Good governance: the G in ESG

Without good ‘G’ (governance), there will be no ‘E’ (environment) or ‘S’ (social). How a company is led will determine whether it practices and embodies ethical policies in all aspects of its management and strategic direction.

Poor governance can have serious consequences, with companies missing business opportunities or failing to take action on key risks. It can fatally undermine a company’s long-term viability. This final article in our short series on ESG investing looks at the G in ESG, meaning how well or poorly a company lives out ethical or sustainable practices.

From Volkwagen’s emissions tests to Facebook’s data misuse, to the global banking crisis – had the chairman, chief executive and board been doing their jobs correctly, the majority of these failures would not have happened. Corporate governance rules aim to create checks and balances to ensure that power is shared effectively within an organisation and the management team is held to account. 

Today, most countries have their own corporate governance code, which sets out expected standards of good practice. The first iteration of the UK Corporate Governance Code was published by the Cadbury Committee in 1992 and defined corporate governance as “the system by which companies are directed and controlled”.

This Code sets the framework for good governance for UK companies. This will include how the management team is constructed – a diverse and independent board, separation of CEO and Chairman roles – so that each can hold the other accountable. Increasingly, companies see diversity as a tool in avoiding ‘group think’, which proved so damaging in cases such as Enron. It also lays out reporting rules and the internal processes and procedures that should exist – whistleblower systems, audit and risk controls, plus the right external oversight.

Research from investment group Hermes suggests that well-governed companies perform far better than companies with weaker governance. In its report ‘ESG investing: how Covid-19 accelerated the social awakening’, it says: “Companies with good or improving corporate governance have tended to outperform companies with poor or worsening governance by 24bps per month on average”. This outperformance is unchanged over time, suggesting it is a persistent factor in share prices.

Part of this outperformance may be explained by the disastrous consequences of poor governance. S&P Global research on governance factors has shown that companies ranking below average on good governance are routinely prone to mismanagement. They may neglect key risks and try to cover them up when they emerge. If management teams score poorly on governance metrics, they are also likely to miss business opportunities and run day to day operations badly.

Governance problems are often a source of shareholder agitation. Many companies have been hit by shareholder disquiet over executive pay: JD Sports, for example, was hit by a shareholder revolt after it emerged boss Peter Cowgill was paid almost £6m in bonuses, despite the company accepting more than £100m in government support. Andrew Leslie, chair of the remuneration committee, was forced to step down after 11 years on the board.

. Sainsbury’s and WM Morrison have also run into trouble. These problems put pressure on the share price, dent a company’s reputation and are an unwelcome distraction for the executive team. There is a lingering sense that if companies are careless with shareholder funds, using them to enrich their executive team rather than directing them to staff or research and development, the company will ultimately suffer.

The Investment Association, which represents UK fund managers, recently wrote to the heads of remuneration at FTSE-listed companies urging restraint on executive pay in the year ahead as many UK households struggle financially. Executive pay has bounced above pre-crisis levels. Companies that appear to be paying excessive salaries to their top team, while pushing up prices and refusing inflation-adjusted pay rises to their workers will look insensitive at best and may face continued shareholder pressure.

Shareholders are increasingly seeking to tie bonuses to environmental and social goals, putting ESG strategy at the core of the business rather than just focusing on shareholder return. There is a growing recognition that targeting shareholder return alone can skew incentives, pushing executives into short-term decision-making that flatters the share price and is not necessarily in the long-term interests of the company.

There are few dedicated good governance options for investors, but it will be part of the investment selection process for the majority of investment managers even where they don’t have a specific ESG mandate. Most have been looking at this longer than they have been looking at environmental or social areas and will have clear processes in place. It’s worth looking at a fund management group’s track record on governance and the extent to which they engage with companies on areas such as executive pay.

Good governance is a key element in the long-term sustainability of a business. Badly run businesses tend to have greater risks, may miss key opportunities and lack transparency. Sustainable investing isn’t a promise of positive performance but it’s a good place to start.

Fineco Bank currently features in the FTSE4GOOD index and the S&P Global 1200 ESG index. The Fineco trading and investment platform has a broad range of tools and resources to help you work out and source investment opportunities in line with your ethical and sustainability beliefs.