Without good governance, ‘ESG’ falls apart

Imagine I give you a crisp £20 note, ask you to buy me lunch and say you can keep the change. What’s to stop you getting the cheapest deal possible and pocketing the difference?

At its heart, good governance resolves this crucial dilemma. It’s what social scientists call an agency problem — how do you get someone to act in your best interests when they control your asset? Because when you invest, you hand your capital over to company managers whose interests may differ markedly from yours.

To align them, we must have an ongoing relationship and there needs to be accountability. Aligning our interests may cost a bit of money and time, but it’s vital. How do we begin to address these tensions at the company and investor level? How do we ensure that companies invest for the long term, aligning their short-term goals with our long-term objectives as investors? It’s corporate governance that’s the hidden glue holding this modern social contract together.

The problem is that you don’t know you need it until it fails. It’s also 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. Volkswagen’s emissions testing scandal is an important example of a company failing to protect the environment. Around 11 million VW cars were fitted with ‘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 prevent detailed scrutiny, with non-independent directors the norm. German governance expert Alexander Juschus 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.”

Checks and balances

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 explosion of the Deepwater Horizon drilling rig in 2010, with a massive 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?

However, the root cause was human failures on the governance side. The National Commission investigating the disaster concluded that a “culture of complacency” prevailed at the companies running the rig. They never subjected key design and operational decisions to risk assessments as they were costly and timely.

This isn’t to say that good governance is a magic bullet — a vaccine against corporate failure in environmental, social and governance (ESG) matters. A myriad of factors can combine to produce a serious controversy. 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.

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?

We’ll keep checking the oil because we all need the car to keep running.