There’s no successful “E” or “S” without a functioning “G” in ESG

12 November 2020

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While environmental and social considerations might have dominated the headlines in the last year, the G in ESG, corporate governance, remains the key ingredient to success.

While environmental and social considerations might have dominated the headlines in the last year and in particular during the pandemic, the G in ESG#, corporate governance, remains the key ingredient to success, with the majority of ESG investors arguing, that “E” and “S” don’t hold much without effective governance: in a survey of 299 investors, an overwhelming 91% cited governance as the ESG factor with the greatest impact on their investment decisions[1].

In this first of our three articles analysing corporate governance, we’re looking at how corporate governance is evolving, what good governance looks like and how governance must be expanded in order to promote sustainable business conduct.

Jargon Buster

UK Corporate Governance Code (The Code): established in 1992 and developed since then, The Code sets out principles of good practice for the corporate governance of listed companies on the London Stock Exchange.

The G-Index: a governance index constructed in 2003 by Paul Gompers, Joy Ishii and Andrew Metrick that used the incidence of 24 governance rules to analyse shareholder rights at 1500 firms during the 1990s[2].

The Entrenchment Index (The E-Index): constructed in 2009 by Lucian Bebchuk, A Cohen and A Ferrell, the E-Index uses six provisions associated with poor governance[3].

The Economic Dimension Score (EDS): developed by ESG ratings firm, RobecoSAM, the EDS includes additional key measurements – compared to more traditional governance scores – to evaluate corporate governance[4].

What’s behind the G?

Simply put, corporate governance refers to the process of decision-making in companies and the processes through which decisions are implemented[5]. Often, corporate governance is only associated with boards of directors that are responsible for the governance of their companies. However, shareholders are equally governing their companies by appointing the directors and the auditors and by monitoring that an appropriate governance structure is in place. And governance not only happens for an entire company: governance structures and processes also must be defined and delivered for smaller units, such as business divisions or locations, and a company’s products.

The concept of governing goes back to solving one of the most discussed dilemmas in economics, the “Principal-Agent problem”[6], whereby conflicts of interest arise if the agent (e.g. staff) personally gains by not acting in the principal’s (a company’s owner) best interest. To minimise this risk, the principal can place restrictions on what the agent is allowed to do and supervise the agent’s actions – the core tasks of today’s governing boards, which, in its traditional version, include: 1) Determining ownership, board and other management structures; 2) Establishing decision authority, policies and standards; 3) Setting strategic aims; and 4) Implementing appropriate disclosure, compliance and auditing processes.

While corporate governance is most often associated with listed or large private companies, there’s also a clear need for governance in private, family-owned businesses. Like any other enterprise, a family business needs to have governance in place to ensure it achieves its business strategies. In addition, governance in family-owned companies can help to formalise ownership structures and to set clear rules around the different ways family members can participate, which becomes vital when more generations get involved[7].

The evolution of corporate governance

Corporate governance has steadily evolved over many centuries. Today, one of the most influential guidelines on corporate governance are the G20/OECD* “Principles of Corporate Governance”, which were first published in 1999 and updated in 2015 to include “corporate governance lessons from the global financial crisis, the increase in cross-border ownership, changes in the way that stock markets function and the consequences of a longer and more complex investment chain from household savings to corporate investments”[8].

Corporate Governance has often been reviewed and strengthened after incidents of failure in corporate governance. In the UK, the “Financial Aspects of Corporate Governance” report, often referred to as the Cadbury Code (named after the chair of the report’s committee, Sir Adrian Cadbury[9]), came about after its sponsors, the Financial Reporting Council (FRC), the London Stock Exchange and the accountancy profession were concerned about the low level of confidence shareholders and the public expressed about not only the financial reporting of businesses, but also about the auditors of companies, which they felt didn’t apply the necessary rigorous checks. The Cadbury Code introduced a Code of Best Practice, aimed at the boards of directors of listed companies, and it was subsequently incorporated into the London Stock Exchange’s Listing Rules.

Similarly following “external shocks”, the Sarbanes-Oxley Act of 2002 was enacted in the US in the wake of a series of high-profile corporate scandals, establishing a series of governance requirements for US companies, in particular to include an internal controls report in all financial reports. The “SOX Act” has influenced similar laws in many other countries[10].

The 2008 financial crisis brought corporate governance yet again into sharper focus: the OECD found that the financial crisis could in part be attributed to poor corporate governance[11]. Consequently, the OECD and the European Commission – through its Green Paper in June 2010 – published new guidance on how to improve governance for banks and financial institutions.

