Corp 2 – Environmental, Social, and Governance (ESG) Considerations in Investment Analysis
How a company treats the environment it operates in, the people it employs, the communities around its sites and the way it sells to customers has become a visible test of management quality. That visibility is why ESG analysis moved from the margin of security selection into the middle of it. This lesson builds the machinery in four steps: how ownership is arranged across markets and what that does to governance, how to judge governance at one named company, how to find the ESG issues that actually matter, and how to push those issues through a valuation until they change a number.
Ownership comes first, because ownership settles the question of who can make a board do anything. Every later governance conclusion rests on knowing where control sits.
Dispersed, concentrated and hybrid ownership
Three broad families of ownership structure exist. Under dispersed ownership there are many holders and not one of them can individually exercise control over the corporation. Under concentrated ownership a single holder, or a coordinated group described as the controlling shareholders, can exercise that control; the group is usually a family, one or more other companies, or a sovereign entity. A hybrid market sits between the two, with some sizeable blocks present but no single pattern of control across listed issuers.
Globally the balance tilts hard toward concentration. The Organisation for Economic Co-operation and Development (OECD) surveyed 47 jurisdictions for a governance report and found 38 of them to be predominantly concentrated. Four of the remaining nine were classified as dispersed, namely Australia, Ireland, the United Kingdom and the United States, and five as hybrid, namely Canada, Germany, Japan, the Netherlands and Switzerland. Anyone who learned governance from a purely Anglo-American text has therefore been studying the exception rather than the rule.
| Group | Jurisdictions named | What drives the pattern |
|---|---|---|
| Concentrated, state as owner | China, Norway, Sweden | The state itself is the characteristic large holder |
| Concentrated, families as owners | Brazil, Mexico, Portugal, South Korea | Families are the predominant shareholders |
| Concentrated, company groups | India, Russia | Groups of affiliated companies hold one another |
| Concentrated, other named jurisdictions | Austria, Belgium, Czech Republic, Denmark, Estonia, Finland, France, Greece, Hungary, Iceland, Italy, Latvia, Poland, Slovenia, Spain, Turkey, plus Chile, Colombia, Indonesia, Israel, New Zealand, Singapore, South Africa and the United Arab Emirates | Concentration without one dominant explanation; 38 jurisdictions in total were classified this way |
| Dispersed | Australia, Ireland, United Kingdom, United States | Financial institutions hold most of the shares in the largest Australian issuers, though still on a dispersed basis. Irish holdings are widely spread apart from a handful of family-controlled names. Very few UK issuers have a holder at 25% or above. US listed companies rarely sit under the control of one major shareholder. |
| Hybrid | Canada, Germany, Japan, Netherlands, Switzerland | A meaningful minority of the largest Canadian issuers do have controlling holders. Many German companies are tightly controlled even where listed shares are broadly distributed. Only a small minority of Japanese issuers have a majority holder. Dutch registers look dispersed until trust offices are counted in. The biggest Swiss issuers are more dispersed than the mid-sized and smaller ones. |
Figures follow the OECD 2017 survey as reported in the reading. The three classifications together account for the 47 jurisdictions examined: 38 concentrated, 4 dispersed and 5 hybrid.
Owning shares is not the same as holding control
The share register on its own can mislead. A controlling shareholder may be a majority shareholder, holding above 50% of the shares, or a minority shareholder, holding below 50% and controlling the company anyway. Three devices drive a wedge between the right to cash flows and the right to vote.
- Horizontal ownership. Businesses linked commercially, typically as major customer and major supplier, take cross-holdings in one another. Arrangements of this kind support alliances and durable trading relationships, and they also remove a block of stock from circulation.
- Vertical ownership, also called pyramid ownership. One company or group takes a controlling stake in two or more holding companies, and those in turn take controlling stakes in operating companies. Voting control passes down the chain intact while the economic stake shrinks at every link.
- Dual-class shares, or multiple-class shares. One class is given superior or exclusive voting rights and another inferior rights or none at all. Layered onto a pyramid, the entity at the apex can allocate itself all or most of the superior voting stock and keep control of the operating companies while owning comparatively few shares in total.
The two calculations below are illustrations built to expose the mechanics. They are not figures taken from the reading, but they reproduce exactly the effect the reading describes.
The discipline this imposes is worth stating plainly. Before forming any view on governance, answer two separate questions: who owns the cash flows, and who casts the votes. In a dispersed market running straight voting the answers coincide. Elsewhere they may not, and the space between them is the first place governance risk hides.
Ownership patterns leave fingerprints on the rules a market writes for itself. Five areas show it most clearly: the independence of directors, the shape of the board, arrangements that protect minority votes, national codes and listing rules, and codes aimed at investors rather than issuers.
