Governance Investing: What does the 'G' in ESG mean?

When SmartPurse surveyed UK parents, we asked which of the ESG values they tend to invest in the most, and the results were fairly predictable. Environmental led the way with 46.43% of the votes, followed by Social (36.5%), and in third place, Governance (16.26%). The more I read about ESG values, and how people chose to invest their money, the more I see this as a recurring pattern. Today, I want to discuss why the 'G' in ESG is so often undervalued, and why you should start actively incorporating it into your sustainability efforts.

What does 'Governance' mean?

'Governance' - the 'G' in ESG, refers to the logistics, decision-making process, and different regulations surrounding corporations. It can also refer to the government of nations, but this is a little less common. Of course, investing in companies and corporations has always included a degree of governance assessment, but this falls into responsible investing when the decisions and changes made help to create a 'better' company, whether this be through the ethics of its board members, its diversity standards, the company culture, or the sustainability of day-to-day operations.

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. - Alva Group

One way of measuring governance which is particularly popular amongst ESG investors is RobecoSAM's Economic Dimension Score, which evaluates corporations against eight key criteria, including many which focus on or support sustainability metrics.

Here's a quick summary of the criteria:

1. Corporate governance: ensures a company is managed in the interest of all shareholders (including minority groups)
2. Codes of business conduct: evaluates whether company practices have been designed to best prevent corruption and i.e. bribery
3. Risk and crisis management: measures the effectiveness of a company's risk strategy, including long-term impact and mitigation efforts
4. Supply chain management: evaluates how a company approaches outsourcing in terms of corporate responsibility
5. Tax strategy: ensures that a company has a clear policy for its taxation
6. Materiality score: assesses whether a company can identify long-term value
7. Policy influence: measures how much money a company allocates to organisations who create or influence public policy or regulations
8. Impact measurement and valuation: evaluates company provisions towards social needs, and whether they measure their impact with responsible metrics

This last point, 'Impact measurement and valuation', is the most obviously 'sustainable' on the list, but deeper evaluation can find social and governance goals in each criteria.

At first glance, it seems clear why governance values are often the least popular as a stand alone hypothesis for investments - a list of eight criteria which largely assess the standard of operations within a company is not the most exciting. But when we consider that these criteria can 'make or break' a company, their importance becomes clearer.

For example, S&P Global Market Intelligence research revealed that firms with more women on their board of directors and in executive positions had greater financial performance than less diverse companies.

In an article on the topic last year, Fidelity noted that Warren Buffet's annual letter to his company shareholders even highlighted how they were making good progress in areas of corporate governance, including the number of women in the boardroom, and how we need to continue pushing for companies to be held responsible for their actions. As Fidelity put it, 'it's revealing to see the value that the world's most famous investor [places] on good governance'.

What does (sustainable) governance include?

We can see examples of governance values amongst the UN's Sustainable Development Goals, especially in the following examples:

In these examples, governance is not the only ESG value at play - gender equality is closely tied to social issues, for example, with Corporate Social Responsibility (CSR) becoming a more important topic of discussion in recent years. What this shows, then, is that even if you don't believe you're actively investing in any governance values, you probably already have.

When, ultimately, all the material elements of Environmental and Social have Governance reporting, and therefore accountability, governance will have become the most significant element of ESG - Alva Group

Is it important that governance becomes the 'most significant element of ESG', as Alva Group says? I am not sure that pitting our sustainability values against one another is the best way to ensure responsible and continued growth, but it does help us to see the intricacies of each investment we make.

Even in thematic funds, which focus entirely on one specific goal, such as green transport, our money goes further than we ever really think it will. An investment in green transport can end up impacting the planning and density of newly emerging cities and communities, and whether companies are held accountable for their actions can determine whether these new cities are built as sustainably as possible. In this way, it does not matter which of the three ESG values you 'prioritise', so long as they are all considered.

How can you include governance in your investments?

It seems as though even when we make investments into super specific environmental or social themes, we are still contributing towards some form of governance impact at the same time. But maybe you're also looking for ways to directly invest in companies with good corporate governance?

There are two routes to begin with: looking at the governance impact on your existing portfolio, and investing in new opportunities to increase the impact that your money has.

Investing in Governance

The best way to increase the impact that your money has on good governance values is to do your research. If you want to check how ethical the corporations you invest in are, there are plenty of opportunities to find this out. You can begin by checking out their reputation. Spend some time researching the company, looking into recent news articles and public opinion from the last few months. If a company is not meeting its promises or living up to shareholder expectations, the beauty (or the curse) of social media is that people will be talking about it.

After this initial research, you might then go on to use ESG metrics and benchmarks for further insight. I've already mentioned RobecoSAM's Economic Dimension Score, which includes some good measurements for sustainability, but you can find some more options in my previous issue on 'the minefield of greenwashing and benchmarking'.

Measuring Governance

The options that I have outlined above for investing in good governance opportunities are also all helpful ways to measure the impact of existing companies in your portfolio.

On top of these options, the World Economic Forum announced their new Stakeholder Capitalism metrics in 2020. These are part of a global effort to 'streamline and standardise reporting on environmental, social, and governance topics', and include 21 core metrics split across four main pillars: Planet, People, Prosperity, and importantly for this issue, Principles of Governance.

The World Economic Forum goes into more detail on their new metrics in their 2020 report, but here's a quick breakdown of some of the key governance themes:

• Governing purpose
• Quality of governing body
• Stakeholder engagement
• Ethical behaviour
• Risk and opportunity oversight

As we've seen, investing in 'governance' as a theme might not be the most intuitive for many of us, but as it plays such an important part of the overall approach you take, it is a criteria to be considered. Be it when you pick single stocks, or funds.

How much attention do you typically pay to governance when it comes to your investments? Let me know in the comments below, and as always, be sure to let me know about any topics or interviews you'd like to see in future issues of Money's Impact.

• Article: Matt Levine's Money Stuff column, Bloomberg, includes some interesting perspectives on corporate governance
• Report: World Economic Forum, Measuring Stakeholder Capitalism: Towards Common Metrics and Consistent Reporting of Sustainable Value Creation