Cognitive Biases on the board & Corporate Climate Change Inertia

By Pamela Ravasio, IDP-C and IDN Board Member

The influence of decision bias is nothing new when scrutinizing corporate governance. For good reason a not insignificant amount of time during INSEAD’s International Directors Programme (IDP) is spent looking into decision biases as well as learning about how to remedy them in the board context.

Further, we all are aware: The consensus that climate change is having already huge consequences not just for the planet but also on corporate operations, risk profiles and profits. And yet: by and large businesses continue to fail to adjust their strategic decision-making processes to become more climate viable. At best they have just barely started on their journey.

Why is that? As we look deeper into the corporate discourse on Climate Change, it becomes evident that one of the silent yet crucial culprits behind the climate change inertia lies in the cognitive biases at play in corporate decision making.

A recap on decision biases: What is it, and what types exist?

There exist a plethora of cognitive biases recognised in psychology and decision making theory. Only a subset however seems to be of practical relevance for the decision process on boards. Some of the most frequently encountered biases in this context are the Anchor Bias, the Loss-Aversion Bias, or Availability Bias – all of which are being looked into during the IDP.

Equally drawing from the IDP: A good part of the Fair Leadership Process is also intended to neutralise such decision biases, or at the very least to make them explicit and challengeable.

Decision Bias and ESG: Cause and Effect

A 2017 California Management Review article found that in the context of corporate decision processes related to Climate Change – notably on boards – four bias types are of particular relevance: Framing Bias, Optimism Bias, Relevance Bias, and Volition Biases.

What are those biases, what do they mean for boards in the context of strategic Climate Change decisions, and what can be done about it?

Bias 1: Framing Bias:

  • Definition: “Framing bias occurs when people make a decision based on the way the information is presented, as opposed to just on the facts themselves. The same facts presented in two different ways can lead to people making different judgments or decisions.” (Source)
  • Board decision impact: Already framing the issue for example as ‘Climate Change’ rather than ‘Global Warming’ or ‘Climate Emergency’ disguises the urgency with which actions are needed, as well as the extremely tight timelines, and concentrated actions and investments needed. Framing is often decisive in identifying how urgent, critical, and bottom line relevant an issue is.
  • What to do about it? Language matters. Choosing wording carefully is a good start. Spelling out underlying assumptions is another good way to get to a more realistic picture of reality.

Bias 2: Optimism Bias:

  • Definition: People tend to overestimate the probability of positive events and underestimate the probability of negative events happening to them in the future. (Source)
  • Board decision impact: An example of the optimism bias in action is the assumption that advances in technology and innovation will allow us to revert Climate Change at a later date. Through such assumptions, responsibility is shifted away from the current context, and leads to inaction in the present.
  • What to do about it: Brutal honesty is necessary – and some significant efforts around spelling out what worst case scenarios could and would look like. Can a company successfully survive a worst case? And how exactly?

Bias 3: Relevance Bias:

  • Definition: Our subjective understanding of how important and critical an issue truly is, based on what we know or think to know. (Source)
  • Board decision impact: An example of this bias in action is that we all know that temperatures will rise between 2 and 5 degrees Celsius still this century. And yet – subjectively those temperature rises seem to be inconsequential. The reason being that as human beings – and as a consequence also in the professional roles we embody – we are already primed to ignore it.
  • What to do about it: Investigate how the information is anchored. For example in the above case, a 2 degrees temperature rise would be perceived through a subjective lens and set of experiences. Next, work on replacing those subjective views through a more objective, data driven but equally tangible (experiential, pictorial) description of the same, with the intent to replace the subjective experiences through those rooted in objective knowledge.

Bias 4: Volition Biases:

  • Definition: Broadly, these are errors in judgement that result from deferring responsibility (‘it is not my problem’), and can come in many forms such as through deference to authority or the ‘others do it as well effect’. (Source)
  • Board decision impact: Being reluctant to act because of an absence of a legal enshrined ‘level playing field’ is one of the most frequently cited versions of a Volition Bias. Another example is when companies finger point other players in their industry, say for not paying a living wage, and in this way justify their own behaviour and inaction.
  • What to do about it: Ask the question “What should the company (the board, the individual) do if the responsibility for change was theirs, and theirs alone?”

Conclusion

Climate Change “is the predominant moral issue of the 21st Century” (James Hansen, NASA climatologist). And yet, a recent survey shows that only 17% of Board of Directors serving on Sustainability committees have sustainability expertise. (Source, page 12).

Hence, while we’re waiting for boards to get their sustainability literacy up to speed and at a level comparable to their financial literacy: taking concrete measures to recognise, and remedy existing cognitive biases and their impact on decisions related to Climate Change action, is an effective, reasonably simple to grasp and implement, low hanging fruit that no doubt bears a considerable harvest.

 

Webinar: Sustainability and Climate in Strategy and Board Agenda

By Karen Loon, IDN Board Member and Non-Executive Director

With climate challenges increasing, the board has a responsibility to assess the impact and define strategies to handle the risk.  Are we as board members doing enough?  Do we understand how to address the topic?  What are the challenges and opportunities here?

INSEAD Directors Network (“IDN”) members had the opportunity to listen to Lise Kingo, IDP-C, NED and former executive director at UN Compact and Novo Nordisk, Stig P Christensen, IDP-C and NED, and Silvio Dulinsky, Head of Business Engagement Latin America, World Economic Forum held on 18 November 2020 in an exclusive webinar for members which was facilitated by IDN Board Member, Liselotte Engstam based in Sweden with Q&A support from Hagen Schweinitz, a fellow IDN Board Member based in Germany.

