ESG Defined
ESG is an acronym for environmental, social, and governance. This idea is also known as sustainable, responsible, and impact investing (SRI).
What separates ESG investing from traditional investing is that ESG investors consider a company's financial performance and its impact on the environment and society.
This investing has become increasingly popular in recent years as more and more investors are looking to put their money into companies doing good in the world.
The Three Pillars of ESG
An effective way to think about ESG is to consider the three pillars: environmental, social, and governance. Each of these three pillars interacts with and influences the others.
- The environmental pillar of ESG looks at a company's ecological impact. This includes everything from their use of renewable energy to their disclosure of carbon emissions. It also considers things like water usage, waste disposal, and toxic chemicals. Investors are looking for companies that are mindful of their environmental footprint and are working to reduce it.
- The social pillar of ESG looks at how a company treats its employees, customers, suppliers, and the communities in which it operates. This includes diversity and inclusion, human rights, and employee health and safety. Investors want to see companies that are good corporate citizens and working to make a positive social impact.
- The governance pillar of ESG looks at how a company is run and how it makes decisions. This includes issues like board diversity, executive compensation, and shareholder rights. Investors want to see companies with good governance practices in place, as this can help to ensure that the company is run responsibly and ethically.
What Is Governance?
Governance is one of the three key factors that make up ESG investing. The other two are environmental (E) and social (S).
Governance is the set of rules, processes, and practices by which a company is directed and managed. Good governance is important for all companies, but it is crucial for the ones that are publicly traded.
Good governance helps ensure that a company is run ethically and responsibly. It also helps to protect the interests of shareholders.
Two Corporate Governance Approaches
There are two main approaches to corporate governance: the stakeholder model and the shareholder model.
Stakeholder Model
The stakeholder model of governance is based on the idea that a company is responsible to all of its stakeholders, not just its shareholders.
This means that the company should consider the interests of employees, customers, suppliers, and the community when making decisions.
The stakeholder model of governance is often thought to lead to better long-term decision-making, as it considers all stakeholders' interests.
Shareholder Model
The shareholder governance model is based on the idea that a company's only responsibility is to its shareholders.
This means that the company should make decisions in the best interests of shareholders, even if it means sacrificing the interests of other stakeholders.
The shareholder model of governance is often thought to lead to short-term decision-making. Companies may sacrifice long-term projects that would benefit all stakeholders to generate returns for shareholders in the short term.
Importance of Governance in Investing
There are several reasons why good governance is important for investors.
Running the Company In An Ethical and Responsible Manner
One of the most important reasons is that good governance helps to ensure that a company is run ethically and responsibly. This is important for two reasons.
First, it ensures that the company is operating in a way aligned with the investors' values. For example, suppose an investor is looking to invest in a company committed to environmental sustainability. In that case, they will want to ensure that the company is indeed following through on its commitment.
Second, it helps to protect the interests of shareholders. This is because good governance practices help ensure that a company is making decisions in the best interests of its shareholders.
Good governance helps ensure that companies are run ethically and responsibly, which is important for both investors and society.
Reduced Risk
Good governance can help to reduce risk by ensuring that companies are run responsibly and transparently. This can help to protect investors from potential losses.
For example, if a company is considering a major acquisition, good governance practices would require the board of directors to consider how the acquisition would impact the shareholders.
This type of transparency can help to reduce the risk of investors being surprised by negative news.
More Profitable
Good governance can also lead to increased profitability. This is because companies with good governance practices are better able to manage risk and avoid financial problems.
In addition, good governance can help to improve a company's relationships with its stakeholders. For example, a company with good governance practices is more likely to have a good relationship with its employees, leading to increased productivity.
Finally, good governance can help to attract and retain investors. This is because investors are more likely to invest in a company that they believe is well-managed and run responsibly.
Better Long-Term Prospects
Good governance can also lead to improved long-term prospects for a company. This is because companies with good governance practices are more likely to make decisions that are in the best interests of the shareholders.
For example, a company with good governance practices is more likely to invest in long-term projects that will generate returns for shareholders over time.
How to Assess Governance
There are several different ways to assess corporate governance.
Board of Directors
The following factors can be used to assess the quality of a company's board:
- Composition: The board should be composed of independent and inside directors.
- Independence: A majority of the board should be composed of independent directors.
- Experience: The board should have a combination of experience, including financial and operational expertise.
- Size: The board should be of a size that allows it to oversee the company effectively.
Shareholder Rights
The following factors can be used to assess the strength of shareholder rights:
- Voting rights: Shareholders should have equal voting rights.
- Shareholder proposals: Shareholders should be able to submit proposals for consideration by the board of directors.
- Board removal: Shareholders should have the ability to remove directors from the board.
- Shareholder rights plans: Shareholder rights plans, also known as poison pills, should not exist.
The Risks of Poor Governance
There are several risks associated with poor governance. These risks include:
Financial Distress
Poor governance can lead to financial distress for a company. This can occur if the board of directors makes poor decisions that result in the loss of shareholder value.
Operational Problems
Poor governance can also lead to operational problems for a company. This can happen if the board of directors fails to oversee the company's management effectively.
Reputational Damage
Poor governance can also damage a company's reputation. This can happen if the board of directors makes decisions that are perceived to be unethical or irresponsible.
Fraud and Corruption
Poor governance can also lead to fraud and corruption. This can occur if the board of directors fails to oversee the company's activities properly.
Final Thoughts
When it comes to ESG investing, governance is an important factor. Good governance practices can help to improve a company's financial performance and long-term prospects while also protecting investors from potential risks.
When assessing a company, consider the quality of its governance to make an informed investment decision.
Carbon Collective focuses its portfolio on companies aiming to solve climate change that function with a high level of governance. Carbon Collective firmly believes these ethically-governed companies are positioned for substantial long-term growth.
To begin investing with Carbon Collective, select “Talk to a Human” at the top of this page.
FAQs
1. What is governance?
Governance refers to the process by which a company is managed and controlled. It includes the policies and procedures to ensure that the company is run responsibly and ethically.
2. Why is governance important?
Governance is important because it helps to protect investors from potential risks. Good governance practices can also improve a company's financial performance and long-term prospects.
3. How can I assess a company's governance?
There are several different ways to assess corporate governance. Some factors that can be considered include the composition of the board of directors, the experience of the board, its size, and the shareholder rights.
4. What are the benefits of good governance?
The benefits of good governance include improved financial performance, enhanced long-term prospects, and increased investor protection.
5. What are the risks of poor governance?
The risks of poor governance include financial distress, operational problems, reputational damage, fraud, and corruption.
