While environmental and social factors are often the focus for investors looking to invest sustainably, the importance of governance issues should not be ignored. Studying the way a company is structured can help identify potential financially material risks before they come to pass, or highlight a well-run company with strong future prospects. This is the main focus of the governance component of ESG.
Issues relating to the management and oversight of companies, such as board, ownership and executive pay, have often proven to be key determinants of the long-term attractiveness of investments and sustainability. A company’s corporate governance affects all areas of its operation and is essential to promoting sound decision making and restricting conflicts of interest among stakeholders.
A well-functioning corporate governance system ensures high levels of transparency, accountability, oversight and respect for investors and key stakeholders – factors that are crucial for the long-term health of companies. There have been many high-profile examples over the years where poor corporate governance practices have been partially responsible for scandals that have significantly eroded investor value. Notable examples of this are the collapse of Enron and the Volkswagen diesel emissions scandal1 .
On the other hand, robust corporate governance can be a strong signal of investment quality. One of the most important indicators of good corporate governance practices is an independent board, which when equipped with the relevant knowledge and experience, can generate effective discussion and challenge management decisions. We also look for directors to take measures to promote diversity, not only at board and senior management level, but throughout the entire company. Evidence shows that diverse perspectives better enable objective decision-making and facilitate long-term value creation2.
Another key governance consideration is around the planning of capital allocation. A company’s investment plans need to be aligned with its long-term strategy and should also incorporate economic, societal and regulatory changes from a broader perspective. The board should have a clear approach to achieving a sustainable balance of capital allocation among competing priorities of different stakeholder groups. This can help reduce the occurrence of poor allocation decisions which could have detrimental consequences over the long-term, such as paying over the odds for an unsuitable acquisition target.
The evolution of governance factors
While the incorporation of environmental and social factors have only recently been widely adopted into investment decisions, governance issues have been on investors’ radars for some time. However, the emphasis has traditionally been quite narrow, focusing simply on aligning the interests of a company’s management team with those of shareholders. A focus on corporate governance typically involved looking at factors such as shareholder representation on company boards and incentivising management to act in the interest of their investors.
Governance factors have significantly broadened in recent years to include consideration of the interests of all stakeholders and addressing issues such as diversity of leadership, board independence and transparency. These developments mean that good governance can positively influence both environmental and social outcomes, as well as investment returns.