Top left – Lise Kingo, Top right – Silvio Dulinsky.  Bottom – Stig P Christensen

In their introductory remarks, the panellists covered three areas:

Responsible business is now a board and senior management agenda however climate and social inequality remains far behind

The Sustainable Development Goals were issued out five years ago.  Whilst there is much broader recognition that responsible business is now a key board and senior management agenda topic, after five years, we are still very far behind in the whole climate area and also social inequality.

Due to the huge gap and climate emergency across the globe, the whole area of climate change has developed and is now one of the most mature areas in relation to how companies can control, manage and set good risk and targets.  In particular, the financial community has put climate risk as a key priority through how they are setting targets.  Another recent initiative is that investors want to know how companies put climate risk costs into their accounts.

Climate will continue to stay on the board and management agenda.  However, companies need to develop more holistic approaches to running their businesses when it comes to ensuring a successful transition to a net-zero economy. There are a number of tools and initiatives in place to support board members in this process, which means there’s no reason for boards not to stat working on a transition strategy.

We are beyond a tipping point in relation to climate.

  1. We are beyond a tipping point – We have no time to waste. Policy-makers and business leaders have to their best to rapidly implement new ways forward, as younger generations are demanding.  Investors are increasingly more supportive of these changes.
  2. Green and digital is core business – There is currently a risk for boards to get stuck on the compliance and risk agenda and not address opportunity agenda. It is often hard for boards to have strong and precise discussions and evaluation of the opportunity side.  Boards should push this agenda beyond climate.  The way forward requires innovation of the regulatory framework which is currently work-in-progress.
  3. Open the windows and doors – Look outside beyond the borders of your company and M&A objectives you are facing with a systems lens on. Create symbiosis between different companies and sectors.
  4. Listen to the crowds – They can’t be on the boards, but they have to be heard by the company.

Tools are available to support boards. A value chain approach should be adopted.

Tools are available to support boards in relation to setting up effective Climate Governance.  Specifically, there are eight climate principles outlined in the World Economic Forum White Paper “How to Set Up Effective Climate Governance on Corporate Boards – Guiding principles and questions”.  These are:

  • Principle 1 – Climate accountability on boards
  • Principle 2 – Command of the subject; boards need the knowledge to debate and stay informed re climate related decisions.
  • Principle 3 – Board structure; the board structure needs to be effective to embed climate in the decision-making processes of the board and senior management.
  • Principle 4 – Material risk and opportunity assessment; management should assess and manage short, medium and long term climate related risks and opportunities.
  • Principle 5 – Strategic integration; management should integrate climate considerations into their strategic and financial planning of the company
  • Principle 6 – Incentivisation
  • Principle 7 – Reporting and disclosure; reporting and disclosure should be undertaken with the same rigour as a financial report.
  • Principle 8 – Exchange; engage peers, regulators, investors and the whole value chain in the process.

All companies, including SMEs are crucial in relation to transforming value chains.  The role of the board is to support the broader value chain changes required.

A challenge is how can we bring on board others who are not yet convinced on the importance of the issue.  The Chair and CEO as well as a critical mass of directors play a critical role to put climate on the agenda of the board to support driving the change.

Top – Liselotte Engstam.  Bottom – Hagen Schweinitz

Following the opening remarks, the panellists and IDN members engaged in lively discussion in relation to topics including:

  • The importance of getting climate on the board agenda.
  • Being proactive on climate before rules becoming mandatory. Global requirements on climate are increasing rapidly.
  • Leadership agenda – Set goals which are not only financial, but also deal with other areas including climate, diversity etc. to drive the change agenda. The importance of the role of the board to drive this.
  • The increasing focus on climate being placed by investors in more recent times.
  • How do boards look at the risks and opportunities in relation to climate?
  • Sustainability reporting including accountability, accounting and valuation considerations.
  • Directors’ fiduciary duties in relation to climate.

As Liselotte Engstam concluded:

“There’s no question that we need to have increased focus from board directors, and it also needs to be more inclusive and holistic, and we are getting much more attention from investors… Don’t just look at this as negative it’s a fantastic time especially now to look at (it as) a source such as an opportunity to rethink and re-set”.

The next exclusive IDN webinar will be on Getting your First Board Mandate which will be held on 1 December 2020 at 1200 – 1300 CET.

 

IDN Webinar: Governance in a post-Covid World Lessons from Africa

By Adrian Moors, EMBA (2004), IDP-C, and IDN Mauritius/South Africa Ambassador

What are the learnings from Covid-19 and how are these being utilized in Africa to help enhance governance in a post-Covid world?

These were the questions discussed in an INSEAD Directors Network webinar, Governance in a post-COVID World – Lessons from Africa held on 4 November 2020.

The webinar was opened by Adrian Moors, EMBA (2004), IDP-C and IDN Mauritius/South Africa Ambassador, and moderated by Liselotte Engstam with support from Hagen Schweinitz, both IDN Board Members.

The panellists were:

The key highlights of the discussion were:

  • Africa is a complex and challenging environment.
  • There are negative perceptions of the continent.
  • However, there are also a number of opportunities.
  • Corporate governance is critical to realise these opportunities in a sustainable manner.
  • There are essential learnings and aspects of governance in Africa that could assist in this regard, particularly in a post-Covid world.

