De-jargoned: The ‘G’ Pillar
Governance – Setting one’s own house in order
The ‘G’ in ESG stands for governance. Governance refers to the way a company is managed – whether the company follows principles of transparency, accountability, independence, fairness and good governance. Good governance practices have a positive correlation with company performance. Simply put, well managed companies perform better.
- Better availability of company level structured data on governance practices
- Investors look at factors such as the company’s board composition, executive pay and transparent accounting practices
- Events such as the COVID-19 pandemic and the Black Lives Matter movement have highlighted the significance of social factors
Understanding through examples
There are several parameters that can help investors to judge the governance risks of a company. For instance, a company whose board is diverse and has a high share of independent members may be able to manage risks better.
Executive pay, management of conflicts of interest, use of transparent accounting methods and compliance with regulations are some of the other factors that impact the governance score of a company.
Poor governance practices can lead to bad decisions which may look good in the short term but may be detrimental to the company’s performance and reputation in the long run.
An example is when the Volkswagen group programmed 11 million diesel cars to cheat emission tests. Revelation of this action not only led to a big scandal but also billions of dollars in criminal and civil penalties.
This aspect of ESG has been evaluated by investors in one form or other for the longest. Evaluating the quality of management has been a part of credit rating evaluation methodology for many years. Consequently, there is better data, reporting and better defined parameters to measure the governance risk of companies.
Through the investors’ eyes
How a company manages its risks and conflicts of interest, adheres to regulations, follows ethical practices have a significant impact on the company’s risk profile. Hence, tracking governance becomes an important part of evaluating a company’s future prospects for investors.