Governance, also known as the ‘G’ in the environmental, social, and governance (ESG) investment community, is an umbrella term that covers a wide variety of modern issues that many investors are interested in. These include board oversight, management structure, company policies, information disclosure, annual audits, compliance measures, executive compensation, and more.
Governance is sometimes overlooked because these issues are rarely relevant outside a business context, whereas environmental and social issues are highly relevant in other aspects of day-to-day life.
That said, a company’s governance structure dictates how strategic decisions are made – including how the company addresses environmental and social issues. This means a strong governance structure provides transparency and accountability, and lays the foundation for effective management.
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So What Does Good Governance Look Like?
Good governance begins with the Board of Directors. The Board is responsible for advising the company’s strategic planning, establishing management policies, overseeing company operations, and protecting the interests of shareholders.
It’s important that directors are sufficiently independent from the executives, however, it is not uncommon for CEOs to also act as the Chairperson of the Board. Since the board appoints the CEO, this effectively means the CEO is their own boss.
A lack of board independence can lead to “group think” and can sometimes lead the company in a wrong direction. Take Meta (formerly known as Facebook), where Mark Zuckerberg is the Founder, Chairman of the Board, and CEO. Many ESG investors exclude Meta from their portfolios based on this governance structure. Why? Because the lack of ability to challenge thoughts and produce products and policies that are in the best interest of all stakeholders have resulted in numerous scandals related to data privacy and hate speech.
What is Engagement?
Engagement is an important tool that public markets investors use to bring about change. For example, voting on the Board of Directors is different from any other type of E, S, or G engagement because voting on members of the board is the only binding vote. This means investors have the most direct influence when voting on the Board of Directors, which can have an enormous effect on a company.
Take the 2021 board election at ExxonMobil. In this case, engaged activists were able to elect three new board members that brought diverse backgrounds with knowledge of climate issues. Because this election was binding, Exxon is now benefitting from the climate expertise on its board, which has reflected in the stock price post-election. Electing the board is one of many ways that an investor may engage around governance issues.
Other key focus areas of engagement around governance over the past few years include diversity of the board, executive compensation, and disclosure of important metrics (like CO2 and firm-wide diversity).
Board diversity considers various diversity standards, including race and ethnicity, professional background, and gender. A diverse board can expand the knowledge, perspective, and expertise of the team, and can help the company reach its stakeholders in an effective and innovative way.
Executive Pay, Carbon Emissions and More
Executive compensation is also an important governance issue for investors as inappropriately compensated executives may be reducing shareholder value by directly taking away from the bottom line. This not only increases the possibility of unethical behavior, it can create a barrier between the executives and other employees.
It is the responsibility of the board to set compensation structure for management, which shows the importance of strong corporate governance within a company. Without these guardrails, there can be too many unforeseen consequences. Fortunately, there seems to be increasing interest in many of these areas.
For example, disclosure-based shareholder proposals around carbon emissions and team diversity were both at an all-time high in 2020 and 2021. Investors felt these two data points in particular were relevant when making investment decisions.
Most companies have complied with the request for these additional disclosures, which has led investors to move away from the disclosure request paradigm and move towards policy change requests. This has come as a direct result of the data provided from the disclosure requests, showing just how essential good governance data has become.
Generating data around these issues was the first step for investors to understand what management is tracking and how they plan on managing the risks that were uncovered. Investors now want to better understand what management is doing to mitigate these risks, and protect and create shareholder value in the process.
Corporate governance is a key component of ESG investing as it affects every aspect of company management. As investors become more interested in various ESG matters, it is essential that governance remains a key component of ESG activism and the public markets impact discussion.
While it may take time to see meaningful change, change is possible through mindful diligence and engagement.