Making Sense of ESG’s Governance Pillar  - EQS Group

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The G in ESG refers to governance and it takes an organisation’s internal operations into account, along with its corporate behaviour.

by Niall McCarthy  | Updated: 12.01.2024 |  4 min When it comes to ESG, the governance pillar is often pushed into the background with more urgent matters concerning the environment and social affairs taking precedence. Unlike the two other pillars in the anacronym, however, data concerning governance has been studied for years and what constitutes best practice is now both widely understood and accepted. A range of issues fall under governance including ethics and values, board diversity, executive and employee compensation as well as responsible lobbying.

At a glance The governance criterium is important for investors who may want to know that an organisation uses accurate and transparent accounting methods and that there have been assurances that there is no conflict of interest in the choice of board members. Let’s take a closer look at a selection of key factors covered by ESG’S governance pillar.

Governance as the gateway to a solid ESG framework An important aspect of governance that is sometimes forgotten is that most companies are already inherently familiar with it, a major benefit when it comes to rolling out a wider ESG framework. While environmental reporting and social relationships may be new territory for compliance teams, governance issues are closely intertwined with existing compliance functions such as legal affairs, internal audits, and human resources.

Debate about what exactly needs to be encompassed by the E and S is continuing, and as such, it makes sense for a company embarking on a new ESG journey to make governance the starting point for its efforts. Compliance teams are already well equipped to deal with most aspects of the governance pillar, especially those proficient in the use of RegTech. Technological solutions specifically catered to environmental and social issues can then be introduced, significantly improving an organisation’s digital ESG framework.

Accuracy, transparency and the impact of technology ESG has become firmly mainstream in recent years, and it is going to stay that way thanks to emerging reporting requirements and investors’ expectations, not to mention a slew of environmental crises threatening the planet. In order to navigate an increasingly stormy ocean of ESG legislation, an effective corporate governance code centered around accurate and trustworthy information is becoming essential.

Good business ethics and corporate governance uphold transparency, integrity and the rule of law, better protecting investors’ interests and maintaining investor confidence. This also increases profitability and returns on investment, boosting economic development and paving the way for a sustainable investment environment.

As a result, companies must ensure that their ESG data is both trustworthy and verified. A failure to do so can lead to a loss of faith among key stakeholders, damaged reputations and a lack of access to capital. Therefore, it is essential for businesses to ensure their ESG reporting is delivered accurately and on time while complying with all the necessary regulations.

As governments join investors in calling for ever more ESG data, accurate reporting can turn into a daunting prospect, especially in companies lacking sufficient manpower. ESG reporting is not yet mandatory in many countries, but this is changing, especially in Europe where a deluge of legislation is on the horizon. The EU’s Corporate Sustainability Reporting Directive (CSRD) improves the existing standards of the current Non-Financial Reporting Directive and it will ensure companies engage in reporting data in areas such as sustainable business practices, diversity and their carbon footprint for the first time.

Thankfully, technological solutions have emerged to ease the burden. Compliance teams have already put technologies to good effect with RegTech initiatives such as digital rulebooks, web-based whistleblowing systems and machine learning revolutionising workflows in recent years.

Similar digital platforms are now available within the ESG spectrum such as data assessment and monitoring programmes, policy portals, climate risk analytics tools and carbon footprint tracking software. Such solutions are already helping organisations generate solid and trustworthy environmental data to greatly facilitate their ominous ESG reporting obligations and appease investors’ expectations.

Ethics and values Maintaining accountability and integrity during the pursuit of success has proven a challenge for many businesses. While good business governance refers to how a company is controlled and run, ethics deals more with personal behaviour, though the two are intrinsically linked. The right tone from the top goes a long way towards building the right values and shaping the ethical governance of an organisation. As such, the managing board of a company needs to ask themselves some important questions:

What values do we want our organisation to have? What type of example does our leadership want to set? What kind of behaviour and mindset do we want across our organisation? Do we have a value management system?  

