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Governance: The Key that Unlocks ESG

The Least Understood Aspect of ESG May Be the Most Important

ESG investing isn’t strictly about social issues and climate change, but for a lot of investors, it may as well be. Studies1 show that environmental concerns, social issues, and employment policies rank at the top of their motivations to consider ESG approaches. Few everyday investors think very much about the G in ESG — governance — and even fewer really understand what it means.

It makes sense. Environmental and social issues are more immediate and impactful to the majority of everyday people. Corporate collapses (such as Enron, Lehman Brothers, and Silicon Valley Bank, among others) make headlines, but it’s not always clear how governance was involved, and there’s rarely any clear accountability.

But zooming out, governance isn’t just one aspect of an ESG strategy. It may be the foundation of how you can use your dollars to drive change.

The Role of Governance

E, S, and G generally function as a business-world equivalent of the three Ps — people, planet, and profit. The concept behind both is to pursue a balance where each factor is considered more or less equally when decisions are made.

But there is an important distinction between the data used to evaluate E and S on the one hand, and governance on the other. E and S data include a lot of measurements about the outcomes of corporate decision making. G considers the corporate decision-making process itself.

Before a company can cause environmental damage, its leadership must make decisions that allow for it. If a company is going to have a history of discriminatory hiring practices, its leadership must create an environment where there are no consequences and no transparency. Before a company can steal from shareholders, its leadership must choose to commit fraud.

These are extreme cases of course. But even for companies that don’t embrace harmful or fraudulent practices, governance remains a central concern for anyone who champions sustainability. Company leadership faces all kinds of decisions that require them to balance the needs of competing constituencies, balance risk with reward, and balance short-term gain with long-term sustainability. There are very few obvious answers.

As an investor, you want to believe you are investing with companies that are capable of consistently making smart choices. But more than that, you want to have some window into what those choices are and how they are being made. G lies at the heart of all those concerns.

Questions and Answers

You have questions, and governance data has answers to offer.

ESG analysts also look at information that helps them gauge where a company’s management is really coming from. For example:

• Shareholder Engagement: Companies that actively engage with their shareholders and seek feedback on ESG matters tend to demonstrate better governance practices.
• Conflict of Interest Management: How a company manages conflicts of interest between its management, board, and shareholders is vital in evaluating governance standards.
• Whistleblower Policies: Presence of robust whistleblower policies encourages employees to report any misconduct or ethical violations.

Better Governance, Better Investments

The review of governance data is one of the key reasons while, imperfect as they may be, ESG funds are a good addition to many people’s portfolios.

Many traditionally run mutual funds evaluate management’s ability to generate profit to the shareholder. That’s good information, but it’s not complete information. Even for successful firms, profit must be consistently balanced against the needs of employees, the desires of consumers, and the concerns of the community. Companies that violate the trust of these constituencies may drive profit in the short run but endanger their business foundation. They can undermine their own sustainability.

That’s not great news for a long-term investor. It’s one theory that explains a recent finding by Christina Zhu et. al., writing for Wharton’s Jacob Levy Equity Management Center. In a paper entitled “Retail Investors and ESG News,” Zhu and her fellow authors researched active, non-professional stock traders — in other words, people who are paying close attention — to identify their motivations. For this community, governance information is of paramount importance.

“We show that all categories of ESG news events generate significant trade by retail investors, with news related to ‘Leadership and Governance’ impacting trade the most. This finding is consistent with survey evidence that governance — among all ESG factors — is the most important for investors’ decision-making given its link to firm performance (CFA Institute, 2020).”

Take a Look

Here’s a fun exercise you can do. Think of a company you know (it must be listed on a stock exchange) or one that is held in a retirement fund or personal investment. Try entering that company name into the free online tools offered by MSCI, Refinitiv, or Sustainalytics. You will not get a comprehensive review of Governance data, but you will see different perspectives of what analysts think is important and how good the company’s management is.

While ESG remains an evolving science, where standards often change, ESG ratings put governance data front and center, using established data and methodologies. As an investor in an ESG fund, you benefit from regular, rigorous and comprehensive governance reviews. That can enhance your impact and your investments.