The G in ESG

The “G” in ESG refers to the governance variables of decision-making. This includes policymaking and the distribution of rights and responsibilities among various participants in companies. They include the board of directors, managers, shareholders, and stakeholders. Governance practices that reflect societal values are important for both enterprises and investors. There are environmental and social concerns to address, but Governance is the the tip-of-the-spear when it comes to creating sustainable business models. It all starts from the top, which guides every other aspect all the way down.

Why ESG Begins with Governance Issues

It is important to understand Governance issues because they are the foundation for effective corporate and business ESG management. They provide the basis upon which corporate social responsibility and sustainability activities can be built and evaluated. Governance is a key element of overall corporate strategy and performance, because it directly affects the way resources (including capital and talent), markets (the boardroom has an important role to play in Markets) and the regulatory and legal environment (i.e., compliance with laws and regulations) can be used in the pursuit of company objectives.

Different countries place different levels of importance, depending on their governance frameworks, on board independence; shareholder democracy; accountability; disclosure; roles and responsibilities; processes for decision-making; transparency; conflicts of interest, whistleblower protections and assurance. Corporate governance is a key component of ESG in the face of businesses’ mistakes and increasing awareness of global diversity and income disparity.

ESG Philosophy

ESG is a philosophy that companies should take into account environmental, social and governance issues when delivering financial value to their stakeholders. Social responsibility has been an integral part of business for decades. In recent years there has been a push from both investors and public institutions to make corporate behavior as responsible as possible.

Aggressive Tax Avoidance and ESG

Corporate tax policies are being scrutinized more thoroughly by governments and investors amid concerns about the use of aggressive tax avoidance techniques. These types of practises are undermining the integrity of the financial markets and putting public money at risk.

ESG issues can be part of the tax avoidance equation, as some companies may choose to divert revenue through low-tax or no-tax jurisdictions, using loopholes in domestic legislation allowing them to lower their effective tax rate.

The Effect of Deferred Tax Payments

There are concerns about corporations who defer tax payments by using offshore subsidiaries or by claiming tax deductions for expenses that may not be legitimate. Some companies use aggressive tax planning to minimize their corporate income taxes beyond what is deemed acceptable under national and international taxation guidelines. This allows companies to generate higher profits and allocate more funds towards executive remuneration and shareholder dividends, at the expense of the local economies which support them.

What is ESG Linked Executive Pay?

ESG-linked pay is a recent development in the field of corporate governance that has been taking place over the past five years. It refers to a new way for companies and their shareholders to structure executive remuneration packages to promote better human capital management, while also increasing transparency and accountability.

We would also recommend you read What are ESG Metrics?

Why should investors care?

Investors today expect more than just solid financial performance from their investments. They are also looking for evidence of positive social and environmental development and stewardship of their assets, and expect companies to respond to these issues.

ESG-linked pay is a regulatory response to the pressure we are seeing from investors for more disclosure on how executive pay structures encourage – or discourage – sustainability policies within companies. It provides an incentive for companies to include governance factors in their ESG Score.

How does Corruption Affect ESG?

Corruption is a major problem in business today. It can have a detrimental effect on not just companies and their investors, but also on governments and society as a whole.

Corruption reduces economic growth. According to analysts at the global business intelligence company Transparency International , corruption costs the world over $2.6 trillion USD every year. This represents around over 5% of global GDP. Corruption internationally adds at least 10% to the cost of doing business and up to 25% during the procurement phase in developing countries.

A wallet being squeezed in a vice representing limited economic growth due to poor ESG planning

Reduces Economic Growth

In addition, bribery is a major problem within companies as it distorts market competition and undermines fair trade. Up to $1 trillion USD is spent as bribes every year according to the IMF. In fact, bribery far outweighs international aid donations. Corruption is a major problem in business today which can have a detrimental effect on all aspects of sustainability.

How Governance Affects Director Nominations and ESG

Over the last few decades it has been found that director nominations and elections have an increasing effect on sustainability within a company. Some of the findings show that the greater the proportion of independent directors on a board, the better overall governance levels are within a company. This happens because most companies with high levels of director nominations and elections outperform their market indices over time.

Long Term Value Creation

What is interesting about these findings is that while there is certainly a correlation between good governance and long-term value creation, it has a long way to go to find the perfect balance. But some board recommendations for better governance outcomes include:

  • Having a formal and structured training program for board members of any company to make them more effective decision makers;
  • Reviewing the skills sets, experience and independence of all directors;
  • To encourage institutional shareholders to become more active in director nominations and elections (and vote on shareholder resolutions)

Diversity Helps (DEI)

They also recommend selecting external directors from a diverse pool of candidates, with an understanding of the company’s sector and expectations for its long-term success.

