The value of corporate governance in a more sustainable world

This part of the Decade of Transition series focuses on the “G” of ESG investment—how governance is increasingly influenced by investors engaging with companies about their impact on the world.

When it comes to creating a more sustainable world, businesses are on the front line. To help the world recover from the pandemic and address the huge challenge of climate change, companies need robust structures in place. Corporate governance will be crucial in this decade, as it shapes how companies are run and how effectively they respond to challenges.

When integrating ESG into investment strategies, corporate governance is often the starting point, largely because investors understand that governance is the primary non-financial factor that affects financial performance.

A 2019 study by the Diligent Institute found that the top fifth of performers on corporate governance in the S&P 500 index outperformed the bottom fifth by 15% over a two-year period. It also found that “companies with corporate crises fueled by governance deficits underperformed their sectors by 35%, on average, a year after the incident, losing approximately $490 billion in shareholder value.” The study reported that two years after experiencing a corporate crisis companies lost approximately $250 billion of shareholder value, and underperformed in their sectors by 45%, on average[1].

Despite the potential costs, surprisingly few directors believe their board has a good grasp of how to manage a crisis. According to PwC’s 2020 Annual Corporate Directors Survey, only 37% of directors say that their board has a “strong understanding of the company’s crisis management plan”.[2] 

“Many of the largest corporate scandals have been due to poor governance structures.” Irfan Patel, Corporate Governance Analyst, AXA Investment Managers

The need for responsible governance is also reflected by its growing importance among investors. Governance-related demands by investors around the world have grown a remarkable 5,000% over the past decade—49% year-on-year—from just 27 in 2009 to around 1,400 in 2019, according to McKinsey. Roughly, 70% of all investor demands over the past decade have focused on governance[3].

AXA Investment Managers (AXA IM) Deputy Head of Framlington Equities, Isabelle de Gavoty says: “Governance is the first pillar that has to be in place before we take any investment decision.” According to MSCI research, “governance-related risks may have had a more immediate impact on equity prices than social issues or environmental issues.”[4]

Efforts to tackle the environmental and social issues important to investors must be embedded in a strong governance structure to be successful, stresses AXA IM Corporate Governance Analyst Irfan Patel. “Companies that are well governed outperform in the long term and are better positioned to take advantage of new opportunities. At the same time, many of the largest corporate scandals have been due to poor governance structures.”

As a result of the growing focus on ESG, corporate governance structures are under increased scrutiny and companies are under more pressure to explain their purpose. In 2019, the U.S. Business Roundtable, which for many years maintained that the primary purpose of a company was to make money for its shareholders, released a new Statement on the Purpose of a Corporation that declares: “Americans deserve an economy that allows each person to succeed through hard work and creativity and to lead a life of meaning and dignity. Each of our stakeholders is essential. We commit to deliver value to all of them, for the future success of our companies, our communities and our country.”[5]

“This has been a focal point for us for a number of years—asking companies, essentially, why do they exist?” says Patel. “What is your purpose, your impact? It’s no longer just about shareholder returns. More and more investors are asking companies about this now. We want them to think about their place in wider society.”

In part, this heightened scrutiny is a response to pressure from asset owners on whose behalf fund managers invest. “Our clients are not just asking if we are members of the PRI [Principles for Responsible Investment], but digging much deeper,” he adds. “They want to know how we vote, engage with companies and collaborate with other investors.”

The coronavirus pandemic has only reinforced the importance of ESG information and the trends that it reflects. AXA IM’s Global Head of Core Investments Hans Stoter says: “Our thematic ESG convictions have become even more relevant in the pandemic. We want to provide transparency around investments, so that clients can ensure their holdings align with their own values.”

This decade of transition requires a more active and more engaged approach to investment, says de Gavoty. “We’re entering a phase where we will use our votes in new ways to influence decision-making in discussion with management,” she says. “As responsible investors, it is our duty to monitor and engage with companies during the period that we own their shares.”

Engaging with companies is key to helping them identify and mitigate the risks that they face; it also enables them to identify new opportunities. In the energy sector companies that have switched their emphasis from fossil fuels to renewables have gone from strength to strength, while oil and gas firms, with their association with pollution and CO2 emissions, have seen their valuations fall.   

For example, at the end of April 2020, for the first time in history, the price for an oil futures contract dipped below zero. And last October, NextEra Energy Inc., the world’s biggest provider of wind and solar energy, briefly surpassed Exxon Mobil Corp., once the largest public company on Earth, in market capitalization. It wasn’t a one-off. According to Bloomberg, Enel, Iberdrola and Ørsted* “are now worth more than comparable oil majors,” underscoring how mainstream clean energy bets have become for investors.

“If you are an ESG laggard, you are unlikely to benefit from the changes that are coming,” Patel says. “But there are huge opportunities for companies that are well-positioned.” However, shareholders have to be clear what they expect. “Too often, we hear from companies that it is not clear what shareholders want,” he adds.

AXA IM is clear about the issues that it considers most urgent and material for investors, but it takes an equally dynamic ESG approach in the face of unexpected events such as the pandemic. Referring to AXA IM’s association with the Access to Medicine Foundation[6], Stoter explains that, “we were in a position to drive investor pressure in the healthcare sector. We made sure companies knew we expected solidarity—including the sharing of manufacturing capacity and intellectual capital—in the fight against coronavirus.”

"Engagement can help protect our clients from ESG risks and help drive industries towards a sustainable future. " Hans Stoter, Global Head of Core Investments, AXA IM

“Our scale gives us influence, and our deep experience means we know to wield that influence with care,” Stoter adds. “For us, engagement can help protect our clients from ESG risks right now—and help drive industries towards a sustainable future in which we can all thrive.”

It is important to remember that engagement takes time, especially in the face of a global health challenge that changes from day to day. “We engaged with one U.S. bank for five years before it implemented the changes we required,” Patel points out. “Engagement is not going to be successful overnight.”

Investors also need to ensure that their messaging is consistent across asset classes and investment styles. “ESG issues affect the performance of a company across all asset classes and active ownership is not just relevant to equities. While in the past, there used to be a distinction between active and passive investors, now even universal owners, who are invested in every company in a benchmark, are taking an active approach to engagement,” Patel says.

A number of factors are coming together to help investors engage more effectively on ESG issues. Regulations such as the European Union’s Non-Financial Reporting Directive and disclosure initiatives including the Task Force on Climate-related Financial Disclosures (TCFD) are making more information available to shareholders. The five sustainability standards organizations—SASB, IIRC, CDSB, GRI and CDP—have pledged to work together to make this information more comparable by producing more consistent and standardized disclosure and reporting.

Meanwhile, digital technologies such as Big Data analysis, artificial intelligence and machine learning are helping investors make more sense of the growing amount of data being generated by companies. “Artificial intelligence (AI) allows investors to collect and analyze more information than ever before when accounting for environmental, social, and governance risks and opportunities,” according to S&P.

“Governance is at the heart of company strategy,” says de Gavoty “The way management teams execute that strategy is linked to the governance that is in place. If it’s not done well, it can have a big impact on the value of the company.”