The key points discussed were:

Africa is a diverse continent

There is Anglophone, Francophone, Lusophone and Maghreb Africa. There are a number of programmes, and corporate governance codes being adopted across the continent. Many of these are linked to the King Code and OECD guidelines. Although the codes vary across the Anglophone, Francophone, Lusophone and Maghreb countries, the narrative around Corporate Governance is changing and complexity being removed.

Codes are also being developed and adopted across the Private Sector and State-Owned Enterprises with sustainability becoming a key element through the Global Reporting Initiative Standards.

Impact of Covid-19 on corporate governance

Covid-19 has highlighted the need for enhanced governance and sustainability for entities. This is also being supported by governments and the African Corporate Governance Network as composed of Institutes of Directors of about 30 African countries, including through virtual training and networking forums.

For example, following governance challenges within KPMG South Africa, the organisation restructured its board by including a number of non-executive directors and a non-executive Chairman.  In order for corporate governance to have meaning and become embedded in an organisation, it has to become part of the culture.  This needs to be underpinned in a real manner by the organisation’s purpose and values.

Governance in family businesses is often informal but underpinned by family values and thus embedded. In many instances it is better than that of listed companies.  Covid-19 has enhanced family businesses’ clarity of purpose and sense of responsibility towards the communities in which they operate.

Covid-19 has brought about significant changes to corporate governance practices and the manner in which boards operate in Africa, including:

  1. Regulators having to change and adapt their processes (e.g. allowing virtual Board Committee and Board meetings as well as Annual General Meetings)
  2. “Paternalistic” and “older” directors being forced to accept a more modern manner of operating.
  3. Staff welfare being prioritized while also having to develop accountability with remote working.
  4. The importance of CSR being elevated with companies that have traditionally neglected their social license to operate being penalized in the market.

It has also accelerated the implementation of initiatives such as linking objectives with performance (in the new remote environment), addressing CEO succession and managing risks, the information gap and fair process

The traditional limited transparency around board and organisational operations in Africa is no longer sustainable.

Understanding Africa

Board diversity in Africa is an important issue. It is not just about race, but also language and tribal.

Awareness of this and a local understanding is critical to successfully operate on the continent.

It needs to be addressed and can be done so through the right local structures and representation.

Having a “big bang” approach to improving governance as applicable to the Mo Ibrahim arrangement, is not practical and should be scaled up in a thematic approach to happen incrementally.

Along with the IDN members and ambassadors, other organisations that can assist in addressing this and finding local directors include the Institute of Directors and major accounting firms.

Conclusion

In conclusion, a learning from Africa is that it is essential to embed good corporate governance to protect business for the future and to grow in a responsible manner.

Chairman of the Future: Diversity at the Top

By Helen Pitcher OBE, IDP-C, President of INSEAD Directors Network, Experienced Chairman, NED and Board Committee Chair

The sustainability of companies and businesses to contribute and benefit all of their stakeholders, is increasingly at the forefront of the minds of Politicians, Regulators, Society Pressure groups and Individuals.

Business of the future

The journey of Boards over the last 10 years towards greater diversity has seen a significant shift and we are starting to see the benefits of these more diverse Boards performing effectively in response to a wide range of challenges.  However, we also need to focus more fully on the diversity drive for the Chairman role, both to reflect these recent diversity gains on our Boards and to provide Leadership and a catalyst for increased change and action from our Boards.  It is time to stop the wastage of talent and get on with the job of facilitating women to achieve the top roles in our companies, we cannot afford to ignore 40% of the potential candidates.

The skills of chairman

The research from INSEAD suggests that there is very slow progress in this area, in the UK for example, if we do nothing, it will take until 2027 to achieve 20% of women as Chairman of our Boards (INSEAD Research by Professor Stanislav Shekshnia).  We need to accelerate the pace of change and ‘skip’ a male generation to drive the appointment of female Chairman more quickly and beyond that 20%.

As you look at the skills and expertise required to be an effective Chairman- the evidence for what makes an effective Chairman is very clear.  The skills that emerge as critical and defining are; an ability to influence others without dominating, having an engaged vision of the future, strong emotional intelligence and coaching skills. These Behavioural-Emotional skills are to the fore are with, the ability to build trust upon which people can rely.

“To be effective, Chairman must recognize that they are not commanders but facilitators. Their role is to create the conditions under which the Board can have productive group discussions. They should recognize that they are not first among equals. They are just the person responsible for making everyone on their board a good director.” (Professor Stanislav Shekshnia INSEAD-Leading from The Chair Programme).

Why do we need to accelerate the pace of change?

Without intervention the progress to women in the Chairman role is too slow; the target should be to get to 35% by 2025 and 50% by 2027.  While the general diversity debate has moved on, advancements towards Women Chairman are pitiful, with still too many active resistors, Headhunters, Chairman, Nominations Committees, and perpetuating stereotypes that you need 10 years Board experience to be considered.

More Women in the Chairman role can help rebuild the trust in our companies and build businesses that deliver business performance combined with social and environmental benefits, leading to greater sustainability in our society.  The social case for women Chairman is clear, ranging from societal benefits, to greater empowerment and inclusion of women, visible role models, as well as access to a broader talent pool and range of diverse skills.

There is a growing and enthusiastic enclave of advocates for the acceleration of progression of Women into the Chairman role across many influential groups, however there is still an inertia of action.  Consequently, in the UK we have started the ‘Diversity at the Top’ initiative as an advocacy group to focus on this Female Chairman issue.

