If you missed the memo about ESG in investing, you’re one of very few investors who have.

Environmental, social and governance (ESG) factors are being used more and more by investors to assess the sustainability and risk profile of companies.

And a good G rating is fast becoming an indicator of solid and reliable companies with great returns.

It’s worth thinking about, because ESG factors can dramatically affect a company’s financial performance and shareholder value, either in a positive or negative way.

What is the ‘G’ in ESG?

G stands for governance.

Governance falls into ESG investing as the decisions and changes made to help create a ‘better’ company.

This could be through the ethics of its board members, its diversity standards, the company culture, or the sustainability of its day-to-day operations.

Governance covers pretty much everything about a company – a broad range of corporate activities including its board and management, as well as a company’s policies, standards, information disclosure, auditing and compliance. Yes, everything!

For example, investors want to know that a company’s accounting is accurate and transparent, and that its business practices are ethical.

They also like to see policies that encourage shareholder engagement and they want to invest in companies with a board of directors that’s both accountable and diverse by gender, race, skills and experience.

What boards do

Every share market-listed company has to have a board of directors. A board is an elected group of directors that represents the interests of shareholders.

A board’s role is different to a the job of the chief executive officer (CEO).

Both boards and CEOs make high-level decisions, but a board can choose (and fire) the CEO, approve sweeping policies and make major decisions.

The board oversees the CEO and makes sure the company’s performance is strong and it’s profitable.

The board usually only meets a few times a year to review how the company’s performing and makes plans for the future.

On the other hand, the CEO makes decisions daily, carrying out the board’s directives.

As CEO, you’re in charge of developing and executing strategy, while the board is responsible for approving and advising you on it.

At some companies, the CEO sits on the board, sometimes even serving as chair. This is not the most appropriate form of good corporate governance because the lines are blurred.

Ideally, board and CEO roles are separated so there are clearly defined roles and the strategy is well executed.

As an investor, you can screen for good governance practices, as you would for environmental and social factors.

Poor governance

What does poor governance look like?

A poorly governed company could be one that’s involved in legally or ethically questionable practices, that opens itself up to bribery or corruption, or one that doesn’t adequately address long-term risks to its business, such as the risks presented by climate change.

Just like environmental and social issues, corporate governance issues also regularly hit the headlines.

Take Volkswagen Group, a perfect example of the negative consequences that can stem from poor governance.
It was revealed in 2015 that the company had cheated emissions tests on more than 10 million of its diesel cars.

Volkswagen had to pay billions of dollars in criminal and civil penalties related to the scandal, which had a significant impact on shareholders.

Even today, the company’s share price hasn’t fully recovered.

CEOs’ salaries under scrutiny

Senior executives’ pay and bonuses are set by boards, and this is a contentious issue, which often comes up for discussion.

Regulators in many countries require publicly-traded companies to allow shareholders to vote on executive compensation packages.

Certain compensation structures work against the long-term interest of shareholders.

Recently, Norway’s influential US$900 billion sovereign wealth fund announced it would focus on curbing excessively high executive salaries at its investee companies.

Diversity is profitable

Gender diversity and gender equity are other high-profile governance issues.

Many institutional shareholders are demanding more women on corporate boards and in executive positions, and want to see equal pay and career prospects for women.

Research from Morgan Stanley shows that a better balance of men and women in the workplace can deliver returns with less volatility, meaning that gender diversity is actually profitable for companies and investors.

In New Zealand, corporate diversity is still lacking on most major company boards. Most are made up primarily of older white men, which is probably not reflective of the needs of the business.

In 2022, New Zealand’s top 50 public companies (NZX 50) have an average of seven board members per company. The average representation of females is two, or in other words, 30 per cent of board directors are women.

Only five out of those 50 companies have majority female directors.

It’s even worse when we look at company leadership. Only four companies in the NZX 50 are led by a woman – PushPay, Sky TV, Spark and, more recently, Auckland Airport.

There are more CEOs called Peter than there are women!

Great governance

However, there are also some great governance stories in New Zealand.

One is Auckland Airport. Despite having a tough couple of years financially, it’s a leader in corporate governance.

Global research house MSCI says Auckland Airport “falls into the highest scoring range relative to global peers”. It went on to say that its governance practices are well aligned with investor interests. Not only does the company have a female CEO, it has majority female representation on its board. This is, unfortunately, unusual in New Zealand.

What is the ideal board?

The ideal board is one with:

• gender balance
• a mix of independent and non-independent directors
• members from different backgrounds
• a variety of ages
• differing skills and expertise.

A diverse board leads to a company making effective decisions, guidance, and risk management. Having a diverse board of directors is a key element to a company’s success.

There are far-reaching effects to good corporate governance. It fosters a culture of integrity and leads to a positive performing and sustainable business.

There have been many studies done that show a positive correlation between good governance and corporate performance, measured in both financial terms and non-financial metrics.

Investors have started noticing this correlation, too. Now, more than ever, they’re demanding better corporate governance from the companies they invest in.