In addition to adapting their skills sets and attitudes towards board membership, they also encourage leaders to consider adapting their timeframes. For example, instead of using quarters as a basis for making decisions, they suggest basing them more on a company’s business model and long-term success.

Cyber Security, Governance and the Effects on ESG

It should come as no surprise that Cyber security has become a major risk for every business. The main risks are often the same, but the precautions unique to each company.

Although there is no doubt about the need for cyber security investment and precautions, many argue that public companies already invest enough towards it based on their financial results. But as we have seen with recent data breaches such as those at Yahoo and Equifax, investing in cyber security does not always mean what we think it means.

World Economic Forum

The World Economic Forum Global Risks Report cites cyber security as one of the top risks that the world will face in the next ten years. In the 2016 edition, cyber risk was ranked fifth overall and second for impact. Cyber security was listed as a top five concern by over 60% of respondents from industry and non-industry alike. This is unsurprising given high-profile data breaches of the time.

Data Breaches on the Rise

Over 5 years later, the number of data breaches is rising exponentially and at a rate that is outpacing the current expenditure on cyber security. According to a study conducted by Dimensional Research, two-thirds of companies have increased their spending on cyber security in the past year, but 75% say they are overwhelmed with just keeping up to current standards.

Cyber security affects governance facilitation and operation, so it is unsurprising that the issue has been recognised in recent years as an important factor for companies to consider when judging their social and environmental responsibility.

How Does Negative Governance Affect Sustainability?

Poor governance of a company affects the triple bottom line in many ways. It affects the company’s ability to invest responsibly across the organisation, and in some cases can lead to fraudulent activity. This can cause a loss of shareholder confidence, which results in lower returns due to decreased share price. Shareholder returns are an important factor for many organisations when measuring their sustainability performance.

How Can Negative Governance Affect Sustainability Disclosure?

The sustainability disclosure is not only affected by how companies manage their performance, but also in how they report on it. Poor governance can lead to poor reporting practices which are difficult to measure against the current disclosure requirements. This means that sustainability reports may not provide a clear picture of what is happening within an organisation, and this lack of information could have a damaging effect on its reputation.

Examples of Sustainable Governance Practises

Sustainable governance practices exist in many forms, including the following:

  • Compliance with laws, regulations and charitable commitments
  • Consistent policies for managing social, environmental and ethical issues
  • A clear process for identifying new opportunities to manage ESG risks & opportunities
  • A clear organizational structure responsible for implementing best practices in ESG risk management.

How Does CSR Governance Affect ESG

CSR covers many different elements and business practices in millions of companies across hundreds of countries worldwide, and they are all governed by people. Some of the best practices in CSR are to encourage companies to protect their employees, respect the environment and work with suppliers who do not exploit children. All of these decisions come from the top of the business structure. Whether a large corporation with a CEO, board of Directors and Shareholders, right down to the locally owned and operated one-person shop in your neighborhood.

The Failure

It is difficult for a business or organization which does not have proper CSR governance or oversight to manage its stakeholder and client interests. Failure to identify significant ESG risks will lead to higher risk of fines and penalties that might impact their sustainability. The world is changing fast and it is in dire need of good governance and sustainable leadership.

ESG Frameworks Download

The ESG Frameworks document will give you an overview of what steps need to be taken and how they can be applied for your business. You might even find some new opportunities for investors or partners along the way! It is designed to help you get started with the Governance of your business.

Caveats and Disclaimers

We have covered many topics in this article and want to be clear that any reference to, or mention of socially responsible investing, factors, criteria, sustainable investing, investment funds, considerations, investment strategies, financial performance, mutual funds, environmental social and governance, funds, corporate governance, risks, investments, institutional investors, impact investing,  investment process, evaluate companies, investors, climate change, governance criteria, environmental criteria, waste management, brokerage firms, socially conscious investing, investment portfolios, capital markets, research, strategy, executive compensation, energy efficiency, investment analysis, integration, global economy, non-financial considerations, accounting transparency, ethical investing, indexes, investment professionals, environmental concerns, metrics, investment processes, supply chain, investment decision making process, own consumer protection, mission related investing, central factors, screen  framework, employee relations, company’s carbon footprint, issues, socially responsible, social criteria, issues, local communities, millennial investors, or cfa institute in the content of this article is purely for informational purposes and not to be misconstrued with investment advice or personal opinion. Thank you for reading.

We recommend you also read What does an ESG Score Mean?