What is the “G” in ESG?

When analyzing environmental, social, and governance factors, the “G” element is often forgotten amid considerations over climate risk, societal implications and other “E” and “S” risks and opportunities. However, understanding governance risks and opportunities in decision-making is critical, as poor corporate governance practices have stood at the core of some of the biggest corporate scandals. Volkswagen’s emissions tests scandal, Facebook’s misuse of data and other recent incidents have caused significant financial damage to these companies. In the face of companies’ missteps and expanding awareness of global diversity and income inequality, corporate governance is a core component of ESG.

The "G" in ESG pertains to the governance factors of decision-making, from sovereigns’ policymaking to the distribution of rights and responsibilities among different participants in corporations, including the board of directors, managers, shareholders and stakeholders. Governance factors indicate the rules and procedures for countries and corporations, and allow investors to screen for appropriate governance practices as they would for environmental and social factors. A corporation's purpose, the role and makeup of boards of directors, shareholder rights and how corporate performance is measured are core elements of corporate governance structures.

S&P Global research on governance factors has shown that companies that rank well below average on good governance characteristics are particularly prone to mismanagement and risk their ability to capitalize on business opportunities over time. S&P Global assesses companies’ governance performance by assessing four factors: structure and oversight, code and values, transparency and reporting, and cyber risk and systems.

Opinions on what interests should be prioritized in corporate decision-making are split. One perspective argues that maximizing financial returns for shareholders is the purpose of companies’ operations, while another believes that stakeholders deserve more importance and support over profitmaking. One example of this dynamism occurred in August 2019, when over 180 CEOs of major corporations worldwide declared as part of the Business Roundtable that companies should concentrate on providing benefits to all stakeholders alongside deriving profits for shareholders. Sustainability-focused groups then called on leaders like these to take further actions that benefit customers, employees and communities along with shareholders.

Gender diversity and equity is another high-profile governance issue, with many institutional shareholders demanding better representation of women on corporate boards and in executive ranks, and equal compensation and mobility for women and people of color. More companies are emphasizing the financial benefit of creating inclusive workplaces in an effort to increase diversity and inclusivity. S&P Global Market Intelligence research revealed that firms with more women on their boards of directors and in C-suite positions had greater financial performance than less diverse companies.

The compensation and oversight of CEOs and top executives, in addition to the structure and makeup of boards of directors, is another element of governance. Regulators in the U.S. and U.K. require publicly traded companies to allow shareholders to vote on executive compensation packages at regular intervals. A more recent effort to contain the growth in CEO pay in the U.S. requires companies to disclose the ratio of CEO-to-median employee pay annually. However, many aspects of existing systems for selecting, evaluating and rewarding top executives remain unregulated, leaving boards of directors solely responsible for this key component of a company’s corporate governance.

Companies like WeWork have been scrutinized for their lack of leadership accountability and oversight, as well as conflicts of interest. Critics of these governance factors are outspoken against the lack of basic internal controls, including inadequate oversight of CEOs and other senior executives, and see them as corporate governance flaws.

Understanding the “G” in ESG is critical, as governance risks and opportunities will likely increase as social, political, and cultural attitudes continue to evolve. S&P Global evaluates governance factors in all of its ESG Solution offerings. Notably, in addition to determining whether the entity is actively and effectively managing its exposure to governance risks and opportunities, the S&P Global Ratings ESG Evaluation weighs potential environmental and social risks to determine an entity’s capacity to operate successfully.