Responsible investing and even capitalism itself are doomed to fail without good corporate governance, the ‘G’ in ESG. It may not be a term which sets pulses of charity investors racing but its role in capitalism is vital: it's the foundation on which responsible investment thrives or fails.
When new ESG analysts join our team at Rathbones, we send them a 700-page textbook, respectfully referred to internally as 'The Bible'. Dog-eared copies are passed down from senior to junior, sections and pages worn thin by constant reference and reading. Analysts can't do their job without the 5th Edition of Corporate Governance by Monks and Minow; an unlikely candidate for centre stage.
Every man for himself?
At its heart, good governance solves a crucial issue – what social scientists would call an agency problem: how do you get someone to act in your best interests when they are controlling an asset you own? That's what investment is – putting your capital in the hands of company management, over whom you have influence but no control, and whose interests may differ from yours.
Or to put it another way, imagine I give you a crisp £20 note, ask you to buy us lunch and say you can keep the change. What’s stopping you from getting the cheapest deal possible from the discount aisle and pocketing the difference? Our interests aren't aligned. To make them align, we must have an ongoing relationship and there needs to be accountability. In other words, aligning our interests is costly and time consuming, but necessary.
Zoom out and apply that at the company and investor level - how on earth do we begin to solve these problems and ensure that companies invest for the long term, aligning their short-term goals with our long-term objectives as investors? In short – corporate governance. It's the hidden glue that holds the modern social contract together. The problem is that you don’t know you need it until it fails. It’s the oil in the engine that keeps the machine running smoothly. Neglect it and you’ll soon find yourself standing on the hard shoulder next to steaming wreckage.
Bad governance is bad for the planet
Volkswagen and its infamous emissions testing scandal is one of the most important examples of a company failing to protect the environment. An estimated 11 million cars were fitted with so-called ‘defeat devices’ between 2009 and 2015, causing untold harm through dangerous levels of undetected air pollution. The company’s arcane governance structure was programmed to turn a blind eye, with no incentive to discover the truth or to investigate it. Large supervisory boards effectively prevent detailed scrutiny, with non-independent directors the norm. Alexander Juschus, director at IVOX, the German proxy adviser commented: “There have been warnings about VW’s corporate governance for years, but they didn’t take it to heart and now you see the result.”
Putting the right checks and balances in place is a vital part of good governance and enables better decision making. When the Gulf of Mexico was rocked by the Deepwater Horizon explosion in 2010, with an unprecedented unstemmed oil leak devastating thousands of livelihoods, much of the talk was technical. How had this or that bit of safety equipment failed, what hadn’t been maintained? But the root cause was human, and the failures were on the governance side. The National Commission investigating the disaster concluded there was a “culture of complacency” that never subjected key design and operational decisions to risk assessments as they were costly and timely.
Encouraging good behaviour
This is not to say that good governance is a magic bullet, a vaccine against corporate ESG failure. A myriad of factors can combine to produce a serious ESG controversy, with knock-on effects for all investors. But this much is clear: it doesn’t matter how well thought through your safety plan is if the corporate culture is weak and pay arrangements encourage behaviours which diverge from those mandated in well-meaning ESG policies.
That’s why we feel strongly that responsible investing means taking great care to investigate governance and culture as well as social and environmental policies. Are the right people with the fewest conflicts of interest given the best information? Do pay arrangements encourage all valuable long-term wealth preservation behaviours and not just short-term financial metrics? Our team learns this and more from day one at the feet of Monks and Minnow. We’ll keep checking the oil because we all need the car to keep running.
Matt Crossman is stewardship director at Rathbones