Director independence
A director counts as independent when no material relationship ties that person to the company through employment, ownership or pay. The share of independent directors runs higher where ownership is generally dispersed than where it is generally concentrated, and the reason is historical. Independence emerged in dispersed markets as a way of reinforcing the board in its monitoring of executives, precisely because no owner there was big enough to do the monitoring. The proportion has climbed over the years as regulators responded to scandals, the collapse of the Enron Corporation in the early 2000s being the reference event.
Where ownership is concentrated, independent directors do a narrower job. The United States insists that certain committees, audit, nomination and compensation among them, be staffed entirely by independent directors. In most concentrated jurisdictions nomination and remuneration committees are not compulsory at all, and where they do exist the local rule normally recommends rather than demands that they be wholly or largely independent. The logic is consistent: with a controlling owner already watching management, the principal–agent problem is a smaller worry than it is in a dispersed market.
Nearly every OECD country now requires or recommends something on independence, but the form differs. Some set a floor on the number of independent directors, typically somewhere between one and three. Others set a floor on the ratio, typically from 20% up to 50% or above.
One-tier and two-tier boards
Boards come in one tier or two. The one-tier form is a single board holding both executive directors, who come from inside the company, and non-executive directors, who come from outside. The two-tier form splits the job in two: a supervisory board sits on top and a management board runs the business beneath it. One tier is the more common arrangement worldwide. Some jurisdictions insist on two tiers, Argentina, Germany and Russia among them, while others let the company choose, as Brazil and France do.
In a two-tier structure the supervisory board is the control function. Its work runs to examining the books and records, going through the annual report, supervising the external auditors, interrogating what the management board reports upward, and setting or shaping the pay of management. Some countries, Germany notably, seat representatives of key stakeholders such as banks and labour or other groups on the supervisory board, which widens the set of interests the board is there to protect.
Special voting arrangements
Several markets have built in mechanisms that strengthen minority holders. Israel, Italy, Portugal, Turkey, Brazil, India and the United Kingdom all run arrangements that draw minority shareholders into nominating and electing directors. The British example is the sharpest. A UK company that has a controlling shareholder can obtain a premium listing on the London Stock Exchange, the top domestic standard for regulation and governance, only if its independent directors are approved twice over: once by the whole shareholder base and once by the shareholders who are not the controller. A controller can therefore be outvoted on the single question of who watches the controller.
Codes, law and listing rules
National governance codes are widespread. Under them a company either discloses that it has adopted the recommended practices or explains why it has not. Several jurisdictions ask for more than that comply or explain standard. A Japanese company that has appointed no outside directors is required to set out why appointing them would be inappropriate. Elsewhere the same end is reached without a national code at all, through company law or regulation as in Chile, or through the requirements of the stock exchange as in India.
Stewardship codes
A parallel family of voluntary codes, called stewardship codes, aims at investors rather than issuers. They press investors to use the legal rights they already hold and to engage more actively in governance. Voluntary is not always the right word. Under the UK Stewardship Code, institutional investors carry a duty to monitor the companies they hold, and UK asset managers holding UK shares must publish a comply or explain statement setting out their commitment to the code. For an analyst this matters twice: it shapes the pressure the companies under coverage will get from their own owners, and it shapes what the analyst’s own firm must disclose about voting and engagement.
Governance done well protects reputation and competitive position, and the payoff appears in the very numbers an analyst already forecasts. The reading lists a lower cost of capital, easier access to credit, dividends that are both larger and more sustainable, stronger profitability, rising return on equity or other return measures, and favourable share price behaviour over long horizons. Governance done badly runs the other way, toward damaged reputation, weaker competitiveness, a share price that is soft and volatile, thinner profits and a cost of capital that is higher.
These factors resist quantification, which is exactly why working through them pays. Reading the disclosed policies and procedures is where to begin. Continuing dialogue and engagement with the company deepen the picture. When dialogue fails, shareholder activism, meaning the tactics shareholders use to try to force a company to behave in some desired way, is the escalation. In practice an analyst converts the governance judgement into a valuation input by moving the risk premium inside the cost of capital, or by moving the credit spread applied to the issuer’s borrowings.
Board policies and practices
Start with how the board behaves, including whether it functions well or barely functions at all in its oversight role. Each capital market carries its own governance problems, shaped by the ownership structure that predominates there, plus its history, its legal system, its culture and the mix of industries listed. A board at a company where a family holds both the shares and the votes, for example, may wave through transactions with related parties that enrich family members or affiliated entities and leave outside holders worse off. A generic checklist has to be read against the local pattern.
