Introduction
When it comes to discussions with companies on Environmental,
Social and Governance, everything was thought to be heavy on the environmental
and philanthropic matters. It seems that the ‘G’ topics have always been less
focused as compared to the ‘E’ and ‘S’ topics. Well, that may all change and here’s
why.
Environmental and Social Performance Are Linked to Good Corporate Governance Practices
Companies have now started to pay more attention to climate
change (E element of ESG) issues that not only include how their businesses
impact to the greenhouse gas (GHG) emissions level, but also how climate change
poses risks to their businesses as well. Now that businesses are striving to
sustain during the current pandemic crisis due to COVID-19, the focus on the S
element of ESG such as healthcare, wellbeing and employee management has risen.
What companies need to be aware of is that whilst they are concentrating to
manage the E and S elements better, they simultaneously would need to revamp on
the G element of ESG; Governance.
According to the Chief Operating Officer (CEO) to one of the world
leaders in the food producers industry, Danone, structurally integrating
Environmental and Social responsibility in companies Governance is the approach
to be more strategic on the E and S elements.
Now that there has been a surged in meeting the demands to better
communicate and manage companies’ stakeholders during the current COVID-19
pandemic, there have even been expectations on the potential establishment of
new, and more agile corporate governance standards and models. This claim is
supported by a project undertaken by the UK’s Institute if
Directors with an independent body
pertaining the key issues of corporate governance affecting Boards as companies
striving from the impact of COVID-19, and at the same time to be able to meet the
ongoing expectations such as the United Nation’s SustainableDevelopment Goals (SDGs), stakeholder
engagement and transparency as well as investment in new technological
infrastructures.
Governments across the world have also been playing their
role to reduce the stress of private companies during COVID-19. Capital
allocations in the form of bailouts, loans, grants, tax concessions and equity
purchases from governments are a precursor for institutional investors to make
quick and smart shifts in corporate governance to be aligned and integrated
with environmental and social goals as well as in stakeholder management as a
whole.
Poor Corporate Governance Practices Have Financial Implications
These shifts would realign corporate governance as the
reference point of strategic asset allocation (SAA) due diligence and approach.
As mentioned in a recent published research by the
Principles for Responsible Investment (PRI), sound corporate governance is
imperative in the cases studies presented from the investment management
industry. In one of the case studies, Aberdeen Standard Investment highlighted
that “We think that corporate governance is often largely ignored by SAA.
Investors focus on economic growth and valuation, without asking enough about
whether the aggregate quality of governance will affect the ability of
companies to translate that growth into shareholder returns.” The case study
clearly indicates that the global financial crisis was directly due the
systematic failure of sound corporate governance in the global financial
services industry that include the mis-selling, lax risk controls, and
over-reliance on short-term wholesale funding. The global financial crisis
resulted in the enforcement of tougher regulations, lower relative returns in
the sector, and a steep learning curve for those involved in the business of
SAA.
The case study focuses merely on sectorial performance
rather than individual companies’ corporate governance practices, where it has been
understood by its SAA within the Japanese equity market, an arena where the shareholder
returns had been dreary for the best part of 30 years. This is partly resulted
from the poor corporate governance practices showcased particularly in
stakeholder management. It is said, just 15% of Japanese corporate boards had
independent directors to represent the interests of minority shareholders in
2011, most Annual Grand Meetings (AGMs) were held on the same (and limited) days
each year, causing the challenge for shareholders for effective and productive
engagements with directors.
Apart from that, due to the poor corporate governance
practised, it was observed that the effort to promote value for shareholders
was inadequate, on top of extremely low profit margins, cash hoarding, and low
pay-out ratios. In the end, Aberdeen’s SAA to Japan was relatively low in
comparison to its international equity holdings.
In 2015, the necessary shift to adopt a new corporate
governance code was established. In turn, 4 years later, around 90% of Japanese
companies had appointed independent directors. Apart from that, the scheduling
of AGMs were organised to ensure no clashes of events occurred. The rise of
shareholder activism was also seen, as well as in the large domestic pensions
funds where special attention was paid to regarding shareholder returns. All of
this had fruitful consequences where the return on equity has increased due to
equity buybacks and payout in dividends.
Aberdeen’s researchers also noted that Japan isn’t special
for this case. It’s is just a mere example. “Governance quality materially
affects our assumptions about margins, buybacks, and valuation multiples for
several equity markets. And it doesn’t stop at equities. We see governance as a
key part of our evaluation of default risk and recovery rates for credit
portfolios,” they added.
Focusing on Sustainability Budgets
According to another case study from Schroders,
‘sustainability budget’ is the answer to imbed ESG in the SAA process and one
element that anchors the process is through corporate governance.
Director of Investment Practices of the PRI, Toby Belsom
stated that; “Good governance has been demonstrated to ‘make a significant
incremental difference to value creation as measured by long-term risk-adjusted
rates of return’. The further along the sustainability spectrum that assets are
managed, the larger the governance budget required to manage those assets in a
sustainable way.”
And, as the number of asset classes managed sustainably
increases, a larger governance budget will need to be assigned. “There is the
need for a new framework… a ‘sustainability budget’, alongside a risk budget,
so that real-world outcomes might be incorporated into SAA decision-making.”
It’s also interesting to note the highlights made by S&P
Global’s Kelly Tang in a study on corporate governance in ESG. She mentioned;
“There is already substantial empirical evidence to suggest that the G aspect
of ESG ultimately yields better corporate returns. Governance data, unlike
environmental or social data, has been compiled for a longer period of time and
the criteria for what comprises good governance and its classification has been
more widely discussed and accepted.”
Conclusion
Companies will soon realise that disintegrating each element
of ESG, or placing one element more important than the other, will no longer be
ideal to meet future demands and expectations from stakeholders. We have widely
seen companies excel in its social and environmental performance, but with
limited information on how they are being anchored by a strong and responsible
good corporate governance practices. In light of COVID-19, the severity of the
pandemic was more related to national and global governance failures, not
taking companies accountable. However good corporate governance practices of
private companies is much likely to influence returns for decades.
All views and opinions expressed on this site are by the author
and do not represent any particular entity or organisation
