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Understanding governance: Unpicking the G in ESG

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Prominent environmental and social issues often steal the spotlight from governance (the G in ESG). However, signs of poor corporate governance can be a big red flag to investors—in this world, words and actions hold equal weight!

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If you’re interested in investing, you may have heard of ‘ESG’. It’s not the reason you can’t stop eating chips (that’s MSG). Rather, investing with an ESG framework can help you choose investments that meet high Environmental, Social and Governance standards.

By now, we’re pretty familiar with the E and S—environmental issues and social factors—around things like human rights, living wages and safe workplaces. Both are easy to grasp and often in the spotlight. But what about the G—governance? It doesn’t always get the same airtime, but good governance can be key to a company’s success. 

ESG might’ve moved from the fringes of the investment industry to a mainstream must-have over a relatively short period, but governance has been around forever. As citizens, we entrust the government to make important decisions about how to make our country (and, by extension, us) productive, prosperous, cohesive and safe from outside threats. 

It’s much the same for companies—just replace ‘government’ with a board of directors, led by its chair. Investment professionals have always been pretty obsessed with corporate governance, particularly the quality of a company’s management and board. In fact, many would argue that it’s the G that makes the E and S possible.

Avoid stools without three legs 

Pathfinder Asset Management’s head of investments, Paul Brownsey, likens ESG to a three-legged stool, where the governance leg keeps the other two standing. 

“Part of corporate governance is deciding how a company uses its capital, how it invests for the future, and this will include environmental and social policies. Without good governance, you can’t have a viable environmental and social agenda, because how would you implement it, cost it and measure it?”

Brownsey says a company’s governance can provide a good idea of its risk as an investment. And risk is something investors are very hot on when it comes to prospective places to park their money. 

“Poor governance can lead to reputational risk, which can lead to financial risk, which can lead to regulatory risk. A company that lurches from controversy to controversy implies bad governance and would be a red flag to an investor,” he says.

The good, the bad and the ugly 

So, what might that look like IRL? 

Let’s say a founder of a listed company shows poor judgement by publicly making controversial remarks, then—along with the company’s board—skirts responsibility. Only once the company’s share price falls does the founder reappear to offer a half-hearted apology, while the company’s board announces hurried restorative measures, like an independent review of company culture. 

Good corporate governance? Or room for improvement?

Independent governance advisor, Felicity Caird, thinks the latter. She says it’s a big concern when a company is facing a reputational scandal, especially if it’s driving headlines, and its board is nowhere to be found. 

“It takes courageous leadership to front up and own unethical behaviour, but it’s vital to good governance and the protection of a company’s brand and reputation. In this [hypothetical!] situation, I’d expect to see the board promptly acknowledge that abhorrent comments were made and what they’d be doing to address it.

“Whether or not a related drop in share price is enduring, the company’s reputation will take a hit and this can have flow-on effects over time. In a situation where a company’s brand is under fire, a good board leads through it, dealing with it swiftly, decisively and honestly,” she adds. 

Optics from the buy-side

So, what’s the investor’s take? To Brownsey, a CEO making comments that would be out of place in the ‘80s let alone 2022, combined with a lack of self-awareness, would be a worry on several levels. 

“Outside the obvious reputational risk is the sheer noise something like this creates around a company’s normal operations. Staff would be feeling it personally, as well as dealing with concerned customers and investors. Not to mention prospective employees being reluctant to work there. Something like this becomes a distraction to a company executing its mission.”

“I’d expect to see a board come out strong and early, pulling the CEO into line. Even if he [or she]’s created the company and its value, a listed entity has a greater responsibility. Ultimately the board controls the company and it’s their responsibility to put in place codes of behaviour and checks and balances around how their staff behave.”

Profits please, but not at all costs

So, good corporate governance isn’t just about coming up with winning ways to maximise the bottom-line? 

As you might expect from someone responsible for nurturing people’s hard-earned savings, Brownsey is clear that profits will always be important. But a company’s role is wider than profits alone.

“A well-governed company must to some degree consider a wider set of stakeholders than just the people who have equity in the company. Companies can’t make a ton of money if they don’t have good employees working for them, or if those good employees don’t have good clients to deal with to generate revenue,” he says. 

“And well-governed companies don’t create self-inflicted wounds.”

Ok, now for the legal bit

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