Jan 07, 2020 Sustainability

Good corporate governance pays off

Corporate governance seems to be the linchpin in sustainable investment. Experience shows that well-managed companies have significantly fewer environmental and social problems.

  • Studies and a specific index suggest that good corporate governance seems to have a positive impact on equity performance.
  • As executive management also has responsibility for and control over the other two ESG areas of the environment and social issues, governance may be regarded as the linchpin in sustainable investment (ESG investment).
  • The topic of corporate governance therefore plays an increasingly important role at annual general meetings.
4 minutes to read

More and more investors want to invest sustainably. Recently, green investments designed to protect the environment have attracted particular interest. But that is by no means the whole story. Finance professionals are focusing more on the third sustainability criterion of corporate governance, which with social and environmental criteria forms the ESG triad. But why is that? And what role does "G" play in ESG?

Analysing governance issues helps minimise risk

Governance is the legal and practical regulatory framework for a company‘s management and supervision. It is meant to ensure that a company manages all its relationships and contracts with individual stakeholders in the best possible way. It is based on individual company guidelines but also mandatory and binding principles, such as the German Corporate Governance Code. The code’s aim is to make it possible for investors to compare how the management bodies of various companies work. To this end, it sets standards for managers and supervisory boards.

Companies that are well managed also tend to have fewer social and environmental problems.

Governance includes issues such as management structure, executive compensation, shareholders' rights, the supervisory board’s structure and duties, disclosure and transparency.

"These factors can all send a signal to investors about how responsibly management behaves and the extent to which its actions reflect a long-term perspective," says Nicolas Huber, head of corporate governance at DWS. "For example, a company that is managed prudently is less likely to get caught up in costly negative events such as legal disputes.

Experience also shows that well-managed companies have significantly fewer environmental and social problems.

"For DWS, governance has always been an important part of portfolio management and risk analysis," says Huber. "It can also be seen as the linchpin in ESG investment, as governance should determine how a company handles sustainability issues."

Governance quality index beats broader benchmark index

So far, so good. But what does this mean for "G"‘s return potential? A meta study conducted by DWS and the University of Hamburg, which analysed more than 2,000 studies on the performance of ESG, provides some insights. It shows that good corporate governance seems to be particularly good at boosting ESG investment. Around 60 percent of studies show that good ESG practice has a clear positive influence on financial returns. Furthermore, the influence of governance on a company’s business development is around 62 percent, with the environmental share at 59 percent and the social component at 55 percent. [1]

A look at the MSCI World Governance Quality Index provides a similar insight. The index has been in existence since November 2009 and represents a subset of the MSCI World[2]. It covers only those company shares that have performed particularly well in terms of both financial and governance quality.

A comparison of past performance clearly shows that the MSCI World Governance Quality Index has beaten its benchmark index. While the index focused on governance quality achieved annualized performance of 12.15 percent, the broad MSCI World index reached just 9.72 percent.[3]]

Long-term performance


Index

11/14 - 11/15

11/15 - 11/16

11/16 - 11/17

11/17 - 11/18

11/18 - 11/19

MSCI World - Total Return in USD

-0,2%

3,8%

24,3%

0,7%

15,2%

MSCI World Governance-Quality - Total Return in USD

1,4%

3,2%

27,4%

4,6%

21,8%

Past performance, simulated or actually realized, is no guarantee of future results.

Source: Bloomberg L.P., DWS International GmbH, as of 31.11.2019.

We shouldn’t just address ESG issues in the investment process but also at annual general meetings.

ESG issues increasingly discussed at AGMs

"In view of this, it is unsurprising that many institutional investors have been taking a stand on governance issues at this year's annual general meetings," says Huber. It is generally no longer enough for fiduciary asset managers to address ESG issues in the investment process alone. "As trustees, we want to make the companies that we invest in more sustainable," Huber adds. "That's why we're increasingly linking ESG issues to voting decisions at AGMs."

In the USA, shareholders are submitting more and more resolutions about sustainability issues. In some cases, these even go beyond transparency requirements. "This is a very helpful lever for pressing home investor interests," says Huber.

Voting on management board remuneration is also important, in Huber’s view. "There, we expect sustainability criteria with defined key performance indicators to be part of an incentive package for medium to long-term bonuses," he says.

Voting to discharge and re-elect the management board and supervisory board is another mechanism. "These decisions should not be based solely on past performance," says Huber. Instead, plans for sustainable commercial activities in future and their gradual implementation should also play a role.

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1. DWS and University of Hamburg 2015: ESG & Corporate Financial Performance: Mapping the global landscape. p. 8. https://institutional.dws.com/content/_media/K15090_Academic_Insights_UK_EMEA_RZ_Online_151201_Final_(2).pdf

2. Global Stock Index, which reflects the performance of more than 1,600 companies from 23 countries

3. https://www.msci.com/documents/10199/4eed2f51-d62e-4d70-8bf4-c20e22f9923c

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