Irresponsible lobbying: how can it become the most material risk in your portfolio
Imagine: You’re a portfolio manager for a 30-stock portfolio within the Weak Governance Exchange (WGX). One of your investments is in bottled water company, Water Power. The business model is simple: selling bottled water. What is different about this business is that half of their costs come from having the most influential Government Affairs team across the whole index. While the team operates within the realms of what is lawful, their only incentive is to increase the company’s quarterly earnings. Notable achievements include:
Lobbying for additional water rights: Water Power’s water rights are so extensive that leaves them enough extra water to sell to farmers and miners and make a profit with higher margins than selling bottled water. Mining companies, and food producers are struggling with increases in water costs.
Lobbying councils to obtain permits to build their facilities in prime locations. Water Power has a real estate portfolio worth more than its core business. This has deeply impacted real estate developers who are confused as to how a bottled water factory got permits to build in prime residential areas and obtained tax breaks.
Finally, the team have effectively lobbied for a tax cut, (arguing that water is a human right). This tax savings has allowed them to further strengthen their Government Relations team with a number of influential ex-politicians.
Water Power’s performance over the last few years has been outstanding, making it one of the most profitable companies in the WGX. However, your fund has not performed as expected. A number of your other holdings, including miners, farmers and real estate companies have been adversely affected by changes in regulation and a more unpredictable political environment, and have performed poorly. You suspect Water Power indeed has a lot of power, but that the positive outcomes of their lobbying have been detrimental to everyone else, including your fund.
This example illustrates how weakly-governed and ill-incentivised corporate lobbying has the potential to be one of the most materially damaging risks for investors.
A matter for good old corporate responsibility and corporate governance:
Corporate lobbying can be a great avenue towards better policy by providing policymakers with data and information they may not have otherwise had. But successful lobbying that pushes for narrow interests of a company or group, disrupting the natural agenda of democratically elected governments, can create unintended negative consequences not only for society but also the rest of the business community and investors.
Lobbying, and successfully influencing a democratically elected official, can undermine democratic processes if not done in a responsible and ethical manner. Therefore, if a company decides to lobby government, it’s a decision that boards need to weigh up seriously. As investors, part of our active ownership role is to ensure that lobbying activities are considered within the scope of the company’s long-term interests, values and corporate responsibility principles. Lobbying without robust guardrails, governance and control mechanisms can impact a company’s social license and reputation, and more broadly, its shareholders.
It’s a matter of incentives: Lobbying should be closely governed by the Board
A large proportion of executive remuneration is rightly linked to financial incentives. However, giving management ‘free rein’ to use lobbying to meet those financial metrics is like bringing a bazooka to a peaceful demonstration. It might get the job done, but can have many long-term unintended consequences, as illustrated in the hypothetical Water Power example. Furthermore, it has the potential to hide flawed business models that overly rely on external factors or ‘loopholes’ which can be deceiving for investors.
Thankfully, boards generally don’t have the same incentives as management. Directors are not usually remunerated on a performance basis, in an effort to avoid bias or conflicts with shorter term decision making [1]. A board’s key core duty is to provide oversight and direction of a company’s strategy. Board members should also represent their long-term investors’ interests.
Arguably non-executive directors are better placed than management to put guardrails and principles around a company’s lobbying activities aligned with the longer-term strategy of a company, within a broader macro environment. They also have a more expansive perspective of the company and are able to overcome the so-called “right hand, left hand inconsistency” which can exist when an organisation (directly or indirectly) lobbies in contradiction to its strategy or to what it is communicating to stakeholders.
The state of play
Fidelity wanted to understand more about how boards are thinking about these issues, so in 2023 we asked 20 Australian boards about the risks associated with lobbying and how these are managed. Here are our key findings and reflections:
Societal expectations are amplifying scrutiny risks – Given increasing societal expectations, company policy engagement activities are coming under more scrutiny and the potential reputational risk from mismanaging political engagements is compounding. It’s critical for companies to engage internally and externally in a consistent way to avoid backlash from stakeholders. From our findings, robust governance structures could help to mitigate any inconsistency between corporate pledges and their actual political engagement practices, however few companies were able to provide details of these.
