When most people think of ESG, they think about the environmental and social impact of an organization.
However, the 'G' in ESG — which stands for governance — is just as important. And while governance issues often fall to directors, compliance officers, and auditors, there is considerable overlap with the EHS and sustainability function as well.
That's why, if you are one of those professionals, it's important to have a solid understanding of governance and how it impacts the work you do. In this article, we'll explore what governance is, why it matters, and a few examples of governance issues.
What is governance in ESG?
Governance describes how a company is controlled and directed. It includes all of the rules, policies, and systems the organization has in place to dictate corporate behavior. Risk management, ethics, compliance, and board management practices are all part of corporate governance.
Why is corporate governance important in ESG?
To understand why governance is important, let’s back up a step and look at what happens when companies don’t have strong governance.
One of the most famous examples of inadequate governance is the Tyco International scandal. In 2002, top Tyco executives Dennis Kozlowski and Mark Swartz were indicted for $600 million in fraud. Stocks plummeted from over $60 a share to around $13.
Another more recent example is Walmart’s seven-year global corruption probe, which began when the retailer was found to have bribed government officials in Mexico, India, Brazil, and China to obtain store permits, and ended in a $282 million settlement.
When governance is effective, your organization should be able to see to it that everyone follows ethical and transparent decision-making processes. Not only does strong governance prevent fraud and abuse, it can also ensure that corporate leaders act in the best interest of customers, employees, and shareholders — which brings us back to ESG.
Why do investors care about governance?
Investors care about the ‘G’ in ESG because it protects their interests. Strong governance practices have a direct impact on shareholder returns. In fact, research published in The Journal of Finance showed that adopting just one governance proposal increases shareholder value by 2.8%.
Transparent management has also been linked to increased employee engagement — meaning that if employees trust their leaders, they will work harder for them. This is key to achieving the company’s mission, vision, and values.
What are some examples of governance issues?
Governance is a sweeping term that touches on all aspects of an organization’s operations. Some of the most common examples of governance issues shareholders are interested in include:
Executive compensation deals with how (and how much) executives are paid. This includes benefits like salaries, bonuses, perks, equity, and so on. Executive compensation is an important ESG issue for investors and shareholders because high pay can help attract and retain the best leadership.
What’s more, the way this pay is structured can incentivize executives to make decisions that benefit shareholders — for example, by making executive pay dependent on the company’s performance. (This is also why we’re seeing a trend toward major companies linking executive pay to ESG performance.)
Investors are also interested in a firm’s CEO-to-employee pay ratio. If the gap in compensation between executives and their employees is too big, this can be an indicator of inequality.
The Institute of Policy Studies found that the wage gap between CEOs and workers is widening, with the average executive making 670 times as much as their employees. Meanwhile, inflation is growing and employee pay is down.
Investors, however, are pushing back on this trend. One recent example is when Carnival CEO Arnold Donald recently resigned amid criticism over his $15 million compensation package.
Board diversity, equity, and inclusion (DE&I)
Shareholders also want to see that the board reflects the diversity of the organization’s customer base, and that boards incorporate equity and inclusion into the way they govern.
Are women, people of color, individuals with disabilities, and other minority groups represented on the board? Are their opinions welcomed and respected? Are efforts made to challenge discrimination? These are all important issues for ESG investors.
In spite of efforts to increase diversity, corporate boards are still overwhelmingly white and male. According to Deloitte’s Board Diversity Census, more than 8 in 10 Fortune 500 board seats are held by white individuals, even though they represent only 60% of the population. Meanwhile, just 26.5% of seats on Fortune 500 boards are held by women.
(Perhaps ironically, the same research also found that “women and minority board members currently are more likely than white men to bring experience with corporate sustainability and socially responsible investing.”)
But companies are facing a reckoning. In 2021, Citigroup, Johnson & Johnson, JPMorgan, and Nike all faced (and fought) shareholder proposals concerning diversity, equity, and inclusion. In all cases, the SEC sided with investors, empowering shareholders to drive ESG issues forward.
Compliance also falls under the governance umbrella. It refers to how your organization ensures that it meets all applicable laws and regulations, as well as its own company policies.
Compliance extends to many areas including the EPA and environmental regulations, labor laws, OSHA, the SEC, financial regulations, customer data privacy, and more. Risk management, internal controls, audits and inspections, and corrective actions are all part of compliance.
Compliance is a key issue for investors because running afoul of laws can result in fines, penalties, and loss of reputation that can ultimately hurt stock performance.
Deloitte Center for Financial Services found that companies that maintain a best-in-class compliance program financially outperform those that do not. And, as Former Deloitte LLP Board Chair Sharon Allen put it, “Once a reputation is lost, no amount of money can buy it back.”
For proof, look no further than Facebook, which was fined $5 billion by the FTC for deceiving billions of users about their ability to control how their personal information is shared. Facebook’s reputation suffered tremendous damage, with users calling for a boycott of the platform.
EHS governance responsibilities
As an EHS professional, not all of these issues will fall under your purview. EHS professionals don’t have much say in how their company’s executives are paid, or who is appointed to their boards. However, some governance issues are the direct responsibility of, or are supported by, the EHS function. These include:
- Ensuring compliance with workplace safety and environmental regulations
- Developing and enforcing internal EHS policies
- Managing EHS risk and implementing appropriate risk controls
- Performing or overseeing audits and inspections
- Setting EHS performance expectations and communicating progress to executives and board members, customers, and shareholders
Along with social and environmental issues, governance has become a critical issue for investors and, in turn, for companies. Today, governance is a key element of non-financial reporting. Companies are expected to disclose information on issues like their executives’ compensation, the makeup of their boards, and their compliance efforts — among other things. Understanding why these issues matter to investors and what information they are looking for is key to developing better, more relevant ESG data collection and reporting practices.