Board structure and CEO duality
The question is whether the way the board is organised, one tier or two, actually delivers oversight, representation and accountability to the shareholders. Bolted onto it is CEO duality, the arrangement under which the chief executive officer is also chairperson. Duality raises the worry that oversight is weaker than it would be with the two roles separated and the chair independent. Where the chair is not independent, or where one person holds both posts, a company may name a lead independent director whose function is to protect the interests of investors.
Board independence, committees, skills and composition
Independence stays central. Having no independent directors, or only a small minority of them, is a negative. Where they are missing, the door is open for management to behave in a self-interested way, and investors will read the corporation as riskier because of it.
Committees differ by company and by industry, but the usual set covers audit, governance, remuneration or compensation, nomination, and risk and compliance. The test is whether committees with real independence exist over the governance issues that matter most: the audit, the pay and the choice of directors. Non-independent members or executive directors sitting on these committees raise conflict and bias questions, over pay at the remuneration committee, over who gets appointed at the nomination committee, and over the integrity of the reported numbers at the audit committee.
Skills and experience can fail in either direction. A board whose expertise is narrowly bunched may not know enough to govern. So may a board whose expertise is broad but has little to do with what the company actually does. Where a business depends on natural resources, or is exposed to large ESG risks, directors normally include people with environmental, climate or social expertise, and the absence of such people is itself a finding.
Tenure is the related test. Governance codes commonly treat service beyond 10 years as long. Long service reads two ways. It can mean deep familiarity with how the business works and a first-hand view of how well management has performed across that period. It can equally erode independence, because a director who has served that long may have grown too close to management, and it can leave a director reluctant to accept change in the business.
Composition covers how many directors there are and how varied they are, across professional background, culture and geography as well as gender, age and length of service. A board that is oversized, or that is uniform, may govern less well than one that is smaller or more varied. Where long-serving members dominate, a board can turn controlling, self-interested or hostile to new policies and practices that would serve stakeholders.
Board evaluation
Evaluating the board keeps a company competitive and answers what investors expect. Four dimensions define the exercise: who conducts it, what falls within it, who receives the output and how it is carried out. The board can assess itself, or an outsider can assess it on the board’s behalf as an external review. Some boards run the exercise only as needed; others prefer a periodic external review. The scope typically takes in how duties are discharged, how the board is led, how it is structured including its committees, and how directors and management interact, culture included. Beyond internal stakeholders the output may be aimed at shareholders, at regulators or at other outside parties.
Executive remuneration
Pay analysis covers how transparent the arrangements are, what performance criteria sit inside the short-term and long-term incentive plans, how tightly pay is tied to the stated strategy, and how far chief executive pay sits above the pay of an average employee. A say-on-pay provision gives shareholders a vote on remuneration, or at least a formal channel for feedback. A clawback policy lets the company reclaim pay already handed over if certain things later come to light: a restatement of the accounts, misconduct, a breach of law, or failures in risk management.
Investor anxiety about pay that is excessive usually gets expressed as a ratio between chief executive pay and average employee pay. The evaluative question, though, is whether the arrangements give management the right incentives to build the value of the business. Disclosure of the measures used inside the incentive plans, the key performance indicators or KPIs, is the most useful raw material for that judgement, because it shows what management is genuinely paid to deliver.
Shareholder voting rights
With straight voting, one share carries one vote. A dual-class structure departs from that principle: founders, or management, typically hold a class carrying more votes than the class sold to the public. The effect is to favour one group of shareholders over another. Since a conflict may open up between minority holders on one side and the founders and executives on the other, several of whom may also sit on the board, an investor needs to establish whether multiple share classes exist before buying rather than afterwards.
Style is a fictional worldwide clothing retailer headquartered in Italy. The Donato family founded it and it is now publicly traded. A junior analyst is reviewing its board. The board runs to 11 members. Its chairperson is Leila Donato, who does not hold the chief executive role. Two directors are independent. Of the six non-independent directors, four are Donato family members, and every one of those family directors has sat on the board for 20 years or more. Age and gender are both varied: five of the directors are women, and ages run from 35 to 75.
The negatives weigh more. Independence looks substandard, with only two independent directors against four Donato family members on the same board, the chairperson Leila Donato among them. Tenure of the family directors is likely to be marked down as well, because 20 years and above sits far past the 10-year point at which most codes start calling tenure long.
ESG integration means putting qualitative and quantitative ESG factors to work inside conventional security and industry analysis, and inside portfolio construction as well. On a risk and reward view it plays out differently across asset classes. On the equity side, integration serves two purposes at once: spotting opportunities and limiting downside. On the fixed-income side the emphasis falls on limiting downside, since a bond pays par at maturity and offers no comparable upside to capture.
Identification itself works much the same way for equity and for corporate credit, since both lean on the same proprietary methods, though the factors that turn out to matter may differ once relevance to credit is taken into account. The techniques overlap too, adjusting forecast financial metrics and ratios being the obvious shared move, but what the adjustment implies is not the same in the two markets.
