Tackling sustainable issues takes holding directors personally responsible for their company's sustainability failures.
Directors who run companies in a way that deliberately damages human or environmental capital must be held accountable for their actions, in the same way they would if they had committed a financial misdemeanour, argue Tom Tayler, Mirza Baig and Vaidehee Sachdev.
Read this article to understand:
- How company directors have all too often been able to flout environmental and human rights laws without being held accountable
- Why investors have a financial and moral imperative to address this market failure, through engagement with companies and – more crucially – governments and other policymakers
- The important role of public rankings of companies on social and environmental issues
In July 2021, Southern Water was slapped with a record £90 million fine after the privately-owned utility admitted it had illegally discharged sewage into the rivers and coastal waters of southern England on no fewer than 6,971 occasions between 2010 and 2015, causing major environmental harm to shellfish waters.1
Later that month, the company’s remorseful chairman felt compelled to publish an open letter, claiming “deep and necessary cultural change” to both the business and its leadership team meant that, since 2017, Southern Water’s “absolute priority” had been to put the environment “front and centre in everything we do”.2
Despite the apparent contrition, Southern Water faced further criticism in the Autumn for dumping sewage in 57 areas within 24 hours and has been subject to a number of public protests this year. It begs the question: despite the commitments of its leadership to address failings in its business, has anything fundamentally changed?3
The episode was just the latest example of a crucial shortcoming in the way some companies, and the people in charge of them, operate. All too often it is cheaper for firms to flout environmental laws and regulations, or in other cases to cut down rainforest and graze cattle on the land, than it is to manage their business in a more responsible and sustainable way.
A similar problem applies to many other types of business. Clothing retailers, for example, may find it more convenient to run the risk of abetting human rights abuses, the use of child labour or modern slavery, than undertake full due diligence of their supply chains and understand all the layers of the companies and suppliers they do business with.
In response to high-profile market failures and a growing public awareness of sustainability issues, rules on how companies operate are gradually being tightened. For example, under a European Union proposal, large firms will be required to “identify, end, prevent, mitigate, and account for negative human rights and environmental impacts in their own operations, their subsidiaries, and their value chains”.4
However, while efforts to tighten rulebooks are to be welcomed, gaps remain in the regulatory framework that could hamper efforts to achieve their desired goal. Although it is possible punitive fines could bring about the desired change in corporate behaviour, the danger is companies will simply continue to view them as the cost of doing business rather than an incentive to behave in a more sustainable manner.
Investors footing the bill
While Southern Water’s chairman may have been quick to reassure customers they would not pay a penny towards the fine, there was no mention of the company’s shareholders and bondholders, who can often be adversely impacted in the form of falling share or bond prices when investee companies are hit by reputational issues.
Part of the problem is the concept of corporate limited liability. That means it is the company that is held responsible for bad behaviour, and not its directors. As a result, the people who ultimately pay the price of the fines are investors, via hits to the valuations of shares and bonds they hold, not those who took the decisions.
While fines can be an important tool, alongside that there needs to be personal jeopardy for directors as the controlling mind of the company if they are choosing or ignoring practices that are damaging natural or social capital. At the moment, directors feel pretty safe behind the corporate veil. They are not going to be held responsible for the actions they take on behalf of the company. Without sufficient personal accountability, there is too little incentive to take positive action.
To begin rooting out the problem, directors need to be held personally liable for deliberate or reckless breaches. Under UK law, individuals can be disqualified from being a director for up to 15 years if they are found to be “unfit”, which can relate to a variety of offences ranging from allowing a company to continue trading when it can’t pay its debts, to using company money or assets for personal benefit. The rules should be applied more widely and more consistently against directors to change negative corporate behaviour.
In the meantime, it is being left to investors, and in other instances non-governmental organisations, to pressure companies to modify their behaviour. In a landmark ruling of May 2021, a Dutch court ordered Shell to slash its CO2 emissions by 45 per cent compared to 2019 levels by the end of the decade.5
Then, in March 2022, Client Earth, another environmental pressure group, launched legal action against the same company’s board of directors, seeking to hold it liable for failing to properly prepare for the energy transition, in the first case of its kind.6
Even though the company is seeking to get the first decision overturned on appeal, and may win the latest case, the outcome of climate-related litigation is becoming increasingly hard to predict. The fact the second case is being brought against the directors, rather than the company, should give some pause for thought.
Sending out a powerful message
If directors not only think their company is at risk but they too could be banned from boardrooms, that sends out a powerful message to act with consideration for a raft of sustainability issues.
Actively engaging with companies on such issues plays an important role. One of the ways investors can focus accountability for sustainability on the shoulders of directors is through voting on their re-election. Each year, we have layered our voting policy to expand the range of issues we hold them individually accountable for: in 2022, for example, we have included deforestation and are also formalising our engagement and stewardship activities around this critical issue.
At the same time, affecting the kind of systemic change required will not be solved on a company-by-company basis alone. Therefore, investors should be looking to lobby regulators as well, to ensure people who are running companies in a way that deliberately damages either human or natural capital understand they are liable to disqualification. After all, financial institutions have a responsibility to seek to influence policymakers to ensure a more sustainable system with markets operating with integrity, since that is in line with the long-term interests of their customers.
In 2011, the United Nations established its ‘Guiding Principles on Business and Human Rights’ in an effort to prevent and address the risk of adverse impacts on human rights linked to business activity. Five years later, a group of investors led by Aviva Investors and civil organisations established the Corporate Human Rights Benchmark (now part of the World Benchmarking Alliance) to create a yardstick of corporate human rights performance and to facilitate a competitive environment for firms to improve their human rights impacts.
The hope is that increased transparency and the public nature of the ranking will change the way in which companies and, just as importantly, the people who run them behave. As a result, initiatives such as this can better align the interests of corporations, shareholders, and other stakeholders in wider society. At the same time, regulation may also be needed to ensure the laggards make the necessary changes. Again, investors have an important part to play through their macro stewardship activities, engaging with the relevant authorities to encourage them to intervene where necessary.
As for the age-old question of whether doing good makes financial sense from a shareholders’ perspective, while it is hard to prove the point conclusively, there is no shortage of examples of shareholders suffering big losses due to companies, and the people who run them, flouting rules and regulations.
Between March and October 2015, Volkswagen shares lost two thirds of their value as the full extent of an emissions scandal became apparent. More recently, more than 75 per cent was wiped off Boohoo’s share price in less than two years after it was accused of modern slavery, with workers making clothes linked to the online British retailer found to have been paid as little as £3.50 an hour.7
Over time there is an argument that sustainability risks are likely to become increasingly embedded in asset prices as market failures are corrected. That would imply responsible behaviour should be better rewarded by investors while damaging behaviour would be reflected in a higher cost of capital for irresponsible companies.
While cases such as Volkswagen and Boohoo illustrate the importance of undertaking comprehensive investment due diligence to mitigate the risks associated with poor business practices, they also highlight why it is in shareholders’ interests that those who took the decisions are held to account.
After all, if executives close their eyes to poor practices in house and in their supply chains, they are not fit to run a company.