What does Governance mean in terms of ESG?
The Governance pillar of ESG refers to the decision-making of companies. This includes the creation of policies, and the distribution of responsibility within a company – usually referring to directors, specific high-ranking managers, shareholders, and finally, stakeholders.
Core issues of Governance include:
A company’s purpose
Individuals on the board of directors
Any compensation for high-ranking executives
Oversight of decision-makers
Of the three pillars within ESG, this area is the most established and developed. In the UK for example, there is a well-established framework around governance, which includes the Companies Act 2006 that sets out the legal requirements for corporate decision making.
The UK Corporate Governance Code established good practice and procedures. The Bribery Act 2010 includes rules on corporate behaviour and The Companies (Directors’ Remuneration Policy and Directors’ Remuneration Report) Regulations 2019 govern how directors are paid. Where appropriated, the penalties for breaching the rules are laid out within the Acts and regulations.
Governance can often be overlooked when investors are reviewing ESG. Although, understanding the G in ESG and its corresponding risks and opportunities within the working of a company’s decision-making is critical. Especially as poor governance practices and decisions have been at the heart of some major corporate scandals. These scandals cause significant financial damage, and these ultimately affect the value of a company.
What can go wrong?
The idea behind the Governance framework is that companies who are found to rank below average on ‘good’ governance characteristics are more likely to be at risk from mismanagement. This means their ability to capitalise on business opportunities is also lower. Key factors that are considered to measure this are:
Structure and oversight
Code and core business values
Transparency with stakeholders
Accuracy of reporting
Cyber risk and other system capabilities
There is no clear priority when it comes to these items.
Diversity and Equality
Gender diversity specifically falls under governance issues. Especially with calls demanding better representation of women within their boards and executive teams. Companies with diverse boards are shown to perform better in the long run than those companies that are less diverse.
It is no secret that CEO-ranking staff earn much more than the median employee. In an attempt to control the regulator in the UK require publicly traded companies to allow shareholders to vote on executive compensation packages at regular intervals.
While many aspects of board-level pay remain vastly unregulated, an investor might look at the ratio of CEO-to-median employee pay annually to help them make their investment decision. If this information is not available, it indicates that the board and shareholders are in complete and undisclosed control over these salaries.
The G in ESG in some ways underpins the E and the S. As decision-making will affect social, political, and cultural attitudes of the company in question.