By Hilary Schmidt, International Banker
They say that the third and final part of a trilogy is usually the most forgettable of the three (think The Godfatheror Alien movies). And given the dry nature of the “G” in ESG (environmental, social and corporate governance) investing, one might be inclined to think the same of corporate governance, especially when the “E” and the “S” typically receive far more attention for the emotive and humanitarian natures of the issues they cover, such as climate risks (the “E”) and human rights and community engagement (the “S”). But while that might be true, the “G” remains just as important to a company’s overall performance and is even a crucial foundational determinant of the company’s likely long-term performance concerning the “E” and the “S”.
Indeed, despite corporate governance referring to the often less glamorous side of ESG—that is, the governance factors of companies’ decision-making, with investors typically seeking to assess how well a company is being run and whether it is operating in the best interests of its stakeholders—it is, nonetheless, the oldest of the three pillars of ESG investing, with the quality of governance having long been a cornerstone of investor research. “Corporate governance includes factors such as corporate structure, board composition, business ethics and anti-corruption,” the World Economic Forum (WEF) explained in June 2022. “Although our understanding of corporate governance is evolving alongside the rise of ESG, it generally predates environmental and social risks as a corporate priority. Consequently, many key governance indicators cover information that readily exists and may already be included in corporate disclosures.”
Today, the definition of what constitutes sound corporate governance has expanded and evolved to encompass a broader array of considerations, most seeking to offer greater transparency in a company’s operational model. As such, accurately gauging this particular component of the holy ESG trinity requires understanding the types of corporate behaviours that are characterised as “good” governance, which have strong positive impacts and bode well for investors, and those considered “bad”, which can seriously erode a company’s reputation and its shareholder returns.
Indeed, evidence of good and bad governance can be determined by examining a whole host of factors, some of the most common being the company’s board and management structures, workplace culture, employment policies, compliance standards, information disclosures, levels of shareholder engagement, auditing history and interactions with competitors, suppliers and other stakeholders. “A company that is governed well works within its regulations and policies and is transparent and fair. Good governance mitigates and controls risks to avoid mismanagement, potential scandal and regulatory sanctions,” explains Isle of Man-based offshore savings, protection and investment provider RL360 Insurance Company Limited (RL360°). “Shareholder rights are also key to good governance. Part of this picture is executive remuneration and avoidance of bribery and corruption, denuding shareholder value for the gain of individuals on the board or within the company. Avoidance of any conflicts of interest within a company shows good governance.”
In partnership with sustainability-focused investment firm RobecoSAM (Robeco Schweiz), in May 2019, S&P Dow Jones Indices listed the key elements or dimensions that it considers part of its corporate-governance score to determine whether a company is being well run:
- Corporate governance: evaluating the systems that ensure a company is managed in the interests of all of its shareholders.
- Codes of business conduct: an ethical consideration focusing on whether the company’s code of conduct and compliance practices sufficiently deter bribery and corruption within the organisation.
- Risk and crisis management: How effective are the company’s risk-management framework and practices, and are they sufficiently independent from business lines? Also, are long-term risks being identified, along with their potential impacts, and what efforts is the company making to mitigate them?
- Supply-chain management: Companies that are globally expanding and outsourcing certain business functions must realise they are also outsourcing their own standards of corporate conduct and their reputations. As such, strategies should be in place to manage the risks from external supply-chain links effectively.
- Tax-strategy criteria: Does the company have a clear policy addressing taxation issues and the potential risks associated with the company’s tax practices? Conflicts of interest could also arise in this regard, whereby it may be prudent to reduce the tax a company pays in a certain operational jurisdiction, even when this could prompt accusations of unfairly exploiting tax-avoidance opportunities that are not available to local populations.
- Materiality: Is the company adept at identifying sources of long-term value creation? And does it understand the links between long-term issues and the business case, develop long-term metrics and transparently report these items publicly?
- Policy influence: Are companies using financial means to influence public policies, legislations and regulations? And how transparent are company disclosures related to such activities? These criteria are more relevant in countries in which large or even unlimited degrees of corporate lobbying of politicians are deemed acceptable.
- Impact measurement and valuation: assessments of the facilities companies have to address various social needs, including strategic social investments, capabilities to gauge their broader societal impacts through various metrics effectively and impacts of any externalities not accounted for in their financial statements but that may eventually have the potential of being priced in.
Investors are also increasingly keen to verify whether companies are not only carrying out such governance policies as stated above in a timely and accurate manner but are also doing so with business ethics taken into consideration and by a board of directors that is transparent, accountable and diverse. This means that through the increasingly common practice of “investor stewardship”, investors seek to engage more meaningfully with companies to help improve their governance standards and ultimately maximise overall long-term value. It also means that social factors are being more frequently integrated into assessments of corporate governance.
Indeed, it is worth emphasising the importance the “G” plays in advancing a company’s efforts regarding the “E” and the “S”. An ineffective corporate-governance framework will habitually feature among factors deemed chiefly responsible for poor environmental and social standards, whether that be weak or ineffective leadership, unsatisfactory anti-corruption policies or lobbying activities that undermine and/or contradict a firm’s environmental and social goals. “Investors should expect the governance element of ESG investing to continue to evolve to reflect changing attitudes, with an increased focus on improved governance as a way of ensuring that companies meet their responsibilities on environmental and social issues,” according to Deutsche Bank Wealth Management. “More generally, governance in terms of the balance of power between corporate stakeholders will also have to be balanced against broader social and environmental concerns to get acceptable ESG solutions.”
ESG also requires a commitment to the long-term, according to Leo E. Strine, Justin L. Brooke, Kyle M. Diamond and Derrick L. Parker Jr. of the law firm Wachtell, Lipton, Rosen & Katz, who noted in a November 2022 article published in Harvard Business Review (HBR) that most companies—even the great ones—are unable to maintain excellent standards at all times under the weight of shifting market dynamics. As such, investors should be aware that company perseverance through tough times might be required “to pursue profits in an ethical and sustainable way, because there may be situations (say, a pandemic) when it is necessary to reduce a dividend to keep paying the workforce and comply with high standards of consumer and environmental protection in accord with a well-thought-out business plan,” the authors wrote. “As historians have noted, if Abraham Lincoln had to face an annual election, he would likely have been tossed out of office early in the Civil War instead of being able to be judged on his full record in 1864.”
Taking this long-term approach to ESG assessments is also crucial in accounting for the consistently evolving nature of ESG. By no means are the definitions concerning this still-blossoming area of investing and organisational strategy set in stone, which means how we view a company in five years may drastically differ from how we view it today. And as technology, ESG reporting and even the nature of the issues themselves (such as climate targets and data security) continue to change over the coming years, so, too, will the nature and scope of ESG assessment—governance included.