How to use the board of directors to build a more resilient enterprise.
Utility boards of directors tend to resemble each other. Pick up any annual report and you're likely to find a group portrait comprising a representative of the investment community, a distinguished accountant, the president of a local bank, the owner of a small but growing local business, perhaps a venerated athletic coach, a responsible public activist-an assortment of indisputably sterling individuals representing the community served by the utility's franchise. Such a board reflects a "stakeholder" view of the utility as an enterprise engaged in the judicious balancing of multiple claims and interests.
These boards efficiently perform the legal functions expected of them, such as approving budgets, and audit reports and officer appointments. They review and approve Sabanes-Oxley compliance meaures. They receive briefings about the utility's business filled with facts, statistics, and organizational charts. They review significant business initiatives and investments and provide (usually) or withhold (rarely) approval. They receive binders filled with performance statistics. They proffer business judgment when solicited. Their very presence imposes a form and regularity to the enterprise, as well as a process discipline around important decisions. Their stakeholder sensitivities help ensure that the company remains sound, sensible, and mainstream.
This stakeholder model of board leadership is valuable and, in many respects, durable. It keeps the utility grounded in its multiple missions.
But this model is also under pressure today from two directions. First is a rising standard of diligence and prudence. Increasingly, statute and case law are placing on board members the burden of knowing with some specificity what the company is doing, not simply what management tells them the company is doing, and taking reasonable steps to ensure that the company's actions are in the interest of shareholders. The industry debacles of 2001, still fresh in the minds of board members, serve as strong cautionary examples of the perils of overreach.
From the other direction comes a rising standard of value performance. Regulatory reform, new wholesale markets, and industry restructuring have opened new opportunities for value creation. These opportunities have expanded the range of corporate aspirations and redefined what it means to be a superior utility. Investment analysts mutter dark warnings of a "growth expectations gap."
As boards address the six major areas of responsibility listed in Figure 1, many are finding that the first two-reviewing and monitoring corporate strategy-have become their greatest challenge. As standards of care become more stringent, and as value demands become more aggressive, the margin for error narrows and the overall level of risk rises. The strategic issues facing the board today are more complicated, the uncertainties greater, and the potential vulnerabilities both more consequential and harder to discern ().
As a consequence, familiar patterns of interaction between utility board and management no longer seem fully adequate for either group. This inadequacy can express itself dysfunctionally, either through mutual disenchantment-a frustrated, under-informed board and a defensive management team-or through an erosion of useful boundaries-a micro-managing board and an order-taking management.
One approach for avoiding these pitfalls has been to reform mechanisms of "governance," adding board committees, requiring outside director dominance in certain decisions, scheduling discussions with only outside directors present, . But once these structural reforms have been implemented, the substantive question remains: How can the board best use its limited time to provide effective corporate oversight that meets legal standards of caution and prudence while also helping management marshal the resources and drive to create shareholder value?
Faced with the expectation that they will know everything important about the company they direct-and with the reality that no matter how conscientious individual directors may be, the time and attention they can give to the task are necessarily limited-the key challenge comes down to choosing and condensing information. In our observation of constructive interactions between boards and management, this process of information distillation, when successful, is supported by three qualities in the board-management relationship: strategic clarity, risk appreciation, and structured dialogue.
While much attention lately has focused on the board's important role in ensuring integrity and compliance, the effective board sees its role more broadly. In a study of companies with market capitalization exceeding $1 billion, Booz Allen found that over a recent four-year period only 13 percent of the total loss in market value suffered by the bottom quartile of those companies was attributable to compliance failures. Eighty-seven percent of the loss was attributable to operational and strategic failures. Since compliance failures are frequently an attempt to obscure strategic failures, the imbalance is likely even greater than these numbers suggest.
Strategic failure comes in two forms: One is the spectacular kind that arrives suddenly amid tumbling share prices, the other the quiet kind that creeps in unobserved until the enterprise is chronically lagging most of its peers. The former is the failure of wrong decision, the latter of indecision. Because it's easier to spot the signs of recklessness than the signs of stagnation, boards tend to focus on the things management shouldn't do. But it's the things management should do to fortify the resilience and value of the enterprise that have the larger impact, and that deserve at least an equal share of board attention.
This is where strategic clarity helps. By "strategic clarity" we mean:
Explicit definition of the objectives of the enterprise; Logical linkage between these objectives and the strategies selected for achieving them; Shared understanding of what resources, capabilities, and environmental realities are needed to make these strategies successful; and Candid acknowledgment of the risks and uncertainties that might render the strategies ineffective.
No one expects the board to develop a strategy. That is management's responsibility. But one should expect the board to help actively in defining the objectives of the enterprise and then to press for clear answers on these issues of linkage, capability, and risk. In the course of asking these questions, and discussing and challenging management's answers, the board helps management refine its thinking and gains for itself the understanding needed to sift the important from the unimportant in the information made available to it.