Source: Financial Reporting Council

The UK’s Corporate Governance Code and the Wates principles

In the UK, the FRC issued a new Corporate Governance Code in 2010, setting standards of good practice in relation to board leadership and effectiveness, remuneration, accountability and relations with shareholders, and, in doing so, embracing an ESG approach for corporates.

The Code has been amended throughout the years and saw its latest iteration in 2018, broadening the definition of governance and specifically emphasising the relationships between companies, shareholders and stakeholders and the importance of establishing a “corporate culture that is aligned with the company purpose, business strategy, promotes integrity and values diversity.” All companies with a Premium Listing of equity shares in the UK are required under the Listing Rules to report in their annual report and accounts on how they have applied the Code[12].

Complying with the Code – 2019 onwards

Workforce/other stakeholder engagement
  • Review how you obtain and take account of workforce views
  • Review your whistleblowing policy and procedure

Board decision-making

  • Consider whether board papers and minutes have appropriate scope and detail

Directors’ time commitments

  • Consider whether directors’ external commitments should be reviewed

Diversity

  • Reassess your efforts to promote diversity (of all types)

Directors’ training

  • Review induction and ongoing development needs for each director

Board evaluation

  • Review the scope and process of evaluation for the board, committees and individual directors

Nomination committee

  • Look at the committee’s responsibilities and terms of reference, especially on process for board appointments, board and senior management succession planning, diversity and directors’ external commitments

Remuneration committee

  • Look at the committee’s composition, responsibilities and terms of reference

Source: lexology.com

In the same year, the FRC also launched a new Corporate Governance Code, the “Wates Principles” specifically for large private companies. Named after the committee’s chair for this code, James Wates, the principles aim to help those companies, which are subject to the thresholds in The Companies (Miscellaneous reporting) Regulation 2018 and now have to report on their corporate governance arrangements. This new reporting requirement applies to all companies that satisfy either or both of the following conditions: 1) more than 2,000 employees; 2) a turnover of more than £200 million, and a balance sheet of more than £2 billion[13].

The principles encourage these companies to adopt a set of key behaviours to secure trust and confidence among stakeholders and benefit the economy and society in general[14]:

The six Wates Principles:

  • Purpose and Leadership: an effective board develops and promotes the purpose of a company and ensures that its values, strategy and culture align with that purpose.
  • Board Composition: effective board composition requires an effective chair and a balance of skills, backgrounds, experience and knowledge, with individual directors having sufficient capacity to make a valuable contribution. The size of a board should be guided by the scale and complexity of the company.
  • Board Responsibilities: the board and individual directors should have a clear understanding of their accountability and responsibilities. The board’s policies and procedures should support effective decision-making and independent challenge.
  • Opportunity and Risk: a board should promote the long-term sustainable success of the company by identifying opportunities to create and preserve value and establishing oversight for the identification and mitigation of risks.
  • Remuneration: a board should promote executive remuneration structures aligned to the long-term sustainable success of a company, taking into account pay and conditions elsewhere in the company.
  • Stakeholder Relationships and Engagement: directors should foster effective stakeholder relationships aligned to the company’s purpose. The board is responsible for overseeing meaningful engagement with stakeholders, including the workforce, and having regard to their views when taking decisions. 

What makes good corporate governance?

As corporate environments can vary in substantive ways around the globe, so can corporate governance. Apart from different geographical approaches to corporate governance (three models are dominating: the Anglo-US model, the German/European model and the Japanese model, which mainly differ in the controlling parties that govern a company[15]), governance mechanisms depend on companies’ ownership structures, which can be vastly different. Therefore, sceptics have been pointing out that aiming to define global standards of good corporate governance would be misleading as there couldn’t be one ‘golden standard”[16].

Yet, there are certain aspects that universally comprise good governance. The International Corporate Governance Network names the following eight:

Principle 1: Board role and responsibilities

The board should act on an informed basis and in the best long-term interests of the company with good faith, care and diligence, for the benefit of shareholders, while having regard to relevant stakeholders, including creditors.

Principle 2: Leadership and independence

Board leadership calls for clarity and balance in board and executive roles and an integrity of process to protect the interests of minority investors and promote success of the company as a whole.

Principle 3: Composition and appointment

There should be a sufficient mix of directors with relevant knowledge, independence, competence, industry experience and diversity of perspectives to generate effective challenge, discussion and objective decision-making.

