Volkswagen Shows Need for Sustainable Corporate Governance : Boards should embed sustainability in corporate DNA

Last week news broke that Volkswagen has been involved in diesel emissions scandal in which they had rigged up to 11 million of their vehicles to pass emissions tests. The Volkswagen scandal involves cheating of consumers, cheating of taxpayers, cheating the climate, and cheating of governments. The scandal shows a failure of Volkswagen’s consumer policy, its integrity policy and its corporate responsibility policy. It also highlights a clear failure of its corporate governance. In other words, shareholders were also cheated. The loss of billions of shareholder value within just one week indicates how much the companies’ board oversight as well as it risk management systems have failed.

Board rooms of enterprises should be a driving force for change and corporate boards should practice what I like to term ‘’Sustainable Corporate Governance.’’ In other words companies should embed corporate sustainability and responsibility in their corporate DNA. This was something clearly missing in the DNA of Volkswagen.

A business case and a moral case for sustainable corporate governance

Expectations of corporations to manage environmental and social risks throughout their operations has increased with the development and recognition of international standards such as the UN Guiding Principles for Business and Human Rights (UNGPs) and the OECD Guidelines for Multinational Enterprises (OECD Guidelines).  Beyond emerging global expectations, businesses, like Volkswagen, are learning that environmental and social risks, including human rights issues can pose material risks to their business operations including serious reputational damage, opportunity costs in the form of lost future opportunities and direct costs arising from lost productivity due to temporary shutdowns and senior staff time being diverted to manage grievances.

For example in the case of the Volkswagen scandal estimated costs associated with recalls as well as penalties that will have to be paid are being reported at USD 35 billion.[1]  Furthermore the case of Volkswagen is by no means an isolated one. A recent study by Vigeo[2] showed that CSR related sanctions for companies are in fact quite common.  Nearly 20% of companies in a sample of over 2,500 were found to be subject to such sanctions between 2012 and 2013, amounting to penalties upwards of EUR 95.5 billion.

What is the role of a corporate board?

Traditionally the issues of sustainability and of corporate governance have been treated as unrelated subjects and kept siloed from one another. This partly explains why a company like Volkswagen are continuing to get in trouble. Indeed in the wake of the Volkswagen scandal the New York Times released an article entitled Problems at Volkswagen Start in the Boardroom. The article described how poor corporate governance structures and hostility towards environmental regulations at Volkswagen has contributed to its current situation. [3]

 Responsibility to manage environmental, social and governance risks is increasingly considered a central element of the fiduciary duty of corporate board members, not only because these risks can also result in significant commercial impacts but also because the conception of board responsibility is being expanded beyond simply maximizing profits for shareholders to also avoiding negative impacts to stakeholders. For example the International Corporate Governance Network recently published a report recognizing that human rights issues are fundamental to good corporate governance.[4]  Reading the recommendations of the OECD Guidelines and OECD Principles for Corporate Governance in tandem likewise reveals a strong relationship between the two and suggests sustainable corporate governance is an approach that responds to the recommendations of both instruments. Thus corporate boards should play a leading role addressing risks to stakeholders and establishing and promoting a culture of corporate responsibility.

In the first instance this means establishing clear buy-in by the board or upper management on responsible business conduct (RBC) potentially through integrating RBC issues into company policies or aligning company practice with international instruments such as the UNGPs and OECD Guidelines.

In addition to having to having policies on RBC and strongly communicating them throughout an organisation the board should have a direct responsibility for the implementation and oversight of RBC issues.  Recent studies by, for example, the Conference Board and the Boston Consulting Group point to Board oversight as a top driver of a company’s attention to sustainability.

This practice is reflected in several existing standards:

  • For example the Indian Companies Act makes mandatory to have a board member that is responsible for responsible business conduct.
  • The Dutch Corporate governance code also integrates responsible business conduct in the tasks of the Supervisory Board and the Executive Board, explicitly making management responsible for the development of results and corporate social responsibility issues that are relevant to the enterprise.
  • Under the OECD Guidelines the board is explicitly given direct responsibility for certain issues, for example for ensuring risk management, financial and operational control, and compliance with the law and relevant standards regarding taxation.

Sustainable remuneration

Many companies are quick to declare the importance of sustainability and point to corporate successes in this regard. However, unless sustainability is tied to measures of performance it often remains simply window dressing and a side show within a company. The board should play a role in establishing the right incentives for sustainability. This can include integrating sustainability experience into recruitment criteria for upper management or building RBC goals into remuneration packages.

