Environmental, social, and governance (ESG) is a set of guidelines for how a business should conduct itself concerning the environment and its employees. It's a concept that may also be used for ethical and long-term corporate leadership. ESG is essential because socially aware investors are now screening potential investments using ESG criteria.
Environmental criteria look at how well a corporation manages the environment. The way a corporation maintains connections with workers, suppliers, consumers and the communities in which it works is examined by social criteria. The ‘G’ in ESG stands for governance, which is a collection of rules and best practices, as well as a set of processes that dictate how an organization is governed and regulated.
Read on to understand why the “governance” aspect of ESG is so important and everything you need to know about it.
What is ESG (Environmental, Social, and Governance) and what are some ESG governance examples?
Before we get into “G,” let’s quickly break down what ESG is.
ESG criteria are a set of guidelines for a company's behavior that socially aware investors use to assess possible investments. Environmental criteria take into account how a corporation protects the environment, such as corporate policy addressing climate change. Social criteria involve looking at workers, suppliers, consumers, and the communities in which a business works. The leadership of a corporation, CEO remuneration, auditing, and shareholder rights are all part of what is covered under governance.
ESG criteria are used to filter investments and push firms to perform ethically based on company policy. Many mutual funds, brokerage firms, and robo-advisors now provide ESG-based investing solutions. When corporations that participate in hazardous or immoral behaviors are held responsible, ESG standards can help investors avoid investment losses. The recent fast expansion of ESG investment funds and ESG investors has prompted accusations that corporations have been dishonest or deceptive in advertising their ESG achievements.
The prevalence of ESG references – from the press room to the boardroom – demonstrates a willingness among all stakeholders in an organization to address environmental, social, and governance challenges. Asset managers and owners were trying to include 'green' shares into their investment strategies, and socially responsible investing was probably at the forefront of the movement. This was not done out of altruism.
Companies should incorporate ESG ratings or indicators in their corporate reporting for this reason alone.
Shareholders interested in ESG investing aren't the only ones concerned about a company's environmental, social, and governance performance. Consumers are increasingly making purchasing decisions based on a company's sustainability track record. These 'conscientious customers' will reward brands that can demonstrate their commitment to the world and its people. When making career selections, employees consider ESG concerns and the alignment of their personal beliefs with those of potential employers.
The supply chain is also interested in ESG; effective governance entails managing and maintaining strong ties throughout the chain, ethical behavior toward suppliers, and requiring sustainable behaviors from those suppliers. Meanwhile, whether it's financing local sports teams, enhancing the local environment, or providing stable employment, the community in which an organization is headquartered has a tremendous stake in its social responsibility activities.
Regulators, the media, and non-governmental organizations are among the stakeholders who evaluate companies based on their ESG performance, making ESG an essential part of risk management, corporate governance, and business policy.
Is ESG Important for company value?
The short answer would be “yes.” Environmental, social, and governance parameters are widely recognized as criteria beyond investors' ethical concerns. Companies may prevent risky behaviors by using comprehensive ESG standards. Volkswagen's emissions issue, for example, caused the company's stock price to plummet, costing investors billions of dollars. Investors and investment firms seek ESG-conscious organizations, and financial services firms such as Goldman Sachs and JPMorgan Chase now produce yearly reports examining various companies' ESG strategies.
What does the G in ESG mean?
The "G" in ESG stands for decision-making governance considerations, these governance factors range from sovereign policymaking to the allocation of rights and obligations among various organizational stakeholders, such as the board of directors, management, shareholders, and stakeholders. The aim of a business, the function and composition of boards of directors, and the remuneration and monitoring of senior executives have become key topics in corporate governance frameworks.
Investors looking at a company's ESG considerations will want to ensure that its accounting and reporting systems are reliable and transparent. Investors will consider how a firm handles its shareholders and their opportunity to vote on significant issues. Investors will want reassurance that the corporation isn't engaging in unlawful actions and that conflicts of interest are avoided when selecting board members.
Understanding governance risks and potential opportunities
While ESG problems are gaining popularity and becoming commonplace in business, the governance aspect is sometimes disregarded. However, while receiving less emphasis, it provides the foundation for long-term value generation and underlies any organization's capacity to meet its environmental and social objectives.
While the growth of ESG has aided in the emergence of a new age of stakeholder capitalism based on the notion of long-term value creation for everybody, the emphasis has mostly been on the ‘E’ and, more recently, the ‘S’ aspects. Environmental imperatives and popular social movements have brought these concerns to the top of the business agenda in recent years.
On the other hand, governance has a lower profile, as it is seen as the domain of the board of directors rather than a sphere of influence for all stakeholders. Only shareholders may expect to be involved in and influence governance choices, and only indirectly, or as a last resort, through a shareholder revolt. Governance has been included with varying degrees of effectiveness, but it hasn't captivated the imagination of stakeholders or garnered widespread public attention, except in catastrophic failure scenarios.
