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Governance Factors in ESG: What to include

21st Aug 2023
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What should be included in an organisation's assessment of its ESG governance requirements? This has become a vital question as environmental, social and corporate governance (ESG) has risen up the agenda for modern businesses.

While environmental issues like climate change and the use of natural resources and social topics like diversity and human rights typically receive more public attention, governance ultimately defines how a company operates when it comes to ESG and other aspects of its business. Governance sets structures and guardrails, providing important rules everyone within an organisation can follow.

Research shows that firms with robust governance benefit through stronger financial performance and better employee retention while they are less likely to become embroiled in scandal or bad publicity through unethical practices. In this blog we assess the factors that businesses must consider in order to meet good standards for the three pillars of ESG.

Why is Governance Important for ESG?

Overall, ESG has become increasingly important as investors, regulators, and customers seek companies that demonstrate sound financial decision making and business performance while contributing more positively to the environment and society.

Having strong governance practices goes hand in hand with strong business practices. Research from Standard & Poor's suggests companies that focus on robust governance practices have stronger financial performance, better staff retention, and more operational efficiency than those with weaker governance practices.

By comparison, poor governance that is not aligned to ESG goals often leads to regulatory risk, reputational risk and ineffective decision making.

ESG has risen up the agenda for modern businesses despite sometimes being misunderstood and occasionally controversial. Some see the rise of ESG as facilitating greenwashing, others are concerned about political agendas, while some believe it is the task of government not business to deal with environmental concerns and social issues.

Ignoring ESG is not an option that businesses can afford any longer due to the legal and reputational risks involved and the growth of ESG investing. This was underlined by a recent Institute of Directors (IoD) survey that showed over half of business leaders believe considering ESG factors helps them to make better decisions for their firm.

The IoD survey also highlighted that a solid governance framework is a pre-requisite for success in the other aspects of ESG. So, getting governance right should be the starting point for the directors of all kinds of companies and other organisations.

Governance for ESG refers to the implementation of decision making, board oversight, rules, business strategy, internal controls, policies, and procedures throughout an organisation relating to the three elements.

Board diversity and composition:

Good corporate governance starts with a strong board, leadership team, and accountability structure. The board must be made up of diverse members and independent voices who understand ESG criteria.

Over the last few decades, it has been found that director nominations and elections have an increasingly positive impact on the long-term viability of a company. Some of the findings indicate that the higher the proportion of independent directors on a company’s board of directors, the better the overall governance levels within the organisation and the more attractive to those pursuing ESG investing strategies.

Companies must establish robust policies and practices to promote diversity within the board of directors, including the implementation of diversity and inclusion initiatives, the establishment of diversity targets, and the development of training and education programs to promote diversity.

They should also implement measures to ensure that the board of directors is composed of individuals with a diverse range of skills, experiences, and perspectives to ensure effective governance.

In addition, policies and procedures should focus on making sure that the board of directors is accountable to all stakeholders, including the implementation of board evaluation and succession planning processes.

Executive compensation:

Many companies have now set measurable ESG targets for their leaders and have also begun to introduce ESG targets in executive remuneration packages.

By incorporating ESG targets within executive pay packages, top-level management is expected to take ESG into greater consideration. However, this brings challenges of its own.

Companies may set out easily achievable strategic targets that they know they will hit. Alternately, there is a danger of ESG targets becoming a box-ticking exercise. Pay should therefore follow strategy; it shouldn’t drive firm strategy.

Therefore, proper corporate governance means publicly traded companies establishing policies and practices to ensure that executive compensation is aligned with the long-term interests of shareholders and other stakeholders.

These should include the implementation of performance-based compensation plans that take into account income inequality, the establishment of pay-for-performance principles, and the development of shareholder engagement processes to provide shareholders with a say on executive compensation.

The company will also need to implement measures that ensure that executive compensation is transparent and disclosed to shareholders and other stakeholders. This should include the provision of detailed information on executive compensation in the company's annual report and proxy statement.

