ESG: Why G(overnance) is overlooked and what you can do about it

ESG: Why G(overnance) is overlooked and what you can do about it

The adoption of ESG investing has grown rapidly as investors increasingly integrate ESG and climate factors alongside financial factors to measure the resiliency of portfolios to long-term ESG risks and opportunities (MSCI, 2021). More socially conscious investors are also asking more from their investments, making decisions based upon their own ethics and values and how these align with a business’ stated mission and conduct.  From the early days of Corporate Social Responsibility (CSR) to the ESG revolution, the core principle remains the same: to be successful a company needs to be both doing the right thing and to be seen to be doing it.

What is ESG, anyway?

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ESG, an initialism for “Environmental, Social and (Corporate) Governance”, refers to three broad categories/areas of interest for these socially responsible investors, who consider it important to incorporate their values and concerns into their selection of investments (Corporate Finance Institute, 2015). 

The three broad categories MSCI (2019) identify as being the objectives of these investors are values-based, impact, and ESG integration:

  • Values-based investing aims to align investments with an organisation’s or individuals’ ethical values through a preference for the industries and companies they invest in. 
  • Impact investing targets investments to generate a profit from positive social or environmental impact in line with the investor’s views or mission.
  • ESG integration aims to assess long-term financial risks and opportunities related to ESG issues as a core component of building a resilient and sustainable portfolio for the specific purpose of enhancing long-term risk-adjusted returns.

Why should I care?

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Pressure is growing on companies to pay attention to ESG issues as it becomes increasingly popular. In 2018, sustainable investing assets in Europe totalled $14.1tn, and $12tn in the US. Across the globe in 2019, 75% of retail and institutional investors applied ESG principles to at least a quarter of their portfolios (Alva, 2020). MSCI (2021) describe three main drivers that are accelerating ESG investment:

1. The world is changing

  • Global challenges (e.g climate risk, increased regulatory pressures, social and demographic shift, and privacy and data concerns) represent new or increasing risks for investors.
  • As a result of the COVID-19 pandemic, economic pressures placed on some industries have affected companies’ exposure to ESG risks and their ability to manage them.
  • Companies face rising complexities and greater scrutiny if they are not adequately managing their ESG or climate risk.

2. A new generation of investors

  • Over the next 2-3 decades the millennial generation is expected to direct between $15-20 trillion into US-domiciled ESG investments, roughly doubling the size of the market.
  • A growing body of research suggests millennials are asking more from their investments.

3. Better data and technology for more meaningful insights

  • Advanced technology, including AI and alternative data extraction techniques, help minimise reliance on voluntary disclosure from companies. 
  • Machine learning and natural language processing help us increase the timeliness and precision of data collection, analysis and validation to deliver dynamic content and financially relevant ESG insights.

So incorporating ESG considerations in my business strategy will make me more attractive to investors?

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Yes, it is very likely it will do.

McKinsey’s (2020) survey of C-suite executives and investment professionals found that 83% expect that ESG programs will contribute more shareholder value in five years than it does today. One quarter would also be willing to pay a premium of 20-50% to acquire a company with an overall positive record on ESG issues over a company with an overall negative record, and 7% would go so far as to pay more than 50%. This willingness even applied to those who did not think that ESG programmes had any impact on shareholder value, who indicated they would still pay a premium of 10%.

Evidence of the link between ESG and financial performance is also increasing. A recent report released by Refinitiv (2020) used correlation analysis to determine if a relationship existed between Refinitiv combined ESG scores and financial performance in large-cap firms across the EU, U.S., Australia and Asia. They placed particular emphasis on the question of how firms’ stock returns, market value, and volatility are related to their ESG performance. They found a negative correlation between ESG scores and stock volatility, demonstrating that firms with higher scores are less risky, on average.

Further investigation into ESG scores and excess returns using panel regression models concluded there was a positive relationship between ESG scores of EU firms and their excess returns. Highly scoring Australian and South Korean firms also had a positive, but not significant, relationship. The resilience of more sustainable firms during the COVID-19 crisis was also higher, with companies with low ESG scores having losses 50% higher than those with high scores.

Hold on, what’s an ESG score?

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Well, put simply: it’s how well you perform when assessed against a set of pre-defined ESG measures. The problem is, it’s actually not all that simple. 

By 2018, more than 600 ESG ratings and rankings existed globally and there is a worry that the current methodologies allow companies to cherry-pick how they are assessed. Some even joke that “if you want a better ESG rating all you need to do is change your rating provider”. Adoption of standard measurement and methodology is the area of ESG data that investors think needs the most development, and the majority cite poor quality/availability of data and analytics as the biggest challenge to adopting sustainable investing (The FT Moral Money Forum, 2020).  

