The "G" in ESG stands for "governance" and refers to whether a company manages its business in a responsible way
Corporate governance is concerned with how companies interact with the full range of external stakeholders, including competitors, suppliers, shareholders and governments. It is the most established of the three pillars of ESG investing, because many of the governance factors focus on questions that prudent investors have always considered before putting their money at risk.
- Investors used to care most about governance issues that might affect shareholder rights
- Today, corporate governance includes how companies interact with competitors, suppliers, governments and other stakeholders, as well as shareholders
- The principle of ‘investor stewardship’ is that investors should engage with companies to encourage them to improve their governance
- Better corporate governance is often associated with higher returns for shareholders
Good governance redefined
The analysis of corporate governance has expanded beyond shareholder rights to include many other governance factors and in particular those that affect a company’s interactions with competitors, suppliers and governments.
Investors should expect the governance element of ESG investing to continue to evolve to reflect changing attitudes, with an increased focus on improved governance as a way of ensuring that companies meet their responsibilities on environmental and social issues.
More generally, governance in terms of the balance of power between corporate stakeholders will also have to be balanced against broader social and environmental concerns to get acceptable ESG solutions.
Governance in business: a brief history
- Before the 20th Century: Concerns about the power of companies and the need to ensure that they act responsibly are nothing new. In the 17th, 18th and 19th centuries, trading companies such as the Dutch East India Company and the British East India Company – which were effectively the world’s first multinational corporations – quickly came under scrutiny and laws were eventually instated to curb their powers.
- The dawn of regulation: However, this was an ad hoc response to specific circumstances, rather than a consistent framework for ensuring companies serve the interests of society. The modern approach to regulating businesses arguably began in the late 19th century when the US passed the first legislation – the Sherman Antitrust Act (1890) – to control the growing monopolistic power of large dominant conglomerates known as corporate trusts. Many other major economies embraced similar laws to promote competition during the 20th century.
- The early 20th Century: After the Great Crash of 1929, the focus of regulation in the US shifted to the problem of ensuring that companies provided accurate financial information and that controlling shareholders could not openly cheat minority investors or manipulate markets, with the passing of the Securities Act (1933) and the Securities Exchange Act (1934).
- Higher standards in the 1970s: Governance became less of a priority in the post-war economic boom and it was not until a fresh economic crisis in the 1970s that the Securities and Exchange Commission began to tackle many issues of financial reporting and corporate accountability to shareholders. In 1976, the term “corporate governance” first appeared in the Federal Register, the official journal of the US government, and in the same year listed companies were first required to have an audit committee composed of independent directors.
- The Cadbury report: Governments in Europe began to embrace similar principles in the 1990s, generally in response to scandals and crisis in their own markets. The UK’s Cadbury Report (1992) set out new recommendations on the structure of company boards and accounting systems. It introduced the “comply or explain” principle that companies should comply fully with a voluntary code of best practice or explain why they were deviating from it.
- Investor stewardship in the 21st century: The Cadbury report helped inform voluntary codes from a range of international bodies such as the Organisation for Economic Cooperation and Development (OECD) and statutory legislation in many countries. The idea that investors should actively exercise their powers to hold companies to account also led to the concept of “investor stewardship” – engaging with companies to encourage them to improve their governance – which is a central part of ESG investing.
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