And it’s not entirely difficult to divine the root of this thinking. As climate change and the environment steal the headlines, the green bond market has emerged almost fully formed as a leviathan in little more than five years; and, as the ravages of Covid-19 batter social structures and life chances from the developing to the developed world, unprecedented allocations of government and private capital have been the necessary response.
But that is to ignore the shifting “metaphysics” – if that is the right word – of ESG. As Emmanuel Faber, CEO of European food giant Danone said in a June interview with the Financial Times, structurally embedding environmental and social responsibility in corporate governance is “a way to be more strategic on the E and S,” whilst noting that companies’ rapid rush to embrace stakeholders during the Covid-19 crisis has opened up the debate on the adoption of new corporate governance models.
This was clearly exemplified when the UK’s Institute of Directors recently assembled an independent body to examine issues of governance facing boards as companies emerge from the coronavirus, including meeting the UN’s sustainable development goals (SDGs), the feasibility of stakeholder-focused governance, and implications of fast-emerging technology, such as artificial intelligence.
And as heaps of government capital have been thrown at the private sector in order to ameliorate the effects of Covid-19 – in the form of bailouts, loans, grants, tax concessions and equity purchases – the call has gone out from institutional investors to make this support conditional on radical shifts in corporate governance towards alignment with climate and environmental goals, equitable labour practices, and stakeholder engagement.
Such dynamics place governance front and centre of the strategic asset allocation (SAA) process. The importance of governance within SAA is highlighted in newly published research from the Principles for Responsible Investment (PRI) centred on case studies from the investment management industry.
A case study from Aberdeen Standard Investments (ASI) states: “We think that corporate governance is often largely ignored by SAA. Investors focus on economic growth and valuation, without asking enough about whether the aggregate quality of governance will affect the ability of companies to translate that growth into shareholder returns.”
ASI’s research correctly points out that the global financial crisis was the direct result of a systemic failure of governance in the global banking industry, comprising mis-selling, lax risk controls, and over-reliance on short-term wholesale funding. The result was tougher regulation, low relative returns in the sector, and a steep learning curve for those involved in the business of SAA.
Aberdeen takes a sectoral rather than idiosyncratic individual company approach to governance, something which has informed its SAA within the Japanese equity market, an arena where shareholder return had been lacklustre for the best part of 30 years.
The blame for this lay squarely on the shoulders of governance: only 15% of Japanese corporate boards had independent directors to represent the interests of minority shareholders in 2011, most AGMs were held on the same handful of days each year, making it difficult for shareholders to question directors, and shareholder activism was non-existent.
As a result of poor governance there was scant focus on shareholder value creation, extremely low profit margins, cash hoarding, and low pay-out ratios. As a result, Aberdeen’s SAA to Japan was low versus its international equity holdings.
But the adoption in 2015 of a new corporate governance code initiated radical change: in 2019, some 91% of Japanese companies had appointed independent directors, and AGMs were moved so as not to clash. Shareholder activism has risen, including in even the large domestic pension funds, and shareholder returns are increasingly the focus. Return on equity has increased as have equity buybacks and dividend payouts.
“Japan is just one example. Governance quality materially affects our assumptions about margins, buybacks, and valuation multiples for several equity markets. And it doesn’t stop at equities. We see governance as a key part of our evaluation of default risk and recovery rates for credit portfolios,” write Aberdeen’s researchers in the PRI case study.
An elegant solution to capturing ESG in the SAA process, and one which anchors the process in governance, is provided by the “sustainability budget”, expressed in the PRI’s research by a case study from Schroders.
“Good governance has been demonstrated to ‘make a significant incremental difference to value creation as measured by long-term risk-adjusted rates of return’. The further along the sustainability spectrum that assets are managed, the larger the governance budget required to manage those assets in a sustainable way.”
And, as the number of asset classes managed sustainably increases, a larger governance budget will need to be assigned. “There is the need for a new framework… a ‘sustainability budget’, alongside a risk budget, so that real-world outcomes might be incorporated into SAA decision-making,” writes Toby Belsom, director of investment practices at the PRI.
“There is already substantial empirical evidence to suggest that the G aspect of ESG ultimately yields better corporate returns,” wrote S&P Global’s Kelly Tang last year in a research piece on governance in ESG. “Governance data, unlike environmental or social data, has been compiled for a longer period of time and the criteria for what comprises good governance and its classification has been more widely discussed and accepted.”
Belsom notes the bigger picture in the context of Covid-19: ”The severity of the Covid-19 crisis was more related to national and global governance failures. However the idiosyncratic governance response from corporations is likely to influence returns for decades. The impact on energy markets, employee relations and levels of regulatory oversight will all have implications for asset classes as well as individual businesses.”