We have discussed the competition and interaction between E and S in this column before, but not the G in ESG. In fact, looking at the range of sustainable investment strategies in the market, it would be fair to think that the G is often neglected!
- Governance can seem neglected compared with the E and S
- Agreement on financial materiality, but impact materiality requires judgement
- The G is actually everywhere – a necessary foundation for SI strategies
Environmental strategies abound, social-themed strategies are fewer, but governance-themed strategies are rare. This could be because corporate governance is important for every strategy, and so is not seen a potentially value-driving theme.
Indeed, it is true that corporate governance is probably the least controversial of all ESG topics in terms of demonstrating their relevance to investors. But it’s hard to find an SI strategy in which governance does not feature in some way.
Few investors would argue that the evaluation of corporate governance and management quality should not play a role in investment decision making in any asset class. Yet, the weight we should attach to good governance is still often debated, or is inconsistent, and there is a lack of agreement on whether poor corporate governance has a direct negative impact on sustainability.
Different perspectives
Three common ways of addressing corporate governance are – as active owners advocating for better managed companies; in ESG integration from a financial perspective; and as sustainable investors from an impact materiality perspective.
As active owners, we advocate for high-quality corporate governance in the companies we invest in, as a matter of routine. There are two angles here. Firstly, we need so find out whether companies meet minimum standards of corporate governance. Then we can ascertain which companies demonstrate the best practices that we might ideally want to have in portfolios, or those that we think would actually support future corporate financial returns.
Minimum standards vs best practices
A minimum standards approach can help to avoid the worst forms of corporate governance that lead to risks of significant mistakes – even as intentional corporate actions – that put the future of the company at risk. We should realistically expect all investments to meet minimum standards.
Best practices are much rarer. Many companies across regions and sectors do not meet a ‘gold standard’, but have a good enough approach to be an acceptable investment risk, or not to detract from making a positive impact on sustainability or a profitable investment opportunity.
Yet, there is some nuance here, and judgement is needed. For example, in some sectors and countries, family ownership of companies is common, and boards can appear less independent than is typically thought optimal. However, research suggests that family ownership also has advantages, and may be correlated with higher shareholder returns, but could become harmful at higher levels.
The nuance lies in determining the optimal level of family ownership. Ultimately, investors need to make their own risk assessments, and a holding that is suitable for one portfolio may not be in another.
Positive correlation for governance and financial materiality
From a financial materiality perspective, there is more agreement. Academic research points to positive links between good corporate governance practices and various forms of value creation. Research supported by proxy voting advisors Institutional Shareholder Services found a direct correlation between strong corporate governance and strong shareholder returns, profitability, dividend pay-outs and yields, and low risk.
Accounting scandals, bribery issues and abuses of power by management can often be traced back to poor governance practices, resulting in increased uncertainty and sub-optimal financial outcomes. Although we cannot claim that a company with strong governance will always outperform, there is sound rationale for all investors to pay attention to it.
Impact of governance on sustainability is less clear
When evaluating the impact that companies have on sustainability, the focus is usually on products and operations, and less so on management practices. There is little evidence so far that best practice corporate governance leads to more positive impacts than would otherwise be achieved. There is more support for the view that poor governance could have negative impacts, though there is no clear agreement on the mechanism for evaluating this. Again, investor judgment is required.
For example, Tesla is an often-discussed example of a company that does not meet commonly accepted standards of corporate governance, though its products play a role in the transition to a low-carbon economy. We have no commonly accepted way (yet) of evaluating whether poor governance detracts from the positive impact of products, so Tesla will be included in some sustainable portfolios, but excluded from others. This doesn’t make it wrong – just a different interpretation or philosophy.
Governance is a necessary foundation
In the SI field, sustainability has often been considered a proxy for good management. The reverse could also be true – good corporate governance could indicate that a company is capable of managing all areas well, including ESG factors.
In fact, good governance could be seen as the necessary foundation for all sustainable companies, as well as for all sustainable investment strategies. The G might seem neglected, but in practice, it’s everywhere.
