sector, location of operations, size and type of company ownership, we believe the Framework for Action provides a template for leadership that is relevant for all companies, industry sectors and countries. Some of us will use the terminology of corporate citizenship, others of corporate social responsibility, ethics, triple-bottom-line or sustainable development, but we believe the core principles and actions required are the same. First, provide leadership. Second, define what it means for your company. Third, make it happen. Fourth, be transparent about it.⁴¹

Building on the 2002 statement, in 2008 another task force of CEOs working with the World Economic Forum, Business for Social Responsibility (BSR), Harvard Kennedy School, AccountAbility and the International Business Leaders Forum focused on the role of business in working collectively beyond their own operations and supply chains to help strengthen public governance. This group outlined specific actions that companies could take as good corporate citizens to strengthen the broader enabling environment in which business operates. Examples ranged from joint efforts to help governments build capacity to deliver public goods such as health, education and training, to tackling corruption at the national level, as well as bringing a business voice to strengthen global governance frameworks. The report was one of the first of its kind that outlined a clear roadmap for building mutually reinforcing links between corporate responsibility and citizenship, corporate governance and public governance.⁴²

Also, in 2008, in a seminal article in Foreign Affairs magazine, the World Economic Forum’s Founder and Executive Chairman Klaus Schwab wrote,

A new imperative for business, best described as global corporate citizenship, must be recognized. It expresses the conviction that companies not only must be engaged with their stakeholders but are themselves stakeholders alongside governments and civil society. International business leaders must fully commit to sustainable development and address paramount global challenges, including climate change, the provision of public health care, energy conservation, and the management of resources, particularly water. Because these global issues increasingly impact business, not to engage with them can hurt the bottom line. Because global citizenship is in a corporation’s enlightened self-interest, it is sustainable.⁴³

In 2011, further impetus came from work by Professor Michael Porter and Mark Kramer, who working with Peter Brabeck, the former CEO of Nestlé, among others, coined the term “Creating Shared Value” to describe how companies can create both economic and social value by reconceiving products and services, redefining productivity in the value chain and improving their operating environment.⁴⁴ In the same year, the UN Guiding Principles on Business and Human Rights, authored by Professor John Ruggie, were unanimously endorsed by the UN Human Rights Council. ⁴⁵ And, in the lead up to 2015, a core group of business leaders from diverse countries and industry sectors played a role in the consultations and negotiations that resulted in the Paris Agreement on climate change and the Sustainable Development Goals (SDGs).⁴⁶

In recent years, such voluntary leadership and commitments by a small number of CEOs and boards have grown substantially. More companies are taking an approach to corporate responsibility and citizenship that is focused on identifying and managing the material ESG&D risks and opportunities in their core business operations and business relationships. As outlined elsewhere, a key driver has been the growing focus on ESG&D issues by many of the world’s largest asset owners and managers, from sovereign wealth funds, pension funds and insurance companies to other institutional investors. The signatories of the UN Principles for Responsible Investment, for example, have grown from 100 in 2006 to over 4000 in 2021 and together accounted for some US $120 trillion in assets under management as of mid-2021.⁴⁷

Today, the focus by a growing number of large companies on integrating material ESG&D risks and opportunities into their core business strategies, operations, supply chains and policy dialogue is more important and relevant than ever. To be effective and sustained, board-level engagement and oversight is required. A lack of clarity and consistency of terminology and metrics remains a challenge for many companies, investors and other stakeholders. These practices are variously described as corporate responsibility, corporate citizenship, corporate social responsibility, corporate sustainability, ESG, triple bottom line, creating shared value, inclusive business models and total societal impact, to name some of the more common terms used. Linked to the challenge of different terminology and approaches, there are a plethora of different measurement and ranking systems that are being used by companies, investors and other stakeholders to evaluate and compare business commitments and performance on ESG&D issues. Yet, in all cases, the attention of leading companies, shareholders and other stakeholders is increasingly focused on the issues that are most material to the company and most salient to people and the environment.

