2017 annual review of emerging corporate governance issues
Ontario Teachers' Pension Plan (Ontario Teachers') is one of the world's largest investors, managing a diversified global portfolio of over C$171 billion in net assets. Over the years we have demonstrated a commitment to good governance and have worked to promote the adoption of good governance practices in our investee companies.
Corporate governance continues to evolve. We constantly monitor current and emerging governance issues and trends to inform the views presented in our Good Governance is Good Business: Corporate Governance Principles and Proxy Voting Guidelines. We have recently updated the document and posted the 2017 edition on our website. Notable Proxy Voting Guideline updates address boards of directors, management compensation and shareholder rights. A summary of all the Guideline changes can be found on page 12 of the document.
In 2017, consistent with our belief that effective boards lead to effective governance, Ontario Teachers' will be focussed on a few key corporate governance areas: board processes that identify and manage environmental and social (E&S) risks and opportunities; how board decisions on executive compensation demonstrate an alignment between pay and performance; and the processes in place that create a strong board culture and encourage diversity.
We understand that at times governance practices can deviate from accepted best practice to reflect unique circumstances present at a particular company, in a market or across an industry. Ontario Teachers' remains committed to being open-minded and pragmatic in our assessment of governance trends and in the development and application of our Proxy Voting Guidelines.
The Board's Role in Identifying and Managing E&S Risks and Opportunities
As Ontario Teachers' continues to focus on the integration of E&S issues into our investment process, we are looking to better understand E&S risks, including climate change, in our portfolio. A key element of this risk assessment is to understand the processes that boards have in place to identify and manage E&S risks faced by the company.
Climate Change Presents Risks and Opportunities: On one hand, climate change has the potential to expose the financial returns of our portfolio to significant risks, impacting the pensions we safeguard. However, climate change could also present investment opportunities. Effective boards will successfully manage the risks of climate change while demonstrating the foresight to identify the opportunities presented by climate change and working with management to develop and implement a strategy that capitalizes on those opportunities.
Therefore, we will look for disclosures that evidence the individual and collective capabilities of boards in assessing and understanding climate change risks and opportunities. Individual skills in assessing the impact of climate change are found in the director biographies and the board skills matrix. A board's collective abilities are demonstrated through a clear description of its role in the development, implementation and oversight of a company's climate change strategy, and the process by which the board is informed of and monitors climate change risk.
Consideration of Environmental & Social Metrics in Executive Compensation Plans: We will look for disclosures that clearly identify relevant E&S risks, along with a description of how these risks are being managed by the board. We believe linking a portion of executive compensation to the successful management of key E&S issues is an effective tool to focus management on important E&S risks.
Aligning Executive Compensation to Performance
Ontario Teachers' considers board decisions on executive compensation to be indicative of board effectiveness. Therefore, we will continue to critically assess compensation program structure and the board's rationale for compensation decisions in our determination of the alignment between compensation and performance.
Pay Ratios: The subject of pay ratios has received a lot of attention in the media, among shareholders and from regulators. While the focus for some has been on a ratio of CEO pay to the average employee, we consider a ratio comparing the CEO pay to his or her direct reports to be more illustrative of potential compensation issues. Absent a compelling rationale, a large CEO to direct report pay ratio may raise concerns about a board's ability to oversee a compensation system that links pay and performance.
Discretionary Payments: Over the past two years we have noticed an increasing amount of "outside of plan" or discretionary compensation payments. Such payments are not part of the normal course and are typically described as sign-on, severance, retention and discretionary payments. While we understand some outside of plan awards are contractual obligations, we expect that discretionary awards will be used sparingly and in exceptional circumstances. Unfortunately, our studies raise concerns that the frequency and size of discretionary awards are making common what is supposed to be exceptional. We typically expect a board will grant outside of plan awards infrequently and their decisions will be supported by convincing arguments.
Creating Effective Boards with Respect to Culture and Diversity
Culture: Board culture is apparent in the decisions of a board, the breadth and depth of shareholder communication and the robustness of governance processes. We believe an effective board culture begins with individual directors. Thus, building a strong board culture is dependent upon how a board evaluates, recruits and selects directors. As a result, we will continue to engage with issuers to understand the robustness of these processes.
Diversity: Board and senior management diversity continues to be an important issue to investors and regulators. We are seeking clear disclosure, are supportive of initiatives that request more transparency on a company's approach to promoting diversity, both on the board and in senior management.
As corporate governance continues to evolve we are encouraged by the efforts of boards to monitor the environment and adapt their governance practices to keep abreast of emerging developments. We are further encouraged when boards seek and consider the views of shareholders on their corporate governance practices.
We welcome dialogue and would be happy to discuss these and any other governance issues with you in more detail. It is against a backdrop of cooperation and evolution that we are contacting you today to encourage a continued and constructive dialogue between issuers and shareholders. To date our conversations with companies and boards have been invaluable and informative, allowing us to gain a better understanding of the motivations and rationales that drives the decision-making processes of public companies.
Should you or your colleagues have any questions or concerns, please don't hesitate to contact Paul Schneider, Head of Corporate Governance, Public Equities at (416) 730-5307 or firstname.lastname@example.org.
Senior Managing Director, Public Equities