Where the adjustments land
Integration normally opens by identifying the material qualitative and quantitative ESG factors attaching to the company or to its industry. Those factors are then examined on a historical basis and on a forward-looking forecast basis, and against peers, before any number is moved.
- Income statement and cash flow statement. Changes usually hit forecast revenues, operating or non-operating costs, operating margins, earnings, capital expenditure or similar lines.
- Balance sheet. Changes here usually express the analyst’s estimate of assets that have become impaired.
- Equity valuation. Changes commonly run through the cost of capital, either by moving the discount rate or by moving a price multiple or the terminal value.
- Fixed-income valuation. The analyst may move the issuer’s credit spread, or the level of its credit default swaps (CDSs), to capture the expected effect.
In equity work the factors are handled by estimating financial metrics and ratios, by changing valuation model inputs such as the discount rate, or by running sensitivity and scenario analysis. An analyst covering a hotel group might lift the operating cost forecast to reflect heavy staff turnover, which brings productivity losses, unhappier customers and extra spending on recruitment, temporary cover and training. Working in the opposite direction, an analyst might cut the discount rate on a snack food producer that looks set to gain an edge by moving a key ingredient onto a sustainable supply. ESG integration is not a synonym for marking a company down.
In credit work the routes are internal credit assessments, forecast financial ratios and a relative ranking of issuers, whether companies or governments. For valuation the usual tools are relative value, spread analysis, duration analysis and sensitivity or scenario work. An analyst might feed the effect of litigation into a toy maker’s credit ratios, cash flow or liquidity, and separately gauge how far that company’s bond spreads could widen. Because the effect on the spreads of an issuer’s obligations or its CDSs can differ with maturity, the maturity profile has to be handled explicitly rather than averaged away.
Stranded assets make the clearest case. The term covers assets that have become obsolete or are no longer economically viable, frequently because regulation or government policy shifted, or because demand did. An analyst who expects a coal producer to face that risk over the long run may conclude that its notes maturing in 10 years suffer far more than its notes maturing in one year. Scenario analysis and stress testing are increasingly used in the same way to size the effect of major factors such as the physical risks that climate change brings.
A credit analyst covers a coal producer with two bonds outstanding, one maturing in a year and one in ten. The analyst concludes that policy change and shifting demand will strand a material part of the reserve base over the coming decade.
The ESG integration framework
Research, both qualitative and quantitative, together with the valuation of equity and fixed-income securities, forms the core of the framework the reading sets out. Building portfolios, allocating assets, running scenarios and managing risk complete it. Read it as three levels rather than as a list, because each level eats the output of the one before it.
Green bonds
A green bond is one whose proceeds the issuer earmarks for a named project, or a portfolio of projects, carrying environmental or climate benefits. The first of them, called the Climate Awareness Bond, came from the European Investment Bank in 2007. Labelling a bond green is primarily the issuer’s call, taken in close consultation with the lead underwriter. At minimum the issuer must tell investors what green eligibility criteria govern the use of the money, consistent with the Green Bond Principles, and the issuer carries responsibility for explaining both how the classification was reached and where the money went. Some issuers pay for an independent review of those criteria so that investors can see further into the arrangement.
Monitoring and reporting on the use of proceeds costs the issuer more than a conventional issue would. In exchange the issuer may reach a broader investor base and, where demand runs hot, price the new issue at a premium.
The Green Bond Principles are voluntary standards written to guide issuers deciding whether a bond qualifies for the green label. A group of investment banks produced them in 2014, and responsibility for maintaining and extending them now rests with the International Capital Market Association, a global self-regulatory body for securities markets. As the market matured, index compilers, rating agencies and the not-for-profit Climate Bonds Initiative each built their own assessment methodologies or standards for labelled issues, and the European Commission has looked at whether specific mandatory criteria for the label are workable.
A green bond generally looks like the same issuer’s ordinary bonds, the difference being the ring-fencing of proceeds for green projects. Credit ratings and the recourse available to bondholders are normally identical to those on the issuer’s conventional debt, all else being equal. Besides plain vanilla corporate paper, the label extends to project bonds, mortgage-backed and asset-backed securities, and municipal issues. California, for instance, sold a $300 million general obligation green bond in 2014 secured on the state General Fund in exactly the way its other general obligation bonds are.
Since only the use of proceeds differs, analysing and valuing a green bond is essentially the same exercise as for a conventional one. Some green issues nevertheless trade rich, at a tighter spread than comparable conventional bonds, purely on demand. Two risks are specific to the format. Greenwashing is the risk that the money never reaches a genuinely beneficial environmental or climate project. Liquidity is the other, since buy-and-hold investors take up much of the supply and secondary trading can be thin.