Getting to Grips with Ethical Risk
Rob Hayward, Chief Strategy Officer at Principia, explains how asset owners can avoid investing in companies at risk of ethical failure by focusing on human culture and capabilities.
In recent years, investors have invested significant time, attention, and resources towards building a more sophisticated approach to the identification and management of ESG-related risks and opportunities.
As companies have become more adept at managing and measuring sustainability performance, more data is available to investors seeking to understand potential risk factors. And as compliance and risk management approaches have evolved to take account of a broader range of ESG-related risks, investors have been able to adapt due diligence and engagement approaches beyond a check-box audit of anti-money-laundering and anti-bribery measures, for example, to understand the effectiveness of risk management.
Risks for investors
The advent of the Corporate Sustainability Reporting Directive (CSRD) and the Corporate Sustainability Due Diligence Directive (CSDDD) will give investors even greater and more granular information on sustainability performance and the sophistication of risk management. A proliferation of data may give investors greater confidence in their understanding of ESG risks across the portfolio, and lead to increased faith in the ability of due diligence processes to uncover hidden risks.
But greater scrutiny and transparency is also bringing greater risk. Stakeholders are increasingly unwilling to accept companies’ statements at face value, and with growing concern over greenwashing, sustainability commitments are under the microscope.
For investors, there is a growing risk of investing in a company that fails to keep its promises, exaggerates its claims on sustainability performance and impact, or neglects to pay sufficient attention to its broader responsibilities to society.
Each of these risks we might term ‘ethical failure’. Increasingly, ethical failure is not simply defined by criminal activity, or egregious failures to abide by regulatory standards. In the context of growing expectations and intense scrutiny, ethical failure can be understood as any failure to live up to the organisation’s obligations and promises, often in highly public, highly damaging ways.
For investors, this broader understanding of ethical risk will require more sophisticated approaches to due diligence. In an environment in which expectations are shifting constantly, a black-and-white approach that focuses on compliance capabilities and immediate red flags is unlikely to be sufficient.
Instead, minimising the risk of investing in companies at risk of ethical failure requires investors to understand the human and cultural factors that shape the company’s ability to respond to shifting expectations and ethical dilemmas.
Human judgement
Implicit across environmental, social and governance issues is the question of ethics, and the role of human judgement in determining the right thing to do. How do organisations determine the right course of action, particularly when values and commitments may be in conflict?
The Covid-19 pandemic, the invasion of Ukraine, and the increasingly fraught landscape of diversity, equity and inclusion (DEI) initiatives in business have each posed challenging ethical questions that go to the heart of organisations’ commitments to stakeholders.
Principia’s recent Ethics Study, conducted in partnership with the International Chamber of Commerce, revealed corporate leaders are facing an ever-more complex operating environment. Eighty-four percent of leaders believe that the events of the last three years have required them to address more complex ethical questions, and 80% report that they have had to make moral and ethical judgment calls where the right thing to do was not clear.
In this environment, what will differentiate leaders is the ability to exercise human judgement. But traditional investor approaches to due diligence and engagement are ill-suited to understanding these human factors. Assessments of the quality of management are often one of the weakest elements in due diligence, and many investors are still playing catch-up in building the knowledge and skills necessary to engage constructively with leaders on more complex ethical questions.
But as a more complex operating environment demands not only mature systems and processes but sophisticated judgement, a genuine understanding of culture and capabilities will be essential to the management of risk.
Enhancing due diligence
The challenge of more effectively identifying companies at risk of ethical failure begins with enhanced approaches to due diligence.
The strategies open to investors will vary significantly according to the nature of their relationship with the target or acquisition. In a competitive deal environment, data and access to key leaders is likely to be at a premium; different deal scenarios may offer greater access.
In either case, potential investors might usefully focus on understanding human capabilities, and the evidence (or lack of evidence) that leaders understand the critical ethical issues for their business and have insight on what is required to respond effectively:
How aware are leaders of the critical ethical issues in their sector?
To what extent are leaders able to talk coherently about ethical issues?
Are leaders expected to develop core capabilities in ethical analysis and judgement as a core competency of their role?
Do leaders see ethics primarily as a black-and-white question of legal and regulatory compliance, or as a series of grey areas that demand judgement?
To what extent do leaders understand what it takes for their people to make effective judgements in ethical grey areas?
How do leaders give themselves confidence that the culture of their organisation supports people in exercising effective judgement?
How do leaders understand how likely their people are to speak up with ethical concerns, or when witnessing misconduct?
The qualitative understanding of the organisation that these questions provide can be supplemented by quantitative data that supplements the traditional focus of due diligence on past legal and regulatory issues. If the organisation has a culture or engagement survey, to what extent do their numbers compare favourably with other players in the sector? To what extent is there evidence that this data is understood and acted upon? Are there areas of concern that suggest capability gaps?
More active engagement on ethics
Beyond the benefits of enhanced due diligence, investors can leverage significant influence on ethics through more active engagement.
With ethical expectations on companies shifting rapidly over the last decade, and the operating environment becoming ever-more complex, board and governance capabilities have rarely kept pace. Equipping portfolio managers and engagers to identify and surface ethical risks and opportunities will contribute immediately to the quality of governance and oversight, encouraging leaders to step back from the immediacy of day-to-day challenges and think differently about their ethical responsibilities.
In addition, active engagement on ethics can act as a spur for leaders to improve the mechanisms by which they monitor and track the culture of their organisation and the capabilities of their people. Whether through enhancing existing approaches to monitor the health of the organisation’s culture and the core underlying drivers of ethical conduct and decision-making, or by creating regular opportunities for people to share their experiences through independently facilitated listening sessions, leaders have numerous tools at their disposal to ensure that their people are capable of acting ethically and responsibly.
A focus from asset owners on these capabilities as critical safeguards and risk mitigation strategies will help to ensure that these issues are addressed as a priority, and that a focus on ethical culture is seen as a core responsibility of every leader across the business.
Setting ambitious industry standards
Investors also have an opportunity to go beyond risk mitigation, and towards an approach that builds on in-house knowledge and capabilities to position portfolio companies as industry leaders on ethics and integrity.
In every sector, ethics and integrity are playing an ever-growing role in shaping companies’ brand, trust, and reputation. Clients and customers are increasingly seeking relationships with partners who have a clear societal purpose, a distinct and transparent value proposition, and a commitment to honouring their promises and commitments.
For investors, there is significant value in bringing understanding and expertise that can help portfolio companies to move beyond an ‘ethics = compliance’ mindset and towards an approach that embraces ethics and integrity as a competitive differentiator. In our experience, this applies particularly to start-ups and scale-ups – and therefore to venture capital funds and early-stage investors – where capabilities in ethics may sometimes be an afterthought.
This engagement represents a valuable opportunity for active stewardship, in helping leadership teams to focus on the factors that will determine success in a new era for business leadership on ethics and integrity.
Embracing the grey
As expectations on businesses grow, so will the challenges for investors in accurately assessing risk. But for those investors prepared to move beyond a black-and-white approach centred on compliance, the rewards are potentially significant.
Those who spend the time to understand the human capabilities required to succeed in an era of greater scrutiny and transparency will enhance their approaches to due diligence, engagement, and stewardship, pooling resources and expertise to build greater capacity to deal with the most significant challenges of our age.
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