Principle 4: Corporate culture

The board should adopt high standards of business ethics, ensuring that its vision, mission and objectives are sound and demonstrative of its values. Codes of ethical conduct should be effectively communicated and integrated into the company’s strategy and operations, including risk management systems and remuneration structures.

Principle 5: Risk oversight

The board should proactively oversee, review and approve the approach to risk management regularly or with any significant business change and satisfy itself that the approach is functioning effectively

Principle 6: Remuneration

Remuneration should be designed to effectively align the interests of the CEO and executive officers with those of the company and its shareholders to help ensure long-term performance and sustainable value creation. The board should also ensure that aggregate remuneration is appropriately balanced with the needs to pay dividends to shareholders and retain capital for future investment.

Principle 7: Reporting and audit

Boards should oversee timely and high quality company disclosures for investors and other stakeholders relating to financial statements, strategic and operational performance, corporate governance and material environmental and social factors. A robust audit practice is critical for necessary quality standards.

Principle 8: Shareholder rights

Rights of all shareholders should be equal and must be protected. Fundamental to this protection is ensuring that shareholder voting rights are directly linked to the shareholder’s economic stake, and that minority shareholders have voting rights on key decisions or transactions which affect their interest in the company.

Source: ICGN

Of course, today’s governance must and has expanded to include measures that help identify ESG risks and bring sustainability practices on the way. Whether it’s reviewing the board’s authority in light of new governing responsibilities to help transition to sustainable business conduct, drawing up new policies or implementing procedures to address sustainability issues, governing boards today have to look at environmental and social impacts as much as at the financial performance and make decisions from this broader perspective.

In practice this means that boards of directors have to vastly increase their remit, and, on top of the more traditional tasks, need to dive deep into issues such as land use, energy, water, and emissions; human rights, equal opportunity and diversity; as well as ethics and other internal standards that not only apply within the organisation, but also to a firm’s supply chain.

One question that often comes up is, how a board’s risk oversight role applies to ESG-related risks. While a number of ESG-related risks, such as for example supply chain disruptions or labour practices would automatically be covered by the board’s responsibility to oversee risks and how they’re being handled, governance experts suggest that boards should make a particular effort to address ESG risks. As part of this process, company boards should ask management to identify any emerging ESG issues or trends that could materially impact the company and how best to allocate corporate resources towards managing the most critical of those ESG risks[17].

Our second and third article about corporate governance will shine a spotlight on the most pressing ESG issues company boards are currently facing as well as highlight how the pandemic has further affected corporate governance and will shape it over years to come.

How to assess the quality of corporate governance

Businesses applying corporate governance guidelines, such as for example the ICGN guidelines, can be an indication for investors and other stakeholders that the governing structure and processes in a firm are fit for purpose. To measure governance performance in greater detail, a number of measuring tools have been developed such as the Governance Index (G-Index) and the Entrenchment-Index (E-Index). Both indices use a reverse negative approach: The G-Index consists of 24 governance provisions that weaken shareholder rights and hence by definition of the index constructors, represent poor corporate governance. The focus on shareholder rights as a dimension to measure governance quality is based on broad empirical evidence, that firms with stronger shareholder rights have a higher firm value and an 8.5% better return each year opposed to those with the lowest shareholder rights[18]. The G-index score ranges from 0-24, with 0 associated with strong shareholder rights and corporate governance. The Entrenchment Index, or E-index, works in a similar way, identifying six corporate governance provisions – four provisions around shareholder rights and two provisions around corporate take overs - that are associated with poor governance and negatively affecting a firm’s valuation.

Both indices, whilst being used globally to assess governance quality, have a clear US bias, focusing on specific US governance elements, and, developed prior to the rise of ESG, are increasingly deemed too narrow to support investors in determining the performance of company boards.  

A governance score that has gained attention in the context of ESG focused corporate governance is the Economic Dimension Score (EDS), developed by ESG rating firm RobecoSAM[19]. The EDS includes additional key measurements that evaluate the quality of a company’s governance and management structures as well as its ability to manage long-term risks and opportunities[20].