Values are more than just about ensuring an organisation’s employees demonstrate good behaviour. They act as the foundation for how business is done, especially in difficult situations where there is no easy answer. A clearly articulated set of values that are applied consistently can greatly assist boards that have to make difficult decisions.

Ultimately, the board is responsible for the organisation’s culture, and as such, it is good practice to establish an oversight committee responsible for implementing and monitoring the ethics policy. This will also help determine policies that can be leveraged when it comes to handling issues such as conflicts of interest.

At the end of the day, good company governance and the implementation of an ethical culture is all about developing trust among relevant stakeholders, whether that includes employees, customers or investors. Trust allows an organisation to flourish and reinforce its good reputation. Ethical organisations with solid values are characterised by upholding the principle of fairness, clear communication, the equal treatment of all stakeholders, effective compliance and financial success.

Board diversity Diversity is a tremendous asset for a company, leading to higher levels of innovation, employee engagement, a wider skillset, cultural interoperability and an improved ability to attract the best talent. Studies have found that greater diversity among board members in particular drives business resilience, sustainability and improved long-term financial performance. The positive impact has actually proven so profound that investors are now demanding it to increase profitability. As a result, companies have been scrambling to improve board diversity with a sense of urgency.

Last year, the World Economic Forum cited board diversity standards as being among the critical ESG metrics for measuring companies’ long-term value creation. Its importance was also reflected by the US Securities & Exchange Commission approving a new Nasdaq disclosure requirement on board diversity while Goldman Sachs announced that they would only underwrite IPOs of private companies with at least two diverse directors.

A July 2021 report by Seattle-based BoardReady looked at the situation at S&P 500 companies, finding that organisations with diverse boards were better prepared to deal with the impact of the Covid-19 pandemic. It also found that companies where more than 30% of board seats were occupied by women delivered better year-over-year revenue in 11 of the top 15 S&P 500 sectors.

Multi-generational boards also had an edge in performance over older boardrooms. While the research did not have enough data to report solid metrics on racial diversity, it still found that companies where at least 30% of board seats were occupied by non-white directors performed better with a 1% year-over-year increase in growth.

Rapid social change and evolving technologies have highlighted the need for fresh perspectives in the boardroom. That means it is imperative to add new and diverse faces in order to navigate modern challenges such as Covid-19. Work needs to be done, however, and the results of a survey show why companies need to be proactive. PwC’s 2021 Annual Corporate Directors Survey found that just 33% of directors felt board diversity could be achieved naturally. A year earlier, that figure was 71%.

Improving the diversity of a company’s leadership takes time and effort and there are a number of ways to accelerate the process. While the chairperson and nomination committee can apply their own efforts, existing board members should have the chance to make their own recommendations. Company leaders can also become acquainted with potential candidates who are offered the opportunity to serve on a sub-committee before being nominated to the board while a board mentor or sponsor can also prove beneficial.

Executive compensation Increasingly, companies are linking executive pay to the accomplishment of sustainable goals and nearly half of FTSE 100 companies have set measurable ESG targets for their CEOs, according to PwC. A growing number of companies are also receiving shareholder inquiries about tying executive compensation to sustainability performance and the practice is becoming more appealing to ESG-focused investors. Public pressure is also playing a part, especially given that CEO pay in the US has skyrocketed 1,322% since 1978.

Business leaders themselves are starting to realise that a solid ESG framework pays off. A Willis Tower Watson survey of 168 board members and senior executives found that 78% agree that strong ESG performance is a key contributor to financial performance. A public announcement linking executive salary to ESG performance by a company demonstrates a commitment to sustainability and a will to be held accountable if goals are not met. Organisations that have made such announcements in recent years include Apple, McDonald’s and BP.

Apple announced that an ESG modifier would be incorporated into its annual cash incentive programme for executives at the beginning of 2021 and it would have the potential to swing the total bonus pay up or down by 10%. BP has similar incentives in place for meeting environmental targets while McDonald’s includes diversity goals in its executive compensation.

