As evidence mounts in favor of evaluating companies on environmental, social, and corporate governance (ESG) criteria, some investors may find the governance part of the equation the hardest to grasp. The importance of environmental and social issues—like a company’s use of renewable energy or the safety of its products—may seem more concrete and tangible than the makeup of its board.
But for impact investors, it is essential to understand just what governance means in the context of ESG and why it matters.
The What and Why of Governance
Corporate governance involves the mechanisms and processes through which companies operate and make decisions. Accordingly, the specific governance issues of concern in ESG investing cover a lot of ground. A 2017 survey found that the top governance issues raised by shareholders included adopting an ESG approach (18%), board refreshment (13%), director tenure (9%), and CEO compensation (8%). Gender diversity and equity on the board and among top management is also a particularly high-profile area. Another issue of interest centers on proxy access and companies’ approach to shareholder engagement more generally—unsurprising given that investors’ abilities to raise their voices can be critical to making progress on ESG areas.
Companies with good governance practices tend to operate fairly and ethically. They are generally open about business practices and are led by an independent board of directors focused on upholding shareholder rights and addressing risks and opportunities. This transparency can give investors insight into areas of potential concern and help them evaluate whether a company’s polices and practices align with its (and their) values.
Investors have several ways to make an impact on a company’s corporate governance practices. First, they can use negative screening to avoid ethically questionable actions or conflicts of interest. They can also actively seek out companies with diverse leadership, transparent auditing and disclosure, or meaningful shareholder rights policies.
Another approach is to engage directly with boards or file shareholder resolutions aimed at pushing for better governance procedures. The majority of S&P 500 companies allow investors who have owned more than 3% of a company’s stock for at least three years to put proposals up to vote on the annual proxy ballots that are sent to all shareholders. Of course, larger stockholders can generally exert more influence, and funds and institutional investors have been active in filing shareholder resolutions. For example, over the past seven years, Pax World Investments has filed gender diversity proposals with at least eight major companies, many of which have added new female board members.
Understanding corporate governance and its place in the spectrum of ESG considerations can help give investors the best chance at making a positive impact with their portfolios.