What is the importance of Governance in ESG?

Over the last few weeks, we have been exploring ESG investments, breaking down each element to get a better understanding of the whole. This time, we are exploring the role of G (governance). So what is governance? Governance includes a broad range of corporate activities. This includes company policies, information disclosure, compliance and auditing, as well as board and management structures.

For instance, when investors review governance, they will wish to have the knowledge that a company’s business practices are ethical and that it’s reporting is transparent and accurate. Equally, they will be looking for policies that indicate the encouragement of shareholder engagement and that the board is diverse and accountable. Good governance is a critical part of ESG investments as it involves understanding the potential of an investment strategy and the wider operating environment.

Just like the ‘E’ and ‘S’ of ESG investments, investors can screen for practices that relate to governance. Such measures can be used to rule out investments and companies where governance policies and practices are exposed to unacceptable levels of risk. One example of a negative screen could be a business that is associated with, or involved with, ethically and legally questionable practices. A positive screen could include companies that have robust and transparent governance policies.

Example topics where companies can be screened for governance include long term strategies to the environment and climate change. For instance, investors will be looking to see how a company’s policy seeks to protect the environment in the long term to avoid future climate damage. Another issue is gender diversity, as many institutional shareholders insist upon a positive representation of women amongst corporate boards. Research by Morgan Stanley illustrates that when there is a better balance of both men and women within a workplace, a company can deliver better returns and less volatility. Gender diversity is thus profitable for both companies and investors.

Alongside this, S&P Global reported that there is increasing evidence that the ‘G’ element of ESG yields better corporate returns. Why? Unlike the E (environmental) and S (social) data, governance has been complied for a longer time period and the criteria regarding what comprises good governance has been widely scrutinised and accepted. Back in 2003, Harvard researchers Gompers, Ishii, and Metrick developed a Governance Index known as the G-Index. It consists of 24 governance provisions that weaken the rights of shareholders and ranks companies in accordance of their scores. Six years later, further research from Bebchuk, Cohen, and Ferrell (2009) identified six corporate governance provisions that illustrate what is considered to be poor governance that can negatively impact valuation. These provisions are called the E-Index, with the E standing for entrenchment. Thus, markets are able to identify which firms have good governance and which firms have poor governance.

As we move forwards with ESG, governance will play a critical role in shaping the corporate landscape. Investors will be looking to establish a connection between ESG performance with risk reduction and value creation. Under the governance strand, companies with a positive screen will be able to boost their overall reputation and brand equity whilst enjoying greater employee commitment and productivity.