Blockers to progress

Women themselves will also need to bolster their resolve, expressing the ambition to be Chairman and reducing their self-limiting belief that it is beyond their grasp.  They need to overcome the mind-set which causes them to seek to ‘over-qualify’ and be ‘over-capable’ before targeting themselves at the role.

Educating Nominations Committee members in how to formulate gender neutral job and person specifications is key, along with conducting a detailed skills audit of the Board with Diversity as a core dimension. This is best practice, but not universally applied.

Also, a shift needs to be made in the Recruitment-Development processes, moving from a stereotypical view of the Chairman role profile, towards a more creative resourcing, on-boarding and mentoring support process developing more appropriate role models.

There needs to be more active sponsorship and development of women at the Board level to engage with development for the Chairman role.  This needs to go beyond the typical Big Four Information sessions on Audit/Risk/Cyber/Governance, into a more creative development framework of Board level development. This will require women to step beyond the existing Board for their development, recognising that many Boards already have limited time allocated to develop knowledge and the interpersonal dynamics within the Boardroom.

We need to increase our ambition and pace of change; it is time to drive practical and direct action to accelerate the acquisition of more female Chairman right across our companies.

It is time to push through this current psychological log jam and actively discuss the facilitative and revolutionary evolution to remove this limiting mental model and stereotype of a Chairman.  There will need to be a concerted effort from Headhunters, Chairman, the media and the other wide range of interested groups to draw on available mentors and sponsors as well as to challenge thinking and make this happen.

As a practical step in the UK the ‘Diversity at the Top Initiative’ gathered together a group of likeminded people from a range of backgrounds who are committed to increasing the number of Female Chairman, as an exemplar of Board performance and a beacon for the diversity of their Executive pipelines.  This group has focused on ‘The Future of Woman Chairman’, over a series of meetings and discussions, and provided a spotlight on the issues and more importantly the potential solutions to this logjam.

A summary of their deliberations and Action Plan, identifying the most important areas to highlight to ‘move the dial’ can be accessed at here.

 

 

Boards and Sustainability: From Aspiration to Action

Boards of directors can play a critical role in determining how much attention their firms pay to sustainability.

In this article, Craig Smith, INSEAD Chaired Professor of Ethics & Social Responsibility and Ron Soonieus, INSEAD Executive in Residence and Chairman of the Dutch NAA Sustainability Club explain how boards can turn their aspirations for sustainability into meaningful action, particularly in light of the fundamental questions boards should be asking in the wake of the COVID-19 pandemic.

From the authors:

“This article is our most elaborative on the subject to date. It includes a fresh take on our “Five Archetypes of Board Sustainability Behaviour”, new insights, recommendations, and our view on how COVID-19 changed nothing (and everything) for boards.”

First published by Management and Business Review.  To read the full article click here.

Synopsis

Boards of directors are vital to firms taking substan­tive action on sustainability. While prior research has suggested that boards pay little attention to the topic, a recent survey by Board Agenda suggests that many individual board members have ambitious aspi­rations for sustainability. Unfortunately, respondents also feel that their companies lack the people, knowl­edge, and tools to take action. We interviewed twen­ty-five directors from the boards of well-known firms, examining the obstacles to greater board engagement with sustainability, including board members’ charac­teristics. In analyzing interview responses, we found five distinct archetypes of board member behavior. These profiles help explain the divergence between the attitudes of board members toward sustainability and the frequently inadequate action of the board as a whole. Our findings suggest ways to motivate each type of board member and the value of auditing the knowledge and mindset of board members toward sus­tainability, offering six approaches to strengthening board engagement with sustainability. While the eco­nomic effects of the COVID-19 pandemic might appear to reduce businesses’ ability to become more sustain­able, we believe the wise course is to focus on the longer-term trend toward meaningful action. We are con­fident that many board members will agree.

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Confronting Governance Conundrums in an Era of Change

How have the role and focus areas of boards been evolving as the corporate landscape has changed? 

By Karen Loon, IDN Board Member and Non-Executive Director

On 16 October 2020, a diverse panel led by Helen Pitcher OBE, IDN President discussed “Confronting Governance Conundrums in an Era of Change” in a session held as part of the INSEAD Directors Forum.  Panellists included:

  • François Bouvard, Vice Chair of Institut Français des Administrateurs & NED
  • Karina Litvack, Non-Executive Board Director, ENI S.p.A., Executive Board Director, Chapter Zero, Member of Board of Governors, CFA Institute, Non-Executive Director, BSR
  • Elena Pisonero, Chairperson of Taldig and former President of Hispasat, former Spain’s Ambassador to the OECD; former Secretary of State of Trade, Tourism and SMEs in Spain

The panellists discussed a wide range of topics including:

  • What COVID has meant for boards
  • Digitisation and data
  • Changes in corporate governance in the future
  • How will the role of directors change in the future?

 What COVID has meant for boards

Over the past nine months, COVID has significantly changed our world.  Whilst some companies anticipated some of the changes, others were less prepared for them.  For many companies, it has created an acid test for workforces, management and boards who face big challenges ahead.  As management may not have enough time to focus on strategy and “reset”, there may need to be a big shift in the roles of management and boards.

