As environmental issues like climate change and social issues like diversity, equity, and inclusion dominate board agendas and stakeholder conversations, it can be easy to give the 'g' in ESG short shrift. But boards overlook governance ' which guides oversight of everything from ESG metrics to ESG risks ' at their peril. What is governance? How does it factor into ESG? What can board members, executives, governance professionals, and sustainability leaders at firms do to strengthen this important area of corporate oversight? Here's our guide.
What is the 'G' in ESG and Why It MattersGovernance, simply put, has to do with the rules, roles, and processes through which a company ' and its board ' is run. Think board composition, executive compensation, corporate disclosure, and more. Governance determines who sits at the board table, how these directors gather information and make decisions, and how they communicate with stakeholders and each other. The importance of good governance may best be illustrated through its absence. An example would be executives or directors engaging in activities like fraud or insider trading or unenforced conflicts of interest ' say if a director has commitments that contrast to the company's environmental or social guidelines.
A Bottom-Line ImpactInsufficient governance practices can have a significant negative impact. 'Governance shortfalls' at 14 companies recently cost shareholders a total of $490 billion in value one year later, according to a 2019 Diligent report. Furthermore, investors may avoid a company known to have poor governance practices in order to shield themselves from the elevated risk of a scandal.
An Overall Competitive AdvantageOn the flip side, good governance practices have strong positive impacts, such as fewer instances of bribery, fraud and corruption over time ' translating to lower costs of capital, lower volatility, and overall competitive advantage. Diligent's 2019 research delivered a powerful argument for good governance. It found that companies in the top 20% in terms of strong governance outperformed the bottom 20% by 15% over two years. Good governance helps investors realize the promise of their environmentally and socially responsible investments ' namely, stability and value over time.
Why Is Governance So Challenging?It can be difficult today for boards to know if they're getting governance right. Take the seemingly straightforward concept of recruiting a new board member, for example. You need an internal evaluation to identify gaps, external intelligence on how peers are handling composition and candidate supply, processes to recognize conflicts of interest, and so forth. Unfortunately for boards today, the latest corporate governance codes and stewardship guidelines are often scattered across disparate sources. Industry data in areas like executive compensation can be proprietary or difficult to access. In a research report by Forrester and Diligent, governance professionals indicated that 'visibility into sustainability and ESG issues' was their greatest dissatisfier.
The Necessity of BenchmarkingHow does your board structure and composition compare to your peers? What skill sets is your board lacking? Just as they do in areas such as environmental reporting, labor/HR issues, or privacy and security compliance, boards must be able to track their governance performance against established metrics and their competitors and peers. They need to be able to identify red flags and discrepancies and then take corrective action on them. This requires centralized, consistent information from a variety of sources ' internal and external.
Communicating the 'G' in ESG To Stakeholders
Boards should be able to explain why [their governance structure] operates the way it does to their investors.Stakeholders want proof that a company and its board have sound governance practices in place. This requires boards and investors to navigate a communication gap as ESG issues escalate, and ESG metrics evolve. Finding the right words is half the battle. Boards must also identify a format and channel that are straightforward to prepare and easy for shareholders to digest. Unfortunately, governance faces the same challenge as environmental and social issues in terms of myriad reporting frameworks with little consistency across them. The good news: Centralized metrics are beginning to emerge. One example is new standards established by the World Economic Forum, which draw from established frameworks and include an entire section on principles of governance.
- Rakhi Kumar, Former Senior Managing Director and Head of ESG Investments and Asset Stewardship at State Street Global Advisors
Where Is the 'G' in ESG Headed?As boards enter 2021, they can be certain of three things: The world as we know it is changing, the next generation of investors is changing the way investment works, and data and analytics are evolving to provide more information than ever.
The Rise of Modern GovernanceMeasuring and reporting are just the beginning in this accelerating business environment. Boards will need to transform their practices to move from traditional oversight to more modern approaches to governance. What is modern governance? It is Netflix adopting a transparent board-management communication model that caps board materials at 30-page outlines and focuses discussions on strategy. Good governance is also Prudential's board realigning its proxy disclosure to six governance principles adopted from the Investor Stewardship Group. In short, modern governance is the practice of empowering leaders with the technology, insights and processes required to fuel good governance.
The Role of TechnologyGetting the right people in the room is one step. Equipping them with the tools to lead is another. Several governance solutions have emerged to help boards analyze their composition, benchmark against peers, identify inefficiencies, and stay up to date with industry trends and stakeholder expectations. These include:
- Analytics programs for benchmarking activities and flagging discrepancies
- Systems that monitor governance 'health'
- Intelligence on standards, trends, news, and stakeholder sentiment
- Reporting solutions that consolidate frameworks and streamline stakeholder communications