Introduction to Corporate Governance and Other ESG Considerations

The investment community is increasingly recognizing and quantifying environmental and social considerations and the impacts of corporate governance in the investment process. Analysts who understand these considerations can better evaluate their associated implications and risks for an investment decision. Following are the core concepts covered in this reading:

• The primary stakeholder groups of a corporation consist of shareholders, creditors, the board of directors, managers and employees, customers, suppliers, and government and regulators. 
• A principal–agent relationship (or agency relationship) entails a principal hiring an agent to perform a particular task or service. In a company, both the board of directors and management act in an agent capacity to represent the interests of shareholder principals. 
• Conflicts occur when the interests of various stakeholder groups diverge and when the interests of one group are compromised for the benefit of another. 
• Stakeholder management involves identifying, prioritizing, and understanding the interests of stakeholder groups and managing the company’s relationships with stakeholders. 
• Mechanisms to mitigate shareholder risks include company reporting and transparency, general meetings, investor activism, derivative lawsuits, and corporate takeovers. 
• Mechanisms to mitigate creditor risks include bond indenture(s), company reporting and transparency, and committee participation. 
• Mechanisms to mitigate board risks include board or management meetings and board committees. 
• Remaining mechanisms to mitigate risks for other stakeholder (employees, customers, suppliers, and regulators) include policies, laws, regulations, and codes. 
• Executive (internal) directors are employed by the company and are typically members of senior management. Nonexecutive (external) directors have limited involvement in daily operations but serve an important oversight role.
• Two primary duties of a board of directors are duty of care and duty of loyalty. 
• A company’s board of directors typically has several committees that are responsible for specific functions and report to the board. Although the types of committees may vary across organization, the most common are the audit committee, governance committee, remuneration (compensation) committee, nomination committee, risk committee, and investment committee. 
• Shareholder activism encompasses a range of strategies that may be used by shareholders when seeking to compel a company to act in a desired manner. 
• From a corporation’s perspective, risks of poor governance include weak control systems; ineffective decision making; and legal, regulatory, reputational, and default risk. Benefits include better operational efficiency, control, and operating and financial performance, as well as lower default risk (or cost of debt), which enhances shareholder value. 
• Key analyst considerations in corporate governance and stakeholder management include economic ownership and voting control, board of directors’ representation, remuneration and company performance, investor composition, strength of shareholders’ rights, and the management of long-term risks. 
• Environmental and social issues, such as climate change, air pollution, and societal impacts of a company’s products and services, historically have been treated as negative externalities.
• Increased stakeholder awareness and strengthening regulations, however, are internalizing environmental and societal costs into the company’s income statement by responsible investors. 
  
• ESG investment approaches are value based or values based. The six common ESG investment approaches are negative screening, positive screening, ESG integration, thematic investing, engagement or active ownership, and impact investing.