Governance – the “G” in ESG – relates to the very heart of the organisation: how is it run, and is it honest, transparent, and does its leadership show integrity? The governance performance relates to the many variables which influence organisational decision-making. These activities include the formulation of policies and the distribution of rights and responsibilities among the various stakeholders.
Stakeholders, in this example, may be comprised of the CEO, board of directors, managers, shareholders, as well as other interested parties. Enterprises and investors alike place a high value on governance practices that are consistent with societal values. There are environmental and social concerns to address, but when it comes to developing sustainable business models, good governance is king.
In this article, we explore why governance outranks social impact and environmental issues. This is true whether one is considering organisational performance overall, or specifically from an ESG perspective. Certainly, the topic of governance can be messy and uncomfortable, and that’s why perilously little is written on the subject.
Understanding governance issues is critical because they serve as the foundation for effective corporate and business environmental, social, and governance management. In addition, they serve as the foundation upon which corporate social responsibility and sustainability initiatives can be developed and evaluated. Regulatory and legal compliance, as well as the use of resources (including capital and talent), markets (the boardroom has a significant role to play in markets), and the regulatory and legal environment (i.e., conformity with laws and regulations) in the pursuit of corporate objectives, is why governance is such an important component of overall corporate strategy and performance.
Board independence, shareholder democracy, accountability, disclosure, roles and responsibilities, decision-making processes, transparency, conflicts of interest, whistle-blower protections, and assurance are all given different levels of importance by different countries, depending on their governance frameworks. Corporate governance is a critical component of environmental, social, and governance (ESG) in the face of business mistakes and growing awareness of global diversity and income disparity.
While the ESG criteria are broad, poor governance undermines all efforts towards meeting the environmental criteria because, without executive leadership, very little change may be realised. Governance is also very much about the employees, and nothing more closely relates to the social factors – the “S” in ESG – than the mismanagement of the organisation’s primary asset.
Environmental, social, and governance (ESG) is a philosophy that companies should consider environmental, social, and governance issues when providing financial value to their stakeholders. For decades, corporate social responsibility has been an integral part of doing business. In recent years, there has been a concerted effort on the part of investors and public institutions to encourage corporations to behave in the most responsible manner possible.
In response to growing public concern about the use of aggressive tax avoidance techniques, governments and investors are scrutinising corporate tax policies more closely than ever. Such practices jeopardise the integrity of the financial markets and put the public’s money at risk of being misdirected.
Tax avoidance can include environmental, social, and governance considerations, as some businesses may choose to divert revenue through low-tax or no-tax jurisdictions, taking advantage of loopholes in domestic legislation that allow them to lower their effective tax rate. While perfectly legal, super-aggressive tax planning in order to reduce corporate income taxes may seem good for maximising shareholder value, but the long-term harm may ultimately prove more costly. One only has to read the media concerning Amazon and METS’s (Facebook) operations in Europe to consider the reputational damage. Such corporate decision-making disincentivises modern private and institutional investors whose investment strategies are more strongly aligned with ESG factors.
As socially responsible investing becomes ever more prevalent, expect to see shareholder activists bringing legal actions against individual board members who are perceived as not adhering to the stated social criteria and values espoused by the enterprise.
Corporate tax avoidance is a source of concern, particularly when it involves the use of offshore subsidiaries or the claim of tax deductions for expenses that are not necessarily legitimate. Some businesses engage in aggressive tax planning in order to reduce their corporate income taxes to levels that are higher than what is considered acceptable under national and international taxation guidelines. At the expense of the local economies that support them, this allows corporations to generate higher profits and allocate more funds toward executive compensation and shareholder dividends.
Pay for environmental, social, and governance (ESG) performance is a recent development in the field of corporate governance that has occurred over the past five years. Executive remuneration packages are being restructured in a new way to encourage better human capital management while also increasing transparency and accountability.
In today’s market, investors expect more from their investments than just strong financial performance. Companies must demonstrate positive social and environmental development as well as good stewardship of their assets, and they must respond to these issues if they want to remain competitive.
ESG-linked pay is a regulatory response to investor demand for greater transparency into how executive compensation structures encourage – or discourage – the adoption of sustainability policies within companies. Businesses are encouraged to include governance factors in their ESG Score as a result of this initiative.
Corruption is a significant issue in today’s business world. The consequences of corporate social responsibility can be detrimental not only to the companies and their investors, but also to governments and society at large.
Corruption has a negative impact on economic growth. According to analysts at Transparency International, a global business intelligence company, corruption costs the world more than $2.6 trillion USD every year. This accounts for slightly more than 5 percent of global GDP. Internationally, corruption increases the cost of doing business by at least 10%, and in developing countries, it can increase the cost of doing business by as much as 25% during the procurement phase.
