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November 22, 2023

The Three Pillars of ESG (Part 3): G for Governance

by Team Rowling

By now you should have a pretty good understanding of ESG’s three pillars: Environmental, Social, and Governance. You also likely understand that ESG analysis focuses on issues that are important for society as a way to better identify risks, opportunities, and projected financial performance in companies, so it isn’t all about “wokeness.”

As we discussed in Part 1 of this series (The Three Pillars of ESG: E for Environmental), we discussed the environmental pillar, and in Part 2 (The Three Pillars of ESG: S for Social) we took a hard look at how social issues can impact a company’s ESG rating, therefore its bottom line.

Today we take a look at governance, perhaps the least understood of the three, but one that certainly doesn’t lack importance.

ESG Governance Factors

What is ESG, and what are the standards?

A reminder if you’ve read the first two parts, or a refresher if you’re just joining us: ESG combines social-good metrics and traditional, economic-focused investment analysis with an overarching aim: to better identify risks, opportunities, and expected financial performance in companies, so investors can act on that information.

Also: As there is no requirement in the United States for ESG disclosure, no accepted standard for ESG reporting details exists. Thus, organizations select what they report; this can be self-driven, or ordered of them by investment firms.

Like environmental and social issues, this means that not all ESG analysis contains the same factors or weighting in the governance sphere. That said, there are definitely some key governance factors that are often a part of these calculations.

 

What ‘Governance’ Means

First, because it’s less self-explanatory than environmental and social, what exactly does “governance” mean? As defined by Deloitte [PDF download], governance is “…the governing structure, policies, and practices employed by an organization to define responsibilities and decision-making rights that provide the foundation for overall accountability and credibility.”

 

What Makes Up The ‘G’ Pillar?

What the governance pillar consists of, specifically, includes:

Audit Committee Structure

Audit committees, per PricewaterhouseCoopers, are the bodies that oversee an organization’s ESG reporting, and they play an integral role in alerting companies to potential risks and opportunities.

Board Composition

From an ESG perspective, according to Deloitte, board composition looks at whether a board has “an appropriate range of skills and experiences across existing members” to address the many ESG areas.

Bribery and Corruption

Fairly self-explanatory: Has the company been found to be engaged in any bribery or types of corruption such as conflicts of interest, embezzlement, undue influence, and even sexually abusive extortion.

Executive Compensation

What do people at the executive level get in terms of pay and other compensation? Interestingly, companies are now linking said compensation to ESG performance.

Lobbying and Political Contributions

More subjects that exist well outside the scope of ESG, the Global Reporting Initiative says that while they can at times help develop publicly beneficial policy, it can also be associated with bribery, corruption and “undue influence.”

Whistleblower Schemes

Do companies have systems in place to encourage and protect, as defined by the UN’s Principles for Responsible Investment (PRI), employees, customers and suppliers who “speak up and share information on activities that violate a company’s ethical code of conduct, its legal and regulatory requirements or international human rights standards”?

 

How the ‘G’ could affect the bottom line

In addition to simply helping with ESG compliance, positive governance factors can also have a positive financial effect for the company—and, vice versa, negative performance can hurt an organization.

Bribery and corruption is a prime example, particularly if a scandal goes public. As Blakes puts it, companies that experience such issues “can face significant reputational damage that can result in poor stock performances, difficulty in retaining or attracting employees, enhanced scrutiny from financial institutions and weaker bargaining power in M&A transactions.”

Board composition can also have a wide-ranging effect on a company, particularly as it pertains to ESG; skills gaps on boards can harm a company’s ESG performance, and as we explored in Part 1 and Part 2 of this series, problems with environmental and social factors can diminish a company’s value.

 

How the ‘G’ is Calculated

When it comes to ESG analysis, the scores for companies are, unsurprisingly, based on that organization’s performance in all three of the pillars.

As we explored in Parts 1 and 2 of this series, there is no single, set standard for ESG reporting in any of the pillars. Thus, there is no solitary method for the conducting of ESG analysis. Things like the weighting of the previously mentioned governance factors, and more, can differ based on who is carrying out these analyses.

The “G” factors in the May 2022 Refinitiv methodology were placed in three different buckets: management, shareholders, and corporate social responsibility (CSR) strategy. These were then divided further into themes: management (structure (independence, diversity, and committees) and compensation); shareholders (shareholder rights and takeover defenses); and corporate social responsibility strategy (CRS strategy and ESG reporting and transparency). These categories were then weighted by Refinitiv—17% for management, 5% for shareholders, and 3% for corporate social responsibility strategy—and applied to the overall ESG score.

This isn’t the only way governance pillar factors (or any other type of factor) are woven into ESG scores. While not specifically revealing percentage weights in their breakdown, in its December 2022 methodology, MSCI included several governance factors such as board diversity, board independence, and bribery and corruption controversies.

 

In Conclusion

As we saw in Part 1, Part 2 and now Part 3 of this series, there is a wide range of factors that go into analyzing a company for ESG performance, and many different ways to do it. The three Environmental, Social, and Governance pillars each contain a set of unique factors often overlooked in traditional analysis that can be analyzed based on ESG performance, and integrated with other investment analysis methods, for a more complete assessment of an investment’s immediate or long-term projected risks and opportunities.

 


At Rowling & Associates, we are dedicated to acting in your best interests and firmly committed to your financial well-being. Please don’t hesitate to contact us directly if you have any questions about how we integrate ESG analysis to manage your investments. We’ll be happy to walk you through our investment selection process and discuss any concerns you might have regarding your own personal portfolio.


 

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