Why governance is a critical part of ESG investment criteria

It’s becoming more common for investors to consider non-financial factors when they make investment decisions. While investors may discuss the environmental and social pillars of ESG investing, they often overlook governance.

Yet, it’s a crucial part of the process.

ESG investing simply means using criteria across three broad categories – environmental, social, and governance – when making investment decisions. ESG criteria can vary between funds and people. What you view as the most important factors could be very different to someone else’s priorities.

When you think about what ESG criteria covers, it’s probably environmental or social issues that come to mind first.

You may think about businesses reducing plastic pollution, cutting emissions, or ensuring workers across the supply chain are treated fairly.

Yet, arguably, governance is the most critical part of ESG investing for investors.

What does “governance” mean?

Governance covers how a business is run, including issues like:

  • How does the company make decisions?
  • How does the company manage risks?
  • How does the board of directors operate and how is it remunerated?
  • How does the company handle data and security risks?

A company that is well governed is transparent and operates within regulations and policies. This then reduces the risk of mismanagement, scandals, or sanctions, which could affect profitability.

Another key part of good governance is shareholder rights.

How does a company ensure its valuable assets aren’t stripped for the gain of board members, manage executive remuneration, or avoid corruption? Good governance in areas like these can preserve your rights as a shareholder and protect your investment.

A strong track record of good governance can’t guarantee investment returns or mean that your portfolio won’t experience volatility. It’s still important to ensure your decisions reflect your goals and circumstance, even when you want to make ESG part of the process.

2 high-profile examples of governance scandals and what they can teach you

There are countless examples of corporate governance scandals that have cost investors money, but here are two of the highest profile cases.

1. Facebook’s data misuse

Social media platform Facebook came under fire after the press reported it had harvested the data of 87 million people without their consent.

Facebook gave the information to Cambridge Analytica. It was then predominately used for advertising during elections, including providing analytical assistance to the presidential campaign of Donald Trump.

A former Cambridge Analytica employee revealed the scandal after they gave an interview to the Guardian in 2018.

The US Federal Trade Commission fined Facebook $5 billion (£4.2 billion). The company also agreed to pay a £500,000 fine to the UK Information Commissioner’s Office.

The number of likes, posts, and shares on Facebook decreased by almost 20% in a month.

Investors were also affected. The value of Facebook shares fell by around 24% – the equivalent of $134 billion (£113.6 billion) – in the week after the news broke.

2. Volkswagen’s emissions cover-up

German carmaker Volkswagen admitted to cheating emission tests in the US in 2015. It resulted in the company recalling millions of cars worldwide, facing huge costs, and reputational damage.

The US Environmental Protection Agency (EPA) found that many Volkswagen cars had a “defeat device”. This device could detect when the car was being tested and change the performance to improve the results so that it appeared to be compliant with regulations.

In reality, the engines were emitting nitrogen oxide pollutants up to 40 times higher than US regulations permit.

Volkswagen had to refit around 11 million vehicles and set aside €6.7 billion (£5.68 billion) to cover the bill.

It resulted in the company posting its first quarterly loss in 15 years. It faced further costs in legal action from car owners, the EPA, and other organisations.

The scandal is estimated to have cost the company €31.3 billion (£23.36 billion) in fines and settlements between 2015 and 2021.

Before the scandal broke, there were concerns about a lack of accountability at the company. It was also noted that voting shares were mostly held by founding families, the local government, and the government of Qatar.

Contact us to discuss ESG investing

Understanding governance issues is crucial and it could affect investment returns. Poor governance is likely to increase risks, while good governance can present opportunities.

If ESG investing is something you’d like to discuss, including what your options are and how to make sure it’s risk-appropriate for you, please contact us.

Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

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