Bribery is a major problem within businesses because it distorts market competition and undermines fair trade practices. According to the International Monetary Fund, bribes amount to up to $1 trillion USD per year. In reality, bribery outweighs international aid donations by a wide margin. The problem of corruption in business today is significant, and it can have a negative impact on all aspects of long-term sustainability.
Over the last few decades, it has been discovered that director nominations and elections have an increasingly positive impact on the long-term viability of a company. Some of the findings indicate that the higher the proportion of independent directors on a company’s board of directors, the better the overall governance levels within the organisation. Most companies with high levels of director nominations and elections outperform their respective market indices over the long term, which is why this occurs.
While there is a clear link between good governance and long-term value creation, there is still a long way to go before we have achieved the ideal balance. However, some board recommendations for improved governance outcomes include the following:
To mitigate ESG risks, it is recommended that external directors be chosen from a diverse pool of candidates who have a thorough understanding of the company’s industry and high expectations for the company’s long-term growth.
Apart from changing their skill sets and attitudes toward board membership, they also encourage leaders to think about changing their timetables. For example, instead of making decisions based on quarterly results, they recommend making decisions based on a company’s business model and long-term success as a starting point. The most significant risks are frequently the same, but the precautions are specific to each company.
It should come as no surprise that cyber security has emerged as a significant risk for every type of company. The most significant risks are frequently the same, but the precautions are specific to each company. Even though there is no doubt about the importance of cyber security investment and precautions, many people believe that public companies are already investing enough in cyber security as evidenced by their financial performance. Reviewing past high-profile data breaches such as the ones that occurred at Yahoo and Equifax, investing in cyber security does not always equate to the level of protection that we believe it to be.
Global risks, according to the World Economic Forum Global Risks Report, include cyber security as one of the most significant threats that the world will face over the next ten years. Cyber risk was ranked fifth overall and second in terms of impact in the 2016 edition of the report. More than 60% of respondents, both from the industry and from non-industry, ranked cyber security as one of their top five concerns in the survey. Given the high-profile data breaches that occurred at the time, this is not surprising.
In recent years, the number of data breaches has increased massively, outpacing the current level of expenditure on cyber security by a wide margin. Dimensional Research found that two-thirds of companies have increased their spending on cyber security in the last year, but that 75 percent of those companies are overwhelmed by the task of simply keeping up with current standards.
Because cyber security has an impact on governance facilitation and operation, it should come as no surprise that the issue has become increasingly recognised in recent years as a critical factor for companies to consider when evaluating their social and environmental responsibilities.
A company’s governance is detrimental to the triple bottom line in a variety of ways. It has a negative impact on the company’s ability to invest responsibly across the organisation, and in some cases, it can lead to fraudulent activity in the organisation. This can lead to a loss of shareholder confidence, which can result in lower returns due to a decrease in the value of the company’s stock. Many organisations consider shareholder returns to be a critical factor in determining their sustainability performance, and they are right to do so.
The disclosure of sustainability information is influenced not only by how companies manage their performance, but also by the manner in which they report on it. The absence of effective governance can result in poor reporting practices that are difficult to assess in light of the current disclosure requirements. As a result, sustainability reports may not provide a clear picture of what is happening within an organisation, and this lack of information may have a negative impact on the organisation’s reputation.
There are many different governance practices, including compliance with all applicable laws, regulations, and charitable obligations. However, it’s important that social, environmental, and ethical issues are addressed through consistent policies with a clear process for identifying new opportunities to manage environmental, social, and governance risks and opportunities. There should be a clearly defined organisational structure that is responsible for implementing best practices in environmental, social, and governance risk management.
Corporate Social Responsibility, CSR, stresses how companies should protect their employees, respect the environment, and work with ethical suppliers. Certainly, there is no more pressing obligation than for businesses to play their part in the fight against climate change. To understand the difference between CSR and ESG, consider CSR as being concerned with enhancing the ethics of the organisation, while ESG is about adding value. The two disciplines are entirely inter-related.
It is difficult for a business or organisation to manage the interests of its stakeholders and clients if it has not established proper governance.
Failure to identify significant environmental, social, and governance risks will increase the likelihood of fines and penalties, which may have a negative impact on long-term viability. A rapid transformation has begun, and good governance and long-term leadership are required.
Leads the daily operations at ESG PRO, he specialises in matters of corporate governance. Humperdinck hails from Bermuda, has twice sailed the Atlantic solo, and recently devoted a few years to fighting poachers in Kenya. Writing about business matters, he’s a published author, and his articles have been published in The Times, The Telegraph and various business journals.
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