ESG investing has a governance problem

When retail investors discuss ESG with a financial adviser and receive a glossy prospectus, the cover image is likely to feature something to do with the environment, like a wind turbine against a backdrop of rolling green hills, or a solar farm at sunset.

There is, after all, nothing picturesque about a boardroom table. This reflects a wider issue in ESG: people naturally prioritise what they feel familiar with. Thanks to media attention, that usually means climate change first, followed by social issues. Governance – the ‘G’ in ESG – is too often overlooked.

Yet corporate governance is arguably the foundation of ESG. It determines how a company is run, who gets to run it and how leadership is held accountable.

These factors directly influence how effectively environmental and social policies are implemented. Governance is not only neglected in favour of ‘E’ and ‘S’, but often misunderstood in terms of the downstream impact it has on all other corporate activity.

Who holds the power?

There are many reasons investors should care about governance. Shareholder rights are one: many retail investors may not even realise that owning shares gives them voting rights over company decisions.

Governance also covers whether a company has the leadership, oversight and accountability needed to deliver its strategy. This includes executive pay, audit practices, board independence, expertise, transparency, accountability and voting structures that do not concentrate power in too few hands.

These issues can be overshadowed by more visible ESG themes such as renewable energy, employment rights and community initiatives. All are important, but the quality of governance often underpins whether those commitments are meaningful or simply performative.

Read more: The death of lazy ESG

Nowhere in ESG methodology does it say E, S and G must be equally weighted, and investors are entitled to prioritise what matters to them.

But governance may be the most important of the three because leadership decisions shape everything else: how a company treats employees, customers, communities, how it handles waste, pollution and broader operations. Leadership comes from the top, and its effects cascade through the organisation.

Therefore, investors wanting to have an outsized influence on sustainability can focus on the composition and behaviour of the board and management to drive lasting change.

More data is needed

Governance is admittedly less engaging than climate and social issues, which can feel more immediate and personal – it’s about the water we drink and the air we breathe. By contrast, corporate governance feels distant and abstract to many of us.

Whereas high expectations are held by investors in terms of regulations and policies in the environmental and social space, people often seem to be content with companies just adhering to the bare minimum standard in terms of governance.

To address this, governance reporting needs greater standardisation, similar to climate-related financial disclosures. Companies already disclose some governance data, but more consistency would be a positive thing. In many cases, incentives should also be strengthened – for example, linking executive pay to genuine engagement with investors.

Governance should also be integrated more explicitly into risk management, as weak board structures and poor leadership represent material business risks.

Success starts at the top

A company’s executive leadership should always be looking to drive sustainability initiatives to protect the long-term value of the company. If that doesn’t happen, the company’s shareholders have a responsibility to step in and either bring in new management or sufficiently incentivise the existing management to implement sustainable practices.

If investors want long-term, meaningful sustainable impact, effective cooperation between boards and shareholders is essential. Greater diversity of thought reduces the risk of groupthink and better allows companies to pursue sustainability credibly.

In the end, investors can champion environmental and social progress all they like, but weak governance can quickly undermine many of their ambitions. Taking action on governance first provides a solid foundation to implement a cascading effect of other ESG issues, providing more consistent and reliable progress in the long run.