Remember the old Sesame Street song, “One of These Things Is Not Like The Others”? Well, the three letters of ESG can bring it flooding back. If the acronym defines the attempt to reshape capitalism so it works better for society, then that last letter can seem the odd one out.
Environmental: check. Social: check. Governance: huh? Although it seems tacked on at the end like an afterthought, governance plays a critical role in ensuring the credibility of the first two elements in ESG and the overall trustworthiness of an entire company.
Order, stability, and predictability have a high value in themselves, and they can only be delivered through a structured mechanism – whether for governments or corporations. ‘Governance’ is the umbrella concept behind the structured mechanism.
Governance describes the controls, internal practices, and procedures that an organization adopts to comply with the law, govern itself, make effective decisions, and meet the needs of stakeholders.
To be clear, governance relates to factors around corporate decision-making and the policymaking of countries. Governance describes the controls, internal practices, and procedures that an organization adopts to comply with the law, govern itself, make effective decisions, and meet the needs of stakeholders.
For corporations, this centers around such topics as bribery and corruption, diversity, executive pay, tax strategy, and treatment of whistleblowers. For countries, governance revolves around the issues of corruption, financial stability, infrastructure, and overall business environment.
Why Does This Matter to Investors?
Research shows that corporate governance ensures that a company is managed in the interest of all shareholders (owners, management, employees, and its wider community). Crises and scandals in the past have triggered a global interest in corporate governance, which has also resulted in increased regulatory oversight.
Understanding governance risks and opportunities in decision-making is critical, as poor corporate governance practices are often at the core of some of the biggest corporate scandals. If you follow the markets, you’ll know that corporate governance issues regularly dominate the headlines.
The New Sustainability Agenda
Sustainability is redefining the relationship between companies and their employees and other stakeholders. Businesses should act now to ensure they stay ahead of this transformation.
Many boards are taking a multi-pronged approach to integrate E, S, and, specifically, G into the overall corporate strategy and unlock its full potential. This includes articulating a strong purpose that employees and customers can relate to, evolving incentive and reward structures, and rethinking board and committee compositions.
Investors are also becoming more active; they are pushing for greater diversity at the board level. Despite gradual improvement, progress remains slow and is not uniform across industries or countries. They are increasingly voting against boards that lack women at annual general meetings (AGMs).
Did you know …
According to Refinitiv (a well-known information and data provider), Australia, Japan, the United Kingdom, and the United States have the most companies scoring highly on governance practices.
As of 2021, women globally earn 37% less than men in similar roles, and closing the gender pay gap has been painfully slow. As of the 1st of September 2021, 26 women are Heads of State and/or Government in 24 countries. At the current rate, gender equality in the highest positions of power will not be reached for another 130 years.
Taxation policies, too, are drawing investor attention, and there are increasing calls for fairness and transparency amidst ballooning public deficits. For example, in May, the European Parliament approved a Commission proposal implementing the recent international agreement on a global minimum corporate tax rate of 15%.
While the goal of good governance is clear, the design and implementation of such schemes have multiple challenges. One is to determine how much of executive pay should be linked to the various factors of E, S, and G. However, unlike the E and S criteria, much historical data is available on G factors and their impact on corporate performance.
Finally, there is the challenge of defining the correct key performance indicators (KPIs) and metrics to measure the various governance structures put in place by the corporates.
Financial Service Companies Have a Critical Role
Financial services companies, in particular, have a unique opportunity to address major societal issues without a significant trade-off in growth or profits. This puts them in a position to impact almost every corner of the economy. Using this influence to create fit-for-purpose governance will enable corporations and governments to respond to today’s megatrends – demographics, technological disruptions, and climate change.
While the ‘G’ in ESG is often forgotten among considerations around climate risk and societal implications of economic activities, there is already substantial empirical evidence to suggest that better governance yields better corporate returns. Governance is not the odd one out, just the quiet one in the background ensuring everything runs smoothly and correctly.
This article reflects the personal views of the author.