The acceleration of change has also brought to the forefront companies which were less or more prepared due to their digital structures.  Those companies which identified the transition of change in society prior to COVID have been transitioning this fairly well compared to sectors which are struggling because they are still doing business in more traditional ways.  COVID has emphasised the need for boards and management to work more closely together to identify the future needs of stakeholders at large, not just shareholders.

The pandemic is an example of a systemic risk – something that none of us can solve because it needs to be solved at a systemic level, but all of us suffer the consequences of if it’s poorly managed, therefore, what are we going to do?  In considering the systemic impact of the pandemic, a broader question some companies have been considering is do boards understand systemic risk, do they talk about it, do they discuss it?  What can they do as companies to influence systemic preparedness, and is there a role for business in influencing the policy environment and the big social infrastructure investments that are made to protect both the society and business environment?

Some panellists feel that it is time for companies, led by their boards to introduce more ‘out of the box’ thinking and change the role of governance.  Boards and companies should not only be considering what they can control but think more broadly about all the things that are going on.

Digitisation and Data

Many companies have a misconception or misunderstanding of what digital is – it is what we can do with connectivity but doing things in a different way. Digital technology is the tool which allows companies to better reach their purpose.

Increasing the extent of use of digital should be viewed as a cultural change; it is not a matter of introducing new processes or new titles for the C-Suite.  It is how companies combine digital and physical means.  Companies need to have a mindset change and consider their whole value chain and how they can better manage and identify best opportunities to change their business models in order to thrive.  Companies cannot succeed at affecting this transformation unless they put people at the centre of it.

One suggestion was that in order to be better prepared for more digitalisation, companies should introduce ‘D’ in ESG because we should introduce as much data as we can to improve our decision-making processes.  Data is a crucial part of a digital mindset to improve decision making and identify and anticipate future risks.

Changes in corporate governance in the future

Boards are now looking at how they govern their companies more holistically, shifting discussion towards stakeholder governance rather than just shareholder capitalism.  Many companies are starting to address human issues (i.e. talent development) more effectively and are connecting the dots in terms of digital to human elements, recognising that at the end of the day that key stakeholders are customers and employees.  Digital has been providing companies ways to be more efficient.

Whilst sustainability is more on the mind of everyone, many companies are struggling with shorter term issues, so have pushed some longer-term questions aside for the moment.  This will continue if the pandemic drags on.  However, boards and management do need to revisit the way they work together on strategy in the longer term.  Whilst in the short term, companies may have lost focus on sustainability, in the longer term the view is there needs to be much more focus on this area as companies have a societal responsibility and everything they do should link back to the organisational purpose.

It is likely that the amount of time which boards spend focusing on more “out of the box” discussions in the longer term will expand, given that CEOs and management teams are required to spend much more time on shorter term issues.

How will the role of directors change in the future?

As the whole landscape changes, directors will also need to change.  This should start with the board of directors.  To be on top of all the issues, not only do they need to be open, read a lot and network well, they need to continue to improve their soft skills to be able to support their CEOs and teams in a supportive and yet challenging way.  Boards need to increasingly take a holistic view of their stakeholders, as well as how they support the development of talent, and how they use digital and data.  There is also likely to be much more interaction between boards and management, often digitally.

Behavioural Risk Management Matters – Be aware

By Ard W. Valk, Luc Albert and Déborah Carlson-Burkart

As illustrated in the previous article, it is not that difficult to list a number of operational risk management failures, including fraud and corruption scandals, non-compliance, as well as major accidents. The London whale, the Libor-scandal, material fines for banks for lacking anti-money laundering controls, the BP oil spill and its consequences, to name a few.

A common denominator and explanatory factor seems to be – surprisingly – human behaviour.

Risk management practices have devoted a great deal of attention to develop standard frameworks and hard controls in terms of design, existence and operating effectiveness. But behavioural and cultural aspects – the soft side – are less frequently addressed.

It is too simple however, to assume that assessing and improving human behaviour only is enough to prevent operational risk management failures.

In this article, control frameworks and individual behaviour are connected to organisational culture.

The internal or “hard control” factor

After emerging scandals that originate from fraud and similar types of failure, the classical response by regulators has been to impose regulations – mostly with regard to finance and risk legislation (Basel II, Solvency III, IFRS 9) – and to tighten them on a regular basis. Following new legislation, the regulator requires companies to adapt internal control frameworks accordingly. Key elements of controls are planning and control, tasks, responsibilities and authorisations.

Corporate governance codes (also) describe internal control requirements. If well implemented, this leads to the publication of a so-called “in control statement”, approved by the managing board, and reflected in the company’s annual report.

Another internal source for controls are the so-called risk & control self-assessments in which companies make an inventory of their most important value chains or processes. Key risks are identified which might materially impact the achievement of defined goals (likelihood and impact) and for which key controls are developed in order to manage, mitigate and monitor these key risks.

These type of controls, which originate from different sources, can be clearly identified. As they are relatively simple to test, they can be seen as hard controls.

According to COSO[1], commonly accepted objectives of a sound internal control framework are: effectiveness and efficiency of operations, reliability of financial reporting, compliance with applicable laws and regulations.

To this end and as described by the COSO, internal control must have five components: Control environment, control activities, risk assessment, information and communication, and monitoring. A typical example of a combination of hard controls is a risk management framework.

The human or “soft control” factor

In 2010, Prof. Dr. Muel Kaptein, KPMG Netherlands, researched the “human” root cause behind 150 corporate risk management failures. He discovered that they could all be linked back to one of eight “soft controls” that influence employees’ behaviour: clarity, role modelling, commitment, achievability, transparency, “discuss-ability”, accountability and enforcement. Consequently, he built a framework and methodology around the concept of soft controls which helps to understand, identify, measure and monitor organisational culture (see annex)[2].