4 Stakeholder Capitalism: From Principles to Practice

Thus, profound changes in the operating context of companies are aligning the interests of shareholders and other stakeholders more closely by increasing the financial materiality of the stewardship of ESG&D risks and opportunities. This has the potential to usher in a new phase of capitalism—stakeholder capitalism—which shifts market economies beyond the managerial capitalism of the 1950s–1970s and the financial capitalism of the 1980s–2010s, a hallmark of which has been the pre-eminence of shareholder value and the segmentation and de facto subordination of environmental, social and broader value chain stewardship issues.

Stakeholder capitalism holds promise for both shareholders and society at large. By better internalizing factors that influence value over time, it could generate stronger and more resilient financial returns for the ultimate owners of companies: people with retirement and other saving accounts intended to fund medium- to long-term family needs. At the same time, it could accelerate progress towards the broader aspirations of society, such as combating climate change, reducing inequality and advancing sustainable development through the fulfilment of the Sustainable Development Goals.

As outlined earlier, the principles of stakeholder capitalism have recently been restated in the World Economic Forum’s refreshment and republication of its 1973 corporate governance manifesto and the Business Roundtable’s statement of corporate purpose, as well as in national regulations and frameworks, such as the revised UK Corporate Governance Code and the UK Stewardship Code 2020 and the 2020 additions to the French Civil and Commercial Codes, among others. But realizing the potential for sustainable enterprise value creation articulated by these principles will require companies to translate them into practice. They must do so by transcending the traditional segmentation of shareholder and stakeholder considerations—exemplified by the concepts of shareholder primacy and corporate responsibility—by integrating them.

Integrated corporate governance, strategy and reporting depart from the mindset and associated practices of shareholder primacy and corporate social responsibility, which have regarded ESG&D factors as primarily non- or pre-financial matters. Instead, it takes a holistic view of shareholder and wider stakeholder interests by systematically internalizing ESG&D considerations into the firm’s strategy, resource allocation, risk management, performance evaluation and disclosure policies and processes. It does so not for ethical or political reasons, although these are crucial factors that must also be fully considered by firms, but out of a recognition that in the twenty-first century, strong and sustained value creation beyond the near term is increasingly dependent upon a rigorous understanding and active management of these considerations as part of the core governance and strategy of the firm.

If stakeholder capitalism is to be more than an optimistic vision, it will require this integration to become better defined in operational terms and translated into practices that are widely adopted by boards and management teams in five key areas:

• 1. Align governance, strategy and capital allocation with the key drivers of shared and sustainable value creation

• 2. Internalize material ESG&D risks and opportunities into enterprise risk management and innovation

• 3. Reinforce preparedness and resilience to crises and systemic shocks

• 4. Recognize that the firm is a stakeholder itself in the vitality and resilience of its operating context and partner with other stakeholders to address relevant systemic challenges therein

• 5. Integrate financial and material non-financial information in mainstream internal and external reporting

Chapter 3 elaborates on these five elements, providing a thematic overview of the leadership agenda required to implement diligently the principles of stakeholder capitalism within a firm. In Part II, Chaps. 4, 5, 6 and 7 provide a practical guide, a more detailed look at what this leadership agenda means in functional terms for the firm with reference to existing examples of good practice: for governance and the role of boards; for strategy and management and the role of the C-suite; for reporting and communications with investors in particular; and for broader system-level engagement, including particularly partnership with other stakeholders to address weaknesses in the underlying economic and societal operating context.

This is an agenda to assist business leaders who subscribe to the precepts of sustainable enterprise value creation and stakeholder capitalism to adapt their firm’s governance, management, reporting and partnerships to the new business operating context of the 2020s through the systematic integration of ESG&D considerations. The extent to which this integration is achieved in practice has an increasingly important bearing upon the performance, licence to operate and resilience of companies, whether they are publicly, privately or state owned. Accordingly, this business leadership agenda is relevant for consideration by any company and its stakeholders regardless of jurisdiction, ownership structure or business model. It is a call to action and practical resource for firms seeking to keep pace with changing economic circumstances and social expectations—to “walk the talk” of stakeholder capitalism. For business to maintain the public’s trust and stakeholder capitalism to be more than an optimistic vision, boards and management teams must integrate these principles and practices across industry sectors and countries. Such integration is central to the art of business leadership in this new era—the key to creating long-term sustainable enterprise value for shareholders and other stakeholders alike.