Exploring the G in ESG

While ESG issues are gaining traction, and becoming common corporate parlance, the governance element is often overlooked. But although it may garner less attention, it is the bedrock on which sustainable, long-term value creation is built, and also underpins every organisation’s ability to achieve its environmental and social goals.

The rise of ESG

The proliferation of references to ESG – from the pressroom to the boardroom – reflects the desire among all of an organisation’s stakeholders that environmental, social and governance (ESG) issues are addressed. Socially responsible investing was arguably at the forefront of the movement, with asset managers and shareholders looking to incorporate ‘green’ shares into their investment strategies. This was not for altruistic reasons.

Good performance on ESG criteria has been linked to strong long-term financial performance, promising healthy returns to those pursuing sustainable investment.

For this reason alone, it behoves companies to include ESG ratings or measures in their corporate reporting.

Shareholders looking for ESG investments are not the only stakeholder group with an interest in a company’s environmental, social and governance performance, however. Consumers are increasingly making buying choices based on the sustainability pedigree of the businesses they buy from. Brands able to demonstrate their commitment to the planet and its people will score highly with these ‘conscientious consumers’. Employees are similarly weighing ESG factors and the alignment of their personal values with those of potential employers when making career decisions.

The supply chain also has a vested interest in ESG – good governance includes managing and maintaining strong links through the chain, ethical behaviour towards suppliers, and the requirement of sustainable practices by those suppliers. The community in which an organisation is based, meanwhile, has an equally powerful interest in its social responsibility efforts, whether they be sponsoring local sports clubs, improving the local environs, or providing secure employment.

Regulators, the media and NGOs all number among the stakeholders judging businesses against their ESG success, making it an essential element of risk management, corporate governance and business policy.

The governance lag

While the rise of ESG has helped catalyse a new era of stakeholder capitalism, rooted in the principle of long-term value creation for all, in reality the focus has largely been on the E and latterly the S elements. Over the last few years, environmental imperatives combined with popular social movements have propelled these issues up the corporate agenda.

Governance, however, has been less popularised, perceived as the realm of the board of directors rather than an area of influence among wider stakeholders. Only shareholders expect to have an interest in, and impact on, governance decisions, and then only through indirect ways, or the last resort of a shareholder rebellion. Arriving late to the ESG party, governance has been incorporated with varying degrees of success, but hasn’t captured the imagination of stakeholders, or wider public attention except in cases of extreme failure.

The Sports Direct zero-hours and working conditions scandal indicated the degree of mismanagement required for governance failings to become newsworthy.

But in spite of a lack of recognition, and even understanding, surrounding the G in ESG, it is nonetheless vitally important to ESG success, securing stakeholder confidence and the creation of a sustainable business.

This becomes clear when considering the impacts of various strands of corporate governance.

• Boardroom diversity: A diverse board brings a wealth of advantages. It offers wider perspectives, makes more robust decisions, fosters innovation, tends to be more agile, and better reflects the business’s investors, customers and community. A diverse board is good for the bottom line.
• Executive remuneration: One governance action sure to hit the headlines is multi-million pay packages for CEOs, particularly those seen as poor performers. According to Ipsos Mori, the most commonly cited reason for lack of trust in business is the perception that executives are overpaid compared to other employees
• Multiple board positions: Failure to limit how many boards directors can sit on can lead to obvious conflicts of interest, compromising their loyalty to one organisation’s stakeholders over another’s.
• Compliance: Governance encompasses information disclosure, auditing, accounting and complying with regulations. Failure to fulfil these obligations can seriously damage the business’s reputation, revenue and longevity.
• Creating and enacting policy: Governance determines that a business is behaving ethically, that it pursues policies in the interests of its stakeholders, that is does not negatively impact the environment. Without the G, there can be no E or S in a business model.

Governance is the key to ESG

If you accept that the premise of ESG as rooted in the stakeholder capitalism model of promoting shared value creation, then governance must be fundamental to that achievement in the long term. Good governance is the foundation of stakeholder capitalism.

ESG risks and opportunities are myriad, and can only be averted or exploited through effective corporate governance decisions.

As ESG evolves there will be blurring of the boundaries between each of its elements. We are already seeing this in the S criteria, with boardroom decisions on corporate social responsibility (CSR) gaining greater importance, and larger, more diverse boards recording better CSR performance. With a future increase in more specific climate change legislation, along with the requirement for reporting on environmental impact, governance will also intersect with the E element of ESG.

The lack of appreciation of governance within ESG criteria highlights the need for more standardised reporting on ESG performance, measuring different types of value creation activities for various stakeholders. If each element of ESG is scored and ranked, then the value of each activity can be acknowledged.

And as governance decisions are based on quantifiable results, as E and S become more mainstream and better measured and the board sees progress in social and environmental policies, the logical extrapolation is that environmental and social performance will become an inherent part of governance.

To maximise ESG performance, the principles of stakeholder capitalism need to be embedded in corporate decision making in a tangible, accountable way.

When, ultimately, all the material elements of E and S have governance reporting, and therefore accountability, governance will have become the most significant element of ESG.

The future role of governance

While the social element of ESG in particular is relatively young in its adoption by companies, the maturing of both it and environmental considerations will result in these issues being treated as business as usual, demanding a similar level of reporting and a comparable regulatory framework to any other area of governance.

Driving this will be not only the growth of regulation and the embedding of it in boardroom practices, but the influence of all the many stakeholder groups demanding recognition of their requirements around ESG. Since the 2016 green paper on corporate governance reform was released, there has been an expectation that board responsibility includes taking on and reporting stakeholder views.

The green paper itself did not mandate specific models of stakeholder engagement, and didn’t result in a governance revolution. But it was a concerted move towards stakeholder representatives at board level, demonstrable mechanisms for regularly consulting with stakeholders, and regular reporting on those consultations.

The future of governance will see codified versions of these aspirations, making it a more visible, and valuable, factor for all of an organisation’s stakeholders.