Including ESG issues such as risk and crisis management, supply chain management and impact measurement differentiates the EDS from the aforementioned more traditional corporate governance metrics. Eight criteria make up the score:

  • The “Codes of business conduct”criterion addresses business ethics and whether the company’s code of conduct and compliance practices are designed to prevent bribery and corruption
  • “Risk and crisis management”examines the effectiveness of the company’s risk management practices, as well as the identification of long-term risks such as climate risks, their potential impact, and the company’s mitigation efforts
  • “Supply chain management”focuses on whether company boards have strategies in place to mitigate the risks that arise when outsourcing parts of the production and as such outsourcing corporate responsibilities
  • The ”tax strategy”category examines the degree to which the company has a clear policy on its approach to taxation issues and is aware of the risks associated with the company’s tax practices
  • The ”materialityscore” assesses a company’s ability to identify the sources of long-term value creation and to develop long-term metrics as well as transparently report these items
  • The ”policy influence”criterion evaluates the amount of money companies are allocating to organisations, which create or influence public policy, legislation, and regulations
  • Finally, the 8th category, “impact measurement and valuation”, focuses on how governance supports the S in ESG, looking at whether companies run social initiatives and undertake strategic social investments, and if they are measuring and valuing their broader societal impacts with metrics [21]

Overview of Governance scoring mechanisms

Scoring mechanism

What it measures

The thinking behind

 Governance Index (G-Index)

It measures 24 governance provisions that weaken shareholder rights and hence represent poor corporate governance

The focus on shareholder rights to measure governance quality is based on broad empirical evidence, that firms with stronger shareholder rights have a higher firm value and a better return compared to firms with weak shareholder rights

Biased towards US governance

No ESG focus

Entrenchment-Index (E-Index)

 It measures six corporate governance provisions – four provisions around shareholder rights and two provisions around corporate take overs

 Similar to the G-index, the E-Index is based on the thinking (and evidence) that firms with stronger shareholder rights have a higher firm value and a better return compared to firms with weak shareholder rights

Biased towards US governance

No ESG focus

 Economic Dimension Score (EDS)

It includes eight measurements that evaluate the quality of a company’s governance and management structures as well as its ability to manage long-term risks and opportunities

Focus lies on measuring how boards deal with ESG issues

With investors screening for governance practices as they do for environmental and social factors, and based on the understanding that a successful corporate ESG approach starts with a strong “G” we can expect governance scoring models to grow in width and depth.  

Notes

#

ESG

Environmental, social & governance

*

OECD

Organisation for Economic Co-operation and Development

Corporate clients who would like to discuss this topic further should contact:

Dr Arthur Krebbers, Head of Sustainable Finance, Corporates or

Varun Sarda, Head of ESG Advisory

Read the further articles in this series: 

Corporate governance: staying abreast of environmental and societal expectations

Corporate governance during the pandemic

Board priorities during and after the COVID-19 pandemic

[1] https://russellinvestments.com/uk/blog/2018-integrating-esg-survey

[2] http://www.corporategovernanceadvisory.com/uploads/4/0/9/3/40931365/cg_and_equity_prices_-_gim.pdf

[3] https://dash.harvard.edu/handle/1/11224528

[4] https://www.robecosam.com/en/insights/2018/knowledge-for-the-ages.html

[5] https://www.unescap.org/sites/default/files/good-governance.pdf

[6] https://corporatefinanceinstitute.com/resources/knowledge/other/principal-agent-problem/

[7] https://home.kpmg/xx/en/home/insights/2017/01/power-of-governance-in-family-business.html

[8] http://www.oecd.org/corporate/principles-corporate-governance/

[9] https://www.frc.org.uk/getattachment/9c19ea6f-bcc7-434c-b481-f2e29c1c271a/The-Financial-Aspects-of-Corporate-Governance-(the-Cadbury-Code).pdf

[10] https://www.sarbanes-oxley-101.com/sarbanes-oxley-compliance.htm

[11] https://www.oecd.org/finance/financial-markets/42229620.pdf

[12] https://www.frc.org.uk/directors/corporate-governance-and-stewardship/uk-corporate-governance-code

[13] https://www.icaew.com/technical/corporate-governance/codes-and-reports/wates-principles

[14] https://www.wates.co.uk/articles/insight/the-wates-principles-report/

[15] https://www.investopedia.com/ask/answers/051115/what-are-some-examples-different-corporate-governance-systems-across-world.asp

[16] https://www.law.ox.ac.uk/business-law-blog/blog/2019/01/universal-corporate-governance

[17] https://corpgov.law.harvard.edu/2018/06/29/esg-and-sustainability-the-boards-role/

[18] https://dash.harvard.edu/handle/1/11224528

[19] https://www.robecosam.com/en/insights/2018/knowledge-for-the-ages.html

[20] https://www.indexologyblog.com/2018/03/14/exploring-the-g-in-esg-governance-in-greater-detail-part-i/

[21] https://www.indexologyblog.com/2018/03/14/exploring-the-g-in-esg-governance-in-greater-detail-part-i/

ESG/Sustainability


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