IFT Notes for Level I CFA® Program
R27 Introduction to Corporate Governance and Other ESG Considerations
8. Risks and Benefits of Corporate Governance and Stakeholder Management
8.1 Risks of Poor Governance and Stakeholder Management
In this section, we analyze the risks a company faces due to a poor governance structure.
Weak Control Systems
Weak control systems and poor monitoring can affect a company’s performance and value. One example is that of Enron where auditors failed to uncover fraudulent reporting that ultimately affected many stakeholders.
Poor decisions include managers avoiding good investment opportunities to maintain a low-risk profile or taking on excessive risk without properly evaluating potential investments. Both decisions are not in the interests of shareholders. Such decisions may result from:
- Information asymmetry: When managers have access to more information than board members/shareholders.
- Outsized remuneration: High remuneration not aligned with long-term strategic goals may result in managers taking excessive risks for personal gains.
- Related-party transactions: Transactions in which managers have a material interest and are not in the interest of the company, will affect the value of the company.
Legal, Regulatory, and Reputational Risks
Improper implementation and monitoring of corporate governance procedures may result in the following risks:
- Legal: Stakeholders such as shareholders, creditors and employees may file lawsuits against the company if their rights are violated.
- Regulatory: Government/regulator may choose to take action if the applicable laws are violated.
- Reputational: A company may be subjected to negative publicity by investors/analysts if there is an improperly managed conflict of interest.
Default and Bankruptcy Risks
Poor corporate governance may affect the company’s performance, which in turn may affect the company’s ability to service its debt. If creditors’ rights are violated and they choose to take legal action on defaulting debt, the company may be forced to file for bankruptcy.
8.2 Benefits of Effective Governance and Stakeholder Management
The benefits of good corporate governance and balancing the interests of managers, board members, company’s stakeholders, and shareholders are as follows:
- Operational efficiency: A good governance structure ensures that all employees of a company have a clear understanding of their responsibilities and reporting structures. The operational efficiency of a company is improved when good governance structure is combined with strong internal control mechanisms.
- Improved control: Good governance implies improved control at all levels to help a company manage its risk efficiently. Control can be improved with a good audit committee, complying with laws and regulations, and introducing procedures to handle related-party transactions.
- Better operating and financial performance: A company’s operating and financial performance can be improved with good governance practices. Proper remuneration for management, mitigation of lawsuits against the company, and improving the decision-making of its managers to make the right investments are ways that will help in improving the performance of a company.
- Lower default risk and cost of debt: A company’s cost of debt and default risk can be reduced by protecting creditors’ rights, ensuring proper audits are conducted, and that there is no information gap between the company and its creditors.
9. Factors Relevant to Corporate Governance and Stakeholder Management Analysis
In the aftermath of several corporate scandals in the early 2000s and global financial crisis of 2008-09, fundamental analysts have now begun focusing on corporate governance issues as part of their analysis of a company. In this section, we look at the areas analysts focus on when assessing a company’s corporate governance and stakeholder management system.
9.1 Economic Ownership and Voting Control
Analysts must examine the voting structure of publicly traded companies. Any structure where voting power is not equal to the percentage of shares owned or one vote for one share results in risks for investors. Examples of voting structures where economic ownerships are separate from control are as follows:
- Dual-class structures: In this structure, there are two classes where one class has a superior voting power than the other. For example, one class may carry one vote per share, whereas another may carry several votes per share.
- Electing board members: Another mechanism is where one class of stock has the power to elect a majority of the board, while another class has the right to elect only a minority of the board.
9.2 Board of Directors Representation
Analysts assess whether the experience, tenure, diversity, and skills of the current board of directors match the current and future needs of a company. The curriculum cites the example of a European pharmaceutical company going through financial distress. The company’s performance turned around for the better when non-executive directors with financial expertise were added to the board. Several years later, when a medical crisis hit the company, the company failed to respond by bringing in someone with medical expertise to the board. The shares fell as they continued to retain the previous directors.
9.3 Remuneration and Company Performance
If information on executives’ remuneration is available, then analysts must assess whether the remuneration plans are aligned with the performance drivers of the company. Some of the warning signs analysts must look out for are as follows:
- Plans such as cash payout and no equity, offer little alignment with shareholders.
- Performance-based plans that have a full payout irrespective of a company’s performance.
- Plans that have an excessive payout relative to comparable companies with a comparable performance.
- Remuneration plans or payouts that are based on achieving specific strategic objectives. Analysts must assess whether these are also aligned with company’s long-term objectives. For example, FDA approval for a drug, or cost savings on a production process.
- Plans based on incentives from an earlier period in the company’s life cycle. For example, remuneration plans for executives in a company that is currently in mature phase is still based on revenue growth as earlier.
9.4 Investors in the Company
Analysts must assess the composition of investors in a company. They must examine, in particular, if the following types of investors are present as it can affect the outside shareholders:
- Cross-shareholdings where a large publicly traded company holds a minority stake in another company.
- Affiliated stakeholders can protect a company from the results of voting by outside shareholders.
- Activist shareholders have the ability to change the shareholder composition in a short span of time.