Finally, the company will need to create mechanisms for shareholders to express their views on the compensation of senior executives, such as say-on-pay votes.

Connecting ESG goals more closely with executive pay is a natural next step for many companies. However, it is important that this is done with care and thought, so as to ensure financial incentives are truly driving the ESG agenda.  

Shareholder rights and engagement:

Shareholder rights and responsibilities play a vital role in corporate governance. Shareholders, as owners of the company, have the power to elect directors and approve corporate actions, and have the right to access information and participate in meetings. Many are now using ESG investing strategies to help decide where they deploy their funds.

It’s essential for shareholders to be aware of their rights and responsibilities in order to make informed decisions about the company.

By exercising their rights and fulfilling their responsibilities, shareholders can ensure that the company is run in their best interest and that ESG investment funds are being used responsibly.

Companies must ensure they have policies and practices to ensure that shareholders have a voice in the company's governance. This means implementing a shareholder engagement processes, the establishment of shareholder voting rights, and the development of proxy access mechanisms to allow shareholders to nominate directors.

Shareholders must have access to accurate and timely financial and non-financial information about the company, including the provision of detailed information on the company's performance and governance practices in the company's annual report and proxy statement. This is essential for a sustainable investing strategy.

Shareholder rights also means having the ability to express views on the company's governance, such as shareholder proposals and the ability to vote on matters related to the company's governance, such as the election of directors.

Anti-corruption policies and compliance:

Anti-bribery and corruption (ABC) compliance and ESG standards are interrelated. Surveys have shown that institutional investors rank anti-corruption as the most important ESG issue in investment decisions, outranking other ESG issues, including climate change and shareholder rights.

Therefore, ABC hazards and controls are a vital part of an organisation’s ESG reporting process. An effective ABC programme can directly influence an organisation’s governance, mitigate reputational threats and maintain shareholder value.

This should incorporate anti-corruption compliance programmes, whistleblowing mechanisms, as well as training and education to promote ethical conduct amongst employees.

Measures to that focus on compliance with anti-corruption laws and regulations are crucial. This will mean due diligence processes for business partners and the development of procedures to detect and prevent bribery and other forms of corruption. In addition, mechanisms for reporting and addressing any concerns about corruption are a requirement.

 ABC reporting can provide relevant stakeholders with additional confidence in an organisation’s operations and controls. This can increase marketability of an organisation, lower costs, improve shareholder and investor trust, and reduce avoidable legal liabilities.

Transparency and disclosure of financial and non-financial information:

The purpose of an ESG disclosure is to provide stakeholders with transparency into long-term risk factors.

To meet these requirements businesses will need to ensure transparency and the disclosure of financial and non-financial information. This means meeting disclosure standards for financial reporting and the development of a sustainability reporting framework.

Financial and non-financial information must be accurate, reliable and timely, so systems and processes must be put in place to ensure this happens. These should include internal audit and assurance processes, and the development of procedures to ensure the integrity of information reported.

In addition, the company must have mechanisms for shareholders and other stakeholders to access and review the company's financial and non-financial information and regularly reports on its performance and governance.

Telling the story

Firms must be able to monitor, assess and communicate their ESG results to stakeholders. An ESG reporting strategy and governance approach should be closely tied to the communications strategy.

There are a lot of potential channels for ESG storytelling if and when you have the data and results to back it up, including internal communications, annual reports, websites, social media, press, and ESG ratings providers.

Final thoughts

As ESG continues to grow in importance, it is critical for modern businesses to keep good governance as a in focus.

This involves multiple policies that need implementing across different corporate departments like finance, HR, and IT. A governance champion who can oversee the organisation's effort will help businesses to stay on top of their obligations and risks.

A holistic approach taking in the many themes and factors discussed in this blog is key to good environmental, social and corporate governance.

How Mercia can help

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