Soft controls intervene in or appeal to employees’ individual performance (based on conviction and personality). They also provide insights about employee’s drive, loyalty, integrity, as well as their standards and values.

Soft controls generally include less-objective measures, like culture and the behaviour of management and employees. Inadequate soft controls can have a major impact on the achievement of business objectives. Hence, the upside potential for the company’s development is substantial, if these eight soft controls are adequately adopted and incorporated.

Soft and hard controls: A fine balance

Soft controls influence behaviour and can help with achieving goals and managing risks. They do not replace legislation, rules, protocols or procedures. Written hard controls are a strong fundament to show what the company control framework looks like. They also allow the company to provide proof to boards, regulators and other stakeholders that the company is in compliance with law and regulations.

But it does not stop with design and existence of a – hard controls- framework, as it is all about operating effectiveness.

Hard controls prove ineffective if they are not communicated, misunderstood, evaded or even deliberately neglected. Implementing hard controls in an environment without enforcement, accountability, or commitment (see annex) is doomed to fail.

Soft controls and the implicit conduct going along with them, serve as lubricating oil; without it the machine cannot run. Hence, soft controls can improve the operating effectiveness of hard controls, but it is not the other way round.

How to connect hard and soft controls?

One should start at the organisational level, once convinced that when behaviour improves, the chance of effectively implementing the hard control framework and of incidents occurring, decreases at the moment soft controls are prominently visible in an organisation.

Organisational culture is expressed in values and behavioural standards an organisation considers important. One of the most important indirect behaviour influencers within an organisation is the organisational culture. Behavioural standards can be set by using soft controls and determining ambition levels.

Defining and achieving a desired organisational culture is difficult. Soft controls are less tangible and there is often no strict standard against which they can be tested. The culture being aimed for should be transparent to all stakeholders and ethically sound.

At the moment an organisation is prepared to learn from failures and mistakes -materialised risks- and turns them into lessons learned in order to reduce likelihood and impact if it should occur again, we are there.

The most indirect behavioural influencer is management behaviour, including their leadership style and role modelling (“tone at the top”). In addition, awareness training, skill improvement and actively encouraging interventions at individual level are instrumental to achieve the desired organisational culture.

Behaviour and culture are an integral part of managing risks: Effective risk management is only possible if structure (hard controls) and culture (soft controls) are in balance. No matter how clearly risk appetite and controls are defined, people working in the company will not consistently make the desired decisions, unless corporate culture encourages them to “do the right thing” naturally.

The benefits of applying soft controls and paying attention to the human factor

As mentioned earlier: When behaviour improves, the chance of incidents occurring decreases.

But there is more.

When role modelling, enforcement, “discussability” and accountability are vividly present, it will open the door for continuous improvement. A critical attitude with regard to the going concern of a company in many aspects will improve the framework, can help in pro-activity and creates the fundamentals for a learning organisation.

Board member awareness and key learnings

Based on the important combination between hard and soft controls, board members should be aware of the following key learnings:

  • Human behaviour is a risk factor
  • In addition to hard controls, soft controls are necessary
  • Hard and soft controls interact
  • Design and existence of a risk framework on its own is not sufficient
  • Soft controls are a conditio sine qua non for operating effectiveness
  • Soft controls open the road for continuous improvement
  • Tone at the top starts in the board room

Concluding: A Board must really understand the company’s risk culture and the human factor and respective behaviour in order to set an effective risk framework and create the conditions for continuous improvement.

 

Author Ard. W. Valk IDP-C is a risk manager, Independent Board Member- Non-Executive Director and Independent Risk Advisor

Co-Author Luc Albert IDP-C is an Independent Board Member

Co-Author Déborah Carlson-Burkart IDP-C is a lawyer and independent board member

Annex

Soft controls – What does it mean?

Enforcement Is desired behaviour rewarded and undesired behaviour sanctioned?
Call someone to account Are people being held accountable by others in the organization for misconduct?
Discussability Do people feel comfortable to voice their opinion, raise issues and discuss dilemma’s?
Transparency Is people’s behaviour visible to others?
Achievability Are activities/targets realistic?
Commitment Do employees feel motivated and engaged to follow the rules?
Role modelling Do managers set a good example?
Clarity Are rules, procedures and desired behaviour clear?

[1] This most well-known and used definition, by both professionals and academics, is originating from the Committee of Sponsoring Organizations of the Treadway Commission or COSO (1992), which provided a first conceptual framework to internal control.

[2] Dr. M. Kaptein, Wallage P., Assurance over gedrag en de rol van soft-controls: Een lonkend perspectief, 2010, KPMG.

What really counts

By Xavier Bedoret, IDP-C, IDN Belgium Ambassador

In this period of pandemic, the financial statements of companies are shaken by a real storm. However, in analyzing the balance sheet and profit and loss account, are boards and audit committees focusing on everything that really counts?

A company’s accounts grant relatively little space to accommodate intangible assets, namely the value accorded to the commercial brand, the technological advantage, the company’s reason for being and its societal responsibility.

It is generally agreed that these intangible assets add value to the organization and broader society. Financial analysts deem that intangible assets today represent more than 80% of a company’s value. This value becomes apparent, for instance, during mergers and acquisitions, when the purchase price represents a multiple of the target’s own funds.