While incentives linked to ESG metrics may sound relatively simple, there is a certain element of risk involved. Focusing on a relatively narrow ESG issue can distract companies from concentrating on a broader objective while organisations have to determine whether it is worth focusing on a short or long-term timeframe. It is also critical to identify how success is determined and incorporate performance scales to achieve ESG targets. To create the best possible strategy, it is important to have company-wide insights and a board that is willing to take risks in order to set uncomfortable targets.

PwC recommends companies keep four dimensions of ESG remuneration in mind when including ESG measures as part of pay:

Internal and external targets: Input measures are internal targets that a company uses to benchmark itself and are not measured by activities leading towards a stakeholder outcome. Output measures are external targets based on stakeholder impact. While both are valid, they need to align with a company’s strategic priorities.

Individual KPIs and scorecards: It is important to keep track and measure progress towards sustainable goals. If a company’s approach is multidimensional, it needs to be carefully constructed and transparently disclosed.

Long term incentive plan and annual bonus: Be specific when creating ESG goals. It is usually better to set ambitious well-calibrated one-year targets rather than vague long-term ones.

Underpin and scale targets: It is good practice to identify how to determine success and this can involve the creation of performance scales to achieve ESG targets, especially for transformational objectives such as emissions reductions.

Accountability in corporate governance and transparency in lobbying As ESG investment continues to gain traction, powerful countervailing forces are seeking to undermine it. The corporate lobbying machine is getting ever stronger, and the industry enjoyed a record year in the United States in 2021, taking in some $3.7 billion in revenue, according to OpenSecrets.org. Negative climate lobbying has proven a long-term issue and its sheer scale was dramatically revealed by a report in 2019. It found that the five largest stock market listed oil and gas companies spent nearly $200 million a year lobbying to block, delay or control policies aimed at tackling climate change.

A separate report from InfluenceMap states that 90% of the world’s largest industrial companies retain links to trade groups opposing climate policy. It is a difficult problem to solve as very little of it happens in public with much of the discussion now moving onto social media. There are some steps that can be undertaken through effective and responsible corporate governance, however.

A number of investor-led initiatives are now seeking to change the situation such as Climate Action 100+ which requires companies to implement improved governance and disclosure processes in addition to adopting climate lobbying positions aligned with the Paris Agreement. Launched in March 2022, The Global Standard on Responsible Climate Lobbying is another example that is supported by major investor groups leading on climate talks with companies and its members manage a collective $130 trillion.

It has adopted a 14-point standard for companies to follow whereby the board is made responsible for the oversight of climate change lobbying while an annual assessment of all lobbying activities must be published by the organisation. In addition, the companies must ensure they take action if any of their lobbying (or of their trade associations) runs counter to the goals of the Paris Agreement.

Measures to address the inherent integrity risks of corporate lobbying include joining one of the above-mentioned initiatives. Self-regulation is also vitally important and establishing a code of conduct for lobbying can also boost transparency. Joining a lobbying association and agreeing to abide by its rules or receiving training from national associations can also prove beneficial. Transparency International Ireland identified five principles for responsible lobbying in 2015 and they are as follows:

Only advocate measures that are evidence-based and never use gifts, entertainment, donations or payments to influence policy makers. Be open and truthful in communications with stakeholders. Align lobbying activities with corporate social responsibility policies and act in accordance with those policies. Organisations should familiarise and train their representatives on their standards, put a system in pace to hold them to account for transgressions and publicly report on implementation. Identify opportunities to work with others on issues that are in the public interest. Conclusion As mentioned initially, many of the elements covered by the G in ESG are already well known to companies, whether it is having the right values, participating in responsible lobbying or ensuring reports are both accurate and transparent. There are plenty of scandals showing how a lack of corporate governance, leadership oversight and accountability can have disastrous ramifications from WeWork to Volkswagen. Amid a tightening regulatory landscape, it is essential for companies to avoid such pitfalls by embracing a solid governance strategy. Not only will that reduce risks, it will also promote investor confidence and lay the groundwork for the creation of a successful ESG framework.  

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Download now Share this article on: Niall McCarthy Niall is a Content Writer at the EQS Group. Originally from Ireland, he previously worked as a journalist, which included reporting on major corruption trends worldwide.

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