The movement towards more rigorous measurement and disclosure began in the late 1990s with the launch of  the Global Reporting Initiative (GRI), a non-profit offering sustainability-focussed reporting guidance, which has since become part of a “big five” group of standard setters along with:

  • CDP
  • Climate Disclosure Standards Board (CDSB)
  • International Integrated Reporting Council (IIRC)
  • Sustainability Accounting Standards Board (SASB)

Additionally, the Task Force on Climate-Related Financial Disclosures (TCFD), which specifically focuses on climate change, has developed a framework on which others can build, rather than develop their own standard. More than 2,000 organisations have expressed support for their recommendations, including companies with a collective market capitalisation of almost $20tn and financial institutions responsible for $175tn worth of assets (The FT Moral Money Forum, 2020).

Which framework or provider you choose is not a question someone can necessarily answer for you, and the sector and size of your company will likely influence which one is the right fit for your business. 

How does governance fit into all of this?

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The governance component of ESG has been less popularised than the “E” and “S” and has been incorporated with varying degrees of success without capturing the imagination of stakeholders or wider public attention, except in cases of extreme failure (Alva, 2021), but interest is on the rise.  Forty-five per cent of executives and investment professionals who responded to the previously cited McKinsey survey (2020) indicated that complying with regulations and meeting accepted industry expectations for performance, transparency and/or accountability is the most important aspect of ESG activities, a significant increase of 10 percentage points from 2009. 

Governance represents the internal system of practices, controls, and procedures a company adopts in order to govern itself, make effective decisions, comply with the law, and meet the needs of external stakeholders (McKinsey, 2019). As laid out by OneTrust (2021), the governance criteria within ESG considers the way in which organisations manage topics such as:  

  • Tax avoidance
  • Executive pay
  • Corruption
  • Director nomination
  • Cybersecurity
  • Company leadership
  • Audits
  • Internal controls
  • Shareholder rights

Good governance is also an essential component in assessing and reporting both the environmental and social impact of a company. Companies choosing not to publicly report their ESG impact have trouble gaining the trust of investors, stakeholders, the public, and regulatory authorities. They now need to prove investment in resources, and responsibility for making changes, by having research and reporting plans in place (One Trust, 2021).

Quoted in AESC magazine “Executive Talent” (undated) Donna Zarcone, President and CEO of the Economic Club of Chicago, says that what investors are looking for is transparency:

“Investors are asking for a clearer picture on what corporations are doing around sustainability-related questions, around customers, employees, suppliers, and communities. Ultimately, if corporations do the right things for these stakeholder groups, the shareholders will benefit in the long run. The investors are saying, you’ve got to be doing things right on all these other fronts so that you will have a long-term, sustainable corporation that benefits your shareholders.”

Okay, but what does “good” look like?

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According to KMPG (2021), good governance drives value creation by ensuring business resilience and continuity. In the context of ESG, they have set out seven principles to gain a competitive advantage:

1. Strategy 

  • Developing a credible strategy for meeting ESG targets requires the board to be aware of, and comply with, existing commitments.
  • Integrating ESG at the core of corporate strategy is a prerequisite for investors and other stakeholders who regard effective ESG management as improving performance by facilitating identification of reputational, operational, and financial risk which, in turn, creates commercial opportunities. 
  • Good governance tends to translate to high performance.

2. Data and Disclosure 

  • Good governance requires stakeholder engagement in corporate strategy.
    • Progressive corporations actively manage their climate and transition risks by tabling realisable ESG strategies for investor scrutiny. 
  • A critical element of engagement is the availability of systems that generate reliable data to assess physical and transition risks and publication of those disclosures in accordance with TCFD recommendations.
    • These recommendations set the global standard for climate disclosures, against which premium listed companies in the UK are required to report.
    • Likely to be mandatory for large corporations, banks, asset managers and pension schemes by 2025.
  • The Sustainable Finance Disclosure Regulation will also require other financial market participants including EU asset managers to disclose an array of sustainability data.

3. Annual General Meetings

  • Stakeholder activists have challenged corporations on working practices, key worker remuneration, and climate change.
  • Shareholder resolutions asking banks to cease financing carbon-intensive businesses have become a feature of recent AGMs. 
  • Increasingly, there is an expectation for an annual vote on climate disclosures, a ‘Say on Climate’ resolution, and publication of transition plans to net zero.
    • The UK Investor Forum has gone as far as asking that the Government make ‘Say on Climate’ votes mandatory for listed companies. 
  • Boards may be well advised to avoid conflicts before they arise, by proactively offering advisory votes which would encourage the corporate and its investors to collaborate in the formulation of transition plans and strategies.