The practice of linking remuneration to sustainability performance is only beginning to emerge but appears to be on the rise. A recent report by Ceres found that while in 2012, only 15 percent of the companies evaluated linked executive compensation to some sustainability metrics, 24 percent of the 146 companies surveyed in 2014 do so.[5] Examples of good practice in this regard are becoming more prevalent and serve to inspire the mainstream. For example Unilever was one of the first major multinationals to introduce incentive structures linked to sustainability criteria, and others have been taking heed as well.  In 2010 US managers of DSM, a global science based company, did not receive a bonus because they did not achieve their greenhouse gas emissions targets.  Likewise Xcel Energy ties a third of its CEO’s annual bonus to energy and greenhouse gas emission goals which are publically reported. Others have gotten bonuses because of a higher ranking in the Dow Jones Sustainability Index. In 2008 Intel started to link 3 percent of its employees’ annual bonuses to environmental sustainability metrics and goals.

If companies really want to embed sustainability in their corporate DNA, incentive structures based on sustainability criteria should not be limited to executive compensation but should extend to all actors which have the capacity to impact sustainability performance such as sourcing directors, designers, environmental and social managers and so on.

Furthermore, the sustainability targets linked to performance pay should be relevant, material, challenging and meaningful to the organization and its stakeholders. The metrics of such incentive structures should be transparent to allow for outside evaluation.

Sustainability reporting

Lastly the board should be involved in communicating on RBC through reporting on non-financial information such as policies and compliance with codes of conduct regarding environmental and social issues. This is something that is already becoming common practice. For example the EU non-financial reporting  directive  requires companies concerned to disclose in their management report information on policies, risks and outcomes as regards environmental matters, social and employee aspects, respect for human rights, anticorruption and bribery issues, and diversity in their board of directors. Similar legislation also exists in China for SOE’s and in India. Likewise the stock exchanges of South Africa, Brazil, and in some South East Asian countries make reporting of certain non-financial information mandatory for listed companies. In this area the OECD Guidelines outlines what good practice is in their chapter on Disclosure. [6]

Boards should not only promote non-financial reporting but they  should also take responsibility for it by formally sign off on the company’s sustainability report before publication, which confirms that sustainability and transparency are priorities for the company.

Oversight and compliance

In addition to providing the right incentives for sustainability it is important to also put in place strong oversight and compliance systems to ensure that these incentives do not lead to perverse results such as in the case of Volkswagen.  In the case of Volkswagen an insular corporate board and a long chain of complicity with regard to fraudulent activities clearly demonstrated that compliance management was not functioning as it should.

In conclusion, sustainability should be embedded into the DNA of business operations and their value chains.   Although traditionally treated a separate issue, sustainability must be integrated into corporate governance with regard to board responsibilities and standards of disclosure and transparency. Strong compliance management systems must also be prioritized. Given the commercial risks and benefits at stake institutional investors should be insisting on this.  In this regard corporate boards should practice sustainable governance by ensuring that sustainability standards are upheld throughout global business operations, that incentive structures are linked to sustainability performance and that they engage in meaningful integrated reporting on sustainability issues. The new board of Volkswagen should start doing that as soon as possible.

[1] Steve Dee,  Dieselgate Scandal Could Cost Volkswagen Up To $35 Billion, Forbes, September 24, 2015, http://www.forbes.com/sites#/sites/greatspeculations/2015/09/24/dieselgate-scandal-could-cost-volkswagen-up-to-35-billion/

[2] Paying the penalty: The cost of CSR misconduct, Vigeo, May 2015

[3] Problems at Volkswagen Start in the Boardroom, New York Times, September 24, 2015. http://www.nytimes.com/2015/09/25/business/international/problems-at-volkswagen-start-in-the-boardroom.html?_r=0

[4] See ICGN Viewpoint: Human Rights, International Corporate Governance Network, April 2015. Available at https://www.icgn.org/policy/viewpoints/human-rights

[5] Ceres, Gaining Ground: Corporate progress on the Ceres roadmap for sustainability, Ceres and Sustainalytics (2014)

[6] Throughout the Guidelines reporting with regard to specific substantive areas such as disclosure on greenhouse gas emissions and on how human rights impacts are addressed, is also expected. Reporting is also a key part of the five step framework for due diligence promoted by the OECD.

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