Environmental and social concerns are often centre stage when it comes to socially responsible investing. Issues such as plastic pollution, climate change and diversity are often uppermost in many investors’ minds. However, Governance, the ‘G’ in ESG, is important too. In fact, of the E, S and G factors it can often be the most significant to returns as it determines the overall direction of company policy and how key risks are addressed.
Governance factors measure the quality and robustness of a company’s structure and practices. Good ‘corporate governance’ means being open and honest, respecting the needs of all stakeholders including shareholders, staff, customers and suppliers, as well as society and the environment, and being accountable for actions.
Specific issues can include board structure, independence, executive pay and auditor independence as well as the fair treatment of workers and health & safety. More broadly, it is about business ethics, transparency and accountability. Diversity and equality are also important. Studies have found that people with different gender, race and experiences can jointly contribute to more robust and innovative ideas from which a company is likely to benefit.
Watch our ESG diaries video from William Matthewman: Discussing Governance
All investors should take note of governance
It is sensible for all investors to consider governance factors, whether they think of themselves as socially responsible or not, as they help shape the structure, culture and strategy of a company and have a significant impact on financial performance and risk.
While failures in environmental and social practices can generate bad publicity and might make it harder for companies to borrow or raise funds, they’ll rarely be terminal for a company’s prospects. Poor governance, on the other hand, can lead to more immediate and, potentially, catastrophic outcomes. To take just three examples from the 1990s, the corporate disasters of Enron, WorldCom and Parmalat were reportedly the result of failures in governance.
How do funds consider governance?
Given the importance of good governance, all fund managers should be giving it serious consideration. We would tend to consider the ‘G’ in ESG as a mandatory part of any professional investor’s due diligence process. However, some place more emphasis on it by making it a central component of the investment approach.
To mitigate governance risks, some investors or fund managers undertake ‘engagement’ or ‘active ownership’, which means interacting with the managers and directors of companies on business strategy and execution, including sustainability issues and policies. This could also extend to undertaking to vote on key decisions at shareholder meeting.
These policies vary in scope, but they are generally seen as a way to reduce investment risk, enhance long term shareholder value, and potentially help to ensure the company does the right thing by society and the environment. A related term in this regard is stewardship: a purposeful dialogue between shareholders and boards with the aim of ensuring a company’s current practices and long-term strategy are effective and aligned with shareholders’ interests.
Other investors are willing to back companies perceived to have are governance issues but where they can effect change and potentially unlock value through a rising share price as a result. This can either be through engagement or, more confrontationally, take the form of shareholder ‘activism’. This is a more public approach whereby investors use their shareholdings to effect change, for example through submitting shareholder resolutions or openly denouncing the company.
Given the variety of approaches, before investing in a fund it is important to read literature carefully. Although a consensus is starting to form around the use of ESG and other terminology in the area, it is still the case that funds may use the same expressions differently. Investors should check that the values of a fund are aligned with their own.
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Investing in the 'G' in ESG
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