Any strategy involves risk. What distinguishes the good strategy is not absence of risk but the clarity with which the risks are identified and the availability of measures to mitigate those risks. It is not the board's duty to eliminate risk, but rather to ensure that it is appreciated and anticipated by management.
In recent years energy companies have become experts in the technical refinements of risk management. They have adopted sophisticated metrics to track capital exposure, return on capital exposed, and value at risk. Yet while these techniques have been valuable in their own realms, they also have been confined. Their application for the most part has been bound within the visibly high-risk box of trading. Meanwhile the industry's really catastrophic meltdowns have come from risk at a higher level, existing entirely outside that box: a high-risk market structure, for instance, in the case of the California utilities, or a high-risk web of financial structures and financial commitments at Enron. Both types of meltdown, ironically, occurred in companies that were celebrated for their risk-management sophistication and proficiency.
As the events of the past few years amply demonstrate, risks at the strategic level (, material risks to the accomplishment of the company's strategic objectives) arise from many sources other than the trading floor: regulatory policy, technology commercialization, fuel prices, capacity swings, credit ratings, natural disasters, and so on. Those utilities that believe avoiding or exiting trading is a low-risk strategy are likely to be disappointed. For the most part they're simply withdrawn from a risk zone that is intimidating because exotic to one that is comfortable because familiar. The risks in that comfort zone may be different, and the company may feel accustomed to them, but they are no less real. Risks remain, and the board needs to understand them.
Fortunately, risks at the strategic level, unlike risks on the trading floor, can be framed in an intuitively accessible way. Once the board understands the logic and the factual premises that link the company's strategy to its objectives, it is in position to appreciate the impact of variations from those premises that may arise as events unfold, to consider the likelihood of such variations, and to assess the adequacy of management's fall-back plans if those variations occur.
This is why executives and board members must treat risk and strategy as two sides of the same coin. Strategy can be assessed only when risk is understood. Risk can be assessed only when strategy is understood. This point seems self-evident, yet governance practice rarely acknowledges it. Typically when the board reviews strategy, that review occurs at a general level. Management pitches the strategy in the most appealing way possible, rarely taking it apart to expose the (inevitable) underlying uncertainties. To the extent alternatives are presented, they often take the form of one alternative that is stupid, or another that is formally recommended. Moreover, these strategy presentations typically are made to the board as a whole, thereby limiting the opportunity for probing interaction. Meanwhile, risk is being addressed in either the audit committee or the finance committee, usually in traditional terms of financial risks and compliance. Linkages between strategic deliberation and risk assessment are purely serendipitous.
This typical separation of risk discussion from strategy discussion brings us to the third element that is indispensable to constructive board engagement: structured dialogue. Board meetings tend to be highly choreographed events. This is what permits boards to get through all the business that's required during the short time available. But for that reason they are awkward venues for the kind of unhurried conversation that is needed to understand corporate strategy and corporate risk. Some board members with whom we have spoken say that to pose a probing question in such a meeting is regarded almost as a discourtesy.
Three devices readily are available to break out of this constricted framework. All of them are in common use. By deploying them in a coordinated way, the board and management can reposition the dialogue on strategy and risk to permit constructive engagement.
Retreats. On an annual or semi-annual basis, the board and management need to meet together with a focused agenda. This should be limited to strategic direction, strategic performance, and risk. Such meetings, of course, require their own discipline and structure, but of a different kind from that employed at normal quarterly meetings. In retreats, the structure aims to draw out discussion, and to pose issues in non-confrontational ways that permit thoughtful exploration. Ideally, these sessions are framed not as "approval" meetings, where management presents a final plan and argues for board consent, but rather as deliberative meetings, where management presents genuine alternatives and straw-man recommendations.
Committee architecture. Board committees exist primarily to provide venues for more detailed and more expert discussion than is possible at the general board level. To provide the linkage needed between strategy development and strategic risk assessment, those two areas belong in the same committee. What that committee is named-audit, finance, governance, whatever-is a matter of company preference. What is important is that each subject is discussed in full knowledge of the other, by a group that is responsible for both.
Key performance and risk indicators. Clear objectives, clear strategies, and clear risk assessments can be tracked through a handful of high-level tracking indicators. (If it's not reasonably apparent what those indicators are, it's likely that the strategy needs further refinement.) The board and management should agree on those indicators, should design a dashboard that gives frequent, succinct updates on those indicators, and should provide a protocol for diagnosing and discussing unfavorable variations in those indicators. Strategic moments-those occasions when existing assumptions are shaken by events and new thinking is required-don't necessarily conform to an annual planning cycle. Board and management need to agree on what a strategic moment looks like, ensure that they have the indicators to recognize it, and provide themselves the occasion for exploring and responding in a timely manner to its implications.
In finding the right space for engaging the board, management will strengthen its own understanding of company strategy and its own capacity for strategic success.
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