4. Merger & Acquisition (M&A) Transactions 

  • When exercising governance of transactions, boards must be aware of ESG factors, including possible government intervention in M&A transactions where governments feel they need to protect national interests. 
    • For example, the Competition and Markets Authority is likely to follow Germany’s approach to countering the power of strategically important digital businesses. 
  • Good governance should insulate against risks of foreign investment or merger controls, and heightened regulatory scrutiny especially in relation to cross-border investments in the fourth industrial revolution’s tech sector. 

5. Litigation Risk 

  • Heightened threats of litigation and broader regulation are emanating from ESG and also from public demand for corporations to take greater responsibility. 
  • Boards must scrutinise their supply chains to protect their businesses from litigation, including class actions.
  • In English law, separate corporate personality protects parent companies from automatic liability for harm caused by their subsidiaries. 
    • Parents of multinational groups should still limit their involvement in their subsidiaries’ business. 
    • For example, an action for environmental and economic damage allegedly caused by a subsidiary’s oil pollution in the Niger Delta was successfully brought in the UK courts against an overly involved London parent.
  • Good governance must manage this litigation risk by achieving an appropriate balance between implementing group-wide risk management policies/procedures and the parent’s degree of control over subsidiary operations.

6. Diversity and Inclusion 

  • Climate change (The “E”) is no longer the only priority for corporate boards and senior management. 
  • Stakeholders are requiring boards to act on a myriad of governance and social issues relating to D&I, human rights and corporate responsibility.
    • Boards must be aware of (and engage in) their management’s actions to address human rights and diversity and inclusion.
  • The human rights impact on businesses and their supply chains present a significant risk for corporations, especially if they have global operations. 
    • Civil claims against corporations have escalated exponentially, giving rise to legal risk as well as reputational risk. 

7. Executive Pay

  • Recent attention on executive pay has required boards to justify their decisions on pay (along with pension contributions and other benefits) to shareholders, investors, regulators, employees as well as the general public. 
    • Increasingly measured against a corporation’s ESG and sustainability performance
    • For example, FCA’s requirement for premium-listed companies to disclose their business’ impact on the climate in reports from 2022 is likely to lead to a further alignment between pay and sustainability metrics.
  • Those who utilise clear reporting to inform of the impacts of events like the pandemic are better placed to explain how decisions relating to executive pay were made. 
    • The Financial Reporting Council has demanded better reporting and detailed disclosures on remuneration. 
  • Companies need to be mindful of the requirements of the Corporate Governance Code, simply relying on doing what they’ve done previously will not be enough.  

That’s a lot to take in, how does someone even begin to put a number on that?

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It is quite a lot to get your head around, for sure.

S&P Global (2019) asserts that governance data, unlike the “E” or “S”, has been compiled for a longer period of time and that criteria for what compromises good governance and its classifications has been more widely discussed and accepted. Initially, metrics specifically tried to identify and measure poor governance, namely the Governance Governance Index (“G-Index”) and the Entrenchment Index (“E-Index”).  The newer Economic Dimension Score (“EDS”) is made up of eight criteria and is designed as a way to evaluate corporate governance. Additional key measurements that evaluate the quality of a company’s management systems, as well as its ability to manage long-term risks and opportunities, are also included. I’ve already taken up quite a bit of your time by now, so if your interest is piqued you can gain a deeper understanding of these criteria from S&P (2021) and Goby (2020). 

Wow, okay. Is there anything you can do to help me?

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There’s nothing we can do to force the hand of you (or anybody else) if you aren’t the type of person who wants to act transparently and with integrity. If you are, we might just have a solution to help you demonstrate good governance at your company.  

Purposeful can help you disseminate your ESG strategy, goals, and reporting progress to your investors and other stakeholders. Doing this creates accountability, builds your reputation, and enhances confidence in your organisation by voluntarily sharing information, making you more attractive to current and potential shareholders. It also provides an opportunity for stakeholders to scrutinise your strategy and give feedback. 

Additionally, it makes it easy to gain attestations from executives and board members that they have been provided with, and are committed to, your strategy and codes of conduct, reducing the potential of reputational risk. 

Using our platform in this way creates an auditable, single source of truth for your company for a variety of interactions such as shareholder resolutions, decision-making processes and outcomes from committees and other governance structures, and policy communication. 

Having these accessible records on a data-rich platform makes reporting easier and can act as your evidence of robust internal practices, controls, and procedures and that you have placed ESG considerations at the core of your company culture. You can even use the platform to implement a whistleblowing channel so your employees can be safe in the knowledge that there’s no chance of their report falling into the wrong hands.

To see how we have begun to implement ESG considerations in our own business, take a wander over to our ESG page.

Schedule a meeting with one of our team to hear more about how we can help you with governance at your organisation and get an insight into the wider applications and improvements we can make to your daily work life.