9.5 Strength of Shareholders’ Rights
Analysts must assess whether the shareholder rights of a company are strong, average, or weak relative to investors’ rights of other comparable companies. They must assess if shareholders have the rights to remove the directors from a board or support/resist external initiatives.
9.6 Managing Long-Term Risks
Analysts must assess the management quality of the company to understand how it manages long-term risks. There are several instances where poor management of long-term risks has resulted in a fall of share prices and negatively impacted the company’s reputation. Poor management may result in repeated fines, lawsuits, regulatory investigations, etc.
10. ESG Considerations for Investors and Analysts
10.1 Introduction to Environmental, Social, and Governance Issues
ESG is an acronym for environmental, social and governance issues. The importance of good corporate governance has long been understood by analysts and shareholders. Therefore, the practice of considering governance factors in investment analysis has evolved considerably. However, the practice of considering environmental and social factors in investment analysis has evolved more slowly.
Some examples of ESG factors are presented in Exhibit 1 from the curriculum:
|• Climate change and carbon emissions
• Air and water pollution
• Energy efficiency
• Waste management
• Water scarcity
|• Customer satisfaction & product responsibility
• Data security and privacy
• Gender and diversity
• Occupational health & safety
• Treatment of workers
• Community relations & charitable activities
• Human rights
• Labor standards
|• Board composition (independence & diversity)
• Audit committee structure
• Bribery and corruption
• Executive compensation
• Shareholder rights
• Lobbying & political contributions
• Whistleblower schemes
10.2 ESG Investment Strategies
ESG investment strategies include:
Responsible investing: This is the broadest definition used to describe investment strategies that incorporate ESG factors. It can be further classified into:
- ESG integration (also called ESG investing): Refers to the practice of including material ESG factors in the investment process. An ESG factor is considered material when it can impact the company’s ability to generate sustainable returns in the long term.
- Socially responsible investing (SRI): The term has traditionally referred to the practice of excluding investments that are against the moral values of investors such as investing in tobacco companies. The term has now evolved to include investing in companies with favorable environmental or social profiles.
- Thematic investing: Refers to investments based on a theme or single factor, such as energy efficiency or climate change.
- Impact investing: Refers to the practice of investing in companies with an objective of meeting social or environmental targets along with financial returns.
Sustainable investing: A term used in a similar context to responsible investing, but the emphasis is on factoring in sustainability issues while investing.
Green finance: It is a responsible investing approach that uses financial instruments to support a green economy. For example, green bonds are bonds where the proceeds are used by the issuer to fund environmental-related projects.
10.3 ESG Investment Approaches
The six main ESG investment approaches are:
- Negative screening: This involves exclusion of certain sectors or companies or practices from a fund or portfolio on the basis of specific ESG criteria. For example, companies engaged in fossil fuel extraction or garment companies employing child labor.
- Positive screening: Positive screening strategy involves inclusion of certain sectors, companies, or practices in a fund or portfolio on the basis of specific ESG criteria. For instance, these companies may have policies focused on the well-being and safety of its employees, and strive towards protecting employee rights.
- ESG integration: Refers to the practice of including material ESG factors in the investment process. Traditional financial analysis metrics such as cash flow forecasts, credit/default risk forecasts, and/or cost of capital estimates are adjusted to account for the ESG factors.
- Thematic investing: This strategy picks investments based on a theme or single factor, such as energy efficiency or climate change. An increasing trend world over is the increasing demand for energy and water. Companies that provide solutions to these socio-economic problems make for attractive investments.
- Engagement/active ownership: This strategy involves achieving targeted social or environmental objectives along with measurable financial returns by using shareholder power to influence corporate behavior. Examples include: venture capital investing and green bonds.
- Impact investing: Investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return. For example, investments that help achieve one of the United Nations sustainable development goals such as SDG6: Clean Water and Sanitation.
10.4 Catalysts for Growth in ESG Investing
The two main catalysts for growth in ESG investing are:
- ESG issues are having more financial impacts. Many investors incurred significant losses when the companies they invested in mismanaged ESG issues.
- A greater number of younger investors are increasingly demanding that their inherited wealth or pension contributions be managed responsibly.
Historically, environmental and social issues, such as climate change, air pollution, and societal impacts of a company’s products and services, have been treated as negative externalities. However, increased stakeholder awareness and strengthening regulations have led to inclusion of environmental and societal costs in the company’s income statement by responsible investors.
10.5 ESG Market Overview
The amount of global assets under management (AUM) related to responsible and sustainable investing has increased substantially. This has led to increased corporate disclosures of ESG issues, as well as a growing number of firms that collect and analyze ESG data. Also, several organizations have been formed to monitor and advance the mission of sustainable investing.
10.6 ESG Factors in Investment Analysis
Some environmental and social factors considered in investment analysis are listed below:
- Natural resource management.
- Pollution prevention.
- Water conservation.
- Energy efficiency and reduced emissions.
- Existence of carbon assets.
- Compliance with environmental and safety standards.
- Human rights and welfare concerns in the workplace
- Data privacy and security
- Access to affordable health care products
- Community impact