Sustainable investing: unpacking the corporate governance factor in ESG
Environmental and social issues often command the most attention in conversations related to environmental, social, and governance (ESG) investing, leaving the G out of the spotlight. However, corporate governance practices determine a company’s approach to building stakeholder value, including how it seeks to mitigate risks and pursue opportunities related to the E and S factors.
What does G in ESG stand for?
G stands for governance, which essentially means the policies and practices—and ultimately the values—that guide how a corporation is operated and governed. Despite being a core component of ESG, corporate governance is often overlooked, and poor governance practices can create fertile conditions for corporate malfeasance, as seen in accounting scandals such as the Enron and WorldCom episodes in the early 2000s and, more recently, the Volkswagen emissions scandal of 2015.1
What does governance entail?
Governance may be understood as having two key components: corporate governance and corporate behavior. The governance piece involves the makeup of a company’s board, ownership, and management teams as well as its accounting, auditing, and corporate disclosure practices. Good governance goes beyond seeking diversity on the board in terms of gender, race, and background. It also involves ensuring that there is a good mix of people who are independent board members from outside the company and can provide a fresh perspective and real oversight, mixed with insiders who are more knowledgeable about the company. Through their oversight roles, independent directors and audit committees can also serve as gatekeepers and potentially reduce the risk of fraudulent accounting practices.
Under the corporate behavior umbrella, there’s the company’s business ethics, transparency, and regulatory compliance as well as the presence of any anticompetitive practices, corruption, or instability.
| Key elements of the governance pillar | ||
| Corporate governance |
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| Corporate behavior |
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How can good governance enhance a company?
Good governance can:
- Affect the bottom line: Just as good governance is key for a company to pursue its goals and objectives, weak governance can have a big impact on a company’s financial health. According to a 2019 Diligent report,2 recent poor governance decisions at 14 companies cost shareholders a total of $490 billion in value a year after the governance crises occurred. It’s also possible that investors may feel less inclined to associate themselves with or invest in stock or bonds issued by a company known to have poor governance practices.
- Maximize operational efficiency: Sustainability-oriented governance leads to better opportunities for companies to put sustainability practices in place, which then can be incorporated into the values and rules of the organization. In this way, with good governance practices in place, a company may protect long-term investor, social, and environmental interests with long-term operational efficiency.
- Create good faith in the market: Addressing and actively working on high-profile governance issues such as gender diversity and equity shows investors that the company and its board are listening to societal cues. In recent years, institutional shareholders have increasingly been pushing for greater representation of women on boards and in executive ranks, and many companies have begun emphasizing the potential financial benefits of more diverse and inclusive workplaces. These actions not only potentially benefit customers and employees but may also add to the growth of communities.
- Create a strong brand: As more millennials become employees, consumers, and investors, their growing influence is likely to put companies under greater pressure to become good corporate actors if they wish to win this young generation’s loyalty. A 2018 survey by Deloitte found that far more millennials believe business leaders are making a positive impact on the world than government or religious leaders.3 By creating a strong brand that embraces good governance, companies may be able to gain the loyalty of millennials as well as those from other generations who place a high priority on ethical corporate behavior. This is also relevant in terms of attracting the best talent in the market, as more employees seek roles in companies with strong corporate values.
The growing importance of good governance
Recent headlines about corporate governance among oil and gas majors and the growing attention paid to sustainability and ESG factors in general mean that publicly traded companies will continue to face pressure to expand their objectives beyond profits and shareholder interests and embrace a broader set of goals and stakeholders. Just as firms have the incentive to make products and services that people want to buy, they’re equally incented to approach governance and corporate practices generally in ways that make customers and clients comfortable doing business with them.
1 “Volkswagen’s ‘uniquely awful’ governance at fault in emissions scandal,” cnbc.com, 10/4/15. [LAL1] 2 “A case for modern governance: The high cost of governance deficits,” Diligent Institute, 5/21/19. 3 “2018 Deloitte Millennial Survey,” Deloitte, 2018.
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