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Corporate governance | ESG Investing | Wealth Management

What is the "G" in ESG?

The "G" in ESG stands for "governance" and refers to whether a company manages its business in a responsible way

Corporate governance

 

Corporate governance is concerned with how companies interact with the full range of external stakeholders, including competitors, suppliers, shareholders and governments. It is the most established of the three pillars of ESG investing, because many of the governance factors focus on questions that prudent investors have always considered before putting their money at risk.

  1. Investors used to care most about governance issues that might affect shareholder rights
  2. Today, corporate governance includes how companies interact with competitors, suppliers, governments and other stakeholders, as well as shareholders
  3. The principle of ‘investor stewardship’ is that investors should engage with companies to encourage them to improve their governance
  4. Better corporate governance is often associated with higher returns for shareholders

 

Why should investors care about corporate governance?

 

Shareholders traditionally focused on issues that could directly protect or harm them. For example, investors would want to be aware of any potential conflicts of interest that might exist between them and company management or controlling shareholders. 

 

They would want to see financial accounts and other information disclosed in an accurate and timely manner. They would want to be confident that board members were capable, independent and diverse enough to provide effective oversight of management without being too closely involved in the company’s day-to-day operations.

 

All of these considerations remain extremely important even for investors who do not explicitly follow an ESG strategy. However, there is much more to measuring the quality of governance in business today than there was when the concept of ESG investing was first formalised almost two decades ago. 

Good governance redefined

 

The analysis of corporate governance has expanded beyond shareholder rights to include many other governance factors and in particular those that affect a company’s interactions with competitors, suppliers and governments. 

 

For example, if a company engaged in bribery or other forms of corruption in order to win a contract, or formed a cartel with rivals in order to control prices, these now would be treated as serious corporate governance breaches. 

 

Not that long ago, some investors would have viewed such behaviour as a normal cost of doing business in many industries and locations. Today, it is recognised that actions like these are likely to expose a company to legal, regulatory or reputational risks and so should be opposed by shareholders on the grounds of self-interest.

 

Beyond that, however, ESG investing principles are based on the conviction that companies have responsibilities that go beyond maximising returns for shareholders and that they must also act in the interests of society. Cartels harm customers by forcing them to pay above market prices, while bribery and corruption is corrosive to civil institutions and causes long-term damage to politics and the rule of law.    

 

Investors should expect the governance element of ESG investing to continue to evolve to reflect changing attitudes, with an increased focus on improved governance as a way of ensuring that companies meet their responsibilities on environmental and social issues.  

 

More generally, governance in terms of the balance of power between corporate stakeholders will also have to be balanced against broader social and environmental concerns to get acceptable ESG solutions.

 

Governance in business: a brief history

  1. Before the 20th Century: Concerns about the power of companies and the need to ensure that they act responsibly are nothing new. In the 17th, 18th and 19th centuries, trading companies such as the Dutch East India Company and the British East India Company – which were effectively the world’s first multinational corporations – quickly came under scrutiny and laws were eventually instated to curb their powers. 
  2. The dawn of regulation: However, this was an ad hoc response to specific circumstances, rather than a consistent framework for ensuring companies serve the interests of society. The modern approach to regulating businesses arguably began in the late 19th century when the US passed the first legislation – the Sherman Antitrust Act (1890) – to control the growing monopolistic power of large dominant conglomerates known as corporate trusts. Many other major economies embraced similar laws to promote competition during the 20th century.
  3. The early 20th Century: After the Great Crash of 1929, the focus of regulation in the US shifted to the problem of ensuring that companies provided accurate financial information and that controlling shareholders could not openly cheat minority investors or manipulate markets, with the passing of the Securities Act (1933) and the Securities Exchange Act (1934). 
  4. Higher standards in the 1970s: Governance became less of a priority in the post-war economic boom and it was not until a fresh economic crisis in the 1970s that the Securities and Exchange Commission began to tackle many issues of financial reporting and corporate accountability to shareholders. In 1976, the term “corporate governance” first appeared in the Federal Register, the official journal of the US government, and in the same year listed companies were first required to have an audit committee composed of independent directors.
  5. The Cadbury report: Governments in Europe began to embrace similar principles in the 1990s, generally in response to scandals and crisis in their own markets. The UK’s Cadbury Report (1992) set out new recommendations on the structure of company boards and accounting systems. It introduced the “comply or explain” principle that companies should comply fully with a voluntary code of best practice or explain why they were deviating from it.
  6. Investor stewardship in the 21st century: The Cadbury report helped inform voluntary codes from a range of international bodies such as the Organisation for Economic Cooperation and Development (OECD) and statutory legislation in many countries. The idea that investors should actively exercise their powers to hold companies to account also led to the concept of “investor stewardship” – engaging with companies to encourage them to improve their governance – which is a central part of ESG investing.

 

Why good corporate governance matters

 

Data on corporate governance has been compiled for much longer than data on environmental and social factors, which means that we have more evidence on the interaction between governance and investment returns.

 

The impact of governance is not always easy to measure. Some firms may comply with the letter of corporate governance codes without embracing the spirit. Others – such as some family-controlled businesses – may be run in a way that scores more weakly on some metrics while still exhibiting good governance in practice.

 

The common consensus among investors is that firms with better standards of governance have stronger returns. Studies tend to support of the idea that good governance in business benefits shareholders. Research on the US stockmarket has found that selecting companies with better shareholder rights tended to produce significant excess returns in the 1990s[1].

 

This relationship appeared to weaken in the 2000s, probably because investors had begun to incorporate governance into their analysis and hence into the price at which securities traded. This does not indicate that governance has become less important – rather that its significance is increasingly recognised and reflects the progressive embrace of ESG factors by the investment community.

 

Integrating governance in to ESG strategies

 

While some investors today pursue dedicated environmental or social approaches to investing – often under the labels of sustainable investing and impact investing – investing in good governance is rarely treated as a standalone strategy. The scrutiny of a firm’s governance standards is instead integrated into investment processes of all types. 

 

This may point the way to how other ESG factors could eventually be seen less as a specialised area of investment and more as an expectation that all investors should balance financial and non-financial factors in their decisions. 

References

1.

Source: Paul Gompers & Joy Ishii & Andrew Metrick, 2003. "Corporate Governance And Equity Prices," The Quarterly Journal of Economics, MIT Press, vol. 118(1), pages 107-155, February.

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