Regardless of the lack of acknowledgment, let alone knowledge, around the ‘G’ in ESG, it is critical to ESG performance, stakeholder confidence, and building a long-term business. When analyzing the effects of many strands of corporate governance, such as the following, this becomes clear:
Diversity in the boardroom - There are several benefits to having a diverse board. It provides a broader viewpoint, makes more sound judgments, encourages innovation, is more nimble, and better reflects the company's investors, consumers, and community. A diversified board is beneficial to the company's bottom line.
Compliance - Information disclosure, auditing, accounting, and regulatory compliance are all aspects of governance. Failure to meet these duties can jeopardize the company's reputation, income, and long-term viability.
Creating and executing policy - Governance assesses whether or not a company is operating ethically, pursuing policies that are in the best interests of its stakeholders, and not having a harmful influence on the environment. Without the ‘G’, there can be no ‘E’ or ‘S’ in a company concept.
Compensation for executives - Multimillion-dollar compensation deals for CEOs, particularly those seen as poor performers, are bound to make headlines. Portland, OR, and San Fransisco, CA, have both been pressured by voters to pass laws that apply additional taxes to businesses with inflated CEO salaries.
Multiple spots on the board of executives - Failure to restrict the number of boards on which directors can serve can result in evident conflicts of interest, putting one organization's interests ahead of another's.
What is the importance of governance in ESG?
If you believe that the basis of ESG is on the stakeholder capitalism model of fostering shared value generation, then governance is critical to long-term success. Stakeholder capitalism is built on the foundation of good governance. ESG risks and opportunities abound, and they can only be avoided or taken advantage of by sound corporate governance decisions.
As ESG develops, the lines between its many aspects will become increasingly blurred. We can see this in the ‘S’ criterion, where boardroom choices on corporate social responsibility (CSR) are becoming more important, and larger, more diverse boards are achieving better CSR results. Governance will connect with the ‘E’ part of ESG when more specific climate change legislation is enacted in the future, as well as the demand for reporting on environmental effects.
The undervaluation of governance in ESG criteria underscores the need for more uniform reporting on ESG performance, which measures various forms of value-generating activities for diverse stakeholders. The value of any activity may be recognized if each aspect of ESG is rated and graded.
And, because governance choices are made based on quantifiable outcomes, as ‘E’ and ‘S’ become more mainstream and better monitored, and the board sees success in social and environmental policies, environmental and social performance will logically become an integral component of good governance. The ideas of stakeholder capitalism must be entrenched in corporate decision-making in a real, responsible way to maximize ESG performance. Governance will become the most crucial part of ESG when all of the material elements of ‘E’ and ‘S’ include governance reporting and accountability.
What are the benefits of focusing on governance in ESG?
There are many benefits to the governance side of ESG, including the following:
Financial performance and scaling through avoiding poor corporate governance practices
A solid ESG offering enables businesses to enter new markets and develop into current ones driving shareholder value. When governments have faith in corporate actors, they are more inclined to provide access, permissions, and licenses that open up new development prospects.
Reduced regulatory and legal intrusions
Companies with a better external-value offering can attain greater strategic independence while reducing regulatory pressure. Indeed, we've found that strong ESG helps firms lower their risk of adverse government action in case after case across industries and locations. It may also get the backing of the government.
Investor confidence is boosted by good governance practices
Good corporate governance encompasses a wide variety of activities such as board and management structures, as well as a company's rules, standards, information disclosure, audits, and compliance. Investors, for example, want to know if a company's bookkeeping is accurate and transparent and whether its business operations are ethical. They also prefer corporations with a board of directors that is both accountable and diverse, as well as practices that encourage shareholder participation. Governance methods may be screened in the same way as environmental and social factors. Negative screens can be used to exclude organizations whose governance rules and practices put them at an unacceptable risk level. It might be a firm that engages in legally or morally dubious acts or one that fails to appropriately handle long-term business risks, such as those posed by climate change. Companies with robust and transparent governance rules and practices can be identified using positive screening.
Clearly, there are a lot of reasons why governance is so underrated.
What is the future of governance in ESG guidelines?
While the social component of ESG is still in its infancy in corporate adoption, the maturation of both it and environmental considerations will result in these issues being treated as business as usual, requiring the same level of reporting and regulatory framework as any other area of governance.
The expansion of legislation and its integration into boardroom procedures will drive this, and so will the impact of all the many stakeholder groups asking that their ESG requirements be recognized. Since the green paper on corporate governance reform in 2016, there has been a growing expectation that board responsibilities involve soliciting and reporting stakeholder feedback.
The green paper did not need particular stakeholder engagement approaches and did not result in a governance revolution. However, there was a deliberate effort to include stakeholder representation on the board of directors and proven procedures for routinely interacting with stakeholders and reporting on such discussions.
These ambitions will be inscribed in the future of governance, making it a more visible and beneficial component for all organizational stakeholders.