If the audit committee broadly ignores intangible assets, it is because many of these are not recognized in the company’s balance sheet. In fact, accounting rules, anxious to apply care and objectivity, do not recognize the value of a good reputation, of a brand created internally (for example, the Apple brand does not appear in the company’s assets), of a strong company culture, or of the quality of the company’s management and of its staff.

Certain organizations have nevertheless considered this issue; “L’Observatoire de l’Immatériel”, created in France in 2007, offers companies a dashboard of intangible assets; and the WICI (World Intellectual Capital Initiative) has promoted a method to value intangible assets since 2016. Both organizations believe that the intangible assets of today are the vehicles for value creation tomorrow. Their absence in the balance sheet should not lead to blindly managing the company’s financial strategy.

It is therefore advisable that the audit committee reconciles its analysis of what is in the accounts with the analysis of what isn’t. For the last few years, the board of directors and the audit committee have expanded their scope in order to intervene in the management of non-financial matters such as: business purpose, societal ambition, people satisfaction, disruption management. In order to be able to report meaningfully in these areas, companies must put in place new processes and measurement mechanisms. The audit committee must ensure their reliability.

In doing so, the audit committee has left the strict perimeter of the company accounts to take an interest in the company’s strategy and risk appetite, in its internal monitoring and organization, as well as in its performance and social responsibility.

The audit committee will likely be called upon to build connections between financial and non-financial information, many of which are concerned with more intangible elements.

This tendency has become apparent over the last few years in the publications of integrated reports and of non-financial reports that put the emphasis on companies’ reason for being, on their societal commitments, on the sources of value creation, and on sustainable development. Could the rigorous approach adopted by the audit committee be extended to the non-financial realm?

All interested parties, namely the shareholders, clients, suppliers, employees and lenders, will benefit from a truer investigation into what really counts.

First published in August 2020 here.

IDN Webinar: Board Dynamic Capabilities in Disruptive Times

Over the past year, boards have become increasingly more dynamic.  However, it is important that they use their energy positively.

By Karen Loon, IDN Board Member and Non-Executive Director

How have boards and their directors been adjusting their approaches to board work since the COVID19 pandemic started?  How have board practices changed?  What digital tools are being used to facilitate ideas, debate and support decision making?

These were the questions which members of the INSEAD Directors’ Network (“IDN”) discussed as part of breakout sessions held during an exclusive session for IDN members held on 16 October 2020, after the INSEAD Directors Forum.  The webinar was facilitated by Liselotte Engstam with support from Hagen Schweinitz, both IDN board members.

The session was opened by IDN President Helen Pitcher OBE, who shared with members details of the key initiatives which IDN have been working on over the past year, followed by IDN board member Thomas Seale who announced the winners of the Inaugural IDN Recognition Awards 2020.

IDN members highlighted a number of interesting trends in board dynamics over the past year.

Boards have become more dynamic

All members agreed that their boards have become increasingly more dynamic since the pandemic started.  Experiences however between boards have varied – for example, in China boards are now meeting in person, whereas in Europe most boards are still meeting virtually.

  • Focus of discussion is now on longer term strategies – For the first three to four months after the pandemic started, many boards were focused on securing the future of their businesses (for example immediate crisis management, stabilising their companies, cutting costs, improving cash flow management). However, in more recent months, boards have focused on their longer-term strategies and survival.
  • More frequent and intense discussions – Members shared that their boards have been having more frequent discussions, are under more pressure as there have been more emergencies to work through, and are having more intense conversations. Whilst boards are meeting more frequently, the meetings have generally been shorter, although in some cases in Financial Services, due to regulatory pressures, meetings have been longer.
  • Improved communication, in more depth – Communication amongst members has also changed, with boards increasingly using of digital technology, and having less formality. Many believe that their board discussions have improved, with some sharing that time has been found to explore in more detail areas such as staff welfare, diversity, team spirit, and proactive reinforcing of corporate culture.  Many directors however acknowledge that virtual meetings are more tiring.
  • Decision making processes have been impacted by not meeting in person – From the outside, it appears that boards are working well. With less travel time and more discipline, board meetings are starting on time, members are more prepared, and discussions are shorter and more to the point.  However, some questioned whether this may be “form over substance”, and whether boards are suffering in other ways due to an absence of physical meetings, and whether some important discussions are not taking place, which would have taken place, for example over coffee.  Decisions at times are taking longer, having been somewhat impacted by the inability of directors to network in person.  Maintaining trust and relationships have become more difficult.
  • Dynamism and innovation vs compliance – Some board members indicated that their boards have been struggling to find a balance between dynamism and innovation vs compliance. This is especially so in highly regulated industries, such as Financial Services.

Not all boards may have become more effective

As to whether boards have become more effective since COVID, there were mixed responses.

For the most capable boards there was a reflection on areas such as:

  • How inadequate the recovery and resolution/ disaster recovery policies were
  • The ability of people to innovate in times of crisis (Apollo 13 mentality) far exceeded expectations
  • The opportunity the crisis created to make a step change in the way the business functions and for some reimagining the purpose.

For the less capable / less diverse boards, there has been lots more stress, centralising of control, dysfunctional blame culture and general myopic behaviour.

There was a view that boards need to ensure that they find a balance between progress vs being dysfunctional.  As Helen Pitcher highlighted “… boards are working harder, some boards are stressed, that’s bringing about some dysfunctional behaviour in some, and some very positive behaviour in others”.