Interestingly, sectors that have previously experienced social license issues tended to have more robust and transparent approaches to policy engagement. For example, companies in the financial sector, which underwent the Royal Commission, had on average more comprehensive approaches to policy engagement. In addition, sectors that are retail facing in general, appeared to have more mature policy engagement practices. This is likely due to tighter regulations and a focus on social interests (e.g., financials, entertainment, healthcare, etc.).
Silos can lead to discoordination risk – Some companies lacked a coordinated approach to policy engagement, thereby creating silos across the organisation with little oversight from the board. Companies that engage across several levels of government (e.g., federal vs. state) and across regions appeared to have a higher risk of mismanaging policy engagements due to the complexity and differing accountability. Without a unified approach to engagement, companies can face conflicting interests internally which can lead to an inefficient use of resources.
Silos can also cause the “right hand, left hand inconsistency” problem. One of the key triggers for our research was a corporate engagement meeting where an executive was presenting a company’s Climate Transition Plan to investors, and couldn’t answer the question if the company had put a submission for the ‘Safeguard Mechanism’ (Australia’s policy to curve emissions in higher emitting sectors) that was aligned with the plan. This raised questions about how and if lobbying budgets were being deployed with a ‘whole of company’ strategy.
As investors, we expect effective allocation of resources from companies, and therefore expect that lobbying and political engagement is fully aligned with a company’s broader long-term strategy.
Short-term vs. long-term objectives leading to conflicting risk – A key challenge for investors is how we assess misalignment between short-term and long-term interests. Companies may engage in public policy that they consider to be an effective short-term strategy with a good return on capital, however this engagement may conflict with their longer-term strategy. Over a longer timeframe, this may impact the company’s social license to operate and directly conflict with the objectives of both long-term shareholders and other stakeholders. From our research, few boards were able to clearly articulate any existing controls for ensuring balancing of long-term interests with short-term interests.
Lack of policy engagement impact assessments – While most company boards are actively involved in the process and monitoring of engagement activities, there was very little discussion or focus around assessing the ‘impact or influence’ that the activities have on policy outcomes. The cost-benefit analysis, if it exists, is largely conducted by the management team, and in most cases it’s unclear whether it’s also assessed at the board level. The lack of transparent impact analysis limits a company’s and an investor’s ability to understand the overall influence a company has on policy development and whether the engagement has been in the best interest of shareholders.
At the RIAA Conference Australia in early May, I joined Andrew Cox, President at Australian Professional Government Relations Association, Naomi Hogan, Company Strategy Lead at Australasian Centre for Corporate Responsibility (ACCR) and Dean Hegarty, Co-CEO at RIAA, to discuss ‘Corporate lobbying and investor stewardship: When priorities collide.’ In this session, we explored the challenges faced by investors in understanding companies’ lobbying activities, the risks for investors and how these can be addressed. More conversations on this topic are required between investors and corporates, and we would be happy to hear from other investors that are interested in discussing ways of addressing this issue. If you attended the conference, please check your emails for a link to view this session recording.
[1] ASX Corporate Governance principles and recommendations February, 4th Edition, 2019 cgc-principles-and-recommendations-fourth-edn.pdf (asx.com.au)
Daniela Jaramillo, Head of Sustainable Investing – Australia, Fidelity International
Daniela is the Head of Sustainable Investing – Australia, at Fidelity International, where she has been since August 2021. She is also a non-executive director at the Responsible Investment Association Australasia (RIAA). Prior to Fidelity she was a Senior Responsible Investment Adviser at HESTA, one of Australia’s largest pension funds. While at HESTA, Daniela set up and was the Chair of the investor group of 40:40 Vision, an investor led initiative to achieve gender balance in executive leadership. Daniela has held roles in responsible investment across the UK (Legal and General) and US (Wespath Benefits and Investments) before settling in Australia. She was also a member of the PRI Stewardship Advisory Committee between 2017 and 2021.
Originally from Ecuador, her career began as one of the founding members of a not for profit focusing on improving education and health outcomes in the region. Daniela holds an MSc. in Environment and Development from London School of Economics and a B.A in Journalism from Universidad San Francisco de Quito.
All information is current as at 15/04/2024 unless otherwise stated.
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