Directors need to find time for personal reflections

  • Mental health and wellbeing – Members also shared that mental health and wellbeing of both management and the board in a Zoom world continues to be important, with management still under significant pressure, as are the board. Board members need to be supportive of their CEO and staff, and thoughtful on when to intervene.
  • Find time to reflect – Board members also need to find reflection time to allow themselves to slow down and think away from the Zoom calls. More time may be required to be spent in out of camera sessions with other board members to seek to defuse tensions.
  • Be careful not to be over boarded – In recognition that directors are generally spending more time with each board, members shared that now may not be a time to be over boarded. Directors should think seriously about whether they want to be on boards given the time investment and energy required in situations such as at present, and that one cannot opt out of boards when things are too busy.

IDN’s next webinar for members on “Sustainability and Climate in the Strategy and Board Agenda” will be held on 18 November 2020.

Distinction-cum-baggage: The board director’s track record

By Pamela Ravasio, IDP-C and IDN Board Member

A recent Bloomberg article found the following as they analysed the past and present professional affiliations of more than 600 directors and executives of the world’s 20 largest banks: Only few individuals had experience in renewable or sustainable industries. Far more had ties to polluting industries: At least 73 individuals even have at one time or another held a position with one or more of the biggest corporate emitters of greenhouse gases, including 16 connected to oil or refining companies.

More specifically: Of the four (4) banks where the boards directors offered some expertise in renewables or sustainability, every single one had significant links to ‘greener’ companies – notably in electric & utilities. The opposite held true for the remaining 16 of the 20 analysed boards.

In more succinct words: the study found that board expertise and prior affiliation of board directors correlated very well with the extent of investments into ‘emitting’ or ‘renewable’ energy companies.

Ironically, it is precisely the directors’ prior track record and experience, one of the very reasons why they got (s)elected onto the board, that could jeopardize their board’s forward decisions. Because – as the Bloomberg study showed – there are very, very few directors or even senior executives, with sufficient experience and track record in either renewables or sustainability. No matter their industry background.

…there are very, very few directors or even senior executives, with sufficient experience and track record in either renewables or sustainability. No matter their industry background.

To that point: there are even much fewer, if any, board directors in circulation that have a track record on how to marry the prosperity of a (their) company with business models that go above and beyond the traditional ‘growth model’, to just name one example. Hence, there is a tendency in relying on their past winning strategies to tackle the challenges in the wait for us to experience – globally as well as within individual businesses. This is like taking to the skies of the 21st century with technology from the era prior to the industrial revolution.

Track record bias: what is it, and why does it matter?

Track record bias is the unintentional bias directors introduce onto the board precisely through the very genuine, authentic and well-earned achievements of their prior career experiences.

Example: The former country manager of a large Aluminium firm with an excellent reputation for engagement with indigenous peoples and H&S joins the board of a major synthetic polymers company.

  • Pros: The new board director is very familiar with extractive industries, their environmental profile, the challenges around labour conditions and the global nature of such a low-margin business.
  • Cons: It may be tough for this new board director to consider viable alternative technologies based on renewable and/or recycled materials of origins, and the respective differences in client relationships, partnership models and global sales and logistics approaches.

Track record bias is something every director brings to the table once joining a board. In itself it is neither negative nor positive. In fact, consciously managed (key word: board thought diversity) it can add tremendous value by directing the board’s discussions into new, and so far unfamiliar terrain and in this way contribute to the resiliency efforts underway.

However, unsurprisingly the opposite it true if a board is not put together with clear priority given to thought diversity, as can be seen in the results of the Bloomberg research mentioned above.

And there is a somewhat simplistic reason for those results: Most board directors are or have been reasonably successful CEOs and CFOs, or else high-flying executives, of large(r) companies. Often in industries that are traditionally considered ‘adjacent’ to the company on whose board they are sitting.

Successful they may have been. But until very, very recently their role would not have required them to understand the implications of the Paris Climate Agreement, the SDGs, or the scientific consensus around climate adaptation for example. For most, such insights were allocated to the job descriptions of their sustainability speciality staff, or possibly the communications team, who in turn would have been required to pitch the traditional business case for any initiatives they saw necessary.

Board Diversity and Complementarity: The Origin of ESG[1] success and capability

In other words: not only do today’s board members by and large have very little practical experience when it comes to renewables, sustainability, or economic models that do not rely on pure and simple GDP growth. But they also have often built track records in industries that since decades are shown (and known) to be among the largest emitters, and thereby at the root of the current climatic challenges.

Therefore, unless such board directors are aware and accepting of the baggage they bring to a board table, and are willing to question the modus operandi of their industries of origin, their industry track record will only lead to more of the ‘old same’. And in this way merely perpetuate and replicate the issues found in precisely those emitting industries.

Once more: this is not to diminish such directors genuine track record acquired through hard work.

It is to point out that their track record on its own is incomplete. Their board is in needs of a complementary skill and knowledge set for proactive decision taking in the decades to come.

[1] ESG / Sustainability is one area where board diversity is of utmost relevance because the world we shortly will be living in will be unrecognisably different from the one we live in now. This is not to say that other subjects – digitalisation for example – do not require it. They do. The difference is fundamental however: ESG / Sustainability requires a fundamental different economic modus operandi made possible by new, so far unknown business models. Digitalisation in contrast will certainly result in new business models, but may not necessarily affect the fundaments of the economic system as such.